The Arbitration System

The premise that underlies the justification for the loss of rights in arbitration is simple: both parties knowingly agreed to binding arbitration. This presumption is based upon the presumptions that 1) signators read contracts before signing, 2) they have the time and knowledge to understand the implications of the arbitration provision, and 3) they have a viable ability to opt-out of agreeing to the provision. Arbitration's entire legitimacy is based upon these fairly specious presumptions. And there has been much written about these presumptions and whether or not binding arbitration is actually the product of an informed voluntary decision by both parties. See “Whimsy Little Contracts' with Unexpected Consequences: An Emperical Analyss of Consumer Understanding of Arbitration Agreements,” Jeff Sovern, Elayne Greenberg, Paul Kirgis, and Yuxiang Liu, St. John's Legal Studies Research Paper No. 14-0009, October 29, 2014 and “Arbitration Clauses Trap Consumers with Fine Print,” Jeff Sovern, AmericanBanker.com, December 2, 2014.

The position of the “Whimsy Little Contracts'...” study is that no one would voluntarily agree to have substantial rights resolved in a quasi-judicial system contaminated by bias. Take a look at this chart and decide for yourself if the system is fair and free of improper influence:

Finally, there is another false assumption that bolsters the presumption favoring arbitration: it is more efficient than the courts: Cheaper and quicker! Unfortunately, I could rattle off twenty examples demonstrating just how questionable this presumption is when presented as a general truth. I received an arbitration award from JAMS 7 years after the claim was filed. I just paid AAA over $20,000 before the Panel has ever convened, and the Respondent buried us in discovery. If I was in Federal Court, I would have a scheduling order protecting my client for approximately $200 in filing fees.

In sum, both the courts and the legislature need to take a hard and honest look at the jurisprudential legitimacy of binding arbitration. Food for thought.

The Harms and Indicators of Excessive Trading

 

Many securities brokers work for commissions. This means that they charge investors a fee whenever executing a trade on their behalf. This method of compensation has, in the past, enticed some nefarious brokers to increase their compensation by making more trades on a customer’s behalf than is in the customer’s best interest.

What is Excessive Trading?

Excessive trading, also known as churning, occurs when a securities broker executes trades in a customer’s account at an unsuitable frequency in an effort to increase their own commissions. Make no mistake, excessive trading is illegal. Unfortunately, in all but the most egregious circumstances, you may need to consult a professional to determine whether you are a victim of excessive trading. There is no “one size fits all” test to determine whether a broker is churning a customer’s account. Instead, courts and regulators balance several factors to determine whether a broker’s trading would be deemed excessive. It is determined by the volume at which trades are being executed, the type of security being traded, the investor’s stated investment objectives and the investor’s risk tolerance (including their age, net worth, and investment experience). For instance, the same number of trades may be suitable for an investor with more speculative objectives but unsuitable for an investor with more conservative objectives. Moreover, one type of product traded a certain number of times may be suitable; whereas, a different type of product—not meant for that volume of trading—traded just as many times may be unsuitable.

The Harms of Excessive Trading 

            Excessive trading can cause significant and irreparable harm to investors beyond simply loss of principal. It will almost always prevent the desired growth due both to excessive fees that accompany it and the excessive switching of investment products that will only yield growth if they are held onto for certain periods of time. Even if an investor’s principal investment remains intact after a ten year period, the fact that an account achieved no, or minimal, growth over that period—when a properly traded account would have seen the growth the investor desired—can cause damage to an investor’s financial health which cannot be undone. 

The Evolution of Excessive Trading           

Excessive trading primarily occurs when securities brokers engage in unnecessarily frequent switching of equities sold on public securities exchanges. When this occurs, the broker “earns” a commission for each trade. Over time, these charges compound and cause substantial harm. In recent years, more and more securities brokers are starting to engage in excessive trading of more long term investment products not sold on public exchanges such as mutual funds, unit investment trusts, private equity funds, closed-end funds, and, most notably, variable annuities. Long-term product switching, especially when it involves variable annuities, does not need to occur at the same volume as equity switching in order to be deemed excessive. For example, annuities are specifically designed to be held onto long term and are often marketed to elderly vulnerable investors with very low risk tolerance. Investors placed in products such as variable annuities may be charged inordinately high[1] fees when they are both placed in and exit the product. That means that the fees investors incur as a result of excessive trading will rack up even more when the trading involves individually tailored private investment products like annuities.

The Indicators of Excessive Trading 

            Regulatory agencies such as FINRA have two main tools to identify excessive trading. One is by looking at the Turn-Over Rate. This is the number of times the securities in the account turn into new securities. The second is called the Cost-Equity Ratio. This is the amount the account would need to appreciate in order for the customer to simply cover the fees they are being charged. A turn-over rate of 6 and a cost-equity ratio of 20 percent are the prime indicators that excessive trading is most likely occurring. However, as noted above, these are just two indicators of many. Excessive trading still may exist where these indicators are not met.

Who Can Stop Excessive Trading? 

More so than both FINRA and the customers themselves, it is actually the broker-dealer who is in the best position to both spot and put a stop to excessive trading. Many securities firms have alert systems in place where they will be automatically be notified if an investor’s turn-over rate reaches 6 and their cost-equity ratio reaches 20 percent; however, case-law dictates that these two numbers are not necessary to make someone liable for excessive trading. Many brokers engaging in this practice know how to effectively skirt these alerts and avoid raising red flags by engaging in trading that falls just shy of reaching the numbers necessary to trigger the alerts. For this reason, FINRA has called on all broker-dealers to be more vigilant in broker supervision beyond merely “checking in on things” once an alert has gone off.

            Unfortunately, it is incredibly difficult for investors to recognize when excessive trading is actually occurring. The investor is not trained in this industry and may only receive quarterly or annual statements from their broker. In some of the most egregious violations, brokers will skirt supervision mechanisms by fraudulently changing an investor’s preferences to allow for more frequent and speculative trading, essentially banking on investors not noticing the change in preferences on their account statements.

            The best thing that investors can do is make sure that their investment objectives and risk tolerance are listed correctly on account statements, actively communicate with their broker, and take thorough notes of their conversations. If investors do have any suspicions, they should never be afraid to call the broker-dealer and speak to a supervising manager. Legitimate brokers are not offended by this action and it will have no affect on your working relationship.

            Here at Cosgrove Law Group, LLC, we have substantial experience dealing with fraud related to brokers and financial professionals. If you suspect that you are a victim of excessive trading, contact the experienced attorneys at Cosgrove Law Group, LLC.

Author: Alexander Oakes, J.D. Candidate 2023, St. Louis University School of Law

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[1] It is not uncommon to see an investor charged 25 percent of their principal investment if they exit an annuity early.