FEND Securities Expert Witness
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Mason Alan Dinehart III Arbitrator - FEND Securities Expert Witness

STATUTE OF LIMITATIONS DO NOT

APPLY IN CALIFORNIA ARBITRATIONS

 

SECURITIES BROKER'S DUTIES

AS A FIDUCIARY TO A QUALIFIED TRUST

 

DUTY TO DIVERSIFY A QUALIFIED PLAN

 

GLOSSARY- CAUSES OF ACTION

 

 

Statute of Limitations do not apply in CA Arbitrations

 

    Arbitration proceedings, as a matter of statutory definition, are not "actions".

Statutes of Limitation therefore do not apply to claims brought in arbitration.

    The California Code of Civil Procedure ("CCP") addresses statutes of limitation

at CCP # 335, et seq.  CCP # 335 provides:  "[t]he periods prescribed for the

commencement of actions other than for the recovery of real property, are as follows...

" (emphasis added).  The CCP then goes on to describe each limitation period as the

time within which an "action" must be commenced.  The Legislature defined the word

"action" at CCP # 22:

                   An Action is an ordinary proceeding in a court of Justice

                   by which one party prosecutes another for the declaration,

                   enforcement, or protection of a right, the redress or prevention

                   of a wrong, or the punishment of a public offense (emphasis added)

     Several California cases have addressed the question of whether a proceeding

other than one taking place in court is an "action" for purposes of California Law.

In CITY OF OAKLAND V. PUBLIC EMPLOYEES' RETIREMENT SYSTEM,

95 Cal. App. 4th 29, 48 (2002, the Court specifically held that statutes of

limitation do not apply to administrative proceedings because they are not

"actions" in a court of law.  Citing to Witkin, the Court held:  :[t]he general and

special statute of limitation referring to actions and special proceedings are

applicable only to judicial proceedings, they do not apply to administrative

proceedings."  Id.

     four years later, in SHEPPARD V.  LIGHTPOST MUSEUM FUND, 146 Cal.

App. 4th 315 (2006) the Court was faced with a motion under CCP # 425.16 to

strike an arbitration claim.  the CCP statute in question permitted the striking of a

"complaint", cross-complaint or petition."  In denying the relief sought, the Court

held:

                    Complaints, cross-complaints and petitions are pleadings

                   which are filed in courts to initiate judicial proceedings.

                   [Citations]  Arbitration claims filed only in an arbitral

                   forum, while in some ways similar to pleadings, are very

                   different because they are not filed in courts and they do

                   not initiate judicial proceedings.  These distinctions

                   indicate that the legislature did not intend to include

                   such claims within the term "complaint"  ID., (emphasis

                  in original).

    The Sheppard court relied heavily upon PARAMOUNT UNIFIED SCHOOL

DISTRICT V. TEACHERS ASSN. OF PARAMOUNT,  26 Cal.App. 4th 1371 (1004)

In Paramount, the parties had submitted their dispute to binding arbitration.  Upon

the motion to confirm the award, the school district, a public entity, argued that the

claim was barred due to the claimant's failure to comply with the claims statute set

forth in the CCP.  (The CCP requires that a Notice of Claim be provided to a public

entity as a prerequisite to an action against that entity (Govt. Code # 900, et seq.).

An untimely notice of claim operates as a bar to an "action" against a a public entity.

As such, it operates exactly like a statute of limitation.

    The Court rejected this claim, specifically pointing out the inapplicability of the CCP

to arbitrations:

                    Nonjudicial  [private contractual] arbitration proceedings are

                   generally regulated by the procedural rules established by the

                   arbitration agency; such proceedings are not necessarily con-

                   trolled by the Code of Civil Procedure unless expressly

                   provided by that code (Code of Civ. Proc., # 1280 et seq.),

                   by the arbitration rules, by the parties' contract or other

                   provisions of law regulating such nonjudicial arbitration.

                   Id., at 1387.

     Most recently, in 2009, a California appellate court ruled that an "action" for the purpose

of recording a lis pendens did not encompass a contractual arbitration claim.

MANHATTAN LOFT, LLC V. MERCURY LIQUORS, INC., 93 Cal. Rptr. 3d 457

(Ct. App. 2009).  In this case, the court followed the analysis of looking to CCP # 22 for

the definition of "action"   and the lix pendens statute, and found that a simple reading of

the statute did not encompass arbitration claims.

     In a relatively recent FINRA arbitration case brought in California, ALLING, ET AL.

V. PACIFIC WEST SECURITIES, ET AL, FINRA Case No. 10-05466 (Master Consol-

idated Case) decided April 5, 2013, a California FINRA arbitration panel appointed to

deal with a multi-party dispute involving private placement securities and due diligence

issues addressed a pre-hearing Motion to Dismiss based on Statute of Limitations

arguments as follows:

                    The rule of the forum generally governs as to procedural issues such as time

                    limitations for filing claims, and here, FINRA Rule 12206(a) allows claims

                    to be filed up to six years after they arise, California statutes of limitation

                   generally refer to actions filed in courts, and are not applicable to this

                   arbitration.

    A decision was reached and an award was granted in which the Panel found Respondents

Pacific West Securities, Inc. and Pacific West Financial Group liable for over $2.1 million

for their failure to exercise due diligence and recommending five unsuitable private

placement securities to Claimants.

     A FINRA arbitration proceeding is an equitable proceeding in a private arbitral forum.

It is not "an ordinary proceeding in a court of justice.   It is not an action as defined by

the CCP.  By the statute's definition, case law, and arbitral findings, statutes of

limitations for "actions" do not apply in FINRA arbitrations.

 

 

 

                Securities Broker's Duties as Fiduciary to a Qualified Trust

 

A. The relationship between any stockbroker and his or her customer is fiduciary in

nature, imposing on the former, duty to act in the highest good faith toward the

customer. ERISA  holds fiduciaries to a prudent man standard of care in the manage-

ment of qualified plans. A fiduciary shall discharge his duties with respect to a plan

with care, skill, prudence and diligence.

 

B. There are three ways one can gain fiduciary status:

     1. Exercising discretionary authority or control over the management of the plan or

        disposition of assets.

 

     2. Rendering investment advice for a fee or other compensation (direct or indirect).

         a. Such person renders advice to the plan as to the value of securities or other

             property, or makes recommendation as to the advisability of investing in,

             purchasing, or selling securities or other property.

 

          b. Such person renders any advice.....on a regular basis, to the plan pursuant

              to a mutual agreement, arrangement or understanding, written or otherwise,

              between such person & the plan....that such services will serve as a primary

              basis for investment decisions with respect to plan assets, and that such

              person will render individualized investment advice to the plan based on the

              particular needs of the plan regarding such matters as, among other things,

              investment policies or strategy, overall portfolio composition, or diversification

              of plan investments. [29 U.S.C. S 1002 (21) (A) (ii)] 29 C.F.R. S 2510. 3-21

              (C) (I) (1992).

 

      3. Exercising discretionary authority in the administration of the plan.

 

C. All of the five following factors are necessary to support a finding of fiduciary status.

 

       1. Providing individualized investment advice (even to sophisticated customers).

      2. The advice was given pursuant to a mutual understanding. It is not necessary

         for the party being added to the Trust Agreement as a fiduciary. In writing or

           orally, the party need only agree to provide advice that is the primary basis for

         the plan's investment decisions.

 

       3. The advice was provided on a regular basis.

 

       4. The advice pertained to the value of the property or consisted of recommen-

          dations as to the advisability of investing in certain property.

 

       5. The advice was rendered for a fee.

           29 U.S.C. S 1002 (21) A

 

D. Notes

 

     1. Court decisions have upheld that one who sells his own property to an ERISA

         Trust is a financial advisor. Further, a financial advisor is always a fiduciary.

 

     2. Any agent is also a fiduciary whose obligation of diligence & faithful service is

         the same as that of a trustee. West's ann. Cal. Civ. code S 2322 (C).

 

     3. There is in all cases a fiduciary duty owed by a stockbroker to his or her cust-

         omers; the scope of this duty depends on specific facts and circumstances

         presented in a given case, including relative sophistication & experience of cust-

         omer, customers ability to evaluate broker's recommendations and exercise an

         independent judgment thereon, nature of account, whether discretionary or

         non discretionary, and actual financial situation and needs of customer.

 

 

 

Broker, If a Fiduciary, Must Diversify a Qualified Plan

 

 

     A broker may be a fiduciary if, in the process of executing orders, he or she is asked for recommendations about investments without receipt of any compensation other than normal commissions and:

     A.  There is a mutual understanding that recommendations are to be on an ongoing basis;

     B.  There is mutual understanding that the recommendations will serve as a primary basis for investment decisions  with respect to plan assets; and

C.     The recommendations are individualized to the full range of the plan’s particular need.

 

     A broker may or may not be a fiduciary with respect to a plan.  One who merely suggests a stock is not.  See Farm King Supply inc. v. Edward D. Jones, 884 F. 2d 288 (7th Cir. 1989.  To be a fiduciary, the court held that the broker must provide advice pursuant to an agreement, be paid for that advice, or have influence over the plan’s investment decisions. Id. at 292.  See also, Wolin v. Smith Barney,  83F.3d 847 (7th Cir. 1996); Olson b. E.F. Hutton & Co., 957 F. 2d 622 (8th Cir. 1992).  If determined to be a fiduciary, the broker will then be held to the standards of conduct of sections 404(a) including the standard to act with care, skill, prudence and diligence under the circumstances.

 

     In the Restatement Third of the Law of Trusts, the major revision has been the change of its investment standard from a “prudent man” rule to a “prudent investor” rule.   This change seeks to incorporate modern portfolio theories of investing into trust investment theory.  The prudent investor standard has the following affect on fiduciary duties of trustees:

(a)     Duty of Loyalty(#170) and Impartiality (#183):  inflation erosion affects a fiduciary’s duty to treat the income and remainder beneficiaries impartially (i.e. investment of trust funds in interest-bearing securities may benefit income beneficiary while inflation erodes the principal remaining for the remainder beneficiary.  Under the Restatement Third, growth investments may be justified in certain trusts, dependent upon trust purpose, beneficiary circumstances and family financial objectives;

(b)     Duty to Delegate (#171): the new Restatement expands the fiduciary’s ability to seek expert assistance regarding investment making decisions (e.g. a fiduciary without investment experience or skill or  when complicated investment strategies are appropriately pursued by trustees managing large diverse portfolios);

(c)     Other Duties:

(1)     Duties of skill and prudence: the Restatement now adopts a “total

Return” (income plus capital appreciation/depreciation) definition as to what constitutes a “reasonable return” on trust assets;

(2)     Care and caution: the new Restatement emphasizes that a

Fiduciary’s undue conservatism, as well as excessive risk taking, in investing trust assets can disserve trust beneficiary’s.

 

Prudent Investor Theory

 

     The prudence requirement is evaluated based upon the fiduciary's conduct or actions at the time a decision is made, not upon the subsequent success or failure of such decision.  To satisfy the prudent man standard, a fiduciary must give appropriate consideration of the facts and circumstances which, based upon the scope of fiduciary's investment duties, are relevant to a particular investment or investment course of action.  The fiduciary should consider each investment or investment course of action in light of the role it plays within the entire portfolio; each investment should be designed to further the purpose of the underlying plan given the risk of loss and opportunity for gain.  The following factors should be considered by the fiduciary:

     (a)  composition of plan's investment portfolio;

     (b)  the diversity or lack thereof of the plan's investment portfolio;

     (c)  the liquidity, rate of return and cash flow needs of the plan; and

     (d)  the projected return from the plan investments relative to the plan's

           funding objectives.

     Generally, a failure to diversify a plan's investments is a breach of fiduciary duty, unless the fiduciary can show that the failure to diversify was "clearly prudent".  Compare Brock v. Citizens Bank of Clovis, 841 F. 2d 344 (N.M. 1988) (investments of over 65% of pension plan's assets in commercial real estate first mortgages violated ERISA diversification requirements where trustees failed to establish that lack of diversification was prudent) with Reich v.King, 861 F. Supp. 379 (Md. 1994) (investment of over 70% of plan's assets in residential mortgages not per se violation of ERISA diversification requirement; finding that non-diversification was not clearly prudent required first).  The diversification requirement is evaluated by the following factors:

     (a)  the plan's purpose;

     (b)  the amount of plan assets;

     (c)  financial and industrial conditions;

     (d)  the type of investment(s);

     (e)  distribution of investments as to industries;

     (f)  distribution of investments as to geographic location; and

     (g)  maturity dates of investment(s).

Lanka v. O' Higgins, 810 F. Supp. 379 (N.D.N.Y. 1992).

 

 

PRUDENT PRACTICES FOR INVESTMENT FIDUCIARIES

 

     Financial advisors, trustees, plan sponsors and anyone else involved in investment decision-making, face a host of issues as they navigate through complex and sometimes uncertain areas.  But, guidance is available.

     One source of guidance deserves our focus.  it is, "Prudent Investment Practices", a handbook for investment fiduciaries, written by the Foundation for Fiduciary Studies.  A major benefit of the handbook is its simple organization.  There are 5 so-called "Steps" and 27 so-called "Practices", which expand on this sound starting proposition:  "To manage a prudent investment process, without which the components of an investment plan cannot be defined, implemented or evaluates."  These Steps and Practices were determined after review of the major investment fiduciary legislation - ERISA (Employee Retirement Income Security Act of 1974 (Uniform Prudent Investor Act) and MPERS (Management of Public Employee Retirement Systems Act).

 

Lets overview the 5 Steps and some of the 27 Practices

 

 

     STEP 1:  ANALYZE CURRENT POSITION

 

The first practice is to review all of the documents relating to the establishment and management of the investments.  These documents include the Investment Policy Statement, minutes from investment committee meetings, trust documents, custodial and brokerage agreements, service agreements such as investment and advisory contracts, regulatory filings such as Form ADV and mutual fund prospectuses, as well as performance reports.  Another Practice is to ensure that the investment fiduciary knows his duties.  Even if the fiduciary has delegated certain decisions to, for example, professional money managers, trustees and consultants, the fiduciary always remains responsible for matters such as: determining investment objectives, choosing an appropriate asset allocation strategy, establishing written investment policies, approving appropriate experts, monitoring activities and avoiding conflicts of interest and prohibited transactions.  Likewise, another Practice requires the fiduciary to prudently manage investment decisions and, if he or she is unwilling or unable to act, then he or she is responsible for obtaining assistance from outside professionals who will do so.

 

     STEP 2:  DIVERSIFY - ALLOCATE PORTFOLIO

 

An important Practice is to identify the risk level appropriate for the investments.  In this regard, investment fiduciaries must ensure that they adequately have communicated the potential negative consequences of an investment strategy or the fact that investment objectives may not be met.  Then, the fiduciary is required to state the presumptions that are being used to model the probable outcomes of a given investment strategy.  Likewise, another important Practice is to identify the investment time horizon.  Along those lines, the fiduciary would prepare a schedule of the investment portfolio's anticipated cash flows.  At this point, one can select the asset classes consistent with the identified risk, return and time horizon.  A Practice suggests that the number of asset classes and investment options will depend upon such factors as the size of the investment portfolio, sensitivity to investment expenses, as well as the decision-makers' investment expertise and ability to monitor the strategies and  options considered.

 

     STEP 3:  FORMALIZE INVESTMENT POLICY

 

One of the more critical functions of the fiduciary is to prepare and maintain the Investment Policy Statement (IPS).  The IPS is the "business plan" for the portfolio.  As such, it defines the duties of all the parties involvement and provides guidance for diversification and rebalancing of investments.  Another Practice suggests that the IPS define the due diligence criteria for selecting investment options.  The goal is to ensure that the fiduciary not chase the latest hot Wall Street manager or the latest top performing asset class.  Additionally, the IPS should define procedures for controlling and accounting for investment expenses.  Another Practice requires that the IPS define the monitoring criteria for investment options and service vendors.

 

     STEP 4:  IMPLEMENT INVESTMENT POLICY

 

An important Practice is to implement investment strategies in compliance with the required level of Prudence.  Critically, while the law does not expressly require a fiduciary to hire a professional money manager, the fiduciary will be held to the same expert standard of care and his or her conduct will be measured against that of the investment professionals.  Additionally, in implementing the investment policy, the fiduciary must choose appropriate investment vehicles.  One example provided relates to the decision of whether to use mutual funds or separate account managers.  Another important implementation Practice is to follow a due diligence process in selecting service providers such as the custodian.

 

     STEP 5:  MONITOR AND SUPERVISE

 

The final Step is to monitor and supervise and there are several Practices worth noting.  First, the fiduciary should prepare periodic reports that compare the investment performance of the portfolio against an appropriate index, peer group and IPS objectives.  A second Practice suggests examining the qualitative and/or organizational changes of investment decision-makers.  There also should be control procedures in place to periodically review matters such as best execution, soft dollars and proxy voting.  Finally, another Practice requires that the fiduciary determine that the fees paid to investment managers (and others) are consistent with agreements and the law.

 

The 5 Steps and 27 Practices are an excellent and highly needed roadmap for investment fiduciaries and should be immediately implemented.

 

 

GLOSSARY

(Causes of Action)

 

 

1.  DEFINITION OF A SECURITY

     Under California Law, the term Security includes an investment contract.  An investment contract is a contract or transaction in which a person entrusts money or other capital to another, with the expectation of deriving a profit, income or some financial benefit from a business enterprise, the failure or success of which is dependent upon the managerial efforts of the other person.

     Source:  People v. Smith.263 Cal. Rptrk. 684,686 (Cal. Ct. App. 1989)

                   See also SEC v. W.J. Howey Co.  328 U.S. 293 (1946

 

2.  REQUIREMENT THAT SECURITIES BE QUALIFIED PRIOR TO SALE

     It is unlawful for any person to offer or sell in CA any security unless such sale has been qualified or unless such security or transaction is exempted or not subject to qualification.

     Qualification entails meeting requirements set by the CA Department of Corporations for the sale of securities in the state.

     Any person who sells a security that is not qualified or exempt from qualification is liable to the person who buys the security from him, and the purchaser is entitled to recover the money paid for the security with interest at the legal rate, less the amount of any income received.

     Source:  CA Corp. Code #25110 and 25503

 

3.  MISSTATEMENTS AND OMISSIONS IN THE SALE OF SECURITIES

     It is unlawful for any person to offer or sell a security by means of any written or oral communication which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.

     Any person who sells a security via misrepresentations and omissions is liable to the person who purchases a security from him who may sue either for rescission or for damages.

     Source: CA Corp. Code #25401 and 25501

 

4.  MATERIALITY DEFINED

     A fact is material if its disclosure would change the total mix of facts available and there is substantial likelihood that a reasonable shareholder would consider the facts important to his or her investment decision.

     Source:  Basic Inc. v. Levinson 485 U.S. 224, 231-232 (1988)

 

5.  LIABILITY FOR MATERIALLY AIDING

     When securities are sold via material misrepresentations and omissions or if the securities are unqualified for sale and non-exempt, not only is the primary seller liable, but anyone who materially aids the seller, or is a control person of the seller is also liable.

      Any person who materially assists in the sale of an unqualified or non-exempt security, or who materially assists in a sale made through misrepresentations or omissions is jointly and severally liable with any other person liable.

Source:  CA Corporations Code #25504.1

 

6.  CONTROL PERSON LIABILITY

     When securities are sold via material misrepresentations and omissions, or if the securities are unqualified for sale and non-exempt, not only is the primary seller liable, but anyone who materially aids the seller, or is a control person of the seller is also liable.

Control Person Defined

     A "control person" is defined as someone who possesses, directly or indirectly, the power to manage, or direct the management and policies of a person.

Source:  Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1569 (9th Cir. 1990)

     Every person who directly or indirectly controls a person liable for selling unqualified securities or for selling securities through misrepresentations and omissions, every person occupying a similar status or performing similar functions, every employee of a person so liable who materially aids in the act or transaction constituting the violation, are also liable jointly and severally with and to the same extent as such person, unless the other person who is so liable had no knowledge of or reasonable grounds to believe in the existence of the facts by reason of which the liability is alleged to exist.

Source:  CA Corp. Code: 25504

 

7.  LIABILITY FOR UNLICENSED BROKER DEALER

     Under California law, a "Broker-dealer" means any person engaged in the business of effecting transactions in securities in this state for the account of others or for his own account.

A person who purchases a security from a broker-dealer that is required to be licensed but is not may bring an action for rescission of the sale.

Source:  CA Corp. Code # 25004 and 25501.5

 

8.  CLAIM OF EXEMPTION

     The burden of proving an exemption is upon the person claiming it.

Source:  People v. Feno 201 Cal. Rptr. 513, 518 (Cal. Ct. App. 1984) Modified

See also:  Kahn v. State,493 N.E.2d 790, 798 (IN Ct. App. 1986)

                 State v. Kershner, 801 P.2d 68m (KA 1990)

                 State v. Tober, 841 P.2d 206,209 (AZ 1992)

 

9.  BREACH OF FIDUCIARY DUTY

     Under CA law, a broker or securities salesman owes a fiduciary duty to his or her customer.  A fiduciary relationship exists whenever trust and confidence is reposed by one person in the integrity and fidelity of another.  The relationship between a broker and a client is fiduciary in nature and imposes on the broker the duty of acting in the highest good faith toward the client.

Source:  Duffy v. Cavalier, 264 CA Rptr. 740,753 n.11 (CA Ct. App. 1989)

              Twomey v. Mitchum, Jones & Templeton, Inc., 262 CA App.2d 690,69 CA Rptr. 222 (1968)