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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?

Regulators have some degree of flexibility in both the enforcement and interpretation of Rule 275 for small firms. Regulators uncovering a recordkeeping violation may direct that the problem be corrected. The anecdotal evidence suggests that enforcement actions usually are brought in tandem with other violations, or in lieu of other violations that are more difficult to prove. On the other hand, failure to comply with recordkeeping obligations could have a more tangible impact on customer arbitrations.

In virtually every arbitration, the sophistication of the customer is relevant, at least to some degree, since evidence of trades will be sent to the customer and can be ratified. The more information that is disclosed to a customer, the less room that is left for the customer to claim that he or she did not know, did not understand, or relied on his or her broker. Documents regularly updating the investor’s age, changes in family composition and liquidity, the purposes for investments, and disclosing the risks of investing and trading on margin (and even having the customer voluntarily assume some of those risks), can go a long way to rebut claims of unsuitability, negligence, breach of fiduciary duty, and failure to supervise.

Rest assured that your recordkeeping practices will be uncovered in pre-arbitration discovery. NASD prescribes in its Discovery Guide the types of documentation that are presumed to be discoverable in all and specified styles of customer cases, and these include account opening documents and new account forms, correspondence with the customer, notes relating to the account analyses and reconciliations of the account, and records of disciplinary action for similar conduct. Therefore, a customer undoubtedly will be provided through discovery the documents maintained by their advisors relative to their investment objectives and information. Gaps and violations become obvious.

At a minimum, recordkeeping violations will paint the picture of an imprecise investment advisor. The “worst case” scenarios are more troublesome. Failing to maintain an arbitration agreement signed by the parties could prevent a claim from being heard in arbitration. Failing to maintain records of customer objectives could permit a customer to claim that his or her objectives were different from those originally stated. In an extreme case, a claimant could argue that the failure to maintain records amounts to per se liability based on the violation of a regulation, leaving a creative attorney to prove only the causation link between the violation and the decline in the customer’s investments.

Make a List; Check it Twice

Many larger brokerage firms have detailed applications that contain questionnaires outlining not only a client’s name, telephone number, address, age, occupation, income, net worth, and objectives, but also the client’s investment experience, how risk is assessed, and an explanation of the risks of investments, such as the risks of trading on margin. Information such as the identity of prior investment counselors, the level of advice given by the prior advisor, the reasons that the client changed advisors, and the client’s overall satisfaction or dissatisfaction with the prior advisor will not only provide insight into the customer’s investment experience but may allow you to improve service to the client. It would be helpful for the advisor to hold regular meetings with the client to discuss market trends and to update investment objectives; records (such as date books) of those meetings should be maintained.

Recordkeeping is more than a passing annoyance in the busy world of serving clients. Not only are the rules and regulations relating to account records growing in leaps and bounds, the records kept by investment advisors today will shape the defense of tomorrow’s customer arbitrations. While compliance with recordkeeping standards may be intended for the protection of the investing public, maintaining such written records also protects investment advisors from claimants’ second-guessing advice in declining markets. An investment in wise recordkeeping today will surely pay dividends in the future.

Charlotte Thomas is a partner in the Securities Law Practice Group of Wolf, Block, Schorr and Solis Cohen, LLP, in Philadelphia. She can be reached at [email protected].


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