Protect Yourself

The NASD statistics are plain: The increasing volume of filed arbitration customer claims highlights the importance of maintaining up-to-date and complete customer account files. While both the total number of member firms and the number of customer regulatory complaints have decreased since 2000, the number of NASD arbitration claims filed have substantially increased during this same time period. In fact, the number of new claims filed increased 16% in 2003 over 2002. Moreover, the 2003 NASD figures show that the volume of cases has nearly doubled since the early 1990s. Arguably, at least some of the increase in claim volume can be attributed to market declines rather than poor investment advice or management. Nevertheless, good recordkeeping practices are of immeasurable importance in the defense of customer claims. Indeed, while maintaining good customer records will not prevent claims from being filed–or even guarantee victory when a claim is filed–poor recordkeeping will almost certainly haunt the most diligent advisor in his defense of customer claims.

So how do you prepare yourself for these claims? Let’s start with the arbitration agreement. All customer files should contain signed agreements that include an agreement to arbitrate. Without a signed agreement to arbitrate, an investment advisor cannot force a customer to resolve his or her claims in arbitration. Yes, arbitration is not a guarantee of a favorable result, and while certain expenses are reduced if a dispute is handled through arbitration rather than conventional litigation (e.g., reduced discovery costs or reduced motion practice expenses), investment advisors should be prepared for some other comparatively higher costs in arbitration, such as filing fees and the fees paid to the arbitrators. Nevertheless, arbitration–particularly with a self-regulatory organization–is usually preferable to litigation if only because disputes are decided by arbitrators who are relatively sophisticated about the issues confronting the industry, rather than jurors or a judge. Of course, the parties also have more control over the selection of the decision makers in arbitration than in litigation.

Resolution of disputes through arbitration cannot be compelled in the absence of an agreement to arbitrate signed by all of the claimants. While agreements to arbitrate customer claims have long been upheld by the courts, the law of arbitration agreements is currently evolving, primarily due to the relatively recent use of arbitration agreements in such fields as consumer lending as a means to combat class actions. As a result, advisors should consider updating arbitration clauses to reflect the areas that courts are currently addressing, such as highlighting the arbitration clause in boldface type, calling for the application of the Federal Arbitration Act, and addressing the costs of arbitration.

Investment advisors also should ensure that any delegation of discretionary authority by a client is reduced to writing. NASD Rule 2510(b) and NYSE Rule 408(a) provide that discretionary authority cannot be exercised in the absence of a prior written authorization to a stated person and acceptance of that authorization by the member or other authorized person. Rule 275-204-2(a), under the Investment Adviser Act of 1940, also requires registered advisors to maintain written evidence of discretionary authority, as do both versions of the Model Rule 203(a)(2) for state regulated investment advisors under the Uniform Securities Act of 1956. A claim of unauthorized trading is difficult to rebut if the investment advisor has not maintained the required written record of discretionary authority. Conversely, responsibility for authorized trades rests with the customer if there is no discretionary authority.

Customer Objectives

The mantra of “know your customer” is repeated time and again in the regulations. NASD Rule 2310 and NYSE Rule 405 require reasonable efforts and due diligence to obtain insight into a client’s investment experience and investment objectives, and Standard IV (B.2) of the Association for Investment Management and Research (AIMR) requires a reasonable inquiry into a client’s financial situation, experience, and objectives on at least an annual basis.

In some instances you also must, and arguably in all instances should, keep a record of the information obtained. Under Rule 17a-3(a), broker/dealers must keep records of a customer’s information and investment objectives. That information similarly falls within the recordkeeping prescription of AIMR’s Standard IV (A.1). Rule 275.204-2 requires federally registered investment advisors to keep most customer records for five years from the end of the fiscal year in which the last entry was made. State regulated investment advisors are required to create and maintain communications related to, and written information forming the basis of, customer recommendations and advice in both alternatives for Model Rule 203(a)(2). The U.S.A. Patriot Act required broker/dealers to implement, by October 1, 2003, reasonable procedures to verify the identity of persons opening accounts and maintain records of the verifying information. Moreover, recent amendments to Rule 275 will also require, by October 5, 2004, compliance programs and the maintenance for five years of the advisor’s policies and procedures, and documentation of the annual review of those policies and procedures (see 17 C.F.R. ? 275.204-2(a)(17)(i), (ii)).

At first blush, the rules appear to be a maze of restrictions. However, they memorialize what should be common sense: Advisors should know their customers, know their objectives and experience, and maintain that information in writing.

But What if I Don’t?