1. Misalignment of Interests: While RIAs are held to a fiduciary standard by the Investment Advisers Act of 1940, this does not entirely eliminate the risk of self-interest affecting an RIA’s advice. For instance, RIAs might favor only those investment products from firms that are paying significant commissions to the RIA for selling that product. This means there is a significant potential conflict of interest causing an RIA to recommend the same small set of investment products to every potential client.
2. Limited Product Offering: Many RIAs have a limited range of investment products due to affiliations with certain investment companies. This could mean you may not have access to the full spectrum of investment options that might be more suitable for your retirement needs.
3. Lack of Transparency: Even though RIAs are required to disclose all material facts to their clients, the complexity of the investment products such as annuities and life insurance products may result in you not fully understanding certain investments, the adviser’s commission for selling a specific product, or the risks involved in an investment strategy recommended by the RIA.
4. Qualifications and Experience: RIA’s expertise and experience can vary significantly. While some have extensive experience and hold multiple qualifications, others might be newer to the industry and less experienced. A less qualified RIA might not provide the best advice or understand the intricacies of complex investment strategies. Further, it is important to check your adviser at brokercheck.org and investigate their history. There are plenty of RIAs who are and RIA because they are unable to be a stockbroker (yes, there is a huge difference.)
5. Costs: RIAs usually charge a fee based on a percentage of assets under management, which might be higher than what you’d pay if you managed your investments independently or did not invest in annuities or life insurance products. Additionally, some RIAs may have hidden costs or might charge additional fees for specific services on top of the percentage fees they charge.
6. Poor Communication: In some cases, you might find that your RIA does not communicate effectively or regularly. This could leave you feeling uninformed about your investment decisions and progress toward your retirement goals.
7. Inadequate Personalization: Some RIAs might use a one-size-fits-all approach to investment strategies, which could result in your retirement assets not being fully able to meet your specific goals, risk tolerance, and timeline to, or in, retirement.
8. Limited Accessibility: Depending on the RIA, you may face issues regarding the accessibility of your adviser. If they manage a large number of clients, they might not be available when you need them, impacting your ability to make timely decisions. This applies to the investment products that RIAs may recommend to you because the investment products often have significant penalties for early ‘surrender’ and withdrawals, or even have no option to gain access to your money.
9. Risk Management: Not all RIAs are skilled in managing risk effectively. A failure to appropriately assess and mitigate risk could potentially result in substantial losses for your retirement portfolio.
10. Lack of Oversight: While RIAs are regulated by either the Securities and Exchange Commission (SEC) or state regulators, this does not guarantee that your investments are safe. If the oversight body does not effectively regulate the RIA’s practices, your retirement assets could be at risk. Another oversight issue is that many RIA’s have no insurance to provide coverage to you for the RIA’s potential negligent or fraudulent handling of your account.

Despite these potential problems, it’s important to remember that many RIAs provide excellent service and can significantly contribute to the growth and protection of your retirement assets. The key is doing your due diligence in selecting an adviser. Check their qualifications, regulatory records, and references. Understand their fees, services offered and their investment philosophy. Good communication is essential, so ensure you feel comfortable discussing your needs and goals with them. Finally, always remember that it’s your retirement – stay informed and involved in the management of your assets.

Retirement planning can be a complex process, but knowing the potential pitfalls of entrusting your retirement assets to an RIA can help you make an informed decision that aligns with your retirement goals and financial situation.

A margin account is a type of investment account that allows investors to borrow funds from their broker-dealer to purchase securities. With a margin account, investors are able to leverage their trades by borrowing against the value of their portfolio. This means that investors can potentially earn larger returns on their investments but also exposes them to increased risk.

Broker-dealers have a number of responsibilities when it comes to margin accounts. One of their primary responsibilities is to ensure that investors understand the risks associated with trading on margin. This includes providing investors with a detailed explanation of how margin accounts work, the potential risks and benefits, and any costs or fees associated with trading on margin.

Another important responsibility of broker-dealers is to ensure that investors meet the eligibility requirements for trading on margin. These requirements may vary depending on the broker-dealer, but typically include factors such as an investor’s financial standing, trading history, and investment objectives. Broker-dealers must also maintain appropriate documentation to demonstrate that investors meet these requirements.

Once an investor has been approved for a margin account, broker-dealers are responsible for monitoring the account to ensure that the investor is maintaining sufficient collateral to cover any potential losses. This is known as a margin call. If the value of the investor’s portfolio falls below a certain level, the broker-dealer may issue a margin call, requiring the investor to deposit additional funds or securities to maintain the required level of collateral.

Broker-dealers should clarify for investors that the broker-dealer has almost unfettered control over the margin account. The broker-dealer, in the face of a ‘margin call,’ can raise money to meet the margin call by selling stocks from an investor’s account without first asking the investor. The broker dealer can even sell out the entire account without the client’s authority to protect the broker-dealer.

Broker-dealers are also subject to the Financial Industry Regulatory Authority’s (FINRA) rules regarding margin accounts. These rules require broker-dealers to provide investors with a risk disclosure statement outlining the risks associated with trading on margin. Broker-dealers must also provide investors with regular statements outlining the status of their margin accounts, including the amount of margin used and any potential margin calls. Additionally, broker-dealers must also comply with all applicable laws and regulations governing their conduct, including the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940.

Another important responsibility that broker-dealers have is the responsibility to ensure that all investors are treated fairly and with integrity. This includes providing investors with accurate and timely information about their margin accounts, as well as ensuring that any fees or charges associated with trading on margin are reasonable and transparent. Broker-dealers must also have adequate safeguards in place to protect investors’ assets and prevent unauthorized access or theft.

Margin accounts offer investors the opportunity to potentially earn larger returns on their investments, but such accounts also come with increased risk. Broker-dealers have a number of important responsibilities when it comes to margin accounts, including ensuring that investors understand the risks and benefits of trading on margin, monitoring accounts to ensure sufficient collateral, preventing illegal trading practices, and complying with applicable regulations. As an investor, it’s important to work with a reputable broker-dealer who is committed to transparency, fairness, and integrity when it comes to margin accounts.

One of the biggest benefits of AI in investing is the speed and accuracy of decision-making. With the ability to process large amounts of data quickly, AI algorithms can analyze market trends and identify profitable investments much faster than human traders. In addition, AI algorithms can be programmed to avoid psychological biases that can negatively impact human traders’ decision-making. This could result in more rational and profitable investment decisions.

Another potential benefit of AI in investing is the ability to identify patterns in data that humans might miss. AI algorithms can analyze vast amounts of data, including financial data, news articles, and social media, to gain a comprehensive understanding of a company and its potential for growth. This can provide investors with a more accurate picture of a company’s financial health and future prospects, allowing them to make better investment decisions. AI algorithms can also be used to develop predictive models for stock market performance. These models can take into account historical data, market trends, and other factors to forecast future stock prices. This information can be extremely valuable for investors, as it can help them identify stocks that are likely to rise in value and make informed investment decisions.

A further benefit of AI in investing is the ability to automate the trading process. AI algorithms can be programmed to make trades based on predetermined criteria, such as a specific stock price or market trend. This can save investors time and effort, as they no longer have to spend hours researching and making investment decisions themselves. It can also reduce the risk of human error, as AI algorithms are not subject to the same emotional or psychological biases as human traders. Despite the many potential benefits of AI in investing, there are also some concerns about the technology. For example, there is a risk that AI algorithms could be programmed to make unethical or illegal trades. In addition, there is a risk that AI algorithms could be vulnerable to hacking or other forms of cyber-attack, which could result in significant financial losses for investors.

Another concern is the potential for AI algorithms to exacerbate market volatility. If a large number of investors use AI algorithms to make trades, this could lead to rapid shifts in stock prices and market trends. This could result in increased volatility, making it more difficult for investors to make informed investment decisions. Despite these concerns, it is clear that AI has the potential to greatly impact the world of investing in the stock market. The technology has the potential to bring about many benefits, including faster and more accurate decision-making, better predictive models, and more efficient trading processes. However, it is important for investors to be aware of the potential risks associated with AI and to carefully consider how they use the technology in their investment strategies. In conclusion, the impact of AI on the stock market will likely be significant in the coming years. While there are still some uncertainties about the technology, it is clear that AI has the potential to bring about many benefits for investors. However, it is important for investors to be aware of the potential risks associated with AI and to use the technology carefully in their investment strategies. As AI continues to evolve, it will be interesting to see how it continues to impact the world of investing and the stock market as a whole

Yet there is one investment risk – the risk of fraud – which at first glance seems uniquely difficult to mitigate. Fortunately, there are indeed several steps investors can take to protect their hard earned investment dollars from fraud.

In the United States, the Securities and Exchange Commission (“SEC”) and the Financial Industry Regulatory Authority (“FINRA”) each offer investor resources for reducing the risk of investment fraud.

FINRA advises investors to follow three specific steps to avoid fraudulent schemes: staying informed about ongoing scams, thoroughly vetting the background of any investment opportunity or professional an investor chooses to engage with and keeping current with common tactics employed by fraudsters. [1]

Stay Informed With Investor Alerts

Importantly, both the SEC and FINRA issue periodic “investor alerts” which explain recent fraudulent investment schemes toward which investors should exercise caution. Investor alerts from the SEC can be found here, and investor alerts from FINRA can be found here. Vet the Investment Opportunity

investors should also thoroughly vet the background and credentials of any investment opportunity or professional they choose to engage with [1]

When it comes to vetting the background of investment professionals, FINRA first recommends directly asking whether the individual is licensed to sell the investment. [2] FINRA and the SEC also both offer online resources to help confirm whether the professional is indeed registered as required under law. [2]

These resources include repositories listing the financial professionals who are registered with federal and/or state agencies, as well as resources which indicate whether the individual has engaged in known fraudulent acts in the past. [2] Investors can also use these resources to determine whether the investment they are considering is registered with the SEC. A one-stop shop for each of these free resources can be found here. Keep Up to Date on Common Fraudulent Tactics

Finally, a third helpful strategy for keeping hard earned investment dollars safes is staying aware of common investment fraud schemes along with “red flags” that often signal fraudulent activity.

Investors should always keep in mind that if an investment opportunity seems “too good to be true,” then it likely is.

In particular, common red flags to be on the lookout for include mentions of guaranteed or overly consistent returns, particularly complex investment strategies, and “pushy” salespeople. [3] Often, fraudsters will employ high-pressure sales tactics to present supposed investment opportunities as exciting ways to make large sums of money with comparably little effort required from the investor. [3]

Investors should also keep in mind that many investments are inherently risky. If a supposed investment professional advertises a new investment opportunity with no risk at all, or if any other red flags arise, it is likely time to dig deeper into the specifics of the investment opportunity.

Exercising careful attention to both the supposed processional and the investment they are offering is often the best strategy to protect investments avoid falling victim to a fraudulent investment scheme.

Sources: [1] https://www.finra.org/investors/protect-your-money [2] https://www.finra.org/investors/protect-your-money/ask-and-check [3] https://www.finra.org/investors/protect-your-money/avoid-fraud/red-flags-fraud

“Boiler room” operations are fraudulent schemes in which high-pressure, coercive sales tactics are used to induce clients into purchasing stocks or other investments. [3] Often, these operations consist of groups of salespeople working from offices in foreign countries who cold-call clients in an attempt to defraud them. [3] The salespeople involved in boiler room schemes are rarely licensed brokers, and the stocks they purport to sell may not exist at all. [3]

In the instant case, the DOJ alleges that the defendants conspired to commit securities fraud when they engaged in a boiler room scheme involving fake investment firms and shell companies used to mislead investors. [1] The alleged scheme operated from approximately June 2019 until August 2021, and defrauded English-speaking investors across the globe of more than $8 million. [4]

The defendants falsely held themselves out to prospective investors as employees of well-regarded investment firms, going so far as to fabricate websites and email accounts that appeared to be associated with these actual firms. [4]

Furthermore, the DOJ alleges that the defendants engaged in classic boiler room scheme telemarketing tactics to convince clients to wire large sums of money from their bank accounts to the defendants, under the false impression that they were purchasing securities. [4] Yet the defendants never invested the money, nor did they return the money to the victims. [4]

After stealing more than $8.4 million through this scheme, the DOJ alleges that the defendants went on to launder over $4.6 million of the stolen money, once again sending it overseas. [4] The proceeds were then split amongst the scheme’s conspirators. [4]

The SEC’s parallel civil action sheds additional light on the details of this boiler room scheme. According to the SEC”s February 9, 2022, complaint, the scheme primarily targeted retirement-age and elderly victims, whom the defendants convinced to purchase fake securities traded on U.S. exchanges. [ 2]

The complaint notes that Defendant Robert Leonard Booth operated boiler rooms with offices in both Thailand and Panama from 2019 until 2020. [2] Booth was not registered with the SEC in any capacity and worked in connection with other defendants who owned the various shell companies which victims were instructed to wire their payments. [2]

The group of fraudsters charged in this case stole the hard-earned savings of more than 140 unsuspecting victims. [2] As noted in the SEC”s complaint, this schemes particularly targeted elderly victims, highlighting the insidious nature of boiler room schemes within this particular vulnerable population. Of course, the hard-selling tactics employed by boiler room investment fraudsters could well mislead any prospective investor.

You can protect yourself from boiler room fraud by staying alert for a few key red flags commonly employed by these fraudsters. Some such red flags include offers for outrageously lucrative yet low-risk investment opportunities, a reluctance to divulge detailed information about the investment firm the salesperson works for, and references to secret or insider information. [5]

Additionally, investors are cautioned not to make immediate investment decisions over the phone or by email. Instead, it is important to carefully consider any potential investment opportunities by pausing and conducting research on the credibility of the firm and investment opportunity. [5] A simple way to check a stock salesperson who calls is to put their name into www.brokercheck.com and see what pops up.

If you think you have been impacted by a boiler room scheme or another fraudulent investment scheme, a trusted attorney at Savage Villoch law is ready to assist you in navigating your situation.

Sources: [1] https://www.justice.gov/usao-sdny/pr/five-defendants-charged-84-million-boiler-room-fraud-and-money-laundering-scheme [2] https://www.sec.gov/litigation/complaints/2022/comp25326.pdf [3] https://www.investopedia.com/ask/answers/what-is-a-boiler-room-operation/ [4] https://www.justice.gov/usao-sdny/press-release/file/1470416/download [5] https://www.forbes.com/sites/bartastor/2017/09/09/cracking-down-on-boiler-room-fraud-self-defense-tactics-to-fight-off-the-crooks/?sh=160a10e527ec

By way of a brief overview, in January 2021 a group of about 100 stocks experienced monumental price and trading volume fluctuations. These stocks, many of which were consumer-centered companies with high brand awareness, gained rapid attention over social media platforms like Reddit and YouTube.

While the SEC’s report addresses the events and impacts of the meme stock phenomenon broadly, it focuses the bulk of its analysis around GameStop Corp (“GME”), arguably the most famous of the meme stocks.

The report notes that five factors – large price moves, large volume changes, large short interest, frequent Reddit mentions, and significant mainstream media coverage – all converged around GME in late January 2021.

In 2020, GME’s stock price swung substantially, starting the year at around $6 per share before falling to $3 in April and then rebounding to reach about $20 per share by the end of the year. [1]

Then, when Ryan Cohen, the co-founder of the popular pet-focused e-commerce company, Chewy, Inc., announced he would be joining GameStop’s board of directors on January 11, 2021, the stock took off. While GME traded at $20.65 per share that day, its rose to a high of $347.51 per share by January 27^th. Along with these price increases came similar increases in volume. Trading volume from January 23-29 averaged 100 million shares trader per day, more than 1,400% higher than average daily trade volume during 2020. [1]

As this market volatility unfolded, perspectives on its driving force into two main camps – those who touted GME as a prudent, even undervalued, investment because of its potential to break into the e-commerce market, and those who felt short interest was fueling the moves. [1] As social media users focused their attention on short interest from large institutional investors like hedge funds, a “short squeeze” on GME was triggered. The Reddit retail investors viewed themselves as fueling GME’s price increases, forcing hedge funds to close out their short positions at significant losses.

However, as GME and other meme stocks skyrocketed, some app-based trading platforms popular among retail investors placed temporary restrictions on trading in these stocks. The platforms cited various reasons for these restrictions, including margin calls from clearing agencies to cover increased risk. Conversely, retail investors believed that the restrictions were put in place in response to pressure from hedge funds with short positions at risk of losing money – claims that made their way to a Congressional hearing in February.

The SEC’s report ultimately provides a few important takeaways for the investing public. First, the report notes that it was “positive sentiment” about GME – whether a legitimate belief in GME’s fundamentals or a desire to profit from a rise in price – that fueled the sustained appreciation of GME’s stock price, not short-sellers who were “buying-to-cover.” [1] In fact, the report quite succinctly noted that “[s]taff believes that hedge funds broadly were not significantly affected” by the run on GME. [1]

Furthermore, the report also briefly touched on the rationale behind trading restrictions enacted by broker-dealers like Robinhood, noting that it had found evidence that clearing agencies had indeed demanded to be paid billions in additional margin by their member firms to account for volatility risks. [2]

The report concluded with four areas targeted for further study and consideration, noted as the following:

1. Forces that may cause a brokerage to restrict trading
2. Digital engagement practices and payment for order flow
3. Trading in dark pools and through wholesalers
4. Short selling and market dynamics. [1]

Each of these areas falls squarely within the ambit of SEC Chairman Gary Gensler’s already stated policy goals, inherent in his aim of promoting a more “fair, orderly, and efficient” market in the United States. [3] While the report did not outline specific improvements to be made, it serves as an important starting point for potential policy changes for protecting retail investor interests moving forward.

Sources:

[1] https://www.sec.gov/files/staff-report-equity-options-market-struction-conditions-early-2021.pdf

[2] https://www.latimes.com/business/technology/story/2021-10-18/sec-gamestop-report-debunks-conspiracies-backs-commission-chiefs-plan

[3] https://www.barrons.com/articles/sec-report-changes-what-we-know-about-januarys-gamestop-frenzy-51634590024

At the heart of the civil and criminal complaints against Nikola are allegations that as its CEO, Trevor Milton, regularly spread false and misleading information about the progress of Nikola’s EV products and technologies. Nikola’s focus is on manufacturing low- and zero-emissions trucks, and the complaints allege in part that under Milton, Nikola published a promotional video of a prototype truck which did not actually work, but appeared to only because the truck was set in neutral and rolled down a hill. [1]

Promotional videos like that one, along with Milton’s enthusiastic social media posts and numerous podcast and television appearances, all painted a picture of exciting and impressive forward progress at Nikola, which Federal prosecutors and SEC regulators allege was nothing more than an illusion. [2]

This illusion allegedly created by Milton came at a steep cost – and was seemingly targeted retail investors in particular. Nikola went public via a Special Purpose Acquisition Company (“SPAC”) in June 2020, and once it began trading publicly, the value of its shares increased by $7 billion. However, Nikola’s value dropped steeply once the public learned of ongoing federal investigations into the company and its operations, leading to huge losses borne by retail investors who had been misled. [1]

Of course, EV companies and their executives are in a unique position given the bounding public interest in, and relative infancy of, the EV market. When attempting to evaluate a new or existing EV company, projections into the future must be made, and no fool-proof roadmap for this technology currently exists.

However, these uncertainties pose a particularly risky situation for prospective retail investors who can be easily misled by companies making false claims about their highly complex products or technologies – especially when, as here, these claims are being shared rapidly over social media.

Here, Nikola’s non-traditional IPO process put unsuspecting retail investors at even greater risk. When a company goes public via a SPAC, the traditional “quiet period” after a company is publicly listed is not required. This allowed Milton to continue amplifying false claims about Nikola on social media just after going public, thereby attracting additional retail investors, and driving the stock price up further. [3]

In pursuing these securities fraud charges against Nikola, the SEC continues to signal its sharp focus on SPAC regulation in the interest of protecting investors. As we all navigate the rapid influx of SPACs along with the continued push for broad adoption of EVs, retail investors should continue to carefully research prospective investments by identifying concrete achievements such as milestones hit and actual sales or delivery figures to date, while steering clear of “bandwagon effect” investing. These careful considerations, along with continued scrutiny by regulators, are some of the best ways to protect your assets in the market.

Sources:

[1] https://www.marketwatch.com/story/nikola-electric-truck-prototypes-were-powered-by-hidden-wall-sockets-towed-into-position-and-rolled-down-hills-prosecutors-say-11627572394

[2] https://www.sec.gov/news/press-release/2021-141

[3] https://www.nytimes.com/2021/07/29/business/nikola-trevor-milton-fraud.html

The PRI is an independent network of investors who promote responsible and sustainable investing by incorporating ESG factors and considerations into their investment decisions. Although the PRI is not a part of the UN itself, the UN supports and partners with the group. In 2006, when the PRI was formed, it managed about $7 Trillion in assets, and in 2020, it managed over $100 Trillion. [1]

So why should you as an investor care about ESG investing? ESG factors and criteria empower investors to make “socially responsible” and sustainable investment decisions by providing important insight into a company’s operations, standard practices, and culture through the lens of Environmental, Social, and Governance considerations.

For example, a company might disclose Environmental factors such as their carbon emissions or water usage, aimed at conserving our natural world. Social factors place an emphasis on how a company treats both its employees and the public and include employee diversity statistics or human rights considerations. Finally, Governance factors focus on the way in which the company is led and include information like executive pay scales as well as political leanings. [2]

When an investor is equipped with meaningful – and truthful – ESG information, they can be confident in their monetary support of a company. As a result, ESG investing continues to be top of mind for investors and regulators in the United States. However, investor interest is not the only factor influencing ESG popularity. Sound ESG investing also yields relatively high returns when compared to conventional funds while providing relatively lower risk, according to a study by Morgan Stanley in 2019. [2]

While many companies voluntarily disclose ESG data, there is currently a gap in investor knowledge, as many ESG disclosures are not yet compulsory. One particular area in which this is true is with regard to climate change disclosures – which the SEC published guidance on in 2010 but have not been adjusted since then.

At Wednesday’s PRI event, Commissioner Gensler focused in on the value and importance of climate change disclosures and provided a glimpse into the future of SEC regulation of the topic. In particular, Gensler emphasized that these disclosures must be “decision useful,” meaning that they include sufficient factual information to allow proper decision-making to take place.

Gensler also highlighted the intense interest modern investors have in the climate risks associated with stocks they purchase, likening the investor push for climate risk disclosure today to the push for disclosure of basic financial information decades ago. In response to this investor interest, Gensler announced that he has tasked his staff with developing a proposal for mandatory climate risk disclosures for review by the end of 2021. [3]

The transition from the SEC’s current climate risk guidance to mandatory SEC climate risk disclosures is monumental, and it will allow investors to compare “apples to apples” when analyzing climate risk data between companies.

Furthermore, Commissioner Gensler spoke about the possibility of requiring disclosure of carbon emissions data not only for the company itself, but for each member of the company’s value chain. Granular data like this will provide investors with a truly actionable and “decision useful” basis for making investment decisions by providing not just a piece of the puzzle, but instead the full picture of a company’s true impact on the environment.

As we enter the back half of 2021, investors should be on the lookout for additional remarks by Commissioner Gensler relating to climate risks and ESG disclosures. While we have only a blueprint now, support and demonstrated investor interest in ESG factors will encourage the SEC to continue its pursuit of meaningful regulation to benefit investors like you.

Sources:

[1] https://www.unpri.org/pri/about-the-pri

[2] https://www.nerdwallet.com/article/investing/esg-investing

[3] https://www.sec.gov/news/speech/gensler-pri-2021-07-28

Margin debt can be simply understood as debt taken on by an investor in order to extend their buying, and earning, power in the market. In essence, an investor borrows money to increase their initial investment and, hopefully, to supercharge their eventual profit.

For example, an investor might borrow $10,000 from their broker on margin in order to increase their initial investment from $20,000 to $30,000. If the shares they’ve purchased increase by 10%, the investor stands to make 50% more than they would have with only their own $20k.

Of course, taking on margin debt is also highly risky. When an investor’s balance falls below the minimum amount required by the broker, they may face a margin call. This margin call requires the investor to deposit more money or securities to maintain the broker’s minimum required value within the account.

Trading on margin is an attractive option when investors feel optimistic about the future of the security they’re investing in, or the overall market. However, this practice may have detrimental, rippling impacts within the market. Because borrowing on margin adds additional investment money into a particular stock or stocks, high levels of margin may actually begin to create a bubble. [2]

Excessive margin debt can be symptomatic of these speculative market bubbles, and eventual bursts, because it may signal overexuberant investor behavior, behavior that is not fully based in fact. As a result, several experts agree that exceedingly high levels of margin debt may signal an impending market drop.

In fact, sky-rocketing levels of margin debt have preceded both of this century’s extended economic downturns. Just before the dot-com bubble burst in 2000, margin debt was up more than 80%, and before the great recession in 2008, margin debt had risen by over 60%. [3] For context, margin debt is currently up more than 50% since this time last year and has risen 10.5% to date in 2021.

While high levels of margin debt are but one indicator of a potential market downturn, they are a critically important one to watch. In 2000 and in 2007, the S&P hit its own peak just a few months after margin debt peaked. Similarly, once margin debt hit its lowest point in 2009 following the recession, the S&P hit bottom just one month later. [4] The takeaway: the cyclical and relational nature of margin debt and overall market performance is not to be ignored.

The popularity of trading on margin has exploded, particularly in light of the newfound ease of doing so through popular app-based platforms like Robinhood. However, it is important for investors to keep in mind the broader market implications that an abundance of such trading may have, potentially in the near future.

Sources: [1] https://www.finra.org/investors/learn-to-invest/advanced-investing/margin-statistics [2] https://www.gobankingrates.com/money/economy/signs-of-market-bubble-crash-what-to-expect/ [3] https://www.fool.com/investing/2021/06/12/whos-ready-stock-market-crash-5-reasons-big-drop/ [4] https://www.advisorperspectives.com/dshort/updates/2021/07/20/margin-debt-and-the-market-up-2-4-in-june-continues-record-trend

FINRA noted three major violations from its investigation into Robinhood’s conduct and operations as a stock-trading app, each of which merited its own penalties.

First, FINRA found that Robinhood has pervasively and negligently provided false or misleading information to its customers. [1] This false information was circulated in spite of Robinhood’s core mission to “de-mystify finance for all” and “democratize finance,” and ranged from misrepresenting customer account balances and buying power, to erroneous communication about customers facing margin calls. [2]

As a result of Robinhood’s misrepresentations, FINRA is requiring the firm to pay over $7 Million in restitution to customers who suffered related losses. [1]

Second, FINRA found that Robinhood did not exercise proper due diligence in its options trading offerings. [1] Given the financially risky character of options trading, Robinhood improperly outsourced an algorithm powered by artificial intelligence to determine customer options trading eligibility. The technology was riddled with inconsistencies, causing eligibility decisions to be made based upon incorrect customer information, and allowing ineligible customers to engage in options trading. [1]

Finally, FINRA also uncovered issues with Robinhood’s technological supervision of its core business tenets. For example, Robinhood experienced a widespread outage of its platform in early March 2020, during which operations halted. Robinhood customers were unable to access their accounts for a period of two days, during which market volatility was incredibly high. This outage, which was only one of many similar situations, resulted in approximately $5 Million in customer losses, which Robinhood has now been ordered to pay in restitution. [1]

Beyond these three severe offenses, FINRA also found that Robinhood has violated several other rules as a brokerage firm in recent years. Robinhood has failed to report failures and customer complaints which are required by FINRA, and has also failed to show customers complete market data as they make sensitive decisions about securities trading.

Robinhood, for its part, responded to the charges by stating that they are actively improving their educational resources, customer support capabilities, and legal and compliance teams. [2] They are “glad to put his matter behind [them]” with a renewed focus on the continued democratization of finance for all. [2]

FINRA’s message through these sanctions is clear – violate brokerage industry rules, pay the price. Its Head of Enforcement, Jessica Hopper, added that “all FINRA member firms, regardless of their size or business model, must comply with the rules that govern the brokerage industry . . . to protect investors and the integrity of our markets.” [1][2]

Given Robinhood’s exploding popularity among retail investors, particularly during the pandemic, this settlement should be a reassuring sign to investors that FINRA is taking its duty to protect their interests seriously. On the same token, customers of platforms like Robinhood should remain diligent in their financial decisions and report any potential issues for assessment by either the firm or by FINRA itself.

Sources: [1] https://www.finra.org/media-center/newsreleases/2021/finra-orders-record-financial-penalties-against-robinhood-financial [2] https://www.cbsnews.com/news/robinhood-finra-70-million-fine/

There are some situations in which FINRA arbitration is required, such as when a written agreement between the parties mandates it. In order to be eligible for FINRA arbitration, an investor must be seeking to file a claim stemming from the business activities of their broker or brokerage firm, and the event in question must have taken place within the last six years (in most states). [1]

Generally, FINRA arbitration allows an investor to seek either monetary or securities damages resulting from the business activities of their broker or brokerage firm. To get the filing process started, an investor must submit a Statement of Claim, a FINRA Submission Agreement, and related filing fees, all of which are available to view on FINRA’s website. [2]

The format and related fees for the arbitration itself vary based on the amount of money in controversy. When the amount in controversy is below $10,000, a hearing session will be conducted with just one arbitrator, and the session fee will be between $50 and $450. If the amount in controversy is above $10,000, a panel of three arbitrators may be used instead, and the hearing session fee will range from a minimum of $600 to a maximum of $1,575. [3]

Once FINRA receives all of the initial required documents, they analyze the claim and determine whether a one- or three-person arbitration panel will be used. A case number is created, and FINRA will notify the respondent – the party the investor has filed their claim against – about the case. So long as the respondent is registered with FINRA, they will be required to arbitrate.

The respondent then has 45 days to research the claim lodged against them and to respond. FINRA analyzes the response along with any counter claims or cross claims.

Next, the parties choose their arbitrators from a randomly generated list of names supplied by FINRA. FINRA arbitrators are not FINRA employees, instead they are contractors who are evaluated by FINRA on the basis of their employment, professional licenses, and education. They are chosen from diverse backgrounds and must take an oath to remain neutral and decide cases solely on the facts and meris.

Once arbitrators are chosen and agreed upon by both parties, there will be an initial pre-hearing conference, where investors are typically represented by an attorney. The arbitration hearing is scheduled, and discovery begins.

Discovery allows both parties to exchange documents and identify witnesses and is governed by rules within FINRA’s Discovery Guide. After discovery is completed, the arbitration hearing takes place.

The arbitration hearing takes place around a conference table, with arbitrators at the head of the table and the parties on each side. The claimant presents their side of the case first, complete with an opening statement, witnesses, and evidence, and is followed by the respondent. Objections are permitted, and the arbitrators determine whether or not they will accept evidence.

At the completion of the hearing, the arbitrator(s) will deliberate, and render their award, typically within 30 days. The award is legally binding on both parties, and FINRA offers no internal appeals process. While a party may choose to appeal an arbitration award in court, it should be noted that judges rarely overturn these awards.

From start to finish, FINRA arbitration cases that don’t settle before their hearing take approximately 16 months. The process allows for a streamlined and more private alternative to litigation in the courtroom, as FINRA arbitration documents are not made public like court documents. We invite you to contact us for details and support on your potential FINRA arbitration claim.

Sources: [1] https://www.finra.org/arbitration-mediation/arbitration-overview] [2] https://www.finra.org/sites/default/files/Education/p117486.pdf [3] https://www.finra.org/rules-guidance/rulebooks/finra-rules/12902]

Let’s consider an example of margin investing with Robinhood. An investor deposits $5,000 cash into a margin account, and Robinhood lends another $5,000 to allow the investor $10,000 worth of securities. The “margin” is the difference between the value of the securities and the loan from Robinhood. This type of investing increases both purchasing power and financial leverage. [1]

If the securities in the margin account increase in value, the investor has the opportunity for a higher profit than they would have had they invested $10,000 of their own.

On the other hand, if the securities decrease in value, the margin investor is at risk of losing more than they would have had they invested $10,000 of their own.

One of the most significant risks of margin investing stems from margin calls. Because securities purchased on margin are used as collateral against the loan Robinhood extends, Robinhood sets “margin maintenance requirements” on each margin account. These requirements are minimum portfolio values that must be maintained by the investor, and they help Robinhood protect the money they’ve loaned. [2]

So, if the market is volatile, as it has been recently, and the value of securities in a margin account falls too far, Robinhood will issue a margin call. The investor must then either deposit additional cash into their account to meet the margin maintenance requirement or close out their position(s).

However, per Robinhood’s Margin Account Agreement and Margin Disclosure Statement, when Robinhood issues a margin call, they also have the right to sell the account holder’s securities without notice nor consultation. [3],[4]

The language of the agreement specifically states that Robinhood is authorized to liquidate or sell the securities in a margin account to cover any margin deficiency, and that they are not required to notify the account holder before making such a sale. The agreement also stipulates that Robinhood has the sole authority to choose which securities are sold in order to satisfy a margin call, and that Robinhood’s margin maintenance requirements are subject to increase at any time, with no advanced written notice required. [3],[4]

Based on this agreement, which all Robinhood margin investors are required to sign, Robinhood has quite a bit of power over margin accounts. Understood in context, however, these stipulations are designed not to put the investor at risk, but instead to allow Robinhood to protect the money they’ve loaned to investors via immediate liquidation and/or covering losses by requiring additional cash deposits. [3],[4]

Margin investors should also be aware that Robinhood’s margin account agreement explicitly states that any disputes must be resolved via arbitration, so neither party to the agreement may sue one another in court. If a dispute arises, an arbitration case would be filed with the Financial Industry Regulatory Authority (FINRA) in order to reach a resolution or settlement. [3],[4] FINRA arbitration is designed to create a fair and expedited alternative to a traditional court case, but it’s important to understand the arbitration process before deciding to make the leap into margin investing.

So, depending on your risk tolerance, margin trading may or may not be an investment tool you want to use in your accounts.

In our next post, we’ll be sharing a start-to-finish overview of what you can expect from the FINRA arbitration process, particularly as it pertains to margin investing.

Sources: [1] https://www.investopedia.com/ask/answers/041315/why-purchasing-stocks-margin-considered-more-risky-traditional-investing.asp [2] https://robinhood.com/us/en/support/articles/margin-overview/ [3]https://cdn.robinhood.com/assets/robinhood/legal/RHS%20Customer%20Margin%20and%20Short%20Account%20Agreement.pdf [4]https://cdn.robinhood.com/assets/robinhood/legal/RHS%20Margin%20Disclosure%20Statement.pdf

Starting with the basics, what is a non-fungible token?

An NFT is a type of digital, cryptographic asset which exists on blockchain. Fungibility refers to interchangeability – assets like dollars, gold, and even Bitcoin, are fungible, because each unit is worth the exact same amount, and is thus readily interchangeable. On the other hand, each unit of a non-fungible asset has its own unique value and thus is not readily interchangeable – think of assets like property, artwork, and other collectibles. [1]

NFTs derive their value from their uniqueness. Each NFT has its own identification codes and related data within the blockchain to distinguish itself. It is impossible to replicate an NFT, which helps to create rarity among NFTs akin to that of traditional and tangible collectibles.

While there are several possible use cases for NFTs, the market is currently largely focused on collectibles. In particular, the popularity of digital artwork NFTs has skyrocketed in 2021. Artists are excited about this new market, as NFTs eliminate the need for intermediaries like art brokers, thereby increasing market efficiency. Artists can now post their artwork on digital marketplaces like OpenSea where anyone in the world can browse and purchase using blockchain-based cryptocurrencies, like Ethereum. [2]

But when you buy an NFT, what do you actually get? In the case of digital collectible NFTs, you are getting not only the digital piece of art, but also the NFT’s unique code and data on the blockchain. The value of the NFT comes from its unique identifiers. You are not, however, getting any intellectual property rights to the piece of art – those still belong to the artist.

Instead, much like physical pieces of art or baseball cards, you are paying to own an “original” or collectible item. For example, when Jack Dorsey sold an NFT of his first tweet, the buyer received a unique token on the blockchain that cannot be replicated. But that does nothing to change the fact that anyone with internet access can look at the tweet, screen shot it, or save a picture of the tweet on their phone.

The concept may seem nebulous to some, but its not so different from physical collectibles. It’s widely accepted that certain early edition baseball cards have inherent value to collectors. If someone were to simply take a picture of one of these collectible cards, that would do nothing to decrease the value of the original card, and similarly, would not suddenly give value to the picture someone took of it.

Of course, rarity alone does not necessarily equate to value – actual interest within the market participants of owning the NFTs is also essential. But it is yet to be seen whether this is what makes NFTs such an interesting and risky investment opportunity.

Many people are currently buying NFTs speculatively, not to own them long-term, but rather with the aim of selling them at a profit sometime in the future. While some NFT purchasers have already made huge sums of money in this way, it remains to be seen whether the current NFT craze will endure, or whether this is a passing fad brought on by the uncertain and unprecedented circumstances we’re all currently under.

In sum, NFTs present an equally intriguing and risky investment opportunity. If you are interested in the market, you should approach the decision to invest with extra care as the NFT market continues to develop and additional use cases and capabilities are explored.

Sources: [1] https://www.investopedia.com/non-fungible-tokens-nft-5115211 [2] https://www.nytimes.com/2021/03/11/arts/design/nft-auction-christies-beeple.html

As defined by SEC Commissioner Allison Lee during her keynote speech at the PLI’s Annual Institute on Securities Regulation in November 2020, a systemic risk is “characterized by the following features: (1) ‘shock amplification’ or the notion that a given shock to the financial system may be magnified by certain forces and propagate widely throughout; (2) that propagation causes an impairment to all or major parts of the financial system; and (3) that impairment in turn causes spillover affects to the real economy.” [1]

Put more simply, a systemic risk is one with the potential to result in the downturn, or even collapse, of an entire market system. The ongoing COVID-19 pandemic is one recent example of such a risk, as we continue to see its economic impacts across every sector of the market. During her speech, Lee noted that although the SEC is not in a position to regulate and slow the actual drivers of climate change, it can – and should – address climate risks through standardization of the environmental, social, and governance (ESG) disclosures that financial institutions make.

The SEC’s interest in managing climate risk seems to be gaining momentum, as John Coates, the SEC’s acting Director of the Division of Corporation Finance, recently echoed Lee’s sentiments by recommending that the SEC take a leadership role in creating a standardized disclosure system for ESGs. [2] Coates commented that ESG disclosures are becoming “less voluntary” than they historically have been, as investor interest in this information has risen significantly. Investors are beginning to expect sustainability reports, and in turn, some form of standardization by the SEC will help protect and inform investors moving forward.

From an outside perspective, a June 2020 report by Ceres, titled “Addressing Climate as a Systemic Risk: a call to action for U.S. financial regulators” offers additional insight into the economic impacts of climate change, along with recommended actions for a slew of financial institutions like the SEC. [3]

The report states that some of the most significant risks inherent in climate change include economic losses and health risks stemming from extreme weather events, as well as the ripple of economic impacts from the eventual transition toward a low or zero-carbon economy.

As seen from this week’s tragic winter storm in Texas, the economic impacts of severe weather events are staggering, and these events are only getting more extreme and more common. Experts are expecting insurance claims from the storm to top $19 billion, the previous record for Texas’ most expensive storm set by Hurricane Harvey in 2017. [4] Not to mention the extensive costs borne by disrupted supply chains, among other market sectors.

Further, as our economy necessarily transitions toward net-zero carbon in order to reduce greenhouse gases that accelerate climate change, there is the potential for widespread disruption of critical industries like transportation and energy. When these multi-trillion-dollar industries suffer, the entire market does too.

While regulatory bodies like the SEC may not lead the charge in slowing climate change itself, they have the unique opportunity to prepare and stabilize the market as climate risks loom. Their recent prioritization of formalized ESG disclosures is a promising sign, but only time will tell whether measures like these will effectively protect the market from the extreme risks posed by climate change.

Sources:

[1] https://www.sec.gov/news/speech/lee-playing-long-game-110520

[2] https://www.reuters.com/article/us-climate-change-disclosures/secs-coates-says-agency-should-help-create-esg-disclosure-system-idUSKBN2AI2CG

[3] https://www.ceres.org/sites/default/files/2020-05/Financial%20Regulator%20Executive%20Summary%20FINAL.pdf

[4] https://www.dallasnews.com/business/2021/02/18/this-years-winter-storm-could-become-the-costliest-weather-event-in-texas-history/

The first cryptocurrency, Bitcoin, was introduced in 2009, and it has since been joined by over 1,900 competitors. Cryptocurrencies operate in a decentralized, purely digital block-chain network. Within the network, a supply cap on “coins” exists, and coin production is left in the hands of collective members of the system through a process known as “mining.” In Bitcoin’s case, there can only ever be 21 million coins mined, of which over 18 million have been mined thus far. Cryptocurrencies like Bitcoin derive their value largely from their limited supply, overall market demand, the cost to produce a bitcoin via mining, and competition from other cryptocurrencies.

Recently, Bitcoin’s price has been on the rise, stirring up a good deal of interest from prospective investors. As of February 6, 2021, one bitcoin is worth $39,255.90 –up about 300% year over year, and 34% year to date. But an investment in Bitcoin, or other cryptocurrencies like it, is unique in its risks. Experts caution that because cryptocurrency is a relatively new technology, and is not yet well understood by the public, prospective investors are at an increased risk of falling victim to fraudulent schemes.

From a regulatory standpoint, the SEC currently categorizes bitcoin as a security. However, bitcoin differs significantly from a traditional stock or bond because it does not represent shares of a corporation– it has no balance sheet, it is not impacted by government-imposed monetary policy or inflation rates, and its digital format makes it extremely difficult for regulators to access. As a result, cryptocurrencies like Bitcoin offer fraudsters a prime opportunity to engage in predatory behavior against investors.

This week, the US Department of Justice brought two recent cryptocurrency schemes to light. First, on February 1, 2021, a California man, John DeMarr, was charged with one count of conspiracy to commit securities fraud for soliciting investments in two companies he owned, which he misrepresented as highly profitable online cryptocurrency mining and trading platforms. DeMarr lured investors in with celebrity endorsements and fake press releases. But rather than investing his victims’ money in cryptocurrency technologies, DeMarr defrauded them of over $11 million, using the funds to furnish his lavish lifestyle instead.

On February 4, 2021, another cryptocurrency scheme unfolded as the 24-year-old founder of a cryptocurrency hedge fund pleaded guilty to one count of securities fraud. Stefan He Qin owned two cryptocurrency hedge funds which he told investors carried minimal risk because they were not impacted by volatile swings in cryptocurrency prices. Qin managed more than $90 million for his investors, which he used for personal expenses while providing his investors with falsified monthly investment performance reports.

These are just two instances of cryptocurrency fraud, but they are symptomatic of a growing trend in the cryptocurrency market. Eager investors looking to get involved in cryptocurrency and related technologies should exercise caution when making their investment decisions. The SEC has recently published an investor alert titled “Ponzi Schemes Using Virtual Currencies” which points out several red flags to be aware of, including investments touted as carrying little or no risk, unlicensed sellers, and investments requiring no minimum investor qualification.

While cryptocurrencies present an exciting investment opportunity for some, prospective investors should keep in mind their myriad risks, and regulators should continue to develop strategies for identifying and deterring fraudulent cryptocurrency schemes.

As has been widely reported this week, when Reddit retail investors discovered that hedge fund managers were widely shorting GameStop, AMC, and others, they urged fellow users to begin buying up these stocks. This frenzy of investment activity resulted in a short squeeze, sending GameStop’s stock price soaring, causing hedge funds to incur huge losses on their short positions, and placing popular online trading platforms in a precarious financial situation. GameStop shares closed the week of January 25, 2021 up 400% in spite of market volatility and restrictions, and without any material change to the prospects of company.

But how did we get here?

For one, through the rise of simple, fee-free, online investment platforms like Robinhood. These platforms have empowered retail investors by providing an easy-to-use interface to enter the market and trade shares at the click of a button. But this innovation hasn’t come without its critics, who counter that the platforms may paint investments as form of gambling for users who may not have the requisite knowledge to make informed decisions about the risk they take on in their accounts.

As trading activity exploded on Robinhood this week, the platform became strained and suspended trading on a group of 13 popular stocks on Thursday, January 29^th. The restrictions disallowed further purchasing of the stocks but allowed selling – making it difficult for prices to continue to rise. As reported by the New York Times, in order to continue operating Robinhood needed funds to pay both its clearing facility and its users who were owed money from prior trades. To that end, Robinhood raised over $1 billion from its credit lines on Thursday night, enabling trading to resume on Friday, albeit with significant stock-quantity restrictions.

Of course, this period of restricted trading has raised some important legal and regulatory questions. First, some Robinhood users viewed the trading restrictions as unjust behavior in the free market, with over a dozen lawsuits, including a class action, filed against the company this week. The lawsuits claim that Robinhood breached its contract with users when it began restricting their trading activity. Further, the class action lawsuit claims that Robinhood’s “actions were done purposefully and knowingly to manipulate the market for the benefit of people and financial institutions who were not Robinhood’s customers.”

According to several legal experts cited by Thompson Reuters, it is unlikely that these lawsuits will succeed, because Robinhood’s user agreement reserves the right to “prohibit or restrict” its users from trading securities at its own discretion. Additionally, federal securities law places strict limits on class actions against brokers, and users will face the tough task of proving the specific damages they suffered because of the restrictions. They will also likely need to show concrete evidence that Robinhood’s restrictions were made for an some “improper reason, such as to favor certain investors” to succeed.

Given the intense public scrutiny and media attention, it’s difficult not to wonder what comes next. In the regulatory realm, the SEC has released a statement vowing that they “will closely review actions taken by regulated entities that may disadvantage investors or otherwise unduly inhibit their ability to trade certain securities.” In fact, the SEC has already had its eyes on Robinhood in recent months. They issued a $65 million fine against the company in December 2020, alleging that Robinhood misled its customers about their main revenue source, causing users to lose $34.1 million between 2015 and 2018.

With commitment this week from both the White House and Treasury to monitor the situation, along with bipartisan support in Congress to investigate, this fast-evolving situation will be one to watch in the coming weeks.

According to the Financial Times, during the ‘consultation period’ when the Securities and Exchange Commission considers comments made about their proposed changes, 2.262 letters were submitted to the Securities and Exchange Commission regarding the proposed change to the disclosure rules. Of these 2,262 comment letters, 99% were against the proposed rule, according to Financial Times. The result of such a large number of letters opposing the rule change is that the Securities and Exchange Commission is expected to withdraw its proposal and keep the current disclosure threshold of $100 million.

The $100 million threshold has been in place since 1975 and it requires hedge funds to file a “13-F” report each quarter to disclose their holdings. The Securities and Exchange Commission looked at the fact that the US equity market capitalization has grown from $1 trillion to an $35 trillion and decided that it was time to raise the disclosure limit. The Securities and Exchange commission also claimed that the disclosure requirements at $100 million were a burden to the smaller hedge funds. This reasoning leaves out the impact that its actions would have on the transparency of the markets. The Financial Times reports that hedge fund managers were skeptical of the Securities and Exchange Commission’s reasoning. The smaller hedge fund managers and even the CFA Institute noted that the costs to file the 13F are negligible and the process was mostly automated by today’s portfolio accounting software programs.

There are plenty of reasons why the proposed rule change is a bad idea that would have long term negative effects on the securities markets. The financial markets need to be as transparent as possible to protect investors and the integrity of the public securities markets. Whenever rules create additional options for hedge funds to obscure their investments, the individual investor is at a disadvantage. The individual investor should have access to understanding the positions taken by hedge funds because it can help guide their own investing and provide clues as to how the ‘experts’ value an investment that an individual investor may want to make.

Financial Times noted that another potential problem with the proposed disclosure threshold increase is that it would permit activist investors to accumulate larger stakes in companies, thus forcing companies to develop new strategies for dealing with activist investors. An ‘activist investor’ is one who buys shares in a publicly traded company in order to get board of director seats and then work to make significant changes to the target company. This may sometimes be beneficial for the target company but it could also lead to negative impacts by derailing management’s plans to grow the target company and ultimately hurting shareholders of the target company.

The New York Stock Exchange’s letter warned that small and medium size publicly traded companies could be hardest hit, according to Financial Times. Since smaller companies have a smaller ‘float’ of shares, an activist company could quickly purchase a significant portion of the company’s shares and in effect take over the company from its current managers by obtaining multiple board of director seats and thus call the shots.

The outpouring of resistance by hedge funds, publicly traded companies and large pension funds to the Securities and Exchange Commission’s proposed rule change is a welcome sign in a world where many people may believe that Wall Street is trying to take advantage of them. Let’s hope that the Securities and Exchange Commission does withdraw this rule change proposal.

It is fundamental to full and fair disclosure that if an individual investor wants to know whether their financial adviser, or a financial adviser they want to hire, has any legal or regulatory problems, that this information is easy for an investor to obtain. To that end, the Securities and Exchange Commission (“SEC”) sought to simplify the process by which an individual investor can access this information. The result of the SEC’s efforts was the “Form CRS.” “CRS” stands for customer (or client) relationship summary.

This information has been available. However, for the average “Main Street” individual investor, the information was not easy to find. And when the customer complaint and regulatory history was found, the disclosures were difficult to understand. The Form CRS[2] was intended to address this complexity and difficulty through simplification. Thus, the SEC created what SEC Chairman Jay Clayton said in November 2018 would be a “clear and concise” document. I think they succeeded. Wall Street, however, failed.

One question on the Form CRS asks is “Do you or your financial professionals have legal or regulatory history.” This is a simple yes or no question. Or so you would think. The SEC’s instructions for Form CRS elaborate, telling financial advisers to answer ‘yes’ if they or their financial professionals have disclosed such legal or regulatory history. The SEC instructs financial advisers to disclose if they or their advisers have disclosed any legal disputes with customers, regulatory penalties or have been terminated while working at prior employers.

Pretty straight forward, right? Well, apparently not if you are a financial professional! According to the Wall Street Journal’s analysis, an astonishingly high number of firms failed to report legal and regulatory issues. 1,300 firms failed to list disclosures on approximately 2,300 individual employees. The Wall Street Journal reports that their analysis shows that approximately 1,600, or almost 70%, of the non-disclosures related to customer complaints.

The failure to answer ‘yes’ approximately 2,300 times by almost 1,300 financial firms on this Form CRS is more than a mistake.

It is the financial industry’s continued attempt to hide this important information from investors. Transparency is important and by ignoring the rules and intentionally (or at least grossly negligently) hiding customer complaints from investors, these firms weaken investors’ trust.

This mass failure to be transparent can only be seen as an intentional attempt by Wall Street to mislead Main Street investors.

When seeking to hire a financial professional, the prudent investor will try to find out if the financial professional they want to hire is trustworthy or has any customer complaints. This information is vital not only to protect individual investors, but it is important to help ‘clean up’ the financial industry by helping to rid the industry of those financial professionals that have significant or numerous customer complaints. Even with the SEC’s simple Form CRS, the Main Street individual investor is at a disadvantage since the firms are not properly disclosing the information.

It is my hope that the SEC acts strongly to prevent a re-occurrence of the Wall Street’s attempt to hide the truth from investors. I also hope that Wall Street becomes more transparent so that individual investors can finally move towards having a level playing field. Proper disclosure by financial professionals of their legal and regulatory history is a big step in the right direction.

[1] https://www.wsj.com/articles/financial-firms-fail-to-own-up-to-advisers-past-misdeeds-11598698800?mod=searchresults&page=1&pos=1 [2] https://www.sec.gov/info/smallbus/secg/form-crs-relationship-summary

Interactive Brokers that Saroop and two others (collectively, the “Investors”) opened accounts with Interactive Brokers where they were required to sign the contracts that provided that all transactions were subject to “rules and policies of relevant market and clearinghouses, and applicable laws and regulations.” Interactive Brokers hired a third-party to trade the Investors’ accounts (the “Manager”). Using the Investors’ margin accounts, the Manager invested in short-term futures, with a symbol of VXX. The Manager sold naked call options for VXX, meaning that the Investors had the right to buy VVX at a set price until the option expired. This works great if the market price increases but is a serious problem if the value decreases. To make matters worse, the Manager traded using the Investors’ margin accounts. A margin account is when you borrow money to purchase stock. This means that you can lose more money than you invested.

The high risk associated with margin trading prompted FINRA to prohibit purchases of VXX using margin.

The Manager was heavily invested in VXX when the market dropped and the Investors’ accounts dropping 80%. The drop triggered a ‘margin call’ for the Investors to deposit money or marketable securities to get the margin balance back to the minimum required. Interactive brokers began auto-liquidating wiping out the Investors’ accounts. The end result was that the Investors owed hundreds of thousands of dollars to Interactive Broker in their margin accounts.

The Investors filed arbitration against Interactive Brokers to recoup their losses alleging, among other things, breach of contract. The arbitration panel found for the Investors and awarded damages based on the account values before the margin trading started.

Interactive Brokers moved to vacate the award and the court criticized the arbitrators, essentially saying that they were not fit to make the decision. This court remanded to the arbitrators to explain their award. The arbitrators explained that the liability was based on FINRA Rule 4120 and that the damages came from value of the Investors accounts before the ineligible VXX investment. Interactive Brokers again asked the court to vacate the arbitration award, and the court did.

The Investors appealed to the Fourth Circuit that held that it is not ‘manifest disregard of the law’ to premise liability on a breach of contract. ‘Manifest disregard’ is one of the ways to overturn an arbitration award. In this case, Interactive Brokers admitted that parties may incorporate FINRA rules into a contract and the arbitrators found that Interactive Brokers had not complied with FINRA rules. As such, the Fourth Circuit held that since the contracts between the parties invoked the FINRA rules, Interactive Brokers breached the contract.

The Fourth Circuit reaffirmed that contract damages are awarded to place the injured parties in the same position had there been no breach of contract. The court found that even if this is not the best reading of the law, a court cannot overturn an arbitration award because it believes the arbitrators misinterpreted the applicable law.

This case is of interest because it holds that when investors sign contracts with a brokerage firm that incorporates FINRA rules, a finding that the brokerage firm did not comply with FINRA rules is a breach of contract. Another interesting feature of this case is that the court pointed out very clearly that it supports arbitration as a valid resolution forum.

Stock fraud may occur when a company defrauds investors when convincing them to buy shares in their company. The investment fraud may be a market manipulation scheme. It may be an unethical brokerage firm forcing their brokers to sell the ‘stock of the day’ knowing full-well the stock is not worth a fraction of what the price the sell to you.

But, perhaps the worst form of stock fraud, to my mind, is the stock fraud that takes advantage of people’s fear about current events. Understandably, potential investors or victims of fraud are today extremely concerned and frightened about catching Covid-19. This is especially true for that frequent target of fraudsters, older people. Not only is this segment of the population more vulnerable to Covid 19, but their fears are likely at a higher level. This set of circumstances just creates a more fertile ground for investment fraud that takes advantage of loneliness and fear such as we have today with the pandemic. So, it is vital to get the word out to older people and their children or caretakers to be especially vigilant about investment fraud phone calls.

Everyone should also take the time to connect with their parents and grandparents to make sure they understand the significant risk associated with potential Covid-19-related stock fraud. Of course, we should all take any claims of huge potential profits with a healthy dose of skepticism. But we all want to believe in the huge investment upside; these outsized profits do occur, but not that often or that quickly. And probably not from the slick-talking stockbroker pitching his or her idea.

There are fraudsters are out there right now working to capitalize on the public’s fear created by the Covid-19 pandemic and the millions of Americans who have tested positive and the more than 150,000 (as of this writing) Americans who have died from Covid-19.

Covid-19 is ripe for stock fraud because investors are rightfully very worried about Covid-19, for which there is no known cure or vaccine. There are many companies are trying to develop a response to Covid-19. With the uncertainty about the pandemic and vaccine creation coming from the government, it is easy work for an unethical salesperson to convince an investor that their recommended stock has the cure or an effective treatment almost ready. It should strike you as odd that some cold-calling stockbroker is letting you in on the greatest investment of all time. People want good news and want to believe the rosy predictions spewed by a fraudster. So, an unethical stockbroker will create and tell a tantalizing story of a company well-suited to make enormous profits from their ‘vaccine’ or ‘treatment’ – “and you, mister or missus investor can get in on the ground floor!”

Most people would understand that the first company to come out with a cure or vaccine for Covid-19 will likely make huge profits. Most would want to participate in that profit. These facts combined with a convincing stock salesperson is a dangerous mix and ripe for investment scams.

Fraudsters are pushing investments in companies that make and sell N-95 masks, or alleged Covid-19 cures, home testing kits for the disease, or even products they falsely claim give people immunity from Covid-19. In fact, according to the SEC in June 2020, it had temporarily halted trading the shares of 30 companies to protect investors and had charged companies with Covid-19 related fraud. The SEC filed charges against a company that made the false claim that they were negotiating the sale of millions of N-95 masks. Another company that the SEC charged had put out a press release stating that they had a home test kit for Covid 19 that would give results in less than 15 minutes. The SEC charged that the test kit was not intended for home and could only be used with the help of medical professionals.

Be wary of a cold-call from a slick stockbroker that purports to get you in on the only stock that cures Covid or effectively treats Covid. Reach out to your loved ones to make sure they understand the risks and to talk you before making any investment based on their fears and concerns.