On October 4, 2011, a FINRA Arbitration Panel sitting Portland, Oregon, in the matter of James D. Brogden, et. al. v. Merrill Lynch Pierce Fenner & Smith, Inc., FINRA Arbitration Number 10-01725 rendered an arbitration award against Merrill Lynch for $96,049 of the $309,358 in damages sought in connection with the recommendation to purchase Federal National Mortgage Association, (“Fannie Mae”) Series T, 8.5% Preferred Stock.
The Arbitration Panel also awarded Claimants $33,287 in interest, and $60,043 in attorney’s fees pursuant to Oregon Revised Statute, Chapter 59, Section 115.
Oregon State Securities Laws
Under the Oregon state securities laws, with respect to “liability in connection with sale or successful solicitation of sale of securities, and specifically Chapter 59, Section 115, “the court may award reasonable attorney fees to the prevailing party in an action under this section,” which could have been very dangerous, particularly if Claimants failed, and Merrill Lynch, as “the prevailing party” sought to recover its attorney’s fees.
The only exemption to an award for attorney’s fees against any non-prevailing party in Oregon appears to be in connection with Class Actions, where Chapter 59, Section 115 (11) provides that “The court may not award attorney fees to a prevailing defendant under the provisions of subsection (10) of this section if the action under this section is maintained as a class action pursuant to ORCP 32.”
Arbitration Panel Awards
What is particularly interesting about this case, is not only did the Panel award just a fraction, or approximately 31% of Claimants’ alleged compensatory damages, the Panel actually stated, that the “recommended investment,” the Federal National Mortgage Association, (“Fannie Mae”) Series T, 8.5% Preferred Stock, “was suitable in every way except that the quantity of shares recommended made a portion (40%) of this investment unsuitable given the investors risk tolerance at the time of purchase.”
Accordingly, the Panel appears to have made a subjective or quantitative decision as to how much, or what percentage of Claimants’ accounts were appropriately invested in the Federal National Mortgage Association, Series T, 8.5% Preferred Stock.
It is unclear if the Arbitration Panel awarded these damages relating to that portion of Claimants’ accounts that were invested in excess of 40% in the FannieMae stock or if the Panel was only awarding Claimants 40% of their actual FannieMae losses.
Arbitration Panel Got It Wrong
Either way, it appears that the Arbitration Panel got it wrong.
Unless the customer was seeking to speculate in FannieMae preferred stock, it is most likely that the Merrill Lynch broker failed to perform due diligence, or disclose the actual risk associated with the purchas of FannieMae preferred stock.
Even “[s]ophisticated investors, like all others, are entitled to the truth.” Longden v. Sunderman, 737 F. Supp. 968, 974 (N.D. Tex. 1990); Hill York Corp. v. American Int’l. Franchises, Inc., 448 F.2d 680, 696 (5th Cir. 1971)(Securities laws do not create graduated scale of duty depending on sophistication of investor); Spatz v. Borenstein, 513 F. Supp. 571, 580 (N.D.Ill. 1981) (“The securities laws entitle all investors, both the experienced and the novice, to the full and truthful disclosure of material information”).
However, “Suitability determinations are a two-step process: the broker-dealer must first determine if the product is suitable at all, and then determine if it is suitable for a specific client.” FINRA Conduct Rule 2310. This case appears to involve the first step of the process, and generally the notion that a broker has a duty to “know his securities,” including the risks associated with those securities prior to recommendation.
FINRA Suitability Rule 2090
As the Securities & Exchange Commission, in its approval of the consolidated FINRA Suitability Rule 2090 recently observed:
Reasonable-basis suitability requires a broker to have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors.
In general, what constitutes reasonable diligence will vary depending on, among other things, the complexity of and risks associated with the security or investment strategy and the firm’s or associated person’s familiarity with the security or investment strategy.
A firm’s or associated person’s reasonable diligence must provide the firm or associated person with an understanding of the potential risks and rewards associated with the recommended security or strategy.
See Securities Exchange Act Release No. 63325 (November 17, 2010).
On May 13, 2008, MLPFS, as the Lead Underwriter in connection with the sale of the Fannie Mae preferred shares, sold $354.4 million of these shares at a public offering price of $25 per share.
Long before May 2008, there was substantial adverse information in the market place regarding the troubles at the Federal National Mortgage Association.
In September 2004, the Office of Federal Housing Enterprise Oversight (“OFHEO”) announced that the Federal National Mortgage Association (“Fannie Mae”) was under investigation for engaging in deceptive accounting practices. Subsequently, in December 2004, Fannie Mae announced a $6.3 billion restatement of its earnings, the largest restatement in American history, and in May 2006, announced a $400 million settlement with securities regulators and the OFHEO for violating certain accounting standards.
In November 2007, Fannie Mae announced a reported a $900 million loss, and a $8.7 billion decline in the value of its assets, the period ended September 30, 2007. In November 2007, Fannie Mae also reported $56.2 billion in exposure in subprime and Alt-A loans as of period ended September 30, 2007.
In a November 9, 2007 conference call with securities analysts, Fannie Mae President and Chief Operating Officer, Daniel H. Mudd, told investors that the Company had approximately $3 trillion dollars at risk in residential home mortgages, but that the Company only had reserves of approximately $41 billion.
As a result, on December 4, 2007, Fannie Mae announced that the Company would reduce its dividend, and in February 2008, the Company, citing continued deterioration in the housing market and an increase in its credit loss experience, reported a $7.1 billion decline in the value of its assets and a net loss of $2.1 billion.
On March 10, 2008, Barrons’ Cover Story, was “Is Fannie Mae The Next Government Bailout?” (“The mortgage giant’s house isn’t well protected against a stormier credit market. If its roof caves in and a bailout is needed, shareholders, could get buried.”).
Following the Barrons’ story, shares of both common and preferred Fannie Mae fell precipitously, as it was widely believed that the company was insolvent.
In April 2008, Merrill Lynch’s own analysts reported that regulators required Fannie Mae to raise an additional $20 billion in capital to remain solvent, and on May 6, 2008, following the announcement that FannieMae planned to raise $6 billion through the offering of the Series T, 8.25% Non-Cumulative Preferred Shares, The Business Wire announced that Fitch Ratings placed these shares on a ratings “negative watch,” based upon the company’s net loss of $2.2 billion for the quarter ended March 31, 2008, and continued expected “severe weakness in the housing market and expected increases in credit losses.”
Even a cursory reading of the “Risk Factors” disclosed in the Fannie Mae Preferred Prospectus reveals the risk associated with these securities:
We have experienced increased mortgage loan delinquencies and credit losses, which had a material adverse effect on our earnings, financial condition and capital position in 2007 and the first quarter of 2008.
Increased delinquencies and credit losses relating to the mortgage assets that we own or that back our guaranteed Fannie Mae MRS continue to adversely affect our earnings, financial condition and capital position. We are exposed to credit risk relating to both the mortgage assets that we hold in our investment portfolio and the mortgage assets that back our guaranteed Fannie Mae MBS. Borrowers of mortgage loans that we own or that back our guaranteed Fannie Mae MBS may fail to make required payments of principal and interest on those loans, exposing us to the risk of credit losses.
Federal National Mortgage Association Prospectus, May 13, 2008
When the broker in this case sold these securities is uncertain. Either the broker failed to perform any reasonable due diligence, and was unaware of information as set forth above, and therefore, lacked any reasonable basis to recommend the purchase these securities, or alternatively, the broker was aware of the foregoing, and recklessly exposed Claimant to considerable risk by purchasing these otherwise speculative securities simply to garner commission income from Merrill Lynch’s underwriting.
The concession or commission associated with the sale of these preferred securities in the Underwriting was 3.14% or $.7875 per share, netting Merrill Lynch more than $11 million, and most likely more than the broker would have made selling alternative, lower risk investments.
In July 2008, several investment analysts reported that Fannie Mae would require an additional $46 billion in capital, following a report by the Federal Reserve that suggested that the company was insolvent.
On September 7, 2008, federal regulators seized control of Fannie Mae. As of even date, these securities are substantially worthless.
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