Winning market-adjusted damages for investors using the FINRA forum

Market-adjusted damages are an accurate and fair measure of compensation when an investor loses money due to a broker’s strategies that are inconsistent with the client’s objective

Philip M. Aidikoff
2016 April

Investors open accounts with brokerage firms to increase the value of their principal in a manner that is consistent with their time horizon, investment objectives, and risk tolerance. It is logical for a client to seek and recover market-adjusted damages when a brokerage firm recommends securities or pursues strategies that are inconsistent with the client’s objectives.

Market-adjusted damages utilize industry benchmarks to compute what an investor would have received had the portfolio been invested properly. These damages compensate an investor for losses caused by wrongful conduct in both a rising and falling market by adding or reducing return according to the actual performance of the market. (This type of damages is known by various names, including “properly-managed account damages,” lost-profit damages, and others.)

This article discusses how an award of market-adjusted damages should be pursued through the forum of the Financial Industry Regulatory Authority (FINRA is a private corporation that acts as a self-regulatory organization). This will include a review of FINRA guidance, case law, and practical application. This article will show why market-adjusted damages are an accurate and fair measure of compensation that appropriately reflects the harm caused to the investor adjusted for actual market performance.

Asset allocation and diversification

A review of historical data and empirical studies provides strong support for the contention that the asset-allocation decision is a vital component of the portfolio-management process. In fact, it has been recognized that, “the most important part of [investment] policy determination is asset allocation.”(Bodie, Kane & Marcus, Investments, (6th ed. 2005), p.946.) Studies have demonstrated that 90 percent or more of the performance in an investment portfolio returns are driven by the asset-allocation decision.

Courts have recognized that a brokerage firm can manage the inherent risk of the market through asset allocation amongst negatively-correlated asset classes and diversification within each class. (See, e.g., Liss v. Smith (S.D.N.Y. 1998) 991 F.Supp. 278, 301 [recognizing a private cause of action for failure to diversify].)  Stockbrokers have been held to owe fiduciary duties to their clients, including the duty to make full and fair disclosure of all material facts, regardless of whether or not an investor is sophisticated or unsophisticated (Duffy v. Cavalier (1981) 215 Cal.App.3d 1517, 1533.) Brokers and brokerage firms also have an independent duty to investigate securities to determine whether they are consistent with a client’s investment objectives and risk tolerance. (See, e.g., Hanly v. Sec. & Exch. Comm’n (2d Cir. 1969) 415 F.2d 589, 595-96.)

A brokerage firm that fails to invest a customer’s portfolio with an appropriate asset-allocation may be held responsible for a breach of duty. This conduct may also constitute a failure to comply with the standard of care in the financial services industry.

FINRA Guidance on awarding market-adjusted damages

FINRA recognizes the importance of asset allocation and managing investment risk:

In big-picture terms, managing risk is about the allocation and diversification of holdings in your portfolio. So when you choose new investments, you do it with an eye to what you already own and how the new investment helps you achieve greater balance. For example, you might include some investments that may be volatile because they have the potential to increase dramatically in value, which other investments in your portfolio are unlikely to do.

Whether you’re aware of it or not, by approaching risk in this way – rather than always buying the safest investments – you’re being influenced by what’s called modern portfolio theory, or sometimes simply portfolio theory. While it’s standard practice today, the concept of minimizing risk by combining volatile and price-stable investments in a single portfolio was a significant departure from traditional investing practices.

In fact, modern portfolio theory, for which economists Harry Markowitz, William Sharpe, and Merton Miller shared the Nobel Prize in 1990, employs a scientific approach to measuring risk, and by extension, to choosing investments. It involves calculating projected returns of various portfolio combinations to identify those that are likely to provide the best returns at different levels of risk.

(FINRA, Managing Investment Risk, Modern Portfolio Theory, available at http://www.finra.org/Investors/SmartInvesting/AdvancedInvesting/ManagingInvestmentRisk.)

Additionally, in explaining different remedies available, the FINRA Dispute Resolution Arbitrator’s Guide recognizes that well-managed account damages (i.e., market adjusted damages) can be awarded: “This measure of damage allows the claimant to recover the difference between what the claimant’s account made or lost versus what a well-managed account, given the investor’s objectives, would have made during the same time period.”

(FINRA Dispute Resolution Arbitrator’s Guide, February 2014 Ed., pg. 63, available at http://www.finra.org/web/groups/arbitrationmediation/@arbmed/@arbtors/documents/arbmed/p009424.pdf.) FINRA’s well managed portfolio remedy is consistent with FINRA’s “know your customer” and “suitability” rules:

  • Rule 2090. Know Your Customer

Every member shall use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer and concerning the authority of each person acting on behalf of such customer.

  • 2111. Suitability

(a) A member or an associated person must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile. A customer’s investment profile includes, but is not limited to, the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation.

(FINRA, Rules 2090 and 2111, available at http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=9858.)

Case law awarding market adjusted damages

For years, courts have explored awarding market-adjusted damages in securities cases involving churning and unsuitable portfolios. The accepted practice in those cases is to calculate damages based on net economic loss or market indexing (such as the Barclays Aggregate Bond Index, Vanguard Total Bond Fund, S&P 500, Dow Jones Industrial Average, or similar benchmarks), regardless of whether state or federal law applied.

The Second Circuit provided a road map for calculating damages using market indexing in Rolf v. Blyth, Eastman Dillon & Co., Inc. (2d Cir. 1978) 570 F.2d 38, 49.   In that case, an investor (Rolf) brought an action against his broker and the brokerage firm seeking damages for stock market losses. Rolf’s long-term advisor retired and his account was reassigned to a broker and an investment advisor who would collectively manage his accounts. Rolf’s long-term investment goals and strategy emphasized preservation and growth of capital, for which he executed an authorization giving his broker full trading authority. Over the course of a year, the value of his investor’s portfolio dropped by approximately 70 percent as the result of purchasing risky securities.

The district court held the broker and brokerage firm liable, but limited the damage award and failed to take into account – market adjusted damages. The broker and brokerage firm appealed the decision and Rolf cross-appealed the district court’s measure of damages.

The Second Circuit affirmed the broker and brokerage firm’s liability and remanded the damage calculation to the district court. Its opinion disagreed that the damages should be limited to those arising in a churning case (i.e., commissions). It articulated the following guidelines for the district court to follow when calculating damages on remand:

First, the district court should determine as near as possible the time when [the broker] began to aid and abet [the investment advisor’s] fraud and compute the market value of [the investor’s] portfolio on that date. Second, the district court should subtract the value of the portfolio on the date when [the broker’s] participation in and assistance to the fraudulent scheme ceased from the value on the date when [the broker] became and aider and abettor. This amount is [the investor’s] gross economic loss. The district court should then reduce [the investor’s] gross economic loss by the average percentage decline in the value of the Dow Jones Industrials, the Standard & Poor’s Index, or any other well recognized index of value, or combination of indices, of the national securities markets during the period commencing with [the broker’s] aiding and abetting and terminating with its cessation.

(Id., 570 F.2d at p. 49, citations omitted.)

The court also acknowledged that the use of the market indices does not hold the broker and brokerage firm responsible for the general decline in the market. It explained that even if the portfolio had not been mismanaged, it would have declined in value during the period where the defendants were liable because there had been a “bear market” during that period.

Shortly thereafter, in Miley v. Oppenheimer & Co., Inc. (5th Cir. 1981) 637 F.2d 318, 318 abrogated by Dean Witter Reynolds, Inc. v. Byrd (1985) 470 U.S. 213, the Fifth Circuit approved the market- adjusted damage calculation utilized in Rolf. The court found that the investor was “entitled to recover the difference between what he would have had if the account had been handled properly and what he in fact had at the time the violation ended with the transfer of the account to a new broker. (Id., at p. 327.)

The Ninth Circuit adopted the Miley analysis for market-adjusted damages in churning cases in Hatrock v. Edward D. Jones & Co. (9th Cir. 1984) 750 F.2d 767, 773-74:

[W]hen a securities broker engages in excessive trading in disregard of his customer’s investment objectives for the purpose of generating commission business, the customer may hold the broker liable for churning without proving loss causation. The investor may recover excessive commissions charged by the broker, and the decline in value of the investor’s portfolio resulting from the broker’s fraudulent transactions. The recoverable decline in portfolio value is the difference between what [the plaintiff] would have had if the account ha[d] been handled legitimately and what he in fact had at the time the violation ended. The finder of fact must be afforded significant discretion to choose the indicia by which such an estimation is made, based primarily on the types of securities comprising the portfolio.

(Id., at pp 773, 773, citations, and internal quotation marks omitted.)

Practical application

Consistent with FINRA guidance and the law, arbitration panels have recognized and awarded market-adjusted damages in asset allocation cases as well as product cases. But it is important to note that many FINRA panels do not describe the award as market-adjusted damages. Rather, the awards reflect a compensatory damage amount in excess of net out-of-pocket damages but based on a market-adjusted calculation.

Before filing a Statement of Claim, it is useful to have a profit-and-loss analysis prepared that includes market-adjusted comparisons (i.e., appropriate asset allocation percentages modeled to determine how a properly managed account would have performed). Broad indices as proxies for both fixed income and equities might include the Barclays Aggregate Bond Index, Vanguard Total Bond Fund and the S&P 500 Index. This provides the practitioner with an understanding of damages and damage defenses that a brokerage firm might plead in an answer. By incorporating the damage analysis into the Statement of Claim it alerts the brokerage firm that the claimant will be seeking market-adjusted damages at the hearing. 

Additionally, it is imperative to propound relevant document requests during the discovery phase of the arbitration. This allows the practitioner the opportunity to adjust the initial profit-and-loss analysis upon receipt of further responsive models and other documents. By way of example, the following categories of documents should be requested:

  • All income and/or growth asset allocation models prepared or used by Respondent;
  • All conservative, moderate and speculative investment asset allocation models prepared or used by Respondent;
  • All documents which mention, relate or pertain to how the Investment at Issue or investment strategy was marketed to Claimants;
  • All documents which concern the suitability of securities purchased on Claimants’ behalf by Respondent; and
  • All documents which concern any research of securities undertaken in connection with any transaction in the Accounts.

In presenting market-adjusted damages at the arbitration hearing, courts have recognized that expert opinions on market-adjusted damages help to reduce speculation. It is important to explain to the panel that market-adjusted damages are based on historical data (i.e., benchmarks) and therefore are not the product of speculation or guesswork.

Asset-allocation cases that have awarded market-adjusted damages typically involve an over-concentration in equities that was inconsistent with the client’s risk tolerance and investment objectives. By way of example, in the case of an elderly client who had conservative investment objectives which included principal protection and a need for income, an 80 percent fixed income/cash and 20 percent equities allocation might be appropriate to evidence what the portfolio should have earned over the same time period.

Product cases that have awarded market-adjusted damages have included a security that Citigroup sold to its clients as a fixed income alternative that would generate tax-free returns between 6-9 percent. In truth, the security was high risk and speculative. In their presentation to clients, Citigroup brokers failed to disclose, inter alia, the high risk and speculative nature of the security to its clients, continued to misrepresent the product and continued to mismanage the security until its implosion in 2008. Again, since Citigroup represented the security as a fixed income alternative, a 100 percent fixed income proxy was a consistent bench mark to establish market-adjusted damages.

Conclusion

Market-adjusted damages are an accurate and fair measure of compensation that appropriately reflects the harm caused to the investor adjusted for actual market performance.

Reprinted with permission of Public Investors Arbitration Bar Association, Norman, Oklahoma (2015) by Philip M. Aidikoff, Robert A. Uhl, Ryan K. Bakhtiari, and Katrina M. Boice, Market Adjusted Damages, PIABA B.J., Vol. 21, No. 2 (2014)

Philip M. Aidikoff Philip M. Aidikoff

Philip M. Aidikoff is a partner in the law firm of Aidikoff, Uhl & Bakhtiari and exclusively represents clients in securities arbitration and litigation. He is a Past President and Director Emeritus of the Public Investors Arbitration Bar Association. He served a five-year term on the National Arbitration and Mediation Committee of FINRA (formerly the NASD). He served as one of three public members of the Securities Industry Conference on Arbitration (ASICA). Mr. Aidikoff was recognized annually as a 2005 to 2015 Southern California Super Lawyer.

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