Wednesday, September 17, 2008

New Jersey lawyer has this finance mess figured out

It was a song that made me aware that a "Philadelphia lawyer" was a folkloric figure - a proverbially crafty, technicality-sleuthing attorney.

I don't know what that says about lawyers in the neighboring state of New Jersey. But I do know that an attorney in Morristown, New Jersey named Mitchell H. Cobert sent a searching piece of writing about the current financial crisis to The St. Louis American today.

We don't have any place to put it in the paper, but I dabble in high finance - intellectually, that is; it's far, far above my pay grade as an "investor," given that I only invest in fancy beer and obscure books and records. I also think this piece deserves a hearing outside of New Jersey, and my stat counter tells me people do come to me (for whatever reason) from all over.

This article was written for the New Jersey Lawyer Magazine, the New Jersey State Bar publication, which retains copyright ownership. Note to self: never, never mess with the copywright ownership of something that's owned by a gang of lawyers!


Securities Fraud: The Failure of Self-Regulation
By Mitchell H. Cobert
In 1996, the National Association of Securities Dealers, a predecessor self-regulatory agency now rolled into the Financial Industry Regulatory Authority (FINRA), was completely reorganized in the wake of a joint Department of Justice and Securities and Exchange Commission (SEC) investigation into anti-competitive NASDAQ market-maker practices.1 In 2003, governance changes were imposed on the New York Stock Exchange by the SEC in response to questionable and illegal behavior by securities firms and stock exchange specialists.2 When the NASD and the NYSE were merged into FINRA in July 2007, the hope was that FINRA would be able to effectively regulate its member firms. As this article will show, FINRA has not accomplished that goal.
Back in the old days, it was simple. Banks sold CDs and broker dealers sold securities. Broker dealers earned commissions from the sale of stocks, and brokers, sometimes called financial advisors, for the most part offered and sold investments that were suitable for their customers. The law of supply and demand worked pretty well. The brokers who made the most money for their customers had the most clients. The broker dealers who provided the best services—such as research and technical support—grew and became the most successful.
The Analyst Conflict

The old days began to unravel in the late 1980s with the advent of discount brokers. Fearful of losing their customer base and a major source of their income, retail broker dealers began to chip away at what was called the Chinese Wall,3 a self-policing mechanism meant to separate the retail business from the investment banking business.4 Broker dealers began to incentivize their sales forces, including their analysts, to bring in initial public offerings (IPOs) and institutional business.

In the high-tech 1990s, broker dealers made huge fees on IPOs and investment deals, at the same time generating commissions by selling these programs to their retail customers. This inherent conflict was perpetuated and intensified because many analysts, who were relied upon to objectively rate these securities, were financially conflicted. When New York Attorney General Eliot Spitzer took action and the tech bubble burst in 2000, the billion-plus dollar fine was spread over so many broker dealers that each paid a relatively minor amount compared to the profits made. The question for FINRA remains: Does the same inherent conflict exist today? Some think that it does.5

The Breakdown of Glass-Steagall

The Glass Steagall Act,6 enacted in 1933 in the wake of the 1929 stock market crash, was repealed in 1999, after decades of lobbying by the financial services industry.7 The barrier between commercial and investment banking activities, so effectively controlled by the Glass Steagall Act, was eliminated overnight.

What were the consequences? Some argue that it led to the sub-prime meltdown.8

Sub-Prime Meltdown

A sub-prime loan is a loan made to a borrower who has poor credit or some other flaw that would disqualify him or her from getting a traditional, conforming loan. Securities are issued using these loans as collateral. As mortgage originators began to realize that Wall Street would accept any loan, regardless of its risk, the sub-prime market exploded.9 In 2001, according to Inside Mortgage Finance, only one out of 20 loans was sub-prime. By 2006, that number, driven by Wall Street, was over one in five.10

Although the public is aware of the sub-prime meltdown, it may not realize that the Alt-A loan market will probably be next. Alt-A borrowers have better credit scores than sub-prime borrowers, but usually Alt-A loans are originated with less than complete information regarding net worth, employment, credit history and other areas where complete information is traditionally required.11 Standard & Poor’s estimated that more than $100 billion in Alt-A loan originations were processed in each of the last three quarters of 2006.12

What role did the rating agencies play in all of this? Since investors always look to buy investment-grade rated debt, getting an appropriate rating on a product is critical. Moody’s net income went from $159 million in 2000 to over $700 million in 2006, in large part from fees generated in these sub-prime and Alt-A deals.13

Managed Funds

Over the last few years, as the larger banks and brokerage firms have merged, a concerted effort has taken place in the industry to encourage managed accounts. The reason is simple: Instead of making a commission only on the purchase and sale of each security, broker dealers now want to annuitize the entire account. That way, the broker dealer can make money every year the account is open.

By way of example, a middle-aged widow has a $200,000 brokerage account funded by her husband’s life insurance policy. She wants to purchase blue chip stocks with half the proceeds and conservative mutual funds with the balance. In the old days, her broker dealer would earn a one-time total of no more than $8,000 in commissions on these purchases in the year the account was opened, and nothing more. Of course that broker would periodically review the account for performance, making adjustments when necessary, but the account would generally be considered a buy and hold account, not generating significant further income to the broker dealer in subsequent years except for occasional corrective trading.

Today, that same broker would be expected to have the middle-aged widow open a managed account, explaining that this was in the customer’s best interest in order to save her money on commissions. In reality, however, it is the broker dealer who benefits. The fee for a managed account of this size is around two percent each year. In this example, the broker dealer would collect $4,000 every year the account is open. Payment of a commission in the first year is, to most investors, an anticipated expense. Payment of a continuing fee, however, reduces the principal each year, and requires the customer to recoup the two percent each subsequent year just to maintain the principal balance.

It is estimated that more than 20 percent of all accounts in the large brokerage firms are now being managed for an annual fee. This is an economic boon to the broker dealers whose profits are increased by this annuitized income stream. There is, however, another benefit to them: Because they are now managing these funds, the broker dealers have complete discretion to trade all of the securities in all of these managed accounts. In fact, to justify the fees they charge they are actually compelled to actively trade those accounts.

The broker dealers now have billions, if not trillions, of dollars in assets they can trade with complete discretion. The concern now raised is how do the broker dealers trade this money? Perhaps they close their own investment banking deals; purchase stock in other financial service firms with whom they do business; buy shares in their own proprietary mutual funds; or buy stock in companies where they also own equity interests or have relationships. The bottom line is that broker dealers are now using these billions of dollars to make more and more money for themselves each year, with their customers unknowingly assuming all of the risk. Instead of the brokerage firm serving the customer, the customer’s funds are now serving the brokerage firm. Actively managed funds also have higher trading costs because they buy and sell more frequently.14

The brokers themselves are often not in a position to prevent this. Inexperienced or marginally producing brokers are being pressured to open managed accounts. Whether explicit or implicit, if they do not, their jobs and careers may be in jeopardy.

Auction Rate Securities

Another questionable program now coming to light involves auction-rate securities, leading to the recent collapse of Bear Stearns. News releases report that nearly all of the big firms sold auction-rate securities, touting them as a slightly higher-yielding but safe alternative to money-market funds.15 It was "like a Moroccan bazaar," said William Galvin, Massachusetts’ secretary of state. "Getting a stallholder in Fez to take back damaged goods is a tall order."16

In August, after joint investigation by several states, the SEC and the North American Securities Administrators Association (NASAA), Citigroup agreed to a settlement in principle to repay $7.5 billion in losses suffered by individual investors, small businesses and charities, all customers of Citigroup, for their losses in auction-rate securities.17 That same month, UBS agreed to a $19.4 billion settlement, Morgan Stanley agreed to a $4 billion settlement, and JP Morgan Chase agreed to a $3 billion settlement.18

Where were the regulatory authorities on this before the bottom fell out? In 2006, the SEC reached a paltry $13 million settlement with 15 investment banks, and the industry agreed to impose a voluntary code of conduct for the auction-rate market.19 Apparently that voluntary code of conduct did not work.20

Investment of New Jersey Retirement Funds

On Jan. 31, 2007, the state’s pension funds were worth $78.1 billion. Seven months earlier, those same pension funds were worth $82 billion.21 A five percent drop in value over a seven-month period might indicate to some a portfolio overly tied to market risk. Today, the retirement funds of the state’s firemen, police officers, teachers and other public servants have $400 million invested in Citigroup preferred stock and $300 million invested in Merrill Lynch preferred stock, according to announcements made by those firms in January 2008.22

When Lehman Brothers needed a $5 billion bailout this year, New Jersey’s Division of Investment, managers of the state’s pension trust fund, authorized an investment in Lehman Brothers of $180 million.23 Investing trust funds in a company admittedly in need of $5 billion may not be considered the wisest of moves. The influence of Wall Street over the retirement money of public servants is a matter of public concern. If that money is lost through unwise trading, will taxpayers be asked to bail out the pension fund system?

New Jersey now has $9 billion of public pension money in hedge funds and other alternative investments.24 In an unpublished August 2008 decision, the court held that the Division of Investment’s hiring of nine outside private managers to make stock selections was not permitted by state law.25

No Effective Recourse

What recourse does New Jersey or any individual investor have if aggrieved? All broker dealers include mandatory arbitration clauses in their new account agreements. The courts have upheld these clauses and, as it stands today, FINRA is the sole administrator of and forum for all arbitrations. The relevant question is whether or not the arbitration process is fair. Many feel it is not.26

Recent statistics published by FINRA show that in 2007, claimants achieved relief in only 37 percent of all arbitrations commenced, including monetary and non-monetary settlements.27 Even that statistic is deceptive, because a matter is considered a win if a claimant recovers $100, even if the claim is for $10 million.

Currently, an industry representative must be included on every three-person arbitration panel. A recent change to FINRA’s rules requires a separate qualification list for chairs, which may also include industry representatives. Consequently, as many as two industry representatives can sit on a three-person panel. It is important to understand that FINRA is a self-regulatory organization whose members include the largest broker dealers in the industry. FINRA has recently instituted a test program with no industry arbitrators at all on the panels.

What was NASAA’s response? In a press release issued on July 24, 2008, NASAA stated:
"NASAA has long advocated a series of constructive steps to restore choice, fairness, and balance to the securities arbitration process. The first step toward improving the integrity of the arbitration system must be the removal of the mandatory industry arbitrator coupled with a prohibition on ties to the industry on the part of the public arbitrator. FINRA’s pilot program, while a positive step, does not go far enough toward resolving immediate investor harm. Since the pilot program will include just a fraction of the arbitration cases that will occur during the next two years, only a select few customers will realize the benefit of having a panel where there is no mandatory industry representative, but thousands of others will not have that choice. Investor protection demands that all investors be given that choice immediately."

An even better solution would be to give all customers the choice of suing in state or federal court.28


Unless FINRA and the regulatory authorities are vigilant and forceful, a future scandal could bring down the whole house of cards. The recent close call with Bear Stearns is a lesson to be heeded; the brokerage community cannot be relied upon to police itself. The integrity of the nation’s economy relies upon the trust and confidence that the public has in its financial institutions and the regulatory agencies that are pledged to protect investors. Unless there is effective oversight, we may all be at risk.

Mitchell H. Cobert ( is a solo practitioner in Morristown with an emphasis on securities law. He is a member of the New Jersey Lawyer Magazine Editorial Board.


1. Roberta S. Karmel, Should Securities Industry Self-Regulatory Organizations be Considered Government Agencies?, 2002, p. 17, available at Karmel is centennial professor of law at Brooklyn Law School and a former commissioner of the Securities and Exchange Commission.

2. Id. at p. 19. See Laurie P. Cohen & Kate Kelly, NYSE Turmoil Poses Question: Can Wall Street Regulate Itself?, Wall St. J., Dec. 31, 2003, at A1. In 2005 the United States Attorney’s Office and the SEC charged 15 specialists for violating federal securities laws through patterns of fraudulent and improper trading. See Press Release, U.S. Attorney’s Office, S.D.N.Y., 15 Current and Former Registered Specialists on the New York Stock Exchange Indicted on Federal Securities Fraud Charges 1 (April 12, 2005), available at; Press Release, SEC Institutes Enforcement Action Against 20 Former New York Stock Exchange Specialists Alleging Pervasive Course of Fraudulent Trading (April 12, 2005), available at In addition, the SEC charged the NYSE with failing to police the accused specialists. See Press Release, SEC Charges the New York Stock Exchange with Failing to Police Specialists (April 12, 2005), available at

3. Bernie DeGroat, Chinese Walls fail to Curb Conflicts of Interest in Securities Firms, Record for Faculty and Staff of the University of Michigan, Feb. 24, 2003. "Our study does not support the logic of the recent deregulation in financial services firms that assumes Chinese walls are effective and appropriate," said H. Nejat Seyhun, professor of finance at the Business School.

4. Christopher M. Gorman, Are Chinese Walls the Best Solution to the Problems of Insider Trading and Conflicts of Interest in Broker-Dealers?, Fordham Journal of Corporate & Financial Law, 2004.

5. Marcy Gordon, New Study Shows Analysts Getting Favors, Associated Press, July 27, 2007, available at This study, coming four years after Attorney General Spitzer and other regulators exposed Wall Street’s conflicts, finds that "Conflicts of interest may still be rampant on Wall Street, with a new study showing that nearly two-thirds of investment-firm analysts received favors from executives of companies they cover and suggesting that the companies get favorable ratings in return." See also, Report on Analyst Conflicts of Interest, a Report of the Technical Committee of the International Organization of Securities Commissions, September 2003.

6. Glass-Steagall Banking Act of 1933, 12 U.S.C.S. §§ 24 and 378(a)(1).

7. Gramm Leach Bliley Act of 1999, 15 U.S.C.S. § 6801 et seq.

8. Explainers: Blame the Subprime Meltdown on the Repeal of Glass-Steagall available at

9. Dale Ledbetter, Understanding the Sub-Prime Debacle, PIABA Bar Journal, Spring 2007, p. 3-6.

10. Id. at 6.

11. Id. at 7.

12. Id.

13. Id. at 8.

14. Conrad de Aenile, International Herald Tribune, May 11, 2007, available at

15. James B. Stewart, Wall Street Journal, Aug. 14, 2008.

16. The Economist, Aug. 14, 2008, available at

17. Id.

18. Citigroup, Press Release, Aug. 7, 2008.

19. Stephen Bernard, Star Ledger, Aug. 15, 2008, p. 49.

20. Jenny Anderson and Vikas Bajaj, The New York Times, Feb. 15, 2008, available at

21. As far back as 2002, the SEC was looking at the auction rate market. SEC No. Action Letter dated May 10, 2002, to Merrill Lynch Investment Managers, Ref. No. 2002281328, File No. 801-11583. See also FINRA Regulatory Notice 08-21, April 2008.

22. Dunston McNichol, Star Ledger, Feb. 22, 2008, p. 20.

23. Susan Todd, Star Ledger, Jan. 16, 2008, p. 57. "This is an equity investment" said Burrows Farber, the chief administrative officer of the State Division of Investment. "The benefit being we didn’t have to go to the open market, so we did it without the fees and with better terms." Id.
24. Associated Press, Star Ledger, June 9, 2008, p. 9; Dunston McNichol, Star Ledger, June 10, 2008, p. 59.

25. Dunston McNichol, Star Ledger, Aug. 23, 2008, p. 7.

26. Id.

27. Mark A. Tepper, Survey Says-SRO Arbitration Unfair, PIABA Bar Journal, Spring 2005, p. 11.

28. FINRA website,

29. Gretchen Morgenson, The New York Times, May 6, 2007: Patrick Leahy and Russell Feingold, writing to Christopher Cox, the SEC chairman asking the SEC to ban mandatory arbitration wrote "Arbitration is fine for straightforward disputes involving modest claims" but "Investors are entitled to a real choice when it comes to settling disputes, and the fact that there seems to be a take-it-or-leave-it trend in brokerage contracts with investors is very troubling."


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