MADOFF SCHEME REVISITED
ARBITRATION v. COURT
SAMPLE QUESTIONS FOR EXPERT
WHY BROKERS SHOULD BE HELD TO A FIDUCIARY STANDARD
MADOFF SCHEME REVISITED
(A Ponzi scheme that should have been uncovered due to numerous “red flags”)
1. Brokerage firms/Registered Investment Advisers and their brokers/advisers who promoted and recommended the Madoff Split Strike Conversion Strategy (Bernard L. Madoff Investment Securities – BLMIS) to investors in California and many other states, had a fiduciary duty to those investors. Incumbent in that fiduciary duty is the duty of due diligence. Selling brokers had a duty to perform reasonable due diligence on the BLMIS investment strategy. The required duty of due diligence is set forth in SEC/NASD/FINRA Rules. It is also found in the Know Your Customer/Product Rule. Broker Dealers/RIA’s are charged with understanding some common features about products before registered representatives can perform the appropriate suitability analysis including, without limitation:
Conduct adequate due diligence to understand the features of the product;
- Perform a reasonable-basis suitability analysis;
- Perform customer-specific suitability analysis in connection with any recommendation.
- Provide a balanced disclosure of both risks and rewards associated with the particular product/strategy, especially when selling to retail investors;
- Implement appropriate internal controls;
- Train registered persons regarding the features, risks and suitability of these products;
- Perform adequate research; and
- Reasonably investigate and vet the legitimacy of investments and trading through BLMIS in the light of numerous red flags.
- Reasonably utilize a high degree of care in investigating and independently verifying all representations of the sponsor BLMIS,
Common failures of selling broker’s due diligence included, without limitation:
a. Failure to learn the amount of money that was under the management of BLMIS.
b. Failure to investigate the names of counterparties utilized for the OTC options (these are the parties on the other side of the option trade).
i. Failure to ask for a list of counterparties.
ii. Failure to review the option agreements of counterparties
c. Failure to verify that trades for its brokerage customers were actually accomplished on the Depository Trust and Clearing Corporation (DTCC).
– Brokers never specifically asked Madoff for permission to independently confirm BLMIS holdings of their customers at the DTCC.
d. Failure to investigate the one man firm Auditor for BLMIS with annual receipts of only $180K when Madoff managed assets of $10 billion.
i. Friehling (the single owner) and BLMIS auditor had not been enrolled in the AICPA Peer Review Program since 1993.
ii. Upon investigation, broker’s would have learned that Friehling notified the AICPA that he did not perform Audits!
e. No investigation of Madoff’s extraordinary trading volumes without affecting the market.
f. No investigation of the affect of stock prices with BLMIS purportedly executing sales of tens of billions of stocks in just a few days, 6 to 8 times per year.
– There were days when trade confirms indicated Madoff traded stocks at prices that were outside the daily ranges of prices for those stocks. Examples were Intel and Merck.
g. No investigation into such large movement of stock sales into and out of treasuries quarterly, and how the price of treasuries would have been materially affected.
2. Registered representatives of brokerage firms are required to understand the following items so they can relate them adequately to customers:
- The liquidity of the product/strategy;
- The existence of a secondary market and the prospective transparency of pricing in any secondary market transactions;
- The creditworthiness of the issuer;
- Where applicable, the creditworthiness of the counterparties;
- Principal, return, an/or interest rate risks and the factors that determine those risks;
- The tax consequences of the product/strategy; and
- The costs and fees associated with purchasing and selling the product/strategy.
3. Brokerage firms failed to conduct adequate due diligence.
– Most individual brokers will admit that they failed to take any specific steps to verify Madoff’s representations regarding the business of BLMIS. Many individual brokers also failed to disclose material facts to their investors.
4. Consequently, they breached their fiduciary duty to their investors.
– In CA there must be the existence of Fiduciary Duty (Duffy v. Cavalier).
– There must be a breach of such relationship.
– There must be damages proximately caused by that breach.
5. Brokers knew, or should have known, based on their experience and sophistication that Madoff (BLMIS) was operating a Ponzi scheme.
- Selling brokers were aware Madoff would not take an investor who worked in or was knowledgeable about the securities business. In fact, Madoff required broker’s to send Madoff a memo to that effect before Madoff would accept funds from any new investor. This is a red flag to someone with a broad background of brokerage training and experience and should have alerted broker’s to the reality that Madoff’s operation was not legitimate. Brokers failed to disclose this fact to their investors.
- Brokers, at Madoff and their Brokerages’ instruction, were required to ascertain whether each new investor was a member of a country club. The purpose of this inquiry was to determine if the new investor could lead Madoff to a new source of wealthy people to tap for Madoff’s ever increasing obligations to his existing investors. There was no relationship between this information and Madoff’s purported business. This is a red flag to someone with long brokerage experience and should have alerted the selling broker’s to the reality that Madoff’s operation was not legitimate. Again, they failed to disclose this material fact to their investors.
- Many brokers lied to their clients about Madoff. Many of them told their investors the following material misrepresentations.
In CA the following criteria is necessary to support this allegation:
There must be a material misrepresentation (false representation, concealment or non- disclosure).
- There must be knowledge of the falsity (scienter).
- There must be intent to defraud.
- There must be justifiable reliance.
- Madoff was not taking new investors;
- The broker would have to talk to Madoff to attempt to convince Madoff to take them in;
- The broker doubted Madoff would take their money; and
- Madoff was making an exception just for them because of their close ties to old friends and other investors of Madoff.
Broker’s clearly must have known over time that these statements were not true because, time after time, Madoff did take each new investors money. Moreover, and importantly, during the time brokers was telling his clients these lies, many saw their “money under management” with Madoff actually grow by over 300% between 2003 and the end of 2007. Even if one assumes for purposes of argument that broker’s didn’t know these representations were untruthful, it is patently obvious that they should have known.
d. Brokers were also keenly aware that Madoff was claiming an implausibly consistent-and consistently high-rate of return. This is a red flag to someone with broad brokerage experience and should have alerted them to the reality that Madoff’s operation was not legitimate.
e. Brokers were all too aware that Madoff’s statements reflected a consistent ability to buy stocks near their daily lows and to sell stocks near their monthly highs, a timing of the market that is virtually impossible to achieve in the absence of deceit and manipulation. This is a red flag to someone with brokerage tenure and experience and should have alerted them to the reality that Madoff’s operation was not legitimate.
f. The typical brokerage fee structure, which broker’s failed to disclose to their investors, literally screamed Ponzi scheme. Broker’s were paid a quarterly fee equal to a certain percentage of the “money under management” their clients had with Madoff. Madoff’s investors (the broker’s clients) received monthly statements showing their purported account balances. However, unbeknownst to their clients, but well known to the broker, their fee was not based on these account balances. Instead, the broker’s fee was based on the cash his clients had invested with Madoff less the cash his clients had withdrawn from Madoff. This is a red flag to someone with assets under management (AUM) experience and should have alerted them to the reality that Madoff’s operation was not legitimate.
Take, for instance, the example of an investor who invested $1,000,000 with Madoff in January, 1995. At the end of 1995 Madoff informs the investor he had made 12.5 % during 1995. The investor decides to withdraw his $125,000 profit. This means that the investor’s monthly account balance statements still show a $1,000,000 account balance but that the broker would be paid his percentage on only $875,000. If the same thing happened in 1996 the investor would still get monthly statements showing $1,000,000 in his account but the broker would be getting paid on $750,000. If this continued for several years, by the end of 2002, the broker would have no fee payable by virtue of this investor’s account while the investor’s monthly statements still show him with a $1,000,000 balance.
And then it gets even more flagrant!! Starting at the end of 2003, under this scenario, the investor’s money invested invested less cash withdrawn would be a negative $125,000 which would be deducted from the broker’s other “money under management” with Madoff before his percentage was calculated. By the time the Ponzi scheme imploded in December, 2008, this investor’s account would be causing that broker a $750,000 deduction from his “money under management” with Madoff, before his percentage was calculated. And, all the while, the investor would be getting monthly statements showing an account balance of $1,000,000 or more.
It is literally inconceivable that this fee structure would not alert a financial adviser with broad brokerage experience and sophistication to the reality that Madoff’s operation was not legitimate and that the monthly account balance statements were not accurate. Moreover and importantly, broker’ had access to an internal report known as the “Cash Database”. The Cash Database consisted solely of the Madoff customer accounts that had been referred by the broker along with other firm representatives. The Cash Database was used to monitor Madoff customer accounts for those customers referred by the broker and other firm representatives to Madoff and to calculate the fees to be paid by Madoff to the broker dealer for the benefit of its broker’s.
For each victim referred to Madoff by a firm representative, the Cash Database calculated and reported the following:
- the name of the owner of the Madoff customer account,
- the tax identification information of the Madoff customer,
- the firm representative associated with the referral for that Madoff customer account,
- the date and amount of each deposit into and each withdrawal from the Madoff customer account,
- the total amount of cash under management at Madoff in the account,
- the amount of fees due to the particular firm representative, and
- the Madoff account number assigned to the Madoff customer account.
This Cash Database provided, on an account by account basis, the true
value (i.e., the account balance without reference to the fictitious profits) of each
Madoff account referred by each broker of a particular firm. Importantly, in
situations where Madoff customer statements showed a positive balance due to
fictitious profits, but the account was actually in a negative position because the
customer had withdrawn from the account more money than the customer had
deposited, the Cash Database showed the negative account balance of the Madoff
In calculating the amount of fees due to broker, the Cash Database was used to
Determine, for each customer account the broker referred to Madoff, the money
under management, based on the net cash activity.
Remarkably, the Cash Database would reduce the commissions due to the broker
in the event of negative net cash activity in an account. This means that
despite the fact that certain Madoff customer accounts appeared to have
significant positive balances due to fictitious profits, the broker knew otherwise
and would no longer be paid once a customer withdrew all of the cash deposited.
This fact alone indicates that broker’s had actual knowledge of the Ponzi scheme.
Based upon that knowledge, referring brokers to BLMIS had an obligation
to disclose certain ramifications related to SIPC coverage. SIPIC coverage is limited
to $500,000 per account. However firms like BLMIS provide additional coverage
for larger accounts on a supplemental insurance or self-insured basis. This would have been
critical at BLMIS due to the larger account size of typical investors in the Madoff scheme.
However, since no trades were made, referring brokers well knew that SIPC coverage, plus
BLMIS’ own self-insured amount, would likely only cover original principal invested, less any
withdrawals i.e. the net amount. Clearly, this risk was never disclosed to BLMIS investors.
Investors who were only withdrawing their “earnings” would have sadly learned, as they
eventually did, that the SIPIC and firm supplemental coverage was only insuring the “net amount”
in the account i.e. original investment less withdrawals. The true risk of this exposure was never
disclosed to investors. Their principal, in fact was being eroded with every withdrawal they
made. There was no protection of investor principal in light of a failure of BLMIS.
g. Beyond these indicia of fraud, broker’s ignored numerous other indications of
irregularity and fraud. Among other things, each financial adviser was on actual or
constructive notice of the following indicia of irregularity and fraud but failed to make sufficient
inquiry. This is called fraudulent concealment
In CA, the following factors must be in evidence to support this allegation:
- The broker must have concealed or suppressed a material fact.
- The broker must have been under a duty to disclose the facts to the investor.
- The broker must have intentionally concealed or suppressed the facts with the intent to defraud the investor.
- The investor must have been unaware of the facts and would not have invested if he had known of the concealed or suppressed facts.
- The investor must have sustained damages as a result of the concealment or suppression of the material facts.
1. The purported consistency of Madoff’s returns was questioned
in a May 2001 article entitled “Madoff Tops Charts; Skeptics Ask
How” published in MAR/Hedge, a semi-monthly newsletter that is
widely read by hedge fund industry players. The article noted that
many current and former traders, other money managers, consultants,
quantitative analysts and fund of fund executives who are familiar
with the split-strike conversion strategy purportedly used by Madoff
to manage the assets questioned the consistency of the reported
returns and observed that “others who use or used the strategy are
known to have had nowhere near the same degree of success.”
2. A May 27, 2001 Barron’s article entitled “Don’t Ask, Don’t Tell:
Bernie Madoff is so secretive, he even asks investors to keep mum”
following the industry newsletter raised similar concerns about the
credibility of BLMIS’ reported compound average returns of 15% for
over a decade. The article noted the skepticism on Wall Street and
lack of transparency around Madoff’s business based on Madoff’s
unwillingness to answer questions about his investment strategy.
3. Madoff did not use either itself or outside brokers when
buying or selling the securities it purported to manage and trade on a
monthly basis on behalf of its investors.
4. Madoff chose not to obtain funding from commercial lenders at
lower interest rates than it paid out. As broker’s were aware, the Madoff customer accounts referred to BLMIS, as well received far higher
purported annual rates of return on their investments with Madoff, as
compared to the interest rates Madoff would have had to pay
commercial lenders during the relevant time period. As such, Madoff
accepted the investment capital referred by brokers in lieu of other
available alternatives that would have been more lucrative for Madoff.
5. Madoff, which reputedly ran the world’s largest hedge fund, was
purportedly audited by Friehling & Horowitz, an accounting firm that
had three employees, one of whom was semi-retired, with offices
located in a strip mall. No experienced investment professional could
have genuinely believed it possible for any such firm to have
competently audited an entity the size of Madoff.
6. Madoff functioned as both investment manager and custodian of
securities. This arrangement eliminated another frequently utilized
check and balance in investment management by excluding an
independent custodian of securities from the process, and thereby
furthering the lack of transparency.
7. Based on some or all of the foregoing factors, many banks, industry
advisers, and insiders who made an effort to conduct reasonable due
diligence flatly refused to deal with Madoff because they
had serious concerns that Madoff’s operations were not
legitimate. Some of these entities included Societé Generale, Goldman
Sachs, Morgan Stanley, Merrill Lynch, Bear Stearns, and Credit Suisse.
8. Madoff purported to convert all of its holdings to cash immediately
before each quarterly report, a strategy that had no practical benefit
but which had the effect of shielding Madoff’s purported trading
activities from scrutiny by government regulators.
9. Broker’s also failed to investigate and disclose the following red flags:
i. The lack of an independent Clearing Firm (BLMIS self cleared all securities transactions).
ii. Peter Madoff, B. Madoff’s brother was the Chief Compliance Officer, while B. Madoff’s two sons and daughter held key positions.
iii. BLMIS business computers lacked the ability to send real time electronic trades. This, when Madoff’s market making business was renowned for cutting edge technology.
iv. The absence of a website where BLMIS investors could view accounts and assets in real time.
v. BLMIS only delivering paper confirms by mail, days after trades were supposedly executed, leaving significant time for fraudulent trades to be imputed.
– The 4+ day delay in paper trade tickets which gave the hedge fund manager the opportunity to manufacture trade tickets that confirmed the investment results.
vi. Madoff alone traded suspiciously large percentages of the total
amount of securities that were reported as trading on the entire
NYSE, NASDAQ and CBOE and did so without any impact on
the prices of those securities.
– Volumes of securities reported on customer’s trade
confirms as well as month-end account statements, far
exceeded reported actual exchange volumes!
vii. Between 1996 and 2008, BLMIS’ trading strategy did not experience one single quarter of negative returns.
viii. During the burst of the dot-com bubble of 2000, the 9-11-01
bombing, plus the recession and housing crisis of 2008,
BLMIS posted only positive quarterly returns, outperforming
the S&P 100 by 20% – 40% (the very stocks owned and which
the split strike conversion strategy did options on).
x. BLMIS virtually always traded more S&P 100 index options (symbol – OEX 100) than were traded on the entire CBOE.
x. Trade confirmations produced by BLMIS were not in accord with industry standards.
– An option trade under the SSC strategy was
supposed to be a private contract between two parties in the
OTC market. The counterparty should have been expressly
identified on the confirms sent to BLMIS customers. They
xi. Because OTC options are private transactions, no CUSIP
(Committee on Uniform Securities Identification Procedure)
number is assigned. Madoff’s confirms, purportedly reviewed
by compliance departments of brokerage firms,
included a CUSIP number!
xii. When BLMIS was forced to register as a Registered Investment Advisor with the SEC in 2006, all BLMIS trades that noted its capacity as Principal were prohibited, without written customer authorization for each trade. Confirms to BLMIS customers all showed BLMIS capacity as Principal, even after 2006.
xiii. In 2007, Madoff posted a Sharpe ratio of 3.09% based upon consistent 9.5% –
11.5% returns for the 10 year period ending 2007 (1997 – 2007). (The Sharpe
Ratio developed by William Sharpe at Stanford University where he won the
Nobel Prize for Economics). You would take the average return for the 10
years of 10.55% and then subtract the safe rate (Treasury Bill rate) of 4.55%
and you get a net number of 6.00%. This is the reward, above the safe rate,
and why you invest in a split strike conversion strategy like Madoff’s. You
then divide that net number by the standard deviation of the total return.
over the 10 years. It was 1.94%. The result is a Sharpe Ratio of 3.09 (6.00%
-: 1.94% = 3.09%. In my 43 years in the securities business, I have never
seen a Sharpe Ratio above 1.6% for 5 years, let alone 10! For Madoff to
achieve this through tough times, the tech crash and following recession is
Anyone viewing Madoff’s Hedge Fund profile sheet for this period reflecting a
Sharpe Ratio of 3.09%, nearly 2 times better than the best one known in the
securities industry would have put anyone on notice, that understood the
Sharpe Ratio, that this was not only impossible for this 10 year period but a
possible Ponzi Scheme. No stronger red flag than this could exist!
6. Based on the foregoing, broker’s did not reasonably believe that Madoff would invest brokerage client’s money in stocks, options and treasury bills!
Broker’s knew or should have known that these statements were false when they made them to their investors.
In CA. there is actionable fraud when:
A. The broker is in a fiduciary relationship with the investor.
B. The broker had exclusive knowledge of material facts non known to the investor.
C. The broker actively conceals a material fact from the investor.
D. The broker makes partial representations but also suppresses some material facts.
7. Broker’s engaged in a scheme to induce people to invest with Madoff for their own financial gain. Part of this scheme was to tell potential investors that they couldn’t get in. The idea was to whet the potential investors’ appetites by telling them how exclusive Madoff was and how Madoff didn’t need or want their money. In addition, the idea was to divert questions away from how Madoff generated the returns they was representing by telling potential investors they couldn’t get in anyway. Based on his experience with Madoff, broker’s knew or should have known:
a. Madoff was taking money from new investors.
b. Broker’s didn’t have to convince Madoff to take new money.
c. Broker’s didn’t doubt new investors would get to invest.
d. The new investors were not getting in because of their close ties to old friends and investors of Madoff.
e. Madoff was not investing the money in stocks, options and treasury bills.
8. Clearly based on all of the above, broker’s clearly knew or should have known that Madoff’s operation was not legitimate.
a. Referring brokers were aware and failed to disclose serious questions about the propriety of the BLMIS investment. Critical to the success of Madoff’s fraud scheme was targeting affluent yet financially unsophisticated investors by burnishing the impressing that one could only get in as an investor with Madoff with special access and as a favor.
b. Madoff categorically instructed referring brokers that they should not use written marketing materials, not make cold calls to prospective BLMIS imvestors, and to not communicate with existing or prospective BLMIS investors via email.
c. On BLMIS account opening forms, the referring broker would be listed as the account representative.
d. Referring brokers provided customer service and assisted BLMIS investors with maintaining their accounts including withdrawal requests, whether BLMIS was in the market or in treasuries and how to read the complex BLMIS account statements.
e. In many monthly statements generated for the actual referring broker’s personal BLMIS accounts, BLMIS listed securities transactions as occurring in months preceding the month of the statement. These brokers recklessly disregarded that these statements indicated that BLMIS was engaging in fictitious backdated transactions.
f. Each year, a referring broker compensation rate (that declined over time from 1.0% to 0.25%) was applied to the then-existing invested capital to calculate commissions. The referring broker and his or her firm thereby had an incentive (1) to refer investors who would park money and not withdraw it and (ii) to dissuade investors from withdrawing their funds.
g. Despite the fact that certain BLMIS customer accounts appeared to have significant positive balances due to purported profits, the referring broker and his or her firm knew that they would be paid less as customers withdrew cash, irrespective of purported profits.
h. Referring brokers and their firms should have known that Madoff needed to pay referral fees to obtain investor money despite BLMIS’ purported investing process, a red flag that should have raised serious questions about the propriety of the BLMIS investment.
8. Violations of Securities Regulatory Acts occurred by referring brokers in the following areas.
1. Section 10(b) of the Securities Exchange Act of 1934 [15 U.S.C. #78j(b)] and Rule 10b-5 promulgated thereunder [17 C.F.R. #240.10b-5]. by using any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange, in connection with the purchase or sale of any security:
(a) to employ any device, scheme, or artifice to defraud;
(b) to make any untrue statement of a material fact or to omit to state
a material fact necessary in order to make the statement made, in the
light of the circumstances under which they were made, not misleading:
(c) to engage in any act, practice, or course of business which operates or
would operate as a fraud or deceit upon any person.
2. Section 17(a) of the Securities Act of 1933 [15 U.S.C. #77q(a)] in the offer or . sale of any security by the use of any means or instruments of transportation or communication in interstate commerce or by use of the mails, directly or indirectly:
(a) to employ any device, scheme, or artifice to defraud;
(b) to obtain money or property by means of any untrue statement of a
material fact or any omission of a material fact necessary in order
to make the statements made, in light of the circumstances under which
they were made, not misleading; or
(c) to engage in any transaction, practice, or course of business which
operates or would operate as a fraud or deceit upon the purchaser.
3. Section 206 of the Investment Advisers Act of 1940;
(a) Section 206 of the Advisers Act prohibits misstatements or misleading
omissions of material fact and other fraudulent acts and practices in
connection with the conduct of an investment advisory business.
(b) As a fiduciary, an investment advisor owes its clients undivided
loyalty, and may not engage in activity that conflicts with a clients’
interest without the client’s consent.
(c) Section 206 applies to all firms and persons meeting the Advisers
Act’s definition of investment adviser, whether registered with the
SEC, a state securities authority, or not at all.
(d) Section 206 provides that an investment adviser must disclose to
clients all material information regarding its compensation.
(e) Section 206 provides that an investment adviser must disclose all
potential conflicts of interest between the adviser and its clients,
even if the adviser believes that a conflict has not affected and
will not affect the adviser’s recommendations to its clients. This
obligation to disclose any benefits the adviser may receive from
third parties as a result of its recommendations to clients.
(f) Section 206 provides that as fiduciaries, investment advisers
owe their clients a duty to provide only suitable investment advice.
This duty generally requires an investment adviser to determine
that the investment advice it gives to a client is suitable for the
client, taking into consideration the client’s financial situation,
investment experience, and investment objectives. Investment
Advisers Act Release No. 1406 (March 16, 1994).
ARBITRATION IS A COURT OF EQUITY
Arbitration v. Court – There is a difference. Basically, Arbitration is a court of equity, not a court of law. Arbitrators are not bound to follow the rules of evidence or strict rules concerning statute of limitations. The newly appointed Director of Arbitration for the merged NYSE and NASD (FINRA) Linda Feinberg has taken the position that legal technicalities, like statutes of limitations, have no place in arbitration. “[T]he strict rules of evidence do not apply….In Arbitration, an NASD arbitration, unlike in court, you get an equitable result. You do not have to have a claim that is cognizable under state or federal law. It can be cognizable under NASD rules. So for example, there is only one cause of action under federal securities law, that’s 10b, very limited, [and] has a very short statute of limitations. The rules that are applied by arbitrators looking for equitable relief are much broader than if they had to strictly follow the law”* The Basic Arbitrator Traininng materials on page 113 instruct, “When the law is not clear or you cannot determine whether it applies to the facts of of your case, you should look to equity, fairness and justice.” Further, FINRA’s instructions to Arbitrators is clear that Awards may be based on equity. For example, the Arbitrator’s Guide leads with this quote from Domke: “Equity is justice in that it goes beyond the written law. And it is equitable to prefer arbitration to the law court, for the arbitrator keeps equity in view, whereas the judge looks only to the law, and the reason why arbitrators were appointed was that equity might prevail.”
State law recognizes the doctrine of equitable estoppel to prevent a defendant from employing the statute of limitations defense where the defendant’s conduct has induced plaintiff’s belated filing. In Leonard v. Eskew, the Texas trial court in an investment situation found that the defendant’s words and assurances regarding the appropriateness of an investment induced the investors to delay filing their claims beyond the limitations period and invoked estoppel to preclude the limitations bar. On appeal, the court found that estoppel was appropriate to preclude a statute of limitations defense where investors could present sufficient evidence to indicate that a seller of securities had induced investors into delaying the filing of their claims past the limitations period.
Arbitrations are equitable proceedings where statutes of limitations have traditionally not applied. See, Mitchell v. Prudential Property & Cas. Ins. Co. (1985) 346 Pa. Super. 327 (“It is well settled that arbitration proceedings are informal adversarial hearings in which the arbitrators are not governed by technical rules employed in court proceedings.”); see also,Champ v. Siegel Trading Colk Inc.55F.3d269 (7th Cir. 1995) (“When contracting parties stipulate that disputes will be submitted to arbitration, they relinquish the right to certain procedural niceties which are normally associated with a formal trial.”) see further, City of Auburn v. King County (1990) 114 Esdh.2d 447 (“The trial court correctly concluded that the statute of limitations by its language does not apply to arbitrations.”) See still further, Skidmore, Owings & Merrill v. Connecticut. Life Ins. Co. (1963) 25 Conn. Supp. 75,78 (“Arbitration is not a common law action, an institution of arbitration proceedings is not the bringing of an action under any of our statutes of limitations.); see also, Vaubel Farms, Inc. v. Shelby Farmers Mut. (Minn. App.2004) 679 N.W.2d 407 (“Because ‘suit’ does not include ‘arbitration,’ NorthStar cannot claim that the two-year limit for suits bars arbitration.”) Although no California cases directly address the question whether statute of limitations as defined by CCP 335, et. seq.,are applicable to private arbitrations, the court’s refusal to treat proceedings outside of the courts as “actions” is consistent with conclusions of other jurisdictions. See, City of Oakland v. Public Employees Retirement System, (2002) 95 CA. App.4th 29,48 (where the court specifically held that the statutes of limitations do not apply to administrative proceedings, because they are not “actions” in a court of law.)
Arbitrations are equitable proceedings where statutes of limitations have traditionally not applied. This is particularly the case for securities related disputes. In seeking congressional approval to administrator securities related customer disputes, the then President of Securities industry Association, Mr. Lackritz, specifically noted that the arbitration process is “fair to customers” because it is purely an equitable proceeding, and allows customers to avoid technical litigation roadblocks – citing statutes of limitations as one such technical procedure.
“Aggreived customers get what so many say they really want: their ‘day in court’. [C]laimants in arbitration not held to technical pleading standards….[T]he hearings themselves…are designed to be flexible and allow the arbitrators to reach the most equitable conclusion. The more streamlined process of arbitration, as compared with the many procedural …obstacles that must be overcome by a plaintiff in a court case, means that nearly every case brought in arbitration….goes to a full merit hearing…” “This is in sharp contrast to court proceedings, where a significant percentage of claims are dismissed on pre-hearing motions to dismiss or for summary judgment. Many of these dismissals are what may be described as technical, or procedural grounds. This includes dismissals for pleading failure, jurisdiction failures, and statutes of limitations….”
* Remarks of Linda Feinberg, President, NASD Dispute Resolution, at first NASAA Listener’s Forum on Arbitration, National Press Club, Washington, D.C., Tuesday, July 20, 2004, reprinted at Lipner, Seth E. and Long, Joseph D., Securities Desk Reference (2009 – 2010 ed.) Appendix N.
SAMPLE QUESTIONS FOR EXPERT
PLEASE STATE YOUR OCCUPATION
BRIEFLY DESCRIBE YOUR EDUCATIONAL BACKGROUND
PLEASE DESCRIBE YOUR EMPLOYMENT EXPERIENCE
WHICH SECURITIES LICENSES DO YOU HOLD OR HAVE YOU HELD
DO YOU HAVE ANY PRIORS ON YOUR RECORD
YOU WERE ASKED TO REVIEW THE ACCT. HISTORY OF MR.
WHAT DOCUMENTS HAVE YOU REVIEWED
DID YOU REVIEW ANY BACKGROUND INFORMATION ON MR.
DID YOU HAVE AN OPPORTUNITY TO SPEAK WITH MR.
WHAT IS YOUR UNDERSTANDING OF HIS BACKGROUND
WHAT IS YOUR UNDERSTANDING OF HIS PRIOR INVESTMENT EXPERIENCE
IN YOUR OPINION DOES A BROKER OWE ANY DUTY TO HIS CLIENT
WHAT IS YOUR UNDERSTANDING OF THAT DUTY (FIDUCIARY DUTY)
HAVE YOU HEARD OF THE TERM “DUE DILIGENCE”
WHAT DOES THIS MEAN IN THE CONTEXT OF THE SECURITIES SOLD TO MR.
BASED ON YOUR TRAINING AND EXPERIENCE, YOUR REVIEW OF THE DOCUMENTS IN THIS CASE AND YOUR DISCUSSIONS WITH THE CLAIMANT, HAVE YOU FORMED ANY OPINIONS AS TO WHETHER THERE HAS BEEN A BREACH OF FIDUCIARY DUTY WITH RESPECT TO MR.
WHAT ARE THEY (FAILURE TO KNOW YOUR CUSTOMER, EXCESSIVE TRADING, EXCESSIVE UNDISCLOSED COMPENSATION, OVER CONCENTRATION IN NASDAQ MICRO-CAP STOCKS, UNSUITABILITY & FAILURE TO SUPERVISE).
WHEN DEALING WITH UNSUITABILITY, ARE THE INVESTMENT OBJECTIVES OF AN INVESTOR IMPORTANT
WHEN HE OPENED HIS ACCOUNT WITH XYZ SECURITIES, WHAT WERE HIS INVESTMENT OBJECTIVES
WHAT WAS HIS AGE & INCOME
WHAT WAS HIS TOTAL AND LIQUID NET WORTH
DO YOU BELIEVE THAT THIS ACCOUNT WAS CHURNED.
WHAT IS CHURNING
WHAT ELEMENTS ARE CONSIDERED TO BRING A CASE FOR CHURNING AGAINST A BROKER/BROKERAGE FIRM
WERE THESE ELEMENTS PRESENT DURING THE RESPECTIVE MONTHS THAT THESE ACCOUNTS WERE ACTIVELY TRADED AT HIS FIRM(S)
WAS CONTROL INDICATED HERE IN EACH CASE
WHAT KIND OF CONTROL
WAS SCIENTER PRESENT HERE
WHAT IS SCIENTER
WAS EXCESSIVE TRADING INDICATED
WHAT WAS THE ANNUALIZED TURNOVER RATIO
WHAT WAS THE COST TO EQUITY RATIO
WHAT WAS THE BREAKDOWN, BY PERCENTAGE, OF THE NASDAQ AND PENNY STOCKS
WERE MANY OF THESE HIGHLY SPECULATIVE
DID YOU PERFORM ANY INDIVIDUAL ANALYSIS TO DETERMINE THIS TO BE TRUE (SCORECARD MASTER – BACKGROUND AND INDIVIDUAL SCORECARDS – COMMON STOCKS/IPO’S/MUTUAL FUNDS/REITS/L.P.S)
HOW LONG WERE THE ISSUES HELD BY THE BROKER, ON AVERAGE BEFORE SELLING THEM
DO YOU BELIEVE THAT THOSE RECOMMENDATIONS WERE SUITABLE FOR HIM
WAS THE ACCOUNT 0VERCONCENTRATED IN ONE ASSET CLASS, TYPE OF SECURITY OR DIVERSIFIED
WAS THE TOTAL COMPENSATION TO XYZ SECURITIES REFLECTED ON THE CONFIRMATIONS I.E. SALES CREDITS TO THE BROKER
DOES THE SEC REQUIRE ALL COMPENSATION TO BE DISCLOSED (SEC RULE 10B-10)
DO YOU HAVE AN OPINION AS TO WHETHER THIS ACCOUNT WAS PROPERLY SUPERVISED
WERE ANY ACTIVITY LETTERS SENT TO THE INVESTOR
DID THEY REQUIRE ANY INITIALS, SIGNATURE OR POSITIVE RESPONSE FROM MR.(I.E. WERE THEY NEGATIVE CONSENT LETTERS)
DID THE BROKERAGE FIRM (BR. MGR.) FOLLOW UP ON THE LETTER(S) BY DIRECT CONTACT WITH THE INVESTOR
WHEN THE FIRM BECAME AWARE OF THIS SPECULATIVE ACTIVITY IN HIS ACCOUNT, DID THEY TAKE APPROPRIATE ACTION TO STOP SUCH ACTIVITY
WERE ANY OF THE TRADES LABELED “UNSOLICITED” ON THE CONFIRMS
WHAT IS THE IMPORTANCE OF THIS
IS LABELING A TRADE “UNSOLICITED” WHEN ITS ACTUALLY SOLICITED A VIOLATION OF ANY SEC OR NASD RULE
HAVE ANY RULES IN THE FIRMS COMPLIANCE MANUAL BEEN VIOLATED
WERE PHONE CALLS/LETTERS SENT TO THE BROKER/BROKERAGE FIRM
BASED ON YOUR TRAINING AND EXPERIENCE AND YOUR REVIEW OF THE WRITTEN MATERIALS IN THIS CASE, DO YOU BELIEVE THAT THE INVESTOR HAS SUFFERED ANY DAMAGES AS A RESULT OF THE CONDUCT THAT YOU HAVE DESCRIBED HERE
DID YOU PERFORM ANY CALCULATIONS TO DETERMINE THE EXTENT OF THOSE DAMAGES (GO THROUGH CALCULATIONS)
DID YOU TAKE INTO CONSIDERATION DISTRIBUTIONS & LOST OPPORTUNITY
WHAT IS TOTAL RETURN ANALYSIS
DO YOU FEEL IT WOULD BE APPROPRIATE IN THIS CASE
YOU WERE HIRED BY MR. TO REVIEW HIS ACCOUNT AND TESTIFY HERE TODAY
WHAT ARE YOU CHARGING HIM
OR THIS ONE FOR DPP PROGAMS:
PLEASE EXPLAIN YOUR EDUCATIONAL BACKGROUND
PLEASE GO OVER YOUR EMPLOYMENT HISTORY
WHAT LICENSES DO YOU HOLD OR HAVE HELD
HOW DOES YOUR RETENTION BREAK DOWN BETWEEN CLAIMANTS AND RESPONDENTS
HOW MANY ARBITRATIONS HAVE YOU TESTIFIED IN
WHAT COURTS HAVE YOU BOTH QUALIFIED AND TESTIFIED IN
DO YOU HAVE ANY PRIORS ON YOUR RECORD.
WHAT WERE YOU RETAINED BY THE ……………………’S TO PROVIDE YOUR OPINIONS
WHAT IS DUE DILIGENCE
HOW DID YOU DEVELOP YOUR SCORECARD DUE DILIGENCE ANALYSIS
HAS IT RECEIVED ANY INDUSTRY ACCEPTANCE
CAN YOU TELL US HOW THE SCORECARD SYSTEM OF DUE DILIGENCE WORKS.
CAN YOU DESCRIBE YOUR SCORECARD ANALYSIS OF ………………………………….
WHAT IS YOUR OPINION AS TO THE REASONABLE BASIS SUITABILITY TEST AS ESTABLISHED IN NTM 05-18 WITH RESPECT TO ………………………………………………
DOES IT MEET THE CUSTOMER SPECIFIC SUITABILITY TEST WITH REGARD TO THE …………………….’s
WHEN IS SUITABILITY MEASURED
PLEASE TELL US YOUR OPINION AS TO THE CUSTOMER SPECIFIC SUITABILITY OF ……………………………….. FOR THE ……………………….’s. as of ……………………………………..
WAS IT SUITABLE GIVEN THE …………………………………..S BACKGROUND
WAS IT SUITABLE GIVEN THE FINANCIAL CONDITION OF THE ………………………….’s
WAS IT SUITABLE GIVEN THE INVESTMENT OBJECTIVES AND RISK TOLERANCE OF THE ………………….’s
WHAT IS YOUR NEXT OPINION
WHAT ARE THE BREACHES OF THE STANDARDS OF CARE
DID THE FINANCIAL ADVISER KNOW HIS/HER CLIENT
DID THE FINANCIAL ADVISER KNOW HIS/HER PRODUCT
DID THE BROKERAGE FIRM AND THE INVESTMENT ADVISER PERFORM REASONABLE DUE DILIGENCE ON …………………………………………………..
DID THE FINANCIAL ADVISER ENGAGE IN OVERREACHING
WHAT IS YOUR NEXT OPINION
WHAT RED FLAGS DID THE BROKERAGE FIRM FAIL TO ADDRESS WITH APPROPRIATE SUPERVISION
WERE THERE ANY SPECIFIC BREACHES OF SUPERVISION
WHAT ARE THE APPROPRIATE DAMAGES IN THIS CASE
WHY BROKERS SHOULD BE HELD TO A FIDUCIARY STANDARD
Broker/Dealers, who support the industry’s 658,000 financial advisors, have maintained over the past 65 to 70 years that their brokers have had no fiduciary responsibility for any advice their brokers might render, and that any advice is just incidental to the trade execution services provided by the broker/dealer. This stance has come to be known as the “Merrill Lynch Rule”. The distinction between brokers and advisors has always been that brokers only make the customer aware of their investment alternatives and execute trades, while advisors provide both implementing and monitoring services, thereby adding value.
The SEC has ruled (SEC Rule 202 (a) (11)-1) that on April 15, 2005 (1) a broker who charges a separate fee or enters into a separate contract for advisory services is held to a fiduciary standard. (2) a broker who provides financial planning services is held to a fiduciary standard and (3) a broker who has discretion over any brokerage account is held to a fiduciary standard. New disclosure requirements have also been passed. Essentially, the rules now require that brokers who “are” offering investment advice be held to the same fiduciary standard as advisors. .
The SEC has thereby established three criteria that will determine whether the broker who “is” providing advice will be held to a fiduciary standard: (1) the services being offered, (2) the brokers relationship with the client, and (3) how brokers and their supporting broker/dealers represent their services. In other words, brokers who directly control (on a de facto basis) accounts might well be subject to the same fiduciary standard
Through time, customers of brokerage firms have demanded this clarification. Every client wants their advisor to evaluate their holdings before they make an investment recommendation so that they can determine if the recommendation adds value. Every client wants their broker/advisor to disclose their role and responsibilities, and that of the money manager and other vendors, along with any conflicts and to clarify the duties of the client. Every client wants full disclosure and their best interests to be put first, ahead of all others. Every client wants eir advisor to continuously and comprehensively monitor their holdings as required by regulatory mandate. Given, every client wants and expects these basic fiduciary services, it is difficult to imagine how a broker would compete without providing these services. It seems clear that brokers and advisors both would have to be held to a fiduciary standard, if the broker is to compete in the free marketplace of financial services. The law is already on the books for advisors. The Investment Advisors Act of 1940 charges advisors with the obligation for those advisors to “exclusively act in the best interests of the consumer with the skill, care and diligence of a prudent expert”. Brokers who do fee business, made possible by holding a Series 65 or Series 66 license (Investment Advisor Representative – IAR license), should fall under the same fiduciary standard.
The reality of all of this is that brokers who “are” providing advice should be held to a fiduciary standard and therefore, their broker/dealers will be obligated to create a prudent process which will “continuously and comprehensively” address and manage the full range of investment and administrative values, as required by regulatory mandate and client directive. Clearly, when a broker has a relationship of trust and confidence with their client (the only type of client relationship worth having) the broker should be held to a fiduciary standard. There are tens of thousands of brokers within large full service brokerage firms, that characterize their services as being financial planning – which the SEC now holds to an objective fiduciary standard. If the SEC is to enforce the fiduciary status of broker/advisors who are in a trust position, who are providing financial planning services and/or providing investment advice, the broker/advisors firm has two choices. Either to absolutely ban those activities, which would cause a significant backlash from broker/advisors who are ethically compelled to do the right thing, or create and support a prudent process that promulgates fiduciary counsel in the truest sense.
There are six financial services that make up the prudent process of fiduciary counsel. They are (1) asset/liability study, (2) investment policy, (3) strategic asset allocation, (4) manager/vendor search and selection, (5) performance monitoring and (6) tactical asset allocation. Only through these critical steps, can a broker/advisor truly add value in ways not possible without a total understanding the client and their holdings. In other words, without the rule clarification and these steps, it is impossible for the broker/advisor to meet the responsibility of NYSE Rule 405, the “know your customer rule”.
Clients know that it is the process, or what the broker/advisor does with the investment products, that adds the value, not the investment products themselves. And by extension, this also means that the prudent process designed to add value and fulfill fiduciary responsibility, preempts investment products, which when sold, as isolated disjointed transactions, make it impossible for the broker/advisor to add value.
The SEC finds itself having to strike a balance between two countervailing forces: the best interests of the broker/dealer versus that of the customer – which by definition compromises consumer protection. The fiduciary responsibilities of advisors are already on the books, they are just waiting to be enforced. To date, the consumers best interests have not been placed before that of supporting broker/dealers. We are in an environment where leadership is demanded, where doing the right thing is more important than creating legal constructs that cleverly circumvent fiduciary responsibility. The SEC is now shifting the balance of the scale of consumer protection back to the customer, which ultimately is in the best interests of the advisor and the industry. Without question, brokers do render investment advice ……..just ask them. They should be held to a fiduciary standard. Fiduciary responsibility is in the investors best interest, is a preemptive value proposition for the broker/advisor, is required by regulatory mandate and is the right thing to do.
Brokers are now required to register with the SEC as investment advisors if, as described above, they hold themselves out to the public as financial planners or as providing financial services. They are further required to register as investment advisors if they offer discretionary accounts to their customers. .
Clarification of SEC Rule 202 (a) (11)-1 – William Mack, a senior assistant administrator of regulation with the SEC’s Philadelphia district office clarified the following aspects of the rule. “If a B/D’s rep had merely assisted a client in reviewing their current financial situation, they could avoid registering as an investment advisor. However, if the advisor had prepared a comprehensive program for the client, then the advisor would have to register”.
BACKGROUND & IMPLICATIONS OF THE MERRILL LYNCH RULE
Under Federal Law, there are two sets of statutes in place for regulating financial service professionals. The Securities Exchange Act of 1934 controls the activities of broker-dealers while the Investment Advisers Act of 1940 regulates investment advisers. It is important to distinguish the two from each other in order to understand their functions, the requirements they lay out as obligations to the client as well as how they are affected by the Merrill Lynch Rule.
The U.S. congress passed the Securities Exchange Act in 1934 in response to the “Great Depression” and loss of confidence in the financial markets. The Securities Exchange Act defines a broker as a person “engaged in the business of effecting transactions in securities for the account of others.” Conversely, a dealer is defined as a person “engaged in the business of buying and selling securities for [its] own account. “Brokerage services” have been interpreted by the SEC to encompass:
“services provided throughout the execution of a securities transaction, including providing research and advice prior to a decision to buy or sell, implementing that decision on the most advantageous terms and executing the transaction, arranging for delivery of securities by the seller and payment by the buyer, maintaining custody of customer funds and securities and providing record-keeping services.”
Only a broker-dealer may perform these tasks of executing securities for clients.
The Investment Advisors Act of 1940 (the ’40 Act) was enacted with the purpose of protecting investors and the general public from receiving poor securities advice. See Johnston v. CIGNA Corp. 916 P.2d 643, 646 (Colo. Ct. App. 1996) (stating the purpose of the Investment Advisers Act of 1940). The Advisers Act provided regulation in a highly unregulated securities market after the Commission submitted the “Investment Council Report” to Congress. The Report recognized two main problems among investment advisers: “(a) the problem of distinguishing between bona fide investment counselors and ‘tipster’ organizations; and (b) those problems involving the organization and operation of investment counsel institutions. The Advisers Act helped resolve these problems and sought to distinguish certain professionals from investment advisers.
As background, up until the end of World War I, customers paid fixed commissions for investment advice. Later, in 1920, investment advice was offered for a separate and specific fee. As a result, it was easy to differentiate broker-dealers from those who received “special compensation.” However, in today’s environment, the line between brokers and financial advisors has been blurred.
The Advisers Act defines “investment adviser” as “[A]ny person who, for compensation engages in the business of advising others, either directly or through publications or writing, as to the value of securities or as to the advisability of investing, in, purchasing, or selling securities, or who for compensation and as part of a regulator business, issues or promulgates analyses or reports concerning securities…”
This appears to include a variety of professionals, from those who publish stock tips online to those who manage complex investment portfolios. In SEC v. Capital Gains Research Bureau, the Supreme Court stated that an investment adviser’s function is “furnishing to clients on a personal basis competent, unbiased, and continuous advice regarding the sound management of their investments.” See, SEC v. Capital Gains Research Bureau, 375 U.S. 180 187 (1963).
The fundamental purpose of this and other legislation adopted at the time was to “substitute a philosophy of full disclosure for the philosophy of caveat emptor and thus achieve a standard of business ethics in the securities industry.” The Investment Advisors Act in particular arose from a “consensus between industry and the SEC that investment advisers could not completely perform their basic function – furnishing to clients on a personal basis competent, unbiased, and continuous advice regarding the sound management of their investments – unless all conflicts of interest between investment counsel and their client were removed. Then, what is the significance of being registered as an “investment adviser”? The law is clear that investment advisers are fiduciaries. As a fiduciary, the investment advisers must place the client’s interest ahead of his own interest. The duty of care, the duty of loyalty and the duty of fair dealing capture much of the essence of what it means to be a fiduciary. Additionally, it is worth noting that the fiduciary duties of investment adviser’s is governed by rules other than contract rules. Whenever the two conflict, fiduciary rules trump contract rules.
In the beginning, there was Leib v. Merrill Lynch. Though written in 1978 by a federal district court judge sitting in the Eastern District of Michigan, and though contradicted by some court decisions rendered since then, brokerage firms continue to cite the case in securities arbitration proceedings to this day. Brokerage firms seize upon the court’s language that, in a non-discretionary account, “all duties to the customer cease when the transaction is closed.” Moreover, brokerage firms quote Leib’s language that a broker “has no continuing duty to keep abreast of financial information which could influence his investments.” In short, this view stands for the proposition that brokers are responsible only for executing trades properly, with no duty to offer advice or warnings about investments.
In today’s environment of “full service” firms, it would seem that virtually every broker at a major wire-house would be deemed a financial advisor. However, Section 80b-2(a)(11)of the Advisors Act provides exceptions under which these professionals can avoid its provisions. The Broker-Dealer Exception provides that “any broker or dealer whose performance of such services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefore…” is exempt from the Advisors Act. It is this exemption that the Merrill Rule discusses and it clearly favors Wall Street and its continual attempts to receive high commissions with no responsibility.
The Merrill Rule was created to determine when a broker-dealers activities are subject to the Advisers Act. The rule was developed in response to the increased use of fee-based wrap accounts. Fee-based brokerage programs provide brokerage services packages for an asset-based fee or a fixed-fee. Packages normally include investment advice. The benefit of fee-based programs if that they discourage churning of accounts. Churning is a problem in commission-based compensation because broker-dealers are tempted to sell packages that will provide them with the greatest commission rather than acting in what is necessarily the customer’s best interests. Contrarily, the fee-based programs often result in an increase in “reverse churning”. Broker-dealers under this program no longer have greater commissions as motivation to act so it is common that they remain idle when account activity would actually be more proper.
The trend towards the use of “wrap accounts” gained significant momentum when Merrill Lynch announced its new Unlimited Advantage program in 1999– a change to traditional brokerage programs because it was to charge an asset-based fee in lieu of a commission. The program was necessary because other brokerage firms were offering services for under $10 per each trade, and the public was no longer as willing to pay Merrill’s hefty commissions. Although many were happy that customer and broker interests would be more appropriately aligned due to a decrease in churning, Merrill Lynch soon realized that its new program would subject it to the Advisers Act. Merrill was obviously selling advice when it advertised that a “Financial Consultant ‘will help you develop investment strategies’, including including retirement planning, saving for college, estate preservation and liability-management strategies. In an attempt to increase the usage of these programs, then SEC Chairman Arthur Levitt proposed to exempt broker-dealer advisory services from the Adviser’s Act regulation. thus, the new Rule 202(a)(11)-1 has been dubbed the “Merrill Rule.”
The SEC first proposed the Merrill Rule on November 4, 1999 under the name “Certain Broker-Dealers Deemed Not To Be Investment Advisors.” Under this new rule, those broker-dealers who are not excepted from the Advisers Act must register under the Act and treat their clients with advisory accounts as advisory clients rather than regular brokerage customers.
Under this initial proposal, the Rule provided that broker-dealers are not considered investment advisers under the Advisers Act regardless of any compensation received as long as 1) the advice given is not discretionary; 2) the advice given is solely incidental to the brokerage services provided and 3) the broker-dealer discloses to his customers that their accounts are brokerage rather than advisory accounts. Immediately after its proposal in 1999, the Merrill Rule became the source of significant controversy. In fact, after the first proposal, the Commission received more than 1,700 comment letters. Not surprisingly, a strong majority of broker-dealers supported the Rule under the guise that the new fee-based brokerage programs better consider customer interests. Moreover, broker-dealers believed that the Rule encouraged development of these new programs because the industry would not be susceptible to the more stringent rules of the Advisers Act. In opposition, financial planners, investment advisors, and those groups who represent investors were against the Rule because it decreases the level of investor protection. The SEC allowed different parties to comment on the proposal for an additional month in August 2004 in order to accommodate late letters, and then considered them for approximately three months.
After reviewing the many comment letters, the SEC revised the Rule and submitted a re-proposal in January 2005. The re-proposed rule included a few notable changes. For example, under the re-proposal, the Merrill Rule now includes greater disclosure requirements in response to commenters’ concerns about investor confusion on the differences between broker-dealers and investment advisers. In addition, the Merrill Rule now requires that “all advertisements for, and all agreements, contracts, applications and other forms governing the operation of, a fee-based brokerage account contain a prominent statement that the account is a brokerage account and not an advisory account. The disclosure must also include an explanation of the customer’s rights and the firm’s duties to the customer, including the appropriate standard of obligation. The following statement must be displayed clearly on all client documents:
“Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours. Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interest. We are paid by both you and, sometimes, by people who compensate us based on what you buy. Therefore, our profits, and our salespersons’ compensation, may vary by product and over time..”
Furthermore, broker-dealers are now required to make available a person within their firm to answer any customer questions on the above issues. The re-proposed rule also attempted to appease commenters’ who worried about when, specifically, advisory services are not “solely incidental to” brokerage services. The SEC responded by stating that investment advice is “solely incidental to” brokerage services when the advice is reasonably related to the regular brokerage services (which of course, provided no real guidance). The Commission also interpreted that financial planning services are not necessarily “solely incidental to” brokerage services. Finally, the Commission mandated that when a broker-dealer exercises investment discretion over a client’s account, he is no longer providing advice that is “solely incidental to” the business of brokerage under the Advisers Act.
In relation to financial planning, the re-proposed Merrill Rule states that a broker-dealer’s advice is not solely incidental to brokerage services if it provides some type of financial plan or services “and (i) holds itself out generally to the public as a financial planner or as providing financial planning services; or (ii) delivers to its customer a financial plan; or (iii) represents to the customer that the advice is provided as part of a financial plan or financial planning services.” In sum, if a broker-dealer advertises financial planning services, he must register under the Advisers Act.
Surprisingly, other than the above restriction, there are no other restrictions on how a broker holds himself out to the public. A broker may creatively title himself any way he chooses without facing liability under the Advisers Act. Even the illusory terms “financial advisor” and “financial consultant” are allowed under the new Rule. The Commission came to the this conclusion based on the fact that professionals in other related industries such as banks and insurance companies typically utilize such “generic” terms to describe a wide variety of different services. The SEC has determined that requiring broker-dealers to notify advisory clients of the stricter legal obligations is sufficient to protect investors.
In the final analysis, the SEC concluded, the role that the broker plays depends on the circumstances.
In its SEC filing, UBS (PaineWebber) took the position that while its financial reports for customers “contain some elements of investment advice”, nonetheless. “the planning analysis and recommendations cover a variety of other topics that do not involve general or specific investment advice at all and for which investment adviser regulation is neither appropriate or required.” Likewise, Citigroup Global Markets (Smith Barney) took the position that its fee-based (not commissioned-based) AssetOne account “is a brokerage account and not an investment adviser account.”
Since those declarations in in 2004 and 2005, brokers have filed class action lawsuits alleging that their brokerage firms violated the Fair Labor Standards Act and state wage hour statutes in failing to pay them overtime. Many cases are still pending and some cases have settled. For example, Citigroup Global Markets and UBS agreed to settle nationally, paying $98 million and $89 million, respectively. Morgan Stanley and Merrill Lynch settled in California but in no other states, paying $43.5 million and $37 million, respectively.
However, one firm, A.G. Edwards, filed a motion for summary judgment. A.G. Edwards argued that commission-based brokers are not entitled to overtime. The federal; district court in California denied the motion for summary judgment in its entirety.
As background, the Fair Labor Standards Act (FLSA) exempts certain employees from overtime pay requirements, so long as the employer proves that the employee meets both of two tests: the salary-basis test and the duties test. In its motion for summary judgment, A.G. Edwards argued that its brokers were paid a guaranteed salary, in effect, because the firm paid them a draw against future commissions. The court rejected that argument that the draw was the equivalent of a guaranteed salary, reasoning that, “Case law and the DOL [Department of Labor] letters cited by both parties, therefore, appear to support that deduction of Plaintiff’s draw salary from a subsequent paycheck is an impermissible offset.”
Turning to the duties test, A.G. Edwards attempted to convince the court that the primary duties of its brokers were “administrative”, as distinguished from “sales”, such that they fell within one of the duties exemptions to overtime pay requirements. A.G. Edwards claimed, among other things, that that its brokers underwent extensive training on management of client portfolios, “only a small portion of which focused on prospecting.” Of course, the argument that brokers had a duty to manage client portfolios flew in the face of Leib and was inconsistent with positions taken more recently that investment advice is “solely incidental” to the brokerage (sales) function. In any event, the court relied on testimony and documents suggesting that the primary duty of A.G. Edwards’ brokers was to sell. Accordingly, the court found that there was a genuine issue of material fact “regarding whether Plaintiffs are engaged in work that results from the product that Defendant profits from, in this case sales of securities and other financial offerings, rather than in the administration of Defendant’s business or that of its existing customers.”
What then are the roles and responsibilities of brokers? Yes, the answer (that brokerage firms provide) depends upon the circumstances. But one thing is clear. What brokerage firms for years have claimed about their brokers’ limited duties to customers, now, in the context of broker class action lawsuits for overtime pay, may come back to haunt them.
On March 30, 2007, the Merrill Lynch Rule was overturned in a 2-1 decision released by the U.S. Court of Appeals for the District of Columbia Circuit in Washington. The decision is a big win for the Financial Planning Association of Denver, which challenged the SEC when it issued its rule in 2005 exempting brokerage firms that charge asset-based fees from investment advisory regulations under specified conditions. The ruling issued by Judge Judith Rogers for herself and Judge Brett Kavanaugh said the SEC exceeded its authority by exempting brokerage firms that charge asset-based fees from regulation under the Investment Advisors Act of 1940. “The rules is inconsistent with the IAA”, Judge Rogers wrote, because it fails to meet the law’s requirements for exemptions.
Under that law, she wrote, brokers can only be exempt from advisory regulation if they do not receive “special compensation” for giving advice. Charging asset-based fees (special compensation) means they must register as advisers. “No…indicators of congressional intent support the SEC’s interpretation of its authority,” Judge Rogers wrote. Judge Merrick Garland, who dissented, said that the SEC’s interpretation of the IAA was reasonable and courts are bound by legal precedent to give government regulators the benefit of the doubt in interpreting the law.
The ruling is “very straightforward” and a “clean decision” commented David Tittsworth, executive director of the Investment Advisors Association in Washington. “This is throwing the rule out.” The decision opens the door for Congress to re-examine the securities laws in light of changes that have taken place in the industry since those laws were enacted in the Depression era. “It looks to me like Congress probably will need to get into this fray to sort it out,” Mr.Tittsworth said. “This rule should have died a quick and merciful death six years ago,” said FPA President Nicholas A. Nicolette. “It would not be the best use of taxpayer dollars to prolong a policy that is contrary to the public interest.”.
The appeals court’s decision forces the broker-dealer to stop selling fee-based accounts and advice without having to register as advisors. Brokers have sold an estimated whopping $300 billion in fee-based accounts in the past eight-plus years under the SEC-ordered exemption. currently, broker-dealers will only have three months to “re-paper” these accounts. “What we’re going back to is the bright-line test that existed for consumers before 1999,” says FPA Director of Government Relations Duane Thompson. “if a broker is offering advice for fees, they must be registered.”
Much of this whole area of all investment representatives i.e. brokers and investment advisers being held to a fiduciary standard is contained in new proposed legislation! It would, if enacted, amend both the Advisers Act, regulating investment advisers, and the Securities Exchange Act of 1934, regulating broker-dealers, by permitting the SEC to set uniform rules requiring all financial intermediaries “to act solely in the interest of the [retail] customer or client without regard to the financial or other interest of the broker, dealer or investment adviser providing the advice.” That would certainly simplify and clarify the entire situation.