Copyright 2009 Shaheen, Novoselsky, Staat, Filipowski & Eccleston, P.C. Chicago, IL All rights reserved.

Avoiding Customer Complaints

PRESENTED BY:

James J. Eccleston, J.D.

April 30, 2009

FPA New York Spring Forum

New York, NY

2

I. FINRA Arbitration

Filings are increasing• In 2008, 54% increase (4,982 vs. 3,238 claims)• Through mid-March 2009, claims filed = 1,475• “Win” rate for customers rebounded, from low of

37% in 2007 to 42% in 2008• “Failure to supervise” claims up 24%• “Omissions of fact” up 337% • “Misrepresentation” up 171%

3

• “Omissions of fact” and “misrepresentation” account for more than 40% of disputes of the 10 listed security types– Reflect explosion of “Derivative Securities” disputes and “Auction Rate

Securities” disputes – with chief allegations relating to what investors were told and not told

• Traditional security types also visible in customer disputes– Mutual funds (171%)– Corporate bonds (130%)– Certificates of Deposit (98%)– Common stock disputes declined in number

FINRA Arbitration

4

Unsuitable investments• An issue in many, if not most, customer arbitrations and claims

against financial advisors

NASD Conduct Rule 2310:• Requires broker/advisor to have reasonable grounds for believing

that recommendation is suitable based on the facts, if any, disclosed by the customer as to his or her other security holdings, financial situation, and financial needs

• Advisor must determine if the recommendation is suitable for anyinvestor, regardless of the investor’s wealth, willingness to bear risk, age or other individual characteristics (so-called “reasonable basis” suitability)

FINRA Arbitration

5

Unsuitability – Typical Scenario• Retiree (or person approaching retirement)• Sold investment (e.g., stock, bond or mutual fund) or product

(e.g., deferred annuity) that is too risky or volatile in view of the customer’s objectives and needs

• Account is too heavily concentrated in one asset class (e.g., stocks/equities) or sector (e.g., financials, technology, etc.)

• Investment risks are not adequately disclosed and/or misrepresentations are made

FINRA Arbitration

6

II. Critical Functions(NYSE Series 7 Examination Content Outline, 1995)

3-5) Considers the tax implications for a customer of particular investments

4-9) If there is to be any power of attorney over the account, obtains the necessary documents and approvals

7-1) Routinely reviews the customer’s account to ensure that investments continue to be suitable

7-2) Suggests to the customer which securities to acquire, liquidate, hold or hedge

7-3) Explains how news about an issuer’s financial outlook may affect the performance of that issuer’s securities

7-4) Keeps the customer informed about the customer’s investments

7

Monitoring

Common Problems• Asset class, sector or stock becomes

over-weighted/over-concentrated• Client changes his/her situation

– New questionnaire– Objectives

Critical Functions

8

VARIATION ON UNSUITABILITYPortfolio Mismanagement by an Investment Fiduciary• Registered Investment Adviser and its representatives have fiduciary

duty to clients• Modern Portfolio Theory (MPT) and Prudent Investor Rule define

standard of care• Financial planning “negligence” – failure to anticipate client’s income

needs, inflated projections based on unrealistic returns, etc.

III. Implications For Investment Advisers

9

MODERN PORTFOLIO THEORYAsset Allocation and Diversification• Fundamental concepts that sometimes are disregarded by advisors

Asset Allocation:• Practice of combining non-correlated asset classes (e.g., stocks, bonds,

cash, REITs, hedge funds)• Significantly reduces risk (i.e., volatility) in portfolio• Does not significantly reduce investment returns

Diversification:• Means not having all of your eggs in one basket (i.e., sector)

Implications for Investment Advisers

10

PRUDENT PRACTICES FOR FIDUCIARY ADVISERSby Financial Planning Association (and Donald Trone)

• Outlines prudent practices for Fiduciary Advisers as defined in the Pension Protection Act of 2006

• FPA states the handbook “represents a standard of excellence for fiduciary advisers”

• Includes a four-step investment management process:1. Organize2. Formalize3. Implement4. Monitor

Implications for Investment Advisers

11

Let’s look at the second step, FORMALIZE:• Practice A-2.1

– Fiduciary adviser will analyze investment options and review them with the client

• Practice A-2.2– Fiduciary adviser should identify and document the investment time horizon for the

client

• Practice A-2.3– Identifying and discussing the client’s risk tolerance

• Practice A-2.4– Identifying, discussing and documenting the client’s expected investment return

necessary to meet the client’s investment objective

• Practice A-2.5– Suggests the procedure by which advisers should recommend particular asset classes

for the client

• Practice A-2.6– “Preparation and maintenance of a client’s investment policy statement (IPS) is one

of the most critical functions performed by the fiduciary adviser, even if it is not stipulated by law or regulation.”

FPA Handbook

12

Let’s look at the fourth step, MONITOR:• Practice A-4.1

– Obligates fiduciary advisers to provide periodic reports to clients which compare investment performance against an appropriate index or peer group and against the objectives of the IPS

– A “watch-list” of underperforming investments is encouraged, and the fiduciary adviser should advise the client how to periodically rebalance investments in the portfolio

• Practice A-4.2– Recommends that the fiduciary adviser periodically evaluate the qualitative and/or

organizations changes of investment managers or other investment decision-makers which may affect the investment offerings within the plan, including corporate stock of the plan sponsor

– Fiduciary advisers are expected to notify the client in writing of any unsatisfactory news regarding a material holding in the client’s portfolio

FPA Handbook

13

IV. Themes of Mistakes

INCLUDE:• Failure to document• Failure to control• Digging the hole deeper

14

Failure To Document

• Define the scope of the engagement– What part of the whole are you responsible for giving advice

about?

• Not obtaining complete financial picture from client• Have clients fill out applications and questionnaires in

their own writing

Themes of Mistakes

15

Failure To Document

• Allowing parts of questionnaire to go unanswered• Not documenting what the objectives are for the

funds you manage• Not obtaining all information from client before giving

advice

Themes of Mistakes

16

Investment Policy Statements

Themes of Mistakes

17

Failure To Control

Letting the client control the advice you give

Example: Clients who want to retire young, but have not yet saved enough

Your choices:• Tell clients what they want to hear• Deliver bad news

Themes of Mistakes

18

Typical example:Someone who is 55 and married just retired from his job and took a lump sum distribution:

• Recommend an aggressive asset allocation to get the numbers to “work”

• Tell client “to go back to work and earn some more money”

Themes of Mistakes

19

Avoiding This Problem• Have a research-backed, consistent

methodology• Follow it with each client, even when it means

saying: “You may want to retire, but you can’t.”

Themes of Mistakes

20

Handling The Spendthrift Client

Identifying potential spendthrift clients• Retirees with lump sum distribution• Clients with limited earning potential• Heirs and trust beneficiaries

Themes of Mistakes

21

Handling The Spendthrift Client

Signs of problems• Living expenses beyond reasonable levels• Unwilling to limit expenses or change

lifestyle

Themes of Mistakes

22

Handling The Spendthrift Client

Solving problems• Communication with customer regarding

expenses• Avoiding growth investing for income model• Reevaluating client goals and expectations• Documenting problems and solutions offered

Themes of Mistakes

23

Digging the Hole Deeper

“No good deed goes unpunished.”

• Admitting that a past strategy was not a good idea• Offering to waive fees or give a discount for poor

performance• When a client does not have the stomach to take

losses, don’t fight him• Sell a position that is going down and revise the

questionnaire to reflect that the client “can’t sleep” with certain investments

Themes of Mistakes

24

• If you and a client no longer have the same ideas about investing, end the relationship

• Document any time that a client took an action against your advice

• Never admit that an investment was a bad idea or a mistake

• Never give a refund/discount for services due to investments performing poorly

Themes of Mistakes

Avoiding Digging the Hole Deeper

25

Dealing With a Customer Complaint

• DO NOT meet with the customer or communicate with the customer

• Notify compliance

Themes of Mistakes

26

V. Senior Issues

FINRA NTM 07-43:• “To urge firms to review and, when appropriate,

enhance their policies and procedures for complying with FINRA sales practice rules, as well as other applicable laws, regulations and ethical principles, in light of the special issues that are common to many senior investors”

• Defined as those “at or nearing retirement”

27

No “special rules,” but:• “Age and life stage (whether pre-retired, semi-retired

or retired) can be important factors, and firms should make sure that the procedures they have in place take these considerations into account where appropriate”

• Suitability of recommendations and communications aimed at older investors are “of particular concern”

• Refrain from making an unsuitable recommendation

Senior Issues

28

Note:“A customer’s net worth alone is not determinative of whether a particular product is suitable for that investor, even when the investor qualifies as an accredited investor.”

– FINRA states that over-reliance on net worth is “particularly problematic” where the investor has met the accredited investor standard based largely on the value of his or her home, “which may represent the largest asset of many senior investors.”

Senior Issues

29

Suitability• Age and life stage

– “As investors age, their investment time horizons, goals, risk tolerance and tax status may change.”

– “Liquidity often takes on added importance. And, depending on their particular circumstances, seniors and retirees may have less tolerance for certain types of risk than other investors.”

– “Retirees living solely on fixed incomes may be more vulnerable to inflation risk than those who are still in the workforce, depending on the number of years those retirees are likely to rely on fixed incomes.”

– “Investors whose investment time horizons afford less time to or opportunity to recover investment losses may be disproportionately affected by market fluctuations.”

Senior Issues

30

Suitability• Liquidity needs, consider

– Customer’s primary expenses (Mortgage?)– Sources of income (Fixed?)– Amount of retirement savings (How invested?)– Health insurance coverage (Relying on assets to pay for health

costs?)

Senior Issues

31

Risk• Caution: older investors may “reach for yield to

maximize retirement income without the appreciation of the concomitant risk”

• Must present a “fair and balanced picture of the risks, costs and benefits”

Senior Issues

32

Particular concerns• Deferred variable annuities, equity indexed annuities

and some real estate investments and limited partnerships– “Have withdrawal penalties or otherwise lack liquidity”

• Using home equity to make investments• Using retirement savings (including IRA withdrawals)

to invest in high risk investments

Senior Issues

33

FINRA Report: “Protecting Senior Investors: Compliance, Supervisory and Other Practices used by Financial Services Firms in Serving Senior Investors”

1. Senior investor not defined by age, but “to include investors who have retired or are nearing retirement”– Age, life stage & “diminished mental capacity” are critical

components– Diminished mental capacity may be more prevalent among older

investors, who may also be more frequent targets for financial abuse

Senior Issues

34

2. Firms are communicating effectively with seniors– Firms increased frequency of contact so they remain informed

about changes in the investor’s financial needs, employment status, health and other life events

– Firms adopted practices to encourage their financial advisers to avoid financial jargon & to document conversations with investors, including by sending follow-up letters

– Firms have drafted written materials, in larger-font versions, aimed at educating senior investors

Senior Issues

35

3. Some firms consider training on how to identify diminished capacity a critical program for employees, especially identifying “red flags”:– Of diminished capacity, including the inability to process simple

concepts, memory loss, difficulty in speaking or communicating, disorientation and erratic behavior

– In financial matters, including refusing to follow appropriate investment advice, making investment decisions inconsistent with long term goals, concern or confusion about missing funds, being unaware or not understanding recently completed financial transactions

Senior Issues

36

4. Practices regarding specific products– Limiting or prohibiting purchases of certain investment

products, such as “structured products” based on life stage and risk profile

– Prohibiting purchases of certain variable life insurance products by investors over a certain age

– Requiring a heightened review of annuity applications for investors over a certain age in a low tax bracket or with low liquid net worth

Senior Issues

37

CONCLUSION

38

James J. EcclestonJEccleston@snsfe-law.com

312.621.4400

Questions?

Thank you!

For more information on the securities practice group at SNSFE, or if you have aquestion about this presentation, please contact:

Shaheen, Novoselsky, Staat, Filipowski & Eccleston, P.C.

20 N. Wacker Drive, Suite 2900Chicago, IL 60606-9719

312.621.4400 (T)312.621.0268 (F)

www.SNSFE-law.com www.FinancialCounsel.com