Hedge Fund Hoax

Though created to “hedge against risk” and maximize gains through aggressive and advanced investment strategies, one recent hedge fund lawsuit against a prominent investment company may undermine confidence in this fundamental function of hedge funds. In September of last year, the Securities and Exchange Commission brought formal charges against Walter V. Gerasimowicz, Meditron Management Group, LLC (MMG) and Meditron Asset Management, LLC (MAM), for misusing client hedge fund assets from September 2009 through September 2011. 

Gerasimowicz, a well established and highly successful New York City investment strategist, is the owner of both MMG and MAM. The SEC’s charges against the three respondents allege all parties played a role in siphoning millions of dollars from their hedge fund client, Meditron Fundamental Value/Growth Fund, LLC. In its Order, the SEC alleges the money was used to keep Gerasimowicz’s failing contracting company, SMC Electrical Contracting, afloat as it dealt with bankruptcy proceedings. Nearly 80% of Meditron Fund’s assets were transferred to SMC over a two year period, in disregard of their client’s investment interests. Gerasimowicz and MAM maintained their claims that MAM held a diversified portfolio and allegedly withheld information regarding their investment deviations, even though these deviations contradicted their stated investment strategies. 

 Over the two year period of the respondents’ alleged shenanigans, Gerasimowicz sent Meditron Fund investors quarterly statements that neglected to show the company’s “investment” in SMC. Furthermore, the Investment Advisers Act of 1940 requires financial statements relating to client funds to be prepared and audited in accord with GAAP, by a PCAOB approved public accountant. Financial statements were prepared by Gerasimowicz, not a public accountant, before being dispersed to clients and audited statements were subject to lengthy, year long delays before completion.

Additionally, the respondents allegedly recruited new MAM and MMG investors and misled current clients by misrepresenting MAM’s assets at $1.1 billion. Though the respondents claimed they were working to minimize risk, their payments to SMC did anything but. The SEC found that third party investors with full knowledge of SMC’s situation were hesitant to invest in the company and could not be maintained unless Gerasimowicz himself personally guaranteed repayment of their financing. The SEC’s Order also alleges that the respondents neglected to perform any valuation analysis of their “investment” of Meditron Fund’s assets in SMC. 

Gerasimowicz, Meditron Management Group, and Meditron Asset Management are alleged to have violated various sections of the Securities Act of 1933, the Securities and Exchange Act of 1934, and the Investment Advisers Act of 1940. The judge on this matter is set to issue an opinion no later than 300 days from the Order’s date of service.

Arbitration Agreements Mandating Arbitration Before the NASD May Be Unenforceable

Keller v. ING Financial Partners, Inc., No. 2011-193026 (S.C. App. Jan. 9, 2013) is an interesting unpublished opinion out of the state of South Carolina whose reasoning, if followed in other jurisdictions, could have a rather profound effect on client/broker-dealer arbitration agreements entered into prior to July 2007. In that case, the circuit court's denied ING Financial Partners’ motion to compel arbitration. The circuit court found the arbitration agreement between the parties designated the National Association of Securities Dealers (NASD) as an exclusive arbitral forum, the NASD was unavailable to arbitrate because it no longer existed, and the court could not substitute the Financial Industry Regulatory Authority (FINRA) for NASD.

The court noted that the Federal Arbitration Act (FAA) does not confer an absolute right to compel arbitration, but only a right to obtain an order directing that "arbitration proceed in the manner provided for in [the parties'] agreement." Volt Info. Scis., Inc. v. Bd. of Trs. of Leland Stanford Junior Univ., 489 U.S. 468, 469 (1989) (emphasis added). The agreement at issue stated "any dispute between you and me arising out of this agreement shall be submitted to arbitration conducted under the then applicable provisions of the code of arbitration procedure of NASD." The NASD's rules indicated that conducting arbitration "under the then applicable provisions of the code of arbitration procedure of NASD" mandated arbitration before the NASD itself. But the NASD was no longer available to arbitrate because in July 2007 FINRA was created through the consolidation of the NASD and the member regulation, enforcement and arbitration functions of the New York Stock Exchange (NYSE).

The court of appeals found that it could not rewrite the parties' agreement to substitute FINRA for NASD. The court noted that neither Iowa state (the law that applied) nor the Eighth Circuit Court of Appeals had decided whether a court may substitute an arbitral forum when a designated forum had become unavailable to arbitrate. Among federal circuit courts, the court noted that a split existed on the issue. In the absence of any controlling law, the court opted to follow Grant v. Magnolia Manor-Greenwood, Inc., 383 S.C. 125, 678 S.E.2d 435 (2009). There, the South Carolina Supreme Court saw "great merit in the Second Circuit's view that Section 5 [of the FAA] does not apply in cases where a specifically designated arbitrator becomes unavailable" to arbitrate. Id. at 131, 678 S.E.2d at 438 (approving of In re Salomon Inc., 68 F.3d 554 (2d Cir. 1995)).

In Salomon, the Second Circuit held that Section 5 of the FAA permits substitution only "when there is 'a lapse in time in the naming of the' arbitrator or in the filling of a vacancy on a panel of arbitrators, or some other mechanical breakdown in the arbitrator selection process." See Salomon, 68 F.3d at 560 (emphasis added). The court noted that the case before it did not present a breakdown in the process of selecting an arbitrator because the arbitral forum simply did not exist. Regardless of any similarities between NASD's and FINRA's procedural rules, the court of appeals found that it could not impose upon the parties the power of an arbitral forum that they did not agree to submit to. As a result, the court of appeals found that the trial court properly denied Appellants' motion to compel arbitration.

FINRA Hearing Panel Concluded that FINRA Arbitration Rule was Preempted by Federal Arbitration Act

FINRA Department of Enforcement recently brought an enforcement action against Charles Schwab (“Schwab”) after the firm amended its customer account agreement to include provisions that would require customers to waive their rights to bring or participate in judicial class actions against the firm. The amended agreement also required customers to agree that an arbitrator would not have authority to consolidate more than one party’s claims. 

In the first two causes of action, FINRA alleged that Schwab’s pre-dispute arbitration agreements which force customers to waive rights to participate in judicial class claims violate FINRA Rules 2268(d)(1) and (d)(3) which state, “(d) No pre-dispute arbitration agreement shall include any condition that: (1) limits or contradicts the rules of any self-regulatory organization; and (3) limits the ability of a party to file any claim in court permitted to be filed in court under the rules of the forums in which a claim may be filed under the agreement.” FINRA argued that Schwab’s agreement interfered with FINRA Arbitration Rule 12204(d) which preserves a customer’s option to file claims as a part of a judicial class action. Since FINRA has separate rules that prohibit class actions in arbitrations, customers would be barred from bringing a class action against Schwab in any forum.

FINRA alleged in its third cause of action that requiring customers to agree that arbitrators lack authority to consolidate parties’ claims violates FINRA Rule 2268(d)(1). FINRA contended that such a provision limits or contradicts FINRA Arbitration Rule 12312 which covers specific circumstances in which an arbitrator may consolidate claims. 

The parties had differing opinions on how the Federal Arbitration Act (“FAA”) played a role in the matter. Enforcement argued that the FAA was irrelevant and inapplicable because the only determination that need be made when imposing sanctions is whether Schwab violated FINRA Rules. Schwab’s position was that even if the waiver violated FINRA Rules, the FAA preempts FINRA rules and bars their enforcement.

In the Hearing Panel’s order, the first two claims were dismissed. While the Panel found that Schwab’s amendments to the customer agreements did violate FINRA Rules 2268(d)(1) and (d)(3), the rules cannot be enforced in light of the FAA, as construed by the United States Supreme Court in AT&T Mobility, LLC v. Concepcion. The Panel stated that the Supreme Court disfavors rules that override agreements to arbitrate and that such hostility to arbitration is unenforceable. The Concepcion case specifically established that class actions are no exception to the general rule and that a party to an arbitration agreement cannot undermine the agreement by participating in class actions.

In regard to Enforcement’s third cause of action, the Panel found that the language which limits the         power of arbitrators to consolidates cases violates FINRA Rule 2268(d)(1) in that the agreement:

(i) “undermines the fundamental operation of rule 12312 and, in fact, the overall operation of FINRA Arbitration Rules generally, by depriving FINRA of its authority to grant and circumscribe the power of arbitrators in FINRA’s forum; and (ii) the consolidation language undermines the specific authority given to the arbitrators to join individual claims in specified circumstances.

The Panel also found that the FAA did not bar enforcement of the rules in this instance because the FAA does not govern how arbitration forums operate. 

Therefore, Schwab was ordered to take corrective action by removing the language regarding an arbitrator’s power to consolidate claims and notify customers that such language is not effective. Schwab was also ordered to pay a fine of $500,000. 

FINRA still has the option of appealing to the National Adjudicatory Council within 45 days of the hearing panel’s decision. Thus, as it stands, while pre-dispute arbitration agreements that require a customer’s waiver of class claims may be volatile of FINRA Rules, such rules cannot be enforced to allow sanctions against FINRA member firms. Essentially, firms could effectively avoid being subject to class claims in any forum. This may prompt FINRA to reevaluate class arbitration rules.

FINRA’s 2012 Year in Review

FINRA just released its 2012 Year in Review Report.  In its opening remarks, FINRA’s Chairman and CEO, Richard Ketchum, stated, “FINRA fulfilled its role as the first line of defense for investors through a comprehensive and aggressive enforcement program, supported by a realigned and more risk-based examination program and the provision, for the first time, of cross-market surveillance programs that more effectively detected electronic manipulative trading. Protecting investors and helping to ensure the integrity of the nation’s financial markets is at the heart of what we do every day.

Regulatory

FINRA noted that one of its regulatory highlights was the success of its referral program in which the Office of Fraud Detection and Market Intelligence (“OFDMI”) shares regulatory intelligence with the SEC and other law enforcement agencies. Its intelligence stems from OFDMI’s fraud and insider trading surveillance of nearly all U.S. equities markets.  In 2012, FINRA referred a total of 692 matters to the SEC and other law enforcement agencies, of which 347 involved insider trading and 260 involved fraud. 

Disciplinary and Enforcement

In addition to its referrals program, FINRA brought 1,541 disciplinary actions against registered firms and individuals, levied fines in excess of $68 million, and ordered $34 million in restitution to harmed investors.  FINRA expelled a total of 30 firms from the securities industry, barred 294 individuals, and suspended 549 brokers from associating with FINRA-regulated firms. 

Some of the complex products involved in 2012 disciplinary and enforcement actions were non-traded REITs, exchange-traded funds (ETFs), and structured products.  Other enforcement actions involved research analyst conflicts, mispricing, and improper reimbursement fees to lobbying groups. 

Another critical aspect of FINRA is its examinations of member firms and associated persons.  In 2012, FINRA initiated 1,846 routine examinations, over 800 branch office examinations, and 5,100 examinations resulting from customer complaints, terminations for cause, and other regulatory tips.  FINRA’s exam procedures were made more efficient due to advances in technology which has provided FINRA with a modernized framework that allows it to identify and prioritize areas of risk exposure at firms. 

Investor Protection

Of grave importance to investors was FINRA’s new suitability rule that was implemented July 9, 2012.  The rule requires broker-dealers and/or their associated persons “to have a ‘reasonable basis’ to believe a recommended investment is suitable for the customer, based on information obtained through ‘reasonable diligence’ to understand a customer’s investment profile.”  For more investor information on FINRA’s suitability rule, click here.

FINRA also proposed an investor-protection initiative in 2012 that attempts to address conflicts of interest relating to recruitment compensation practices of member firms offering incentives to recruit registered representatives.  Currently these compensation arrangements are not disclosed to the representative’s customers when they are asked to transfer their accounts to a representative’s new firm.  The rule would require the member firm to provide certain disclosures before a customer makes the final determination to transfer an account to the new firm.  The view the text of the proposed rule, click here.

In September 2012, FINRA obtained approval to file proposed rules that would require firms to include a reference and a link to BrokerCheck on their websites to make it easier for investors to obtain information on firms and brokers. FINRA also increased the user friendliness of BrokerCheck by including a zip code search and a combined search function that provides for easier access to the SEC’s Investment Adviser Public Disclosure (IAPD) database. 

In November 2012, FINRA Dispute Resolution released data which reflects the outcomes of cases heard under its all-public panel program that was implemented in February 2011 which allows investors the option of a panel comprised of all public arbitrators versus a panel made up of one arbitrator with securities industry experience (nonpublic arbitrator) and two public arbitrators. The all-public panel option represents an investor-friendly change to the program, designed to ensure a fair playing field for all parties. To date, the data indicates that in cases decided by three public arbitrators, customers were awarded damages 51 percent of the time, whereas in cases decided by a panel including one nonpublic arbitrator and two public arbitrators, investors were awarded damages 32 percent of the time.  For the full data report, click here.

Notably, FINRA and the FINRA Investor Education Foundation have continued to enhance its outreach strategies and investor education by distributing educational brochures, holding live events, and creating an Outsmarting Investment Fraud curriculum.  The Foundation also put  more focus into providing services for military families through their military financial readiness project. 

Crowdfunding

A hot new topic in 2012 was “crowdfunding” since new provisions relating to crowdfunding were introduced in the April, 2012 JOBS Act.  To ensure that the capital-raising objectives of the JOBS Act can be advanced while simultaneously protecting investors, FINRA has requested and solicited comments on specific rules it should adopt for registered funding portals that become FINRA members.  In addition, FINRA has also asked for comments on the application of its existing rules to broker-dealers engaging in crowdfunding activities. 

If you’re a FINRA member firm, associated person, or an investor involved in a potential FINRA-related claim, contact the experienced attorneys at Cosgrove Law Group, LLC for assistance. 

Former Morgan Stanley Branch Manager Awarded $1 Million in Compensatory Damages in a FINRA New Years Day Award.

In 2011, Claimant Gregory Carl Torretta (“Torretta”) filed a claim with FINRA against Respondent Morgan Stanley Smith Barney (“Morgan Stanley”) for violations of FINRA rules, breach of employment contract, and wrongful termination.

Torretta was a former branch manager at Morgan Stanley at a two-branch complex in Garden City, New York. His termination allegedly stemmed from his oversight of another manager who was underperforming in his duties. The unidentified manager complained to Torretta about the oversight process in an email that was copied to Torretta’s boss. The email also implied that Torretta had discussions about leaving Morgan Stanley and suggested that Torretta encouraged the manager to follow him.

Despite denying the allegations of having those discussions with the manager, Torretta was given the choice to voluntarily resign or be terminated. Torretta chose to voluntarily resign. The key issue in the case was Morgan Stanley’s own procedures for handling such matters which Torretta alleged were not followed.

In Torretta’s statement of claim, he requested compensatory damages in the amount of $4.5 million. At the close of the hearing, Torretta requested compensatory damages ranging from $8 million to $9 million.

The hearing took place in New York City in front of Chairperson Marguerite Filson, Public Arbitrator Paul Blederman, and Non-public Arbitrator Joel Morton Newman. On January 1, 2013, the panel awarded Torretta $1 million in compensatory damages. In customary fashion, the panel did not explain the award.

If you believe you have been wrongfully terminated from a FINRA Member Firm, please contact the experienced attorneys at Cosgrove Law Group, LLC.

For a copy of the opinion, see FINRA Cause No. 11-01914.

FINRA Discusses Expungement for Unnamed Persons in Arbitration Claims at December 2012 Board Meeting

The FINRA Board of Governors met last week to discuss a number of issues, including several rulemaking items. A summary of one of the more pertinent rulemaking items is included below:

Expungement for Unnamed Persons in Arbitration Claims

The Board authorized FINRA to file a proposal with the SEC that establishes three different procedures that would permit registered persons who are identified for alleged sales practice violations in an arbitration claim, but are not named as parties in that claim (unnamed persons), to seek expungement relief. The unnamed person could seek relief under Rule 12805 by asking a party to the customer-initiated arbitration in writing to seek expungement on his or her behalf. Alternatively, the registered person could initiate In re proceedings under new Rule 13807 at the conclusion of the underlying customer-initiated arbitration case. Finally, the unnamed person could seek expungement relief at the conclusion of the customer’s case by asking the panel for an expungement based on the record compiled in the underlying case. The proposal incorporates many of the comments and suggestions received on Regulatory Notice 12-18, as well as feedback from several FINRA committees. FINRA believes that these proposals provide unnamed persons with a remedy to seek redress concerning allegations that could impact their livelihoods, yet maintains the protections of FINRA’s expungement rules to ensure the integrity of the CRD records.

The authorization to file a proposal with the SEC is interesting and important news for associated persons who are mentioned in but not named as parties to an arbitration.  If ultimately approved, this will permit these individuals to seek expungement relief by the three methods mentioned above.  Currently, allegations mentioning an associated person must be reported in the same way that customer complaints are reported—to the Central Registration Depository system on Forms U4 or U5. The Code of Arbitration Procedure for Customer Disputes and the Code of Arbitration Procedure for Industry Disputes do not presently provide unnamed persons with express procedures to seek expungement of these types of allegations.

Federal District Court Denies Questar's Motion to Vacate 3.25 Million Dollar Arbitration Award

On November 12, 2012, Senior Judge Thomas B. Russell of The United States District Court, WesternDistrict of Kentucky, issued a 60-page Opinion denying a Petition to Vacate and a Motion to Vacate filed by Questar Capital Corporation. Questar is a fully owned subsidiary of U.A. Allianz. Questar filed in federal court after a 3-arbitrator FINRA panel sitting in Louisville issued a $3.25 million Award to a client of St. Louis' Cosgrove Law Group, LLC. The client is a former independent contractor, broker-dealer agent, and investment advisor representative of Questar.

The Court spent the first 1/3 of its Opinion addressing the broker's contention that Questar had waived its right to file a Motion to Vacate by failing to comply with the 30-day post-Award deadline set forth in FINRA Rule 13904. The broker had filed a Motion to Dismiss Questar's Petition to Vacate because, while it was filed within 30 days of the Panel's Award, Questar subsequently filed a Motion to Vacate about 75 days after the Award. The Court denied the Motion to Dismiss, concluding that, despite conflicting legal precedent, Rule 13904 “did not establish a 30-day time limit for filing a Motion to Vacate.” (Opinion at 23). Specifically, Judge Russell concluded that it is sufficient if a movant files within the 90-day time limit set forth in Section 12 of the Federal Arbitration Act (FAA).

Approximately half-way through his meticulous Opinion, Judge Russell initiated his analysis of “the heart of this proceeding”--the merits of Questar's application for vacatur. He began by noting the limited grounds upon which an arbitration award may be vacated under the FAA, noting that the Sixth Circuit recognizes an extra non-FAA judicial basis-- “manifest disregard of the law” by the arbitrator. Finally, rather than proceeding to evaluate sequentially each and every specific claim set forth by Questar, the Court divided Questar's allegations and the Court's analysis into the four FAA grounds of vacatur, as well as the Sixth Circuit's manifest disregard basis.

As to FAA Section 10(a)(2)-- “evident partiality” --the Court concluded that Questar's challenge to the sufficiency of pre-hearing disclosures the Panel Chairman made was without merit. (Opinion at 29-39). The Court's detailed analysis in this regard notes, among other things, that “...a party cannot remain silent as to perceived or actual partiality or bias and then later object after the panel reaches an unfavorable decision.” (Opinion at 37).

Judge Russell proceeded on to address Questar's multi-layered contention that the Panel violated FAA Section 10(a)(3) in that it allegedly refused to hear evidence pertinent and material to the controversy. In this regard the Court noted that “the standard for judicial review of arbitration procedures is merely whether a party to arbitration has been denied a fundamentally fair proceeding.” (Opinion at 40). The Court observed that only two of Questar's myriad of claims fell within this category: 1) that despite allowing the broker to introduce evidence through the testimony of his former attorney, the Panel improperly allowed him to assert the attorney-client privilege on Questar's cross-examination, and 2) that the Panel improperly excluded testimony from the broker's former clients. (Opinion at 41-42).

As to the first, the Court concluded that the claim was factually without merit. As to the latter, the Court concluded that the Panel's provision of 10 subpoenas in response to Questar's request for 55 subpoenas in the middle of the five-months of hearing sessions was more than adequate, noting that “arbitrators are not required to hear all of the evidence tendered by the parties; they need only afford each party a fair opportunity to present their arguments and evidence.” (Opinion at 42-49).

As to FAA Section 10(1)(4), the Court evaluated Questar's general challenge to the sufficiency of the evidence to support Claimant’s claims for defamation, negligence or tortious interference. At the outset of this analysis, the Court noted:

“...the award is devoid of any rationale or explanation as to the factual basis for the Panel's decision, the particular theory or cause of action upon which the award is based, and/or how the Panel calculated the award figure. But, Importantly, this is precisely the outcome contracted for between the parties. Cf. United Steelworkers v. Enter. Wheel & Car Co., 363 U.S. 593, 598 (1960) (“Arbitrators have no obligation to the court to give reasons for an award.”); Dawahare v. Spencer, 210 F.3d 666, 669 (6^th Cir. 2000) (“Arbitrators are not required to explain their decisions.”). As the Sixth Circuit has stressed, where the arbitral agreement imposes no duty of explanation on the arbitrator, “remand for the purpose of having the arbitrator clarify his reasoning would be inappropriate.” Id. at 977 n.9.

(Opinion at 50-51).

Aptly enough, Judge Russell stated: “The Court will not be lured into reviewing the merits of the Panel's decision.” (Opinion at 51). The Court proceeded to rebuke Questar's sufficiency challenge after a careful review of the appropriate controlling precedent and standard of review for Motions to Vacate. Judge Russell cited a fundamental tenet on this point:

“The Supreme Court and this Circuit have both admonished courts that “as long as the arbitrator is even arguably construing or applying the contract [to arbitrate] and acting within the scope of his authority, that a court is convinced he committed a serious error does not suffice to overturn his decision”; accordingly, “courts must refrain from reversing an arbitrator simply because the court disagrees with the result or believes the arbitrator made a serious legal or factual error.” Misco, 484 U.S. At 38; Salvay, 442 F.3d at 476.

(Opinion at 56).

Finally, the Court evaluated Questar's Motion to Vacate under the Sixth Circuit's “manifest disregard of the law” standard. This analysis bore no fruit for Questar either. Judge Russell cited Coffee Beanery, Ltd. v. WW L.L.C., 300 F.App'x 415 (6^th Cir. 2008) for the proposition that vacatur is only appropriate under this standard if “the decision [flies] in the face of clearly established precedent.” Id. at 418. (Opinion at 57). The Court also made the insightful distinction between a manifest disregard of the law, and the manifest disregard of fact that Questar was essentially peddling. (Opinion at 58-59).

The attorneys at Cosgrove Law Group, LLC spent approximately five (5) months briefing the various post-Award issues in this matter. In doing so, they reviewed dozens upon dozens of FAA and vacatur opinions. Judge Russell's Opinion in this matter may be the most thorough and instructive. You would be remiss not to digest it and save it if you practice in this area.