Monthly Archives: June 2010

The Financial Industry Regulatory Authority (FINRA) has issued a Regulatory Notice on a proposed rule to improve oversight of broker/dealers’ back-office operations. Specifically, the new rule would expand registration requirements to individuals who engage or supervise activities related to sales, trading support and/or handling of customer assets.

Previously, FINRA’s registration requirements only applied to brokers, investment bankers, traders or other financial professionals who gave advice to customers and handled securities transactions. Individuals who could be required to register under the new proposed rule include those who develop and approve valuation models; manage trade confirmations, account statements, trade settlement and margin; or oversee stock loan/securities lending, prime brokerage, receipt and delivery of securities, and/or financial regulatory reporting.

According to a statement from FINRA, the proposal is designed to provide “reasonable assurance” that these individuals understand their professional responsibilities, including key regulatory and control themes, as well as the importance of identifying and escalating red flags that may harm a firm, its customers, or the integrity of the marketplace or the public.

The Securities and Exchange Commission (SEC) must approve the rule change before it becomes effective.

Merrill Lynch’s sales of risky collateralized debt obligations (CDOs) have come back to haunt Main Street, with many investors alleging they didn’t thoroughly understand the dangers that the complicated products present.

“We were just lambs being led to the slaughter,” said investor Michael Slomak in a June 11 story in the Wall Street Journal.

Slomack is part of a Cleveland family whom he says invested $2.65 million in several Merrill-issued CDOs. According to the WSJ article, the structured securities had a level of risk that was never adequately explained to Slomack and other family members. The family lost all but $16,500 and has since filed arbitration claim against Merrill Lynch with the Financial Industry Regulatory Authority (FINRA),

Merrill Lynch, which is now part of Bank of America, may be especially susceptible to the wrath of investors because it has sold the biggest inventory of CDOs and had the industry’s biggest brokerage force to sell them in the years leading up to the financial crisis. As the Wall Street Journal article points out, it was common practice for Merrill to pitch retail clients the lowest-rated CDO slices while it sold the higher-rated tranches to larger institutions.

At issue in the Merrill case – and in other cases and arbitration claims related to CDO deals – is the idea of investor sophistication. Even though there are certain regulatory rules in place regarding the types of investors who can purchase higher-risk financial products like CDOs, newer investment products have become more complex in recent years. As a result, the complexities and risk levels of these products may not be fully understood by even the most sophisticated retail customer.

Boston businessman Russell Stephens knows this only too well. Stephens, who considers himself a “sophisticated” investor, bought a $400,000 CDO from a Merrill Lynch adviser in Virginia. Stephens, 56, said he was sold the tranche most vulnerable to losses in the event of default, yet was told that the CDO would be an appropriate replacement for a municipal bond. As fate would have it, the CDO hit a wall, and Stephens faced an unexpected tax charge. Ultimately, the value of his investment plummeted to $80,000.

“It’ been a nightmare,” Stephens said in the Wall Street Journal, adding that the deal “wasn’t fully explained” to him.

Lack of disclosure also was a problem for investor Alan Lipson. Lipson lost $20,000 in a Merrill Lynch CDO. He attributes the loss to the fact that he missed a key section of the prospectus, which cited information on how banks that provide the CDO assets could stop paying interest at any time.

For Ralph Cortell, a former Ohio hair salon business owner, the issue regarding his CDO losses was alleged misrepresentation. Cortell, who died in 2008, invested $2.65 million as a nest egg for his four daughters. In late 2004, Cortell and his son-in-law sought the advice of two local Merrill brokers on how they should invest proceeds from the sale of 200 hair salons.

The brokers allegedly assured them that CDOs were “very safe with little or no risk.” Later, a former Merrill Lynch vice president told Cortell to put even more money into CDOs, stating that they had “zero risk.”

A complaint with FINRA is now pending in Cortell’s case.

Goldman Sachs is facing yet another lawsuit involving toxic synthetic collateralized debt obligations (CDOs). Australian hedge fund manager Basis Capital’s Yield Alpha Fund claims it was defrauded by Goldman when it purchased $78 million of the Timberwolf CDOs in June 2007 and that Goldman knew at the time of the sale the securities were destined to fail as the mortgage market began to decline.

Basis Capital is seeking more than $1 billion in damages.

The lawsuit comes on the heels of another fraud lawsuit against Goldman Sachs. In April, the Securities and Exchange Commission (SEC) filed a civil suit against Goldman in connection to the sale of a synthetic CDO known as Abacus. As reported June 9 by the Wall Street Journal, Goldman and the SEC are reportedly working to settle that case, which could cost Goldman between $500 million and $1 billion in fines.

Emails will likely play a central role in the Basis Capital case. According to complaint, one email from a former Goldman executive describes the $1 billion Timberwolf CDO as “one s—-y deal.”

Basis Capital was forced to liquidate the Basis Yield Alpha Fund in late 2007 after sustaining heavy losses betting on the subprime mortgage market, including buying instruments like Timberwolf.

“Goldman was pressuring investors to take the risk of toxic securities off its books with knowingly false sales pitches,” said Eric L. Lewis of Baach Robinson & Lewis PLLC, Basis Yield Alpha Fund’s lead counsel, in the Wall Street Journal article. “Goldman should be called to account for its deception of BYAFM and other investors who were misled.”

Goldman Sachs is accused of trying to hide key information and bypassing a congressional investigation into the causes of the financial crisis, according to the Financial Crisis Inquiry Commission (FCIC). On June 4, the FCIC issued a subpoena to Goldman for failing to comply with the panel’s request back in January for documents and interviews over Goldman’s synthetic and hybrid collateralized debt obligations.

The deadline to provide the information was Feb. 26. The FCIC later gave Goldman several deadline extensions. Still, the requested information never materialized.

“They stretched us out thinking they played the game cleverly,” FCIC Vice Chairman Bill Thomas said in a June 8 article in USA Today. “They may have more to cover up than we thought.”

Phil Angelides, chairman of the FCIC, had similar comments for Goldman. In a June 7 story on CNBC, he stated the following:

“We are not going to let the American people be played for chumps here. We should not be forced to play ‘Where’s Waldo’ on behalf of the America people.”

Goldman Sachs also is facing a civil fraud lawsuit by the Securities and Exchange Commission (SEC) in connection to a mortgage-related investment that it created and sold in 2007.

Non-traded REITs such as Behringer Harvard REIT I, Behringer Harvard Opportunity, Wells Real Estate Investment Trust II, Inland America Real Estate Trust and Inland Western Retail Real Estate Trust may become more transparent thanks to a new platform under development by the Depository Trust and Clearing Corporation (DTCC).

As reported June 6 by Investment News, the intent of the platform it to provide standards, centralize data and automate transactions for alternative investments like private placements, non-traded real estate investment trusts, limited partnerships and hedge funds. Through the new platform, the DTCC will operate as a go-between among firms that create alternative investments and the broker/dealers and companies selling them.

The platform – called the Alternative Investment Product (AIP) – currently is being used by Pershing LLC. The Charles Schwab Corp. is testing it, according to the Investment News story, and National Financial Services LLC, a clearing unit of Fidelity Investments, plans to have it operating by 2011.

In the interim, about 15 DTCC- affiliated sponsors of alternative investment products are testing the platform.

Alternative investments like non-traded REITs and private placements have come under fire by regulators in recent months for their lack of transparency. In July 2009, the Securities and Exchange Commission (SEC) filed fraud charges against the Tustin, California, lender Medical Capital Holdings in connection to private placements that the company issued to more than 20,000 investors nationwide.

Non-traded REITs also faced intense scrutiny lately. Last year, some of the most prominent non-traded REITs, including Behringer Harvard REIT I, Inland America Real Estate Trust, Inland Western Retail Real Estate Trust and Piedmont Office Realty Trust slashed dividends to investors and/or shut down their redemption programs.

The AIP is intended to standardize the way the alternative investment industry communicates information about these types of investments, providing more new clarity.

“The challenge for many alternative investments is that they’re non-standardized,” said one anonymous industry executive in the June 6 Investment News story. “They’re not always priced and valued on a regular basis. This is an investor need, a broker/dealer need.”

Sales of private placements in Provident Royalties LLC have come back to haunt broker/dealer Okoboji Financial Services. On May 28, the Iowa-based company filed notice with the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) of its intent to withdraw as a broker/dealer. Investment News first reported the story on June 2.

Last summer, the SEC brought a fraud lawsuit against Provident Royalties and its related funds and business entities. In the complaint, the SEC charged Provident with selling fraudulent private-placement offerings from September 2006 through January 2009. According to the SEC, Provident raised $495 million from at least 7,700 investors throughout the country.

Okoboji Financial also is named in the SEC’s lawsuit for having received a 5% payout in connection to selling Provident notes. As reported in the Investment News article, Okoboji was fined $30,000 by FINRA in 2009 for selling private placements to prospective investors with whom neither the firm nor its representatives had a pre-existing relationship.

In March 2010, Okoboji Financial lost a $978,000 arbitration claim over unsuitable structured settlements, according to records with FINRA.

In April, a lawsuit was filed in federal court in South Dakota involving an Okoboji representative who sold private placements in Provident and Medical Capital Holdings to 87-year-old Thelma Barber. As in the Provident case, the SEC charged Medical Capital Holdings with fraud in July 2009. It is now under a court-appointed receiver.

A Los Angeles Financial Industry Regulatory Authority (FINRA) arbitration panel has awarded investors more than $550,000 in damages for their complaint involving a fixed-income municipal arbitrage investment known as MAT Three.

Created and launched by Citigroup Global Markets and sold through Smith Barney in February 2006, MAT Three was represented as a fixed-income alternative product – an investment that supposedly had similar volatility to that of the Lehman Brothers Aggregate Bond Index. In reality, the highly leveraged fund exposed investors to 100% or more loss of principal and was 2.5 times more volatile than the S&P 500 and 7.8 times more volatile than a traditional portfolio of municipal bonds.

When MAT Three imploded in February 2008, investors suffered devastating losses.

“Despite widespread evidence that Citigroup misrepresented MAT’s risk level to its own brokers, who then passed the misleading information on to their clients, Citigroup elected to employ the ‘blame the customer’ defense,”’ stated Steven B. Caruso of Maddox Hargett & Caruso, P.C. “The FINRA arbitration panel obviously rejected this defense.”

Maddox Hargett & Caruso, P.C. and Aidikoff, Uhl & Bakhtiar provided legal representation to the investors in the case.

The award represents a return of 100% of the investors’ losses, according to Caruso, who says that the win is the second significant investor win in a MAT case for his firm’s clients in recent weeks.

A recent Medical Capital win by an investor over soured private placement deals is an encouraging sign for other investors with similar losses. The $400,000 award, which was issued May 10 and reported June 1 by Investment News, appears to be the first successful claim against a broker/dealer for selling Medical Capital investments.

The investor in the case was Marilyn Hazell, who filed her complaint against broker/dealer Peak Securities of Largo, Florida. In the complaint, Hazell cited breach of contract, breach of fiduciary duty, negligence and fraud.

Private placements in Medical Capital are at the center of a July 2009 fraud complaint by the Securities and Exchange Commission (SEC). In its complaint, the SEC charged Medical Capital Holdings with fraud in the sale of $77 million in notes. According to the SEC, Medical Capital told investors that any funds raised from its private placement deals would be invested in medical receivables. Instead, the SEC alleges that the company took $25 million in administrative fees for one fund, Medical Provider VI.

Federal prosecutors also have opened a criminal investigation of Medical Capital’s officers: Sidney M. Field and Joey Lampariello. In late May, U.S. District Judge David O. Carter agreed to let them tap more than $100,000 in previously frozen assets so they could hire criminal defense attorneys.

As reported in the June 1 Investment News article, Medical Provider Funding VI is the last in a series of offerings that raised $2.2 billion from investors. About $1 billion in investors’ money has reportedly been wiped out.

Since then, many investors have filed arbitration claims against the broker/dealers that sold them Medical Capital notes.

Peak Securities lost its registration with FINRA in November.

Maddox Hargett & Caruso P.C. continues to file arbitration claims with the Financial Industry Regulatory Authority (FINRA) on behalf of investors who suffered investment losses in Medical Capital. If you purchased Medical Capital Notes from a broker/dealer and wish to discuss your potential rights for recovery, contact us.