For years, regulators have typically pursued brokerage firms over the failure of investments they sold rather than going after individual stockbrokers, because the target was larger and the possibility of reaching a financial settlement was greater.
Now, regulators are shifting their focus in their fight against fraud to encompass brokers. The shift comes even as some brokers are casting themselves as victims, saying they were duped by the same complex products that they once happily sold to customers.
Brokerage firms project a public face of their employees as attentive, diligent and proficient. In television and Internet marketing, they highlight the expertise and sound guidance of their advisers. In contrast to that depiction, brokers are now saying that some products were so complicated that they did not have the knowledge to sell them. Some have sought to have complaints about the products they sold expunged, and others have filed claims against their firms.
On Sept. 25, Michael Farah, a former broker at Wedbush Securities, won a $4.3 million arbitration award from his former employer — including $1.4 million in punitive damages. Arbitrators for the Financial Industry Regulatory Authority, the industry-financed group that oversees such claims, took up his case in a nine-day proceeding.
Mr. Farah said in his statement of claim that he was “unaware of the true state of facts” about the ill-fated collateralized mortgage obligations, the mortgage-backed securities that are pooled and grouped by risk. He recommended such products after his firm endorsed them, but said that his business was hurt after his clients lost money on them. “A broker has the right to rely on what he’s told about an investment by the firm,” said his lawyer, Philip M. Aidikoff. Wedbush didn’t respond to requests for comment.
Such actions may seem distasteful to the investors who lost substantial amounts to soured investments. But legal experts say that even when firms have been held liable for troubled products, the brokers are often off the hook.
“I call it the tsunami defense,” said Bill Singer, a New York securities lawyer who represents investors and brokers. Brokers often go unnamed in regulatory actions and arbitrations, as plaintiffs’ lawyers pursue the deeper pockets of the firm. But even when brokers are named when a product blows up, “typically there’s no liability on the broker,” Mr. Singer said.
Regulators, however, are considering tougher standards for the sale of complicated financial products that are sometimes not understood by either broker or customer.
In a 43-page report sent to brokerage firms in October, Finra said that its members needed to pay more attention to brokers’ understanding of complex products. The group outlined ideas it considered effective, such as limiting the ability of brokers to sell a product if they were unable to explain risks to investors.
In a decision last year, a Finra hearing panel took up a case involving collateralized mortgage obligations and inverse floaters, which are debt instruments whose interest rates move in the opposite direction of a benchmark rate, sold to customers of Brookstone Securities.
The panel found that the products “were so complex that it is inconceivable” that investors could understand what they were buying. Finra fined Brookstone $1 million and ordered the firm and two of its brokers to return $1.6 million to its customers. The firm closed less than two weeks after the Finra decision on June 4, 2012, and is appealing the ruling.
Alan M. Wolper, a lawyer for Brookstone and three of its employees, said that his clients described the product “in sufficient detail” so that customers could understand it.
Some experts are calling for more oversight over such products. Frank Partnoy, a professor of law and finance at the University of San Diego School of Law, said he would like to see a broad standard that prohibited brokers from selling products that customers did not understand, even in cases where customers had signed documents that labeled them as “sophisticated.”
“There’s been a proliferation of complex products on the retail side over the past couple years,” he said. “It’s sort of shocking it would happen postcrisis, so Finra must be feeling pressure to do something about it.”
As governed by their licenses, brokers are supposed to have a duty to make sure products are “suitable” for their clients, and the Finra chief executive, Richard G. Ketchum, said at the annual meeting of the Securities Industry and Financial Markets Association in November that brokers should take on an even higher obligation to act in a clients’ best interest.
On Nov. 22, the S.E.C.’s investor advisory committee recommended similarly that brokers be held to a so-called fiduciary standard. Brokers should understand the products they are selling so that they can give the best advice, but much is open to interpretation.
Finra rules only specify that brokers are responsible for due diligence when they are trying to sell a product that isn’t on their firm’s approved list. If a broker is selling something the firm has recommended, “each situation has its own facts and circumstances,” said a Finra spokeswoman, Michelle Ong.
In a letter on Nov. 13 to the S.E.C. chairwoman, Mary Jo White, Mr. Ketchum said that Finra had begun an initiative this year to focus on high-risk brokers, including those who had worked for problematic firms. That might lead to more penalties against brokers, but it doesn’t address why brokers often go undisciplined when they’ve sold products that lead to penalties against their employers.
In addition, brokers who have had to list customer complaints about questionable products in their “Broker Check” — the dossier of employment and regulatory history available online — are often successful in having negative marks erased from their records.
On Feb. 7, a Finra arbitrator in Omaha granted requests to expunge customer complaints from the records of 22 brokers at Securities America who had sold securities that were sold to select investors to raise capital known as private placements in Medical Capital Holdings and Provident Royalties. Those private placements turned out to be frauds.
The arbitrator wrote that the brokers were “unaware of any alleged failures of Securities America in approving the securities at issue.” In a separate ruling on May 22 that granted a request to expunge the record of six other Securities America brokers, the same arbitrator, Frank D. Connett Jr., appeared to put more responsibility on the investors than he did on the brokers.
Mr. Connett said that the securities the brokers sold were “not suitable for anyone.” Yet, he said that the investors who purchased them were knowledgeable and “were made fully aware of the risky nature of these notes.”
John Nester, a spokesman for the Securities and Exchange Commission, would not comment on any specific cases but said: “As a general matter, charging decisions are based on a careful analysis of the individual facts and circumstances to determine culpability.”
Individual investors, virtually all of whom give up the right to make a claim in court when they open brokerage accounts, have the option of going to arbitration when a Wall Street product fails. Even then, though, lawyers usually advise suing only the firm, which is most likely to have the resources to pay an award if the investor wins.
Joseph Borg, director of the Alabama Securities Commission, said that it was not practical for a regulator to go after hundreds or thousands of brokers when it could pursue a single firm and potentially land a settlement that could be used to pay back defrauded investors.
Mr. Singer said that as long as Wall Street continued to promote impenetrable products, investors needed to be alert that brokers were sales representatives first.
“If you want to buy into the mythology that stockbrokers are highly trained professionals who care about customers and research their recommendations,” he said, “keep watching TV.”