Securities Compliance Sentinel - Analysis of Cutting Edge Securities Industry Issues

The North American Securities Administrators Association on behalf of state securities regulators, following 37 members of Congress, recently asked the SEC to exercise its authority under Dodd-Frank and do away with mandatory arbitration agreements.  Consumer groups have also jumped into this fray.

Does this signal the beginning of the end of arbitration clauses in customer agreements?  In my view, probably not, but the ability to force a customer into arbitration is likely to be curtailed.

The likely result will be that firms will have to offer a customer the option of arbitration or some other form of relief.  This does not mean that firms are not without methods to limit the costs associated with customer initiated litigation.

For example, if firms are required to let their customer proceed in a court, I would encourage the firm to require mediation as a pre-condition to a customer lawsuit.  This way, firms and the customers may be able to quickly resolve an issue without litigation.

I would also encourage firms to have venue and choice of law provisions.  In other words, force the customer to sue the firm in a particular court and pursuant to a particular state law. 

Similarly, I would recommend including a provision that requires the customer to waive a jury trial.  This may help you avoid a claimant shopping for a more favorable forum at your expense while, at the same time, expedite the ultimate resolution of the case.

Yes, it does appear as though firms may someday soon be limited in their ability to force arbitration, but you are not without tools to limit litigation.  Be creative, you can still structure your agreements to streamline litigation that may be initiated in the future.

The prudent answer to this question should be probably not, but we can hold out hope.

A FINRA panel recently upheld a class action exclusion in a broker-dealer agreement to arbitrate contained in its customer agreement.  In other words, the provision prohibits a customer from seeking class action status against the broker-dealer, forcing all customer complaints to be brought in arbitration.

FINRA has since appealed this decision to its National Adjudicatory Council.  As such, the issue will not be firmly grounded for some time.  In the interim, what should broker-dealers do.

At a minimum, broker-dealers should immediately revisit their customer agreements.  Until the FINRA appeal is exhausted, it may make sense to include a provision barring customer class actions.

Although this issue remains in flux, there is a window of opportunity to limit the claims brought against you.  Act now or regret it later.

 photo from freedigitalphotos.net

Both federal and state courts are exceedingly reluctant to halt securities arbitrations.  

As an example, a California federal court refused to issue a temporary restraining order stopping a securities customer arbitration.  In fact, the court was somewhat perturbed at even being bothered, indicating that TROs were "for emergencies only."  See Stanchart Securities International Inc. v. Galvadon, S.D. Cal., No. 12cv2522-LAB (MDD), 10/24/12, and  http://docs.justia.com/cases/federal/district-courts/california/casdce/3:2012cv02522/397668/9/.  Clearly, the court was also influenced by the fact the FINRA arbitration had been going on for over a year, and this was the first attempt to stop it.  In fact, the TRO was filed a mere 3 days before the FINRA arbitration hearing was to take place-- not a good move on the part of the parties seeking a stay. 

In any event, if you are an optimist, one supposes you could infer if the parties had sought relief sooner, the response may have been different.  However, we do not really think that is something we will see in the foreseeable future. 

FINRA announced that it is seeking proposed rule changes to make it easier for investors to use BrokerCheck.  See http://www.finra.org/Investors/ToolsCalculators/BrokerCheck/.

These proposed amendments to FINRA Rule 2267, Investor Education and Protection, would require member firms to include a BrokerCheck reference on their websites and those of any associated person.  Additionally, FINRA Rule 8312, BrokerCheck Disclosure, would be amended to allow the public permanent access to BrokerCheck information on state or foreign settled cases against associated persons as well as permit various data downloads.

Essentially, FINRA wants to ensure that BrokerCheck remains a key resource for investors.

Never, under any circumstances, should you have your client sign an account opening document in blank, for you to complete at some later time.  To most of you, this is not much of a secret, but I have seen it enough in my practice of defending brokers to know that it happens all too often.

So what is the problem with taking this shortcut?  After all you are just going to use your notes to fill in the gaps.  What gives?

For one, having account forms signed in blank is worse than submitting incomplete forms.  By controlling the ultimate content, you expose yourself to a claim that you exercised control over all of the customer’s accounts.  The greater control that you have, the greater your duties become to that client.

Having your client sign forms in blank also opens you up to fraud claims.  What do you say when the client alleges that his account was miscoded as aggressive, when he was a conservative investor where you completed the forms without client participation.  In short, there is not much to say other than to ask for a settlement demand.

If the circumstances dictate that you need to complete an account document at a later date, then do so, but without the client pre-signing the blank form.  This way, you can send the completed form to the client with a covering letter/email explaining what you did and then have the client sign off on how you completed the form.  By doing so, you can avoid the fraud claim associated with a form signed in blank.

Not having clients sign forms in blank is not a “best practice”.  Rather, it is the only way that you should complete account forms.

            * Photo from freedigitalphotos.net

In a prior post, I discussed the traps that people fall into when it comes to email.  One of the areas of greatest concern for me when I defend brokers and investment advisors are the emails that are generated immediately after a complaint (particularly an informal one) is received.

It goes without question that the broker/advisor will be upset when a customer makes a complaint.  That is, however, no reason to lose your discipline when reporting to compliance/legal about the complaint.

For one, never bad mouth or editorialize about a complaining customer.  Fight the natural reaction of wanting to call the complainant a pain, crazy, an idiot or anything in the pejorative.  Those emails may be subject to discovery and will be used against you to demonstrate that you did not have the customer’s best interests in mind.

Once a complaint is made, email about the customer should only be used to forward information, without additional comment.  Any debriefing about the customer should be in person or on the phone between you and your compliance/legal team.

If email is necessary to explain what happened, that email should be forwarded to someone in your legal team, which can improve your ability to assert the attorney-client privilege or work product to avoid producing that email in discovery.  If you do not have a legal team, you should avoid creating these types of emails as they may not be protected from discovery.

Dealing with customer complaints can be an arduous process.  Do not make a worse with loose emails after a complaint is received.

            * Photo from freedigitalphotos.net

A few years ago, I defended a financial advisor over a bee sting. 

The customer wanted to take the cash value out of a life insurance policy to buy a second home.  The advisor cautioned against doing so before completing underwriting on a new policy.  The customer ignored this advice, contacted the company directly, and liquidated the policy before completion of the underwriting process. 

While waiting for underwriting to conclude, the client was stung by a bee and died.  His wife sued the broker-dealer and the advisor for letting the client cash out the policy before underwriting was complete on the new one.

Fortunately, the advisor took the time to document his advice to the client in contemporaneous notes.  In the end, the case ended well for the broker-dealer and advisor because the notes reflected the caution that the advisor provided to the client.  So what is the lesson to be learned other than knowing if you allergic to bees. 

Notwithstanding the fast paced world in which we live, it is critical for you to document, in some fashion, the advice that you provide to your clients.  You can write letters or emails or, at least, have contemporaneous notes in your file.  Documenting client contact is even more important when a client ignores that advice.

Often cases are won and lost based upon the respective credibility of the customer and advisor.  That credibility pendulum will likely swing in your favor if you have paper trail of all of your advice to your clients.  Without a paper trail, a bee sting will be more than a bee sting.

It has been two months since FINRA Rule 2111 has come into effect.  This new rule requires that there must be a reasonable basis to believe that the recommended transaction or investment strategy involving a security is suitable for a customer, where a strategy can involved the recommendation to buy, sell or hold a security.  So what does it mean to make a suitable investment recommendation?

I have effectively argued in arbitrations that a 100% equity growth investment portfolio was suitable for a investor.  Although this may seem a bit out of whack, the panel did not think so; why.

The key for making suitable investment recommendations is to make sure that you first know your customer.  Equally important, you must document the rationale for making such a recommendation.

From my experience, the more documentation in your file to demonstrate your explanation to the customer of the respective risks and benefits of a proposed investment strategy, the more likely that an arbitration panel will agree that you had a reasonable basis for the investment recommendation. 

To protect yourself, never take a shortcut.  Make sure your fully  document you recommendation in your notes, with prospectus or other written materials.  If you  do, you stand a reasonable chance of prevailing if that same customer decides to bring a claim against you.

On August 24, 2012, FINRA filed a proposed rule change with the SEC relating to when industry parties seek the appearance of witnesses or the production of documents from FINRA members and individuals associated with the members.  The new rules would require arbitrators, unless the circumstances dictate otherwise, to issue an order directing the production of documents or appearance of witnesses from non-party FINRA members without resorting to the subpoena process.  An arbitrator may issue a subpoena to non-party FINRA members if, for example, a firm failed to produce documents pursuant to an arbitrator’s order, or if a former associated person has left the industry and the arbitrator believes that an arbitrator order would not be effective.

The new rules would also address the issue of costs when a FINRA member and/or employee or associated person requests a subpoena directed to a non-party FINRA member and/or employee or associated person.  If an arbitrator issues a subpoena, the party requesting the subpoena shall pay the reasonable costs of the non-party’s production and/or appearance, unless the panel directs otherwise.  If a dispute arises as to the reasonableness of the costs, the arbitrator will determine whether production costs are reasonable.

Finally, FINRA is proposing to add new rules to provide a mechanism for non-parties to object to a subpoena or an arbitrator’s order.  The non-party may, within 10 days of service of the subpoena or arbitrator’s order, file written objections with the Director.  The party issuing the subpoena or arbitrator’s order would have 10 days from the receipt of the objections to respond.  After considering all objections, the arbitrator will rule on the objections.

In my practice defending broker-dealers and investment advisors from customer complaints, I have seen most clients fail to employ the easiest risk avoidance technique.  Frequent communication with their clients.

Although the advances in technology have improved the ways in which to communicate with your clients, most brokers and advisors do not have adequate communication with their clients.  In many instances, a client complaint can be avoided altogether if there was an open dialogue between customer and professional.

All too often I hear the similar refrain; my broker never spoke with me when the market went south.  Needless to say, the lack of communication leads to acrimony and, potentially, lawsuits.  Minor things become major problems when you do not have frequent, open and honest communication with your clients.

When there are large market fluctuations either negative or positive, you should be in front of your clients.  Clients want to feel that they are more than just a commission to you; they want to know you actually care.  A simple phone call, email or text message to a client that you understand the situation, are available to discuss it, and are prepared to assist the client pursue their goals and objectives goes a long way to diffusing what may otherwise be a difficult situation.

What many professional lose site of is that, every time you have client contact, you improve your chances of the client increasing their investments with you or referring a family or friend.  Even when times are bad, every single instance you speak with your client you have the opportunity to market yourself and increase your business.

I recommend direct personal contact, such as a telephone call, on at least a quarterly basis.  If there is significant market volatility, you should increase the frequency of contact.  In addition, you should meet with your client face-to-face, on at least a yearly basis.

By maintaining consistent contact with your clients, you will, more than not, have a satisfied client.  In the end, client communication can only help you avoid the risk of being sued and improve your chances at business development.  Do it and watch the results.

The case below should be immediately filed in the “Uh Oh” category because the result indicates the potential for increased liability for securities clearing firms when a fraudulent transfer is alleged.

The United States Court of Appeals for the Second Circuit refused to vacate an arbitration award against a securities clearing firm where it had been alleged a fraudulent transfer occurred.  See Goldman Sachs Execution and Clearing LP v. Official Unsecured Creditors’ Comm. of Bayou Group, LLC, 2012 U.S. App. LEXIS 13531 (2^nd Cir. July 3, 2012).  The Second Circuit found that the sole clearing broker and prime broker for a group of hedge funds affiliated with Bayou Fund LLC were required to arbitrate a matter involving fraudulent transfer claims, and that the FINRA arbitration proceeding, finding the clearing broker was the initial transferee of such transfer and not a mere conduit of the ultimate transfer, was valid.  As such, the FINRA arbitration panel awarding the clearing broker $20 million dollars would not be vacated.  In keeping with FINRA fashion, the arbitration panel did not issue a written decision.

Further, the Second Circuit based its conclusion that the FINRA arbitration panel had not manifestly disregarded the law on the Bear Stearns Securities Corp. v. Gredd, 391 BR.l (S.D.N.Y. 1997), case.  In the Gredd case, the Court found that Bear Stearns was liable as the initial transferee in a ponzi scheme customer where Bear Sterns had controlled the customer funds.  The Second Circuit believed that the current case and Gredd were very similar.

            In short, although the Second Circuit concluded this was not a novel approach, securities clearing firms should certainly prepare for the worst—given those firms now seem to have a target on their backs!!

A couple of years ago I defended a broker-dealer in an arbitration that lasted 44 days in which multiple claimants argued that my client failed to stop one of its brokers from running a ponzi scheme.  Not only were we faced with difficult facts, but we also had an arbitrator who took an active role in the case itself by offering his “opinions” and taking over examinations.

I knew I had an issue when, in the first week of the arbitration, the arbitrator questioned out loud, during a break in front of one of the witnesses that I was presenting, how he found it amazing that my client did not immediately conclude that what happened was a fraud.  In another instance, he suggested that the two brokerages defending themselves simply pay two thirds of what the claimants wanted; the claimants ultimately asked for in excess of $15 million.

Not to be outdone by his unsolicited and improper opinions, the arbitrator frequently took over witness examinations, as opposed to asking limited follow-up at the end of the examination like every other arbitrator I have ever had would do.  As a result of his “examinations”, this arbitration lasted much longer than it should have because we frequently covered the same ground multiple times.

So what can you do when faced with an “advocate arbitrator”.  For one, you cannot let it rile you, and especially never let anyone see that it has riled you.  As the commercial used to go, “Never let them see you sweat”.  The most important thing that I did after this conduct appeared to be a constant was to make a record and not be afraid to call the arbitrator out for his conduct.

When the arbitrator made off the record comments regarding the evidence, I began to remind him that his obligation as an arbitrator required him to have an open mind and not to judge the evidence until the end of the trial.  During the hearing when he interrupted my examinations, I respectfully asked that he refrain from interrupting me and reserve his questions as my examination would likely cover what he wanted to know. 

This approach was not without risk; it could have angered the arbitrator toward my client.  In the end, however, the interruptions and unsolicited remarks eased a bit and the other two arbitrators tried to keep the third in check.  Most important from my client’s perspective, the arbitrator remembered what his role really was and, in the end, fairly judged the evidence as the award was a far, far cry from what the claimants wanted.  I thought the result was a vindication for our client and proof that you can respectfully stand up against an advocate arbitrator and come out on top.

The 11^th Circuit Court of Appeals recently vacated a FINRA arbitration panel arbitration award because the panel had failed to decide if the securities firm had waived its right to arbitration by engaging in litigation. 

The arbitration arose out of a bond offering and a dispute between underwriters.  Ultimately, there was an arbitration award that was later confirmed by the federal District Court.  The 11^th Circuit stated that the district court did not consider the waiver issue of the party’s litigation conduct.  However, in vacating the award and remanding, the court did say that the district court, if it concluded that no waiver occurred, may then re-enter its order confirming the arbitration award.

This is an interesting decision because it does permit some insight into the courts' reasoning as it relates to a review of arbitration awards.

Late last week, one of my colleagues sent me an e-mail where he copied 8 other people, half of them I could not identify if my life depended upon it.  I then heard about the person who had a Twitter account with over 17,000 follwers, and was now being sued by his former employer over ownership of the account-- really, does anyone think the person knows 17,000 people?  Firms and persons working in financial services industries generate trillions of e-mails every year, encompassing the mundane to the critical. 

These firms and their employees also seem to be involved in numerous civil, regulatory and criminal investigations and litigations.  Much of the vast amount of money in legal fees paid to defend these firms and their employees (sums that sometimes greatly exceed the GDP of several developing countries) often relate to e-mail review and production.  General counsels and firm management looking for ways to save money on these bills should, initially, read my article that was published in the New Jersey Law Journal, outlining the "CC" problem and ways of clamping down on this terrible plague afflicting our society, http://www.foxrothschild.com/newspubs/newspubsArticle.aspx?id=4294970187.

Once read, please do your part in stopping this madness because the dollar you save maybe your own!!

Great program, 13th Annual FINRA Listens... And Speaks, to be held at the New York County Lawyer's Association on Monday February 6, 2012 at 5:00 PM at NYCLA. 14 Vesey Street (between Broadway and Church Street), New York, New York.  Katherine M. Bayer, regional director of the Northeast Region, FINRA Dispute Resolution, will speak. This program allows for an exchange of views among arbitrators, counsel for claimants and counsel for respondents.  Although the program has no fixed agenda, Ms. Bayer will discuss recent initiatives, including: revisions to the arbitrator disclosure checklist that all arbitrators must complete at the outset of cases on which they are serving, the new discovery guide, granting movants a right to reply, and the new composition of arbitration panels in promissory note cases; proposed rules allowing arbitrators to make referrals during the arbitration proceedings and precluding collective action claims from being arbitrated under the Industry Code; and updates, including FINRA's recent experience with investors' opting for an all-public arbitration panel and with the new discovery guide. As usual, Ms. Bayer will field questions from the audience.  NYCLA Evening Forums are free and open to the public. Entrance and facilities for those with disabilities are available. For wheelchair access, a ramp is provided. Please call 212-267-6646 at least one day in advance to make arrangements.

Those, who can attend, should!!

Interesting, NY Court of Appeals decision affirming an arbitration award despite a claim of partiality.  Check out the great write up from CPR!!

http://www.cpradr.org/Resources/ALLCPRArticles/tabid/265/ID/733/Arbitration-NYs-Top-Court-Sets-Evident-Partiality-Standard-for-Tribunal-Disclosure-Nov-15.aspx

In January 2001, the Securities and Exchange Commission (“SEC”) recommended the implementation of a uniform fiduciary duty standard for broker-dealers and registered investment advisors. Significant debate has followed regarding the potential parameters and scope of such a duty. Recently, the Securities Industry and Financial Markets Association (“SIFMA”), a lobbying group for large broker-dealers, proposed a framework for a uniform fiduciary duty.

Although SIFMA reiterated its support for such a standard, it also recommended against applying the fiduciary duty found in the Investment Adviser Act of 1940 to broker-dealers, stating that it would adversely impact “choice, product access and affordability of customer services”. Among other things, SIFMA proposed a new fiduciary duty for broker-dealers to accommodate broker-dealer conduct that would otherwise be in violation of the 40 Act.

In doing so, SIFMA recommended that, in its rulemaking, the SEC “provide the necessary rule-based guidance regarding when the fiduciary duty begins and ends and what disclosures and consents, if any, are necessary to satisfy the duty where a broker-dealer gives “advice involving principal trading, structured products, hybrid accounts, complex investment strategies, concentrated positions, and receipt of commissions and differential loads for different products.” To implement this standard, SIFMA proposed that it be articulated in the initial customer agreement. SIFMA also recommended that the fiduciary duty apply on an account-by-account basis.

By implementing a new fiduciary duty standard unique to broker-dealers, SIFMA believes that the SEC will properly take into account the distinctions in the law between registered investment advisers and broker-dealers while taking customer service into account. It remains to be seen if SEC heeds this call to action, or if the SEC simply rubbers stamps the 40 Act fiduciary duty standard to broker dealers.