California Securities Fraud Lawyer Blog

Here is a bit of good news for investors with securities arbitration claims against 14 of the largest brokerage firms, including Merrill Lynch, Morgan Stanley Smith Barney and Wells Fargo. The Financial Industry Regulatory Authority (FINRA) has agreed to extend its year-old pilot program established to give investors the option to request an arbitration panel composed entirely of arbitrators that are not affiliated with the securities industry. Currently, a 3-person arbitration panel must include one industry arbitrator and two public arbitrators. The pilot program was created in response to criticism over whether an industry arbitrator, such as a stockbroker or branch manager, can act impartially when a customer is complaining about securities fraud or account mismanagement by their broker. I've participated in arbitrations with both good and bad industry arbitrators. The trouble is, allowing an industry arbitrator to sit on a panel gives the appearance of bias and takes away from the legitimacy of the proceedings. That should be reason enough to dump the industry arbitrator. My California securities law firm is in favor of the pilot program and we have been actively encouraging clients to participate whenever possible.

The brokerage firms who have agreed to participate in the pilot program are:

Ameriprise Financial Services
Charles Schwab
Chase Investment Services
Citigroup Global Markets
Edward Jones
Fidelity Brokerage Services
LPL Financial
Merrill Lynch
Morgan Stanley Smith Barney
Oppenheimer
Raymond James
TD Ameritrade
UBS Financial Services
Wells Fargo Advisors / Wachovia Securities

Each of the above firms has committed to participate in a limited number of cases under the program on a first come, first served basis. The pilot program will end on October 5, 2010. Since the average arbitration hearing takes 14 ½ months to conclude, most cases in the pilot program have not gone to hearing yet. FINRA plans to compare the results of the pilot program cases with non-pilot cases. Of the 396 arbitration cases that have been decided this year, only 139 (45%) recovered anything at all. Hopefully, the arbitration award results for cases in the pilot program will be much better. If the pilot program results in more awards in favor of customers, will the brokerage industry lobby to keep the industry arbitrator? Let's hope not.

Before discussing the Financial Industry Regulatory Authority's (FINRA's) latest action against Merrill Lynch and UBS, I want to share a related story about a client at my San Mateo, California, securities law practice who had invested a substantial part of her portfolio in a Closed-End Fund (CEF) that, unknown to her, was purchased as part of an Initial Public Offering (IPO). The client, who had recently been widowed, had made a large deposit in her brokerage account following the sale of her deceased husband's business. Needless to say, the widow wanted to proceed cautiously and preserve her capital. Unfortunately for the widow, the broker did not share with her the "dirty little secret" about investing in CEFs:

This came as a shock to the widow, but it is a well known fact within the industry and is supported by a large body of research going back over 20 years. The reason is simple. CEFs almost always trade at a discount to their Net Asset Value (NAV) in the secondary market. However, when an IPO is structured, the fund's offering price is typically set at or above the NAV. Thus, the fund's price usually plunges after the IPO when the shares begin trading in the secondary market. See e.g., Lipper Research Report, "Buying a Closed-End Fund Initial Public Offering: Caveat Emptor!" (November 8, 2004)

The moral of the story is, never be in a hurry to invest in a newly launched CEF. By waiting several months after the IPO, an investor can purchase the fund at a discount and avoid paying an underwriting charge. The only way to conceivably benefit from buying a CEF at the IPO is to hold onto it for a period of time that is long enough to recoup the higher price paid at the IPO.

Back to FINRA's Recent Action Against Merrill Lynch and UBS

As part of the settlement with FINRA, Merrill Lynch and UBS consented to FINRA's findings that the brokers had earned high fees through short-term trading of CEFs by recommending that their clients invest in CEFs at the IPO and sell them a few months later, usually at a loss, so that the proceeds could be invested in yet another CEF-IPO. FINRA determined that both Merrill Lynch and UBS failed to adequately supervise, monitor and detect the broker's improper activities. Without admitting any fault, Merrill Lynch and UBS agreed to pay fines of $150,000 and $100,000, respectively. They also agreed to repay a total of $5 million to victims that were identified during the investigation.