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.
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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.