FINRA Takes Action Against Unscrupulous Broker

by Joseph Bendel

FINRA filed a preliminary injunction this past month against Westor Capital Group for the misappropriation and misuse of customer funds. FINRA charges that Westor has refused to allow customers to withdraw money from their accounts, as well as executed unauthorized trades within customer accounts, and has requested a cease-and-desist order from the court. Further, FINRA has issued a complaint against Westor for, among other things, failure to maintain control of investor accounts, as it is required to do under federal securities law.

While the complaint has been filed in court, it is unlikely that it will ever come to a trial. FINRA allows for the named parties in a complaint to respond to the complaint. In such case, the issue will be heard by a FINRA disciplinary panel and may result in fines, censure, or other non-judicially imposed sanctions. This case highlights FINRA’s market regulation at the investment firm management level to protect consumers. See the full story here.


Promise of Higher Returns Always Means More Risk

by Aaron Snellenbarger

The potential for a swing in what has become a gigantic bond bubble due to the decline in interest rates since the mid-1980s is slowly coming to an end. On the edges of this change, previously conservative investors have been pushed toward riskier investments in search of higher interest payments. The riskier investments have often times been junk bonds and risky private placements. Investors have chosen junk bonds for two reasons: 1) higher interest payments to supplement income; and 2) the misguided conception that because the investment is a bond, it is not as risky.

Interest rates have not been as low as they are now since the 1950s. For investors, most importantly retirees living off interest, this means that interest payments on investment-grade fixed-income investments are also at an all-time low. Retirees using these investments to supplement their income have seen their incomes greatly diminished, often resorting to more exotic forms of investment in search for higher returns to supplement their income. Forms of exotic investments include below-investment-grade bonds, normally referred to as junk bonds, and private placements. However, many investors have been confused by the specifics of these investments.

Junk bonds refer to bonds with less than a BB rating on the Standard & Poor scale. Although these bonds carry the same rights as normal securitized debt in bankruptcy, they have much greater risk associated with them, normally due to either the industry or business plan associated with the debt offering. The risk is that the funds raised through the debt offering will be invested in a company or project that does not generate enough return to pay back the loan from the bond purchasers. Furthermore, solely because a company has a reputable name does not mean that the bond carries any less risk than other bonds with a similar rating. Junk bonds may have a similar amount of risk as stocks of the same company without the upside for potential growth.

There is also a more general risk to investing in bonds in the current market. The benefit to bond investors in future interest payments carries an inverse relationship to interest rates. An easy example is a home mortgage. An individual would want to take out a mortgage or refinance a mortgage when interest rates are low because money is cheap. But, the bank, the investor in this example, would not receive as much return on the mortgage when the interest rates are low. A consequence of interest rates being so low is that they only have one direction to go, which is up. With an increase in interest rates in the future, the price of previously issued bonds will decrease as investors are able to purchase new bonds paying higher interest rates. Thus, an investor seeking to sell her bond would have to sell at a discount.

Investors should also be aware of the risks associated with investments in private placements. Even savvy investors are coaxed into these investments for the same reasons investors buy junk bonds: the potential for substantial returns. Just like all other investments that promise high returns, the amount of risk is directly proportionate. In general, investors should give careful consideration to a company’s management and capitalization before investing in a private placement.

IRC Supports Proposed FINRA Rule Change Regarding BrokerCheck

The Investor Rights Clinic (“IRC”) today submitted a comment letter to the Securities and Exchange Commission (“SEC”) supporting a proposed rule change to amend FINRA Rule 2267 (Investor Education and Protection) to require that FINRA members and associated persons include a prominent description and link to BrokerCheck on their websites, social media pages, and any comparable online presence. The IRC’s comment letter, drafted by second-year law student Julianne Bisceglia, is available here.

U.S. Department of Justice Files Suit Against Standard & Poor’s Over Credit Ratings

by Craig Distel

In the aftermath of the financial crisis, the U.S. Department of Justice, along with a number of state agencies, are poised to file civil charges against Standard & Poor’s Rating Service (S&P).  Accusations center on fraudulent ratings of mortgage bonds.  The Justice Department began its investigation during the summer of 2011 in an effort to determine the causes of the financial crisis.  Though the Justice Department and S&P were in settlement negotiations, those talks recently broke down.  This would be the first suit against a credit rating agency in response to the financial crisis.  The Justice Department reportedly was seeking roughly a $1 billion settlement before the talks broke down.  If a judgment reaches that amount, it would eliminate all of last year’s earnings of $911 million of S&P’s parent company, McGraw-Hill.

S&P has apologized that its ratings did not accurately predict the risk of collateralized debt obligations (CDOs) but has denied any wrong doing.  S&P claimed that other rating agencies and the United States government all reviewed the CDOs, which were sold as low risk due to S&P’s ratings at the time and featured prominently in the 2008 financial collapse. The Justice Department is attempting to hold S&P responsible for its failure to accurately rate the securities which were never actually low-risk investments.  S&P has also pointed to its downgrading of certain securities as proof of its innocence.  A spokesperson for the firm stated that the Justice Department’s law suit is merely a case of “hindsight being 20/20” and that the ratings were put forth on a good faith basis.  Given what we now know about the complexities associated with the packaging of CDOs, the Justice Department’s allegations may have far reaching effects. A victory for the Justice Department would expose all credit rating agencies to a level of liability they have never experienced.  This would, in turn, alter how assets are rated and how they are recommended by financial advisors to their clients.  The suit will likely be filed in California, where many have experienced the negative effects of the crash.

Click below for additional information on the dispute between the Justice Department and S&P:

U.S. Inquiry is Said to Focus on S&P Ratings –

U.S. Accuses S&P of Fraud in Suit on Loan Bundles –

Courts Weigh In on Definition of Customer

by Alex Lewis

Within the world of securities arbitration, a recent series of court decisions have threatened to destabilize the ability of investors to arbitrate their claims before the Financial Industry Regulatory Authority (FINRA) instead of bringing their claims in court. Those cases have arisen out of arbitration claims filed against Morgan Keegan due to the collapse of the Regions Morgan Keegan (“RMK”) funds. For more details on the RMK funds, click here.

Arbitration is traditionally a matter of contract and can only be compelled where two parties have agreed to do so. If the parties have not agreed to arbitrate, one party cannot normally force the opposing party to arbitrate. However, under FINRA rule 12200, a “customer” of a FINRA member such as Morgan Keegan may force the member to arbitrate a claim – rather than filing the claim in court – even without a contractual agreement to arbitrate. The disputes in the Morgan Keegan cases arise from the ambiguity in the FINRA definition of “customer”. FINRA rule 12100(i) simply states that, “A ‘customer’ shall not include a broker or dealer.” It has been up to the courts to interpret this vague definition of the term “customer”.

In the line of cases dealing with the RMK funds, investors who did not have accounts with Morgan Keegan have attempted to compel Morgan Keegan to arbitrate their claims relating to the RMK funds. These investors argue that as “customers” of Morgan Keegan, Morgan Keegan did in fact agree to arbitrate the claims as a condition of FINRA membership. They allege that the RMK funds were overleveraged and marketed by Morgan Keegan as safer than they actually were. The investors allege that, in purchasing the RMK funds, they relied on marketing materials provided by Morgan Keegan. They further allege that management of the RMK funds by a Morgan Keegan affiliate supports their position. These investors have sought to compel Morgan Keegan to arbitrate their claims for losses on investments in the RMK funds, despite the fact that they did not hold accounts directly with Morgan Keegan. However, the courts have found that because the investors purchased shares of the RMK funds through third-party broker-dealers with no affiliation with Morgan Keegan, the investors were not “customers” of Morgan Keegan under the FINRA rules, and thus, cannot compel Morgan Keegan to arbitrate. The courts in the Morgan Keegan cases are thus establishing a rule that there a “customer” must have a direct investment relationship with the broker-dealer.

The case primarily relied on by the courts in the Morgan Keegan cases is Fleet Boston Robertson Stephens, Inc. v. Innovex, Inc. In Fleet Boston, a brokerage firm filed a claim against a company for breach of contract, claiming that the company had failed to pay certain fees and expenses. The brokerage firm had provided advice to the company regarding its acquisition of stock in a merger. The company filed a motion to stay litigation and compel arbitration, but the motion was denied on the grounds that the company was not a “customer” under the FINRA rules.

The court in Fleet Boston determined that the company was not a “customer” under the FINRA rules on the grounds that the claim did not arise out of investment or brokerage services. The court found that it was inappropriate to apply the FINRA rule in a strict sense due to the fact that such an application would be overly broad. The court further stated that the claim arose out of services that were too remote for a FINRA member to reasonably expect to arbitrate them solely due to its FINRA membership.

The recent Morgan Keegan decisions thwart investor’s ability to compel arbitration when the investor does not have a direct investment relationship with the FINRA member, even if the FINRA member distributed marketing materials that misrepresented the risk of investing in a fund managed by an affiliate. These rulings promote a line of reasoning that reads additional conditions into the FINRA definition of “customer”. The basis for this reasoning is the precedent established in the Fleet Boston case.

At the same time, other courts that have ruled more favorably for investors in similar cases. In a recent case, Twenty-First Securities Corporation v. Crawford, the Second Circuit Court of Appeals found that an investor was a “customer” of a member due the investor’s reliance on the member firm’s investment advice despite the fact that the customer did not have an account with the firm. Thus, while the Morgan Keegan cases present setbacks for investors seeking to arbitrate their claims, there are still courts willing to find in favor of the investors and compel member firms to arbitrate claims.

The relevant Morgan Keegan Cases are Morgan Keegan & Co., Inc. v. McPoland, 829 F.Supp. 2d 1031 (W.D. Wash. 2011); Morgan Keegan & Co., Inc. v. Johnson, 2011 WL 7789796 (E.D. Vir. 2011); Morgan Keegan & Co., Inc. v. Louise Silverman Trust, et al., 2012 WL 113400 (U.S.D.C. Maryland 2012), aff’d Morgan Keegan & Co., Inc. v. Louise Silverman et al., 2013 U.S. App. LEXIS (Feb. 4, 2013); Zarecor v. Morgan Keegan & Co., Inc., 2011 WL 5592861 (E.D. Ark. Jul. 29, 2011).


Supreme Court to Decide Time Limit for SEC to Bring Fraud Suits

On January 8, 2013, the United States Supreme Court heard oral arguments in the case of SEC v. Gabelli, 11-274,  related to when the clock begins to run for the Securities and Exchange Commission (SEC) to bring a fraud suit. In Gabelli, the Obama administration asserts that the time limit accrues from the time the government discovers the wrongdoing–a contrast from the traditional view that the limitations period begins at the time of a fraudulent transaction.

The SEC complaint was filed in 2008 and centered on conduct occurring between 1999 and 2002, calling into question the five-year limitations period of 28 U.S.C. § 2462. The SEC alleges that two officials of Gabelli Funds LLC secretly allowed market timing practices by a client.

Although the “discovery” rule does apply in private actions brought by investors, the Gabelli case implicates only governmental actions brought to impose fines, not to disgorge profits or impose criminal penalties.

The Court’s ruling is not expected to come until June, but the Justices’ questions seemed to indicate that many of them disagreed with the Obama administration’s stance. The Justices further hinted that their decision could have broad implications applying to time limitations imposed on actions brought by other governmental agencies like the Federal Trade Commission and Defense Department, among others.

For more information and to listen to the oral arguments before the Supreme Court click here.