Wednesday, January 7, 2015
Arbitration's Cancer – The Systemic Bias Created by the Co-existence of Paid Arbitrators, Arbitrator Strikes, and Award Histories
It has been said: “because bias is so subtle, it's extremely effective.” So it should come as no surprise that one of the cornerstones of the rules of judicial ethics is that bias is to be avoided or ferreted out. Bias should be no more acceptable in an arbitration forum than it would be in a federal court. But it seems to be just that, as a confluence of procedures in our private arbitration forums produce an "extremely effective" systemic bias.
These facts are known to any reasonably informed arbitrator:
1) The FINRA Member, or private party that inserted AAA or JAMS in to its commercial contract, has a procedural right to strike and rank potential arbitrators, without cause or explanation.
2) The FINRA Member or private party will have access to the details and magnitude of the arbitrator's prior compensatory, punitive, cost and fee awards.
3) A federal court has never vacated an arbitration award on the grounds that the compensatory award to the investor or broker wasn't big enough, or because the panel failed to award punitive damages, costs, or fees.
4) JAMS, FINRA, and AAA can, and have, removed an arbitrator from their roster without explanation after the arbitrator chaired over the issuance of a substantive award.
In order to combat this bias, arbitrators must first be able to identify and somehow neutralize the bias these indisputable facts generate. But since they are subconsciously biased, neutralizing this bias is a very tall order. It is certainly an unrealistic expectation. FINRA, JAMS, and AAA arbitrators are human. And even though most, no doubt, are individuals of high integrity and intelligence, they want to serve as arbitrators, and they are compensated to do so. Many of them are full-time arbitrators, at least partially dependent upon that compensation.
In order to eradicate the insidious bias created by the system in favor of (statistically undeniable) depressed compensatory awards and rejected punitive, cost and fee claims, the system must be changed. Until it is, the federal courts' rather convenient strict adherence to a purported congressional policy (lobby) in favor of arbitration will be perverted by a money-bias--the same bias the judiciary espouses to be intolerable and inconsistent within its own jurisprudence.
How do you remove this “extremely effective” bias pressing upon compensated private arbitrators? The solution is “simple, but not easy:”
1) Drastically reduce or eliminate arbitrator compensation, and/or
2) Eliminate the granting of strikes and rankings to FINRA Members and to volume-consumers of other private arbitration services (e.g. Fisher Investments).
Until arbitrators are wholly ambivalent to what FINRA Members and arbitration consumers with strikes think about their past Awards, arbitrators will suffer from a subtle but highly potent bias against claimants.
FINRA itself as well as the owners of for-profit arbitration services like JAMS and AAA could still, however, influence arbitrators. For example, an arbitrator chairman that issued a multi-million dollar award to one of my clients was subsequently relieved of his duties by FINRA. Probably just a coincidence, but... Do we need lifetime appointments for arbitrators? Or minimum terms?
Sunday, November 30, 2014
Each January, The SEC’s National Exam Program (“NEP”) issues examination priorities for the year ahead. The priorities are based upon the SEC’s evaluation of those areas in the financial markets that it believes will be presenting a risk of harm to investors, the markets, or capital formation.
The NEP has four program areas: 1) Investments advisers, 2) broker-dealers, 3) exchanges and SRO’s, and 4) clearing and transfer agents. Recall that the SEC and State regulators split the regulatory oversight for investment advisers with the SEC retaining jurisdiction over the “larger AUM” RIA’s.
The 2014 NEP priorities for investment adviser agents and registered investment advisers included safety of assets and custody and conflicts of interest and marketing claims related to investment objective and performance. In the opinion of this author, one would think Fisher Investments endured a substantial SEC exam in 2014 in light of these priorities. The SEC is already foreshadowing what will be included in the list for 2015.
Hearsay and rumors in our corner of the market indicate that the SEC is currently concerned about investment adviser sales practices related to 401(k) to IRA rollovers. If it is indeed a 2015 priority, there will certainly be several large RIA’s under the microscope. Of no surprise, word on the street is that the priority list will include cyber security and dual registrations. As for the broker-dealer area: it looks like costly mutual funds and “bad brokers” will be an SEC priority for 2015. But enough speculation – we should have the list in a matter of weeks. In the meantime, let us know if we can help you with your compliance or litigation needs. Food for thought.
The attorneys at Cosgrove Law Group, LLC frequently handle business disputes on a contingent fee basis in arbitrations and the courts. We are typically litigating in the financial industry arena where slashing, cross-checking and full-body blows are routine. Although they may be routine, they may also cross a generous line and sow the seeds for a future arbitration award or court judgment.
When an investor, broker-dealer agent or investment adviser representative comes to us for help, our first task is to gather all of the facts. This is, of course, a critical task. But the next step is just as critical – identifying the most applicable and powerful causes of action. The cause of action is your gateway from facts to recovery, and the evidentiary elements of and recovery available under different causes of action vary greatly. Luckily, you don’t have to choose just one. For example, an investor may have a claim for breach of fiduciary duty that does not provide for punitive damages in an arbitration forum, but he or she may also have a claim for a violation of a state’s model security act. That act explicitly provides for punitive damages, costs and/or attorney fees under certain provisions. As such, an arbitration panel would be empowered to grant those remedies.
Another example: a broker may have a U-5 defamation claim against his former broker-dealer. If she signed a financial adviser agreement that has a Missouri choice-of-law provision (because that is where her broker-dealer is headquartered), but her broker-dealer defamed her to her clients in Georgia as well, the broker likely has a Missouri breach of contract cause of action and Georgia common law tort claims for defamation and tortious interference with a business relationship. So, if you are a member of the financial industry arena or an investor, and you just took an illegal cross-check, make sure you hire the right legal counsel, and do so as soon as possible.
Saturday, September 6, 2014
The SEC has approved FINRA Rule 2081 that would disallow brokers from conditioning settlement of a customer dispute on a customer’s consent to the broker’s request for expungment from the Central Registration Depository (“CRD”). The CRD is the licensing and registration system used by all registered securities professionals. The system enables public access to information regarding the administrative and disciplinary history of registered personnel, including customer complaints, arbitration claims, court filings, criminal matters and any related judgments or awards. Because of the open nature of information available to its investors, registered professionals would like sensitive matters, such as customer complaints, expunged from the record.
The purpose of Rule 2081 is to make sure that full and reliable customer dispute data remains available to the public, brokerage firms, and regulators to prevent concealment by prohibiting the use of expungement as a bargaining chip to settle disputes with a customer. Furthermore, it allows regulators to make informed licensing decisions about brokers and dealers and improve FINRA’s transparency on broker-dealer complaint histories. This prohibition applies to both written and oral agreements and to agreements entered into during the course of settlement negotiations, as well as to any agreements entered into separate from such negotiations. The rule also precludes such agreements even if the customer offers not to oppose expungement as part of negotiating a settlement agreement and applies to any settlements involving customer disputes, not only to those related to arbitration claims.
On one hand, Rule 2018 will make it more difficult for brokers to sanitize their CRD report from a past claim, ensuring that future investors can more accurately assess the quality and integrity of a registered securities professional, ensuring protection from potential fraud and abuse. On the other hand, settlements are a significant part of resolving FINRA claims in a timely manner. If more FINRA claims reached arbitration, then the average FINRA claim would take substantially longer to adjudicate. Ultimately, Rule 2081 could dissuade broker-dealers from settlement prior to arbitration because they may want to take their chances in arbitration, making an already potentially slow moving process, slower.
When investigating historical use of expungement in arbitration, pursuant to SEC Release No. 34-72649, the SEC found “despite the very narrow permissible grounds and procedural protections designed to assure expungement is an extraordinary remedy…, arbitrators appear to grant expungement relief in a very high percentage of settled cases.” In order to even seek expungement, FINRA Rule 2080 requires a showing that (1) the claim, allegation or information is factually impossible or clearly erroneous; (2) the registered person was not involved in the alleged investment-related sales practice violation, forgery, theft, misappropriation or conversion of funds; or (3) the claim, allegation or information is false.
In approving Rule 2081, however, the SEC cautioned FINRA that the new rule should not be the last word on the subject of expungement and that FINRA should continue to consider making improvements to the expungement process. In this regard, even though “the proposed rule change is a constructive step to help assure that the expungement of customer dispute information is an extraordinary remedy that is permitted only in the appropriate narrow circumstances contemplated by FINRA rules,” the SEC nonetheless remains concerned about “the high number of cases where arbitrators grant brokers’ expungement requests.” SEC Release No. 34-72649
Official rule language:
2081. Prohibited Conditions Relating to Expungement of Customer Dispute Information.
"No member or associated person shall condition or seek to condition settlement of a dispute with a customer on, or to otherwise compensate the customer for, the customer’s agreement to consent to, or not to oppose, the member’s or associated person’s request to expunge such customer dispute information from the CRD system. See Regulatory Notice 14-31."
Cosgrove Law Group, LLC has experience with financial industry disputes including representing investors in recouping their losses and registered representatives seeking expungement. We also provide training, information, and compliance for registered professionals through the Investment Adviser Rep Syndicate.
Authored by Mercedes Hansen
Tuesday, August 12, 2014
Social media such as Facebook, Twitter, LinkedIn, or blogs have become popular mechanisms for companies to communicate with the public. Social media allows companies to communicate with clients and prospective clients, market their services, educate the public about their products, and recruit employees. Social media converts a static medium, such as a website, where viewers passively receive content, into a medium where users actively create content. However, this type of interaction poses certain risks for investment advisers and this topic has been a hot button for securities regulators.
The SEC previously issued a National Examination Risk Alert on investment adviser use of social media. As a registered investment adviser, use of social media by a firm and/or related persons of a firm must comply with applicable provisions of the federal securities laws, including the laws and regulations under the Investment Advisers Act of 1940 (“Advisers Act”). The Risk Alert noted that the various laws and regulations most affected by social media are anti-fraud provision, including advertising, compliance provisions, and recordkeeping provisions. Advisers Act Rule 206(4)-7 requires firms to create and implement social media policies, and periodically review the policy’s effectiveness.
Anti-fraud provisions with respect to advertising are probably most affected by the use of social media. All social media use and communications must comply with Rule 206(4)-1. While advertising policies should already be included in a firm’s compliance manual, such policies may not be sufficient enough to address some of the concerns with advertising in the context of social media. Establishing a specific policy to address social media may be prudent.
The area of advertising that has caused the most confusion is the prohibition on the use of testimonials. The SEC has previously defined testimonial to include a statement of a client’s experience with, or endorsement of, any investment adviser. Firms and IARs must ensure that third-party comments on their social media sites do not constitute a testimonial. Furthermore, the SEC vaguely discussed whether the popular “like” function on many social media sites would be deemed a testimonial:
[T]he staff believes that, depending on the facts and circumstances, the use of “social plug-ins” such as the “like” button could be a testimonial under the Advisers Act. Third-party use of the “like” feature on an investment adviser’s social media site could be deemed to be a testimonial if it is an explicit or implicit statement of a client's or clients' experience with an investment adviser or IAR. If, for example, the public is invited to “like” an IAR’s biography posted on a social media site, that election could be viewed as a type of testimonial prohibited by rule 206(4)-1(a)(1).
The types of policies that firms must create concerning advertising and testimonials depend greatly on the function of a specific website. For instance, approving the firm or IARs use of certain websites may turn on whether that website allows for review and approval of third-party comments before such comments are posted on the site or whether the “like” function can be disabled. A firm’s monitoring capabilities and the latitude it wants to provide employees with respect to personal use of social media cannot be ignored either.
The SEC has outlined various factors that should be considered by an investment adviser when evaluating the effective of their compliance program. These factors are:
- Usage and content guidelines and restrictions on IAR use of social media whether on behalf of the firm or for personal use
- Mechanisms for approval of social media use and content;
- Monitoring of social media use by the firm and IARs and the frequency of monitoring;
- Consideration of the function or risk exposure of specific social media sites;
- Establishing training and requiring IAR certification;
- Whether access to social media poses information security risks; and
- Firm resources that can be dedicated to implementation of social media policies.
Friday, August 1, 2014
A customary practice in the securities industry is for financial advisors to receive a transition bonus above and beyond an advisor’s standard commission compensation upon joining to a new firm. The bonus amount is usually determined using a certain percentage or multiplier of the advisor’s trailing 12-month production. These are usually referred to as “promissory notes” or Employee Forgivable Loans (“EFL”). Promissory notes are often used to solicit new employees/contractors from another brokerage firm. However, this “incentive” is usually cloaked with many restrictions. Typically these loans are forgiven by the firm on a monthly or annual basis but the advisor has to commit to the firm for a specified number of years or be required to pay the balance back to the firm should the advisor leave before the end of the term.
Brokerage firms can enforce promissory notes through FINRA arbitration. Promissory note cases are one of the most common types of arbitration and the brokerage firms experience a high success rate with these cases. These proceedings are governed, in part, by FINRA Rule 13806 if the only claim brought by the Member is breach of the promissory note. This rule allows the appointment of one public arbitrator unless the broker rep. files a counterclaim requesting monetary damages in an amount greater than $100,000. If the “associated person” does not file an answer, simplified discovery procedures apply and the single arbitrator would render an Award based on the pleadings and other materials submitted by the parties. However, normal discovery procedures would apply if the broker rep. does file an answer. Thus, if a broker wants to make use of common defenses to promissory note cases and obtain full discovery on these issues, the broker should ensure that he or she timely files an Answer.
A recent trend with promissory notes is that the advisor’s employer does not actually own the Note. Sometimes this entity holding the note upon default is a non-FINRA member company, such as a subsidiary of the broker-dealer or holding company set up specifically to hold promissory notes. Many believe the practice of dumping promissory notes into a subsidiary is to circumvent the SEC requirement that brokerage firms hold a significant amount of capital (one dollar for each dollar lent) to protect against loan losses. By segregating promissory notes into a separate entity, firms likely can retain much less to meet its capital requirements.
Because a non-FINRA member firm may ultimately attempt to enforce the promissory note, questions arise as to how an entity can use FINRA arbitration to pursue claims against an agent. The Note likely contains a FINRA arbitration clause but this may create questions of the enforceability of the arbitration clause. Furthermore, non-FINRA member entities cannot take advantage of FINRA’s expedited proceedings for promissory notes under Rule 13806 as this rule only applies to “a member's claim that an associated person failed to pay money owed on a promissory note.”
However, in order to make use of the simplified proceedings under Rule 13806, some member-firms have started a practice of sending a demand letter to the broker requesting full payment be made to the broker-dealer, rather that the entity that actually owns the note. Broker-dealers have also attempted to simply add the Note-holder as a party to the 13806 proceedings. Reps should immediately question the broker-dealer’s standing to pursue collection or arbitration, the use of Rule 13806 to govern the arbitration, and potentially consider raising a challenge to a non-FINRA member firm attempting to enforce its right through FINRA arbitration.
If you have recently received a demand letter seeking collection of a promissory note or are party to an arbitration, you may wish contact the attorneys at Cosgrove Law Group, LLC for legal representation.
Tuesday, July 29, 2014
According to a variety of authorities including the SEC, the much-debated fiduciary duty for registered investment advisers and their representatives includes a subset of responsibilities. Common sense would, or should tell you that the appropriate damage calculation for a breach of fiduciary duty will be directly dependent upon and vary according to the particular unfulfilled responsibility. For example, a breach of the fiduciary duty regarding conflicts of interest or honesty, as opposed to mere suitability, will call for out-of-pocket damage compensation if these breaches occurred before any market-losses at issue. Even in a suitability only arbitration, however, expert witnesses may debate the applicability of out-of-pocket loss calculations as opposed to model portfolio based market-adjusted damage calculations.
It is common in breach of fiduciary duty cases involving trustees to award damages in the amount necessary to make the beneficiary whole. Restatement of Trusts, Second, § 2205, (1957), provides that proof of harm from a breach of fiduciary duty entitles an injured party to whom the duty was owed to damages that: (a) place the injured party in the same position it would have been in but for the fiduciary breach;(b) place the non-breaching party in the position the party was in before the breach; and (c) equal any profit the breaching fiduciary made as a result of committing the breach. See also Restatement (Second) of Torts § 874 (1979) (“One standing in a fiduciary relation with another is subject to liability to the other for harm resulting from a breach of duty imposed by the relation.”).
Delaware law is consistent with this principle. In Hogg v. Walker, 622 A.2d 648, 653 (Del. 1993), the court noted that “where it is necessary to make the successful plaintiff whole” for a breach of fiduciary duty, courts have been willing to allow the plaintiff to recover a portion of trust property or its proceeds along with a money judgment for the remainder. The court in Hogg stated that “[i]t is an established principle of law in Delaware that a surcharge is properly imposed to compensate the trust beneficiaries for monetary losses due to a trustee’s lack of care in the performance of his or her fiduciary duties.” Id. at 654.; see also Weinberger v. UOP, Inc., 457 A.2d 701, 714 (Del. 1983) (stating that in measuring damages for breach of fiduciary duty the court has complete power “to fashion any form of equitable and monetary relief as may be appropriate, including rescissory damages.”); Harman v. Masoneilan Intern., Inc., 442 A.2d 487, 500 (Del. 1982) (finding that “the relief available in equity for tortious conduct by one standing in a fiduciary relation with another is necessarily broad and flexible.”) (citing See Restatement (Second) of Torts, § 874 (1979)).
In O'Malley v. Boris, 742 A.2d 845, 849 (Del. 1999), the court stated that the relationship between a customer and stock broker is that of principal and agent. The court stated a broker must act in the customer’s best interests and must refrain from self-dealing, and that these obligations are at times described “as fiduciary duties of good faith, fair dealing, and loyalty.” (emphasis added) Id. The court further found that fiduciary duties of investment advisors “are comparable to the fiduciary duties of corporate directors, and are limited only by the scope of the agency.” Id. Bear, Stearns & Co. v. Buehler, 432 F.Supp.2d 1024, 1027 (C.D.Cal. 2000) (finding that reasoning from case addressing breach of fiduciary duty by a trustee was persuasive in case involving investment advisor because, “[l]ike a trustee, an investment advisor may be considered a fiduciary.”).
In sum, it is critical to identify the particular duty at issue in order to arrive at a proper damage calculation. The broker’s duty of suitability is essentially a limited duty of care akin to the one at play in a negligence matter. The fiduciary duty, however, carries within it an entire penumbra of duties of which portfolio/investment suitability is just one. If an alleged breach of fiduciary duty is limited to the adviser’s responsibility to recommend or make a suitable investment only, the damage calculations may indeed mirror the broker-dealer damage calculation. An adviser’s breach of its fiduciary duty beyond the mere standard of investment care, however, requires the finder-of-fact to calculate “make-whole” damages.
Miley v. Openheimer, 637 F.3d 318 (1981) is “the seminal case on damages in a suitability case[.]”
 A “surcharge” is relief in the form of monetary compensation for a loss resulting from a trustee’s breach of duty. The Supreme Court in CIGNA Corp. v. Amara, 131 S.Ct. 1866, 1880 (2011), stated that an ERISA fiduciary can be “surcharged” or ordered to pay money damages under the ERISA provision allowing a participant or beneficiary of the plan to obtain “other appropriate equitable relief.” In making this determination, the court stated that “[t]he surcharge remedy extended to a breach of trust committed by a fiduciary encompassing any violation of a duty imposed upon that fiduciary.” The court went on to conclude that “insofar as an award of make-whole relief is concerned, the fact that the defendant in this case, . . . , is analogous to a trustee makes a critical difference.”