III.    The Economics of Investing/Modern Portfolio Theory.

Modern Portfolio Theory is really not so modern. Harry Markowitz introduced the terminology in 1952. Thirty-eight years later, he shared a Nobel Prize with Merton Miller and William Sharp for the Broad Theory For Portfolio Selection that has come to be summarized under the description of Modern Portfolio Theory. Through the years, the validity of Modern Portfolio Theory has been demonstrated again and again by academic studies. Every year, sixty to seventy percent of actively managed mutual funds fail to reach their target unmanaged benchmark. See Barton Malkiel, "A Random Walk Down Wall Street" (1973). When expert stock pickers have contests against people or chimpanzees throwing darts at the Wall Street Journal, the dartboard almost always wins.

I analyze Modern Portfolio Theory into three basic principles. The first is that there is an invariable and inverse relationship between risk and return. To get a higher return, you must take a higher risk. If any investment professional or scam artist tells you or your client that his investment will provide a higher than average return at a lower than average risk, he is lying.

The second basic principle is that the actions of the stock market are random and no one can predict them. Sixty to seventy percent of managed mutual funds under-perform their target unmanaged index every year. Almost no one outperforms his or her target index over an extended period of time.

The third basic principle is diversification. How you deal with the randomness and the invariability of the risk return relationship is to diversify your assets widely. Diversify among asset classes (stocks, bonds, cash, real estate). Diversify within asset classes (large cap, mid cap, small cap in stocks, different maturities and credit quality for bonds). Diversify among industry groups and internationally.

If you succeed in properly allocating and diversifying your assets, when some assets are going down, others will be going up. The secret of successful long term investing is never to have your assets so decimated by a downturn that you have no assets left to invest and cannot benefit when the market turns around.

The U.S. and world economies are growing. The basic assumption of an investment plan based on modern portfolio theory is that this growth will continue. This growth is not linear, however. There will be down years and sometimes a series of down years in any specific market. The secret of long-term success is never to have all of your eggs in the same basket, but to invest in all of the baskets in a disciplined way. That enables you to take advantage of the power of dollar cost averaging. You will always be buying more of the lower priced investment than you are of the high priced investment. That is how you buy low and sell high without knowing what is going up, what is going down or when anything will happen.

IV.    Where Things Go Wrong for Investors.

4.1    Early Retirement Scams.

Unfortunately for many seniors, there is a provision in the Internal Revenue Code that allows a retiree to take distributions from his IRA before he reaches the age of 59 ½. To qualify for this provision (called 72t), the investor must commit to take and then actually take a fixed amount from his IRA every year. Investors who are approaching retirement are often targeted by brokers and insurance agents and invited to free investment seminars. Tragically, employers often sponsor these seminars. In some cases, the broker encourages investors to take some or all of the following actions: (1) retire earlier than they might otherwise have done; (2) opt out of the company's retirement plan and take a lump sum payment; (3) open a traditional IRA at the broker's firm; (4) invest the IRA in variable annuities, equity index annuities, Class B mutual funds or other high commission securities that are substantially riskier than the fixed benefit pension they gave up.

The senior is often encouraged to go along with these recommendations by the broker's false promise that the investor can receive a higher monthly retirement income than he would under his pension plan and can grow the investment with little or no risk. As a result of this type of bad advice, many investment professionals have become millionaires and many seniors have lost their entire nest egg.

4.2    "Free" Lunches, Dinners and Seminars.

Smart financial service professionals know their target market. Most of the investable wealth that they can get their hands on belongs to seniors who are getting ready to retire or are retired. Many seniors are, understandably, nervous about this new responsibility and uneasy about their competence for that responsibility. They are thus very susceptible to the influence of someone who can persuade them that he or she has an easy answer to their concerns.

For this reason, and because many seniors are lonesome for the interactions of the workplace that they have recently left, the idea of a "free" meal or seminar at which they can become better educated on retirement investments is very attractive. What the seniors do not know, and often do not realize until it is too late, is that the whole purpose of this get together is to lock them in a room, lower their defenses with good food and wine, and hot box them. The investment seller has no agenda to provide appropriate education. He has something to sell, and the entire presentation is designed to lead the senior down the primrose path to concluding that the investment for sale that night is the answer to all of his problems.

4.3    Unsuitable Recommendations and Investments.

For seniors who put their wealth into brokerage accounts, there are a number of pitfalls. They are all deviations from the basic modern portfolio theory principles of diversification and allocation.

Many brokers fall in love with a stock or a class of stock and overload their customers' portfolios with it. Often, the brokerage company is pushing the individual representatives to sell a stock or class of stocks for the brokerage firm's benefit, such as to support an initial public offering until they can sell out the insiders at a profit. In any case, brokerage accounts often get overloaded with an excessive concentration in one or two stocks or one asset or industry class. This leads to complete disaster rather than a minor setback when that stock or asset class goes into a tailspin.

Another favorite type of security for brokers that is almost always bad for investors is options. What is so good for the broker and bad for the investor about options is that they regularly and periodically expire, and the money must be reinvested, thus earning the broker an additional commission. Another problem with options is that they are highly leveraged. Some option transactions can create risks that are hundreds of times the size of the transaction.

Another great risk that is often seen in seniors' accounts is margin. It is possible to borrow up to 50% of the value of a portfolio to buy more stocks. The brokers love it when customers do that. Not only do they earn an interest spread on the margin balance, they also get to buy and sell twice as many stocks. If the account is fee based, they have an asset base that is twice as big against which to charge their percentage fee.

Mutual funds, though they should be a core investment of any properly diversified portfolio, can also be abused. Problems with commissions, expenses and B-Shares have been discussed above. The other problem that we often see with mutual fund portfolios is that all of the mutual funds in the portfolio are buying the same stocks. Thus, the mutual funds become a vehicle for over-concentration, not for proper allocation and diversification. Over-concentration inevitably, sooner or later, leads to precipitous and disastrous losses.

Variable annuities and other insurance products are almost always wrong for seniors. Funds that the senior might need because of an illness or other unanticipated event are available only by paying exorbitant redemption fees. While the funds continue to be held in this investment, the myriad of fees and charges are bleeding it to death by a thousand cuts. To try to make up for this, the advisor almost invariably recommends an excessively risky underlying investment portfolio. All of this is a recipe for disaster at the first market downturn.

For commission compensated brokers, a common abuse is excessive transactions. In a brokerage account, this is called churning. Churning is trading that is excessive in amount for the investment objective of the account. Index mutual funds typically have a turnover ratio (total purchases divided by net account equity) of .25 or less per year. Actively managed funds seldom significantly exceed 1.0 turnover per year. Any amount of trading in excess of two times per year is highly suspect. Turnover in excess of six times per year is presumptively churning. On the mutual fund and insurance products side, the same sin is committed by brokers persuading their customers to redeem one mutual fund or variable annuity (and often have to pay a redemption fee) and use the funds received from the redemption to buy another mutual fund or annuity. The purpose of such a switch is, typically, to earn an additional commission.

Another sure sign of investor abuse is unauthorized transactions. A broker cannot legally execute a transaction in a customer's account without express advance approval from the customer of that specific transaction unless that broker has a written discretionary authorization from the client. These authorizations are usually in the form of a power of attorney. Most customers do not understand this and tolerate their broker's trading in their account without authority, or even think that is what brokers are supposed to do. The broker knows better. If he is violating this rule, he or she is probably violating his or her customer's interest in other ways.

Another wrong that we often see committed by brokers is simply misrepresenting the risks or the potential rewards of an investment that they are touting. This will often be accompanied by misrepresentations of fact and suggestions that the broker has "inside" information about his investment. If your client reports a conversation like this with his broker, alarm bells should be going off.

Finally, let me address the concept of unsuitability. This is not a concept that is found in the securities laws or any SEC regulation. In its most basic form, it is embodied in the NASD Conduct Rule 2310(a) which states:

"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 to his financial situation and needs."

The rule then requires the broker to make a reasonable effort to obtain information about the customer's financial status, tax status, investment objectives and other information that should be considered in making recommendations to the customer.

In summary, the suitability rule says that there is no one size fits all investment. Each investment and each investment recommendation must be tailored for the specific financial needs and objectives of the customer. All of the broker misconduct mechanisms that I have discussed above are simply specific and common examples of brokers violating this suitability rule. There are a number of other ways that this rule can be violated. Particularly for those of you who are not trained, skilled and experienced in evaluating investment portfolios, I recommend this concept of "suitability" as your touchstone. If what the investment advisor or broker has been recommending to your client does not seem to you to be suitable to your client's needs, for any reason, further inquiry is warranted.

V.    What To Do If You Discover Financial Abuse.

5.1    Contact the Broker's Firm?

This is certainly a logical first thought. It is what the broker would like for you to do. It is what the NASD and the SEC urge you to do on their websites. It is, however, a communication that is fraught with peril.

Correspondence between the firm and the customer will be an exhibit at any contested arbitration or litigation. The customer almost always feels more responsibility for his demise than is justified, and that feeling is typically reflected in the letter to the brokerage firm. Brokers never pay more than a pittance in response to a letter from a customer. Brokers will use the letter writing process to deter the customer as long as possible from making a formal claim, hopefully until after the expiration of applicable statutes of limitations. This letter should be written only by an attorney who knows all of the tricks of the game, knows the buzz words to use and not to use, and knows how to craft this letter so that it will be an asset to the customer rather than a liability at the hearing.

5.2    Contact the SEC/SIRA/NASD?

I never do this. This simply creates another set of documents that the brokers can discover and use for their own benefit. They can find something in any document that they can twist against your client. The SEC and SIRA/NASD will not share any information with you, will not help you with your case and will not help your client. As much as I feel a public duty to turn in bad brokers so they can be kicked out of the industry, my primary duty is to my client. I believe I disserve my client by contacting any federal securities regulator.

5.3    Contact Your State Securities Commissioner?

This is a more complicated call than the federal agencies. State securities agencies sometimes exert significant pressure on securities miscreants to reimburse their victims as part of the settlement of the securities commissioner's enforcement case. If you have a relationship with your State Securities Commissioner or anyone in the office, they are much less rigorous than the Feds about withholding information that they learn in the course of their investigation. If you or your client has any political clout, the potential upside of getting the State Securities Commissioner involved probably outweighs the downside. If you do decide to contact your State Securities Commissioner, make sure that you control all of the communications. Otherwise, your client or some member of his or her family is very likely to create a record which is going to come back to haunt you.

5.4    Contact an Attorney Experienced in Representing Abused Investors?

This should be your first step if you have concerns that your senior client has suffered from investment abuse. We can tell you fairly quickly if you would be wasting your time and your client's money to pursue a claim further. If you are inclined to pursue a claim after the initial conference, we can guide you or take the entire responsibility from your shoulders. This is not an area of the law in which amateurs should be dabbling. Securities arbitration and litigation does not work like ordinary litigation, either substantively or procedurally.

VI.    How a Claim Proceeds.

6.1    Client Intake.

The first step in developing an investment abuse case is a thorough inquiry into all information that your client and his or her family may have. Particularly important are the documents they can provide. This process often takes several weeks before an intelligent evaluation can be made about whether there is a case worth pursuing.

6.2    Case Investigation and Evaluation.

In today's world of the Internet and instantaneous communications, a treasure trove of valuable information is publicly available. This information should be gathered and evaluated before anything public is done with the claim.

6.3    Demand Letter to Broker.

There are good attorneys in my area of practice who never write such a letter. I almost always do. The principal exception would be if the running of a crucial statute of limitations were imminent. In that case, I very well might contact general counsel for the broker and ask for a tolling agreement.

I find a demand letter sometimes results in the receipt of information that is valuable to me in the future. The responsive letter from the broker, or the broker's failure to respond, are always good evidence of the broker's bad faith when you get to the hearing and are asking for attorneys' fees. The letter to your client's broker must be written extremely carefully, though, or your demand letter will wind up being much more valuable to them than their response is to you.

I typically give the broker thirty days to respond. Almost without exception, someone in the broker's compliance department or legal department or outside counsel will contact me on day 29 and ask for an additional thirty days. Almost without further exception, nothing happens in the next 30 days, and we must follow up with the broker and demand a response. Sometimes this gets a response. Sometimes it doesn't.

The response, if and when it arrives, is inevitably a denial of liability and an explanation of the broker's position as to why it has no liability. Knowing what the broker's position is in advance can be very helpful in drafting a claim to initiate a formal legal proceeding.

6.4    Selection of Forum.

The first bad news in this area is that your client has in all likelihood signed an agreement to arbitrate any claim against the broker. Almost without exception, the courts will and regularly do enforce these agreements.

Even if there is no agreement, court is often a bad place to be with a customer claim against a broker. The brokers' attorneys are experts at motion practice and discovery. They can turn a court case over a $100,000 claim into a $200,000 attorneys' fee endeavor for the claimant's counsel very quickly. If you get through all of their motions and wind up in court, the decision may be made by a jury of twelve people who have never had two nickels to rub together and view both your client and the broker in the same category of "rich people." So much complexity has developed in the securities laws through seventy-five years of litigation that the instructions the court must give to the jury would be incomprehensible to most law school professors. Except in the rarest of cases, or when there is no way to get the case into arbitration, I usually opt for arbitration.

The number of available arbitration forums was reduced to one by the recent merger of NASD and NYSE. The only available arbitration venue is now the forum sponsored by SIRA. They have a brand new set of rules and are now without competition. There are a lot of things not to like about the SIRA arbitration forum and process. But as the gambler responded when asked why he kept losing at the local roulette wheel that he knew was rigged, "It's the only game in town."

6.5    Expectable Outcomes.

The good news is that historically, seventy to eighty percent of all filed arbitrations settle. This does not mean, by any stretch of the imagination, that your client gets his or her investment losses back. The broker's first offer will almost always be less than the cost of defense. The broker's negotiating range will be a percentage of your client's net out-of-pocket loss. Out-of-pocket loss is almost never the damages computation that the claimant will want. Cases get settled in this area for the same reason they get settled everywhere. The parties are willing to take a resolution that is less favorable than they think they would get if they went to trial in order to avoid the risk, expense and unpredictability of a trial.

Of the cases that go to decision (called an "award") in NASD arbitration, the historical figures are that 60% of the claimants win something and on the average, they win 60% of what they request. Recently, those statistics have gone badly downhill for claimants. In the past several years, according to an analysis recently done by one of the nation's premiere arbitration attorneys and his expert economist, the statistics are more like 40% of claimants win something and, on the average, they win 20% of what they are asking for.

My analysis of the reason for this change in fortunes is:

(1) The historical 60-60 figures included a lot of very large successful claims against really schlock brokerage houses that promptly went out of business without paying the arbitration award. In terms of realistically collectable awards, the historical figures are probably more like 50-40.

(2) The second reason for the change is the market crash of 2000 to 2002. This had two effects on the arbitration system. First, it brought in a flood of cases, many of which were bad cases where the culprit was the market, not the broker. The second factor is that this market crash brought in a flood of new attorneys, largely personal injury and mass tort attorneys, who did not understand or have any experience in securities arbitrations. They thought they were going to rush in and make a quick buck in this area. They learned otherwise, much to their dismay and to the distress of their clients.

6.6    Prospects for the Future.

My predictions for the future are:

(1) Good and relatively small cases (under $500,000) will continue to settle once the brokerage firm is convinced that the claimant and the claimant's attorney are prepared to try the case;

(2) Big cases (over $1M) will continue to have to be tried and there will continue to be a lot of disappointing "wins" in which the investor receives an award of only a fraction of his or her actual losses;

(3) Averages will trend back toward 60-60; and

(4) Good attorneys with good cases will continue to get consistently good results.

As I trust you understand, it was beyond the aspirations of this brief article to make life care planning law attorneys into securities arbitration lawyers. The goal of this presentation is much more modest. I hope that with this information, you will be able to recognize when your client has been financially abused by the financial services industry and will be in a better position to work with your client and his or her family to decide whether and how to proceed to recover some or all of the damages that have been inflicted.

Copyright 2007. Not to be further reproduced without written consent of the Author.

Click here to view this article in PDF