SEC & FINRA Warn Investors on Income Stream Products

The Securities and Exchange Commission (“SEC”) and the Financial Industry Regulatory Authority (“FINRA”) issued an investor alert concerning the risks involved when selling the rights to an income stream or investing in someone else’s income stream.  Investor alerts are statements issued by the SEC and FINRA seeking to raise public awareness about suspicious activities in the securities markets.  This particular investor alert can be viewed here.

Lori J. Schock, Director of the SEC’s office of Investor Education and Advocacy, stated, “Investors should always learn as much as possible before making an investment decision, and this is certainly true with respect to investing in pension or structured settlement income stream products.”  This particular invest alert was brought about because of the increased popularity of income stream products, and seeks to educate investors about inherent potential pitfalls in pension and settlement income stream products. 

One potential pitfalls include the high fees usually associated with these products.  Yet another is the fact these product may not be considered “securities” under US law and are likely not registered with the SEC.  Also, investors should consider the non-liquid nature of these products, as they may be difficult to sell in the event you need the capital you invested in the products. 

If you have purchased a pension or settlement income stream product and believe there has been suspicious activity surrounding your purchase, please contact the attorneys at Block & Landsman to discuss your legal options.

SEC Uncovers Deficiencies in how Investment Advisers Handle Custody of Clients' Assets

The Securities and Exchange Commission (“SEC”) recently published a new Risk Alert and Investor Bulletin regarding investment advisers’ handling custody of their clients’ assets.

According to the SEC, there are significant deficiencies in how investments advisers handle the custody of clients’ assets. Recent examinations of investment advisers have uncovered custody related issues in one out of three firms inspected. The SEC highlighted three areas of particular concern:

1) “Failure to recognize that they [investment advisers] have custody, such as situations where the adviser serves as trustee, is authorized to write or sign checks for clients, or is authorized to make withdrawals from a client’s account as part of bill-paying services;”
2) “Failure to meet the custody rule’s surprise examination requirement;” and
3) “Failure to satisfy the custody rule’s qualified custodian requirements, for instance, by commingling client, proprietary, and employee assets in a single account, or by lacking a reasonable basis to believe that a qualified custodian is sending quarterly account statements to the client.”

The investment advisers found to be deficient in the aforementioned areas were required by the SEC to change their compliance policies and modify their business practices. These are serious issues and serve to remind investors to remain vigilant in overseeing their investment accounts. 

Equity Indexed Annuities - Seniors At Risk

If you are an elderly investor looking for a conservative way to invest in the stock market, you should be aware of an Investor Alert recently issued by the Financial Industry Regulatory Authority ("FINRA") regarding the dangers of equity indexed annuities ("EIAs"). In contrast to the way they are often sold, EIAs are in fact complicated with confusing features that make them difficult to understand. As a result, they are often misunderstood to be solidly conservative investments.

An annuity is a contract between a purchaser and an insurance company that promises to make periodic payments. Annuities are either "fixed," meaning the insurance company guarantees the rate of return as well as the ultimate payout, or "variable," meaning that the rate of return varies with the performance of the investments (stocks, bonds) purchased within the annuity. Unlike fixed annuities, variable annuities carry the risk of loss if the underlying investments decrease in value. As a result, variable annuities are considered securities and are registered with the Securities and Exchange Commission ("SEC"). Fixed annuities escaped similar regulatory oversight due to a late amendment to the Dodd-Frank Wall Street Reform and Consumer Protections Act passed in July 2010, even though the stocks purchased within the fixed annuity remain subject to SEC regulation. As a result of this exeption, sellers of fixed annuities do not have to be licensed securities brokers.

EIAs have characteristics of both fixed and variable annuities because their value is dependent on the performance of the stock indices they track except they do not decline in value if held to maturity even if the underlying indices they track do decline. As a consequence, the returns vary more than a fixed annuity but less than a variable annuity with a risk of loss that is less than variable annuities but more than fixed annuities.

In the abstract, EIAs may seem to some investors to be an attractive middle ground between fixed and variable annuities. As FINRA describes them, however, EIAs are complex financial instruments that are not well understood by the general investing public. The gains that are linked to the performance of the underlying index is dependent on various features that an EIA uses. For example, insurance companies often limit the percentage of the stock index increases that is credited to the annuity. Moreover, some insurance companies add a spread/margin/asset fee which is subtrracted from any gain in the index linked to the annuity. Other EIAs place a ceiling on the amount of the annual return the annuity can gain. These an other features reduce the gains which EIAs can achieve. Therefore, conservative investors may not find these investments suitable.

EIAs not only limit the upside potential, they are structured to be long-term investments that carry significant penalties if the investor needs to withdraw his or her funds early. Investors who pull their money out of EIAs early may suffer losses that occurred in the underlying stock index. Such investors typically also face surrender charges that further add to the losses. Additionally, any investor who withdraws from tax-deferred annuities before the age of 59 1/2 are subject to a 10% tax penalty in addition to having any gain taxed as ordinary income.  As a result, elderly investors may question the suitability of EIA investments.

Strengthening Public Pension Funds by Attacking Investment Fraud

Public pension funds are under intense financial pressure because of concerns, real and imagined, about their potential inability to meet benefit payment obligations within a few years. Critics fling accusations that often appear more directed at assigning blame than in finding a remedy to relieve the concerns of the funds and, most importantly, the firefighters who benefit from the funds. Now, more than ever before, boards of trustees must evaluate all available options to discharge their fiduciary responsibility to protect public pension fund assets.

The good news, however, is that boards have concrete steps they can take to strengthen their funds' financial position by recovering investment losses caused by inappropriate investment strategies employed by outside investment advisers. Investment fraud by advisers is a scenario that has been all too common in recent years, and public pension funds are not immune from this danger. Between 2001 and 2009, aggrieved investors have filed, on average, nearly 6,500 securities arbitration claims per year against their brokers, a figure that increases by including investors who were able to pursue their claims in court rather than in arbitration. At any given time, pending arbitration disputes between investors and their advisers involve collective losses of more than one billion dollars. Public pension funds in Illinois, and across the country, have begun pursuing their own claims of investment fraud.

The Illinois Pension Code (the "Code") empowers trustees to invest fund assets in specific securities, and in allowable percentages, as defined by statute according to the size of the fund's net assets. Because investment decisions concerning these assets can be complex, the Code permits the board of any Article 3 or 4 pension fund to appoint an investment adviser for professional guidance. For funds seeking to invest in common or preferred stocks (available only to funds with net assets of at least $5 million), retention of an investment adviser is mandatory.

Pursuant to the Code, any investment adviser hired by a public pension fund is considered a fiduciary, imposing a heightened standard of care that requires the adviser to act in the best interests of the fund. The adviser must act only pursuant to a written contract with the board, and the contract must contain, among other things, an acknowledgement that the adviser is a fiduciary to the fund and will follow the board's investment policy which is based on the allowable investments identified in the Code.

Despite these statutory requirements, trustees, like any investor, can find themselves relying on the guidance of an investment adviser who provides inappropriate investment advice, and which results in significant investment losses. Where an investment adviser engages in wrongdoing that causes a fund to lose money, the trustees (who are themselves fiduciaries to their funds) may have a reason, and indeed an obligation, to investigate and pursue claims against the fund's adviser to recover those losses. Fortunately, the Code specifically provides the funds with a remedy for an adviser's misconduct. Section 114 provides that any fiduciary of a fund who breaches a fiduciary duty imposed by the Code "shall be" liable to a pension fund for any losses resulting from such breach. The Code also allows for additional remedies, including recapture of the adviser's profits and all other equitable or remedial relief that may be appropriate given the circumstances. Section 115 of the Code authorizes a board of trustees to bring an action against the investment adviser for such losses. Moreover, other statutory and common law causes of action exist to use for recover of these losses.

Understanding a fund's right to recover wrongfully caused investment losses, and deciding to act to protect those rights where appropriate, is becoming an urgent matter for public pension fund boards. Recent volatility in the securities markets has exposed the unsuitable nature of many investment strategies, but there are various time limitations that may be running which may restrict or eliminate a fund's ability to recover these losses if too much time passes before a claim is filed. Because the limitations periods which apply to any given investor depend on several factors, they should be discussed with an experienced attorney as soon as the board becomes concerned that investment losses may have resulted from inappropriate investments or strategies. Because trustees are themselves fiduciaries, and are required to act in the funds' best interests, they should not unduly delay their investigations into the causes of their investment losses.

Recovery of improperly caused investment losses can help strengthen the financial position of a public pension fund, and would allow the trustees to ultimately concentrate on the important tasks of caring for the health and well-being of the firefighters they serve. 

The Epidemic of Financial Abuse Against The Elderly in the United States

Senior citizens deserved to be protected against financial scams. And, like anybody who has been victimized by investment fraud, the elderly need the people who care for them to ensure that our nation's elderly do not have to deal with the devastating consequences caused by fraud. A pilot project initiated by Baylor College of Medicine trained physicians to detect elderly patients who were victims fo financial fraud and report their concerns to the state securities department. The project uncovered several instances of fraud, including one Ponzi scheme that raised $10 million from 130 investors and which resulted in a conviction for that fraudster

Mickey Rooney, the 90 year old legend who starred in more than 200 movies, exposed painful and embarrassing details of his personal life when he testified before a Senate panel that he was the victim of financial abuse. Rooney's testimony was offered in support of pending legislation called the Elder Abuse Victims Act, which would establish an Office of Elder Justice within the Department of Justice.

Financial abuse of senior citizens is serious problem. According to a study by Duke University, nearly 9 million Americans over the age of 71 are susceptible to financial exploitation because of cognitive difficulties ranging from mild impairment to Alzheimer's disease. Indeed, according to a wide-ranging study by the Investor Protection Trust ("IPT"), one in five elderly U.S. citizens have been victims of fraud.

The exploitation of seniors who are vulnerable to financial fraud is made more likely because the people closest to these victims -- their adult children -- are unaware of the dangers to their parents. For example, the IPT study found that 37% of elderly Americans are solicited to buy into one of several financial schemes. Yet, only 19% of all adult children believe that their elderly parents are the targets of fraudsters. In addition, only 5% of adult children who speak with their parents' physicians said that the healthcare providers expressed concern regarding their parents' ability to handle their own money. In contrast, nearly 20% of these same physicians reportedly raised concerns with these adult children about their parents' mental comprehension.

The combination of vulnerability and lack of family appreciation of the danger of elder financial abuse fuels the efforts of scam artists to target senior citizens. In response to this looming danger, the North American Securities Administrators Association ("NASAA"), in cooperation with IPT and various medical associations across the country, created the "Elder Investment Fraud and Financial Exploitation" prevention campaign intended to education medical professionals to identify seniors who are vulnerable to financial fraud and to refer suspected victims to the appropriate state securities departments. This program deserves the whole-hearted support of the medical community, securities regulators across the country, and family members of the elderly.

Supreme Court Widens Gap Between Investor Protection and SEC Enforcement

Is punishment an acceptable replacement for reparation? Is it sufficient fidelity to the securities laws for participants in a fraud to be prosecuted but not held accountable to the victims of their criminal behavior? According to the U.S. Supreme Court, the unfortunate answer is yes.

In a 5-4 decision handed down on June 14, 2011, the Court held that mutual fund investors do not have a right of action under Rule 10b-5 to parties other than the issuer for fraudulent disclosures of risk. The decision does mean that the other participants have not committed securities law violations. Rather, it merely shields them from liability for their conduct. As a result, the victims of the misbehavior by non-issuing parties are foreclosed from seeking compensation for their losses even if the perpetrators admit that they engaged in misconduct.

In Janus Capital Group, Inc. v. First Derivative Traders, the Court narrowed the application of Rule 10b-5, which makes it illegal for "any person, directly or indirectly. . .[t]o make any untrue statement of material fact" in connection with the purchase or sale of a security. In that case, shareholders in a Janus mutual fund sued Janus Capital Management LLC, the management company for the fund, in connection with alleged fraudulent disclosures in the fund's prospectus. The plaintiffs alleged that the management company participated in the preparation of the misleading prospectus, and was liable for their losses resulting from the fraudulent disclosures. In an impressive display of linguistic gymnastics, the Court focused on the meaning of the phrase "make any untrue statement" in Rule 10b-5. Rejecting the arguments of the investors as well as the arguments of the SEC itself, the majority adopted a restrictive definition of the phrase, limiting its reach only to those who had ultimate legal control over the content of the prospectus. Because the management company did not "issue" the prospectus, it cannot be held liable for the investors' resulting damages, even if the management company drafted the misleading disclosure that appeared in the prospectus. While they may be guilty, they are not responsible.

The Court's decision does not exonerate the non-issuing participants, and it does not inhibit the SEC's ability to bring regulatory enforcement actions against them for their misconduct. Instead, the Janus ruling is just the latest in a string of opinions by the Court that impede the securities laws from protecting the very investors for whose benefit the laws were enacted. 

SEC and FINRA Issue New Warning About Investing in Principal Protected Structured Notes

A type of high risk investment product that imploded with the economic meltdown in the Fall of 2008, leading to investors' losses of hundreds of millions of dollars, continues to concern securities regulators. The Securities and Exchange Commission (SEC) has joined with the Financial Industry Regulatory Authority (FINRA) to issue a joint Investor Alert to warn investors about complex financial products known as "structured notes with principal protection." While the name of this security suggests safety, the structured notes present a variety of extreme risks to uninformed investors.

The notes combine a zero-coupon bond, which pays no interest until the bond matures, with an option or other derivative product whose payoff is linked to an underlying index, benchmark or other asset. These notes are designed to return some of all of an investor's money at a set maturity date (which can be as long as ten years) and offer a potential interest payment linked to a predetermined change in the value of the underlying asset.

There are many risky variations of both components that make up the structured note product. For example, although some notes return the entire amount of an investor's principal at maturity, many return less than 100 percent. Moreover, the principal guarantee -- that investors will receive all or some of their principal at maturity -- is entirely dependent on the creditworthiness of the securities firm that structures and issues the note. If the issuer goes bankrupt -- as was the case with Lehman Brothers, which issued large volumes of these type of notes -- investors have no protection and become unsecured creditors of the defunct firm.

The potential upside benefit of being able to participate in an increase in the underlying assets is similarly subject to signficant risks depending upon how the note is structured. As a result, the issuer can limit the amount of interest it owes investors even if the note reaches maturity. The upside potential is linked to the performance of the underlying assets, which are not limited to common benchmarks such as the S&P 500 or the price of a single commodity. Rather, exotic cominbations of assets such as spreads between interest rates or baskets combining unrelated asset types such as an index, a commodity and a currency, are often chosen as the meaure of interest the bond will ultimately pay above the return of principal. The issuer can select unfavorable formulas to calculate the gains or losses linked the the performance of the underlying asset, so-called "market-linked" returns, which can limit the extent to which investors are allowed to participate in the underlying asset's gains. Additionally, the issuer can determine that only a portion of the underlying asset's gain is credited to the note, which has the effect of restricting the interest paid to the investor at maturity.

The unlimited variations to the structure of these complex financial products makes it difficult for typical investors to assess the true risks and benefits of the notes. For this reason, the SEC and FINRA issued their Investor Alert and provided a series of questions that investors should ask their advisers who recommend structured notes with principal protection, such as: (a) what is the level of principal protection offered, (b) describe any conditions to the principal protection, (c) what are the fees and costs, (d) are there limits to potential gains in the underlying asset, (e) what is the credit risk of the issuer, (f) what other risks are associated with the product, and (g) what alternative investments are available.

Complex risks often hide behind the safe-sounding structured notes, and investors should be wary of recommendations to invest without obtaining direct and clear explanations. Any investor who has lost significant monies in these type of structured notes should consider consulting with an investment fraud lawyer to determine any liability on the part of the financial advisor recommending the security.

FINRA Rules Inch Toward Holding Brokers Fully Accountable to their Customers

Later this year, the Financial Industry Regulatory Authority ("FINRA") will put in effect new rules of conduct that narrow the gap between brokers' duties and investors' expectations of their brokers' responsibility.

Many investors would be surprised to learn that licensed brokers generally do not owe a duty to act in the best interests of their customers. Instead, the duty of a broker to a customer with a non-discretionary account has been much more limited: only to recommend investments that are suitable in light of their client's objectives, financial needs and circumstances. This is true even where customers place exclusive reliance on their brokers and always follow their recommendations.

The Securities and Exchange Commission has approved new FINRA Rule 2111, an updated version of the old NASD Rule 2310 (Suitability) requires brokers and their firms to "have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based o n the information obtained through the reasonable diligence of the member or associated person to ascertain the customer's investment profile."

FINRA's new Rule 2111 expands a broker's responsibility toward the customer. While not reaching the level of requiring brokers to act in their customers' best interests, the new standard is an improvement in the protection of investors because it will explicitly cover situations that industry members have historically opposed. Specifically, the new suitability standard will no longer apply only to recommendations concerning the purchase or sale of a security. Rather, it now applies also to the recommendation of investment strategies. Additionally, the new rule directly applies the suitability standard to a broker's recommendation to hold a security, rather than just to purchase or sell a security. This expansion nullifies years of denials by brokers and their firms that a recommendation to "hold" a security constitutes actionable behavior. It recognizes the reality that investors sometimes refrain from executing a transaction on the advice and recommendation of their adviser.

The rule further explains the three primary suitability obligations of a broker. First, a broker must make a reasonable-basis suitability determination, based on reasonable diligence, that the recommendation is suitable for at least some investors. What constitutes "reasonable diligence," however, is undefined, and depends on a variety of factors such as the complexity, the risks and the rewards associated with the security or the investment strategy. Second, assuming the recommendation is suitable for at least some investors, a broker must then make a customer-specific suitability determination to ensure that the recommendation is suitable for a particular customer based on his or her investment profile. Finally, where brokers exercise actual or de factor control over a customer's account, they must have a reasonable basis for believing that a series of recommended transactions, even if individually suitable, are not collectively unsuitable for the customer. Factors relevant to this determination are turnover ratio, cost-equity ratio and the existence of short-term trading.

The new rule is undoubtedly an improvement over the former suitability rule, and will benefit investors in their interactions with their brokers, and in customer arbitration claims where their brokers have violated the rules. The benefits of the revisions, however, are mitigated by the new rule's limitations. For example, the rule leaves much ambiguity regarding the precise contours of a broker's obligations. Additionally  the duty is only triggered by a "recommendation" of the broker, as opposed to an adviser acting under a fiduciary duty, who in required in all respects to provide guidance in the client's best interests. While the regulatory trends appear to favor protecting investors, much work still needs to be done, and investors must remain vigilant to ensure their advisers are recommending securities and investment strategies that are appropriate for their purposes.

Targets of Investment Fraud: Professional Athletes

Professional athletes are the targets of relentless efforts of investment advisers who engage in fraudulent financial advice. According to a 2008 survey conducted by Sports Illustrated, 78% of former NFL players have gone bankrupt or are under financial stress by the time they have been retired for two years. The same survey found that 60% of former NBA players are broke within five years of retirement. Major league baseball players are also not immune from fraudsters, and dozens of players have filed lawsuits in the past several years seeking tens of millions of dollars in investment fraud losses.

Laurence Landsman, a partner in the Chicago law firm Block & Landsman, has published an article on the problem of athletes who face the devastating effects of financial fraud. The article, which was published by the National Sports Law Institute at the Marquette University Law School, discusses several examples of athletes being defrauded by trusted advisers, and explores how the scams successfully lure unsuspecting athletes.

Athletes are targeted for financial fraud because of their youth, inexperience in investment matters, and the large sums of money they earn. Last year, players on NFL rosters earned a collective $3.3 billion in salaries, with an average of $1.8 million in earnings per player.

Mr. Landsman's article explains how fraudsters use current or former players, who are often victims themselves, to lure their teammates into investment scams that promise large returns that are, in reality, impossible to be achieved. The article also looks into the ineffective effort by the National Football League Players' Association ("NFLPA") to create a program to deter financial fraud against players.

Budget Cuts Put Illinois Investors At Risk

Illinois investors will soon find themselves a little further out on the limb of self-reliance in the fight against investment fraud. Under the Dodd-Frank Wall Street Reform Act, enacted by Congress last year, state securities regulators are required to assume responsibility to oversee investment advisers who manage between $25 million and $100 million in assets, which previously was in the purview of the Securities and Exchange Commission ("SEC").

Unfortunately, this increase in responsibility is not being supported with an increase in funds to the Illinois Department of Securities ("IDS"), the regulator responsible for protecting investors against fraud in Illinois. To the contrary, according to reports, the current financial challenges facing state governments is causing the the director of the IDS, Tanya Solov, to submit a funding request for the next fiscal year less than the $12.4 million in funding for the present year. The greater responsibilities placed on the department's shoulders requires additional staff, and Ms. Solov plans to add three examiners and one attorney to her team. These staff additions, however, will cause the department to forego new computer equipment and choose other cost-saving measures that may be a drag on the Department's ability to effectively meet the challenges of its expanded responsibilities.

The IDS mandate focuses on regulating financial advisers and bringing enforcement actions to stop those who violate Illinois securities law. In that capacity, the agency is recognized throughout the state as a proactive and effective advocate for Illinois investors. But the pressure facing the regulatory agency of an increasing workload under the serious budget constraints means that investors need to be more diligent than ever in protecting their financial future. This means that investors must research their advisers' background by contacting the Investment Advisor Registration Depository("IARD"), the Financial Industry Regulatory Agency ("FINRA") and the IDS to find out what licenses their adviser holds, if any claims have been made or are pending against the adviser, and whether the adviser has been subject of any regulatory discipline. While important, this type of due diligence is no guarantee against investment fraud, and Investors who suffer losses because of misconduct by their adviser need to consider retaining a securities attorney to review their litigation options.

The IDS remains an important tool in the fight against fraud, but investors would be well-advised to actively join that fight in their own best interests.

Victory for Investors - Securities Arbitration Now Offers All-Public Arbitrators

In a long-sought victory for investors, the Securities and Exchange Commission ("SEC") has approved a proposal by the Financial Industry Regulatory Authority ("FINRA") that arbitration panels, which decide investor claims of broker misconduct, no longer are required to include an arbitrator who is a member of the financial industry. For the first time since the U.S. Supreme Court allowed brokerage firms to require investors to arbitrate disputes, investors will have a choice of selecting an all-public arbitration panel.

For years, investors and their advocates have complained that the presence of an industry arbitrator on panels creates an unfair bias in favor of the industry members who are accused of wrongfully causing investment losses. Brokerage firms have long resisted any changes to the use of the industry, or non-public, arbitrators who, the firms claim, are better able to understand the standards that they are required to follow.

Although some disputes may be appropriate for selection of an industry arbitrator, investors will now be permitted to choose the the make-up of the arbitrators who will decide their cases.

As a result, the playing field is becoming even for investors who pursue arbitration claims for investment fraud.

Ponzi Scheme Victims - All May Not Be Lost

Common wisdom says that victims of Ponzi schemes will never see their investment monies again. In most cases, that is likely true. But not always, and victims should be aware that sometimes they may have viable remedies to recover some or all of their losses.

The problem is enormous. Ever since the $50 billion Ponzi scheme masterminded by Bernard Madoff exploded two years ago, securities regulators have become more vigilant in pursuing these illegal investment scams. All of a sudden, we seem to be inundated with the disclosure of new Ponzi schemes nearly every week. According to a recent analysis conducted by the Associated Press, 150 Ponzi schemes collapsed in 2009, nearly four times the number that fell apart the year before, resulting in losses to victims of more than $16.5 billion. The Securities and Exchange Commission ("SEC") issues 82 percent more restraining orders against Ponzi schemes and similar securities fraud cases in 2009 as compared to 2008, and the FBI has opened more securities fraud investigations than ever before. Once the final statistics for 2010 are available, there is no reason to believe they will show any improvement.

Any victim of securities fraud faces potentially devastating losses. For investors who lose money due to the misconduct at brokerage firms, the opportunity to recover their losses through arbitration exists. Because most Ponzi schemes are run by fraudsters unaffiliated with brokerage firms, the collapse of these schemes often leaves victims with no recourse.

Recovery of losses, however, is not always out of the question. In 2010, the investment fraud lawyers at Block & Landsman were hired by a couple who were victimized by a woman who is now imprisoned in a federal penitentiary for operating a massive Ponzi scheme. The fraudster represented to our clients that her firm was selling interests in a bond yielding 8% interest and that they could pull their money out any time they wanted. The investors believed these promises and wire transferred their investment to a bank where the schemer said the money needed to be deposited. As soon as the transfer was complete, however, the fraudster withdrew the funds and used them for personal expenses. Although the investors soon discovered the fraud, their money was already gone, and they felt all was lost.

Fortunately for our clients, they may find relief. The bank they transferred their money to has an affiliated brokerage firm. The woman now in prison used to be registered as a broker with that brokerage firm, until she lost her securities broker license for stealing money from a customer's account. Despite this background, the affiliated bank allowed her to open numerous accounts on behalf of others in her capacity as a financial adviser, ignoring the many red flags that she was continuing her criminal enterprise.

FINRA Arbitration Statistics - Closing the Book on 2010

The Financial Industry Regulatory Authority ("FINRA"), which provides the arbitration mechanism for resolving securities disputes involving investment fraud, has published its 2010 arbitration statistics. The results show a gradual, very gradual, trend that may be favoring investors.

Investors filed 5,680 arbitration cases in 2010. Although this number is twenty percent less than the number of arbitration cases filed in 2009, it is the second largest annual figure in the past five years, representing a general increase in the number of investors who are claiming losses due to broker misconduct. The majority of cases filed in 2010 involved claims for breach of fiduciary duty and misrepresentations involving common stock and mutual funds, although a significant number of cases involved annuities and bonds as well.

2010 did not just usher in an increased number of new arbitrations. A large number of cases (6,241) were closed during that year as well, which is a result of the increased filings in 2009 following the near collapse of the financial markets in the Fall of 2008. These statistics follow a general pattern regarding an uptick of arbitration activity following major market downswings, although these figures did not quite reach the record number of cases filed on the heels of the tech bubble burst early in the decade.

Of the cases closed in 2010, 22% were resolved by hearing or decided just on the submission of documents, and 62% were settled through mediation or through direct discussions between the parties. This is fairly consistent with method of case resolution seen in prior years.

Notably, 47% of all customer cases decided by arbitration resulted in an award of damages in favor of the investor. This statistic requires a significant asterisk: it includes the award of any dollar amount in favor of the customer, regardless of how little it is compared to the amount of the claimed losses. Even with that qualification, the 2010 results confirm that the percentage of victories for investors is gradually trending upward; in 2007, only 37% of customer claims received an award in favor of the investor. Indications remain, however, that arbitration presents significant undue challenges to investors by failing to provide a level playing field.

Arbitration statistics over the next two years will shed light on the impact of important changes that FINRA is implementing to its arbitration procedures. Among the most significant changes is the elimination of the industry arbitrator for claims involving more than $100,000. Additional improvements, such as making arbitration voluntary rather than mandatory, are likely in the wake of SEC action pursuant to the requirements of the recently enacted Dodd-Frank Act. Whether such changes impact the results of arbitration hearing is a question that investors and industry members will closely watch.

If you believe your investment losses may have been caused by fraud or broker misconduct, call the investment fraud lawyers at Block & Landsman for a confidential consultation. Please visit our website for more information.

Federal Task Force Diagnosis Financial Fraud Epidemic in U.S.

Last month, Attorney General Eric Holder announced the results of Operation Broken Trust, a nationwide operation organized by the Financial Fraud Enforcement Task Force to target investment fraud. According to these results, investment fraud is a virus that has infected our system of finance so thoroughly that no investor is immune from its opportunistic attacks.

The task force is a coordinated effort by the U.S. Department of Justice, the Securities and Exchange Commission, the Internal Revenue Service, the U.S. Postal Inspection Service and the U.S Commodity Futures Trading Commission, to lead an aggressive and proactive effort to investigate and prosecute financial crimes. During its initial three-and-a-half month effort, beginning on August 16, 2010, the task force initiated 211 criminal cases and 60 enforcement actions involving fraud schemes that defrauded more than 120,000 victims. The calculated losses of these victims: $10.5 billion.

The vast scope of financial fraud revealed by the task force's preliminary efforts is shocking, but should not be surprising. Such schemes have flourished for generations in the absence of meaningful efforts to curb their growth. It has been reported, for example, that the FBI slashed its financial fraud work force in the wake of the September 11, 2001 attacks in order to concentrate on terrorism investigations, a necessary focus that had the consequence of leaving victims of fraudsters to fend for themselves. The resulting wild west atmosphere allowed investment schemes to mushroom. Time and again, the task force broke up multi-million dollar scams that had been successfully operating for years without the threat of meaningful criminal or civil liability.

The schemes themselves are wide-ranging, but pursue a singular goal. According to one task force member, "the operators of these schemes often promise high returns to investors, but engage in little to no legitimate investment activity. Such schemes include Ponzi schemes, affinity fraud, prime bank/high-yield investment scams, foreign exchange frauds, business opportunity fraud, and other similar schemes."

Victims of investment fraud should not merely rely on efforts of governmental agencies to seek retribution. Investors who have lost money due to investment fraud can, and should, pursue their own rights. The investment fraud lawyers at Block & Landsman can help evaluate investors' claims of investment fraud and pursue lawsuits or arbitration proceedings that seek to recover their losses. If you would like to consult with the investment fraud lawyers at Block & Landsman, please visit our website for more information.

The SEC Is Poised To Add Necessary Investor Protections

In an article recently published, Larry Landsman, partner of Block & Landsman, discusses major reform that is coming to the rules governing the broker-investor relationship. On July 21, 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in response to the 2008 financial meltdown in the U.S. economy. Among the many challenges the statute is intended to address are long-simmering battles concerning the relationship between brokers, broker-dealers and their customers. After protracted clashes between investor advocates and industry representatives, the Dodd-Frank Act has authorized the SEC to engage in rule-making that will overhaul the securities laws in ways long sought by investors. 

Soon brokers will be held to higher standards of care toward their clients, and investors will have access to greater protections where brokers have breached their standards of care.

This post will address the revised standard of care they brokers may be held to. In a later post, I will explore the changes expected in the arbitration proceedings used when an investor has a claim of wrongdoing against a broker. In both instances, the changes will offer greater protections to the investor against historical abuses that have been hotly disputed for years.

1. Brokers' Owe Limited Standard of Care to Investors

Under current law, brokers are required to adhere to relatively lax standards of care as compared to investment advisors whose conduct is governed by the Investment Advisors Act of 1940. Brokers, who are regulated by the Financial Industry Regulatory Authority ("FINRA") are required only to recommend investments that are "suitable," meaning that a broker need only have a reasonable basis to recommend the security in light of the client's investment objectives and financial circumstances. Investment advisers, on the other hand, must abide by a more stringent fiduciary standard of care which mandates a duty of loyalty and obligates them to act only in the best interests of their clients. The principal distinction is that brokers need not put the clients' interests ahead of their own, while an investment adviser must. The Dodd-Frank Act is poised to eliminate this difference.

From the investor's perspective, it is difficult to discern that the "advice" given by brokers is held to a lesser standard than that given by investment advisers. In a 2008 study commissioned by the SEC, the Rand Corporation found that the roles of brokers and investment advisers are confusing to investors, who are not clear about their respective legal duties. Indeed, a majority of participants erroneously believed that both brokers and investment advisers were required by law to act in the client's best interest and to disclose any conflicts of interest. The study found that investors were confused on key distinctions between investment advisers and brokers -- their duties, the titles they use (brokers often designate themselves as "financial consultants" or "financial advisors") or the services they offer.

2. The SEC Is Poised To Add Necessary Investor Protections

The difference in these standards of care has a significant impact on investors. The obvious effect is in the propriety of the securities in an investor's portfolio -- whether or not thy were selected in the bests interests of the client. Fortunately for the investor, the confusion regarding the scope of a broker's duties may soon be eliminated. The Dodd-Frank Act empowered the SEC to determine the existence of, and correct, any deficiencies in the broker's standard of care as compared to the fiduciary duty governing investment advisers' conduct. Indicates are that the SEC will do just that. The Rand report mentioned above found that current securities laws and regulations are based on distinctions between brokers and investment advisers that date back to the early 20th century, "and that these distinctions appear to be eroding today." 

Additionally, the Chairperson of the SEC, Mary Schapiro, recently recognized that "investors who turn to a financial professional often do not realize there's a difference between a broker and an adviser -- and that the investor can be treated differently based on who they're getting their investment advise from." Ms. Schapiro further advocated that the only duty owed to investors flow "from the perspective of the investor we are seeking to protect" rather than "from the perspective and legal regimes of the adviser or broker." Given this background, Ms. Schapiro has advocated a uniform fiduciary standard and is "pleased" that the new legislation gives the SEC the authority to implement it.

While the SEC Chairperson's position does not constitute an official decision by the Commission, it is apparent that there is clear support to equalize the standards of care of brokers and investment advisers, and rules achieving that goal can be expected to be implemented. Such a result will provide significant protections to investors by making their interests the controlling concern for any financial adviser.

In my next post, I'll discuss the changes we can expect in the arbitration process when investors believe their brokers engage in misconduct.

The investment fraud lawyers at Block & Landsman concentrate their practice in the area of securities arbitration and securities litigation. Please visit their website for additional information.

New Investor Protections Are On The Horizon, Part II

The Dodd-Frank Wall Street Reform and Consumer Protections Act ("Dodd-Frank Act") is intended to spawn regulations that will significant alter the arbitration landscape for investors who are victims of securities fraud. Currently, securities firms uniformly require investors to sign mandatory arbitration agreements when opening a brokerage account, a result of the U.S. Supreme Court's 1987 decision in Shearson/American Express v. McMahon that firms were entitled to mandate that all investor disputes be resolved through arbitration. The vast majority of securities disputes between investors and brokers are arbitrated through the dispute resolution forum maintained by the Financial Industry Regulatory Authority ("FINRA").

1. Securities Arbitrations Involve $1 Billion Per Year in Investment Losses

Securities arbitrations involve, collectively, enormous sums of money. Between 2001 and 2009, aggrieved investors filed, on average, nearly 6,500 arbitration claims per year against brokerage firms. According to an in-depth analysis of investor arbitration proceedings sponsored by the Securities Industry Conference on Arbitration, more than 65 percent of the investor arbitration claims that were studied sought damages in excess of $100,000. Thus, at any given time, FINRA is responsible for ensuring the fair adjudication of claims for alleged investment fraud responsible for losses exceeding one billion dollars. It is, accordingly, no surprise that investors as well as industry participants have a vested interest in the significant changes to the rules governing these disputes that will be ushered in by the Dodd-Frank Act.

2. The Rules Governing Securities Arbitrations Disadvantage Investors

The stated goals of the existing securities arbitration framework are to streamline and make more accessible the dispute resolution process. To be sure, the arbitral forum in its present state offers concrete benefits to investors and industry participants alike. For example, statements of claim need not satisfy the pleading requirements applied to complaints filed in court, and respondents are precluded, with limited exception, from filing motions to dismiss.  Additionally, the rules of evidence which govern courtroom trials do not apply to FINRA arbitrations, thereby allowing the parties greater flexibility to present information they believe relevant to their case. Moreover, arbitration awards constitute a final resolution of the dispute, as the bases to appeal the arbitrators' decision are severely restricted by federal and state statutes.

The benefits, however, come at significant monetary and strategic costs which are disproportionately borne by members of the investing public. For example, the cost of bringing a FINRA arbitration proceeding can be prohibitively expensive to an investor compared to the relatively well-funded brokerage firm. In a claim seeking more than $100,000 in damages, an investor faces fees of thousands of dollars regardless of the outcome -- significantly more than the cost of filing a lawsuit. Investors also face substantial costs of retaining expert witnesses to testify on issues of liability and/or damages, whereas respondent brokerage firms often rely on the testimony of employees rather than outside experts to provide such evidence.

Investors face extremely limited ability to obtain discovery in arbitration, which poses a great disadvantage against brokerage firms that have far superior understanding of their inner workings and have unilateral access to all employees who can explain to respondents' attorneys how and why certain actions were taken.

Perhaps the most controversial aspect of FINRA arbitration procedures is the existence of the "industry" member on the three-arbitrator panels for all cases seeking damages in excess of $25,000. The vast majority of FINRA investor disputes are decided by a panel that includes one arbitrator who has significant ties to the securities industry in addition to two "public" arbitrators. Investor advocates strenuously object to the perceived unfairness of the "industry" arbitrator deciding these claims while securities organizations dispute the presence of any resulting pro-industry bias.

3. The Inequities of the Current Arbitration System Have Advsersely Impacted Investors

The impact of such disparate burdens on investors in arbitration is subject to much debate. It is indisputable, however, that as arbitrations have become more expensive, time consuming and dependent on courtroom-style litigation tactics, the success rate for investors has declined. Between 1997 and 1999, investors won between 56 percent and 59 percent of arbitration claims that proceeded to a hearing. Ten years later, investors are faring far worse; between 2007 and 2009, claimants won between 37 percent and 45 percent of hearings. Even these figures inflate the true success rate for claimants because FINRA records any award in an investors favor, regardless of amount, as a "win." For example, as reflected in the SICA report on securities arbitration, 5.3 percent of the investor "wins" it studied returned an award to the claimant of less than 1 percent of the amount claimed to have been lost.

4. Dodd-Frank Should Level The Playing Field for Investors in Arbitration

The Dodd-Frank Act is poised to level the playing field to litigate disputes with brokers. It gives the SEC broad authority to prohibit or limit the use of mandatory arbitration agreements, and to design a dispute resolution mechanism that satisfies the demands of investors for more fairness as well as the desire of industry participants to arbitrate rather than litigate in court.

The SEC should not prohibit arbitrations. The procedure does provide benefits to all parties that are not available in a court of law. Investors, however, should be given a meaningful and voluntary opportunity to choose arbitration. The arbitration option cannot exist without revisions to the rules in order to assuage investors' legitimate concerns regarding fairness. If substantive reforms addressing such inequities are enacted, investors should be more willing to exercise their choice to arbitrate disputes rather than go to court. Indeed, even though the SEC has yet to act, Dodd-Frank has already ushered in a significant benefit to investors in arbitration. On October 26, 2010, FINRA filed with the SEC a proposed rule change to permit investors with claims of more than $100,000 to select three member arbitration panels that do not include the contentious "industry" arbitrator.

While the elimination of the "industry" arbitrator is a substantive step toward fairness, the SEC will have to consider additional measures to reverse the existing bias against investors to make arbitration a viable alternative. Such changes should allow investors greater access before an arbitration hearing to evidence in the exclusive possession of respondent, should prevent well-documented discovery abuses by brokerage firms in arbitration, and should establish burdens of proof to end the need for expensive expert witnesses who are more appropriate to a courtroom trial than an arbitration hearing.

The investment fraud lawyers at Block & Landsman concentrate their practice in the area of securities arbitration and securities litigation.