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Friday, 31 October 2008

Don't Cry For Justice
Securities attorney Jonathan Kord Lagemann starts off today's Forbes.com Investor Team discussion with a harsh accusation against the securities industry. His clients are not investing, he says, because they know that if they need to go to arbitration they stand virtually no chance of recovering any of their losses, even if there's fraud or mismanagement involved... Seventy-one percent of customers in arbitration reported that they weren't satisfied with the outcome, and 65% believed the process was unfair. Fifty percent think they'd have gotten a different result if they had gone to court rather than arbitration, and of those who had taken separate cases to court rather than to arbitration, 76% said arbitrations were either very or somewhat unfair.

Don't Cry For Justice
Michael Maiello 10.31.08,

Securities attorney Jonathan Kord Lagemann starts off today's Forbes.com Investor Team discussion with a harsh accusation against the securities industry. His clients are not investing, he says, because they know that if they need to go to arbitration they stand virtually no chance of recovering any of their losses, even if there's fraud or mismanagement involved.

"If you have to be made whole through arbitration, particularly if you're a foreigner, you cannot win," Lagemann says as his clients have taken a dour view of their investments during the global financial crisis.

Is Lagemann right? Investors who have dealt with the Financial Industry Regulatory Authority (FINRA) arbitrators sure seem to think so. Mandatory arbitration has been the law of securities land ever since the Supreme Court decreed that arbitration clauses were legal and enforceable in 1987.

That decision forced investors with complaints to rely on an industry-sponsored arbitration system (first by the National Association Of Securities Dealers and now by FINRA, which represents the combined regulatory operations of the New York Stock Exchange and the NASD). The arbitrators of any dispute are chosen either from within the securities industry or from "the public." Stephen Choi, Jill Frisch and A.C. Pritchard studied arbitration awards between 1996 and 2006 and found that arbitrators who were lawyers who have brokerage firm clients in other matters give customers lower-than-average compensatory awards.

Jill Gross of Pace University and Barbara Black of the University of Cincinnati both, they report, have, "written frequently on securities arbitration and have concluded that the process is fair when measured against hallmarks of procedural fairness." Still Gross and Black surveyed participants in recent securities arbitrations proceedings. They sent out nearly 30,000 questionnaires and got better than a 10% response rate. The responses support Lagemann's contention that a perceived unfairness in securities arbitrations may be keeping people out of the markets.

Seventy-one percent of customers in arbitration reported that they weren't satisfied with the outcome, and 65% believed the process was unfair. Fifty percent think they'd have gotten a different result if they had gone to court rather than arbitration, and of those who had taken separate cases to court rather than to arbitration, 76% said arbitrations were either very or somewhat unfair.

Lagemann's complaint inspired a lively discussion of Wall Street wire houses and the virtues of smaller money-management operations with Forbes Investment Team members John Osbon of Osbon Capital Management and Marc Lowlicht of Further Lane Asset Management. All agree that Wall Street stacks the deck against the little guy, with Osbon and Lowlicht focusing on the cookie-cutter financial planning offered by the big firms.

Lowlicht recalls his earlier years at one of the firms. If he came up with a financial plan for a client that differed from what the firm's computers suggested, he had to get a lawyer's approval in order to implement it. Lagemann replied that were he general counsel he'd never allow such a thing. The lawyer's goal is to protect the firm, not serve the client, he says and the firm is best protected by selling similar plans to everyone.

No Justice, No Investment

Lagemann: My clients tend to be not the people strapped of cash. A lot of my foreign clients are rich beyond the dreams of Croesus, and from them I hear there is a malaise, that things are going to get a lot worse before they get better. There's a reluctance from most of my clients to invest anything at all. There's great uncertainty in the markets, certainly. But also, it's about risk and who they're dealing with. With arbitration clauses, I have to tell all of them that you're not going to recover anything if you have to be made whole through arbitration, particularly if you're a foreigner, you cannot win. Win rates went down to 35% and recovery rates for million-dollar claims are under 5% when you do win.

Osbon: Why is this? I thought we had protections in place?

Lagemann: We have protections. It's like your family dies in a rollover and you have to try your claim in front of the National Association of Tire Manufacturers.

Lowlicht: As a CFP [certified financial planner] I hold myself out as having a strong fiduciary responsibility to my clients. Brokers who hold themselves as advisors and treat themselves as planners are a scandal.

Lagemann: Look as an independent advisor, in many states you are a fiduciary. Everybody holding themselves out as an independent adviser but is working at a wire house is a scandal. It's perfectly awful.

Osbon: That is the key difference in the service models for clients. The standard for Broker-Dealers is suitability the standard for a registered independent advisor at a trustee level.

Lowlicht: All the regulation does is it allows guys to find new ways to hurt the client. When they changed B-share rules, guys started selling annuities. Guys who misled continue to mislead, in my case and John's case you are a fiduciary. I don't want to compare this to guns because I'm not all for guns, but guys who are going to break the rules are going to break them every time.

Lagemann: One of the fundamental problems with a wire house--I wanted to say Merrill but of course it doesn't exist anymore--is that as a fiduciary you could not offer people anything but the products created by your own company. That's what the wire houses have done. They're not buying stocks, bonds and options, they're selling products.

Osbon: Can you sue a wire house, and I have nothing against brokers, I know them, like them and need them, but have you had any success suing on the grounds that they are acting like advisors?

Lagemann: If somebody takes discretion they are a fiduciary, and I would sue at that basis.

The Virtues of Independence

Lowlicht: This crisis is a good thing from that standpoint. When I went independent everyone was like "you're crazy it's a big mistake." But I knew I could be completely unbiased. At a big firm, you work for the firm. I work for the client. John works for the client, not the firm. People used to say "My money's at Merrill, it's safe there." All of the sudden that philosophy has been wiped out. My guys are still intact.

Osbon: With all the layoffs in the industry it's good to know that when you own your firm you're not going to fire yourself.

Lagemann: That's why I became an independent lawyer in 1991.

Lowlicht: This is not an attack on the big firms. I know a lot of people there who are smarter than I am, honorable ethical guys, but it's an observation about how the business has changed and evolved.

Lagemann: One interesting thing: There's over three-quarter million registered reps and fewer than 95,000 are at wire houses. They can move product; that's what they're there for at some level.

Lowlicht: One of my larger clients is a securities litigator and I've gotten referrals from him. I did have clients who had money at Refco through some of their managed accounts. They had money at Refco and they're still in the process of getting it back even though there was fraud involved, because of the bankruptcy laws. I ran into one of the issues, and Kord may be able to chime in on this. The majority had investments through their IRAs, which should have been protected from bankruptcy reach and everything else, but because Refco went bankrupt and these guys were investors in Refco limited partnerships they still have problems.

Lagemann: You think there's [the Employee Retirement Income Security Act] and then you find that ERISA is not going to protect you.

Lowlicht: These types of markets perpetuate that problem. Brokers who are sales people are trying to find a way to make up for revenue. My argument has been with clientele that I don't get paid to buy you an investment. I get paid to give you advice. I saved people six figures or seven figures in estate-tax issues, transferring of wealth, just from dealing structurally with attorneys and accountants as to how to make investments and where. I give the option pay me hourly or for assets. At the end of the day, it'd be cheaper for them to pay me assets under management. I'm not the kind of guy where somebody comes in with $4 million and says "I'd like to invest it." I ask about children and grandchildren, what's long-term, short-term, and medium-term? Is there philanthropic intent? If so, how do you structure the charity?

Lagemann: I'm not using my investment adviser right! When we started looking my wife was at Harvard, they gave us a list and I said let's use the smallest guy on our list. We've survived this very nicely.

Osbon: The smallest guys are like corks in the ocean, we float easily.

Lagemann: At State Street I'm amazed at [the] impersonality of the services they render. They're very one-size-fits-all.

Lowlicht: I was at a very large trust company where I had provided advice to a sizable client who had a good sum of money, and everything at the wire house had to go through the home office for approval. So rather than using my knowledge to create the best recommendation I could, they gave me a computer-generated 40-page report so cookie-cutter I couldn't believe it. They don't know the client. I've dealt with this guy for 10 years: He's sick, he's dying, he has two children. I structured my own plan, which had to go through the computer for approval. Ninety percent of the time they don't approve it because you're managed to the level of the worst guys out there.

Lagemann: If I was general counsel I would not have approved your modifications. As a lawyer in house I want to protect the firm and I always will, always at the expense of the client.

Lowlicht: Went independent and won this account based on what they'd done. As an independent, and going back to John's point, you have the ability to structure what you need for each and every client.

Lagemann: Say I've got three grandkids, right, and maybe I like one, not the other two. That's peculiar to me, it's not going to fit into somebody else's model. But they have the model for two reasons: It's safe and it's cheap.

Lowlicht: You're not paying for advice. The most educated or proficient planner at Merrill is managed to the guy who has 12 nicks on his U4, has been in arbitration and has made mistake after mistake. Rather than provide the highest level of service, Merrill is protecting themselves from the lowest 10, who happen to be great revenue generators.

Lagemann: That was my job a long time ago--make sure we took care of the rogues that could hurt the firm.

Osbon: The biggest dangers of working at the big firms are your fellow financial engineers. I remember getting presentations in the private-wealth department at Morgan Stanley about CDOs [collateralized debt obligations]. We all had to memorize the acronym. We puzzled over it for a long time, but it made money for a long time. A lot of product sold from one part of the firm to another. What sunk AIG? A small group of people, 21 people in a rogue trading department. One of the things that's most difficult to deal with was well intentioned, highly talented employees picking you off for their benefit.

The End of Financial Alchemy

Osbon: Kord, maybe your clients have reason to be happy because we've reached the end of financial alchemy. The engineers made inconceivable amounts of money in inconceivable ways. Now they have lost inconceivable amounts of money and they've done it in ways that we understand. It's back to Business 101. Companies that make things that improve life.

Lagemann: The end of securitization of debt, the repackaging as CDOs and Wall Street manufacturing money.

Lowlicht: And creating moral hazards. You've shifted the risks from the person who wrote the loan to an investor. The person who wrote the loan isn't responsible or held to any standards to which he wrote the loan. "I sell it, it's his problem."

Lagemann: It's like the pump-and-dump schemes of the '90s. A.R. Barron? Stratton Oakmont? They went into the mortgage business.

Osbon: I see some optimistic parts of this. I'm from the Midwest, like a farmer, and they say that the farmer is an optimist or he wouldn't be a farmer. Look at the migration of human capital. Three hundred thousand financial related jobs are going to be lost, 35,000 in New York alone. That sounds terrible, and it is, but look at the last time we had a flight of human capital in the U.S. After Vietnam all these rocket scientists left the military. They became computer geeks! The first PC was in the nose of a missile. What if all this talent went into green energy?

http://www.forbes.com/intelligentinvesting/2008/10/30/Intelligent-Investing-Arbitration-Securities-Law-Advisers-Panel.html

 
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