Investment Advisory Firm Fraud

Advisory firms – including big-name firms like Merrill Lynch, Charles Schwab, and Morgan Stanley – routinely face allegations from investors and regulators of fraud and investment advisor misconduct. Registered Investment Advisors (RIAs) are supposed to adhere to the fiduciary rule, the legal obligation to put the investors’ needs ahead of the advisors’.

But investors be warned: Advisory firms have ample financial incentives to ignore their customers’ best interests.

• Advisors may earn more on riskier products, like alternative investments and variable annuities, creating an incentive for them to recommend these more often.
• Firms may work with affiliates who share commissions with firms that provide client referrals. This could include affiliated brokerage firms and financial planning services.
• Investment advisory firms may earn more when they serve as the principal in certain trades – that is, when they buy and sell securities for their own accounts.

Investment advisors should face consequences when they violate their fiduciary duties. This is where securities attorneys come in, since recovering unfair losses is not straightforward. In the securities industry, a dispute settlement process called arbitration may prevent investors from obtaining the settlement they deserve.

How Do Investment Advisors Resolve Disputes with Investors?

The majority of investment advisory firms use investment contracts that require their investors to recover losses via arbitration.  If there is no arbitration requirement, investors may choose to sue their investment advisory firm in civil court.

Resolving Disputes with Brokerage Firms

RIAs and brokerage firms have different requirements for recovery. RIAs are registered with the Securities and Exchange Commission (SEC), while brokerage firms register with the Financial Industry Regulatory Authority (FINRA).

Investors who have a dispute with a FINRA-registered brokerage firm will typically go through FINRA arbitration. The regulator provides the platform for dispute resolution as well as neutral arbitrators, but it does not offer guidance or rulings on investor disputes. The SEC, however, provides no such platform, leaving it up to advisory firms to select an outside arbitration platform or to settle disputes in civil court.

Benefits of Arbitration for Investment Advisors

The majority of Registered Investment Advisory firms impose mandatory arbitration, presumably because of the benefits arbitration affords firms. According to an SEC report to Congress from 2023, the regulator estimates that 61% of investment advisory firms require their customers to sign an agreement to use arbitration services to resolve disputes. This number is an estimate because advisory firms do not have to publicize their investment contract requirements.

These are just some of the advantages that advisory firms may count on when they require investors to agree to arbitration:

• The SEC report highlighted the fact that arbitration simplifies the dispute resolution process and does not offer investors the right to appeal.
• Firms may also have an advantage when they choose a familiar arbitration forum because of the “predictability and efficiency” of a known venue
• Advisory firms benefit from the non-public nature of arbitration proceedings.
• The price of arbitration may discourage investors, especially since some firms require investors to have the money to cover arbitration costs put aside before beginning proceedings.
• Investment advisory firms that resolve a dispute via arbitration do not have to record the results of the arbitration in a public forum, the way FINRA does for brokers on BrokerCheck. FINRA arbitration proceedings are non-public, but the regulator does publish the result of arbitration as well as the amount awarded to the investor.

Civil cases may be less predictable than arbitration – the outcome may hinge on the bias of the judge who hears the case. In a civil case, the investor would also have the right to an appeal, which could result in drawn-out litigation.

Criticism of Mandatory Arbitration

Critics of arbitration requirements argue that these agreements are not in the investor’s best interest. According to Advisor Hub, “The report also raises concerns that mandatory arbitration agreements included clauses that would preclude clients’ participation in a class action, limit damages, or impose other restrictive terms.” This differs from FINRA arbitration – receiving a settlement or an award through FINRA proceedings does not mean the investor waives the right to participate in a class action lawsuit.

Arbitration with Advisory Firms

Out of the advisory firms that required arbitration, they typically specified the type of arbitration services the investor could expect to use. The majority – over 80% — selected the American Arbitration Association. A small minority chose JAMs or FINRA arbitration.

Investor Class Action Lawsuits

Class action lawsuits can be a valuable tool for investors who have lost money after advisory firms violated the fiduciary duty on a large scale. These types of lawsuits benefits investors by divvying up the cost of litigation costs among claimants.

For instance, Morgan Stanley, along with other big-name advisory firms, is facing a class action lawsuit alleging the firm placed investors’ uninvested funds in cash sweep accounts that generated significant returns for the firm but paid investors dismally low rates.  

How Can Investors Protect Themselves?

Investors should be proactive when selecting an investment advisor. Advisory firms are required to disclose their fees and conflicts of interest in their Form ADV. You can find a firm’s Form ADV by visiting the firm’s Investment Advisor Public Disclosure database (IAPD). Firms are required to update these forms every year.

• Firms also must disclose whether they work with Registered Investment Advisers who have allegations of misconduct on their records. You can find records of specific instances of alleged misconduct on the IAPD as well.
• Descriptions of regulatory actions by state and federal regulators appear in the Form ADV.

Help for Investors

With a securities attorney, investors will have an expert who can help promote fairness throughout the proceedings. Investment Advisory firms have experience and skilled legal representation to defend themselves against investors’ claims. Call Kurta Law if you have questions about a potential case: (877) 600-0098 or info@kurtalawfirm.com.