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EVALUATING INVESTOR CASES

 ARBITRATION

 CONTROL PERSON LIABILITY

 ATTORNEY’S FEES

 DAMAGES

 POINTS OF ANALYSIS AND DETERMINATIONS

 

                  Before even evaluating the case for the investor, it is important to determine if the time was right for a growth investment to have been made in the first place.  A critical ratio I always use is what I call the Market Investment Ratio.  At the time of the investment It combines the current U.S. inflation rate, the U.S. Unemployment Rate and the S & P 500 P/E Ratio (based on 24 mos. of trailing earnings).  From 1930 to the present time, the ratio has averaged 26.7% (median through 2013). When the ratio is below that percentage, history has shown that it has been a good time for growth investing.  For example, the S&P 500 has produced an average annualized return of 14.6% following indicator readings below that median, assuming dividends are reinvested.  By contrast, the S&P has returned just 4.7% annualized, on average, whenever the indicator is above that median.  Clearly, when the ratio has climbed above that ratio in the past, the results have been less than favorable.  When this happens, growth investments should be examined much more carefully since warning signs are on the horizon.  As of 9-23-13, the Ratio looked like this:

     U.S. Inflation Rate           1.50%

     U.S. Unemployment Rate 7.30%

     S & P 500 P/E Ratio      19.41%

                           Total        28.21% (Market Investment Ratio)

                    Since the ratio is above the historical average, my advice would be to tread slowly with growth investments for the present until the ratio improves and provides a spread below the historical average.  That spread provides a better opportunity for investment growth.

A. Client Analysis

•  Age/education/health

•  Income/source

•  Total net worth/liquid net worth

•  Investment experience

•  Investment objectives

•  Determine investors risk tolerance

•  Types of accounts and quantity

•  Any accounts with other bkge. firms

•  Margin, options or other features

•  Tenure of accounts

•  Date of last statement

•  Commission to equity ratio & cost to equity ratio (comp. to a low load M/F)

•  Turnover in account

•  Any Penny Stocks (Priced under $5 and not traded on an exchange)

•  Is a Penny Stock Disclosure form signed by client

•  Are mutual funds being switched

•  Are mutual fund shares A, B or C type

•  Determine broker’s basis for investment recommendations

•  Are the trades solicited or unsolicited

•  Does the client routinely follow the brokers advice and recommendations (de-facto broker control)

•  Does a third party have discretion

•  Concentration of speculative security(s) as a % of liquid net worth

•  Activity letters sent to client (were they negative consent type)

•  Evidence of communication between A/E and client i.e. E-Mail/letters

•  How diversified is the portfolio

•  Are insurance policies being replaced

•  Are variable annuities being sold to the elderly; within an IRA

•  Are stocks being held for term or traded actively

•  Are all trades authorized prior to trade execution

•  Did the client ratify the brokers’ activities

•  Did the client do anything to mitigate damages

•  Do the tax returns support the clients information

•  How does the client keep track of the brokers activities

•  Are any conversations between client and broker tape recorded

•  Were firm research reports or materials provided to the client

•  Were “Dealer Use Only” materials provided to the client

•  Were prospectuses receipted for by the client, prior to the trade

B.  Broker Analysis

•  All names used by broker/education/years in business

•  CRD information

•  State Securities Commissioners’ information if any

•  Any complaints on file at the firm

•  Any indication of discipline by firm or regulators

•  Is the account set up on a fee or commission basis or both

•  Is the broker an RIA or Associate RIA through the firm

•  Does the broker have any financial planning designations such as CFP or IARFC

•  Did the broker do a financial plan on the client

•  Percentage of clients assets under mgmt. by broker

•  Specific client investments

•  Incentives for broker to sell proprietary products i.e. trips or extra commissions or extra sales credits

•  How did client and broker meet one another

•  Does the broker tailor products to the client or provide the same to all

•  Has the broker ever had “special supervision”

•  Does the broker engage in activities outside the brokerage firm

•  How does the broker rank in sales within branch and B/D

•  Does the broker keep notes of meetings and trades with clients

•  What specific documents did the broker ask for to “know his customer”

•  Did the broker determine if the client could afford, understand and/or tolerate the risk

•  Was the new account form in the brokers handwriting

•  What % of the brokers’ business is in proprietary products

•  Did the broker diversify the client choosing products from different asset classes, different stock exchanges and differing holding periods

•  Did the broker provide a copy of the new account form to the client

•  Did the broker provide firm research reports or “dealer use only materials” to the client

•  Did the broker report any trades to be unsolicited

•  Did the broker continue to monitor the account and communicate with the client after the initial products were sold

•  Does the broker buy any products sold to client

•  Does the broker’s family buy products from the broker, sold to client

C. Supervision Analysis (Broker-Dealer and Branch Office Mgr.)

•  CRD information

•  State Securities Commissioner information

•  Does the firm consider the broker to be an employee or independent contractor.

•  What does the independent contractors’/employee agrmt. say

•  What is the chain of command in the compliance dept.

•  What is the structure of compliance i.e. active account report generation

•  How many employees are in the broker’s branch

•  How does the branch rank in terms of total production

•  Is it a satellite or office of supervisory jurisdiction (OSJ)

•  Did the Branch Office Mgr. ever talk with or write the client

•  Is there any oversight or review by peers as a disciplinary tool

•  Does the Broker-Dealer provide unannounced branch audits

•  Does the Broker-Dealer have a Compliance Review Committee

•  Does the Broker-Dealer provide annual compliance reviews

•  What does the branch office manager’s supervision show

•  What do the compliance and supervision manuals show

•  Does the Broker-Dealer have an approved product list

•  Were all products sold on the approved product list

•  Did the Broker-Dealer do research on the company’s represented by the securities sold

•  Is there a complete due diligence file on each security sold

•  Was the Broker-Dealer an Underwriter, Principal or Market Maker in the securities sold

•  Does the Broker-Dealer offer a variety of products to be sold by brokers

•  Does the Broker-Dealer offer a number of proprietary products for sale

•  Does the Broker-Dealer offer any special incentives for these products

•  Did the Broker-Dealer rate and rank the securities in question

•  How does the Broker-Dealer check or measure the accuracy of new account information taken by the broker on the new account form

•  Does the firm require receipts for prospectuses mailed to clients

•  How does the Broker-Dealer measure if the broker is meeting the clients investment objectives

•  How does Broker-Dealer monitor receipt of activity letters

•  How does the Broker-Dealer measure if its brokers are disclosing all material facts and avoiding material omissions about the securities that are sold to clients

 INVESTOR’S GUIDE TO

SECURITIES INDUSTRY DISPUTES

How to Prevent and Resolve

Disputes with Your Broker

PUBLISHED BY THE PACE LAW SCHOOL INVESTOR RIGHTS CLINIC

EDITORS:

Professor Jill Gross, Director and Supervising Attorney, Pace Investor Rights Clinic

Alice Oshins, Esq., Staff Attorney, Pace Investor Rights Clinic

Generously funded with a grant from the FINRA Investor Education Foundation

This Investor’s Guide has been authored and published by

attorneys with the Pace Investor Rights Clinic (PIRC), a legal

services organization affiliated with Pace University School of

Law. PIRC offers free legal services to eligible individual

investors who have disputes with their securities brokers and

brokerage firms. PIRC aims to protect the rights of individual

investors, particularly investors of modest means who

traditionally have been underrepresented in the legal system.

This Guide is made possible by a grant from the FINRA Investor

Education Foundation. The Foundation supports innovative

research and educational projects that give investors the tools they

need to better understand the markets and the basic principles of

saving and investing. For details about grant programs and other

FINRA Foundation initiatives, you may visit

www.finrafoundation.org.

Caution: The descriptions of the securities laws and rules,

including FINRA’s rules, contained in this booklet are not intended

to be comprehensive. For completeness and accuracy, investors

should refer to the text of those laws and rules.

This guide contains legal information, not legal advice. This guide

is not intended to provide, nor should it be construed as providing,

legal or investment advice in any particular matter.

For legal advice, please consult a licensed attorney in your area or

call your local bar association for a referral to an attorney. For

more information on finding an attorney experienced in securities

mediation or arbitration, please read the section of this booklet on

“How to Find an Attorney.”

For investment advice, please consult a licensed and registered

investment professional.

©Pace Investor Rights Clinic and FINRA Investor Education Foundation

This Guide is distributed in cooperation with the American Bar

Association Section of Dispute Resolution.

INTRODUCTION

PART I Page

Avoiding Disputes: Investor Rights and Responsibilities

What are my top ten responsibilities as an investor? . . . . . . . . . . . . . . . 1

What are my broker’s duties to me as a customer? . . . . . . . . . . . . . . . . 6

How can I address problems that may arise with my investments? . . . . 8

How can I find an attorney to assist me? . . . . . . . . . . . . . . . . . . . . . . . . 9

PART II

Resolving Disputes: The Arbitration Process

What is arbitration? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

Why arbitration? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Is there a deadline for filing an arbitration?

What do you file?

What happens after a claim is initiated? . . . . . . . . . . . . . . . . . . . . . . . 14

Can I change the Statement of Claim after it has been filed?

 What are counterclaims, cross-claims and third party claims? . . . . . . 15

What happens when a respondent does not file an Answer?

How are arbitration fees determined?

How many arbitrators serve on an arbitration? . . . . . . . . . . . . . . . . . . 16

Who is your arbitrator?

How are the arbitrators selected? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

What is Simplified Arbitration? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

What are Motions?

What is the Initial Prehearing Conference?

What is Discovery? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

Where does the hearing take place? . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

What happens at the hearing? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

When do the arbitrators decide the case?. . . . . . . . . . . . . . . . . . . . . . . 22

What is contained in an arbitration award? . . . . . . . . . . . . . . . . . . . . . 23

How can I collect on an award or settlement? . . . . . . . . . . . . . . . . . . . 24

PART III

Resolving Disputes: The Mediation Alternative

What is mediation?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

Why should I agree to use mediation?

Can parties agree to mediate and arbitrate the same dispute? . . . . . . . 26

What fees must I pay? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

What takes place during the mediation process? . . . . . . . . . . . . . . . . . 28

CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Table of Contents

Introduction

The Pace Investor Rights Clinic produced this Guide to

Securities Industry Disputes for the individual investor

who hopes to prevent or may already have a dispute

with his or her securities broker. Our goal is for

investors to learn more about their legal rights and

responsibilities before a dispute arises and to gain an

understanding of their options in case a dispute does

arise. We hope that informed investors will be better

able to prevent misunderstandings with their broker as

well as identify and resolve legitimate grievances.

The first section of this Guide covers investors’ rights

and responsibilities, tips on how to research

brokerage firms and brokers, and brokers’ duties to

their customers. The second section will take you

through the arbitration process, including when

arbitration is appropriate, procedural requirements,

fees, and what to expect at the hearing. The third and

last section focuses on an increasingly popular

alternative to arbitration – mediation.

This Guide can also assist individual investors

representing themselves (“pro se” investors) by

providing a foundation in the basic rules and

procedures in arbitration and mediation.

Note: A resource available to both attorneys and

parties to arbitration is the staff of the Financial

Industry Regulatory Authority (FINRA). FINRA,

formerly known as NASD, is the largest nongovernmental

regulator for all securities firms doing

business in the United States. FINRA also operates the

largest securities dispute resolution forum in the world

and offers arbitration and mediation facilities in 73

locations around the United States and abroad.

FINRA staff attorneys are neutral. They cannot offer

legal advice or opinions as to the probability of

success or failure of a particular claim or defense.

However, they can provide information about the

procedural requirements under FINRA’s arbitration

and mediation codes of procedure.

                                                                                  1

What are my top ten responsibilities

as an investor?

In order to protect your money and your investments, it is important

that you are aware of and carry out your responsibilities as an investor.

Responsible investing will help to protect you from unexpected losses

and avoid disputes with your broker. This section lists and details your

top ten investing responsibilities.

1.  Understand that all investments involve risk.

When you invest, you take certain risks.

Market risk

With many types of securities, such as stocks, bonds, and mutual funds,

one of the risks you face is market risk, or a risk that the investment

principal will decline in value if the price falls and you sell for less

than what you paid.

Liquidity risk

You could also be taking liquidity risk, or a risk that the investment

might not be easily sold or converted to cash when you need that cash.

Inflation risk

Even with bank investments that preserve your principal, such as

certificates of deposit (CDs), you face inflation risk, which means that

you may not earn enough over time to keep pace with the increasing

cost of living.

If you want to reap the financial rewards of investing successfully, you

have to be willing to take some risk. In general, remember that every

investment carries some degree of risk—and the greater the potential for

high returns or earnings on an investment, the greater the risks as well.

PART I

Avoiding Disputes: Investor Rights and Responsibilities

                                                                                    2

PART I Avoiding Disputes: Investor Rights and Responsibilities

2.  Research the broker and the brokerage firm

before opening an account.

Doing some research up front about brokers and

brokerage firms before you hand them any money can

help you avoid problems later. If you are looking for

a broker to work with, try to meet with several of

them face-to-face to compare them before making

any decisions. Learn about which products and

services he or she offers and how they would meet

your needs. Be wary of anyone that promotes a onesize-

fits-all approach to investing or who touts only a

particular product.

Once you are seriously considering a broker or

brokerage firm, there are a few more steps you should

take before handing anyone your money:

ASK whether the broker and firm are properly

registered and licensed with FINRA and your state’s

securities regulator. Ask about the broker’s work

experience, disciplinary history (including any past

customer complaints), and financial health (including

any outstanding arbitration awards or court judgments).

Ask about your firm’s customer complaint record.

VERIFY the broker’s and firm’s registration, licensing,

and other background information by using FINRA

Brokercheck (www.finra.org/BrokerCheck) and by

calling your state’s securities regulator. For more

information on FINRA BrokerCheck, see the Sidebar

on page 6. For the contact information of your state’s

securities regulator, please call the North American

Securities Administrators Association at (202) 737-

0900 or visit www.nasaa.org.

VERIFY any professional designation or credential by

contacting the issuing organization and determining

whether the broker is currently authorized to use the

designation and whether he or she has been

disciplined. For more information, see FINRA’s

“Understanding Professional Designations,” at

www.finra.org/designations.

VERIFY that the broker is also licensed by your state’s

insurance commissioner, if he or she sells any

insurance products. In order to sell variable annuities

or variable life insurance policies, your broker must be

properly licensed with both FINRA and your state’s

insurance commission. Look up the contact

information of your state’s insurance commissioner

through the National Association of Insurance

Commissioners at www.naic.org.

VERIFY that your brokerage firm is a member of the

Securities Investor Protection Corporation (SIPC).

While SIPC does not insure against losses attributable

to a decline in the market value of your securities,

SIPC does provide limited customer protection by

replacing certain customer assets if a firm becomes

insolvent or bankrupt. See www.sipc.org for more

information.

Remember that a little more research

up front about brokers and brokerage firms

that you are considering can help you

avoid problems later.

3.  Formulate investment goals and

communicate them clearly to your broker.

Most people invest to achieve specific financial goals.

For example, many people want to own their own

home, send their children or grandchildren to college,

and retire comfortably. Some investors may have

other goals, such as accumulating enough money to

start a business or to leave a job in order to pursue

other interests.

Make sure to have a clear sense of what your investment

goals are and when you want them to happen.

Communicate this clearly to your broker.Your broker

will need this information in order to make suitable

investment recommendations for you and will record

this information in what is called a “customer profile” or

“account record.”Ask for a copy of this document, and

make sure it accurately reflects your investment

objectives and ability to tolerate risk.Also update your

broker if your financial circumstances or goals change.

4.  Learn about your account’s features.

Often investors do not know about or understand the

features of their brokerage account until it’s too late.

Here are some key account features that you should be

aware of:

Pre-dispute arbitration clause— Virtually every

brokerage account agreement contains a pre-dispute

arbitration clause, which requires that you arbitrate all

claims concerning your account in a securities

arbitration forum, such as FINRA Dispute Resolution.

By signing the account agreement, you give up the

right to sue your broker and brokerage firm in a court

of law. See Part II of this Guide for more information

on arbitration.

Authority to make decisions— Make sure you know

and understand exactly who has the authority to make

decisions in your account. Typically, you’ll indicate

your choice in your account opening form. Having a

discretionary account means that your broker may

make investment decisions for your account without

consulting you in advance about the price, type,

amount, or timing of each trade, as long as trades are

consistent with your stated investment objectives.

Having a non-discretionary account means that you

make the decisions. Before you consider a

discretionary account, be sure to seriously consider

whether such an arrangement is right for you.

Ability to borrow—You should also know whether

you have a margin loan account (customarily known as

a “margin account”) or cash account. A margin loan

account allows you to borrow funds from your broker

to buy securities. In a cash account, you must pay for

your securities in full when you buy them. Typically,

you’ll choose whether you want a margin loan account

or cash account in your account opening form. In some

cases, however, you may be given a margin loan

account by default, unless you specify otherwise.

Make sure to read your account opening documents

carefully concerning margin loan accounts. If you have

any questions, ask your broker.

Beware: Borrowing funds to buy securities can expose

you to significant risks. For more information, visit

www.finra.org/investor/margin, and read FINRA’s

Investor Alert, “InvestingWith Borrowed Funds: No

Margin for Error,” at www.finra.org/alerts/margin.

5.  Learn about the fees you may pay for

investment services and products.

Investing with a brokerage firm costs money. To avoid

surprises later, it is very important that you understand

up front what services your broker provides and how

much those services cost.Ask about all the fees relating

to your account, such as account opening, closing,

transfer, and maintenance fees, as well as any other

costs.Also ask about how your broker is compensated—

and whether that varies depending on the issuer or type

of the product you buy. This can influence your broker’s

investment recommendations to you.

                                                                                     3

Avoiding Disputes: Investor Rights and Responsibilities PART I

In addition, make sure you ask about and understand all

the fees and expenses you’ll have to pay with regard to

each investment. These can include commissions, as

well as sales charges or “loads,” transfer fees, surrender

charges (penalties for converting an investment to cash

before the permitted time), and annual management

fees. If you don’t fully understand them, the investment

may not be right for you.

6.  Understand your investments, and avoid

investments you do not understand.

When choosing an investment, make certain that you

understand what you are buying. This can help you

form realistic expectations, avoid disputes with your

broker, and make better buy, sell, or hold decisions.

Investing in a financial product that promises high

returns, but that you don’t fully understand, may

expose you to risks that you are not prepared to take.

You are entitled to ask your broker questions until you

fully understand an investment. At a minimum you

should know:

• How the investment works.

• How and when the investment value grows or

shrinks.

• How and when you would earn money on the

investment (for example, does the investment pay

interest or dividends?).

• How much risk you would be taking.

• How and why the investment is right for you.

7.  Read carefully all documents relating to

your account and investments.

When you open a new brokerage account, you will

complete and sign a number of forms and agreements,

including your account agreement, a legally binding

contract that governs the terms of your relationship

with your brokerage firm. Make sure to keep copies of

these forms and agreements.

As you make trades and invest in your account, you

should receive trade confirmations, which include

details about each transaction, and regular account

statements, which summarize your holdings and your

investment activity on a monthly or quarterly basis.

Promptly review your trade confirmations and account

statements. This enables you to monitor your account

for any unauthorized activity, as well as make better

investment decisions.

For certain investments such as mutual funds and

variable annuities, you should receive documents

describing the investment, called prospectuses, at or

shortly after the time of purchase. If you don’t receive

these documents, you need to ask for copies. These

documents can be lengthy and complex, but the law

expects you to read and understand them. In a legal

dispute, courts and arbitrators generally do not favor

investors who rely on oral statements from a broker

that are contradicted by these written disclosures.

Ask questions if you do not understand anything in

these documents.

                                                                                    4

PART I Avoiding Disputes: Investor Rights and Responsibilities

8.  Keep documents and note conversations

with your broker.

You may need the following documents in the future to

report or pursue a problem, look up information for tax

purposes, or for other reasons:

• Account opening agreement, including pre-dispute

arbitration clause.

• Customer profile or account record.

• Any document that gives your broker discretionary

authority over your account.

• Account statements.

• Trade confirmations.

• Notes of discussions with your broker.

• Correspondence with your broker.

• Prospectuses or other offering circulars for

investments.

9.  Report any problems with your account

immediately and in writing.

If you notice an error in the documents you receive, if

a trade confirmation does not accurately reflect your

investment decision, or if you have questions about

your account, notify your broker or branch manager

immediately. This will help you minimize any

financial losses and preserve your legal rights.

10.  Ask questions.

Asking questions is one of the best ways to

invest wisely and to avoid misunderstandings between

you and your broker.You are taking a risk if you

assume that your broker will tell you everything you

need to know. Remember that you are the customer and

are entitled to have all your questions answered—after

all, it is your money at stake.

                                                                                    5

Avoiding Disputes: Investor Rights and Responsibilities PART I

Your Top Ten Investing Responsibilities

1. Understand that all investments

involve risk.

2. Research the broker and the

brokerage firm you select.

3. Formulate investment goals and

communicate them clearly to

your broker.

4. Learn about your account’s features.

5. Learn about the fees you may pay for

investment services and products.

6. Understand your investments,

and avoid investments you do

not understand.

7. Read all the documents relating to

your account and investments.

8. Keep documents and note

conversations with your broker.

9. Report any problems with your

account immediately and in writing.

10. Ask questions about your money.

FINRA BrokerCheck

FINRA’s BrokerCheck is a database that holds

licensing and registration information on more

than 675,000 brokers (registered representatives)

as well as more than 5,000 brokerage firms.You

can check the background of your broker by

calling (800) 289-9999, a toll-free hotline

operated by FINRA, or by accessing BrokerCheck

on the Internet at www.finra.org/BrokerCheck.

When researching brokerage firms, you can

search by the name of the firm or by a CRD

number, which is a locator number in the FINRA

database. For each firm, BrokerCheck provides

the company’s profile, history, and description of

operations, and discloses any arbitration awards,

disciplinary or regulatory events, and

bankruptcies.

You can also research brokers by name or CRD

number. With respect to brokers, BrokerCheck

will list the states in which the broker is licensed

to sell securities, the securities qualifications

examinations he or she has passed, and certain

information involving arbitrations, civil litigations,

and customer complaints against the broker.

The broker’s employment record may also be

informative. You will be able to view the broker’s

employment history going back ten years. You

will be able to see whether the broker has had any

employment terminations for certain reasons, such

as for securities violations, or has any pending or

final disciplinary actions taken by regulators.

Finally, BrokerCheck will tell you whether the

broker has been involved in any bankruptcy

proceedings in the past 10 years, which may also

affect your decision whether or not to use this

particular broker for your investments.

What are my broker’s duties to

me as a customer?

Brokers owe certain duties to their customers. The

following list of brokers’ duties to customers, while

not intended to be a comprehensive restatement of

all of your broker’s legal duties to you, can help you

prevent disputes from arising. When you know what

the broker is legally obligated to do, you will be in a

better position to spot a disagreement concerning

your funds and/or account, as well as violations of

the broker’s legal duties to you. Also, you will be

better equipped to take steps to correct problems

right away.

1.  To deal fairly with customers.

Brokers have a duty to observe high standards of

commercial honor and deal fairly and equitably with

customers in the conduct of their business. Examples

of conduct that are not considered fair dealing are

trading securities in your account without your

authorization, excessive trading for the purpose of

generating extra commissions, and the unauthorized

use of your funds or securities.

2.  To know the customer.

Brokers must ask about their customers’ financial

situation, such as their income, expenses, financial

goals and objectives, and their other investments,

before making any recommendation to purchase, sell

or exchange securities.

3.  To make only suitable investment

recommendations.

Before recommending the purchase or sale of an

investment, a broker must have reasonable grounds for

believing that the recommendation is suitable for a

customer in light of the customer’s other security

holdings, financial situation, needs and objectives.

                                                                                  6

PART I Avoiding Disputes: Investor Rights and Responsibilities

4.  To disclose accurate and truthful

information.

Brokers must provide accurate and truthful

information about investments. Brokers must also

provide to investors additional disclosures of the risks

of investing in certain transactions or strategies that

involve speculation such as:

• Margin trading – purchasing securities with funds

borrowed in full or in part from the brokerage firm.

• Day trading – buying and selling securities within

extremely short time periods.

• Penny stock investing – buying low-priced stocks of

small companies that are not well-established.

• Options trading – buying and selling contracts that

give the purchaser the right to buy or sell a security

at a fixed price within a specified time period.

5.  To trade only in accordance with the

customer’s instructions.

Unless you have a discretionary account, your broker

must separately obtain permission for each individual

trade that he or she recommends for you and must

execute any orders that you place.

Note, however, that if you have borrowed funds to

purchase securities in your margin loan account, there

are circumstances that allow your broker to sell any of

your securities without consulting you—whether you

have a discretionary or non-discretionary account. For

more information on margin loan accounts, read

FINRA’s Investor Alert, “InvestingWith Borrowed

Funds: No Margin for Error,” at

www.finra.org/alerts/margin.

6.  To avoid excessive trading in a customer’s

account.

Frequent or excessive trading in a customer’s account

for the sole purpose of generating commissions,

instead of helping to achieve the customer’s stated

investment objectives, is called churning. In the case of

mutual funds and variable annuities, it may be called

switching. A broker who has discretionary authority

over or otherwise controls your account is prohibited

from churning and switching.

Additional resources:

For more information on these and other duties,

you can review:

The Investor Bill of Rights at

www.nasaa.org/Investor_Education/Investor_Bill_

of_Rights/433.cfm

FINRA’s Investor Protection literature, at

www.finra.org/InvestorInformation/

InvestorProtection

The SEC’s “Top Tips” for Investors, at

www.sec.gov/investor/links/toptips.htm

The SEC’s “Invest Wisely: Advice From Your

Securities Industry Regulators” at

http://www.sec.gov/investor/pubs/inws.htm

                                                                                      7

Avoiding Disputes: Investor Rights and Responsibilities PART I

                                                                                      8

How can I address problems that

may arise with my investments?

In the event that a discrepancy or dispute arises, you

should take steps to notify the firm and its compliance

department of the problem. The firm’s compliance

area is responsible for the firm’s and its employees’

compliance with all applicable securities laws

and regulations.

First: If you suspect there has been unfair or improper

business conduct by a securities professional in your

account, report it to a branch manager or the

compliance department. Confirm your complaint to the

firm in writing and keep written records of all

conversations. Sometimes the compliance department

has the authority to take steps that will rectify the

problem quickly. If it is just a misunderstanding,

management intervention may be enough to put the

transaction back on course.

If you receive a trade confirmation reflecting a

transaction that you did not authorize, you should

complain immediately to the broker and to the broker’s

direct supervisor, whether it is a branch manager or

compliance officer. Any complaints should be

confirmed in writing.

Second: If you do not receive a satisfactory response,

file a written complaint with the SEC (at

www.sec.gov/complaint.shtml) or with FINRA’s

Investor Complaint Center (at

www.finra.org/complaint). You can also contact your

state securities regulator. You can obtain its contact

information at www.nasaa.org. The SEC, FINRA and

state securities regulators will investigate your

complaint for potential violations of securities laws or

regulations, and can bring disciplinary action against a

wrongdoer, but they cannot pursue a claim for

monetary damages on your behalf.

Third: If you still are not satisfied with the response,

or want to seek monetary damages, you can initiate

more formal dispute resolution processes.

• You can pursue any claim against a FINRA registered

brokerage firm or its registered

representative (your broker) in arbitration. For more

information about arbitration, see Section II of this

Guide.

• If the brokerage firm and broker consent, you can

pursue mediation of your claim. For more

information on mediation, see Section III of this

Guide.

• If you have not signed an enforceable arbitration

agreement, consult an attorney to determine if you

are able to bring your claim in state or federal court.

PART I Avoiding Disputes: Investor Rights and Responsibilities

                                                                              9

How can I find an attorney to

assist me?

Investors often fare better in the arbitration process if

they are represented by an attorney with experience in

securities arbitration matters. You should try to locate

an attorney that can help you. You should be aware that

brokers and brokerage firms most likely will be

represented by attorneys, and that investors without a

legal background may have difficulty with the

arbitration process. An attorney can help you assess

whether you have a claim that is likely to lead to a

recovery of some of your losses and whether to bring

the claim or not in an arbitration proceeding. If for

some reason you are unable to obtain or pay for

representation, a law clinic or the Dispute

Resolution staff at FINRA may be able to answer

procedural questions.

For more information on finding an attorney

experienced in securities mediation or arbitration,

you can consult the following websites:

• FINRA’s “How to Find an Attorney,” at

http://www.finra.org/ArbitrationMediation/Parties/

Overview/HowToFindAnAttorney/p086223.

• The Public Investors Arbitration Bar Association’s

“Find An Attorney” service, which lists attorneys

who specialize in representing investors, at

www.piaba.org (click on “Find An Attorney”).

• The American Bar Association’s “Consumer’s

Guide to Legal Help,” at www.abanet.org

(click on “Find Legal Help”).

“Pro se” representation. If you are unable to obtain

legal representation, you have the option of

representing yourself in a dispute—also known as

proceeding with your claim pro se. The FINRA

website has information that may be helpful for those

proceeding without an attorney. Go to

http://www.finra.org/ArbitrationMediation/Parties/

index.htm.

Law school clinics. If the dollar amount of your claim

is modest or you cannot afford to hire a lawyer but you

need legal representation, you should consult a law

school clinic, such as the one at Pace Law School,

which provides free or reduced-rate student legal

services to investors in the resolution of securities

disputes. Under the guidance of a supervising attorney,

clinic students can represent you in a negotiation,

mediation or arbitration, and can also gain valuable

law practice experience. Law schools currently

operating clinics are listed on the following page.

Avoiding Disputes: Investor Rights and Responsibilities PART I

                                                                              10

New York

Albany Law School

Securities Arbitration Clinic

80 New Scotland Avenue

Albany, NY 12208

(518) 445-2328

cchung@albanylaw.edu

Benjamin N. Cardozo

School of Law

Securities Arbitration Clinic

55 Fifth Avenue, Suite 1116

NewYork, NY 10003

(212) 790-6648

esgoldma@yu.edu

Brooklyn Law School

Investor Rights Clinic

1 Boerum Place, Room 304

Brooklyn, NY 11201

(718) 780-7572

Karen.vaningen@brooklaw.edu

Fordham University

School of Law

Securities Arbitration Clinic

33West 60th Street, 3rd Floor

NewYork, NY 10023

(212) 636-6943

radvany@law.fordham.edu

Hofstra University

School of Law

Securities Arbitration Clinic

Hempstead, NY 11549-1210

(516) 463-4607

lawcep@hofstra.edu

New York Law School

Securities Arbitration Clinic

57Worth Street

NewYork, NewYork 10013

(212) 431-2100, Ext. 3

hmeyers@nyls.edu

Pace University School of Law

John Jay Legal Services, Inc.

Investor Rights Clinic

80 North Broadway

White Plains, NY 10603

(914) 422-4333

jjls@law.pace.edu

St. John’s University

School of Law

St. Vincent De Paul

Legal Program, Inc.

8000 Utopia Parkway

Belson Hall Room 2-26

Queens, NY 11439

Attn: Securities Arbitration

Clinic

(718) 990-6930

securities@stjohns.edu

Syracuse University

College of Law

Securities Arbitration Clinic

MacNaughton Hall, Suite 306

Syracuse, NY 13244

(315) 443-4582

bksiegel@law.syr.edu

California

University of San Francisco

School of Law

Investor Justice Clinic

Kendrick Hall, 211

San Francisco, CA 94117-1048

(415) 422-6107

usflawijc@usfca.edu

Illinois

Northwestern University

School of Law

Investor Protection Center

Bluhm Legal Clinic

357 E. Chicago Avenue

Chicago, Illinois 60611

(312) 503-0210

Investor-Protection@law.

northwestern.edu

Pennsylvania

Duquesne University

School of Law

Securities Arbitration Practicum

900 Locust Street

Pittsburgh, PA 15282

(412) 396-5877

stewarta@duq.edu

PART I Avoiding Disputes: Investor Rights and Responsibilities

Law School Clinics

PART II

Resolving Disputes: The Arbitration Process

                                                                                11

What is Arbitration?

Arbitration is an alternative to going to court or mediating (described

in Part III) in order to resolve a dispute. Arbitration panels composed

of one or three arbitrators read the claims filed by the party that

initiates the arbitration, weigh all of the arguments of the parties,

study the evidence, and then decide how the matter should be

resolved. The panel’s decision, called an “award,” is final and binding

on all the parties. All parties must abide by the award, unless it is

successfully challenged in court. Arbitration also is confidential, and

documents submitted in arbitration are not publicly-available, unlike

court-related filings.

In 2007, FINRA published a “plain English” Code of Arbitration

Procedure for Customer Disputes for cases filed on or after April 16,

2007. Anyone can access the new rules that apply to customer cases,

also known as the Customer Code, on the FINRAWeb Site at

www.finra.org/rulefilings/customercode. Pro se investors in particular

should read these rules.

Parties can agree to use arbitration either before or after a dispute

arises. (See “Why arbitration?” on the next page.) By agreeing to

arbitration, you give up some features of litigating in court. For

example, in arbitration, you are limited in the fact-gathering processes

that you may use to build your case (called “discovery”). In addition,

arbitrators are not strictly bound by rules that govern the admission of

evidence in court. In making decisions, arbitrators are guided by

principles of equity (fairness) and justice, rather than by a strict

application of settled legal rules to the facts. As a result, arbitration is

considered by many to be a faster and less expensive method to resolve

disputes than litigation.

It is very difficult to challenge an arbitration award. To do so you

would file the papers needed to ask a court to “vacate” (cancel) or

“modify” (change) an award. But the circumstances under which courts

are permitted to do so are very limited. If you decide to challenge an

arbitration decision in federal court, the Federal Arbitration Act

requires you to act quickly. You must file a motion to vacate or modify

an award within three months of the date the arbitrator delivered the

decision. Some states may have arbitration statutes that require you to

file the motion in even less time.

Why arbitration?

There are two reasons to use arbitration to resolve your

dispute:

You agreed to before the dispute arose. When you

opened your brokerage account, you entered into a

customer account agreement. It is very likely that this

agreement includes a clause that requires you to use

arbitration to resolve all disputes with your broker.

FINRA CUSTOMER CODE 12200

You want to because you prefer arbitration.

Even without a pre-dispute arbitration agreement, all

brokerage firms that are registered with FINRA and

any of their employees must agree to arbitrate any

dispute upon the demand of the customer.

FINRA CUSTOMER CODE 12201

Is there a deadline for filing an

arbitration?

Yes. A claim is not eligible for arbitration if “six years

have elapsed from the occurrence or event giving rise

to the claim.” There are rarely any exceptions to this

rule, and you can lose the right to recover any losses if

you wait too long to file. Additionally, other time

limits imposed by state and federal law, called statutes

of limitation, may also apply, so don’t delay.

FINRA CUSTOMER CODE 12206

What do you file?

To initiate an arbitration proceeding, you must send to

FINRA the following items:

Statement of Claim. To begin an arbitration

proceeding, the investor, or “claimant,” writes and files

a Statement of Claim with FINRA, which, unlike a

complaint filed in court, has no required format.You

can write it as a letter or in a style more similar to a

formal legal complaint. No matter what form your

Statement of Claim takes, you should state the basic

facts of the dispute and the remedies you are seeking,

including the amount of money you are seeking as

damages.You can also attach any documents – such as

account statements, prospectuses, or trade

confirmations – that help to prove your claim.

Remember to submit the appropriate number of copies

– one for each respondent (the person or entity against

whom the claim is brought) and each arbitrator (one or

three as determined by Customer Code 12401).

FINRA CUSTOMER CODE 12302

Common legal claims that investors allege in a

Statement of Claim include claims that their broker,

firm or both:

• Breached their duty to make only suitable

recommendations (a “suitability” claim).

• Misrepresented material facts or failed to disclose

material facts, whether inadvertent (“negligent”) or

intentional (“fraudulent”).

• Excessively traded the account for commissions

(“churning” or “switching”).

• Made trades in the account that were not authorized

(“unauthorized trading”).

• Failed to execute an investor’s order.

• Failed to supervise a broker according to industry

standards (“negligent supervision”).

                                                                                12

PART II Resolving Disputes: The Arbitration Process

There may be other legal claims that you can bring

against your broker or firm. If you are unsure whether

you have a viable claim, you may want to seek the

help of an attorney experienced in securities law.

Uniform Submission Agreement. Along with the

Statement of Claim, you must fill out, sign and send to

FINRA a Uniform Submission Agreement stating that

you agree to abide by the procedural rules of the

arbitration forum and to be bound by the decision of

the arbitrators. You can download the form at:

http://www.finra.org/ArbitrationMediation/Parties/

Overview/P007950. Click on “Materials to Initiate an

Arbitration Claim.”

Claim Information Sheet. FINRA asks that you

complete this form to help its staff process your case.

This form is also available at:

http://www.finra.org/arbitration/ufg.

Forum Fees. You must pay an arbitration filing fee as

listed in the fee schedule in Customer Code 12900. If

you do not include a check for the appropriate amount

in your application,  FINRA will not process your

claim. The Director may waive all or part of the filing

fee if you can show financial hardship.

FINRA CUSTOMER CODE 12900(a)

An easy way to calculate the fees you must pay to

initiate your arbitration claim is to use FINRA’s online

“Arbitration Filing Fee Calculator.” Go to

http://www.finra.org/arbitration/feecalculator.

Caution: If the application packet is not complete,

FINRA will consider your claim deficient and will

require a correction within 30 calendar days.  You must

include all the following items to avoid having a

deficient claim:

A Statement of Claim that includes

• Your home address at the time the events took place

that caused the dispute.

• Your current home address or that of your legal

representative.

• Your name.

A FINRA Submission Agreement that

• Is properly signed and dated.

• Names all the parties in your Statement of Claim.

• The right number of copies of the FINRA

Submission Agreement, Statement of Claim, and

any other documents you wish to include.

• The correct filing fee.

FINRA CUSTOMER CODE 12307

                                                                              13

Resolving Disputes: The Arbitration Process PART II

Online arbitration claim filing

On the FINRA web site, investors can submit an online Claim Information Form (as distinguished from a paper

Claim Information Sheet) along with an electronic version of the Statement of Claim. Following the online

submission, you still need to mail in your filing fee and send by postal or electronic mail your Submission

Agreement, any additional materials (such as exhibits) and a copy of the tracking form that is generated once

you file online. Even though you still need to use postal mail to a certain extent, online filing can help

expedite the processing of your case.  FINRA will consider receipt of the claim to be the date it receives the

Submission Agreement. You can consult the directions for filing online at:

http://apps.finra.org/Mediation_&_Arbitration/online_filing.asp.

What happens after a claim is

initiated?

Once you have filed the application materials, FINRA

will serve the Statement of Claim on the respondent(s)

(the party or parties named in the Statement of Claim).

In turn, each respondent must file an Answer within 45

days from the day it receives the Statement of Claim

which must specify “the relevant facts and available

defenses” to the claim. In other words, it must contain

the respondent’s version of what happened and the

reasons why the respondent believes the claimant is not

entitled to the remedies sought.

FINRA CUSTOMER CODE 12303

In addition to the Answer, each respondent should file:

• A signed Uniform Submission Agreement.

• Any additional documents supporting the Answer.

• Any counterclaims against the claimant, cross

claims against other respondents, or third-party

claims against new parties, specifying all relevant

facts and remedies requested, with all required fees

for additional claims.

Parties must file with FINRA all pleadings and any

other documents subsequent to the initial Statement of

Claim at the same time and in the same manner in

which they are served on, or delivered to, the other

parties. With each filing, parties must include a

certificate of service, which is a list stating the names

of the parties served, the date and the method of

service and the addresses to which service was made.

FINRA CUSTOMER CODE 12300(c)

Can I change the Statement of

Claim after it has been filed?

You can change the original Statement of Claim

submitted for the case. This is called an “amended

pleading.” For instance, you may need to add a party to

the claim, you may have discovered additional

information that changes the type of claim you assert,

or you may need to change the amount of damages

from those you originally requested.

Here are some rules on amended pleadings:

• A party may amend a pleading at any time before

FINRA has appointed arbitrators.

• To amend a Statement of Claim that you have filed

but FINRA has not yet served (sent to) the other

parties, file a sufficient number of copies of the

amended claim by sending them to FINRA.

• To amend a Statement of Claim or any other

pleading that FINRA already has sent to the other

parties, you must send the amended pleading

directly to all other parties and also file it with

FINRA. If you amend a pleading to add one or more

parties to the arbitration, you must provide each new

party with copies of all arbitration documents

previously served by any party or sent to the parties

by the Director.

• Once FINRA has appointed an arbitration panel, a

party may only amend a pleading if the panel

allows. This means that you have to make a motion

to amend the Statement of Claim. (See “What are

Motions?” on page 18.) A respondent must answer

the amended pleading within 20 days.

FINRA CUSTOMER CODE 12309

                                                                           14

PART II Resolving Disputes: The Arbitration Process

A pleading is a statement describing a party’s arguments or defenses. Documents that are considered

pleadings are a Statement of Claim, an Answer, a Counterclaim, a Cross Claim, a Third Party Claim, and any

replies. (See the following page for the definitions of counterclaim, cross-claim and third party claim.)

FINRA CUSTOMER CODE 12100(s)

What are counterclaims, cross

claims and third party claims?

Counterclaims are claims asserted by a respondent

against a claimant in response to allegations in the

Statement of Claim. A cross claim is a claim by one

respondent against another respondent. Third party

claims are any claims that respondents may file against

another party that is not yet part of the arbitration case.

What happens when a respondent

does not file an Answer?

If a broker or a firm does not file an Answer, but is still

licensed or registered with FINRA, then the arbitrators

may, upon the claimant’s request, bar that respondent

from “presenting any defenses or facts at the hearing.”

FINRA CUSTOMER CODE 12308(a)

Claimants may be able to request default proceedings

against respondents that are suspended, barred, or

expelled from, or for other reasons are no longer in

good standing in, the securities industry, and who fail

to file an Answer. It may, however, be difficult to

actually collect an award from a respondent that has

been barred or expelled because FINRA can no longer

force that respondent to pay the award.

If there is more than one claimant, the claimant seeking

this procedure must obtain agreement from all the other

claimants in the case to use default proceedings against

that respondent and notify all the parties remaining in

the case. FINRA will then appoint a single arbitrator to

consider the claim against the defaulting respondent,

based on the Statement of Claim and other documents

presented by the claimant. The arbitrator will not hold

in-person hearings. Even in a default arbitration

proceeding, claimants must present a sufficient basis to

support the making of an award. The default award will

have no effect on any non-defaulting party.

FINRA CUSTOMER CODE 12801

How are arbitration fees

determined?

In arbitration, both sides are required to pay fees.

Investors must pay a filing fee when filing the

Statement of Claim. The filing fee ranges from $50-

$1,800 and depends on the amount of damages that

you are seeking.  FINRA will partially refund this fee if

the claim is settled or withdrawn more than ten days

before the date of the hearing – less any other fees or

costs assessed against you under the Code, including

any hearing session fees assessed under Customer

Code 12902. However, certain surcharges and

processing fees that the brokerage firms are required to

pay cannot be assessed against you.

In addition to the initial filing fee,  FINRA charges

hearing session fees for each hearing session that takes

place with the arbitrator(s), whether telephonic or in person.

For a panel with one arbitrator, the cost of one

hearing session ranges from $50-$450, depending on

the size of the claim. For a panel of three arbitrators,

that amount is $600-$1,200. The total fee depends on

how many hearing sessions are conducted. A typical

live hearing day consists of two sessions, because

FINRA defines a “hearing session” as a meeting with

the arbitrators of no more than four (4) hours. In the

award, the panel decides which parties are ultimately

responsible for the hearing session fees.  FINRA will

bill you for any fees you owe to the forum after the

case is closed. For the most comprehensive and up-todate

information on fees, see Customer Code 12900

and 12902.

FINRA CUSTOMER CODE 12900 and 12902

                                                                           15

Resolving Disputes: The Arbitration Process PART II

Agreement of the Parties

Generally speaking, your case will be governed by

the provisions in FINRA’s Customer Code.

However, the Code also allows for modifications

of its provisions – if all parties agree in writing.

For instance, parties can agree to remove and

replace arbitrators or to proceed under the new

Code as opposed to the old Code. They can also

extend deadlines to complete arbitrator list

selection, file answers or responses to motions, or

exchange documents or witness lists.

FINRA CUSTOMER CODE 12105

How many arbitrators serve on

an arbitration?

The number of arbitrators on a case depends on the

amount of damages.

•  If the claimant is seeking $25,000 or less in

damages, exclusive of interest and costs, then one

arbitrator hears the case.

• If the claimant is seeking more than $25,000 and up

to $100,000, then one arbitrator hears the case,

unless any party requests a panel of three arbitrators

in its initial pleading.

• If Claimant is seeking more than $100,000 in

damages, then three arbitrators hear the case.

FINRA CUSTOMER CODE 12401

Who is your arbitrator?

A one-arbitrator panel is made up of:

• one public arbitrator who has no affiliation with the

securities industry and who is qualified to be

Chairperson (a Chair-qualified arbitrator).

A three-person panel is made up of:

• one Chair-qualified public arbitrator,

• one public arbitrator, and

• one non-public (industry) arbitrator.

FINRA’s Customer Code 12100(p) and (u) define

public and non-public arbitrators.

FINRA CUSTOMER CODE 12402

FINRA launched a two-year pilot program in Fall 2008

that will allow some investors making arbitration claims

to choose a panel made up of three public arbitrators

instead of two public arbitrators and one non-public

arbitrator. For more information, see “PublicArbitrator

Pilot Program FrequentlyAsked Questions,” at

http://www.finra.org/arbitration/arbpilotfaq.

                                                                                16

PART II Resolving Disputes: The Arbitration Process

How are the arbitrators selected?

FINRA’s Neutral List Selection System (NLSS) holds

the names of about 7,000 arbitrators qualified to hear

cases. NLSS randomly generates lists of arbitrators for

the parties, from which they can select their arbitrators.

Along with the lists,  FINRA will send the parties

Arbitrator Disclosure Reports, which disclose

education and employment history, past arbitration

awards and other background information for each of

the arbitrators on the lists.You should review the

information disclosed, and research past awards, to

confirm that the arbitrator does not have any potential

conflicts of interest with the witnesses, issues or

products in your case.

Parties select the arbitrators for their panel through a

process of striking and ranking the arbitrators on

their lists.

For a one-arbitrator panel,  FINRA will send only one

list of eight public arbitrators for arbitrator selection.

For a three-arbitrator panel,  FINRA will send three

lists:

• a list of eight public arbitrators from the Chair-qualified

roster;

• a list of eight arbitrators from the non-public

(industry) arbitrator roster; and

• a list of eight additional public arbitrators.

Each party to the arbitration can strike up to four of

the arbitrators from each list for any reason; at least

four names must remain on the list. Each party ranks

all the remaining arbitrators on each list in order of

preference. Each list must be ranked separately.

Parties may strike and rank arbitrators for any

reason, including the arbitrators’ educational and

work experience and any perceived or actual

conflicts of interest.

Once FINRA receives the rankings from all parties, it

will consolidate the lists and appoint the arbitrator(s)

with the highest combined ranking(s) who is also

available to accept the appointment. If the number of

arbitrators available to serve from the consolidated

list(s) is not sufficient to fill an initial panel,  FINRA will

appoint the required number of arbitrators from names

generated randomly by FINRA’s arbitrator database.

FINRA CUSTOMER CODE 12403-12406

Once appointed, you can ask an arbitrator to withdraw

from the case for good cause. If the arbitrator refuses

to withdraw from the case, you can ask the Director of

Arbitration before the first hearing session begins to

remove the arbitrator for conflict of interest or bias.

The Director will grant your request to remove an

arbitrator if it is reasonable to infer that the arbitrator is

biased, lacks impartiality, or has a direct or indirect

interest in the outcome of the arbitration. The Director

will grant this request if you make it after the first

hearing session begins only if it is based on new

information that was required to be disclosed by the

arbitrator earlier.

FINRA CUSTOMER CODE 12409-12410

                                                                                 17

Resolving Disputes: The Arbitration Process PART II

                                                                                 18

What is Simplified Arbitration?

If claimant is seeking damages of $25,000 or less,

exclusive of interest and expenses, then FINRA’s

Simplified Arbitration process applies. One public

arbitrator will decide the claim and issue an award

based on the written submissions of the parties, unless

the parties agree in writing otherwise. The parties can

request documents and information from other parties

to submit in support of the claim or defense.

If the amount in dispute increases to more than

$25,000 either because you amend the claim to

increase the damages request or an opposing party

counterclaims for damages, the arbitration will no

longer be administered as a Simplified Arbitration.

FINRA CUSTOMER CODE 12800

Voluntary Direct Communication

Between Parties and Arbitrators:

In general, no party or legal representative of

a party may communicate with any arbitrator

outside of a scheduled hearing or conference

unless all parties or their representatives are

present. If all sides have obtained legal

representation, however, and all parties and

arbitrators agree, you can proceed under the

voluntary direct communication rules,

Customer Code 12210 and 12211. These rules

allow you to send items by regular mail,

overnight courier, facsimile or email directly to

all arbitrators and parties in your case. Copies

of all materials sent to the arbitrators must

also be sent at the same time and in the same

manner to all parties and FINRA.

Remember: Even under this rule, parties should

not communicate with the arbitrators unless all

parties are participating in the communication.

What are Motions?

A motion is a request for the arbitrator(s) or Director

of Arbitration to direct some act, whether by issuing

an order or ruling. For example, if you wish to

change your hearing location or Statement of Claim

after the arbitration panel is appointed, you must

make a motion. A party may make motions in writing

or orally during a hearing session. However, FINRA

requires that a party make an effort to resolve the

matter with the other parties before making a motion,

and to include a description of those efforts as part of

the motion. Motions, like other arbitration filings, are

not required to be in any particular form. Written

motions generally must be served at least 20 days

before a scheduled hearing. Parties have 10 days

from the receipt of a written motion to respond,

unless the party making the motion agrees to an

extension of time, or the Director of Arbitration or

panel decide otherwise. Please note that, because

FINRA discourages parties from filing motions to

dismiss an entire claim before the hearing, Customer

Code 12504 bars parties from filing motions to

dismiss a claim before a party has presented its casein-

chief, except in very limited circumstances.

FINRA CUSTOMER CODE 12503, 12504

What is the Initial Prehearing

Conference?

The Initial Prehearing Conference is the first time

when all the parties and the arbitrators come together

to set the schedule for the case. Usually this

conference takes place on the telephone. During this

telephone conference, the arbitration panel

establishes discovery deadlines, schedules any

motions that the parties request to file, and sets dates

for the arbitration hearing.

FINRA CUSTOMER CODE 12500

PART II Resolving Disputes: The Arbitration Process

What is Discovery?

The discovery process allows both parties to obtain

facts and information from other parties in order to

support their own case and prepare for the hearing.

FINRA has published a series of guidelines to help the

parties in the discovery process, called the “Discovery

Guide,” which is available at www.finra.org. In the

search box, type in “Discovery Guide.”

The Discovery Guide contains lists of documents that

parties should exchange automatically in all cases, and

the lists vary depending on the subject matter of the

dispute. In addition, each party can request

information and documents that are relevant to the

case and that may be in the exclusive possession of an

adverse, or opposing, party. Rules 12505 to 12511 of

the Customer Code govern the discovery process, and

include provisions for parties’ requests for discovery

items that are outside of the document production lists,

for parties’ objections to discovery requests, and for

arbitrators’ authority to issue sanctions against parties

for discovery abuses.

You can object to a discovery request (argue that you

don’t need to respond to it) if it asks you to provide

documentation and information that you believe is

overly burdensome, not relevant to the case, or

involves confidential or privileged information. Clearly

state in writing to which request you are objecting and

why, and send the written objection to all parties in the

case. There are timeframes for producing documents,

requesting additional discovery items, and responding

and objecting to requests. These timeframes are

contained in Rules 12505 – 12508.

If the parties cannot agree on their own how to resolve

any discovery dispute, then the party who still wants

more documents or information may make a motion to

compel the reluctant party to produce the requested

documents. The requesting party should explain to the

arbitrator(s) why the discovery is relevant and

necessary to the case and ask the panel to issue an

order compelling production. The arbitrator(s) will

then decide whether or not the reluctant party must

provide that information.

If a party fails to produce documents or information

required by a discovery order, the arbitrators can

issue sanctions against that party. Sanctions could

include assessing fees or penalties, including

attorneys’ fees; prohibiting a party from admitting

evidence; drawing an adverse inference against the

party; and even dismissing a claim, defense, or case.

The panel may also initiate a disciplinary referral

against a registered broker or brokerage firm that is

involved in the proceeding.

Subpoenas

A subpoena is a legal document that compels a

person or an entity to show up at the listed time

and place to testify under oath. A subpoena

duces tecum compels a person or an entity to

produce the listed documents to the requesting

party at a particular time and place. Parties to

arbitration can use subpoenas to gather

information that is relevant to the case.

In a FINRA arbitration, only arbitrators – not

attorneys for the parties – can issue a subpoena

to third parties (persons or entities that are not

claimants or respondents in the arbitration). If

you believe that your case requires information

from third parties and want the arbitrators to

issue a subpoena, you must make a written

motion for the arbitrators to do so. The

arbitrators will then determine whether the

subpoena should be issued and how costs will be

assessed to the parties.

FINRA CUSTOMER CODE 12512

                                                                             19

Resolving Disputes: The Arbitration Process PART II

Document Production Lists

The Discovery Guide lists documents that parties

should provide to each other. In general, parties

must make available to the opposing parties all

documents, notes and records that each party

has pertaining to the dispute. These include

account opening documents, cash sweep, margin

and option agreements, trading authorizations,

trade confirmations and the customer’s account

statements during the time period of and relating

to the transaction. Parties must also produce

correspondence between the claimant and the

firm and recordings and notes of telephone calls.

The broker will be expected to provide the forms

filed with FINRA when employing or terminating

the employment of a broker (Forms U4 and U-5),

customer complaints identified in these forms, all

customer complaints of a similar nature against

the broker, and records of disciplinary actions by

a regulator or employer for conduct similar to the

conduct alleged in the arbitration.

Claimants must provide all their records

regarding the disputed issue, including any notes

or correspondence. They may also be asked to

provide financial records, such as federal income

tax returns for the three years prior to the first

transaction at issue, and other financial

statements showing their assets, liabilities,

and/or net worth for the periods covering three

years prior to the first transaction at issue.

Claimants are also expected to disclose any prior

complaints that they have filed involving the

broker or any other securities matter. For the

complete list of discovery requirements, refer to

FINRA’s Discovery Guide, available at

www.finra.org. In the search box, type in

“Discovery Guide.”

Where does the hearing take

place?

The hearing takes place in a conference room either at

a regional FINRA office or in an office building

arranged by FINRA in the city where the hearing will

take place. Generally, the Director of Arbitration

decides the city for the hearing based on where the

Claimant lived at the time of the challenged

transactions. You may seek to change the hearing

location by obtaining the other party’s agreement or by

writing to FINRA and requesting a change in location.

FINRA CUSTOMER CODE 12213

                                                                                 20

PART II Resolving Disputes: The Arbitration Process

What happens at the hearing?

The law requires that the arbitrators provide each side

with a full and fair opportunity to be heard. Thus, in all

arbitrations except for those subject to Simplified

Arbitration procedures, and those settled or dismissed

before a hearing under FINRA’s rules, the arbitrators

will hold a live hearing.

FINRA CUSTOMER CODE 12600

Testimony and Evidence

The arbitration hearing is where the claimant(s) seeks

to prove the claims that are alleged in the Statement of

Claim, and respondents try to establish any defenses to

those claims and seek to prove any counterclaims.

Arbitrators usually accept two types of proof: oral

testimony by witnesses and documentary evidence.

Customer Code 12514 requires that parties inform the

other party of witnesses they intend to call and provide

copies of any documents or other materials that they

plan to use at the hearing as evidence at least 20

calendar days before the start of the hearing. Also,

parties need to arrange for witnesses and all

documentary evidence to be available for presentation

at the hearing.

At the hearing, all parties will be present in the room

with the arbitrators. The arbitrators open the hearing

by reading from a script prepared by FINRA to cover

administrative matters. Each party can then give an

opening statement outlining what it intends to prove

during the hearing, if it wants.

Direct and Cross Examination

Generally, each claimant then calls witnesses to testify

on his or her behalf as to facts within the witnesses’

personal knowledge. In addition, each claimant can

ask expert witnesses who have specialized training or

knowledge to testify as to their opinion on a technical

matter to help the arbitrators draw conclusions and

render a decision. The claimant conducts a direct

examination, or asks questions of any witnesses it

calls. Each respondent can ask questions of claimant’s

witnesses, too, in what is called cross examination, and

the arbitrators can also question these witnesses.

Exhibits

Parties should offer into the record as exhibits (a paper

or document produced and shown to an arbitration

panel during a hearing) any documents they would like

the arbitrators to consider as evidence. Parties can

argue that any evidence presented by another party

shouldn’t be considered in the arbitrators’ decision by

objecting orally at the hearing. After hearing the

objecting party’s reasons why, the arbitrators will

examine the documents presented to determine if they

will be admitted into evidence (considered as part of

your case or disregarded) and into the case record.

Arbitrators generally will accept any authentic

document into the record, as long as it is relevant and

necessary to prove your claims, and it is not unfair to

any other party.

Rebuttal Evidence

Once each claimant has presented his/her case, each

respondent has the right to call fact and expert

witnesses, too, and offer any relevant exhibits. Once

all parties have presented all their evidence on any

claims and counterclaims, including rebuttal evidence

to contradict the other side’s arguments or evidence,

all parties generally make a closing statement,

summing up the evidence and arguing to the panel

what they believe they have proven and what they

contend the other side has not proven. Claimants

should be certain to repeat their request for damages

and any other relief, and to provide specific

calculations supporting their request for a damages

amount, whether with or without expert testimony.

                                                                               21

Resolving Disputes: The Arbitration Process PART II

An arbitration hearing in brief

Arbitration hearings generally take place in this

order, although the arbitrators have authority to

change the order:

• Swearing in of arbitrators, parties and witnesses

• Opening statement from each party (optional)

• Presentation of facts of the case to arbitrators,

including documents and live or written

testimony – claimant(s)

• Presentation of facts of the case to arbitrators,

including documents and live or written

testimony – respondent(s)

• Presentation of any counter-claims,

cross-claims or third-party claims

• Rebuttal evidence

• Closing statements

(claimant can choose to go last)

• Arbitration panel closes the record

After the arbitration panel has heard all testimony

and the record is closed, the panel will then

deliberate and issue an award.

When do the arbitrators decide

the case?

After closing the hearing, the arbitration panel

considers all of the evidence, deliberates together, and

decides whether the claimant is entitled to any relief.

In a three-arbitrator panel, an award is based on the

vote of a majority of the arbitrators; a unanimous

decision is not required. Within thirty days of the date

the record is closed, FINRA will mail to the parties the

award describing the determination of the panel.

FINRA CUSTOMER CODE 12904

PART II Resolving Disputes: The Arbitration Process

                                                                                22

What is contained in an

arbitration award?

Awards must be in writing, but arbitrators are not

required to write opinions or provide explanations or

reasons for their decision. Decisions made in FINRA

arbitrations are final; even if new evidence surfaces

later, arbitrators cannot reconsider their decisions. In

the award, the panel must also decide whether to

assess any costs and forum fees against any party, and

how to allocate those costs and fees among the parties.

Past arbitration awards are available online at

http://finraawardsonline.finra.org/.

The award contains the following information:

• Names of the parties

• Names of the parties’ representatives, if any

• An acknowledgement by the arbitrators that they

have each read the pleadings and other materials

filed by the parties

• A summary of the issues, including the type of

any security or product in controversy

• Damages and other relief requested

• Damages and other relief awarded

• A statement of any other issues resolved

• Allocation of forum fees and any other fees

allocable by the panel

• Names of the arbitrators

• Dates the claim was filed and the award rendered

• The number and dates of hearing sessions

• Location of the hearings

• The arbitrators’ signatures

FINRA CUSTOMER CODE 12904

                                                                                   23

Resolving Disputes: The Arbitration Process PART II

How can I collect on an award or

settlement?

Many arbitration cases end with a settlement between

parties either through direct negotiation or through

mediation. Others are withdrawn or closed before the

process begins. Of arbitration claims that go to a final

decision each year, roughly one-half of claimants

historically have received some type of monetary

award, although that statistic has varied substantially.

If you are awarded damages, you can expect to be paid

within thirty days of receiving the arbitrators’ final

decision, unless the losing party files a motion to

vacate (overturn) or modify the award in court.

If a broker or firm does not pay an award within thirty

days after receiving the award, you should notify

FINRA. FINRA can suspend or cancel the registration

of a brokerage firm or broker if the member does not

comply with an arbitration award or settlement related

to an arbitration or mediation. As a result, brokerage

firms and brokers who remain in the business

generally pay the arbitration awards or amounts under

settlements that they owe. The broker or firm can

legitimately delay paying an award, however, if it has

filed a motion to vacate or modify the award in court.

Alternatively, if the broker or firm is no longer

registered with FINRA, you may have to go to state or

federal court to enforce the award or settlement. If

your broker or brokerage firm goes out of business or

declares bankruptcy, you might not be able to recover

your money – even if the arbitrator or a court has ruled

in your favor. Being able to collect once an award is

rendered or a settlement is signed is perhaps the single

most important reason to carefully select your broker

and brokerage firm by thoroughly checking their

history and longevity in the securities industry.

For additional information on steps that a claimant can

take if the award or settlement is not paid, see “What if

I Don’t Get Paid,” at

http://www.finra.org/arbitration/nonpayment.

                                                                                  24

PART II Resolving Disputes: The Arbitration Process

                                                                                  25

Resolving Disputes: The Arbitration Process PART II

PART III

Resolving Disputes: The Mediation Alternative

What is mediation?

Mediation is an informal, voluntary, and non-binding dispute resolution

process in which all parties agree to present their claims to a neutral

third-party, called a mediator, who will then help the parties try to reach

a mutually consensual resolution of the dispute. The mediator does not

decide who is right or wrong, or how much the parties pay.

FINRA administers a securities mediation forum. Its rules of procedure

are contained in the Code of Mediation Procedure. Complete

information about FINRA’s mediation forum, including its Mediation

Code, is available online at www.finra.org/ArbitrationMediation/.

In addition, parties can agree among themselves to use any other

mediation forum to which they consent, or they can even hire a private

mediator outside of a forum. Since mediation is an entirely consensual

process within the parties’ control, any forum and/or mediator could

facilitate a successful settlement of the dispute.

Why should I agree to use mediation?

There are a number of reasons why parties should consider mediation as

an alternative to litigation or arbitration.

Mediation generally costs less than arbitration or litigation. The fees and

expenses associated with mediation are relatively modest because the

process takes less time and involves fewer formal procedures. For

example, there is no formal discovery process, so parties do not incur

attorneys’ fees for that process. Instead, before mediation sessions

begin, the mediator generally asks the parties to submit information they

feel will help the mediator understand the dispute and their respective

positions and interests.

The mediation process is non-binding, which means that parties may,

but are not required, to settle. Because parties control the outcome,

however, settlement potential tends to be high. The mediator merely

facilitates negotiations as opposed to handing down an award. Parties

can enter mediation without jeopardizing their option to arbitrate or

litigate. The emphasis is on reaching a solution satisfactory to both

sides. Once a settlement agreement is signed, of course, it is enforceable

as with any other contract.

Mediation typically achieves a faster resolution, with

less financial strain to either party. Parties don’t have

the right to appeal from a mediator’s recommendation,

as it is not binding, so the process can begin and end in

a matter of days, or weeks, rather than months or years.

The more flexible and less adversarial nature of

mediation maximizes the chances for preserving

professional relationships.

Mediation can narrow the issues in dispute, leading to

a more efficient resolution in arbitration or in court.

Therefore it is valuable even when parties do not reach

a settlement.

Mediation is confidential in most states and under

FINRA’s rules, so you can freely disclose facts to the

mediator without worrying that the mediator will

disclose them publicly.

If these factors are important to you, then you should

consider initiating your claim in mediation before

pursuing arbitration or litigation.

Of course, mediation is not always the best option for

everyone. For those who seek an outcome that has the

potential to publicize the broker’s and/or firm’s

behavior, perhaps to warn other investors of the

conduct, then arbitration or litigation (if available)

may be better alternatives.

Mediation is not right for everyone —

Consider its features and decide

whether it is right for you.

Can parties agree to mediate and

arbitrate the same dispute?

Parties may mediate before filing a formal claim or

pleading in arbitration, instead of pursuing arbitration,

or they can initiate mediation of all or some of the

issues in dispute at any stage of a pending arbitration

matter. Parties also can choose whether or not to have

the mediation run separate from, but concurrent with, a

pending arbitration or litigation. Unless the parties

agree, a pending arbitration will not be delayed at all if

there is a concurrent mediation. If the two procedures

run concurrently, then the parties incur the costs of

both, but do not risk prolonging the arbitration process.

Alternatively, if the parties agree to put the arbitration

on hold, they avoid potentially unnecessary arbitration

costs if the mediation is successful but delay the

arbitration process if the mediation is not successful.

If cost is the most important factor to you, then you

should not pursue both mediation and arbitration at the

same time. On the other hand, if time is the most

important factor to you, then you should pursue them

both at the same time.

PART III Resolving Disputes: The Mediation Alternative

                                                                                 26

Type of Fee When due Amount Due From Customer*

Depends on size and complexity of case;

number of parties involved; mediator’s rate.

Split between parties equally, unless they

agree otherwise.

Hourly rate + Preparation + Travel + Other

(e.g., parking, etc.)

Note: if amount in controversy is $25,000 or less,

some mediators will reduce hourly rates.

Administrative

Filing Fee

Mediation

Session Deposit

Mediator Fee

When all parties to

the dispute agree to

mediate

When parties have

signed submission

agreement and before

mediation begins

When parties select

their mediator

Amount in

controversy

$.01 – 25,000

$25,000.01 –

100,000

Over $100,000

Fee if case

directly filed

in mediation

$50

$150

$300

Fee if case

initially filed

in arbitration

$0

$100

$250

*Respondents pay higher fees

FINRA Mediation Forum Fees

*This table does NOT include attorney’s fees.

What fees must I pay?

FINRA CODE OF MEDIATION PROCEDURE 14110

Resolving Disputes: The Mediation Alternative PART III

                                                                               27

What takes place during the

mediation process?

1.  Parties agree to mediate.

Mediation is a voluntary process. Therefore, while no

party may be compelled to mediate, investors

interested in initiating mediation and using a case

administrator must alert a mediation forum of their

intent to mediate. For example, FINRA requires an

“Intent to Mediate” form.

2.  Parties submit the matter to mediation.

Once all parties to the dispute have agreed to mediate,

they must sign a written agreement which indicates that

all parties agree to submit to the mediation process.

FINRA calls this a “SubmissionAgreement.”

3.  Parties agree to a mediator.

Who are the mediators?

Mediators are independent neutral third parties, many of

whom have extensive knowledge of securities law and

industry practice. For any mediator assigned or selected

from a list provided by FINRA,  FINRA will provide the

parties with information relating to the mediator’s

employment, education, and professional background.

In addition,  FINRA will describe the mediator’s

experience, training, and credentials.

How are the mediators selected?

• By the parties from a list supplied by the Director of

the forum

• By the parties from a list or other source of their

own choosing; or

• By the Director of the forum if the parties do not

select a mediator after submitting a matter to

mediation.

What is the mediator’s role?

The mediator’s role is to help the parties reach an

agreement that is acceptable to both sides. Depending

on the parties’ needs, the mediator may have the

parties meet face-to-face to discuss all of the issues

surrounding the dispute. The mediator may also hold

private meetings with each party separately, known as

caucuses. It is the mediator’s job to help the parties

communicate in a productive and positive manner.

Therefore, the mediator may assist the parties by

clarifying issues, addressing questions, and offering

creative solutions.

PART III Resolving Disputes: The Mediation Alternative

                                                                               28

Resolving Disputes: The Mediation Alternative PART III

                                                                               29

4.  Parties schedule mediation sessions.

The mediator and the parties select a mutually

convenient date and location for the mediation. After

the sessions are scheduled, meetings may be

conducted in person, by telephone, video conference

or any other method agreed to. Both joint and private

sessions may be appropriate. Parties may present facts,

address liability and damages, provide background

information, and vent key concerns and/or needs.

However, participants do not provide sworn testimony

and are not subject to cross examination.

Mediators facilitate the exchange of settlement offers

and help the parties reach a common solution. Efforts

to reach a settlement through mediation will continue

until:

• The parties agree to a resolution and execute a

written settlement;

• The parties conclude that further efforts to mediate

would be useless; or

• Any party or the mediator withdraws from the

mediation process for any reason.

5.  Parties may reach a settlement.

Historically, parties have reached a settlement in about

75% to 80% of FINRA mediations.

If the parties reach a mutually acceptable resolution, they

(or their lawyers) will draft a document detailing all

terms of the settlement. At the close of mediation, once

all parties have agreed to its terms, the parties sign and

execute the written settlement agreement. This

agreement is final and binding on the parties.

Even if the parties do not fully settle their dispute

during mediation, the process of mediation improves

the lines of communication between the parties so that

they will be in a better position to settle the case at a

later stage.

                                                                                  30

PART III Resolving Disputes: The Mediation Alternative

Conclusion

We hope this Guide has been helpful to you in learning

about some of your rights and responsibilities as an

investor and customer of a brokerage firm, how to

avoid disputes with your securities broker, and how to

resolve those disputes in arbitration or mediation if

they arise. If a dispute does occur, we hope you will

consider the factors we set out in Section II about

arbitration and in Section III about mediation before

identifying the appropriate dispute resolution process

to resolve your claim.

For additional information or assistance in finding

an attorney to represent you, please contact the

Pace Investor Rights Clinic:

John Jay Legal Services, Inc.

Investor Rights Clinic

Pace University School of Law

80 North Broadway

White Plains, N.Y. 10603

(914) 422-4333

(914) 422-4391 (fax)

jjls@law.pace.edu

John Jay Legal Services, Inc.

Investor Rights Clinic

Pace University School of Law

80 North Broadway

White Plains, NY 10603

Non Profit Org.

US Postage

PAID

Pace University

                                       Control Person Liability Analysis

                Normally, in securities arbitration, we seldom name the broker, directly.  The reason for this was summed up in a recent NASD arbitration where the arbitration panel assessed a sizeable award against the broker only,  and not joint and several against the broker and the firm.  This position is also because the broker, if named, will often fight any settlement to the death and usually enlist their own outside attorney.  We now face two attorneys, one for the firm and one for the broker.  Further, the arbitration panel might split the award separately between the firm and the broker leaving us with only one viable collection source.  The only exception to the above rule is when we have a financially shaky brokerage firm and there is a collectibility problem there.  Then, and only then, do we name the broker.  We also do something else at that time.  We name all of the Control Persons of the B/D.

                In these times of economic uncertainty and volatility, it is essential to pursue claims that provide a reasonable measure of collectibility.  To pursue claims against broker-dealer firms that are not viable financially is folly indeed.  Too many of these entities have vanished, declared bankruptcy or been taken over with an “asset only purchase”, leaving claimant’s with an award that is uncollectable.  It is essential therefore, to consider naming “control persons” in statements of claim even if the names, by necessity will have to be furnished later.  This will usually follow the subpoena of Form BD from the NASD where the Control Persons along with their percentage ownership is indicated, relative to the time period at issue.

                The Securities Exchange Act of 1934 was enacted to strengthen protection for individual investors.  Section 20 (a)* makes a “controlling person jointly and severally liable for the securities violations caused by those persons whom they control.  By enacting Section 20(a) of the 1934 Securities Exchange Act, Congress intended to broaden the liability of “controlling persons” to deter those in a position to directly or indirectly exert their influence over the policy and decision making process of securities firms.

               The control person statute broadens joint and several liability for “controlling persons” for securities violations irrespective of whether the control person directly supervised the primary wrongdoer.  The importance of “controlling person” liability, as compared to respondeat superior, is the broader policy of holding those persons liable who control the policy and activities of the firm which allowed the specific wrongful conduct to occur.  As opposed to common law which does not permit liability without knowledge, federal law provides for liability with or without knowledge.

              In order to invoke Section 20 (a) in the ninth circuit, a plaintiff must first prove that the defendant  is a “controlling person” within the meaning of Section 20 (a).  In Hollinger v. Titan Capital Corp., the ninth circuit adopted the SEC definition of control as the “possession, directly or indirectly of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities or by contract, or otherwise.”

             Previous ninth circuit cases required a plaintiff to prove that the “controlling person” was a “culpable participant” in the act or omission. The language of Hollinger dispelled the notion; the court stated: “(w)e hold that a plaintiff is not required to show “culpable participation” to establish that a broker-dealer was a controlling person under Section 20 (a).  Once a plaintiff proves that a secondary actor is a “controlling person” within Section 20 (a), the burden of proof shifts to the defendant to prove that he acted in “good faith.”

            Recently, in Harrison v. Dean Witter Reynolds, the seventh circuit set forth the standards for control person liability.  The circuit requires a showing similar to the ninth circuit; it mandates that a plaintiff prove: “some direct means of discipline or influence, although short of actual direction, is sufficient to hold a person possessed the power or the ability to control the specific transaction upon which the violation was predicated.

           The tenth circuit suggests that the control person doctrine is to be interpreted liberally and only requires some indirect means of actual influence or direction by a broker-dealer to hold him liable as a “controlling person.”

           In First Interstate v. Pring, the court articulated a position similar to the one set forth in the Hollinger court requiring a plaintiff to prove:  1) a primary violation and,  2) that the secondary defendant was a control person.  A control person need not have been involved in the particular transaction in issue.

          Once the plaintiff established a prima facie case under Section 20(a), as in the ninth circuit, the burden of proving “good faith” shifts to the defendant.  To meet this burden, a defendant must prove that “he exercised due care in his supervision of the violator’s activities in that he maintained and enforced a reasonable and proper system of supervision and internal control”, one that was set in place to prevent violations.”

·         Section 20 (a) states:  “Every person who, directly or indirectly, controls a person liable under any provision of this chapter or of any rule or regulation thereunder shall also be liable jointly and severally with and to the same extent as such controlled person to any person to whom such controlled person is liable, unless the controlled person acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action.” (15 U.S. C. #78T (a) (1988).

In addition to identifying the officers and directors of the firm on the form BD, the firm’s are also required to designate their “control” persons.  There is a box conveniently marked “control person” in which the firm is required to say “yes” or “no” as to each individual.  In addition, there is also a box for “ownership code” wherein the firm is required to set forth the percentage of ownership of each person listed as an officer, director or other control person.  On the reverse side of Form BD, is an instruction page which, under section 4, provides a definition of control person as follows:

               “Control – The power, indirectly or indirectly, to direct the management or policies of a company, whether through ownership of securities, by contract, or otherwise.  Any person that (i) is a director, general partner or officer exercising executive responsibility (or having similar status or functions); (ii) directly or indirectly has the right to vote 25% or more of a class of a voting security or has the power to sell or direct the sale of 25% or more of a class of voting securities; or (iii) in the case of a partnership, has the right to receive upon dissolution, or has contributed, 25% or more of the capital, is presumed to control that company. (This definition is used solely for the purpose of Form BD)”

Note that the last sentence of the definition purports to self limit the control person definition only for  the purposes of the Form BD.  Respondent’s counsel will likely rely on this purported limitation to undercut claimant’s counsels argument that the brokerage firm itself, in reporting to the regulatory authorities, has indicated who the control persons are.  There is no discovered case law which addresses whether or not respondent’s counsel is correct in attempting to limit the definition for control person to the form and not to the statutory definition of control person.  However, an argument can be made by claimant’s counsel that since the Form BD is a public document, the brokerage firm is informing the world that there are specific people at the brokerage firm who are in control of its activities.  In Gardner v. Stratton Oakmont, No. 96-02076, 1997 WL 290168, (N.A.S.D.) respondent’s counsel made this precise argument which the panel rejected in awarding more than $10 million dollars in punitive and compensatory damages against four control persons.  The panel expressly found that the award was premised upon these control persons’ “participation in the overall business” of the firm even though they had no direct contact with or even knowledge of the claimants account.    In CA, one would be wise to read –  http://tinyurl.com/7hp6boo.

                                                         ATTORNEY’S FEES

E.  The awarding of attorney’s fees in arbitration.

           It is well settled, in arbitration, that there must be a legal precedent for attorney’s fees to be awarded by a panel.  Typically, attorneys for claimant turn to California Civil Code # 1717 which contends that attorney’s fees may be awarded only by contract.  When there is a margin agreement, signed by  claimant, that has an “attorney’s fee provision”, it is argued that there is an implied agreement (contract) between the brokerage firm and the claimant.  In other words, if one party has the right to collect attorney’s fees, the other part has a reciprocal right.  Arbitration panels have often awarded attorney’s fees to a claimant, as the prevailing party, based upon this legal precedent.  However, what if there is no margin agreement and hence no contract.

          In the United States Court of Appeals for the Ninth Circuit – 2002 U.S. App. Lexis 14924 No. 02-56016, No. 02-56052 – June 5, 2003, (Coutee v. Barington Capital Group, L.P., Morton Berale Gropper; Bruce Adam Gropper; James Anthony Mitarotonda; Jerome Snyder; John Telfer) Argued and submitted, Pasadena, California, July 28, 2003, Filed:

          The Court of Appeals reversed the district court’s vacature of the attorney’s fee portion of the arbitration award.  Attorney’s fees were upheld for the following reasons:

          1.  The arbitrators granted attorney’s fees pursuant to California Welfare and Institutions Code section 15657*, which provides that where a defendant is guilty of financial abuse toward an elder, “the court shall award to the plaintiff reasonable attorney’s fees and costs.”  Cal. Wel. & Inst. Code #  15657 (a).  Note – The failure to adhere to the California choice of law clause was considered a “harmless error’.

          2.  An arbitration panel may award attorney’s fees, even if not otherwise authorized by law to do so, if both parties submit the [recovery of attorney’s fees] issue to arbitration.  See First Interregional Equity Corp. v. Haughton, 842 F. Supp. 105, 112-13 (S.D.N.Y. 1994).

               Where both parties to an arbitration seek attorney’s fees, courts routinely hold the parties’ consensual jurisdiction to award attorney’s fees, U.S. Offshore, Inc. v. Seabulk Offshore, Ltd., 753 F. Supp. 86,92 (S.D.N.Y. 1990).  In Seabulk, the Court concluded that since both parties had requested attorney’s fees , the arbitrators had the power and authority, given them by the parties who both asked for them, to award legal fees and costs: If both parties sought attorney’s fees, as was apparently the case here, then both parties agreed pro tanto to submit that issue to arbitration, and the arbitrators had jurisdiction to consider that issue and to award them.  Seabulk Offshore, Ltd., 753 F. Supp. at 92; accord First Interregional Equity Corp. v. Haughton, 842 F. supp. 105, 112 (S.D.N.Y.1994), citing Neuberger & Berman v. Donaldson Lufkin and Jenrette Securities corp., No. 91-16833 (N.Y. Sup. Ct., N.Y. County 1992).  In Marshall & Co., Inc. v. Duke, 114 F.3d 188 (11th Cir. 1997), the Eleventh Circuit court of Appeals reached the same conclusion, that it was sufficient support for an award of fees that the parties agreed to submit the issue of attorney’s fees and expenses to the Panel so that an enforceable “bi-lateral agreement” existed.

      *  As quoted in Section IV. G. California Welfare and Institutions Code section 15600(h) states that is is the “intent of the Legislature…to enable interested persons to engage attorneys to take up the cause of abused elderly persons…”  section 15657 of such Code in pertinent part provides:

             “Where it is proven by clear and convincing evidence that a defendant is liable for …financial abuse as defined in Section 15610.30**, and that the defendant has been guilty of recklessness, oppression, fraud, or malice in the commission of this abuse, in addition to all other remedies otherwise provided by law:  (a) the court shall award to the plaintiff reasonable attorney’s fees and costs…[Emphasis added.]

               **Section 15610.30 defines “financial abuse” as follows:

      (a)  “Financial abuse” of an elder or dependent adult occurs when a person or entity does any of the following:

               (1)  Takes, secretes, appropriates, or retains real or personal property of an elder or dependent adult to a wrongful use or with intent to defraud, or both.

               (2)  Assists in taking, secreting, appropriating, or retaining real or personal property of an elder or dependent adult to a wrongful use or with intent to defraud, or both

     (b)  A person or entity shall be deemed to have taken, secreted, appropriated, or retained property for a wrongful use if, among other things, the person or entity takes, secretes, appropriates or retains possession of property in bad faith.

               (1)  A person or entity shall be deemed to have acted in bad faith if the person or entity knew or should have known that the elder or dependent adult had the right to have the property transferred or made readily available to the elder or dependent adult or to his or her representative.

               (2)  For purposes of this section, a person or entity should have known of a right specified in paragraph (1) if, on the basis of the information, received by the person or entity or the person or entity’s authorized third party, or both, it is obvious to a reasonable person that the elder or dependent adult has a right specified in paragraph (1).

There is another theory for possible recovery of attorney’s fees in arbitration.  There exists statutory grounds that provide authority for the award of attorney’s fees to claimants.  The statutory grounds for attorney’s fees relate to the deceptive and misleading statements of the respondent firm’s broker.  The Consumer Legal Remedies Act (California Civil Code # 1750, et seq.) #1780 states: (This theory is based on the advice, rather than the securities themselves, being deceptive and misleading goods and services)

      ” (a)  any customer who suffers any damage as a result of the use or employment by any person of a method, act, or practice declared to be unlawful by Section 1770 may bring an action against that person to recover or obtain any of the following:

          (1)  Actual damages, but in no case shall the total award of damages in a class action be less than one thousand dollars ($1.000).

          (2)  An order enjoining such methods, acts or practices.

          (3)  Restitution of property.

          (4)  Punitive Damages.

          (5)  Any other relief that the court deems proper.

     (d)  The court shall award court costs and attorney’s fees to a prevailing plaintiff in litigation filed pursuant to this section.”    #1780 (e)  (Emphases added).

     California Civil Code #1770 makes it unlawful to use unfair or deceptive methods of competition.  The following are certain enumerated deceptive and unfair methods of competition:

          “(5)  Representing that goods or services have…characteristics…uses, [or] benefits…which they do not have…

           (7)  Representing that goods or services are of a particular standard quality, or grade or that goods are of a particular style or modes, if they are of another.

          (16)  Representing that the subject of a transaction has been supplied in accordance with a previous representation when it has not.

         (17)  Representing that the consumer will receive a rebate, discount, or other economic benefit, if the earning of the benefit is contingent on an event to occur subsequent to the consumption of the transaction.”

              The statute describes the exact nature of misrepresentations made by a broker to his client.  California case law supports the theory that claimant’s are entitled to attorney’s fees.  The California Supreme Court recently held that claimant’s that prevail under the Consumer Legal Remedies Act in arbitration would be entitled to costs and attorney’s fees.  Broughton v. Cigna Healthplans of California,  21 Cal. 4th 1066 (1999).  The Broughten court states in pertinent part:

          “We agree with plaintiffs that the availability of costs and attorney’s fees to prevailing plaintiff’s is integral to making the Consumer Legal Remedies Act (CLRA) an effective piece of consumer legislation increasing the financial feasibility of bringing suits under the statute (See enrolled Bill Rep, on Assem. Bill No. 3756 (1987-1988 Reg. Sess.) p.3.)…” Broughten  at page 1087.

                                                      DAMAGES

F.  Damages Analysis  – The following methodologies were taken in large part from a 2000 Practising Law Institute article by Mary Calhoun and Ross Tulman.   My own comments and relevant case citings are added, when applicable, and where the experts disagree, I have added my own thoughts, selected a preference and taken certain editorial liberties.

                                       MARKET ADJUSTED DAMAGES

               Market adjusted damages calculations adjust the gain or loss in the account to a market-based equivalent.  In other words, they calculate what the account would have earned had it been invested in some other investment alternative or equivalent such as the S&P Composite Index or composite of mutual funds with a growth or growth and income objective.

             The proper measure of damages in California for breach of fiduciary duty is to put the Claimant in the position he would have been in if not for Respondent’s conduct.  (Twomey v. Mitchum, Jones & Templeton, Inc. (1968) 262 Cal. App. 2d 690, 730.)  The Federal standard is in accord.  Medical Associates of Hamburg v. Advest, Inc. (W.D.N.Y. (1989) 1989 U.S.D.C. Lexis 11253.)  In fact, Hamburg held that when unsuitable transactions are involved, the proper measure of damages is to assume that the funds had been placed in suitable indexes.  See Rolf v. Blyth, Eastman Dillon & Co., Inc., 570 F. 2d 38, 48-50 (2d Cir. 1978) (stating that the proper method of calculating damages is to take the initial value of the claimants’ portfolio, adjust by a percentage change in an appropriate index i.e. the Standard & Poor’s 500 Composite Index, during the relevant period, and subtract the value of the portfolio at the end of the period.  See also Randall v. Loftsgarden, 478 U.S. 647, 661-62 (1986) (stating that ordinarily “the correct measure of damages…is the difference between the fair value of all that the plaintiff received and the fair value of what he would have received had there been no fraudulent conduct”).  The “well-managed” account” theory of damages was approved in the case of Miley v. Oppenheimer & Company, 637 F.2d 318, 326 (5th Cir.) Rehearing denied, 642 F.2d 1210 (5th Cir. 1981).  The proper measure of damages in California and federal law, is spelled out in Civil Code section 3333 as follows:  “For the breach of an obligation not arising from contract, the measure of damages, except where otherwise expressly prohibited by this Code, is the amount which will compensate for all the detriment proximately caused thereby, whether it could have been anticipated or not.”  The California court of appeals held in Walsh v. Hooker & Fay (1963) 212 Cal. App. 2d 450, that out-of-pocket damages are not the proper measure in a fiduciary breach situation.  In addressing the fiduciary relationship with a broker, the court said:  “An exception to the foregoing rule is recognized where a fiduciary relationship exists between the fraudulent and the defrauded parties… as to such cases the much broader provisions of Section 3333 and 1709 of the Civil Code are applicable.”  (Id. at pp. 458-459; Twomey, supra, 262 Cal. App. 2d 690, 731.)  The court went on to make it clear that in the case where a party is entitled to recover damages from a fiduciary, the proper damages are all damages suffered or all detriment proximately caused by the breach of fiduciary obligation.   In the final analysis, the law clearly recognizes that a brokerage firm’s client is entitled to the “benefit of the bargain” or “properly managed account” damages.  See Levine v. E.F. Hutton & Co., 636 F.Supp. 899-900 (N.D. Ill. 1986) (plaintiffs recovered the difference between losses incurred on the sale of speculative securities and the greater amount plaintiffs would have received had they not been defrauded); Hatrock v. Edward d. Jones & Co.,750 F.2d 767, 773-774 (9th Cir. 1984)(investor may recover the decline in value of the investor’s portfolio in an amount equal to “the difference between what [the plaintiff] would have had if the account ha[d] been handled legitimately and what he in fact had at the time the violation ended”).   Lastly, in applying the benefit of the bargain rule, it doesn’t matter whether the investment markets are ascending or declining during the relevant time frame.  See Medical Associates v. Advest, and Rolf v. Blyth, Eastman Dillon & Co. Inc., mentioned above.  Also see Salahutdin v. Valley of California, Inc., 24 Cal. App.4th 555 (1994), citing Walsh v. Hooker & Fay, 212 Cal. App. 2d 450, 458-459 [fiduciary relationship between stockbroker and client made application of benefit of bargian rather than out of pocket rule appropriate].

              The case-law basis for market adjusted damages is simply that they provide an automatic adjustment for any market-based activity, such as “crashes”, that were not caused by the respondent’s wrongdoing.  In other words, even if the claimant’s investments declined along with the general market, they would not have declined as much as they did in speculative, heavily-margined securities.  Thus, market-adjusted damages avoid what is sometimes called in the case law “unjust compensation” received by the investor, who presumable assumed the general risk of investing in the market, but not the specific risk of investing in unsuitable securities or investing on margin.

               Thus, in a falling market, market-adjusted damages reduce the loss caused by unsuitable or otherwise improper activity; in a rising market, market-adjusted damages compensate the investor for lost total return because of improper investments.  These types of calculations go by many names:  “Miley” damages, after one of the seminal damages cases (Miley v. Oppenheimer & Co., 637 F.2d 318, 326 (5th Cir.) reh’g denied, 642 F2d 1210 (5th Cir. 1981), “well-managed account” damages, “properly-managed account” damages, “lost-opportunity” damages, “benefit of the bargain” damages, or “lost profits” damages.

                Generally, we tend to use the market-adjusted damages terminology under a properly-managed account theory.  We tend not to use “well-managed”, since it’s not necessary that an account be well-managed; it is only necessary that an account be suitably, or properly managed.  In other words, had an account been invested suitably and properly in accordance with the investor’s financial profile, understanding, and investment objectives, it would have performed differently than it actually did.  In most cases, the claimant’s damages calculation indicates that, had the account been conservatively managed, there would have been no out-of-pocket loss, and, instead, the account would have generated a positive total return.  Thus, the claimant seeks as damages the out-of-pocket loss plus a market-adjusted damages component.

                  There are instances when even if the account had been suitably maintained, the account would have suffered losses.  Therefore, it is possible that this measurement of damages could provide a remedy that is smaller than the out-of-pocket loss.  It is ironic that respondents sometimes discount the validity of this theory of damages.  The proof of its merit is that, if done properly, it does not discriminate between profits or losses.  Its usefulness is merely to adjust for harms created in proven causes of action.

                  When the claimant has an out-of-pocket gain, the market-adjusted loss may still be significant, if the claimant’s portfolio significantly under-performed one composed of more suitable securities, or one that was not excessively traded.

                 In general, the primary questions in a market-adjusted damages calculation are:

                   1)   What is/are the appropriate investment alternative(s) to use in the calculation? And

                   2).  How is the calculation performed?

                  In choosing investment alternatives or equivalents, there are many choices.  One approach is generally to present a “Model Portfolio” to the panel, representing a portfolio allocated to the investor’s specific investment objectives.

                                     PRESENTING A MODEL PORTFOLIO

                  The first step in presenting a Model Portfolio is to select the appropriate alternative theories and building blocks to present to the panel.

Unadjusted Portfolio

                 The simplest form of unadjusted portfolio calculation is made when an investor deposits a large amount of a single security as collateral in a margin account.  Much to the alleged surprise of the investor, the security is sold pursuant to margin calls, and the claimant requests restoration of the position or monetary damages.

                  This calculation is relatively straightforward, in that it requires a calculation of the current value of the shares, adjusted for splits and dividends.  Other losses occurring in the account may be sought as damages, as well as margin interest.

                   More complex unadjusted portfolio damages might be used when the claimant brings to the brokerage firm a portfolio of predominantly blue-chip stocks and investment-grade bonds.  These securities are sold and the registered rep launches the account into a frenzy of heavily-margined trading of speculative securities.  While simple in theory, the calculations for unadjusted portfolios can be extraordinarily complex.  One rule of thumb is that 90% of the securities are simple:  find the current price, adjust for splits, and add dividends.  However, the other 10% may take many hours of research due to mergers, spin-offs, liquidations, name changes, and the like.  Additionally, proceeding with this approach assumes that all securities that were received in by the broker would have been maintained throughout the life of the account.  From a practical standpoint, this rarely occurs.  For these reasons, we often recommend the use of a market index or equivalent as a proxy for a properly-managed account in this scenario.

 Market Indices

                     Market indices such as the S&P 500 Composite Index, S&P Utility Index, Lehman Brothers Corporate or Government Bond Index, or the Dow Jones Industrial Average are frequently used.  Indices such as the NASDAQ composite may be used to represent the speculative portion of an investor’s portfolio.  There is explicit support for the use of such indices in the case law.  For example, in Miley, the plaintiff’s damages were reduced ”by the average percentage decline in value of the Dow Jones Industrials or the Standard and Poor’s Index during the relevant period of time”.  Likewise, Rolf v. Blyth Eastman Dillon, 570 F.2d 38 (2nd Cir., 1978) (“Rolf II) reduced damages by “the average percentage decline in value of the Dow Jones Industrials, the Standard & Poor’s Index, or any well-recognized index of value, or combination of indices, or the national securities markets…”

                     While the courts have generally accepted this approach, there are some inherent problems.  The use of an index ignores the typical costs incurred when investing with a full service broker, although this adjustment can be factored in.  Few investors walk in to see a broker and ask to invest in an index; few brokers recommend index funds; and even fewer brokers make recommendations that over time perform as well as or better than an index.  Therefore, respondent’s counsel may argue that the use of an index is merely speculative since the investor’s account was unlikely to be so invested or to perform that well even if suitably maintained.  Non-index mutual funds as portfolio alternatives may also be used except in instances where an index is a more appropriate investment proxy than a fund.

Mutual Funds

                   The use of mutual fund averages is an ideal way to provide a “real-world” model portfolio for the investor whose funds should have been conservatively managed.  Software that performs these portfolio calculations for literally thousands of funds in the mutual fund universe as well as indexes is available from Thomson Financial/CDA Wiesenberger and Morningstar, Inc.  In the Thomson financial Investment View, which I prefer, the data is updated monthly and can be accessed by CD-ROM or downloaded directly from the company’s web site.  The software encompasses historical data for more than 10,000 open end funds, closed end funds, indexes and variable annuities.  It also includes templates that allow for empirical modeling.

                   Often, it is extremely effective to present calculations to the panel using the respondent brokerage firm’s own in-house funds.  Where the firm does not have in-house funds you could use the list (often provided on the brokerage firm’s website) of fund families with whom the firm has selling agreements, then use the Thomson Financial software to calculate portfolio results using flagship funds in those families.

                   You could use all of the funds that fit the customer’s objectives from the chosen fund family or families that were in existence for the life of the accounts at issue.  The results can be averaged or looked at individually, giving the panel a degree of flexibility if they choose to apply this remedy.  Thomson Financial also has the capability of making time weighted deposits and withdrawals.

Other Investment Alternatives

                   Often, investors should have some percentage of their funds invested in alternatives such as money-market funds or CD’s.  Where appropriate, we include these calculations in the alternatives presented to the panel.

                                     Calculating Market-Adjusted Total Return

                  In the two seminal market-adjusted damages cases, Miley (1981 and Rolf ( 1978), the market-adjusted damages calculation is very simple: the out-of-pocket loss is reduced (in the declining market of the ‘70’s) by the percentage decline of a market index during the period.

                  It’s always helpful to remember that these calculations were made long before the PC era; the simplicity of the calculation reflected the tools (green accounting paper, calculator, pencil, eraser) available at the time.  However, the simplicity of the archaic calculation is offset by its deficiency:  because  it is neither time-weighted nor dollar-weighted, it may under-compensate some investors and over-compensate others.  Moreover, and in some cases even more significant, it ignores the effect of dividends and interest where non-total-return indices are used.  One additional archeological fact known to most damages experts is that there is an error in the Miley calculation as stated in the opinion: it double-counts the dividends.  Most experts ignore the error and perform the calculation correctly.

                Today, spreadsheets, databases, and the widespread availability of index-based data make far more sophisticated, accurate calculations possible.  We utilize such sophisticated tools to actually simulate the performance of an account utilizing different investment alternatives.  It is easy to use our models to time-weight and dollar-weight performance, add dividends and interest, and to do so for literally thousands of investment alternatives.  Although the models have the ability to perform some calculations on a daily basis, we simplify the calculations to use monthly compounding in most cases.

                 The basic calculation is to take the starting amount of equity, add to it any funds or securities deposited that month, subtract all funds or securities withdrawn that month, and then adjust the equity for the actual percentage gain or loss in the index or equivalent during that historical month.  Since some indices do not provide total return, an additional step may be required to add the average dividend return for that index for the month in question.  The result of the calculation becomes the hypothetical ending equity.  This calculation is repeated every month.

                  At the end of the period, the model’s calculation of beginning equity, plus money and securities in, minus money and securities out, minus ending equity must equal the out-of-pocket gain or loss in the account.  And the hypothetical ending equity, minus the out-of-pocket loss in the account, equals the market-adjusted component of damages.  Where the account showed a gain, the hypothetical ending equity is equal to the market-adjusted component, since the gain in the account has by definition been removed form the calculation.

Selecting a Model Portfolio

                  As noted above, typically, we present the panel with a range of investment alternatives or equivalents, then select a “Model Portfolio” representing an appropriate allocation given the client’s individual suitability profile.  The calculation using this model portfolio is carried forward to the claimant’s request for damages.

                   For example, calculations for an investor who wished to invest for growth (but not speculation) might utilize a Composite Index of Weisenberger Growth Mutual Funds.  Conversely, an investor with more balanced objectives might invest in the Wiesenberger Composite Index of Balanced Mutual Funds.  Of course, an alternative might be to invest 50% in the average growth-objective mutual fund plus 50% in the Lehman Brothers Corporate Bond Index.

                   Occasionally, the portfolio that an investor forms with the help of an investment advisor, subsequent to the period in question, may determine an appropriate portfolio allocation.  We may also present the panel with a 10% rate of return calculation.  This way, if the panel chooses to calculate a 6% return, for example, they can approximate the correct figure as 60% of the 10% calculation.  Another approach is to use whatever statutory interest rate that is applicable in the state in which the claimant resides.  In choosing an appropriate model portfolio for a specific investor, we draw on our investment experience and knowledge, but defer to the panel to select an appropriate model portfolio for the claimant.  In other words, should the panel wish to choose a somewhat different model portfolio, we have made it easy for them to do an alternative calculation.

The Market-Adjusted Damages Period

                  One frequently-asked question is; whether the calculation of market-adjusted damages should extend through the present date, or end as of the date that the brokerage account was closed.  Although there is a strong argument to be made for extending it through the present, which is that, had there been no misconduct, the account would still be open and generating total return at the equivalent rate of the model portfolio, our experience is that most arbitrators feel that it is appropriate to end the calculation as of the date of closing the account.  Typically, therefore, we will end the calculation as of the closing of the account, calculating pre-judgment interest from that date to the present.  Often we will present the calculations to the panel in both ways.

Allocation of Market-Adjusted Damages for Unsuitable Securities

                Basically, “suitable maintained account” applications should look at the whole account.  However, there are instances where specific securities are at issue and when this is the case, the market adjustment should be the equivalent of the state’s statutory interest rate.

                                                   RESCISSION

                In general rescission and rescissionary damages are governed by State law.  For example, Florida’s 517.211 statute is known to every expert who performs damages calculations.  We recommend consulting with counsel to determine the statutory specifications of any rescissionary calculation, as there are slight differences in the general formula, and significant differences in the statutory rate of interest to be applied.

               Most calculations for rescission are relatively straightforward: apply a statutory rate of interest to the purchase price of the security, and subtract any distributions or sales proceeds received.  If the security is still held, it is to be transferred to the brokerage firm.  The primary advantage of the calculation for the claimant is that if places the burden of current valuation of illiquid securities upon the respondent.  For a defrauded seller, the concept is similar:  Restore the security to the claimant, or pay monetary damages to restore the financial position occupied before the transaction, less any sale proceeds received.

                                           BENEFIT OF THE BARGAIN

                Market-adjusted damages are, of course, a type of benefit of the bargain damages, the “bargain” being the explicit or implicit representation by the broker and brokerage firm that the account will be properly managed.  In this context, however, we are using the term with reference to different types of contracts or “bargains”.

Explicit Contract

                Occasionally, there is an explicit contract between the registered rep and the investor.  Such a contract in itself may be improper in that it may constitute a violation of the prohibition against reimbursing a customer for losses.  It does, however, suggest a damage alternative to be presented to the panel.  The calculation is straightforward.  For example, the rep has stated (sometimes in writing!) that he will personally guarantee a profit on the transaction(s).  If an explicit amount is stated, that becomes the amount requested as damages.

Failure to Execute a Buy or Sell Order

                 Here, the claimant requests lost profits for a buy order that was never placed in a security that dramatically increased in value.  Usually, there is little question about the price at which the security “should have” been purchased: however, there can be considerable disagreement about the valuation price to fix for the calculation of damages.  If the panel determines that the claimant’s intent was to hold; the security, then restoration of the securities may be the appropriate remedy.  If the security would have been traded, the panel must determine at what time and price it would have been sold.  Unless there is some fact that guides the calculation (for example, the claimant states that he would have held the security until it doubled, we recommend presenting the panel with a range of dates and prices related to the facts and/or to a “reasonable time and price” for sale.  For failure to sell orders, the rationale is very similar.  The key is the panel’s determination of the time and price at which the securities should have been sold.  Again, we recommend presenting the panel with alternative dates and damages representing different fact-based “reasonable” periods of time.

Misrepresentations of Account Value

                 From time to time, cases arise in which extremely unsophisticated investors are told that the total portfolio value on their statement is the value of their account.  In other words, they are instructed to look at the total securities owned, including the margin debt, rather than at the account equity.  Often, the total portfolio value of the account grows, through increasing use of margin, while the account equity actually declines.  Of course, the burden is on the claimant to establish the fact that the misrepresentation was made, and that they relied on it.  We would typically prepare an exhibit for the panel requesting restoration of the account value to the level misrepresented, plus interest.

                                              CHURNING DAMAGES

                Churning Damages are more complex than they may seem at first glance.  The traditional remedy for churning, based in case law, is the award of transaction costs as damages.  This is sometimes called the “quasi-contractual” remedy.  This discussion is not meant to exclude the calculation of market-adjusted damages in churning cases.  Indeed, most cases in our experience are a hybrid of suitability and churning claims, and arbitrators may find some mixture of remedies appropriate.  Moreover, we discuss below the award of transaction costs as disgorgement in situations where they are clearly double-counted.  Here, however, we will concentrate solely on damages based on transaction costs.

                The complexity arises because ”transaction costs” themselves are quite complex.  Are we talking about agency commissions, sales credits, spreads, markups, margin expense, or all of the above?  Moreover, commissions wear two hats for damages purposes: on the one hand, they represent a cost to the customer of trading in the account, which may have meaning for restitution purposes; on the other hand, they represent the “profit” to the registered rep and/or the brokerage firm, which may have meaning for disgorgement purposes.

Transaction Costs as Restitution in Churning Cases

               In a “pure” churning case, an account has been excessively traded, but all of the securities were suitable.  In this case, the theoretical and actual damage to the customer is the cost of trading the securities.  Therefore, the traditional award of transaction costs to the customer according to case law is correct.  It is a restitutionary remedy, not a disgorgement remedy.  In any churning case, the award of margin interest may also be appropriate; however, for simplicity, we will limit our discussion to other forms of transaction costs.  The complexity comes when we try to determine the cost of trading the securities.  If all of the securities are traded on an agency basis, it is simple: the cost of trading is the agency commissions.

              With public offerings purchased on a net basis, in most cases, the compensation to the broker and the brokerage firm is paid by the issuer.  However, this non-recoverable cost does indeed ultimately come out of the customer’s pocket.  With closed-end funds purchased in an initial public offering, the sales commission is paid directly by the customer.

              With other securities actively traded on a net basis, for example, bonds traded on a principal basis or Nasdaq transactions in which the brokerage firm is a market-maker, the customer is actually paying the spread on the security.  A markup/markdown paid on a transaction is, of course, equal to or smaller than the actual spread.  Because the purchase and sale of the security take place at different times, the actual spread must be calculated in some reasonable way.  In order to do this, several methods are used:

1.      At some firms, there is a practice of writing the actual spread at the time of order entry on the order ticket.

2.      Where historical bid/offer data is available, the closing spread of the day may be used as representative of the typical spread on the security.

3.      The gross sales credit is used as an approximation of the spread.

Transaction Costs as Disgorgement Remedy in Churning Cases

             The identification of transaction costs is much simpler in a disgorgement remedy, where the amount to be disgorged is that received by the wrongdoer.  As with restitution, agency commissions are easy to identify and calculate.  With net transactions, where the disgorger is the registered rep, it is their sales credit, regardless of the type of transaction.  Where the disgorger is the firm, the amount to be disgorged may be the sales credit as an approximation of the spread earned by the firm on a principal transaction or of the fees earned by the firm on an underwriting.  Alternatively, the spread may be calculated as indicated above.

Disgorgement of Commissions in a profitable account

                 Ill-gotten gains in a churning case are subject to disgorgement even if the account is profitable, overall.   Nesbitt v. McNeil,  896 F. 2d 380 (1990).    In the Nesbit case, supra the district court found that the broker was liable to the plaintiff for the full amount of commissions generated as a result of churning.  The court of appeals affirmed the decision.  The Nesbit case is distinguished by one fact.  In that action, the plaintiff’s account realized a gain.  The defendant’s in Nesbit argued that the gain should be offset against the ill-gotten commissions and therefore the Plaintiff should take nothing.  The Nesbit case states:

          “The district court disagreed, and gave the following instruction to the jury:  ‘If you find that the plaintiff’s have proven their claims for churning, excessive trading, plaintiff’s may recover as damages any commissions they paid as a result of the churning in excess of commissions that would have been reasonable on transactions during the pertinent time period.’  The district court did not go on to instruct the jury that it could then offset the trading gains against those commission losses.”   Nesbit   Id at 385.

The Nesbit court further stated:

          “there are two separate and distinct possible harms when an account has been churned, and those are:  first, and perhaps foremost, the investor is harmed by having had to pay the excessive commissions to the broker…  Second, the investor is harmed by the decline in the value of his portfolio…as a result of the broker’s having intentionally and deceptively concluded transactions, aimed at generating fees, which were unsuitable for the investor.  The intentional and deceptive mismanagement of a client’s account, resulting in a decline in the value of the portfolio, constitutes a compensable violation of both the federal securities laws and the broker’s common law fiduciary duty, regardless of the amount of the commissions paid to the broker.”  Id at 385.

The Nesbit court also stated:

          “The jury did not do so.  Instead, it found that plaintiff’s were indeed wronged by the defendants’ churning of the accounts… As a result, the defendant’s were properly required to disgorge the inappropriate portion of their commissions , . . . . ”  Id at 387

Calculation of “Excess” Commissions

                 One question that arises in both restitutionary and disgorgement calculations is whether to request all commissions or only “excess commissions.  Clearly, case law indicates that “excess” commissions are appropriate; however this refinement is often omitted for simplicity.  Moreover, some argue that an acceptable level of turnover is near zero and no subtraction should be made.

                  Where it is desirable to calculate the “acceptable” level of commissions, subtracting 1% a year is a relatively easy calculation and approximates the expenses the investor would pay in an account with occasional turnover or in a mutual fund.  In a disgorgement calculation, since the concept is that only “ill-gotten gains” should be disgorged, it may be appropriate to subtract a level of “acceptable” commissions.

                                       OTHER DAMAGES CALCULATIONS

Punitive Damages in Churning cases

                   An award of punitive damages is warranted in a churning case based on the nature of the malicious and fraudulent activity.  California Civil Code #3294 states in pertinent part:

                      “When permitted

                             (a) In an action for the breach of an obligation not arising from contract, where it is proven by clear and convincing evidence that the defendant has been guilty of oppression, fraud, or malice, the plaintiff, in addition to the actual damages, may recover damages for the sake of example and by way of punishing the defendant.  [Emphasis added.]

                            (b) An employer shall not be liable for damages pursuant to subdivision (a) based upon acts of an employee of the employer, unless the employer…authorized or ratified the wrongful conduct for which the damages are awarded or was personally guilty of oppression, fraud, or malice.  With respect to a corporate employer, … must be on the part of an officer, director, or managing agent of the corporation.

                           (c)  As used in this section, the following definitions shall apply:

                                    (1)  ‘Malice’ means conduct which is intended by the defendant to cause injury to the plaintiff or despicable conduct which is carried on by the defendant with willful and conscious disregard of the rights or safety of others.

                                   (3)  ‘Fraud’ means an intentional misrepresentation, deceit, or concealment of a material fact known to the defendant with the intention on the part of the defendant of thereby depriving a person of property of legal rights or otherwise causing injury.”

The Mihara case applied this statute to award punitive damages against defendant’s liable for churning.  Mihara states in pertinent part:

          “The Court instructed the jury that malice or actual fraud must be found before they can award punitive damages.  The Court also instructed that ‘malice may be inferred from acts or conduct done with knowledge that such acts of conduct were substantially certain to vex, harass, annoy or injure plaintiff.’  The Court’s instruction was proper as to the punitive damages issue.”  Mihara, supra at 825 and 826.

Commissions As Disgorgement in Non-Churning Cases

                  There is support in the case law (most clearly in Davis v. Merrill Lynch, 906 F.2d 1206 (8th Cir. 1990) for double counting of commissions and margin interest.  In other words, claimants may request out-of-pocket and/or market-adjusted damages plus commissions and margin interest as a disgorgement measure, even though they are already built into the calculation of out-of-pocket gain or loss in the account.  When this is done, we feel strongly that the expert should testify on direct examination that the numbers are double–counted, and for counsel to provide the legal argument for doing so as a disgorgement measure.

Gains and Losses Occurring After the Period in Question

                   One question that frequently arises is how to handle gains and losses on securities transferred away from the brokerage firm in question, after the delivery of the securities to another brokerage firm.  What happens after an account closes is not material to what occurred during the period giving rise to the dispute.  When liquid securities are involved, they are marked-to-the-market at the time of the account transfer.  Gains that occur after transfer do not offset damages just as losses that may continue to mount should not be charged as damages to respondent.  As experts, our primary role is; to calculate numbers and present them to the panel.  It is counsel’s role to evoke the necessary facts in testimony and provide argument for the panel’s consideration in determining whether to include post-account losses in damages.

Other Disgorgement Remedies

                   Many of the “boiler room” cases are now behind us.  However, variations of the “chop shop” manipulative schemes usually seen in these cases will occur from time to time.  In these cases, where the claimant is able to prove that respondents have engaged in market manipulative activity, it is often appropriate to request as damages disgorgement of the actual trading gains received by individual respondents from trading in their own accounts the same securities as those for which claimant suffered trading losses.

Pre-Judgment Interest

                  This is a straightforward calculation that is usually based in State law.  Statutes typically call for simple rather than compounded interest.  Our practice is to ask counsel to specify the statutory rate of interest to be applied.  Generally, we run the calculation through the anticipated date of completion of the hearing, and then asking the panel to extend the time to the date when actually paid.

Re:  California

California Civil Code Section 3287 in pertinent part provides:

(a)  every person who is entitled to recover damages certain, or capable of being made certain by calculation, and the right to recover which is vested in him upon a particular day, is entitled also to recover interest thereon from that day, except during such time as the debtor is prevented by law, or by the act of the creditor from paying the debt.  This section is applicable to recovery of damages and interest from any such debtor, including the state or any county, city, city and county, municipal corporation, public district, public agency or any political subdivision of the state.

     California Civil Code section 3287, Section 12(2)of the 1933 Act and California Corporations Code section 25501, all provide for an award of prejudgment interest, the latter statute providing that such interest shall be “at the legal rate from the date of sale” [of the subject security].  Relevant case law has established that the award of interest is in fact mandatory.   Boam v. Trident Financial Corp. (1992) 6 Cal.App.4th 738.  The applicable legal rate in the State of California for breach of contract in which the amount of interest is not stipulated, is 10%.  Cal. Civ. Code #3289.  the applicable rate for breach of an obligation not arising from contract, is left to the discretion of the trier of fact.  Cal. Civ. Code #3288.

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