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Understand How Elusive Damages Measurements Can Be In Customer Arbitrations
n considering damage calculations in arbitrations involving customer losses, I am reminded of the following joke. "How much does 1+1 equal", asks the client of his accountant. The accountant's response, "How much do you want it to equal?" Brokers should pay careful attention to the possible variations because, most often, arbitration panels find that the broker and the brokerage firm equally are responsible for payment of the damages award (so called "joint and several liability").
In any legal action, the parties contest both liability and damages. The law on damages does not require one to establish the amount of damages with mathematical precision, so long as there is sufficient evidence introduced to provide an intelligent means in determining an appropriate award without speculation. As a result, in securities cases the parties can use several measures of damages. The simplest, but by no means the most accurate, is the "net loss" basis, where "net loss" basically accounts for the difference between the "money in" and the "money out". Today, in the midst of a lengthy bull market, brokers and brokerage firms favor that approach.
But is that a fair method of calculating damages in a bear market? What if the customer lost 25% of her initial equity by investing in stocks, but the "market" (however defined, for example the S&P 500 index) fell by 15%? Under those circumstances, should the broker and the firm be liable for a 25% loss, or only the market return adjusted loss of 10%? In order to prevent the customer from obtaining a windfall, courts have ruled that market adjusted net losses are more accurate and should be employed.
However, what goes around comes around. Courts also have ruled that the same market adjusted net loss theory of damages can be utilized in a bull market. Now, the customer with a "profitable" account, under a net loss theory of damages, can claim that the broker should have performed better. The customer argues that the damages awarded should account for the superior returns of the S&P 500, the Dow 30 or some other index or measure such as the average growth stock mutual fund.
Even if one believes that this measure of damages (sometimes referred to as the "well managed portfolio" theory) is too generous for the customer, know that under most state securities laws, the customer is entitled to net losses plus some measure of "pre-judgment interest" (Illinois provides for 10% interest compounded annually) as "rescissionary" damages.
Assume that a customer has made money under every theory -- net loss, well-managed account and rescission. Is the broker off the hook? Not if there has been churning. In churning cases, arbitrators can order the brokers and the firm to "disgorge profits" earned by the excessive trading. These include commissions and margin interest. Moreover, brokers cannot be confident that arbitrators will remember that the broker earned only a part of the commission and earned no margin interest. Here, without competent counsel, arbitrators likely will react in a knee-jerk fashion, awarding disgorgement of profits "jointly and severally".
Finally, brokers often tell me that the customer's investment provided tax benefits despite losing money. Should these tax benefits offset the losses? While some argue that tax benefits should do so, the U.S. Supreme Court in 1986 (coincident with many limited partnership cases) ruled that tax benefits should not be deducted in a case alleging violations of the federal securities laws.
Remember that nothing is certain in measuring damages in securities cases. Be prepared to argue a different theory to minimize the financial hit that you as the broker, and the firm, may be liable to pay together.
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Sponsored by James J. Eccleston, an attorney representing stockbrokers, financial planners and
investors nationwide in arbitration, litigation and regulatory matters, and a shareholder with the law firm
Shaheen, Novoselsky, Staat, Filipowski & Eccleston
P.C.(www.snsfe-law.com). This Web site contains material
of general interest. It is neither intended to, nor constitutes, either legal advice or investment advice.
Always consult an attorney and/or investment advisor when building and protecting your wealth.
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