COVID-19 Update: How We Are Serving and Protecting Our Clients.

Articles Posted in For Public Investors

Arbitration at FINRA has long been known as a quicker, more efficient alternative to court litigation of disputes eligible for submission to FINRA’s Dispute Resolution forum.  This continues to be true, to an even greater extent, during the COVID-19 pandemic.

Many courts at the federal and state levels, both in New York and across the US, have indefinitely suspended the filing of new nonessential cases during this time. Courts have also frozen the commencement of trials and the perfection of appeals in pending cases. And conferences, depositions and other in-person court appearances cannot take place where social distancing and large-group gathering guidelines are in effect. Thus, both new and pending court cases are in large part on hold until further notice, to protect the safety of parties, court personnel and the public.

At FINRA, however, the processing and handling of arbitration cases is primarily done electronically, with very little need for in-person contact until the final hearings on the merits. Even during the current unprecedented situation, parties can still file new cases at FINRA using the Dispute Resolution Portal, and can choose arbitrators and engage in discovery. Because FINRA arbitration does not allow for depositions except in extraordinary circumstances, the discovery process and exchange of documents and information can be done completely remotely and electronically, and without delay.  Parties or potential parties should be reassured that their new or already-pending cases will continue to be administered as they were before the current pandemic.

We are increasingly hearing from investors who say that their investment representative at their “self directed” broker dealer—such as T.D. Ameritrade—recommended an outside investment advisor who was not formally affiliated with the firm and incurred investment losses as a result.

There could be many reasons why this may happen: the investment representative may have a financial arrangement with the advisor, or a personal relationship, or even just trying to be helpful. However, this is a problem that is obviously foreseeable for such firms, and sometimes lands an unwitting investor with a fraudster.  In fact, such firms discourage their investment representatives from giving any investment advice because that can expose them bring to potential liability if the advisor or advice is unsuitable or fraudulent. Nevertheless, investment representatives sometimes make recommendations of outside unaffiliated advisors to their customers.  The question is can the firm be legally responsible if the recommended advisor’s strategy is not suitable or fraudulent. The general rule is that if an investment representative recommends that a customer use an outside advisor, or even brings such an advisor or her strategy to the attention of the customer, the firm may be liable in FINRA arbitration to the customer if the advisor/strategy is unsuitable or fraudulent and losses are incurred as a result.

Brokerage firms that use the self directed business model try to protect themselves by inserting language in their client agreements that purports to absolve them of such liability. However, FINRA frowns on brokerage firm attempts to insulate themselves contractually for liability resulting from breach by their registered representatives of industry rules, such as the suitability rule. In addition, at least one FINRA panel has awarded damages against T.D. Ameritrade in just such a case. https://www.finra.org/sites/default/files/aao_documents/18-01404.pdf

Mortgage REITs have often been recommended by brokerage firms as safe investments that generate consistent income.  However, during the recent market turmoil the bottom has fallen out for many Mortgage REITs.  For example, AGNC Investment and Annaly Capital are down over 50% in the last month or so, a way larger drop than the general equities markets.  Another Mortgage REIT, AG Mortgage, is down 75%.  Many of these mortgage REITs do not expect to be able to meet upcoming margin calls.

How did these mortgage REITs end up here?  Well, first of all, a REIT is a real estate investment trust which is a security that invests in real estate directly either through properties or in this case, mortgages or mortgage-related bonds.  The mortgage REITs listed above are publicly held and sold on exchanges. There are also what are called non-traded REITs which are often sold through broker-dealers and are not traded publicly.  Mortgage REITs invest and own property mortgages. They also loan money for mortgages to real estate owners, buy existing mortgages and purchase complicated MBS (mortgage-backed securities). Mortgage REITs generate revenue by collecting interest on the mortgage-related products.

As reported widely this week, the Mortgage REITs often fund themselves by pledging bonds in return for cash in the repo markets.  They are highly leveraged which in good times allowed them to pay dividends at higher yields than most bonds.  Brokers often recommend to investors to reach for yield in low yielding time periods and many brokers sold Mortgage REITs to investors without fully disclosing the risks associated with them.  In recent weeks, many Mortgage REITs found that the mortgage bonds they held dropped in value which triggered margin calls which then forced the Mortgage REITs to sell bonds into a falling market.

Margin call disputes often arise during times of market turmoil such as now.  Knowing what to do and whom to speak to when a margin call is issued is vitally important to an investor’s financial well-being.  Here is a little primer on what to do.

A margin call often occurs when the value of an investor’s margin account falls below the broker dealer’s required amount. A margin call is the broker dealer’s demand that an investor deposit additional money or securities so that the value of the account is brought up to the minimum value, which is known as the maintenance margin.  Some margin calls are small and an investor simply has to move securities in from another account or write a check to the broker.  However, in other situations, the acts by the broker dealer prior to the margin call being issued may have played a role in the margin call itself.

For example, a conservative investor often should not be holding any securities on margin at a brokerage firm.  If the firm recommended an unsuitable investment strategy that contained a significant amount of margin, and the market turned bad, and the investor sustained losses, said investor may have a potential FINRA arbitration claim against the broker.  In these situations, when a margin call is issued on the account, we highly recommend that the investor call a law firm such as ours who regularly represents investors in disputes with the financial industry.  It is paramount that the investor receives legal advice as soon as possible.  Most broker dealers have very broad powers in how to handle margin calls pursuant to onerous margin agreements.  The brokers sometimes even blow out investors’ portfolios without providing any notice (though they are supposed to exercise good faith in any decision they implement).  Time is usually of the essence.  It is important to have counsel engage with the broker dealer as soon as possible to potentially work out any issues.

Many firms, such as TD Ameritrade, Charles Schwab and Fidelity, whose business model includes or is tailored primarily to investors who want the benefits of a self-directed account also offer to introduce investors who wish independent investment advice to professional investment advisors who are technically “unaffiliated” with the firm.  Such investment advisors are often small SEC Registered Investment Advisors (“RIA”s) who are thinly capitalized and have supervisory systems that are well below FINRA broker dealer standards. The brokerage firms contract with such RIAs to be on their platforms and available to provide advice to customers that the firm introduces them to.   Those contracts are often designed to, among other things, insulate the brokerage firm from liability for investment advice given to the investor. This is so even though the brokerage firms vet such advisors, who become part of a “platform” they market to investors. Investors who are “introduced” by their firm to an RIA who will provide them investment advice may not realize that the firm’s position is that if the advice is inappropriate the RIA and not the firm is legally responsible.  Indeed, the firms structure their contracts with the customer as well as the RIA to give them this protection. Customers can be easily misled by such “introductions” into believing that the firm stands behind the RIA. Although the legal documents, couched in legalese, may so specify, the customer, who often does not read all the legalese in these documents, can be forgiven for believing that the firm that recommended the advisor and investment plan should have some responsibility if that advisor acts improperly. Investors at such firms need to know that they are taking a risk that if their firm recommended RIA gives them unsuitable advice they may be stuck suing a potentially judgment proof RIA in court (rather than the more cost effective FINRA arbitration).

In a move intended to emphasize that FINRA’s ultimate mandate is to protect investors, the SRO’s National Adjudicatory Council last week issued newly-revised Sanction Guidelines including tougher ranges of recommended punishments to be meted out against member firms or brokers who commit fraud or make unsuitable recommendations to customers.

Since 1993, FINRA has maintained and published “Sanction Guidelines” setting forth common securities rule violations and the range of disciplinary actions FINRA can issue for such violations, including monetary fines as well as suspensions, bars from the industry and other sanctions.

Specifically, the revised Guidelines, announced in Regulatory Notice 15-15 available on FINRA’s website at www.finra.org, contain revisions to the Sanctions relating to two specific areas: (i) fraud, misrepresentations or material omissions of fact; and (ii) suitability and the making of unsuitable recommendations to investing customers. According to the Notice, the ramped-up sanctions are meant to reinforce that fraudulent conduct is unacceptable, and that FINRA adjudicators on the Regulatory side should consider strong sanctions for such conduct, including barring or expelling repeat offenders, particularly where aggravating factors outweigh mitigating ones. With regard to unsuitability, the heightened punishments include an increase in the high-end range of suspensions from one year to two, as well as recommending bars, suspensions or expulsions for the most egregious recidivists.

What are non-traditional exchange-traded funds (ETFs) and non-traded real estate investment trusts (REITs)? Why are independent broker dealers selling these complex products without proper supervision? FINRA wants to know and just slammed LPL Financial for doing such a thing.

This week, FINRA censured and fined LPL $10 million for broad supervisory failures in the sale of complex products such as leveraged ETFs and non-traded REITS. It also ordered LPL to pay an additional $1.7 million in restitution to certain customers who bought non-traditional ETFs.

This is a watershed moment for these and other complex products. First, LPL has over 14,000 brokers nationwide and is by a wide margin the largest independent broker dealer in the U.S. (Lincoln Financial Network with over 8,000 brokers is second). The biggest independent broker-dealer getting hit like this by FINRA is the equivalent of FINRA fining the old Merrill Lynch in wire house terms.

Merrill Lynch was fined almost $20 million by the Financial Conduct Authority (FCA) in London for incorrectly reporting more than 35 million transactions from 2007 to 2014. Merrill Lynch didn’t report, at all, another 120,000 transactions. It’s the largest fine ever levied by the FCA for reporting failures. While this may not seem like a big deal to the investing public, it is. The proper reporting of transactions is a hallmark of the securities industry. Without it, during tumultuous times, investors will not have a perfect view of the trades that occurred in their portfolios. Indeed, for some of the transactions, Merrill didn’t identify the counterparties on trades. This is problematic for over the counter derivative investors because investors couldn’t ascertain counterparty risk on their trades and if the trades went bad, it would be impossible for the investor to know how to potentially resolve the issue. What’s worse is that the FCA had warned Merrill in 2002 and fined Merrill in 2006 for the same types of infractions. In today’s fragmented, digital marketplace, proper reporting is absolutely necessary. Let’s hope the record fine is a wake up to call Merrill and others.

Here is a New York Times piece on it.

http://www.nytimes.com/2015/04/23/business/dealbook/british-regulator-fines-merrill-lynch-19-8-million-for-reporting-failures.html?smprod=nytcore-ipad&smid=nytcore-ipad-share&_r=0

In what has become a hot issue this Spring, the Labor Department yesterday proposed a new set of standards for brokers who offer advice in connection with 401(k)’s and other retirement accounts. Currently, brokers are required only to recommend products that are “suitable” for investors, which permits the sale of products that earn the broker high fees. Reuters reports that the new standards will require brokers to put their clients’ best interests first ahead of any personal financial gain. The Labor Department proposal will require “best interest” contracts between brokers and investors.

Rich Intelisano and Katz LLP represents investors in FINRA arbitrations and other litigations against broker-dealers and other financial firms.

I noted in my March 20 post that the Chair of the SEC had just come out in favor of a rule requiring brokers to act in their clients best interests. While investors wait for the SEC to move forward on the issue, the New York City Comptroller, Scott Stringer, is proposing that New York State require brokers to disclose the present state of their relationship to clients – “I am not a fiduciary” and “I am not required to act in your best interests, and am allowed to recommend investments that may earn higher fees for me or my firm, even if those investments may not have the best combination of fees, risks and expected returns for you.” The Wall Street Journal posited that New York’s adoption of such a requirement could spur other states to impose similar regulations.

A recent report by the Public Investors Arbitration Bar Association (“PIABA”) shows why Stringer’s proposal is critical. U.S. News describes the PIABA report which contrasted brokers’ advertising campaigns with the legal positions taken by those brokers in litigation against their clients. For example:

• Ad: “It’s time for a financial strategy that puts your needs and priorities front and center.”

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