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 Helping individuals recover their investment and retirement plan losses…
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151 Answers to Most FAQs From the Book Investor Rights for the 21st Century Co-Authored by Andrew Stoltmann 1) Is there one type of investment professional who is most likely to defraud the public? No. Today, it is not just stockbrokers who defraud investors. As investors’ financial assets have exploded in recent years, to $27 trillion in 1999 from approximately $15 trillion in 1990, brokerage firms have attempted to position their employees not as “stockbrokers” but rather as “financial professionals.” Usually, this is a distinction without a significant difference. Regardless of what a firm calls its sales force, investors must be careful in their dealings with anyone in the securities or insurance industry. 2) How significant of a problem is securities fraud? Unfortunately, abuses in the securities industry are widespread. In 1999, the North American Securities Administration Association (NASAA), which represents state securities regulators, reported a 30 percent increase in fraud from the previous year. The group estimates that securities fraud costs American investors $10 billion a year, or $1 million every hour. The number of arbitration cases at the NASD alone has increased from 318 in 1980 to 5,558 in 2000. 3) Are securities abuses underreported? Yes. The overwhelming majority of all investment abuses are never reported. The cases that are actually filed against brokers, insurance agents and investment advisers are the very small tip of the iceberg. Often, investors feel embarrassed by their supposed gullibility or degree of trust that they placed in their broker. Investors often assume they are simply the victim of the market and there is nothing that can be done. However, if an investor is the victim of fraud by an investment professional, then they do have legal options. 4) How do investors go about recovering their investment losses? Usually through securities arbitration. Since 1987, the U.S. Supreme Court has allowed the securities industry to force investors into arbitration instead of court litigation. In arbitration, the decision of the arbitrators is binding and final. The arbitration proceeding is similar in many respects to a trial in a court of law with some notable exceptions. In arbitration, as in a trial in court, there are opening and closing statements, the presentment of evidence and witnesses, and a decision rendered by the panel. However, unlike court litigation, the rules of evidence are more relaxed and the arbitrators many times are concerned with what is fair and equitable. 5) How can investors check the background of their broker? One of the most important steps an investor should take when choosing a financial advisor is to examine the advisor’s background. To check out a broker, acquire a copy of the broker’s disciplinary and employment history from the National Association of Securities Dealers (800-289-9999) or from the state securities division (See Appendix 1). Another option is to log onto the NASD Regulation website (www.nasdr.com) where an investor can review brokers’ employment history, find out where they are licensed, determine what products they are registered to sell and request disciplinary records. Unfortunately, the NASD’s website section has numerous problems that often makes retrieving the information nearly impossible. Typically, the best source for retrieving information about a broker is through a state securities division. When reviewing a broker’s Central Registration Depository (CRD) report, first examine the broker’s disciplinary history. On the NASD website, this information will fall under the heading “Disclosure Events.” It includes civil or criminal actions by securities regulators, plus arbitration cases, lawsuits and settlements stemming from investor complaints. It also lists all investor complaints filed in the past 24 months. An investor, even after checking with the NASD, should also call the state securities office of the state that the investor resides in. There are times when state regulators may disclose information that the NASD will not. 6) How can investors check the background of their financial planner or money manager? The first step, once again, is to check the CRD System. Even if the financial planner or money manager is not a licensed broker, some advisors are listed in the system. However, the most important step in checking their background is to review a copy of the adviser’s standard regulatory filing, known as Form ADV, which can be acquired from either the advisor, the investor’s state securities regulator, or the Securities and Exchange Commission (www.sec.gov). Advisers must provide investors with Part II of their ADV, which contains information about their compensation, experience and training. In Part II, examine questions 1C, 1D, 13A and Schedule F which will disclose any financial arrangements that could contaminate the adviser’s judgment and make her recommend one investment over another. For instance, check to see if the adviser receives compensation from a mutual fund company for recommending that family of funds. Other important information can be found in the answers to Item Seven of Schedule D which deals with financial planning credentials, Question Six, which asks for the adviser’s educational and business background and Question Eight which lists any business ties to insurers, broker-dealers or other businesses. Part I is also important to examine and will list any legal or regulatory problems. When reviewing the ADV, first examine Question 11 of Part I. A “yes” answer to any of the questions is a signal that the adviser has had regulatory or legal problems. 7) Does the Central Registration Depository accurately reflect all broker wrongdoings? No. The CRD is supposed to give investors an accurate look at a broker’s record and includes information such as disciplinary problems, customer complaints, bankruptcy and criminal records. Some information does not make it to the CRD because the broker or brokerage firm failed to file it or was not required to disclose it. There are times, however, when information should go onto a broker’s permanent record and it does not. For instance, a Wisconsin arbitration panel ordered a Wisconsin brokerage firm to pay $86,500 to a Milwaukee investor who filed a complaint alleging unsuitable investments, unauthorized trading and churning. The arbitration complaint accurately identified the broker by name, yet a full two years after the order, the information did not appear on the broker’s CRD. Even though investors and arbitrators can get detailed history on a broker’s background, there is no guarantee that all complaints and awards will be recorded. 8) What is the difference between a broker, an investment adviser and a financial planner? Brokers generally collect commissions based on the transaction while advisers and planners charge a flat advising fee or take a percentage of the investors’ assets under management for their services. However, today some brokers charge a percentage of assets while other planners may charge commissions. In essence, the investment functions of each can overlap with one another thereby blurring the distinction between the three. There is a much higher degree of overlap today than there was even ten years ago. Going forward, the line should blur even further. 9) Who regulates investment advisers and financial planners? Brokers must register with the NASD and be licensed by the states in which they do business. Financial planners, money managers and other advisers must be licensed as “investment advisers” by their states, or if they have $25 million or more under management, by the SEC. Even accountants and lawyers who provide financial advice must be licensed as investment advisers by securities regulators, unless the advice is “incidental” to their main business. 10) Are most investment professionals unethical? No. Even though investment abuses are widespread, underreported and extremely costly to defrauded investors, many investment professionals are honest and do add a great deal in performance to their investor’s returns. Good stockbrokers, financial planners and money managers are extremely valuable. Financial planning is not like learning how to knit. It cannot be learned on the weekends. Like any profession, it is the minority of dishonest and unethical stockbrokers, insurance agents, financial planners and accountants that cause most of the problems and bad publicity. 11) What is the major reason for investment abuses? There are many reasons why investors get taken advantage of by their investment advisor. Probably the most common reason is greed on the part of the registered representative. Though the securities industry is attempting to move away from commission based transactions with investors, the vast majority of all securities transactions are still commission based. For instance, insurance agents and financial planners may receive commissions of up to 7 percent on annuities, which they share with their firm. Load based mutual funds pay only, on average, 4 percent to the registered rep. Selling stocks or bonds pay the representative only 1 percent. Therefore, the incentive in many instances is to sell a product that might not be suitable for the investor because the one who is making the recommendation gets paid more. 12) What is another cause for investment abuses? Unfortunately brokers and investment advisers prey and feed off of investors’ ignorance. An uninformed investor is generally less likely to ask questions because often he is too embarrassed to admit his lack of knowledge. For example, a survey done by the AARP in 1998 showed that 64 percent of those investors surveyed were unaware that brokerage firms often pay higher commissions for the sale of riskier investments and 15 percent of those surveyed did not even know that they paid a commission or markup to buy or sell stocks, mutual funds or bonds. Those surveyed were investors who had used financial advisers and brokers in the past. A study from the Columbia University Graduate School of Business found that out of 3,300 mutual fund investors surveyed, 72 percent didn’t know if they were invested in domestic or international mutual funds and 75 percent didn’t know if they were invested in equity or fixed income funds. Unethical brokers, financial planners and insurance agents thrive off of ignorance and generally prefer that their clients stay uninformed. 13) What securities firms have had problems in the past? The question with a much shorter answer is which securities firms have not had problems. Most well known firms budget millions of dollars annually to pay their attorneys and damaged investors through arbitration awards. In the insurance field, one well-known company defrauded tens of thousands of investors and eventually was forced to pay investors $2 billion for the firm’s fraudulent sales practices. In the brokerage industry, a regional firm paid investors over $138 million due to losses that were incurred in a short term, government bond fund that plunged in value after a surge in interest rates battered the funds massive holdings in mortgage derivatives. By definition, the fund should have been one of the safest mutual funds in existence. In 1996, one of the largest brokerage firms in the nation agreed to pay $250 million, including a total of $45 million toward a restitution fund and civil penalty, to settle an SEC civil administrative complaint and related class action claims that some of its brokers misled investors in selling hundreds of millions of dollars in limited partnerships. In 1997, another well-known brokerage firm agreed to pay approximately $70 million to settle allegations that the firm’s dealers unfairly kept prices and profits in NASDAQ stocks unduly high between 1989 and 1994. Unfortunately, the list goes on and on. 14) Are discount brokerage firms immune from defrauding investors? Absolutely not. In 1998, a well known “full service discount firm” was fined over $5 million by the SEC for fraudulent sales practices. The firm’s brokers were found to have been pressured by management to sell particular stocks in the firm’s inventory where the brokers would receive a markup on the stocks from six cents a share to over a dollar a share, all the time the firm was advertising “commission free” trades. Many other discount brokerage firms now provide research reports, generate investment ideas for their clients, provide “unbiased” advice on mutual funds, provide 24 hour access to brokers over the phone, recommend certain industries to purchase stocks from and asset allocate the portfolios for the firm’s clients. One firm’s co-CEO rhetorically asked in a SmartMoney article in 1998 that if what his firm provides is not full service, then what is? These are the traditional functions that full service brokerage firms provide to their clients and therefore in many cases, the “discount” firms have the same stringent legal obligations as full service brokerage firms. 15) Are online investment firms immune from defrauding their clients? No. There are an increasing number of arbitration claims being filed against online brokerage firms. In 2000, 214 claims against online firms were filed, up from none in 1998. The authors’ law firm commenced an arbitration claim against one of the largest online brokerage firms alleging margin account and suitability abuses. The client, a 27 year-old graduate student with virtually no investment experience, lost more than $40,000 in savings for medical school by trading Internet stocks in his margin account. The online firm gave the investor no warning that a margin call was imminent and virtually no time to meet his margin call before they sold the investor out at a substantial loss. Fortunately, he was able to recover his losses. The market volatility in the spring of 2000 led to hundreds, if not thousands, of other unauthorized margin liquidations for clients of online firms. In February of 2001, one of the nation’s largest online firm’s was fined $225,000 by the New York Stock Exchange Division of Enforcement for engaging in “conduct inconsistent with just and equitable principals of trade” including a failure to maintain appropriate procedures for supervision, maintaining inadequate telephone systems, allowing multiple non-exchange registered employees to engage in activities that required registration and failing to report, as required under the Exchange rules, over 18,000 complaints.As online trading continues to grow, arbitration complaints against e-brokers will continue to increase. 16) Are accountants immune from defrauding investors? No. Today, accountants sell investments and manage money just like full service brokers. A survey of accountants by the American Institute of CPAs concluded that 12 percent of their 329,000 members surveyed are already receiving fees and commissions relating to financial advisory services. At least 35 states have enacted legislation permitting accountants to receive commissions, which was once completely forbidden in the accounting industry. It is much more common today for investors to complain about abuses caused by the management of their portfolio by their accountants than even five years ago. 17) Are banks getting in on the investment business? Yes, and unfortunately many of the same abuses caused by full service firms are now occurring at banks. For example, in 1998, a well-known national bank agreed to pay $6.75 million in fines to settle federal charges that it misled mostly elderly investors by marketing volatile securities as safe banking products. An investor must take all of the same precautions when dealing with a bank as would be taken when dealing with a full service broker. 18) Stocks The most common disputes in arbitration continue to involve individual stocks. Individual stock recommendations continue to be one of the broker’s favorite vehicles for defrauding investors. At the end of 1999, American households possessed over $5.4 trillion in individual stocks, which was second behind only the $7.4 trillion in pension funds. An individual stock purchased at a full service firm costs approximately 1 percent of the purchase price. While this may not seem to be a large amount, the commissions can pile up quickly if a broker trades frequently in the investor’s account. Investment abuses with individual stocks are well documented. However, in recent years, more complaints are surfacing dealing with initial public offerings or IPOs. It is common for brokers to make misrepresentations and false claims concerning IPOs. The temptation is great for brokers to “sell the sizzle” and make guarantees on returns and inaccurate price forecasts with IPOs because investors generally only hear about the highly successful IPOs like Microsoft and Apple and not the hundreds of poor performing IPOs. A study commissioned by the Midtown Research Group in New York showed that of 341 IPOs in 1997 that exceeded $20 million, 55 percent traded below their IPO price and 24 percent were down more than 50 percent at the time of the study. IPOs are typically unsuitable investments for many investors.Brokers will use an IPO to convince relatively conservative investors to start purchasing individual stocks. The IPO serves as a “lure” to convince investors to take more risk than the broker knows is appropriate. IPOs are often high-risk, speculative investments. There is never a guarantee that an IPO will open above the price that the investor paid. When coupled with the compensation that brokers usually receive from IPOs, which is typically greater than a traditional stock purchase, it is no surprise that brokers find IPOs so attractive to sell. Firms that bring many companies public will often use future IPO allocations as a recruiting tool when trying to hire brokers from other firms. 19) Bonds Bonds are one of the investments that are the least understood by investors. As a result, few other investments are as wrought with as many abuses as bonds. First, brokers typically do an awful job of disclosing the risks associated with bonds. Brokers sell bonds as a conservative investment, when in fact many times they are not. Government bond funds often load up on mortgage-backed bonds such as Ginnie Maes to increase their yields. While these bonds are backed by the government, they can still be very volatile due to changing interest rates. This is typically not disclosed to investors. Brokers also fail to tell investors that any bond, regardless of whether it is a government bond or an AAA rated bond, can lose money if it is not held to maturity. For example, a government bond purchased when interest rates are at five percent will plummet in value if interest rates subsequently rise to seven percent. If an investor sells her bond at that point, she will have a loss on the safest investment available. Another problem is that unlike stocks and mutual funds, bond prices are not readily discernable to most investors. In the usual principal transaction, a broker buys a bond at one price and sells it to the investor at a higher price and the broker and brokerage firm pocket the difference. When a broker buys a bond from an investor, they do the opposite, charging a “markdown.” Unfortunately, bonds do not trade on an exchange, meaning investors have little way of gauging the actual market price. The NASD only requires that bond markups be “fair.” Another problem investors need to be wary of is that brokers are often given financial incentives to push one bond over another. Brokers receiving extra compensation for selling certain products is a significant problem in the securities industry and is especially common for fixed income products. Brokers will push a bond from their firm’s inventory because they can make more in commissions. Instead of recommending a bond to a customer because it is suitable or the best fit for that investor’s portfolio, brokers are encouraged by their compensation system to recommend one bond over another because of the higher payout that the firm’s inventoried bonds provide. Unfortunately, brokers usually receive more in compensation for selling lower quality bonds, which often takes precedence over suitability considerations. 20) Mutual Funds One of the major problems investors face with mutual funds is the high degree of switching between different funds. Mutual funds are one of the most popular investments that stockbrokers and financial planners sell to their clients in large part because the commissions are so high. For “A” shares, still the most frequently sold share type, the brokerage firm receives approximately 4 percent up-front on the purchase price for a load mutual fund and a “trailer” commission each year based on the amount of money in the fund. The “trailer” is usually a very small percentage of the assets in the fund averaging anywhere from approximately 5 basis points (1/20 of 1 percent) to 25 basis points (1/4 of 1 percent) Even though most mutual funds should be held for a minimum of five years, the average holding period for growth and value funds is under three years. Brokers are a big part of the problem. If a broker can convince a client to sell one mutual fund and purchase another one from a different family of funds, the broker can receive another 4 percent commission instead of the lesser yearly “trailer” commission. Brokers find it an easy sell to convince investors to liquidate a mutual fund that is not the current year’s hot fund. The high degree of switching is caused, in part, by brokers failing to distinguish between investment returns and investor returns. What many investors fail to realize is that there is a major difference between investment returns (what the mutual fund’s total return is from January 1st, to December 31st) versus investor return (what the investor who invests in that mutual fund actually receives as a total return). For example, from 1984 to 1995 the average stock mutual fund posted a yearly investment return of 12.3 percent. An impressive result especially when compared to the long-term returns for stocks. However, the average investor return over that same time frame was only 6.3 percent while the average investor in a bond mutual fund earned 8 percent. In other words, the average mutual fund bond investor did better than the average mutual fund stock investor during one of the greatest eleven year time periods in the history of the market! There are a number of reasons for this discrepancy between what the average mutual fund returns and what the average investor who invests in those mutual funds receive. One of the major causes, however, is that brokers and financial planners generally sell investors whatever the newest, hottest mutual fund that is currently being touted. Typically, by the time the investor gets into the fund, most of the gains have already been made. The broker then has an easy sell a year or two later when he touts the new, hot, popular mutual fund. The broker’s incentive is a large commission from the purchase of the new mutual fund coming on the heels of the previous load commission from a year or two back. 21) Margin Margin is an extremely popular tool brokers use to take advantage of investors. A margin account allows customers of the brokerage firm to buy securities with money borrowed from the firm. The customer pays an agreed upon interest rate to the brokerage firm for the right to borrow the money. The Federal Reserve requires that investors making their initial purchase of a stock must pay cash for no less than fifty percent of the price. This is known as a margin requirement. A margin call is a demand that an investor deposits enough money or securities to bring a margin account up to the minimum requirement. If the investor fails to respond, securities in the amount will usually be sold. One reason why margin accounts are so popular with brokers is because they give the client extra buying power. This extra buying power can be used to purchase more securities and therefore generate more commissions for the broker. One of the problems with margin accounts, though, is that many brokers are using margin for investors who are inexperienced or do not understand the risks involved with these accounts. Brokers fail to inform investors that the risks with margin accounts are extremely high. Often, the first time an investor learns about the risks inherent in a margin loan is after the investor receives a margin call and extensive loses are sustained. Brokerage firms and brokers typically do not do an adequate job of disclosing the risks to investors before they take out a margin loan. Unfortunately, margin abuses increased dramatically in 2000 and 2001. In 1997, there were only 25 margin complaints filed with the NASD compared to 284 in 2000. Through March of 2001, the number of margin complaints was 98. If the trend continues through the rest of 2001, there will have been almost 400 margin complaints filed with the NASD, almost a 16-fold increase in only four years. 22) Annuities One of the major problems with annuities is that brokers have an extra incentive to sell variable and fixed annuities due to the high payouts that they provide. Annuities are typically sold, not bought. Insurance agents, stockbrokers and commission-paid financial planners can receive a payout of up to 7 percent on annuities, which they share with their firm. Very few investment products pay this well. Load based mutual funds pay only, on average, 4 percent to the registered rep. Selling stock or bonds pay the representative only 1 percent. Therefore, the incentive in many instances is to force a product that might not be suitable for the investor because the one who is making the recommendation gets paid more. A second problem with annuities from the investor’s perspective is that annuity expenses are often extremely high. Investors pay the traditional annual management fee just like they would with a traditional mutual fund. However, with annuities there is an extra layer of fees. In addition to the investment fee on the portfolio, there is a “mortality and expense risk” charge, typically 1 percent or more a year. In 1999, the expenses (the portfolio management fees plus the mortality charge) averaged a hefty 2.1 percent a year. That is double what it costs to manage the average mutual fund and ten times what it costs to manage the Vanguard Index 500 fund. The best evidence of how attractive annuities are to financial representatives is that in 1998, approximately $21 billion of annuities sold went into IRAs. One of the major advantages of annuities that financial planners, brokers and insurance agents push is that annuities are mutual funds that allow for tax deferred growth. That is undoubtedly true. However, putting an annuity in an IRA is virtually useless. There is no legitimate reason to put a tax-deferred investment like an annuity into a tax-deferred account like an IRA because an investor is already getting the benefit of tax deferred growth via the annuity. 23) Options Not a great deal needs to be said about options. Though there are some option strategies that are conservative in nature, most options are inherently speculative and should only be used with a highly sophisticated, experienced investor. Most brokerage firms have relatively strict criterion for who can buy, sell and trade options. Options are usually not a suitable investment for most individual investors. 24) Fee Based Accounts Many brokerage firms are moving toward fee based compensation for their brokers which claim to align the broker’s interests along with those of the investor.With a fee based account, an investor is usually charged anywhere from half a percent (50 basis points) to three percent (300 basis points) annually. The investor then receives a substantial number of stock purchases and sales a year with no commission being charged on the individual stock transactions. Despite the grand claims made by the brokerage firms, often the fee-based account does not serve the intended purpose of what it was designed to do. Brokers infrequently place active investors (AKA profitable investors) into a wrap or fee based account. The fee-based account is often used to increase income from buy-and-hold investors. While a buy and hold strategy is usually the best option for an investor, that client does not generate much, if any, revenue for the broker. The solution for the broker and brokerage firm? Put the investor into a fee-based account and charge the investor up to three percent annually. Often, there are other problems investors face with these accounts. For example, many fee accounts base the annual management fee off of the gross assets under management-including assets bought on margin. Therefore, brokers have an inherent incentive to use margin to increase the total account value, thereby increasing their fee. Assuming a one percent annual fee on a $100,000 account, a broker who utilizes margin for another $100,000 in the account can double his fee, regardless of the suitability of the margin. Equally problematic is that the management fee is not usually based on a rolling average of the assets under management but rather it is calculated based on the total assets in the account, as of a particular day at the end of the quarter. Therefore, if a broker buys stock on margin just prior to the date the fee is calculated, he gets a larger fee. Many times, there are other undisclosed commissions or markups a broker can receive for buying certain investments being recommended by the brokerage firm. The client usually has no idea of these extra fees. 25) What other investment products or scams do investors need to be wary of? The North American Securities Administrators Association annually releases their “Top 10 Investment Scams.” For 2001, they listed the following scams: 1. Unlicensed individuals, such as life insurance agents, selling securities. To verify that a person is licensed or registered to sell securities, call your state securities regulator. If the person is not registered, don’t invest. In Indiana, 11 of the 16 “cease and desist” orders issued by the Securities Division in the first quarter of this year have targeted insurance agents who were selling securities without the proper license. Most were independent life insurance agents.26) What securities are involved in arbitrations? Securities arbitrations involve all different types of securities. However, certain securities appear in more arbitrations than others. In 2000, the most common security involved in arbitrations at the NASD were common stocks with 2,018 claims filed. The second most common security type in NASD arbitration in 2000 were options with 299 cases filed followed by mutual funds (261), corporate bonds (141) and limited partnerships (72). 27) How much compensation was awarded to customer Claimants at the NASD in 2000? In 2000, customer Claimants were awarded $76 million, which was comprised of $21 million in punitive damages and $55 million in non-punitive damages. In 1999, customer Claimants were awarded $126 million ($48 million in punitive damages and $78 million in non-punitive damages). The punitive damage number can be misleading, however, since a significant percentage of the punitive damages awarded were against defunct, bankrupt brokerage firms which makes collectibility almost impossible. 28) What is a misrepresentation or omission? A broker may be liable to a customer if the broker misrepresents material facts (lies) or fails to disclose material facts (leaves out important information) to the investor in the sale or recommendation of an investment. Usually, misrepresentations or omissions disguise the risk associated with a particular investment. The broker has a duty to fairly and accurately disclose all of the risks associated with an investment and not just the bullish, optimistic sale points. 29) How common are misrepresentations and omissions? In 2000, there were approximately 1,321 cases filed with the NASD alleging a broker misrepresented a material fact or failed to disclose material information to an investor. 30) What is an example of a misrepresentation or omission? Examples of an omission might be if a broker fails to disclose to an investor that the individual company he is recommending lost money in the previous three years or the brokerage firm is charging the customer an undisclosed commission or markup. If a broker told an investor that the stock being recommended had a new drug pending before the Food and Drug Administration and that was not the case, that would at a minimum be a misrepresentation. 31) Is a stockbroker a fiduciary for the customer? In many cases, yes. In the past, some courts and arbitrators have said there is always a fiduciary relationship between the investor and broker. A broker is generally considered the agent of a customer. As a customer’s agent, the broker owes certain duties to the customer. The level of duty that is owed to the customer can only be determined by evaluating the entire relationship between the broker and the investor. In many circumstances, the duty between a broker and his customer is considered to be a fiduciary duty. 32) How common is it for a broker to breach his or her fiduciary duties to the customer? Unfortunately, it is very common. In 2000, a broker breaching a fiduciary duty was the most common type of abuse perpetrated against investors with 2,489 complaints filed with the NASD. 33) How do arbitrators decide whether there is a fiduciary relationship or not? To determine the duty of a broker to his customer, arbitrators may evaluate the following factors, just to name a few: a)the sophistication of the investor;34) What is the result when a broker is classified as a fiduciary? When a fiduciary relationship exists between a broker and his client, the broker automatically owes his client a very high standard of care and therefore must unequivocally act in the best interests of the investor. The broker owes the client the highest possible duty of care and loyalty. A deviation from these obligations would result in almost automatic liability against the broker. However, regardless of whether there is or is not a fiduciary relationship, at the very least, the broker has an obligation to act in good faith, and with honesty and integrity. 35) What is an unsuitable recommendation? An unsuitable recommendation is one which, in light of the investor’s objectives and background, the broker knows or should know is inappropriate. For instance, if a broker recommends to a 65 year-old investor to short sell a technology stock when the broker knows the investor’s investment objective is current income or long-term growth, then the broker will have made an unsuitable investment recommendation. 36) How common are suitability claims? In 2000, there were 900 cases filed against brokers at the NASD alleging unsuitable investment recommendations. A survey done by Prophet Market Research & Consulting in 1996 helps illustrate how wide spread the problem is of brokers and financial planners making unsuitable investment recommendations. The research company surveyed the sales practices of 21 of the nation’s largest full service brokerage firms using 93 “mystery shoppers” presenting themselves as unsophisticated, first time investors. The survey found that brokers handed out specific investment advice to more than half of the mystery shoppers without asking even the most basic questions about their finances, such as their tax bracket or income level. Incredibly, almost half of the shoppers were recommended stock mutual funds and nearly a quarter were pitched individual stocks without the broker profiling the investor. A broker cannot make a suitable recommendation without finding out detailed information such as the investor’s tax bracket, income level, investment objectives and risk tolerance level. Unfortunately, the Prophet survey confirms what occurs on a regular basis: brokers and financial planners do not adequately profile their clients and this in effect makes it nearly impossible for many brokers to make suitable investment recommendations. 37) Why would a broker make an unsuitable recommendation? Extra compensation is one very common reason. Brokers make varying amounts of compensation depending on the type of security sold to the investor. For example, a broker can make considerably more in commissions by selling lower priced stocks, unit investment trusts, limited partnerships, options, new issues and in house mutual funds than by purchasing conservative certificate of deposits, T-bills or money market funds. The broker therefore has a built in incentive to sell speculative investments, regardless of suitability considerations, than more conservative (and often more suitable) securities. The mentality of many stockbrokers is to try to fit a square peg in a round hole rather than making an individualized determination based off of the facts and circumstances of that individual investor. Often, brokers use compensation as the primary means for determining suitability. 38) What is the NASD Suitability rule? NASD Conduct Rule 2310 mandates that: a)“In recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and his financial situation and needs.”39) What is the New York Stock Exchange “Know Your Customer” rule? NYSE Rule 405 mandates that “Every member organization is required…to use due diligence to learn the essential facts relative to every customer, every order, every cash or margin account accepted or carried by such organization…” 40) Is there a difference between the NASD’s Suitability rule and the NYSE’s “Know Your Customer” rule? Yes. An important difference between the NASD and NYSE rules outlined above is that there is arguably a question as to whether the NASD suitability rule is only applicable when a broker recommends an investment while NYSE Rule 405 applies anytime any investor makes any type of transaction with a brokerage firm, regardless of who recommended it. The NYSE essentially requires its members to ensure that an investment is suited to a client’s needs and circumstances before making the sale, even if the transaction was the investor’s idea. In comparison, if a customer trading through an NASD firm buys a stock that has not been recommended by the broker, the firm arguably is not under an obligation to evaluate whether the investment is appropriate (or at least it is not as clear cut). As online trading continues to grow, this distinction becomes more important. A customer of an NASD deep discount e-broker member firm who trades his way into huge losses from an inappropriately risky investment might have a hard time recovering on suitability grounds (clouding the issue tremendously, however, is the fact that many online firms like E*Trade, Charles Schwab and Ameritrade offer research reports and other services that do make specific recommendations.) However, a customer at a NYSE member firm will have an easier chance to recover his or her losses due to NYSE Rule 405. NYSE member firms have an obligation to, as the Rule states, “use due diligence to learn the essential facts relative to every customer, every order, every cash or margin account accepted or carried by such organization…” Simply because the firm does not recommend an investment or transaction does not shield them from liability. The online firm cannot escape liability by saying “it was the customer who wanted to do the trade and therefore our hands are free.” 41) Should the same suitability standards that apply to traditional full service brokers also apply to online brokerage firms? Yes. Day/short-term trading at online brokerage firms threatens billions of dollars in the retirement and brokerage accounts of this nation’s small, inexperienced individual investors. In order to protect the least experienced investors, the NASD needs to clearly extend the suitability rules that full service brokerage firms face to the online firms. The growth of online trading is well documented. At the end of 1999 there were approximately 7.5 million online trading accounts nationwide. By the end of 2000, that number was expected to swell to 10.5 million according to Concord, Mass.-based Gomez Advisors. By 2002, the number is expected to reach 18 million. Online firms actively promote themselves as a substitute for full service brokerage firms. Yet they try to hide behind their standing as an online firm to claim they have no obligations for their investor’s actions. Since many online brokerage firms are positioning themselves as a type of less expensive, full service firm, they must also be forced to abide by the same suitability standards as full service firms. Online firms offer what looks like the same detailed research that the full service firms provide to their customers. E*Trade customers have access to work from BancBoston Robertson Stephens. Investors who use Fidelity.com now can get research from Salomon Smith Barney Inc. Discover Brokerage Direct investors have access to Morgan Stanley Dean Witter & Co. stock picks. And investors who use Charles Schwab Corp.'s Schwab.com can choose research from either Credit Suisse First Boston Inc. or Hambrecht & Quist Group. Almost all of the major online firms also provide financial planning tools on their website that permit customers to specify certain criteria and then, based on those criterion, presents customers with investment alternatives. Most online firms provide research dealing with particular companies and their securities. Many e-brokers have links from their websites to external sites that reference and address particular pre-chosen securities. When online brokerage firms provide research reports, generate investment ideas for their clients, provide chat rooms that allow investors to discuss investment ideas and send out price and news alerts on individual companies these activities can only be viewed as an implicit sales solicitation and an encouragement to trade. The technology offered by these firms is extremely enticing to novice and inexperienced investors. Equally important is that online firms actively promote themselves through their advertising and marketing as a substitute for full service firms while at the same time downplaying the risks of day/short-term trading. Charles Schwab’s new advertising campaign pushes the firm as a “full-service electronic investing” firm even though Schwab made its name as a discount broker. Discover Brokerage Direct runs an ad featuring a tow truck driver shocking his towing customer with claims of his online day trading profits and the purchase of his own island-in reality, the driver says, it is a country. Online brokerage firms must be required to make a threshold determination that the investor's strategy is appropriate for that investor. Online firms must be required to first determine if a day trading strategy is suitable or too risky for particular investors. The state does not allow a person to have a driver license without a showing of competence in driving. Nor should online brokerage firms be able to look the other way when an inexperienced investor with limited investment assets is looking to commit financial suicide by engaging in a high-risk day trading strategy. During the account opening stage, the e-brokerage firm should be required to tell the investor that his or her account will be monitored for unusual activity and to present the customer with a “pick list” of activities that will be monitored, such as: frequency of trading, efforts to liquidate more than a specified percentage of account assets and purchases and sales that exceed a certain amount of money. If the investor's trading activity runs counter to the initially stated customer investment goals and financial situation, then the online firm must be compelled to intervene. 42) What is the NASD’s position on online suitability obligations for e-brokers? In March of 2001, the NASD released Notice To Members 01-23 (NTM 01-23) which addressed, for the first time, the suitability obligations of online brokerage firms. Specifically, NASD NTM 01-23, while disclosing "whether a particular transaction is in fact recommended depends on an analysis of all the relevant facts and circumstances," reasoned that a key factor in determining when online suitability obligations are triggered is whether a "communication from a broker/dealer to a customer reasonably would be viewed as a 'call to action,' or suggestion that the customer engage in a securities transaction." NTM 01-23 concluded "[T]he more individually tailored the communication to a specific customer or a targeted group of customers about a security or group of securities, the greater the likelihood that the communication may be viewed as a 'recommendation.'" NTM 01-23 considers the following scenarios to be recommendations, with the suitability obligations therefore attaching: -a firm provides a portfolio tool that allows a customer to indicate an investment goal and input personalized information such as age, financial condition and risk;While NTM 01-23 is a good first step by the NASD, it clearly does not go far enough. Online firms should have the obligation to monitor all accounts at their firm to ensure the trading is consistent with the investment objectives listed on the new account application. For example, if a 65 year-old online investor discloses when opening an account that her objectives are conservative income and immediately engages in a high risk strategy of shorting technology stocks, online firms should have the obligation, at a minimum, to contact that investor to inquire why there is such a dramatic discrepancy between her listed investment objectives and actual investment purchases. While online firms would likely argue this is too paternalistic an obligation, when dealing with investors’ life savings and retirement funds, online firms should have the threshold responsibility to ensure the investments are suitable since the result of an unsuitable investment strategy is many times financial devastation. The obligation is even greater when it is discovered that many online firms target less experienced investors who are typically the most likely to be swayed by the frequent barrage of encouragement by online firms to actively trade. 43) Does a branch manager or brokerage firm have an obligation to supervise the financial professionals working for the firm? Yes. Brokerage firms and their managers have an absolute obligation to supervise their employees and attempt to prevent securities violations. NASD Conduct Rules require brokerage firms to establish and enforce written procedures for supervising the activities of registered representatives, reviewing customer accounts and keeping records. Failure to reasonably do so will make the brokerage firm liable. NASD Conduct Rule 3010 outlines the brokerage firm’s obligation to supervise. Specifically, 3010 requires: (a) Supervisory System44) How common are claims for failure to supervise? In 1998, failure to supervise claims were the fourth most common type of abuse alleged by investors with approximately 1,270 claims filed with the NASD. 45) When does unauthorized trading occur? Unauthorized trading occurs when a broker makes a trade in a client’s account without having either written or oral authority to do so. Brokers need to get their client’s explicit authorization before each and every trade unless it is a discretionary account. Failure to do so makes the broker liable for engaging in an unauthorized transaction. 46) How common are unauthorized trading abuses? Investors filed approximately 611 unauthorized trading claims with the NASD against financial professionals in 2000. 47) What is a discretionary account? A discretionary account is a type of brokerage account where the broker gets permission from the client, upfront, to place trades in the investor’s account without the client’s approval. Therefore, a broker does not need to speak with a client before placing a trade. If the broker does have written discretionary power, then the investor cannot make a successful unauthorized trading claim. Almost all brokerage firms have very specific, detailed procedures a customer must go through to grant a broker discretionary authority over his account. In recent years, most major brokerage firms have implemented an absolute prohibition on any type of discretionary trading due to the inherent temptations a broker faces with this type of authority. It is not hard to imagine brokers abusing their authority in managing discretionary accounts. 48) What is negligence with respect to a broker customer relationship? Negligence is conduct that falls below the “legal standard” established to protect others against unreasonable risk of harm. For example, a brokerage firm that sends out monthly statements with an inaccurate account balance will have engaged in negligent conduct, at a minimum. For an act to be negligent, the broker did not need to intend the consequence of his conduct, but a “reasonable person” in his position would have anticipated those consequences and taken reasonable precautions to guard against them. The standard of care that a broker owes his client is at least “reasonable care.” It is left up to the arbitrators to determine what is “reasonable.” However, arbitrators many times apply a common sense evaluation to these cases. 49) How common are negligence claims against a broker? 1,936 negligence claims were filed against brokers with the NASD in 2000, making it the second most common type of abuse. 50) What is churning? Churning occurs when a broker overtrades the securities in a customer’s account for the purpose of generating commissions. Churning is a synonym for over-trading where the stockbroker advances his or her interests over the interests of the client. 51) How common is churning? In 2000, there were approximately 473 cases filed at the NASD alleging a broker churned an investor’s account. 52) When does churning occur? One definition states that churning occurs when a broker, exercising control over the volume and frequency of trading, abuses his customer’s confidence for personal gain by initiating transactions that are excessive in view of the character of the account. Some of the traditional “trademarks” of churning are high turnover, frequent in and out trading, and large commissions. 53) Why would a stockbroker churn the investor’s account? The reason has to do with the broker being able to make more in commissions. Most stockbrokers are still paid on a commission-based system. What this means is that a broker makes a commission for each buy or sell that occurs in a client’s account. The commission percentage is usually between one and three percent of the total transaction size. Therefore, if a broker can trade a client’s account more frequently, that means the broker will make more in “gross” commissions (brokers usually keep approximately one-third to one-half of their gross commissions) and therefore make more in take home pay. 54) What elements must be proven in an arbitration to establish churning? Three basic elements need to be established to prove the investor’s account has been churned. First, it must be established that the broker had control over the account. Second, trading in the account must have been excessive in light of the customer’s investment objectives. Finally, the broker must have intended to defraud the customer or had willful or reckless disregard of the customer’s interests. Most courts will simply imply the third element if the other two were established. 55) What are the different types of control a broker can have over an investor’s account. There are two types of control that a broker can have over an account. The first type is discretionary control. Discretionary control is where the customer gives the broker discretion as to the purchase and sale of securities, including selection, timing and price to be paid or received. The second and most common type is implied control. 56) How is implied control over an investor’s account established? Whether or not the customer has sufficient intelligence, understanding and market experience to evaluate the broker’s recommendation are sometimes important considerations in establishing implied control. Some of the other factors arbitrators may use to evaluate implied control are: a)the identity, age, education, intelligence, and investment and business experience of the customer;57) How important is the investor’s education level or profession in churning claims? While these can be important factors, they are by no means the most important factors arbitrators consider. There is a significant difference between success in life or success in a field like medicine, law or business and a person’s investment sophistication. Some of the most ignorant investors are those who have reached the pinnacle in their respective career. Sir Isaac Newton, widely considered to be one of the smartest individuals ever, lost his fortune in a stock market scam. Often, people hire a stockbroker or financial planner because they lack the knowledge in investing or do not have the time to monitor their investments. That is why they are hiring someone else to manage their money. Unfortunately, often this hands off approach is too big a temptation for a broker, financial planner or insurance agent. Many times the result is a churned account. 58) How is excessive activity determined? One definition of excessive activity is outlined in Hecht v. Harris, Uphan & Co. where the Court defined it as “whether the volume and frequency of transactions, considered in light of the nature of the account and the situation, needs and objectives of the customer, have been so ‘excessive’ as to indicate a purpose of the broker to derive profit for himself while disregarding the interests of the customer.” The three most common real world methods for determining excessive trading are the turnover rate, the cost equity ratio and an in-and-out trading analysis. 59) What is a turnover rate? The turnover rate is the number of times the average net equity is used to purchase securities. The rate measures volume rather than cost. The formula for determining the turnover rate is the dollar amount of purchases divided by the average net equity divided by the amount of time.
For example, say an investor had $100,000 of purchases in a one-year period and the average net equity is $20,000. We arrive at a turnover rate of 5 by dividing the total purchases of $100,000, by the average net equity of $20,000. We would then divide that number by the length of time that the investment was held. 60) What turnover rate establishes churning? Some case law sets forth the following rules of thumb:
It seems in the last decade the collective thought has moved to the belief that an excessive turnover rate is now lower than what it was before. A well-regarded North Carolina Law Review article entitled “A Model for Determining the Excessive Trading Element in Churning Claims” by David Winslow and Seth Anderson convincingly argued that point concluding that much lower turnover ratios constitute churning than what has been accepted in the past. The article argued that using mutual funds as an appropriate proxy would lead to the conclusion that a turnover rate in excess of three for any account would be evidence of churning. The article explicitly stated that courts should lower their threshold levels of the optimum turnover rates in investor’s accounts. 61) What is the cost equity ratio? The cost equity ratio, created in 1978 by longtime PIABA member and founder Stuart Goldberg, is used to determine the percentage of return on the client’s average net equity needed in order to pay the broker’s commissions. The cost equity ratio is computed by dividing the costs of the transactions divided by the average net equity. For instance, say a customer has a $100,000 equity account and the broker’s commissions off of the account for the year were $35,000. The cost equity ratio would be 35 percent. What this means is that the customer would have to earn a rate of return of 35 percent just to meet the expenses of the account. Considering the historical rate of return of the stock market is between 10 percent to 12 percent annually (according to Ibbotson Associates), it is easy to see why this so clearly would be considered problematic for a broker who recommended such a strategy. 62) What cost equity ratio establishes churning? Many commentators believe the following analysis should be utilized to evaluate if churning occurred:
It is not difficult to understand why even a two percent cost equity ratio would lead to an inference of churning. If one assumes the historical rate of return for the market is between 10 percent to 12 percent annually, trading that generates commissions of two percent means between 16 percent to 20 percent of an investor’s return (assuming the historical return) is going towards paying a stockbroker’s commissions. That is simply too much. 63) What is in-and-out trading? In-and-out trading occurs when the stockbroker purchases a security, resells it after a relatively short duration, and then uses the proceeds from the sale to purchase another security that is of the same general type. For example, if 1,000 shares of XYZ preferred stock is bought on August 15th and sold four weeks later on September 15th, and then the broker purchases 1000 shares of ABC preferred stock, the original two transactions could be the subject of in-and-out trading within a one month period. 64) How does an investor establish excessiveness through the three methods? Arbitrators usually want expert testimony and statistical data to establish “excessiveness.” While expert testimony isn’t required, an investor would be well served to have an expert testify as to this element. 65) How is the final element of churning, an intent to defraud the customer or reckless disregard of the customer’s interests, established? Most courts simply imply the third element if the other two elements are established. Since churning involves a conflict where the broker seeks to maximize his pay in disregard of the customer’s interests, intent tends to be obvious and therefore implied. 66) Does a profitable account preclude an investor from prevailing on a churning claim? No. Profitability does not preclude a claim for churning. In the bull markets of 1982-1987 and the 1990’s, a generally rising market masked a great deal of churning. The churning that took place in the investor’s account may have had the effect of decreasing the overall profit due to the sale of the original portfolio which might at the time of the filing of the statement of claim have had a market value, if left undisturbed, in considerable excess of the newly acquired securities. 67) Is there a difference between churning and excessive trading? Yes. Arbitrators can find that an account was not churned but excessively traded. For instance, take the investor who had $75,000 worth of purchases in a one-year period and the average net equity was $50,000. We have a turnover ratio of 1.5, which is below an inference of churning. However, if the investor was 65 years old and told the broker he only wanted to buy and hold municipal bonds, then the arbitration panel could find that the broker was liable for excessive trading, but not churning, and still award the investor damages. 68) What are the odds of a stockbroker being able to successfully trade an investor’s account over any extended period of time? Between slim and none. The overwhelming majority of evidence leads one to conclude that an actively traded account by a stockbroker leads to substantial fees and commissions for the broker, almost certain underperformance relative to the S&P 500 Index by the investor and a dramatically increased absorption of risk for the investor in receiving these meager returns. Paul Samuelson, a highly respected U.S. economist, summarized it best when he stated: “A respect for evidence compels me to the hypothesis that most portfolio managers should go out of business.” Replace “portfolio manager” with “stockbroker” and the truth of his statement is still accurate when it comes to market timing efforts. Successful short term trading by a stockbroker is almost impossible. Virtually every piece of credible evidence points to the principal that the more an investor’s account is traded, the more likely the investor is to under-perform the market. Brad Barber and Terrance Odean, two professors at the University of California at Berkley, commissioned the study “The Common Stock Investment Performance of Individual Investors.” The study examined 60,000 accounts at a large discount brokerage firm (believed to be Charles Schwab) between 1991 and 1996. The study concluded that the most active accounts in terms of trading also had the lowest investment returns. The correlation between trading and performance was clearly established as being positive-the more trades in an investor’s account the lower the investment returns. The authors concluded by noting “trading is hazardous to your wealth.” The virtual impossibility of a stockbroker successfully engaging in a short term trading strategy for clients relative to the performance of the S&P 500 Index is further shown in an analysis from University of Michigan Business School Finance Professor Najet Seyhun in a study entitled “Stock Market Extremes and Portfolio Performance.” This fascinating study found that the stock market does not rise or fall steadily but rather lurches dramatically over very short intervals of time. Unfortunately for stockbrokers who believe they can time the market through trading, these movements are extremely difficult to anticipate since they happen over such short periods of time. The study found that over a 30-year period (1963 to 1993), 95 percent of the stock market gains stemmed from only 1.2 percent of the trading days. Stated another way, if a stockbroker missed the best 1.2 percent of the trading days for his client, the investor missed out on 95 percent of the stock market’s return. The study also found that over a 67-year period (1926 through 1993) more than 99% of the total return of the market was "earned" during only 5.9 percent of the months. A clear example of this phenomenon occurred in April of 2001. From March of 2000 through March of 2001, the NASDAQ declined approximately 70 percent from its peak. However, in April of 2001, in only 10 trading sessions, the NASDAQ soared 33 percent. Unfortunately, many investors missed this dramatic rebound because their stockbroker had them sitting on the sidelines, out of the market, waiting for signs that the market had “bottomed out.” Unfortunately for the customer whose account is actively traded, the only way a stockbroker can successfully identify when those top 1.2 percent of the trading days will occur is through a crystal ball and the mythical 20-20 hindsight. Nobody knows when it is that the best days in the market will occur. If a broker is trading a client in and out of securities, it is highly probable that the investor will miss out on the top performing days and therefore miss out on most of the market returns. Unfortunately, stockbrokers will still earn their commissions, regardless of their investor’s performance. Further demonstrating the negligence involved with a stockbroker trying to engage in a successful short term trading strategy is the concept in academic finance called skewness. The concept is based off of the premise that a stock index’s return in any year is extremely narrow and concentrated in only a few stocks. In most indexes (i.e. the S&P 500, NASDAQ or Russell 2000), it is typically only a few stocks (i.e. 5-10 stocks) that will make up a majority of that index’s return. The concept of skewness is based on the simple mathematical principal that the most a stock can decrease in any year is 100 percent but the most a stock can appreciate is unlimited. Therefore, investors need to cast a wide “net” (typically through a mutual fund) through a buy and hold strategy in order to own those unpredictable, small number of stocks that are needed in order to propel an investor’s investment return. A broker’s attempt to identify those five to ten stocks in an index like the Russell 2000, for example, is extremely difficult to do. Short term trading makes it even more likely that an investor will not enjoy the full appreciation in one of the few “highflying” stocks since they will not be held long enough to enjoy the full and complete run. Assuming, hypothetically, that a stockbroker could accurately time the market and successfully identify stocks that would appreciate in the short term, the costs to the investor in engaging in this type of strategy would serve as such a substantial drag on the investor’s return, the account would still likely under perform the market. As noted in the Wall Street Journal in 1998 by John “Launny” Steffens, Merrill Lynch’s former Vice Chairman who was responsible for managing the firm’s 14,000 stockbrokers, “[I]f people turn their account over two to three times a year, they are guaranteed not to make money.” There are multiple costs associated with active stock trading. The first cost incurred by an actively traded account is commission charges. Commissions typically range between one percent to three percent per transaction. When an account is actively traded, these commission costs add up quickly. The second costs investors incur are capital gain taxes. If a broker engages in short term trading (positions held less than 1 year) for a client, then short-term capital gain taxes apply and the investor is taxed at his or her ordinary income tax rate. Typically, the individual tax rate of an investor will be higher than the long-term capital gain tax rate of 20 percent for stocks held more than one year. A third cost incurred with an actively traded account are the spreads (the difference between the bid and the ask) associated with individual stocks. On larger capitalization stocks (i.e. Microsoft or IBM), the spread is typically about 6 cents a share. Generally, lower priced stocks trade with larger spreads. Therefore, as soon as a stockbroker buys a stock for a customer, the investor is already down in that stock. Buy and hold investors only incur the spread once and have the time to make up the initial upfront loss. The spreads tend to serve as another drag on the investment returns of actively traded accounts. Rather than focusing on trading an investor’s account, stockbrokers need to become more like financial planners and determine what asset allocation an investor should have. The single most important decision a stockbroker makes for an investor is the asset allocation for the portfolio. According to Gary Brinson, as outlined in his now famous study entitled “Determinants of Portfolio Performance” that appeared in the Financial Analyst Journal in 1986, 94 percent of an investor’s investment return is derived not from market timing or stock selection but rather from asset allocation-how much is invested in stocks versus bonds and cash and then how each one is divided up from there. University of Chicago Professor Eugene Fama concluded in his study that 97% of all investment returns are determined by asset allocation determinations. Professor Fama concluded by saying “I’d compare stock pickers to astrologers, but I don’t want to bad-mouth astrologers.” Both Brinson and Fama’s studies support the theory that markets move in a random manner making stockbroker’s efforts to time the market almost impossible. It would appear safe to assume if Wall Street’s top mutual fund managers, with access to the best investment research available and an army of stock analysts at their disposal cannot beat the market over any consistent period of time, a retail stockbroker would be unable to do it as well. Larry Swedroe, in his excellent book “What Wall Street Doesn’t Want You To Know” examines in great detail how mutual fund managers are unable to beat the performance of the plain vanilla, basic S&P 500 Index. The following facts from Mr. Swedroe’s book show how difficult it is for even the brightest minds in the securities industry to be able to outperform the market and therefore further establishing how foolish it is for stockbrokers to think that through active trading they can beat the market: -In 1998, fewer than 20 percent of all equity mutual funds outperformed the S&P 500 Index. That figure drops to 11 percent over the previous 10 years and to just 4 percent over the previous 15 years. The four percent of money managers who did beat the Index can mainly be attributed to mere random statistical variation rather than some special insight into the stock market that others lack. -Piscataqua Research, in a study covering the time period 1987 through 1996, found that only 10 out of 145 major pension funds (7 percent) outperformed a portfolio consisting of a 60 percent-40 percent mix of the S&P 500 Index and the Lehman Bond Index. -In the March 9th, 1998 edition of Business Week, the magazine detailed a study performed by Mark Hulbert which analyzed the performance of the portfolio of 32 market timing newsletters for the 10 years ending in 1997, a period when the S&P 500 Index was up 18 percent. The study found that the market timers’ annual average returns ranged from 5.84 percent to 16.9 percent, the average return was 11.06% and not one of the market timers beat the market. -The same article analyzed a study done by MoniResearch, which tracked 85 managers with a total of $10 billion under management. The study found the timers annual average return ranged from 4.4 percent to 16.9 percent, the average return was 11.04 percent and none of the timers beat the market. If transactions costs like taxes and commissions were taken into consideration, the performance of the timers would have been even worse. -In 1990, the Nobel Prize in economics was awarded to Harry Markowitz, William Sharpe and Merton Miller for their contributions to the body of work known as Modern Portfolio Theory. A major conclusion of Modern Portfolio theory is that the market is efficient at pricing securities and the current prices of securities reflects the total knowledge and expectations of all investors and no investor can consistently know more than the market does collectively. This makes it very difficult, if not impossible, for active market timers to beat the market. Sir Issac Newton, widely considered to be one of the smartest individuals in the history of the world, summed it up best when he stated in 1768, after losing his fortune in a stock market scam, “I can calculate the motions of the heavenly bodies but not the movements of the stock market.” The foolishness of a retail stockbroker trying to short term trade the market for clients in the face of overwhelming evidence of the near impossibility of that task would almost be comical if the attempts by brokers weren’t so widespread. Unfortunately, it is the investor who pays the price in the form of lower returns, an increased assumption of risk and in many cases, the decimation of the entire portfolio. 69) Is penny stock firm fraud still prevalent? Yes. Many experts claim that penny stock fraud is at an all time record high. Senator Susan Collins (R., Maine) stated in 1997 that “[T]he subcommittee has information that penny stock fraud is roaring back.” Investors lost an estimated $6 billion in fraudulent penny stock schemes in 1998. The New York attorney general’s office estimates final figures for 1999 may be 40 percent higher. The North American Securities Administration Association reported a 30 percent increase in fraud complaints last year. The group estimates that securities fraud costs American investors $10 billion a year, or $1 million every hour. Penny stock crooks typically don’t disappear but rather scatter like cockroaches only to reappear at a later time, with a different firm, with the same modus operandi. 70) What is penny stock fraud? Penny stock firms and their employees engage in a variety of abusive and fraudulent sales practices. Some of these practices include high pressure selling tactics, misrepresenting material facts, the omission of important negative information concerning recommended NASDAQ over the counter stocks, unauthorized trading in customer accounts and simply refusing to sell house recommended stocks. These firms employ a systematic scheme to defraud unsuspecting investors. The organizations and their brokers generally establish credibility through misrepresentations about themselves and their firm. In the initial series of calls, these brokers will make a relatively small investment recommendation in a well-known blue chip company. Shortly after this account opening initial transaction, the account opening broker will refer the client to a “senior account executive” that has the “experience and expertise” to handle the client’s accounts. In reality, the second broker is generally a seasoned, skilled, high-pressure salesman. After the initial transaction, the brokers in these organizations only recommend house stocks. Usually, once the investor sends the penny stock firm funds, it is virtually impossible to get the money back. 71) What can be done to rectify the problem of penny stock fraud? One very good option would be to expand SIPC coverage to include all arbitration awards that result from fraud or other violations of securities regulations, such as suitability requirements. The nation’s financial markets have changed considerably since the SIPC was established in 1970. Brokerage firms currently pay only a nominal charge of $150 a year for SIPC coverage, regardless of their size. If investors were only charged a penny a trade that would probably cover the cost of full compensation for defrauded investors. In 1998, SIPC paid only $16 million to defrauded investors when securities fraud cost investors in excess of $10 billion. Not surprisingly, the securities industry opposes expanding SIPC coverage for such illogical reasons that it would cause investors to take less responsibility for investment decisions and lessen their incentive to question brokers about proposed or executed trades. 72) What should an aggrieved investor look for when hiring an attorney for representation in a securities dispute? Probably the single most important factor in choosing an attorney to represent an investor in arbitration against a brokerage firm is experience in the securities arbitration field. Securities arbitration is a complex, esoteric area of law that is substantially different than traditional court litigation in many ways. When an investor is looking for legal representation, the first question that should be asked is whether the attorney has handled securities arbitration cases in the past. If the answer is no, the investor should be very reluctant to let the attorney experiment on him. Ask the attorney whether she has handled arbitration complaints similar to the investor’s case. Find out if the attorney has securities industry experience (i.e. experience working for a brokerage firm or for a regulatory organization like the NASD or SEC). Because brokerage firms have the deep pockets to hire the best defense attorneys money can buy, it is imperative that the investor finds an attorney with extensive experience in the securities field and in securities arbitration. 73) What about non-attorney representation? Avoid them at all costs. Only hire a licensed attorney with experience in this area. Non-attorney representatives, who are generally unregulated, often do more harm to investors than unethical stockbrokers and brokerage firms. 74) Should the investor make contact with the brokerage firm’s legal department before retaining an attorney? No. There is virtually no better way for investors to decrease their chances for recovery than dealing with the brokerage firm’s legal department on their own. A common ploy used by many brokerage firms is to have the people who first take the complaint to be very cordial and they will sound genuinely concerned. The compliance department or legal department will ask the investor to put the complaint in writing and submit it to the legal department for consideration. Unfortunately, regardless of the validity of the investor’s complaint, the overwhelming majority of the time the brokerage firm will reject the investor’s request for remuneration. The rejection is not particularly surprising. However, now the brokerage firm has the investor locked into a story as to what happened. If the investor later decides to pursue the complaint via arbitration and the case goes to a hearing, the brokerage firm’s attorneys will hammer the investor if the story told at the arbitration deviates one iota from what was originally written in the letter to the brokerage firm. If the investor left out one fact that was not thought to be important, the firm’s defense attorney will pounce on that seemingly innocent omission. Therefore, it is in the investor’s best interest to contact an experienced securities arbitration attorney at the first hint that there might be a problem with the broker’s actions. 75) How are securities arbitration attorneys compensated? There are a variety of ways that a securities arbitration attorney can be compensated. Probably the most advantageous way from the perspective of the investor is through a contingency fee arrangement. Under this type of arrangement, the attorney will only earn a fee if an award is won and the money is collected. Under a contingency arrangement, the attorney and investor’s interests are aligned to the extent an attorney has as big an incentive to recover investment losses as the investor since neither one will receive any compensation if the claim is unsuccessful. A typical contingency fee is one-third to forty percent of the amount recovered. Some law firms or attorneys do not have the financial backing or the desire to take cases on a contingency basis due to the inherent uncertainty present in the outcome of security arbitration cases. Therefore, these attorneys take cases on an hourly basis with an up-front retainer. The client will be charged based on the number of hours that the attorney works on the case with the investor usually being billed on a monthly or quarterly basis. Hourly rates for securities attorneys vary from as low as $150 an hour too as high as $300 an hour with top attorneys charging considerably more. 76) What type of expenses can be expected in securities arbitration disputes? There are three major expenses that can be present in a securities arbitration dispute. First, there is the nonrefundable filing fee and hearing session deposits. These fees will vary depending on the size of the matter in dispute. In 2000, a $100,000.01 claim, for example, has a claim filing fee of $225 and a hearing session deposit of $750. A $1 million claim has a claim filing fee of $500 and a hearing session deposit of $1,200. The second major expense will be the attorney fees. As discussed previously, these fees can be based on an hourly amount or can be based on a contingency fee arrangement. The third expected expense deals with the professional fee for an expert witness or witnesses. The expert’s fees can vary considerably depending on the amount of work required by the expert and his or her reputation. An experienced securities arbitration attorney will have a number of experts he has worked with in the past and will make the determination of whether an expert is needed and which expert will eventually be used. Finally, routine office expenses such as copy charges, long distance telephone fees and overnight courier services will be incurred. 77) How is an arbitration initiated? An arbitration is commenced by filing a Statement of Claim, a Uniform Submission Agreement and a check for the appropriate amount of money in order to cover the hearing expenses and filing fee. 78) What is the Uniform Submission Agreement? In order to initiate any arbitration proceeding, signed submission agreements must be provided to the sponsoring organization (i.e. the NASD). When the investor signs the submission agreement, the investor is contracting to submit the dispute to arbitration and abide by the decision of the panel. A claim will not be processed unless the Uniform Submission Agreement is properly filed out. 79) What is a Statement of Claim? The Statement of Claim is the investor’s version of what happened between him and the broker. The Statement of Claim does not have to be in a particular format. Many attorneys who generally practice in the court system rather than the arbitration forum use the format that a complaint in a court of law would follow, with a caption, identification of the parties, statement of facts and request for damages, in numbered paragraphs. Some arbitrators, however dislike this type of format. Another option is to use an informal, letter format that tells the arbitrators the story of what happened in narrative form. There are no official requirements for a Statement of Claim other than disclosing, as outlined in Rule 10314 (A) of the Code, the “relevant facts and the remedies sought.” However, the five crucial elements that all Statement of Claims should have are: a) an introduction; b) identification of the parties; c) fact sequence; d) analysis; and e) demand for relief. The Statement of Claim must be clear and should be in chronological fashion to make it as easy as possible for the arbitrators to determine what offenses may have taken place. The investor should generally attach copies of documents and supporting materials as exhibits to the Statement of Claim and provide sufficient copies for each party, the arbitrators, and the NASD (usually eight copies is sufficient). The goal of the Statement of Claim is to provide the basic information that the arbitrators will need to decide the case in favor of the investor. Most of the necessary and relevant information should be in the Statement of Claim if for no other reason than the Statement of Claim is automatically admitted into evidence at the beginning of the hearing as “Arbitrators’ Exhibit #1.” 80) What happens if the dollar amount of the Statement of Claim is under $25,000? If the amount of the claim is $25,000 or less, the claim may be processed under the Simplified Arbitration Procedures. In these smaller disputes, unless the investor requests a hearing, the claim will be decided solely on the basis of reading the parties’ submissions (Statement of Claim and Answer). The arbitrator, however, may request a hearing or require either party to submit additional documentation. 81) What happens after the Statement of Claim and the Uniform Submission Agreement are filed? After the filing of the Statement of Claim and the Uniform Submission Agreement, the NASD staff serves the documents, along with instructions for the arbitration process, on the broker and brokerage firm. Service is typically done by mail to the address of the broker or brokerage firm. 82) How long does the brokerage firm or broker have to provide an answer to the Statement of Claim? In 1998, the SEC approved an amendment to NASD Rule 10314. The amendment increased from 20 business days to 45 calendar days the time within which a brokerage firm or broker may serve and file answers to initial claims, cross claims and third-party claims. The amendment also includes a provision that disfavors staff granted extensions of time to answer. Since the broker and brokerage firm’s time to answer has been increased substantially, the staff should grant an extension only if there is an extraordinary reason. The amendment does not apply to smaller claims filed under the simplified arbitration procedure. 83) Is an investor ever entitled to have a single arbitrator hear his case if the amount in controversy is over $50,000? Yes, in certain circumstances. In 2000, the Securities and Exchange Commission approved Rule 10336 and added it to the NASD Code of Arbitration Procedure. The new rule, which establishes the Single Arbitrator Pilot Program, is the first opportunity investors have been granted to have a single, public arbitrator hear their dispute for claims between $50,000.01 and $200,000. The Rule will be tested through May 15, 2002, at which time the Pilot Program will be evaluated to determine if it should become a permanent program at the NASD. Rule 10336 allows parties with pending securities arbitration claims at the NASD between the amounts of $50,000.01 to $200,000, including damages, interest, costs, and attorneys’ fees, to select a single arbitrator to decide their case, rather than the panel of three arbitrators they would otherwise select. Claims that include a request for punitive damages will not be eligible for the Pilot Program unless all of the parties agree. After parties receive notice that a panel of three arbitrators has been selected, as provided by Rule 10308, the parties may agree to have one of the arbitrators serve as the single arbitrator who will decide their case. The parties shall have a 15-day window from the date the NASD sends notice of the names of the arbitrators to agree on a single arbitrator. This 15-day period will run concurrently with the time period to select a chairperson under Rule 10308(c)(5). Parties may send written materials, including information requests and motions, directly to the single arbitrator, provided that copies of such materials are sent simultaneously and in the same manner to all parties and to the NASD. Parties shall send the NASD, arbitrator, and all parties proof of service of such written materials, indicating the time, date, and manner of service upon the arbitrator and all parties. Service by mail is complete upon mailing. If the arbitrator and all parties agree, written materials may be served electronically. If the arbitrator agrees, parties may initiate conference calls with the arbitrator, provided that all parties are on the line before the arbitrator joins the call. The arbitrator may initiate conference calls with the parties, once again provided all parties are on the line before the conference call begins. Parties may not communicate orally with the arbitrator unless all parties are present. 84) What are the advantages and disadvantages of utilizing Rule 10336? First, the Rule has the ability to remove the industry panelist from the panel. Under the Rule, any of the three chosen arbitrators may be the single arbitrator, but both sides must agree to the selection. Second, if the Claimant’s counsel, after agreeing to the Pilot Program, learns of additional claims that would increase the damages in excess of the $200,000 limit under Rule 10336, the Claimant may request that the other two panel members originally chosen be reinstated and the action proceed without the damage limitation of Rule 10336. If the single arbitrator refuses to grant the Claimant’s counsel request to reinstate the other two arbitrators, then the attorney may move to dismiss the claim without prejudice and the claim can then be re-filed as a regular, three-person case. Unfortunately, the new, re-filed action would involve the payment of another filing fee. The biggest advantage for Respondent’s counsel under the Pilot Program is that arbitration claims that include a request for punitive damages are not eligible, so long as both sides do not specifically request that they be considered. At the agreement of both parties, punitive damages may be considered by the arbitrator but the $200,000 limitation will still apply. An advantage for both parties under Rule 10336 is lower expenses. Hearing session fees are reduced in the Pilot Program to reflect lower arbitrator honoraria. For claims between $50,000.01 and $100,000, hearing session fees under the Pilot program will be $550 per session, or $1,100 for a two-day session. This represents a reduction of $200 per session for the parties when compared with normal NASD arbitration costs. For claims between $100,000.01 to $200,000, hearing session fees under the Pilot Program will be $750 per session or $1,500 for a two-session day. This is a savings of $375 per session for the parties. 85) What type of pre-hearing discovery exists in securities arbitration? In court proceedings, all parties are entitled to discovery through depositions and the exchange of documents prior to the actual trial. In arbitration, however, discovery is much more limited in its scope. A problem with this limited discovery is that investors often do not have all of the necessary documents needed to prove their case. Documents like personnel files, commission runs, compliance manuals and monthly statements are crucial documents in an investor’s case. Today, if an investor has an outstanding discovery problem, a pre-hearing conference call can be requested to clear any outstanding discovery disputes. 86) How has the discovery process changed in the last few years? Discovery disputes have become more numerous and time consuming in recent years. The same discovery issues unfortunately repeatedly arise. Many of the discovery abuses in traditional courthouse litigation have found their way into arbitration. Some attorneys make it their common practice to object to even the most relevant discovery requests simply to slow the process down. Changes needed to be made to the discovery process. In January of 1999, the NASD proposed the creation of a guide to streamline the discovery process that has been implemented as outlined in NASD Notice to Members 99-90. The guide contained two changes to help standardize the discovery process. One calls for the early appointment of arbitrators to conduct an initial pre-hearing conference in which all arbitrators would participate. The initial pre-hearing conference gives the arbitrators and the parties the chance to organize the management of the case, set a discovery cut-off date, schedule hearing dates and resolve any other preliminary issues. The second change provides the parties to the arbitration with Document Production Lists at the time that the NASD serves the statement of claim in customer cases. The arbitrators and the parties are to consider the documents listed in the Document Production Lists to be “presumptively discoverable.” Presumptively discoverable documents are those that have to be turned over automatically if a request is made by the opposing side. Absent a written objection, the documents on the Document Production Lists are required to be produced no later than 30 days from the date that the answer is due or filed, whichever is earlier. If both sides comply fully with the Document Production Lists, each side should have many of the documents needed to try their case, assuming there are no unusual issues. 87) Under the NASD discovery guide, what documents must the brokerage firm turn over to the investor (what documents are on the brokerage firm’s Document Production List)? 1)All agreements with the customer, including, but not limited to, account opening documents, cash, margin, and option agreements, trading authorizations, powers of attorney, or discretionary authorization agreements, and new account forms.In addition, other documents will have to be turned over depending on the type of claim involved. The complete list can be found on the NASD’s website at www.nasdr.com. 88) Under the NASD discovery guide, what documents must the investor turn over to the brokerage firm (what documents are on the investor’s Document Production List)? 1)All customer and customer-owned business (including partnership or corporate) federal income tax returns, limited to pages 1 and 2 of Form 1040, Schedules B, D, and E, or the equivalent for any other type of return, for the three years prior to the first transaction at issue in the statement of claim through the date the statement of claim was filed.In addition, other documents will have to be turned over depending on the type of claim involved. 89) Are there problems with the current pre-hearing document discovery process? Yes. Despite the NASD and other self-regulatory organizations best efforts, certain abuses still occur. Brokerage firms many times are reluctant to provide even the most basic and legitimate documents requested by the investor’s counsel. While most arbitrators can see through the remedial attempts by the defense bar to avoid turning over particularly damaging documents, sometimes key documents are left out of the arbitration pre-hearing discovery production because of defense attorneys delay tactics or subterfuge. 90) What is the NASD’s pre-hearing exchange? The NASD’s Code of Arbitration Procedure, 10321(c), mandates that at least twenty calendar days prior to the first scheduled hearing date, all the parties exchange copies of documents in their possession that they intend to present at the hearing and shall identify witnesses they intend to present at the hearing. Any documents not exchanged or witnesses not identified may be excluded by the arbitrators. The rule does not require service of copies of documents or identification of witnesses that the parties may use for cross-examination or rebuttal. A well chronicled abuse that some attorneys use is to “sandbag” as much information as possible by introducing documents, mainly in cross examination, and then claiming they were not required to turn the documents over because their introduction took place via cross examination. This ploy defeats the purpose of the pre-hearing exchange and arbitrators need to be made aware of its use by counsel. 91) Are depositions used in securities arbitration? In most securities arbitration cases, depositions are not used. This is surprising to attorneys who are used to traditional courthouse litigation. However, typically depositions are not needed in securities arbitration and when they are, appropriate measures can be taken. 92) Can depositions be utilized in arbitration? Yes, but only in extreme cases. If there is a witness who might be inaccessible at the hearing for a legitimate health reason, then the arbitrators may order depositions to be taken. For example, if a potential witness was diagnosed with a terminal cancer, it would be reasonable to request a deposition to ensure the testimony of the witness would be preserved. But these cases are the very rare exception rather than the rule. Certain nonessential witnesses may also testify telephonically under certain conditions. 93) Do brokerage firms have the right to compel customers to arbitration? Yes. Brokers and their firms are contractually bound to arbitrate their disputes with customers, even in the absence of a written contract with the customer. The contractual obligations arise from membership in the NASD or in the various stock exchanges. Every stockbroker is a member of the NASD. Upon applying for membership in the NASD, the broker-dealer and the broker agree to be bound by the rules of the NASD. The NASD Code provides that members and associated persons must arbitrate their disputes with customers at the demand of the customer. 94) What does a standard arbitration agreement look like? While there is no one universally accepted arbitration agreement, most look something like the following: I agree that all controversies that may arise between us concerning any order or transaction, or the continuation, performance or breach of this or any other agreement between us, shall be determined by arbitration before a panel of arbitrators selected by the National Association of Securities Dealers or the New York Stock Exchange, Inc., as I may designate, pursuant to the rules of the organization in existence at the time of the submission to arbitration. I understand that a judgment upon the arbitration award may be entered in any court of competent jurisdiction. 95) Are more arbitrators needed? Absolutely. The requirements to become an arbitrator are minimal. A potential arbitrator will be required to participate in a very basic arbitrator skills training program before being assigned to a case. Applicants are required to attend a four-hour training course and pass a simple, objective test that examines the knowledge of what was just taught in the training session. There is also a $100 fee that covers the cost of the training materials, the onsite instruction, and test administration. 96) Are there any other requirements? Yes. The NASD requires that individuals have at least five years of business, professional, investing, or other related experience. A potential arbitrator needs to fill out the NASD arbitrator application (which can be found at www.nasdadr.com) and submit two letters of recommendation from individuals who can attest to the character of the applicant. 97) Do arbitrators receive compensation for their services? Yes. While arbitrators are not employees of the NASD, they do receive an honorarium at the rate of $200 per single-session hearing; $400 per double session. A single session lasts up to four hours and a double-session hearing lasts for more than four hours. Compensation for service on cases decided without an in-person hearing is $125 per case. 98) What other advantages are there to being an arbitrator? Besides the financial remuneration, arbitrators provide an invaluable service to the securities industry as people from all walks of life rely on their service. Arbitrators typically serve as the last line of defense to guard the American public against dishonest and unethical stockbrokers and brokerage firms. Qualified arbitrators are desperately needed at the NASD and NYSE. 99) What is the demographic profile of the arbitrator pool? The arbitrator pool is mostly comprised of attorneys, accountants, businessmen and members of the securities industry. The lack of diversity in the pool is a major problem at both the NASD and the NYSE. The arbitrator pool is nowhere near being representative of society as a whole. Unfortunately, both the NASD and NYSE have done an extremely poor job of recruiting minorities and women to be arbitrators. Women and minorities make up a very small segment of the arbitration pool. While the NASD and the NYSE claim they are doing all they can to recruit diverse arbitrators, so far the effort has not yielded enough results. With millions of new investors from all walks of life investing in the market for the first time, the obligation to have a truly representative arbitrator pool is more important than ever. The NASD and NYSE need to raise their efforts dramatically in the coming years to recruit not just women and minorities but people from all walks of life to serve as arbitrators. All possible efforts need to be exhausted to get the arbitrator pool representative of society as a whole. 100) Do investors get a fair “shake” in arbitration? Generally, but certainly not all the time. There are many practitioners and commentators who think that securities arbitration is tilted to favor the industry and large brokerage firms. Some people even think that the NASD is a shill for the brokerage industry and the retail investor cannot get the equivalent of his or her day in court, so to speak. However, investors generally get a fair and equitable opportunity to present their version of what happened at the arbitration hearing. That is not to say there aren’t inherent disadvantages for investors in arbitration that certainly favor the brokerage industry. For example, at least one of the arbitrators will be from the securities industry. The purported reason for this mandatory industry representative is to ensure at least one member of the panel has the necessary expertise to be able to wade through the complexities inherent with a securities dispute and provide some guidance and insight to the other members. However, in reality, this expertise is not needed. Juries across the country decide complex medical malpractice cases without a mandated doctor or nurse sitting on the panel to provide a medical perspective to the deliberations. Many securities arbitration practitioners feel very strongly that the reason why the securities industry demanded an industry representative on the panel was to ensure that at least one panel member would guard the interests of the securities industry and hopefully convince other panel members to do the same. As in the court system, there will usually be a “winner” and a “loser” in every arbitration hearing. Sometimes, arbitration panels will make a decision that nine out of ten other people would not make if they were the ones deciding the case. Many times, the losing party complains in much greater frequency than the winner who goes off on his way, usually without making a great deal of noise. It is important to remember that the word “arbitration” is derived from the word “arbitrary.” Sometimes the decision is not what either party expects, but the same can be seen in any courthouse in America. 101) Is the arbitration system perfect? Absolutely not! There are major, significant problems with the arbitration system. There is still a great deal of work that needs to be done to level the playing field to make it truly fair for investors. Until those problems are addressed, arbitration cannot be said to be as fair as a court of law. 102) What could be done to improve securities arbitration? Some arbitration practitioners believe that mandatory mediation should be required and if the dispute cannot be resolved in mediation, then the investor should have the option to bring an action in a court of law or arbitration. 103) What was the biggest disadvantage when broker-customer disputes were decided in the courts prior to McMahon? The biggest disadvantage under the old system was the time that it took for investors to have their “day in court.” Judge Irving Kaufman of the Court of Appeals for the Second Circuit noted that the “twin demons of expense and delay” plague parties in litigation in the court system. Unfortunately, under the previous system of court litigation, some investors in bigger cities like New York, Los Angeles and Chicago had to wait five years before they even had a chance to have their case heard in front of a judge or jury. At the NASD, the average turnaround time from when an arbitration claim is filed to when it is closed is approximately thirteen months. 104) What is another advantage to arbitration? Besides the time advantage described above, another claimed advantage is that arbitration is less expensive for the individual investor. A report from Deloitte, Haskins & Sells for the New York Stock Exchange ten years ago found that the average legal costs for arbitration were approximately $12,000 less than those for court litigation. A major portion of the savings comes from the elimination of pretrial discovery, the lack or severe limitation of depositions and interrogatories and the liberal rules of evidence that decrease the amount of time fighting over esoteric legal technicalities. Unfortunately, in recent years arbitration has become considerably more expensive. Filing fees alone at the NASD can run as high as $600 and hearing session deposits for three arbitrators can cost an investor $1,200. When compared to the costs of filing a lawsuit in federal court, which will typically be under $200, it becomes apparent that even arbitration can be a costly substitute. 105) Is having a securities industry panelist inherently unfair for investors? It depends. Securities arbitration has the equivalent of a qualified “jury” determining the outcome. The overwhelming majority of all arbitrators are either attorneys, accountants or CPAs, business owners or brokerage firm employees. As previously discussed, the alleged advantage for a securities arbitration attorney and his or her client is that arbitrators tend to be more sophisticated decision makers than someone off the street. An attorney has to spend less time going over the remedial basics of the broker-investor relationship because the arbitrators already have training from a seminar necessary before becoming an arbitrator and more than likely they already have had a brokerage account in the past. Some commentators bemoan the presence of an industry panelist being on a three-person arbitration panel. However, there are times when the industry panelist is the first one to spot the fraudulent conduct on the part of the stockbroker or management and cut through to the issue at hand. The widespread fear that the industry panelist will contaminate the panel in favor of the broker is at times unfounded. However, undoubtedly there are security industry panelists who are solely looking to protect the broker and brokerage firm. It is crucially important to identify and remove these panelists from the pool of arbitrators. 106) Is arbitration becoming more like litigation? Unfortunately, yes. Arbitration is beginning to look more and more like traditional court litigation with motion practice, unending hearings and frivolous discovery requests. Arbitrators need to do everything in their power to see to it that arbitration remains an efficient process for investors to recover their losses. Without steps taken by arbitrators to keep the process streamlined, arbitration is bound to become as inefficient as traditional courthouse litigation. In recent years, arbitration has also become less civilized. Antics familiar in court are creeping into arbitration. For instance, the throwing of tantrums or the calling of the other side or its lawyer’s unprintable names is much more frequent today as opposed to even 5 years ago. 107) Are motions allowed in arbitration? Yes. Motion practice is becoming increasingly prevalent in arbitration. Most motions are raised shortly before the hearing. Motion practice does little more than over-legalize the arbitration practice. The goal of arbitration is to expedite the resolution of the case. Tactical motions hinder arbitrators from focusing on the facts. 108) How are arbitrators selected? Arbitrators are now selected under the List Selection Rule. The List Selection Rule was designed to give the parties a more significant role is selecting arbitrators and is now the way that the NASD chooses arbitrators. Arbitrators are placed into the NASD’s database and a list of arbitrators is chosen based off of four criterion: public or non-public classification, geographic hearing location, rotation and conflict of interest with the parties. A party can also request that the lists include some arbitrators with subject matter knowledge on the dispute in question. The NASD staff then provides the parties with a single round of public and non-public arbitrator lists. The parties can strike any listed arbitrator and rank those remaining in order of preference. The arbitrators are then appointed based off of the rankings. If the parties do not select a full panel, then the NASD staff will appoint arbitrators, much in the same way arbitrators use to be chosen. 109) How is a chairperson selected under the List Selection Rule? Parties are supposed to agree on who from the panel should act as the chairperson. If the parties cannot agree, then the NASD staff will select one of the public arbitrators to lead the panel. 110) Are arbitrators expected to be like judges? It depends. According to the NASD, arbitrators are appointed to resolve disputes “on the equities,” that is to say, on the basis of fairness, not necessarily on the strict letter of the law. Arbitration is an alternative to court, not a substitute for it. Some believe the arbitrator’s main duty is to render a just and equitable decision regardless of legal technicalities. However, failing to follow the law also raises the possibility of an award being overturned on appeal if it rises to a manifest disregard of the law. 111) What is the “best” arbitration forum for an investor to have his or her dispute heard? Either the NASD or the NYSE. The NASD handles over 90 percent of all arbitration cases. Their pool of arbitrators have handled the most hearings and their staff attorneys are generally competent when it comes to making sure the arbitration process runs smoothly. The NYSE consistently handles most of the remaining claims.An investor or his attorney should choose either the NASD or NYSE for their claim. 112) What occurs in a “typical” arbitration hearing? An arbitration hearing is considerably different than a trial in a court of law. The hearings usually take place in a conference room at a hotel or office or at the NASD regional office. The arbitration starts off with the chairman of the arbitration panel reading an approved script to all of the parties. The script contains standardized information like an introduction of the arbitrators, reconfirmation of any disclosures previously made by the arbitrators, oral confirmation by both sides of the arbitration panels composition, the oath of arbitrators and other technical procedural points. Next come the opening statements by each side. As in a court of law, opening statements serve as a brief, non-emotional road map of what the attorney intends to prove during the hearing. It is imperative that the opening statement outlines the themes of the case that will be developed throughout the hearing. After the opening statement, the investor’s attorney will begin to build his case and start calling witnesses. The attorney should focus on establishing the liability of the broker. Once liability is established, then the attorney must establish the damages suffered by the investor, if any. After the investor’s attorney has presented his case, the broker or brokerage firm presents their case. In a suitability action, for example, the defense will tend to build their case based on the investor’s sophistication, including other brokerage accounts, and knowledge of investing. Finally, each side will have an opportunity to give a closing statement. The closing statements provide an opportunity for each party to argue their case and make a final demand for damages. Since the investor has the burden of proof, he has the option, as outlined under IM-10317, to reserve his entire closing for rebuttal or to go first and then give a rebuttal after the Respondent gives his closing. There are certain strategic advantages to deferring the entire closing for the rebuttal but different practitioners have different preferences. 113) Can arbitrators ask the witnesses questions? They can and it is relativity common for them to do so. Often, the arbitrators will have questions or concerns about the testimony of a witness. The arbitrators will typically ask the witness whatever questions they need answered to help them resolve the issue or case. An attorney should pay very close attention to what an arbitrator asks and make sure that those concerns are addressed during some point in the hearing or in closing statements. 114) Are subpoenas used in arbitration? Yes. Under 10322 of the Code, arbitrators and any counsel of record to the proceeding shall have the power of the subpoena process as provided by law. In addition, arbitrators have the power, without resorting to the use of subpoena, to direct the appearance of any person employed by the securities industry. 115) What is the guiding principal of arbitration? The stated goal of arbitration by the NASD is an outcome based off of fairness and equity. In the NASD’s Arbitrator’s Manual, the following quote appears: “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 judge looks only to the law, and the reason why arbitrators were appointed was that equity might prevail.” Domke on Aristotle.116) Should an attorney make frequent use of objections? Generally, no. Most panelists are not fond of objections. Objections that are most likely to be sustained are the ones that address a witness that is not answering a question or when a question has been asked and answered. Of course, there are some very valid strategic reasons for objecting to a line of questions. However, the use of objections should be made selectively. 117) How difficult is it to schedule arbitration hearing dates? It is many times very challenging. Unfortunately, in recent years, some securities defense attorneys have used alleged scheduling conflicts as a common ploy in attempting to delay the start of a hearing. It is not uncommon for some defense attorneys to contact the chairman of the panel a week or even days before the start of a scheduled hearing with an alleged “emergency” and a request that the hearing be delayed. Because the arbitrators are essentially acting as volunteers (they do receive a small stipend from the forum but hardly enough to compensate them for their time) and it is necessary to reconcile an agreeable hearing date between three arbitrators, at least two attorneys, the investor, broker and necessary witnesses, it becomes readily apparent why arbitrators should avoid rescheduling a hearing but for an absolute, legitimate emergency. 118) Are stipulations to be encouraged in an arbitration? Yes. Stipulations entered into between parties as to factual matters not in dispute can go a long way towards moving a hearing along and can considerably shorten the presentation of evidence. Stipulations are usually actively encouraged in court litigation and it would be helpful if they were used more often in arbitration. 119) What type of evidence is admissible in an arbitration hearing? Generally, anything the arbitrators want. The rules of evidence are typically not as stringently applied in an arbitration hearing as they are in a court of law. Rule 10323 of the Code specifically states “The arbitrators…shall not be bound by rules governing the admissibility of evidence.” The rules of evidence in arbitration can be interpreted rather liberally, depending on the arbitration panel. Much information is allowed to be introduced “for what it is worth.” This is significantly different than what typically occurs in a court of law. 120) Can affidavits be admissible evidence? Yes. Affidavits are typically allowed in arbitration. Affidavits can help expedite arbitration hearings and move them along in a timely fashion. There are times when affidavits are absolutely necessary making their acceptance extremely important in some cases. 121) How long does an arbitration usually last? A small case (under $50,000) usually takes no more than two days and can often be completed in just one day. For the average sized claim ($50,000 to $500,000) the arbitration will usually take three days. Large cases (over $500,000) can expect to take at least three to five days and sometimes longer. Unfortunately, over the last ten years the length of time a typical arbitration proceeding lasts has increased. Many of the same delay tactics prevalent in a court of law have found their way into the arbitration process. Arbitrators need to do everything in their power to keep the hearings moving along and not focused on minute detail. 122) Are expert witnesses used in arbitration hearings? Yes. Many of the issues in securities arbitration can become rather complicated. It is often necessary for either the investor and/or broker or brokerage firm to hire an expert witness to help guide the arbitrators through these issues. Expert witnesses many times play a crucially important role in arbitration hearings and must be chosen carefully by Claimant’s counsel. 123) Can the expert witness attend the entire hearing? Usually, the answer is yes. However, the arbitrators have the final say. Rule 10317 of the Code states “[T]he attendance or presence of all persons at hearings including witnesses shall be determined by the arbitrators. However, all parties to the arbitration and their counsel shall be entitled to attend all hearings.” Typically, expert witnesses will be allowed to attend the hearing. Other fact witnesses usually will not be allowed in the hearing room. 124) Can investors represent themselves in an arbitration? Yes they can. However, it is generally not recommended unless the case is too small to justify hiring counsel. NASD statistics suggest investors with counsel fare better than pro se claimants. Often, the broker or brokerage firm is represented by the best defense attorneys money can buy. The image that comes to mind when investors attempt to represent themselves against these attorneys is a lamb in a slaughterhouse. However, arbitrators usually do attempt to bend over backwards to assist the pro se investor in allowing them to present their case. 125) Can arbitrators initiate disciplinary referrals against brokers? Yes. However, often the NASD does not follow up on the disciplinary referral. Once a referral gets to be two years old, it seems to be the NASD’s unofficial policy at some district offices to not follow up on it. Since the typical time frame from an alleged wrongdoing to conclusion of a hearing is more than two years, usually nothing happens with the action. Therefore, it is becoming more common for arbitrators to decide to punish the broker or brokerage firm in the pocket book, where they will feel the pain immediately rather than waiting for action from the NASD on the disciplinary referral that usually never comes. 126) If the investor is the one who initiates all of the purchases, can the broker be held liable? Usually, the answer is no. However, more arbitrators are now willing to accept a “financial suicide” argument patterned after the “Dram Shop” line of reasoning that hold bartenders liable for serving a patron even after the person has had too much to drink. Recently, brokers have been held liable for clients who trade aggressively, even if the broker never recommended the investment and marked the ticket unsolicited. For instance, in TNGS (Belken) vs. PaineWebber, an arbitration panel awarded $2 million to a customer with an MBA from Harvard, despite the arbitrator’s findings that the investments were suitable and the customer understood the risks involved. The arbitration panel concluded that the broker and the firm undertook an express duty to monitor the performance of the customer’s investment selections. While not common and difficult to win, these types of cases are coming through the arbitration “pipeline” more frequently with the proliferation of discount brokerage firms and online firms. 127) What is a statute of limitations? An investor’s ability to bring an action against a broker or brokerage firm is arguably limited by certain time restrictions. Statute of limitations serves as a means of barring any complaint that is filed after a certain period of time. For example, if the law states that a customer has three years to bring a claim and the investor waits four years before bringing the action, then the customer might be time-barred from asserting a claim against the broker. The typical reason provided as to why we have statute of limitations is because of concerns that over time documents get lost, memories fade and employees relocate. If there is to big of a delay between when the fraudulent conduct took place and when the claim is filed, there might be too great of a burden on a broker or brokerage firm. There are a number of practitioners who believe statute of limitations are not applicable at all in securities arbitration because statute of limitations apply only to judicial proceedings and arbitration is generally considered to be an equitable, not judicial, action. Rule 10304 of the Code specifically references “applicable statutes of limitation” which begs the question when are statute of limitations “applicable.” 128) When do statute of limitations begin? Statute of limitations generally begin to run either when the customer actually knew or should have known of the facts that caused him to have a claim. Statute of limitations based on state blue-sky laws typically varies from state to state. 129) What is the eligibility requirement? Parties in arbitration have a time limit to file a securities claim with the NASD. Rule 10304 of the NASD Code states that no dispute “shall be eligible for submission to arbitration where six years have elapsed from the occurrence or event giving rise to the dispute. This Rule shall not extend applicable statutes of limitations, nor shall it apply to any case which is directed to arbitration by a court of competent jurisdiction.” 130) Is eligibility different than the statute of limitation requirements? Yes. Even when a claim is filed within the six-year eligibility period, federal or state law can still preclude a monetary award for the action that took place during that time frame. However, it is important to remember that actions can be taken to toll the statute of limitations. For instance, if there is fraudulent concealment, the statute of limitations can be extended. If there is a breach of contract claim, then the statute of limitations is considerably longer. It is also important to remember that arbitration is an equitable proceeding, according to the NASD, designed to get a fair resolution for the parties. Therefore, some argue, the arbitrators may decide to follow the statute of limitations less stringently than a judge, who is bound by the strict letter of the law. 131) How have some in the brokerage industry abused the statute of limitations in arbitration? Arbitrators are arguably not bound to the application of statutory limitation periods in a matter where fundamental fairness is the purpose of the proceeding. As most arbitrators are aware, arbitration was the forum of choice selected by the securities industry, and strenuously defended as the exclusive forum for the resolution of disputes between customers and members of the industry. When the securities industry decided to impose arbitration as the sole choice for investors, they did so with the knowledge that the statute of limitations might not apply to arbitration. The industry made a trade off in choosing arbitration, namely that in exchange for quicker, more cost efficient resolution of disputes, they would lose the benefit of excluding older claims. Since the brokerage industry has required its investors to arbitrate their disputes, some argue it is unfair to allow technical legalisms that do not belong in arbitration. To allow the brokerage firm or broker to do so, in essence, allows them to have two bites at the apple: one, depriving the investor of a judicial or court forum, and the other, picking the judicial standards it wished to have applied, to the extent it benefits them and deprives the investor. 132) What are the defenses of estoppel, waiver and laches? All three defenses are equitable defenses that argue that an investor should not be allowed to delay for an extended period of time before suing the stockbroker because excessive delays cause an unfair disadvantage to the stockbroker or brokerage firm. Estoppel is a defense where the broker argues that the customer deliberately misled the broker into performing certain acts and therefore the investor should be precluded from suing on such acts. Waiver is the voluntary relinquishment of a legal right. Laches is a defense based on a fairness argument which argues that it is unfair to allow a customer to sue after a reasonable period of time expires from the discovery of the wrongful conduct. 133) Does the investor’s failure to complain hurt his or her arbitration case? Generally, no. It is not uncommon at all for an investor not to realize for weeks, months or even sometimes years that some type of fraudulent conduct has taken place in his investment account. There are many investors who never open their monthly or quarterly statements and even if they do, they do not review in great detail the activity that took place in the account. Many investors find the brokerage statement to be very confusing and poorly organized. Some investors place complete trust in their broker and do not find it necessary to check up on the broker because of the high degree of trust they place in the broker. Therefore, an investor’s failure to complain is not necessarily a significant issue in arbitration proceedings. 134) What is a “happiness” or “comfort” letter? Often, when brokerage firms detect abuses in an investor’s account the firm will send to the customer a “happiness” or “comfort” letter in an attempt to cover for the fraudulent conduct of their broker. The letter generally states something to the effect that “we are pleased to have you as a client, we value your business, if you have a problem with your account please contact the firm.” Sometimes, it may say “unless we hear back from you, we will assume you accept the risks associated with such aggressive trading in your account.” Typically, a failure to respond negatively by an investor is not damaging to his or her case since many times, the investor is not aware of the fraud until some considerable time after the “happiness” or “comfort” letter was issued. In addition, it is common for a broker to tell a client who received a happiness letter not to worry about it and that it is just a formality. A letter of this type is generally not given a great deal of credence in an arbitration hearing. 135) How important is the new account application form in an arbitration? It depends on the case. An account application must be filled out before a brokerage account is opened. The application contains important information about the investor that should guide a stockbroker in recommending securities. The application contains information such as the investor’s investment experience, risk tolerance level, financial goals and age. Unfortunately, it is not uncommon for information on the application to be inaccurate or forged by a broker. Usually, the account application is filled out by the broker either in a face-to-face meeting with the client or more frequently over the telephone. In the past, investors have told their broker one thing and the broker has recorded another. For instance, an investor might tell a broker who is filing out the account application that he is a 57 year-old, conservative investor who is interested solely with income preservation. The new account application might then contain information in the broker’s handwriting that the investor is a 47 year-old, aggressive investor who is interested in speculation. One well-known brokerage firm was fined by the SEC, in part, because of widespread doctoring of new account applications by their brokers. Arbitrators are usually aware of the problem that sometimes intentional or unintentional inaccurate information is recorded on new account applications. 136) What are the most common types of damages awarded at an arbitration hearing? The most common type of damages in securities arbitration hearings are Out-of-Pocket damages. The investor receives the difference between the price he paid for the investment and its actual value absent the broker or brokerage firm’s fraudulent conduct. Out-of-pocket damages also many times take into consideration all the interest or dividends earned in the investor’s account. Consequential damages may be awarded in addition to out-of-pocket damages. Consequential damages can include, for example, lost profits in the form of dividends on stock sold as a result of the fraud, taxes incurred by the investor as a result of the broker’s fraud and expenses incurred by the investor while trying to mitigate losses. Rescission damages are another type of damages often awarded in arbitration disputes. Rescission damages are based on the concept of preventing a broker or brokerage firm from unjustly retaining the benefit from the fraudulent actions. It attempts to put the investor back where he was before the fraudulent actions occurred. With rescission, the investor returns the security in exchange for return of consideration paid. If the security is no longer available, the investor can obtain recovery of the difference between the consideration paid for the security and any consideration received for it. 137) Can arbitrators award interest to the investor? Yes. Arbitrators can and do award interest to investors. Arbitrators have discretion as to the interest rate, when the interest starts accruing and who has the responsibility to pay it. Typically, however, the individual state securities act will delineate the interest rate to be applied. 138) Can arbitrators award attorney fees? Yes, arbitrators may award attorneys’ fees and costs. In order to put the investor back into his or her original position, it is typically necessary to award attorney fees. Sometimes, arbitrators might ask counsel for evidence of their authority to award the fees and costs under the individual state securities act or case law. 139) What is a “well managed account” measurement of damages? A “well managed account” measurement of damages focuses on what the investor would have gained by being invested in a typical portfolio or mutual fund consistent with their objectives at the time the broker was “managing” the account. For instance, say a 40 year-old investor brought a $1 million portfolio to a stockbroker. The portfolio consisted of $500,000 in blue chip stocks and stock index funds and another $500,000 in government and high-grade municipal bonds. Instead of leaving the account in its properly diversified state, the broker decides to liquidate the holdings and purchase technology and biotechnology stocks and stock options. A “well managed account” measurement of damages would focus on the difference between what the investor’s return was under the broker’s direction and what the account would have returned if the broker had left the account alone in its already well-diversified position. In the scenario outlined above, if the broker lost 25 percent of the investor’s portfolio due to the brokers recommendation of unsuitable investments over a 12 month period and the account would have returned, but for the broker’s negligence, 10 percent a year, then the investor’s damages under a “well managed account” measurement would be $350,000 ($250,000 in out of pocket losses plus $100,000 of damages for what the account would have returned if the broker had not acted negligently). 140) Are punitive damages allowed in arbitration? Yes. In 1994 the U.S. Supreme Court ruled in Mastrobuono v. Shearson Lehman Hutton, Inc. that a choice of law provision in a pre-dispute arbitration agreement that specified New York law did not preclude an award of punitive damages, even though New York arbitration law would prohibit such an award. The Court’s decision, however, did not directly consider the appropriateness of arbitral awards of punitive damages. Instead, the Court focused on ambiguities in the agreement because of references both to NASD documents that permitted punitive damages, and to a choice of law provision that did not. As a result, the Court applied basic contract law and construed the contract against the drafter, Shearson Lehman. Thus, Mastrobuono did not resolve the policy issue of whether punitive damages should be available in securities arbitrations. However, today, arbitrators can award punitive damages. In 2000, arbitrators awarded $21 million in punitive damages.The year before, arbitrators awarded $48 million in punitive damages. In 1995, the NASD released several recommendations made by a “blue-ribbon task force” proposing to revamp securities arbitration. The Board of Governors of the NASD appointed an eight-member task force in 1994 to address the various problems that undermine customer confidence in the fairness of securities arbitration. The result was a 156-page report that contained 70 recommendations to the NASD Board of Governors and all other self-regulatory organizations that offer arbitration. One of the most controversial recommendations was to limit arbitrator’s ability to award punitive damages to the lesser of $750,000 or two times compensatory damages. The proposals are still in the hands of the SEC waiting for a final determination of the issue. 141) How important is it for arbitrators to retain the right to award punitive damages? Crucially important. Punitive damages often serve as the only effective police mechanism against fraudulent stock scams. Arbitrators must retain the ability to make appropriate punitive awards even if they do so infrequently and the award is more a matter of sending a message to the industry through punishment than of a windfall to investors. Contrary to what the brokerage industry would like the SEC and the NASD to believe, there is no runaway punitive damage problem in the securities industry. On average, only 2 percent of arbitration cases that go to hearing result in punitive awards. In almost every case where punitive damages are awarded, they are indeed warranted. No one can realistically question the appropriateness of a $10.5 million punitive damage arbitration award against Stratton Oakmont. Stratton Oakmont repeatedly ignored regulator’s warnings to end customer churning and unauthorized trading and their brokers continued to make grossly unsuitable recommendations; all the while the firm’s president allegedly earned up to $7 million a year. Capping punitive awards takes away the arbitrator’s ability to punish the most egregious brokerage firms like Stratton Oakmont. 142) How long does it usually take for the parties to receive the award from the arbitrators? The goal, as outlined in 10330 (d) is that “arbitrator(s) shall endeavor to render an award within thirty business days from the date the record is closed.”While this is the goal, it is becoming more and more infrequent. However, even in some of the slowest situations, the parties usually have the award within 60 days (although certainly not always). 143) What form does the award have to be in? The arbitration award does not have to be in any particular form although there is some information that must be present. According to 10330 (e) “the award shall contain the names of the parties, the name of counsel, if any, a summary of the issues, including the type(s) of any security or product, in controversy, the damages and other relief requested, the damages and other relief awarded, a statement of any other issues resolved, the names of the arbitrators, the dates the claim was filed and the award rendered, the number and dates of hearing sessions, the location of the hearings, and the signatures of the arbitrators concurring in the award.” Arbitrators are not required to provide a reason for their decision or even a statement as to how they arrived at a damage figure. Sometimes, arbitrators will issue a “reasoned award” which outlines their findings and is similar in form to an opinion written by a judge. 144) What type of flexibility do arbitrators have in awarding damages to an investor? Arbitrators have wide flexibility in deciding what damages to award to investors. Arbitrators have considerably broader authority than do courts in deciding what type of award an investor will receive. This is a major difference with arbitration since arbitrators can sometimes let common sense, fairness and equity guide the fashioning of a remedy. 145) Are arbitrators ever constrained in rendering an award by other factors? Yes. Some Claimant attorneys complain that some arbitrators are intimidated and unwilling to give “fair” awards to investors who have lost money at the hands of certain wirehouses or large, national brokerage firms. These arbitrators are concerned about being struck from future arbitration panels by defense attorneys who deal frequently with these larger brokerage firms. Therefore, in order to ensure future selection as an arbitrator, they are unwilling to grant larger awards to plaintiffs even in cases where they are warranted. However, with the proliferation of a group like PIABA, it could be argued that arbitrators who consistently guard the interests of the securities industry at the expense of investors run the same risk of being permanently struck in future cases by Claimant attorneys. 146) Can arbitration awards be appealed? Yes, however it is rare for an arbitration award to be successfully overturned. The grounds on which an award can be overturned are very narrow. Typically, so long as the award was not procured by fraud or there was no manifest disregard of the law, courts will allow the award to stand. Each party is given an opportunity at the end of the hearing to state affirmatively whether they feel they were given a fair chance to be heard. If there is a reason why a party does not feel as though they had a fair opportunity, it is important to say so at that time. 147) Are arbitration awards final? Yes. Arbitration awards are extraordinarily final. It has been said that a “lowly arbitrator” has more “final order” power than judges on circuit courts of appeals. Arbitrators are generally free to fashion the applicable rules and determine the facts of a dispute before them without their award being subject to judicial revision. 148) What is mediation? Mediation is a method of dispute resolution in the securities industry that serves as an alternative to binding arbitration. The NASD defines mediation as “an informal, voluntary process that employs an impartial person, the mediator, to facilitate negotiations between disputing parties, in an effort to reach a mutually acceptable resolution.” 149) How is mediation different than arbitration? Mediations are really just supercharged negotiations. In mediation, either side can walk away from the proceedings at any time. If one of the parties is not happy with the end result of the mediation, there is no obligation to accept the final negotiated settlement. An arbitration is similar in form to a court proceeding. In arbitration, the arbitrators make a final decision. Their decision is binding upon the parties. If the investor or brokerage firm is not happy with the result, short of an appeal, which is very difficult to prevail on, nothing can be done. 150) How often do securities mediations end in a settlement? It is the authors’ experience that approximately 75 percent of all mediations end in a settlement either at the session or within a few weeks of the actual mediation. 151) Is mediation a good option in lieu of arbitration? For the right cases, mediation is an extremely attractive option. In many cases, the investor in an arbitration action has lost a significant amount or all of his or her life savings. Going to arbitration and allowing three arbitrators to decide the investor’s fate is an unattractive option for some investors since the uncertainty factor in the outcome is high. An investor can have a case that 97 out of 100 arbitrators would decide in his favor on. But any case that goes to arbitration has some potential to provide the investor with nothing. Mediation affords the luxury of allowing the investor to know exactly what outcome will result since the mediation is simply a negotiation session. As a result, many investors and their attorneys find mediation to be an extremely attractive option. |
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About Our Lawyers Learn more about Andrew Stoltmann, Dave Neuman and Joe Wojciechowski Stoltmann In The News Various news articles and TV transcripts quoting Andrew Stoltmann or profiling his clients. Stoltmann Arbitration Awards Arbitration Awards by Andrew Stoltmann. InvestmentFraud.PRO Blog Read the InvestmentFraud.PRO Blog. Arbitration Process Questions and Answers on the Arbitration Process. Checking Out Your Broker Tips for Checking Out Brokers and Advisers. 151 Answers To Most Faqs. Excerpts from the book by co-authored by Andrew Stoltmann on Investor Rights for the 21st Century. Group Arbitration Actions Learn more about Group Arbitration Actions. Insurance Abuses Life Insurance Twisting Ponzi Scheme Scheme usually offers abnormally high short-term returns... Bond Fraud At Stoltmann Law Offices, we've represented many clients in arbitrations ... Get Started, Schedule A Meeting. Contact our office to schedule a meeting. Cases Pending/Current Investigations Specific broker’s/brokerage firm’s name and actions Free, 24 Hour, Online Evaluation
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