Customers who abuse the system, and harm their brokers.
These days, it seems that every major publication, and every television news show, has done, or is doing, a story on “rogue brokers” – brokers who care nothing about their customers, or their firms, or the regulations, and are solely concerned with the generation of commissions, at the expense of their customers.
Whether these brokers exist in any significant numbers in an industry with over half a million registrants is of little concern to these “news” sources, nor to the regulators. Each new wave of disclosures regarding unlawful conduct by a broker or a firm results in a new series of regulations designed to address the new “abuse” or the perceived dangers posed by these brokers.
Ed: This article originally appeared in the October 1997 edition of Research Magazine. The stories remain relevant, but some of the abuses addressed herein have been addressed.
In turn, each new series of regulations imposes new obligations and burdens on the remainder of the industry, making it more difficult to operate a brokerage business, without running afoul of a new regulation. However, one group has benefited from all of this increased scrutiny and regulatory burden. Rogue customers.
Yes, rogue customers. Customers who abuse the system for their own profit and benefit. Customers who send complaint letters, file regulatory complaints, commence arbitrations and start federal lawsuits, accusing their brokers of a wide variety of fraudulent activity, when the customer himself knows that the complaint is without merit. These are the customers who are taking advantage of the system, to the detriment of the system, and the financial burden of the industry.
The number of rogue customers is increasing at a dramatic rate, and shows no sign of decreasing, as the regulators and industry continue to ignore the problem, and, unintentionally, encourage them to abuse the system and the industry.
Encouragement of rouge customers comes in a variety of ways. The NASD and NYSE arbitration departments unintentionally encourage customers to file frivolous claims in a number of ways. First, in the manner that the decision is made as to where a hearing is held. In the court setting, a judge faced with the situation of a California customer suing a New York brokerage firm, will, pursuant to established guidelines from higher courts and the legislature, examine the facts underlying the case, and determine where the hearing will be held – in New York, or Los Angeles. This is not an insignificant decision, as one of the parties will have to bear the burden, and the expense, of traveling to a foreign city to conduct the hearings.
The NASD and NYSE however, have decided that every arbitration, regardless of the underlying facts, will be held in the city where the customer resides. This policy, which is not in writing, but which is well known by customers and their attorneys, is inviolate, and applied to every case, across the board. And because customers and their attorneys are aware of it, they are encouraged to file arbitrations of dubious merit, knowing that there is no chance that they will bear the cost of traveling, and that, regardless of the merit of the claim, the brokerage firm will have to give serious consideration to settling the case, given the extreme costs of traveling to defend themselves.
A customer in San Francisco has abused this rule time and time again. In November 1993, this gentleman, a retired real estate broker in his early 60s, had approximately 10 brokerage accounts. At that time, he opened an additional 18 accounts, all with small East Coast brokerage firms. Shortly thereafter, he began complaining to the firms, accusing his brokers of failing to execute a sell transaction, or a buy transaction, or of lying about a particular security. By 1995 he had filed complaints at 8 of those brokerage firms, with letters taunting the brokers and their managers, reminding them that they would have to come to California to arbitrate their dispute, and suggesting that they settle with him without arbitration. Most firms do settle with him, by paying him the costs of traveling to California, rather than bear the expense. I first ran into this gentleman in 1995, when my clients refused to accede to his demands and prevailed in an arbitration with him. Incredibly, I came in contact with him again this year, when he filed a claim against another of my clients, alleging, again, a failure to sell.
The Arbitration Departments also encourage the filing of complaints by, in many instances, completely ignoring any concept of fairness or due process (something that is required by our Constitution) during the course of the hearings. In the Los Angeles office of the NASD arbitration department, according to arbitrators and attorneys who practice there regularly, the customer is permitted to submit, at the start of the hearing, all documents that he wants to submit to the panel, without any consideration of relevance, and without any opportunity for the broker’s attorney to review or object to the documents. There is no testimony regarding the documents, no discussion or thought of the relevance of the documents, the customer simply makes copies of all of the documents he wants to present and gives them to the panel.
I had the misfortune of seeing this practice in action recently. The case was a simple case of a single unauthorized trade. The customer wanted to submit documents showing that the broker had been arrested for assault years ago, before he had become a broker, and well before the events in dispute in the arbitration. In a court setting, no judge or jury would ever hear of the arrest, as it simply had nothing to do with the dispute, and was not relevant. More important to the concept of fairness, it the prejudicial effect of such information would render it inadmissible.
Not so in a Los Angeles arbitration. The documents, along with other proposed exhibits, are handed to the arbitrators at the start of the hearing, without any discussion, or opportunity for objection. When an objectionable document is discussed by a witness, counsel has the opportunity to object, but he is doing so while the arbitrators are reading the document! While defenders of the practice will argue that arbitrators are professionals, and will not be swayed by such information in their decision, the simple fact is that arbitrators are people, who simply cannot “disregard” such information, and who cannot help but view an individual with an assault conviction in a different light, regardless of how remote in time the conviction occurred.
Again, customers, and their attorneys, are aware that arbitrators in California at least, will allow this information to be part of the arbitration record, before ever stepping into the hearing room. The practice bolsters customers who are filing frivolous claims, encouraging them to do so, knowing that such information will become part of the record, and either sway the arbitrators or force the brokerage firm to settle the claim, for reasons having nothing to do with the merits of the case.
One of the advantages of arbitrations is the ease with which they can be filed, and taken to hearing. With limited discovery and simplified hearing procedures, an arbitration claim can be filed, heard, and resolved in under a year. If the customer represents himself or uses an attorney who is retained on a contingency, there is virtually no cost for the customer in filing a claim, except for the filing fees themselves, which are less than $2,000, and in smaller cases, less than $500. This simplification, together with the absence of any possible sanctions against the customer for filing a frivolous claim, has in part caused arbitration claims to explode, and customers take a low-risk shot at recovering their losses.
Examples of this encouragement in action occur on a frequent basis. Recently I defended a broker in a case involving losses of $250,000 and involving allegations of misrepresentations, churning, unsuitability, and negligence. As the hearings approached, we learned more and more about the customer and the high level of his sophistication in the markets. During cross-examination of the customer, it became clear that he was a rogue customer, filing a claim in order to “take a shot”. That case settled in the middle of the cross-examination for less than the broker’s costs in finishing the case, but the matter remains on his U-4, and he paid money to a customer who simply had no legitimate claim, but who was taking advantage of the system.
In a recent arbitration, an extremely sophisticated day trader, who lost a significant sum of money in a failed attempt to short an extremely volatile NASDAQ stock, commenced an arbitration against the discount brokerage firm that handled his orders, claiming that the trades were unauthorized. During the course of discovery, he denied having any logs of his trading, but during the hearing, when it suited his needs, he produced those very logs. There was no penalty for not producing the documents during discovery but having a contemporaneous log of transactions in an unauthorized trading case is a significant advantage for a customer. When my co-counsel and I finally saw the logs, we noticed that some of the claimed unauthorized trades were reflected on the logs! We soon understood why he initially claimed he didn’t have such logs. They proved his claim had no merit, and that he too was a rogue customer. Apparently, he thought that he could keep the logs secret, deny they existed during discovery, and take advantage of the very system that is designed to be fair to public customers.
The abuse of the process by customers extends to the regulatory side of the industry as well. Customers have virtually no disincentive to file a complaint with a brokerage firm. It costs the customer nothing to file that complaint. For the broker, however, the complaint has an eternal effect – it stays on his public record, regardless of the merit of the complaint, for the rest of his career.
Rogue customers use this to their advantage. With no possible adverse consequences to them, they threaten to file complaints, knowing that the complaint is without merit, in the hope that the broker, or firm, will restore their losses in order to avoid a permanent mark on their record.
The practice of filing, or threatening to file, unwarranted complaint letters occurs all too frequently. However, the practice reached absurd highs last year, when a small broker-dealer, making markets in a handful of small-cap stocks, found itself in the midst of a bear raid. In one day, the value of the securities where it was the major market maker fell by over 50%. Amazingly enough, over the next few days, hundreds of customers claimed that they had called their brokers to sell their securities the day before the precipitous decline. Prior to these events, the firm had virtually no customer complaints, and the overwhelming majority of its brokers had clean U-4s. Suddenly, because of a one-day drop in the price of these securities, nearly every broker in that firm wound up with a serious complaint letter against him, alleging a refusal to accept a sell order. While mass hysteria at the brokerage firm might explain how this could occur, the existence of rogue customers is the more realistic explanation. The fact that less than 20% of the customers who filed complaint letters actually proceeded any further to an arbitration, further proves the point that these customers were filing letters in an effort to recover their market losses, regardless of the truth of what they were saying, or the damages that they were causing to their brokers.
Despite the increasing problems of rogue customers, little if anything is being done to curtail their activities. Rogue customers cause obvious harm to the brokers whom they deal with, but cause additional harm in that they consume resources of the regulatory agencies and the arbitration forums which could be better utilized to resolve and investigate, serious complaints by sincere customers.
Dealing with rogue customers is not something that can easily be dealt with given the existing regulatory climate and popular opinion. However, some changes must be made. First, the arbitration departments of the various exchanges must communicate to arbitrators that the concept of due process applies to arbitration proceedings. Documents and testimony cannot be read or heard by the arbitrators where a party objects unless the issues of fairness and relevance are at least addressed by the parties. Arbitrators must learn that they have an obligation to all of the parties who appear before them, not just the public customer. The parties are looking for a fair hearing, nothing more, and nothing less. Permitting testimony and exhibits that have nothing to do with the issues at hand, and are designed solely to sling mud at a party, does nothing to promote fairness, and only encourages other parties in future arbitrations to do the same.
Arbitrators must also be aware that they have the authority to force a rogue customer to pay damages to the broker or brokerage firm. Some arbitrators hesitate to punish a rogue customer, perhaps for fear of public opinion. However, while a damage award should be entered only where such damages are truly justified, such awards serve to put customers on notice that frivolous claims will not be tolerated, and that traditional defamation principles apply in arbitration just as they do in the rest of society. Ultimately, all participants in the process benefit from the removal of claims by rogue customers.
On the regulatory side, while the regulators must take all complaints seriously, and all must be investigated, the staff of the SROs must understand that there is a significant number of customers who are simply abusing the process, and using the SROs as a stick in order to beat a settlement out of their broker.
Traditionally, regulators do not advise brokers when their investigation is unable to conclude that a violation has occurred. The NASD does, on occasion, advise brokers and customers, in writing, when it finds no violation after investigation of a customer complaint, but those letters are few and far between. Such a confirmation, in writing, can often assist a broker in battling a rogue customer in arbitration, and the process needs to be expanded, so that all brokers, and customers, are advised of the resolution of an investigation, as soon as that investigation is complete.
Rogue brokers are certainly a problem for the industry and are a problem that vast resources are being used to address, and correct. Rogue customers are also a problem; a problem that does not require nearly the same amount of resources to correct. A simple recognition that they exist might go a long way toward curbing their abuses.
Nothing herein is intended as legal or financial advice. The law is different in different jurisdictions, and the facts of a particular matter can change the application of the law. Please consult an attorney or your financial advisor before acting upon the information contained in this article.
Mark Astarita is a nationally recognized securities attorney, who represents investors, financial professionals and firms in securities litigation, arbitration and regulatory matters, including SEC and FINRA investigations and enforcement proceedings.
He is a partner in the national securities law firm Sallah Astarita & Cox, LLC, and the founder of The Securities Law Home Page - SECLaw.com, which was one of the first legal topic sites on the Internet. It went online in 1995 and is updated daily with news, commentary and securities law related links.