FINRA to Level the Arbitration Playing Field

Five years ago, I sent a letter to Congress advocating the elimination of the so-called “industry representative” from investor arbitration proceedings administered by FINRA. Since then, I’ve written several op-eds and numerous blog posts on the subject in the hope that FINRA would eliminate the requirement that a representative of the securities industry sit on all investor arbitration panels. Today, FINRA announced a proposal to permanently give investors the option of “all-public” panels, finally freeing them from Wall Street’s influence.

FINRA’s decision will assuredly help level the playing field for investors. Previously, securities industry representatives tended to side with Wall Street and their fellow brokers. The practice was akin to suing your chiropractor and arguing your case in front of another chiropractor.

Needless to say, this is an important step, however, there are other improvements FINRA could make to the arbitration system as well. Such as, a more diverse pool of panelists that is more reflective of the U.S. population.

Also, arbitration proceedings shouldn’t be so secretive. FINRA should consider allowing observers into arbitration proceedings. If journalists or other watchdogs were allowed to attend, investors could see for themselves how brokerage firms mistreat their own clients and important precedents could be set.

Having said that, FINRA deserves credit for listening to investors and their representatives. To be sure, this is a win for individual investors.

Attending the NASAA Conference

This afternoon I was in Baltimore, Maryland attending the National American Securities Administrators Association (NASAA) conference, where I took  part in a panel discussion entitled “Guiding Investors Through the New Market.” My comments focused on a number of key investor issues including the need for a fiduciary standard, the lack of uniform federal regulation and the general failure of the Dodd-Frank bill.

I also highlighted the imbalance between state and federal regulation. While state regulators are taking a stand on behalf of investors against large financial institutions such as Bank of America and Citigroup, federal regulators have consistently remained asleep at the wheel.

I’ve submitted a more detailed position paper detailing these issues into the conference record.  You can view the document here.

Making a Mockery of Financial Reform

According to a recent New York Times report, the very same people that allowed investors to be exploited over the past decade at the SEC are being rehired by Wall Street to carve out loopholes in the Dodd-Frank financial industry reform bill. It’s what’s known as the “revolving door.”

Their objective is to water down the approximately 243 financial rules and 150 “studies” the bill calls for. Of course, this comes after the devastating influence Wall Street lobbyists have had on shaping the bill from its inception. It’s a one-two, knockout punch for investors.

A “fiduciary duty” standard for brokers probably doesn’t stand a chance even though its the one Dodd-Frank provision that affects nearly every investor. Dodd-Frank calls for the SEC to “study” what effect a broad application of the fiduciary standard for brokers would have. You can bet Wall Street lobbyists will work their former colleagues behind the scenes so that the new standard will only be applied in special circumstances, making it effectively meaningless.

The battle between financial regulators and Wall Street over Dodd-Frank will be a David versus Goliath story. Unfortunately, because of the revolving door, Goliath is getting bigger every day.

Merrill Lynch’s CDOs: The Thundering Herd Tramples Its Wealthiest Clients Yet Again

Individual investors who choose to do business with Merrill Lynch would be wise to take the time to read the complaint filed two years ago by Massachusetts regulators. They outlined, in impressive layman’s language, how the firm deceived its clients into believing that auction rate securities were safe, liquid, cash equivalent investments when in fact they were risky and illiquid.

“Time after time, when confronted with conflicts of interest, Merrill Lynch was consistent in that it placed its own interests ahead of its investor clients,” the complaint alleged.

An excellent compendium to that complaint was an article recently published by the Wall Street Journal about how Merrill brokers duped a bevy of the firm’s high net worth investors into buying high risk collateralized-debt obligations with assurances that they were also risk free.

“This was a great chance to participate with the big boys,” one client whose family lost millions because of Merrill’s CDOs recalls a broker as saying.

CDOs are indeed for the big boys and Merrill was the leading issuer of these toxic products.  But what Merrill clients clearly didn’t understand  — perhaps because they were never told — was that the CDOs they were buying were the lowest-rated slices; the higher rated slices were sold to more sophisticated institutional investors, the Journal says.

The Journal says that Merrill targeted investors with a net worth in excess of $5 million, and, therefore met the SEC standard of what constitutes a “sophisticated investor.”   That standard should have been altered long ago. For example, one of Merrill Lynch’s victims was a hair-salon entrepreneur - should someone who can leverage an expertise in shearing and coloring hair into a multi-million dollar business, automatically be qualified to evaluate highly sophisticated financial products?

Merrill’s defense is that the offering documents disclosed that the CDOs carried considerable risk, but that warning statement is contained in virtually every financial product the firm sells.  That’s why investors rely heavily on the representations made by their brokers.  And those representations will figure heavily into arbitration claims; if clients can prove that their brokers misled them, Merrill will likely need more of a defense than hiding behind it’s standard legal boilerplate.

Merrill ultimately was forced by the SEC to make whole the clients it fleeced with auction rate securities.  Buyers of CDOs likely have similarly strong claims and should aggressively pursue arbitration or court cases.  And investors who choose to continue doing business with Merrill should be wary of any product their brokers pitch that can’t be readily understood.  If a financial product sounds too good to be true, it probably is.

Double Dealing: How UBS Profited From Lehman’s Accounting Duplicity

One of the recurring themes of my blog posts is that it’s nearly impossible to orchestrate financial wrongdoing of significant magnitude without the complicity of major financial institutions. Banks and brokerage firms almost invariably put their financial interests ahead of their clients, and any investor who believes otherwise should take the time to read this complaint by Massachusetts Secretary William Galvin alleging fraud in connection with Merrill Lynch’s sale of auction rate securities.  While Galvin’s complaint relates to Merrill, the countless allegations about how that firm failed its customers are pretty typical of how Wall Street treats its clients.

The Lehman bankruptcy examiner’s report made public last week further documents how Wall Street firms are quick to aid and abet wrongdoing.  To dress up its balance sheet, Lehman engaged in a myriad of “Repo 105″ transactions, a financial legerdemain that allowed the company to raise cash by parking assets at rival overseas firms and booking the sham swaps as “sales.”   This accounting hocus pocus, while not permissible under U.S. rules, was deemed kosher in the UK providing that Lehman orchestrated repo transactions through its London-based subsidiary and with non-U.S. banks. The examiner’s report makes clear that the foreign banks that facilitated Lehman’s sham sales were very much aware of the firm’s “desperation” to create the illusion that it had significantly shed assets and reduced its leverage.  For those not well versed in accounting, allow me to explain in simpler but cruder terms about what transpired: About a half dozen foreign banks played an active role in helping Lehman put some heavy duty lipstick on a pig.

One of Lehman’s most active beauticians was UBS.  UBS reportedly transacted approximately $10 billion in Repo 105 deals with Lehman, likely garnering the firm tens of millions of dollars in interest payments relating to the sham sales.  But UBS had another reason to help Lehman deceive investors about its flailing financial health. During the period Lehman was orchestrating its “Repo 105″ transactions, UBS’s retail brokers were aggressively peddling to their customers a product deceptively known as Lehman Brothers “100 Percent Principal Protected Notes.”  Although UBS marketed these notes to investors as being “risk free,” they were in fact extremely risky unsecured IOUs whose repayment was entirely dependent on Lehman’s financial solvency.  UBS paid its brokers high commissions to sell the risky Lehman notes to unsuspecting investors, which explains why the sales force successfully unloaded more than $1 billion of the paper. When Lehman collapsed, its notes instantly became nearly worthless.

UBS’s sale of the Lehman notes was questionable even before the bankruptcy examiner’s disclosure.  New Hampshire’s securities regulator charged in a filing last June that UBS engaged in “dishonest and unethical” practices selling the Lehman notes, causing New Hampshire investors to lose $2.5 million. The North American Securities Administrators Association (NAASA) has said it was considering convening a task force on the Lehman notes, and it’s my understanding the SEC is also looking into the matter.  I recently won a significant arbitration award on behalf of a client in South Carolina who bought Lehman notes from a UBS broker; it was the first arbitration decision relating to UBS’s sale of Lehman notes, and my office has more than a dozen pending.

Rest assured, UBS is going to have to account for why it continued to aggressively market Lehman notes to retail customers as highly conservative investments while on the institutional side facilitating transactions that were designed to mask Lehman’s troubled financial condition.  Ernst & Young, Lehman’s auditor, also has some “accounting” to do; that firm, as it happens, also is UBS’s auditor.  It will be interesting to learn how UBS booked the assets that Lehman “sold” the firm.

Individual investors owe Lehman bankruptcy examiner Anton Valukas a tremendous debt of gratitude. His report lays out in painstaking detail Wall Street’s fundamentally dishonest ways and makes clear the industry cannot be trusted to regulate itself.  Individual investors also should note that in early 2007, the year Lehman began its financial shenanigans, Charles Schumer and Michael Bloomberg, respectively New York’s senior senator and Mayor, issued this report by McKinsey & Company saying that the U.S. markets were fast losing ground to the UK because they were overly regulated.  As Lehman’s “Repo 105″ transactions were only permissible in the UK and not the US, we obviously shouldn’t be looking to that country for a regulatory model worth emulating.

Ironically, a significant number of investors who bought Lehman notes from UBS reside in the UK.  Fortunately for them, they can file arbitration claims in the US to seek redress.

An Investor Litmus Test for the New Supreme Court

Did the addition of Supreme Court Justice Sonya Satamayor make the court friendlier to investors?  That question should be answered shortly as the Supreme Court decides the case of “Jones v. Harris Associates,” which could impact the 92 million Americans that own shares in mutual funds.  The legal issue the court will address is whether the excessive fees and expenses mutual funds charge is a violation of Section 36 (b) of the Investment Company Act (ICA) that says mutual fund advisors have a “fiduciary duty” with respect to compensation for their services.  The ICA also provides mutual fund investors with the right to file lawsuits if mutual fund advisors violate the law’s provisions.

While the decision itself focuses on this issue, there are broader practices which will also be exposed. Rules state that decisions regarding fees must be done by a board of independent directors.  But it’s not always clear what constitutes being “independent” for this purpose.

In this case, Harris Associates is the manager of several mutual funds including the flagship “Oakmark Fund.”  Investors claim that annual expenses have inappropriately increased as the fund grew larger. Indeed, the firm allegedly increased its expense charges from 1.05% to 1.1% of total assets.  Traditionally, mutual funds decrease expenses as they grow larger because they gain economies of scale.  Moreover, investors contend that Harris charged a smaller fee to large pension funds.

Investors in the Oakmark Fund allege that the expense charges were increased without a careful review by the supposedly independent board that oversaw the fund.  A major problem is that directors are paid by these expenses and routinely mutual funds have a “good ole’ boy” network of directors.  Harris Associates actually had former employees on their mutual fund boards.

Ideally for small investors, the Supreme Court will come down hard on Harris Associates and by doing so accomplish much for these investors.  Mutual fund directors would be more independent, and thus less likely to approve extremely high fees, while at the same time reinforce the fiduciary standard rule as defined by the ICA.

It’s an important decision for investors but it’s also a potential indicator of future decisions that will be of importance to investors.

Financial Regulatory Reform: The Good, The Bad, and The Ugly

Regulation of the United States financial system throughout its history could be described as disjointed…at best.  In response to the current regulatory framework, the administration presented its plan to overhaul the system with an emphasis on consolidating a fractured system of multiple regulators.  It is in no way a guarantee that fewer individual regulators will translate into better regulation, but investors should feel cautiously optimistic that they will be better protected once the plan is implemented.

Of course the devils in the details, however on the surface the following provisions look promising: improved hedge fund regulation, derivatives oversight, elimination of the Office of Thrift Supervision and the creation of an agency that will oversee financial products targeted at consumers.

Hedge funds have traditionally operated outside the regulators’ reach.  Unfortunately, it was only when hedge funds either collapsed or committed fraud that regulators got involved.  Because they now control such a huge swath of capital and are responsible for such massive trading volumes, hedge funds pose significant risks to the system.  Moreover, hedge funds are also big players in the commodities trading industry and have the capacity to impact food and energy prices.  Registration of these funds, which includes confidential disclosures about strategy and assets under management, would help regulators assess their stability and impact on the system.

Derivatives, to borrow Warren Buffet’s expression, are financial weapons of mass destruction.  Whether used to insure against losses, as an investment or as a hidden way to ramp up leverage, the use of derivative instruments needs to be controlled.  The new plan to introduce transparency into this opaque side of the financial industry is well overdue.  Exposure to these instruments, to recall, is what caused A.I.G. to collapse.

The elimination of the Office of Thrift Supervision will help guard against “regulator shopping.”  One central bank regulator makes a lot of sense.  And the creation of a special agency to oversee products targeted at consumers is certainly a good idea.  One concern however, is that this agency does not oversee securities sold to individual investors.  Rather, this new agency will focus on credit cards, loans and annuities.  As we’ve seen, Wall Street approaches the sale of securities in the same way the corner electric store sells microwave ovens; therefore they should be regulated as such.

Oversight of securities sold to investors remains with the SEC and FINRA.  While the SEC has made strides in the past few months, its ability to keep up with the mad scientists on Wall Street is questionable.  For example, the mass marketing of risky structured products such as reverse convertibles, principal protected notes and auction rate securities was left unchecked.  Individual investors were not adequately informed as to the risk of these instruments and ended up bearing the brunt of their losses while Wall Street earned fat commissions.

Increased responsibilities for the SEC should help in this regard.  The SEC will require more transparency and improvement in the timing and quality of disclosures regarding securities products and will be required to perform “field tests” to ensure investors understand the risks.  Perhaps the most important SEC-related provision is the establishment of a fiduciary responsibility for broker-dealers offering investment advice and to “harmonize the regulation of investment advisers and broker-dealers.”

Where the Plan Falls Short

Improvements, however, need to be made in the enforcement area.  It’s great to have more stringent regulations, but if Wall Street is allowed to ignore them and pay pithy fines it’s worthless.  The President’s plan supports ramped up efforts to ban crooked brokers and advisors from the industry, but seems to ignore the fines.  As I’ve written before, fines have become the cost of doing business on Wall Street.  They are viewed the same way as expenses for travel, office supplies and client entertaining.  This cannot continue.

Fines for wrong doing, especially when the accusations involve individual investors, should be damaging.  The multi-billion dollar auction rate securities debacle could have been prevented if Wall Street was more effectively policed when in 2006 regulators found impropriety.  Not only do fines need to be larger, they need to be felt, which is why instead of coming out of the general litigation budget, fines levied with regard to frauds committed against retail investors should come out of the bonus pool.  This is especially important for financial institutions that have received federal funds of late.  To pay a fine using tax payer money adds insult to injury.

There are undoubtedly areas of improvement, but like many investors, I’m cautiously optimistic.

What to Expect from Madoff’s Hearing

All reports indicate that Bernard Madoff will plead guilty tomorrow to orchestrating the largest Ponzi scheme in history. A plea bargain does not appear to be in the cards and this is a good thing because if there were any side deals or leniency of any kind, investors would be outraged.

Bernie Madoff will undoubtedly be put behind bars for, effectively, the rest of his life. I suspect about 20 years, but maybe more. The biggest question that remains is what will happen to his immediate family members and key employees of the firm. I would not count out jail time for immediate family members if they are implicated in any of the charges. Lest we forget, the wife of Andy Fastow, Enron’s CFO who pled guilty, served a year in jail as a result of the Enron scandal. Family members shouldn’t get a pass and I doubt they will if there was wrongdoing.

Though there appears to be no deal in the works, Madoff may get some leeway as to the prison in which he lives out the remainder of his life.  My guess is he’s hoping for a place closer to home and away from the most hardened criminals. But any leeway Madoff gets will surely be contingent upon any help he gives to prosecutors. He could be helpful in providing information about feeder funds and their complicity or knowledge of the fraud. Any money that can be recovered from the feeder funds to help make investors whole could help his cause as well. Madoff could also be helpful in indentifying overseas accounts which the SIPC trustee may not have found yet. I’m hopeful he will.

It’s likely that Bernie Madoff will be sent to prison tomorrow. However, that is unlikely to offer much comfort to his victims. 

But they should rest assured; Bernie Madoff will spend the rest of his life in jail. My hope is that all those involved in the largest Ponzi scheme in history be brought to justice and prosecuted. And further, that any money that can be recovered, is recovered and given back to investors who deserve it. I am confident U.S. prosecutors will do their best to accomplish this end.

Stanford Financial Scheme Uncovered

Well, it’s nearly official.  Another alleged fraud of massive proportions has been uncovered.Antigua, which claims to have $8.5 billion in assets and 30,000 clients in 131 countries.  The New York Times is reporting that the SEC has accused Mr. Stanford and two other executives and some affiliates of conducting a “massive ongoing fraud.”

There will no doubt be a steady stream of articles comparing the Stanford Financial case to that of Bernie Madoff, and indeed the similarities are striking.  Investors and depositors were lured in by very consistent, outsized returns. Bonuses were paid to brokers that seemed extremely high relative to the firm’s revenues.  Mr. Stanford was also a “pillar of the community,” in Antigua much like Mr. Madoff’s persona within the clubby world of Florida country clubs.

And perhaps most importantly for investors wanting to avoid exposure to alleged schemes, it is reported that neither Stanford Financial’s offshore bank nor its Houston-affiliate were registered as an investment company…a major red flag.

Based on reports, the Stanford Financial situation is also similar to another major white-collar scandal: that of Dennis Kozlowski, the former CEO of Tyco.  Both executives spent lavishly and conspicuously.  Among the Mr. Stanford’s reported expenditures are:

• A $20 million prize to the winners of a single Cricket match in a tournament in Antigua.
• A “gold-plated helicopter,” used to transport Mr. Stanford to said cricket match.
• “Millions” spent on a Caribbean airline that went quickly went bust
• A gold plated toilet seat on a private jet bearing a golden eagle: the logo of Stanford Financial Group.

In some ways, this might work to an investor or depositor of Stanford Financials advantage.  These assets could be used to pay back allegedly defrauded investors and depositors.  Also, part of the SEC’s complaint is that Stanford Financial falsely stated in marketing materials that client funds were placed in liquid financial instruments, when in fact they were invested in private equity funds and real estate.  These could be “hard assets” and also used to pay investors and customers back.

Madoff Securities Alleged Ponzi Scheme Exposed: What’s an investor left to do?

In a bull market, investors are happy and tend not ask many questions. But when times get tough, they start wanting answers and Ponzi schemes are inevitably discovered.

The latest, of course, involves Bernard Madoff, a fixture on Wall Street for decades and one of the creators of the NASDAQ exchange. Mr. Madoff is the founder of Bernard L. Madoff Investment Securities. He was arrested by Federal Bureau of Investigation agents and charged with criminal securities fraud by federal prosecutors in Manhattan. The SEC has shown up late to the party once again and filed a civil suit, years after they were alerted of suspicious activity at Madoff Securities’ investment arm. All told, the alleged Ponzi scheme totaled $50 billion, possibly half of which was investor funds.

Naturally, Bernard Madoff’s clients are wondering if there’s anything left, and if so, how they can get their money back. Some investors will have an up-hill road to travel but for others there are legal options they can immediately pursue.

Firstly, to the extent that there are any funds left, claims can be filed against Madoff Securities directly. But it’s unlikely that there will be any money left. “It’s all a lie,” Mr. Madoff told investigators who were there to arrest him.

And it is doubtful there will be any recourse through the Securities Investor Protection Corporation (SIPC) because the money management function at Madoff Securities was held outside of the brokerage unit.

But investors that were placed into the Madoff Funds through other “fund-of-funds” or by another hedge fund manager could have more maneuverability. Indeed, managers of fund-of-funds could have liability for failing to perform a reasonable amount of due diligence on Bernard Madoff’s dealings. They had an obligation to research Mr. Madoff, his firm, and his returns. Managers of fund-of-funds were compensated to do this and likely marketed their due diligence capabilities to their clients.

The red flags were very clear in this case. Perhaps the most compelling was the fact that Mr. Madoff was generating such high returns using a strategy tied to the S&P 500. And this was all happening while the overall market sank in 2008!

The magnitude of Mr. Madoff’s deception is astounding. And the destruction of wealth that has apparently occurred here is shockingly awful. But if there is a silver lining to this at all, it’s that during this economic crisis the unnecessary middle men, fraudsters, hucksters and Wall Street’s ugly underbelly are being exposed and eliminated.

While that is likely of no consolation to Madoff Securities clients and investors, rest assured, they will also have their day in court.