Elements of Portfolio Management: Recognizing Potential Unsuitability Claims

By David Newfield

The most common claim customers make against their brokers in FINRA arbitrations are unsuitability claims. Under FINRA Rule 2111, a broker has a duty to make sure any recommended transaction is suitable for the customer. Many factors contribute to an assessment of suitability for a portfolio. FINRA issued guidance on the specifics of Rule 2111 in Regulatory Notice 12-25. The notice explains the three main suitability obligations of the rule. These obligations are reasonable-basis suitability, customer-specific suitability, and quantitative suitability.

Customer-specific suitability requires the broker to consider a specific investment, or investment strategy, in the context of a particular customer. The customer’s age, experience, and risk tolerance are a few of the factors a broker must consider. Many brokers fail to consider customer-specific suitability. Therefore, it is important for a customer to be aware of the basic elements of portfolio management, in order to recognize when his or her broker may have behaved improperly.

Traditional portfolio management theory seeks to find an optimal balance of assets in order to effectively manage risk while still seeking maximum return. Most portfolios are made up of a balance of fixed income and equities. Deciding how to balance these elements will depend on the specific needs of the customer. Three useful factors to look at are age, asset, and allocation.

1)     Age: When investing, the age of an investor is one of the first questions to ask. As people age, their needs and investment goals change. Someone starting to invest for retirement may be interested in growth, and have a higher risk profile; whereas somebody already retired will be interest in safe, income-producing, investments. (Tip: A common trick many people use to calculate an ideal stock-bond balance is to invest the same percentage in bonds as a person’s age. Thus, a 25 year-old should invest 75% of his or her portfolio in stock.)

2)     Asset: Not all stocks and bonds are created equal. Although some stocks or bonds may offer a higher return, this comes along with greater risk. It is important for an investor to consider both the asset class as well as the specific asset. (Tip: When choosing stocks, consider the size, style, and sector of the stocks.)

3)     Allocation: Everybody knows the age-old adage: Don’t put all your eggs in one basket. It is important for every portfolio to be appropriately diversified. An investor should consider if his or her investments appear to be too concentrated. (Tip: Try to invest in a handful of companies that you know, trust, or even use in your day to day life.)

Although this list is not exhaustive, an investor can begin to gain insight in to his or her portfolio by considering age, asset, and allocation. Furthermore, FINRA Rule 2090 requires brokers to “know your customer.” A broker has an obligation, when opening and maintaining an account, to know the essential facts concerning every customer. It should raise a red flag to an investor if he or she feels that his or her broker has not inquired about his or her background and investment goals.

Municipal Advisors Face Increased Regulation Under Dodd-Frank

By Nathaniel Touboul

The financial crisis of 2008 led regulators to the realization that municipalities needed a system that protects their own interests when dealing with Wall Street. To achieve this goal, the Dodd-Frank Act, among other things, created a new class of regulated persons called “Municipal Advisors” (MAs). Under new regulations, MAs may not provide advice on behalf of, or to municipal entities without first registering with the Securities and Exchange Commission (SEC). MAs will also be held to a fiduciary standard. These new regulations are aimed at issues regarding MA misconduct such as “pay to play” practices, undisclosed conflicts of interest, advice rendered without adequate qualifications and failure to place their duty of loyalty to their clients ahead of their own interests.

Ultimately, the goal is to protect the investor and the integrity of the market. The Municipal Advisor Examination Initiative (“MA Examination Initiative”) will provide the SEC with valuable information that will allow it to discover new areas of potential MA abuse. Also, the new registration process will create a direct link between MAs and the SEC, thereby facilitating oversight.

It is often the case that when an advisor orchestrates a transaction for a municipality, the advisor will provide advice and counsel to the municipality as well. The issue with this system is that not all underwriters and brokers are fair. An example of this misconduct occurred in 2008 in Jefferson County, Alabama, where a J.P Morgan Chase banker led officials into entering a complicated interest rate swap deal. Although the banker and some county officials later pleaded guilty to corruption charges related to the deal, it eventually led Jefferson County into bankruptcy in 2011.

From the investor’s perspective, scenarios such as Jefferson County’s bankruptcy show that even investments that have traditionally been viewed as “safe” such as municipal bonds are not immune from disasters. Even when making “safe” investments, it is important for investors to understand the potential risks, including the risks of a municipality defaulting on its debt obligations. These new regulations will create more oversight and facilitate compliance with new regulations designed to prevent the kind of misconduct that led to the Jefferson County bankruptcy.

To respond to situations such as the one that occurred in Jefferson County, the SEC announced that the Office of Compliance Inspections and Examinations (“OCIE”) is launching an examination initiative directed at newly regulated MAs. The OCIE examines MAs through the National Exam Program (NEP), which is comprised of staff of the SEC’s 11 regional offices and the home office in Washington, D.C. The NEP’s mission is to “protect investors and maintain market integrity through risk-focused examinations that promote compliance, prevent fraud, monitor risk and inform policy.” Through launching the MA Examination Initiative, the NEP will be able to conduct focused, risk-based examinations of MAs that are registered with the SEC, but not registered with FINRA. The MA Examination Initiative will be conducted over the next two years and will have three primary phases described as follows:

Engagement Phase:

This initial phase consists of outreach programs aimed at informing newly registered firms about their obligations under the Dodd-Frank Act and the MA Examination Initiative. This phase will also provide a forum for MA senior executives or principals to discuss issues, ask questions and communicate directly with the administrative agencies.

Examination Phase:

During this phase, the NEP staff will review the MAs selected for examination, and will determine whether they are in compliance with all applicable rules. The OCIE will focus on the following areas of identified risks:

1) Registration

2) Fiduciary Duty

3) Disclosure

4) Fair Dealing

5) Supervision

6) Books and Records

7) Training/Qualifications

Informing Policy Phase:

This final phase will consist of a final report from the NEP to the SEC containing common practices in the areas identified in the Examination phase, industry trends and other issues.

Federal Court Orders Former FINRA-Registered Broker’s Assets Frozen, Places Emergency Injunction on Firm

By Nathaniel Griffin

On June 3, 2014, the Securities Exchange Commission (“SEC”) petitioned for an emergency injunction preventing Albany, NY-based Scott Valente and The ELIV Group, LLC. (“ELIV”) from engaging in fraudulent securities trading. In its complaint, the SEC alleges misappropriation of customer funds and misrepresentations of customer account performance, investment guarantees, account values under management, and broker and firm qualifications.

ELIV Group claims to be an accredited organization; however, the firm is not registered with The Financial Industry Regulatory Authority “FINRA,” nor is Valente. In 2009 Valente was barred from associating with any FINRA members. This ban came after more than twenty customer disputes and other regulatory investigations by FINRA.

ELIV solicited customers through internet advertisements and investment seminars, claiming gains of over 34% for its managed customer accounts. The SEC alleges in its complaint that the customer accounts of over 80 persons were commingled within one account totaling over $8.8 million in initial investments, and that these funds have not seen gains, but have instead suffered dramatic losses. Further, the SEC claims that Valente made monthly and annual reports falsely stating the values of customer accounts and misrepresenting significant gains to his customers.

ELIV allegedly made numerous unauthorized withdrawals from customer funds for his personal use. In the customer agreements, Valente was entitled to 1% of the assets under management as his management fee. However, the total of the allegedly unauthorized withdrawals far exceeded that amount.

The sales tactics used by Valente are not at all uncommon, including in South Florida. According to the Financial Industry Regulatory Authority, approximately half of all investment seminars examined offered literature with exaggerated, misleading, or otherwise unwarranted information and 12% of seminars appeared to involve fraud.

For more information on advertising awareness, see FINRA’s Investor Alert: “Free Lunch” Investment Seminars—Avoiding the Heartburn of a Hard Sell.

Investing in Technology IPOs: Why You Should Think Twice About Uber-Valuations

By Eli Rodrigues

On Friday, June 6, 2014, Uber Technologies Inc., a car-hailing smartphone application was valued at $18.2 billion, more than quadrupling its previous year’s valuation. Uber has secured more than $1.5 billion, with the most recent billion dollar round of funding coming from Fidelity Investments, Wellington Management and BlackRock Inc. According to Uber’s Founder and CEO Travis Kalanick, Uber is “growing faster this year than last year,” achieving an annual revenue in the hundreds of millions of dollars that is “at least” doubling every six months.

Uber has already left its mark in history by joining elite group billion-dollar startups, finding itself in second place to none other than Facebook Inc. in securing capital from private investors. With all of the publicity surrounding Uber’s latest valuation and funding, heated bidding for pre-IPO shares has begun as the company is preparing itself to go public. Now, the big question crossing many investors’ minds is: “When do I invest?” The answer: not until sufficient research has been performed and the company’s lock-up period has expired.

There is no specific answer for when an investor should add a company to their portfolio. No investment is a sure thing, especially when it comes to technology companies. Most recently, history has provided a much different picture for the technology industry, with IPOs often flopping, leaving heartbroken investors with fractions of their investments. Groupon Inc. is a one of the most recent examples that investors should learn from and hopefully subdue their excitement for Uber and other future technology IPOs.

What should an investor understand before committing any of their assets to a newly public company? As a general rule if the markets are doing well then so will IPOs. Additionally, IPOs have a much higher beta and are therefore much more volatile once they hit the market. If as an investor you are unable to tolerate price fluctuations, then this investment is not for you. Moreover, gathering reliable information about a company going public is very difficult because private companies do not disclose their financial information publicly, and numerous analysts generally evaluate the strength of their operations. It is important to note that IPOs do offer investors a prospectus, but the company, not an unbiased third party, writes that document. Under the rules governed by the Securities and Exchange Commission, insiders of any company going public are typically prohibited from selling their shares for a period of time, typically 180 days. It is very important for investors to find out if a lock-up period exists and when the period expires because the value of the stock can drastically change in anticipation of insider liquidation.

But Uber is different, some say. Its disruptive technology has dominated the transportation industry internationally and is now offered in more that 130 countries around the world. This might be true; however, technology IPOs often follow a different business plan because they are members of a sharing economy, bringing together users with service providers. Uber allows professional and nonprofessional drivers to sell their time and services to users. Uber does not own anything other than an application and its dispatch service. This business model has low barriers to entry and a potential investor should be weary of the ease in replicating the business. Many companies like Uber entered the market, offering an identical service at more competitive pricing. With driver and user loyalty driven on cost and an increasingly strict international regulatory environment, Uber has already been forced to rethink its cost structure, a fact investors should certainly be aware of the before making a decision to invest.

Barclays Capital, Goldman Sachs and Merrill Lynch Fined $1 Million by FINRA for Submitting Inaccurate Blue Sheets

by Michael Lorigas

On June 4, 2014, FINRA announced that it had censured and fined Barclays Capital, Inc., Goldman, Sachs & Co. and Merrill Lynch, Pierce Fenner & Smith, Inc. $1,000,000 each for their failure to provide complete and accurate electronic blue sheets to FINRA, the SEC, and other regulators.

Blue sheets are questionnaires requested by a regulatory authority that contain detailed information about trades performed by a firm and its clients. Some of the information includes the security’s name, the date traded, price, transaction size and the parties involved. They came to be known as blue sheets because they were originally filled out on blue paper. Due to the high volume of trades, the information is now submitted through electronic blue sheet systems (“EBS”).

This is not the first time each company has been in trouble for this violation. In January 2006, Merrill Lynch and Goldman Sachs each received a censure and fine for failure to submit accurate trading information on electronic blue sheets. Barclays was censured and fined for the same offense in October 2007.

Electronic blue sheets are important to investors because they allow the SEC and FINRA to monitor securities and transactions to determine if there has been any federal securities violations, especially insider trading and market manipulation. EBS also allows the regulatory agencies to examine why a specific security may have experienced a large level of volatility, which then allows the agency to conduct market reconstructions.

Accurate blue sheets are necessary for the agencies to enforce regulatory mandates. The information contained in electronic blue sheets allows the SEC and FINRA to ensure that the market is operating effectively and protects the integrity of investments and their investors.


FINRA Board of Governors Finds Charles Schwab & Co. Violated FINRA Rules by Attempting to Prevent Customers from Participating in Class Action Lawsuits

By Wayne Grossman

On April 24th, the Financial Industry Regulatory Authority’s (FINRA) Board of Governors issued a decision that found Charles Schwab & Co. (Schwab) violated FINRA rules by sending certain amendments to its customer account agreements to 6.8 million of its customers. These amendments prohibit customers from participating in class action lawsuits against the firm, and also require customers to agree that FINRA arbitrators have no authority to consolidate claims made against the firm. This decision, in part, reversed the findings of a FINRA Hearing Panel which had held that, although the amendments did violate FINRA rules, these rules were unenforceable because they were in conflict with the Federal Arbitration Act (FAA).

When a customer opens a brokerage account at a FINRA member firm, the customer contractually agrees to resolve disputes with the firm through arbitration. Dispute resolution is then governed by the contractual terms of a pre-dispute arbitration agreement. Section 2 of the FAA provides that such agreements are “valid, irrevocable, and enforceable….” In general, member firms enjoy a significant degree of latitude in drafting pre-dispute arbitration agreements, subject to certain limitations under FINRA rules.

On February 1, 2012 FINRA filed a complaint alleging Schwab violated FINRA rules that allow customers to participate in class actions and FINRA arbitrators to consolidate similar cases. Schwab argued that it had the right to require customers waive their rights to participate in class actions. The original Hearing Panel held that Schwab did violate these rules, but that these rules were unenforceable because they were inconsistent with Section 2 of the FAA which affords primacy to the terms and conditions of an arbitration agreement over FINRA rules. Because FINRA rules explicitly allow arbitrators to consolidate claims, the Hearing Panel found against Schwab on this matter and fined the company $500,000.

Upon independent review, the FINRA’s Board of Governors (the Board) reversed the Hearing Panel’s findings. Based upon the language and intent behind the FINRA rules, the Board found that the rules were intended to “preserve investor access to the courts to bring or participate in judicial class actions…and that Schwab violated FINRA rules.” However, the Board also found that Congress validly delegated authority to the Securities and Exchange Commission to approve FINRA’s rules on arbitration agreements, and that this authority overrides Section 2 of the FAA. The Board stated that FINRA rules have the force and effect of federal law. Stated differently, the Board ruled that Schwab’s amendments to its customer agreements violate enforceable FINRA rules, and referred the case back to the Hearing Panel to determine appropriate sanctions.

This ruling suggests that although member firms of FINRA have a significant degree of discretion in designing pre-dispute arbitration agreements, investors and their advocates should be aware that there are limits under FINRA rules. Additionally, FINRA rules have the force and effect of federal law and can affect investor rights. In this case, FINRA rules have been interpreted to recognize and protect investor rights to participate in class action suits.

Risks and Benefits of Foreign Investments

by Raymond Nicholas

On May 6th, 2014, Alibaba, a Chinese E-commerce goliath filed its IPO with the United States Securities and Exchange Commission (“SEC”), in what many economists predict could be the largest or one of the largest initial public offerings in United States history. Alibaba currently controls eighty percent of China’s E-commerce market and is worth more than 100 billion dollars.

The Alibaba IPO presents numerous risks investors should consider before investing in foreign equities. According to a report by William Alden of the New York Times, notable risks of foreign equities include: 1) corporate structure; 2) U.S. Securities laws being less stringent on foreign companies; and 3) increased market volatility. Alibaba is also subject to economic downturn in the Chinese market, which would adversely affect its success in the US market. The SEC, U.S. News, and Financial Industry Regulatory Authority (“FINRA”), all warn investors of volatility in foreign markets directly related to political instability.

China has a developed economy; however, the Chinese Government heavily regulates the economy and Internet infrastructure, presenting another risk to investors considering investing in foreign companies. Government regulation varies by country, making it difficult to accurately gauge the success of a foreign company in a U.S. Market. Finally, foreign companies are subject to fewer causes of action in U.S. courts due to complicated jurisdictional issues.

Contrary to the risks of international investment, there are advantages to investing in foreign companies. A report from T. Rowe Price that some international companies are growing faster than their U.S. counterparts. Alibaba appears to be one of them. Many economists, including Rick Ferri of Forbes, state international investments are key to a well-diversified portfolio, and recommend a 70% to 30% ratio of U.S. stocks to foreign stocks. The advantages and disadvantages listed here are by no means all inclusive. Investing in foreign companies requires consideration of factors not relevant in domestic companies. Alibaba’s IPO illustrates the benefits and disadvantages of investing in foreign companies. Most importantly, the Alibaba IPO reaffirms the importance of due diligence and thorough research. It is crucial to sift through the hype surrounding an investment to ensure safe, well thought out investing.

The Puerto Rico Bond Crisis and Its Effect on U.S. Investors

By Thais DelaCuba

The Puerto Rico Bond Crisis has had a large impact on the United States’ almost $4 trillion municipal-debt market, which includes bonds issued by states and other local authorities as well as by cities. As a result of the sinking market, Puerto Rico’s current debt is between $52 billion and $70 billion, which is the third largest in the United States, only behind California and New York.  This amount of debt is alarming because Puerto Rico has a much smaller and poorer population compared to other heavily indebted states. Indeed, according to the Economist, the average state debt to personal income ratio is 3.4% in the United States, whereas Moody’s rating agency puts Puerto Rico’s tax-supported debt at 89%.

The current financial instability of Puerto Rico may have a grave effect on many smalltime investors around the United States. This is because U.S. mutual funds are heavily invested in Puerto Rican bonds due to a special tax exemption, which allows Puerto Rican bonds to be triple tax-exempt. In short, this means that bondholders do not pay federal, state, and local taxes for their coupon interest from the bonds. According to Morningstar, as a result of this exemption, around 70% of U.S. mutual funds own Puerto Rico securities.

The special tax exemption – which was intended to bring investors and business onto the island – has ultimately created the financial crisis occurring in Puerto Rico today. The financial crisis began in 2006 when a federal tax break for corporate income expired, which prompted many businesses to leave. Subsequently, unemployment on the island increased drastically and Puerto Rico began borrow funds to avoid further deficit. Finally, in February 2014, all three major ratings agencies downgraded Puerto Rico’s debt to below investment grade, widely referred to as ”junk” status. This indicates a greater risk of possible default or a debt restructuring. For U.S. investors, this means that the crisis in Puerto Rico will have a severe impact – not only on Wall Street, but also on thousands of everyday investors.

The Lehman Brothers Saga Continues: Broker Wins $5.4 Million Against UBS

By Abirami Ananthasingam

On September 15, 2008, Lehman Brothers filed the largest bankruptcy in history with over $639 million in assets and $619 billion in debt. Despite the residual effects of this failure, for one broker, the torment is finally over. On April 7, 2014, Edward Graham Dulin, Jr. was awarded a $5.4 million award to compensate him for the diminution in the value of his career and the damage to his business from being held responsible for losses sustained by investors to whom he had recommended the purchase of Lehman Principal Protected Structured Products (“Structured Products”). UBS’ actions led to the disclosure of thirty-nine (39) customer complaints on Mr. Dulin’s Central Registration Depository records – forms U4 and U5.

The hearing lasted twenty-one days and involved two experts, Dr. Craig McCann and Terry Ormsbee, and thousands of exhibits. The theory of the case focused on the knowledge of UBS compliance officers and managers at the time the products were sold in 2007. UBS attempted to assert that its compliance officers and managers were unaware of the instability of Lehman Brothers and the risks associated with the Structured Products. Nevertheless, Seth Lipner, counsel for Mr. Dulin, was able to show UBS’s knowledge of the failings of Lehman Brothers in 2007 through his examination of UBS employees and presentation of documentary evidence. [The original version of this post incorrectly identified Mr. Lipner as a witness in the proceeding. The IRC apologizes for any confusion caused by the incorrect information in its original post.] Mr. Lipner was further able to present evidence of UBS’s express decision to not cause any panic amongst the brokers by not informing them of this information. Shockingly, UBS compliance officers and managers did not correct any misunderstandings even after the broker in question communicated his misunderstanding via e-mail.

The evidence established that the compliance officers and managers did not understand the product and did not understand the implications of their actions. These misunderstandings were transferred onto the customers by providing them with inaccurate sales materials and free writing prospectuses. The decision to remain mute as to the risks led to dozens of customer complaints and millions in losses.

Mr. Dulin asserted the following causes of action: Intentional Interference with Business Expectancy, Injurious Falsehood, Breach of Contract, and Violation of Arizona Securities Statutes and Regulations. The hearing resulted in an award for the broker of $4 million in compensatory damages, $1 million in punitive damages, $250,000 in attorneys’ fees, $85,000 in costs, $52,000 in arbitrator fees. The panel even recommended the expungement of all thirty-nine (39) of the customer complaints against the broker.

Investors Eager for Puerto Rico’s $70 Billion Debt?

By Fernando Langa

The Puerto Rican economy has significantly suffered because of the territory’s $70 billion debt.  The debt has constrained the island, which has been in recession since 2006, crimping tax revenue and pushing the jobless rate well into double digits.

Rating agencies have reacted to the territory’s economic crisis.  On February 2014, Standard & Poor, Moody’s, and Fitch downgraded Puerto Rico’s debt to junk status.  Standard & Poor believed that liquidity constraints did not warrant an investment grade rating.  Puerto Rican officials and market analysts believed that Puerto Rico would face significant challenges in obtaining any type of investments because of the economy’s inability to portray any type of recovery.

However, on March 11, 2014, Puerto Rico issued $3.5 billion of general-obligation bonds and received more than $16 billion in orders.  Hedge fund managers who received half the amount they requested considered themselves lucky.  Market advisors believe that the fears of widespread default are misplaced.  Moreover, these bonds are tax-exempt and are yielding at 8.73%, which is double the rate of general municipal bonds. Since the last quarter of 2013, Puerto Rico has implemented measures that have already had an impact on the economy: increasing retirement age, raising taxes, and cutting bonuses for public officials.

FINRA is currently examining the trading and demand for these bonds.  The prospectus for the bonds states that the debt would be issued in minimum denominations of $100,000 unless Puerto Rico’s credit rating was upgraded.  However, recent activity shows that the bonds are trading in denominations as low as $5,000.  FINRA fears that these bonds, which are junk-rated, are currently being sold to individual investors as safe, conservative investments (which they are not).

Because Puerto Rico is relying on the credibility and success of these bonds to improve its credit rating and attract investors to its territory, it will be quite unfortunate if FINRA finds some type of violation in the trading of these bonds.