Stumping the Schwab: Investor Submission to Class Action Waivers

By Josh Brandsdorfer

Since 1987, when the Supreme Court in Shearson v. McMahon ruled that a brokerage firm could force customers to agree to arbitration, this method of dispute resolution has become the virtually mandatory in the financial regulatory industry. However, this previously preferred method of dispute resolution could be facing a new frontier if Charles Schwab has its way. In 2011, Charles Schwab added a clause to their agreements that mandated that clients could not pursue action against the corporation in class action suits. Class actions, common amongst investors who cannot afford representation or whose claims are not lucrative enough to hire a lawyer, provided a course of action for aggrieved customers.

The court in Charles Schwab v. FINRA, finding in Schwab’s favor, reinforced that there is little to protect consumers from downright predatory customer agreements, even for the nation’s top financial regulators.

In February, Charles Schwab won its initial panel hearing; and while FINRA, the brokerage industry’s self-financed policing arm, appealed this decision, it could prove disastrous for customers looking to recover against unscrupulous broker-dealers. Though some arguments arise that class action suits benefit the attorneys more than the aggrieved investor, class action suits are sometimes the only options for individuals who do not meet the high loss thresholds many law firms hold for these types of disputes. Instead, customers are forced to become part of a class; individuals similarly situated who all have claims against a common broker or product. These actions can provide powerful results to customers who otherwise could not afford representation and allows investors seek clarity in their legal issues.

The addition of non-profit clinics, such as the University of Miami’s Investor Rights Clinic, at least gives customers another avenue should the appeals court hold that Charles Schwab, and likely every other broker-dealer, can shield themselves from class action lawsuits. It is, however, unlikely that the number of non-profit clinics will be able to cover the customer cases that were once engulfed by class actions. A Charles Schwab spokesman indicated that the company will offer to pay the arbitration forum fees for claims under $25,000, but this sum usually only accounts for a few thousand dollars. While a nice gesture, it does not solve the problem. For claims this low, it is not economical for attorneys to take these cases, unless they are categorically similar, in which the attorney would previously cluster these claims together into a class action suit.

Though class actions may be very lucrative for some attorneys, the only parties who truly suffer from the unfavorable judgment in Schwab v. FINRA are the rights of investors. If the appeals panel does rule that Schwab’s action were reasonable and class action suits are in fact not required in brokerage contracts, look for more pro bono or small scale legal practices, like the Investor Rights Clinic here at Miami to become more popular. Law students can gain an insightful look into real legal practice in this pro bono environment. Perhaps more universities will embrace the idea of providing free legal services to investors whose investment claims remain too low for most private attorneys.

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Grand-Scale Example of Misrepresentation

By Erin Fitzgerald

On September 13, 2013, the U.S. Securities and Exchange Commission (SEC) charged the operator of Miami-Dade County’s largest hospital with misleading investors about its financial condition before the 2009 sale of $83.3 million of bonds. The bond sale was to raise money for capital improvements at Jackson Health System that included upgrading fire alarms and renovating elevators, and the bonds were to be repaid solely from Jackson’s revenues.

Based on the 2009 bond prospectus, the bonds were given an A+ rating with stable outlook. Yet, federal investigators for the SEC who examined accounting documents, financial projections, and internal emails discovered that the Public Health Trust, the governing authority for Jackson Health System, had grossly underestimated its losses. This misstatement of losses was enormous. At the time of the bond, Jackson’s board projected a budget deficit of $56 million. However, about six months later, the Board reported a non-operating loss figure that was more than four times higher, at $244 million.

How did the Board do it? According to the SEC’s findings, the Public Health Trust misstated current and future revenue due to problems with a new billing system that inaccurately recorded revenue and patient accounts receivable. In effect, the Board used stale cash collection numbers to calculate its revenue figures in the midst of known problems with the billing system. Moreover, the SEC found that a lack of communication among hospital departments led to the budget department not updating its collection rates on time. The SEC also charged Jackson’s Board with failing to properly account for an adverse arbitration award from 2008, and misrepresenting that the hospital system’s 2008 audited financial statements were prepared according to generally accepting accounting principles (GAAP). Overall, Eric Bustillo, the head of the SEC’s Miami office, reports: “The Public Health Trust fell short in its obligation to maintain adequate accounting systems and controls that ensure truthful disclosures to investors about its financial condition.”

The Public Health Trust did not admit or deny the investigative findings, but agreed to settle the charges with the SEC. The Public Health Trust will not face a civil monetary penalty due to its cooperation with the federal government during the investigation and its current financial condition, however the SEC secured a promise that it would not engage in fraudulent activities tied to future bond issues.

This story suggests the importance of investors diversifying their portfolios, so that if one investment, such as the revenue bond in this case, goes terribly wrong, an investor can still rely on their other investments.

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