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May 2012 Archives

May 12, 2012

When Running to the Courthouse, Schwab Failed to Exhaust Remedies in SRO class action waiver conflict

By Edward Pekarek, Esq. and Kristen Mogavero


One of the nation's largest retail securities brokerages, Charles Schwab & Co., quietly amended its customer agreements in September 2011, just months after the U.S. Supreme Court determined in AT&T Mobility v. Concepcion that a California state law banning "unconscionable" class action waivers was pre-empted by the Federal Arbitration Act.

The firm famous for the slogan, "Ask Chuck," began to distribute the contract in October 2011, with a provision requiring its customers to waive the right to participate in class actions against the San Francisco-based broker-dealer. Schwab initially distributed the amended agreement to approximately seven million customers. Since then, Schwab has required at least an additional fifty thousand new account holders to agree to the contentious contract clause and allegedly continues to use the amended agreement containing the waiver, according to a February 1, 2012 disciplinary proceeding initiated by the Financial Industry Regulatory Authority (FINRA).

A FINRA member since 1970, Schwab has some 340 offices in the U.S., staffed by over 7,000 FINRA-registered employees. Notably, in its SRO membership application, Schwab agreed to abide by and adhere to FINRA (then NASD) rules. On February 1, 2012, FINRA announced it had initiated disciplinary proceedings against Schwab, charging the brokerage firm with violations of FINRA rules by including the provision in its customer agreements. In its disciplinary pleading, FINRA seeks to estop Schwab from including or enforcing the challenged provisions in its customer agreements and also seeks sanctions, including monetary sanctions, pursuant to FINRA Rule 8310(a). Schwab responded with a rush to the San Francisco federal courthouse by its lawyers from the firm Arnold & Porter, LLP, seeking preliminary injunctive relief from the SRO action. Schwab maintained in a press statement that it "believes a federal court is in the best position to properly and efficiently resolve this novel dispute, and intends to defend against any disciplinary action brought by FINRA." In response, FINRA sought an expedited hearing as a result of Schwab's continued use of the agreement.

USMJ LaPorte tells Chuck its complaint is dismissed

Schwab's injunctive relief application was referred to a United States Magistrate Judge, the Honorable Elizabeth LaPorte, of the U.S. District Court for the Northern District of California. Judge Laporte opined on Friday, in a 21-page opinion granting FINRA's motion to dismiss, that Schwab failed to show it had exhausted its administrative remedies, the disciplinary options of the FINRA disciplinary proceedings, before initiating litigation in federal court. Parties must first see the dispute to its conclusion in the administrative forum before seeking relief from a district court, according to the court's order. Judge Laporte agreed with FINRA that Schwab must follow SRO procedures for disciplinary cases before seeking judicial intervention. That process ultimately includes federal court review, but contrary to Schwab's tactic, it does not begin at its endpoint, which Judge LaPorte deemed sufficient to dismiss the complaint.

Schwab maintained it would be "irreparably harmed" by having to endure up to four or more years as the FINRA disciplinary process unfolded. Nonetheless, delay is an insufficient basis to avoid the SRO disciplinary process, according to Judge Laporte. The federal judicial officer opined that Schwab failed to demonstrate it was "entitled to an exception" from FINRA process. President of the Norman, Oklahoma-based group of securities arbitration lawyers the Public Investors Arbitration Bar Association (PIABA), Ryan K. Bakhtiari, told Reuters, "The rules are clear and unequivocal that Schwab did not have the right to prohibit class actions." Despite Friday's dismissal, unresolved questions remain as FINRA continues the disciplinary proceedings against Schwab, William Jacobson, a Cornell Law School professor and director of its Securities Law Clinic in Ithaca, New York, told Reuters.

FINRA alleges class action waivers violate SRO rules

FINRA alleges the class action waiver constitutes a violation of FINRA Rule 2268(d)(1) (formerly NASD Rule 3110(f)(4)(A)), which prohibits members from imposing "any condition" in a pre-dispute arbitration agreement that "limits or contradicts the rules of any self-regulatory organization." FINRA alleges Schwab's waiver is improper as it contradicts Rule 11204(d) of the FINRA Code of Arbitration Procedure for Customer Disputes, which provides that a member firm may not enforce an arbitration agreement against a member of a putative class action unless: 1) class certification is denied by a court, 2) the class is decertified for some reason, 3) the member of the putative or certified class action is excluded, or 4) the member withdraws or chooses not to participate in the class.

Schwab, for its part, contends the waiver provision is entirely valid and consistent with the rule of AT&T Mobility, decided on April 27, 2011, in which the U.S. Supreme Court held that California state contract law, which deems class action waivers in arbitration agreements to be unconscionable, and therefore unenforceable, when certain criteria are met, are preempted by the Federal Arbitration Act (FAA). The Court found California's law created an impermissible obstacle to the accomplishment and execution of the full proposes and objectives of Congress and was therefore preempted.

Does AT&T Mobility even apply?

At first glance, it may seem that the Supreme Court's AT&T Mobility decision specifically invites provisions such as the class action wavier included in Schwab's customer agreements. However, there is an important distinction to be made between the customer agreement in AT&T Mobility and the Schwab customer agreement. The disputed provision at issue in AT&T Mobility was part of a cellular telephone contract between a customer and a wireless service provider. In contrast, Schwab customer contract clause is part of a brokerage firm's customer agreement, and the particular brokerage firm, Schwab, is a registered FINRA member.

Schwab is bound by the rules and regulations of FINRA, an SRO overseen by the SEC. Moreover, the FINRA Rules, by which Schwab promised to abide, are approved by the SEC, pursuant to the Securities Exchange act of 1934. As such, FINRA's rules are federal law equivalents and therefore federal preemption, which carried the day in AT&T Mobility, is not a valid argument for Schwab in this dispute, according to Pace Investor Rights Clinic Director, Jill I. Gross, among the first academics to address the Schwab matter in her February 1, 2012 blog post, the same date the FINRA disciplinary proceeding was initiated and when Schwab rushed to the federal courthouse to seek the judicial intervention Judge LaPorte denied.

Considering the quasi-federal nature of the FINRA Rules, we suspect FINRA will ultimately prevail on this issue. However, AT&T Mobility and the Schwab class action waiver raise serious concerns about the future of class actions. Many, if not the majority, of consumer transactions in the U.S. are accompanied by a customer agreement which includes some type of dispute resolution clause. If these clauses are amended to include class action waivers, it will eventually pose significant barriers to justice for those customers. In many cases, customer claims are of low dollar value, individually, to warrant litigation or arbitration, and the only way for those customers to have their day in court is through consolidated or class actions. Without these options, customers will be denied the judicial or dispute resolution process, rights we believe are a universal entitlement for U.S. citizens. Moreover, such obstacles will inevitably encourage corporations to commit "small frauds" and other wrongs that in the aggregate may amount to substantial harms to society.

Therefore, the issue here is bigger than the parties' right to contract and federal preemption─-there remains the fundamental question of whether the judicial system will allow U.S. citizens to be deprived of court access through the use of adhesive consumer contracts. We hope judicial officers will recognize the potentially disastrous impact of these draconian waiver provisions and determine them to be unenforceable, particularly in the securities context.


Mr. Pekarek is a Visiting Professor of Law and Supervising Attorney at Pace Law School, who also serves as Assistant Director for the non-profit Pace Investor Rights Clinic of John Jay Legal Services, Inc.

Ms. Mogavero is a third-year law student at Pace Law School and student-intern for the non-profit Pace Investor Rights Clinic, as well as a member of the Pace Law Review and the national championship team of the 2011 FINRA/St. John's Securities Dispute Resolution Triathlon, and winner of the 2012 Justice Sondra Miller Scholarship, awarded by the Westchester County Women's Bar Association.

May 25, 2012

Darwin or Dodo? Non-Traded REITs Will Either Reform or Perish

by Edward Pekarek, Esq. and David Haimi

Dodo-bird.gifDo you want a safe "middle of the road" investment that isn't affected by ups and downs on Wall Street? Do you want 7-8% dividends? Do you want the peace of mind that comes from putting your hard-earned cash in a proven investment featuring years and years and years of stable stock prices and returns? Then you need to invest in non-traded REITs right now! Variations of this "too good to be true" sales pitch have been the sales siren for many of the non-traded Real Estate Investment Trusts sold domestically to thousands of elder investors seeking steady income in an unprecedented low interest rate environment. FINRA has focused enforcement efforts on deceptive sales of these illiquid shares, charging Long Island-based brokerage David Lerner Associates (DLA) (CRD #5397), and its namesake CEO (CRD #307120), in a highly publicized 2011 enforcement action with misconduct related to its sales of allegedly unsuitable "Apple" (no, not that Apple) non-traded REIT shares. Last week, a FINRA arbitrator awarded equitable rescission relief to a pair of Apple REIT shareholders who can now tender the stock and be refunded their original investment. Not surprisingly, a DLA lawyer told the Wall Street Journal that the FINRA member headquartered in Syosset, NY "disagrees with the decision." A number of class actions are pending presently.

A half-century of REITs

REITs date back to the passage of the Real Estate Investment Trust Act, as part of the Cigar Excise Tax Extension of 1960, and have a long history of allowing individuals to purchase a piece of large real estate speculation. REITs collect pools of money from investors and then use the pooled capital to buy real property as assets. Over time, REITs have evolved into three main types: equity, mortgage, and hybrid, and can be either private or publicly held concerns. The non-traded equity REIT variety is distinct because the stock is not traded or quoted on any securities exchange, but these issuers are registered with the Securities Exchange Commission ("SEC"), and subject to SEC (as well as state and SRO) regulation. For a company to qualify as a REIT, and receive an exemption from corporate income tax, it must adhere to sections 856 and 857 of the Internal Revenue Code. The major requisite of these provisions, and what is a major selling point of REITs, generally, is that the issuer must distribute at least 90% of its annual income to its (100 or more) shareholders to qualify for the tax exemption. The seemingly assured large dividends are often used to lure would-be investors.

Questionable to the core?

Non-traded REITs have received substantial negative attention lately, due largely to the FINRA enforcement action and class action complaints against Apple REITs Six through Ten and their sole underwriter, DLA. Roughly 60-70% of DLA's business is comprised of non-traded REIT sales. These Apple REITs, along with other non-traded REITs, are alleged to have lured unsophisticated investors with misrepresented share values and deceptive dividends seemingly sourced from income, but often derived from shareholder capital and extensive debt. Forbes columnist Brad Thomas, established a blueprint for non-traded REIT reform in two April 2012 columns.

Recipe for REIT reform

Mr. Thomas, in Dividend REITs As Reliable As Jack Nicklaus And Tiger Woods, discusses the success of publicly traded REITs, especially eight specific public REITs, comparing them to the success of the famous golfers Jack Nicklaus and Tiger Woods. Mr. Thomas contributes the success of these REITs to their ability to maintain "consistency (including increased dividends during the great recession) and sound risk-control - the mark of greatness." He goes on to state that "[w]ithout fail (sound risk-control), these eight equity REITs are all distinguished by consistency in dividends paid and increased quarterly." Mr. Thomas then concludes his column with investment icon Ben Graham's maxim, "...[w]e think that a record of continuous dividend payments for the last twenty years is an important plus factor in a company's quality rating."

While consistent dividends might be an indicator of a sound REIT in the public securities market, investors in non-traded REITs do not have the benefit of being able to rely on the "efficient-market hypothesis" as there is no regular price discovery for these illiquid securities. Non-trade REITs, as the name suggests, lack a secondary market which often results in significant informational asymmetries between insiders and investors, with no public trading to adjust the imbalance. One of the biggest issues with Apple REITs has been their alleged masking of losses through large scale leveraging and reinvestment of capital, so as to keep dividends constant and create the illusion of operational success.

In Non-Traded REITs: The Evolution Of A Repeatable Income Alternative, Mr. Thomas builds on his previous description of what makes a public REIT exceptional, and identifies some non-traded REIT standouts. Mr. Thomas' work singles out American Realty Capital for its industry best practices of "shorter life cycles, fully covered distributions, elimination of both internalization fees and follow-on offerings, along with lower fees and pay-for-performance management compensation." These practices, along with consistent dividends sourced from Funds from Operations ("FFO"), make up the majority of the recipe for a non-traded REIT to be considered an appropriate investment as a portion of a qualified investor's portfolio.

The shorter non-traded REIT "life cycle" refers to transitioning to the publicly traded market, where price discovery tends to better reflect the true financial condition of an issuer. Mr. Thomas maintains that the REITs that make an expedient transition, typically gain value and achieve great investor confidence with the enhanced transparency offered by publicly traded shares. "Fully covered distributions" means dividends paid from FFO, not from leveraged assets that can and often do lead to a debt spiral. The last of his proposed ingredients is reduction of excessive upfront fees associated with non-traded REITs, which often depress share value by 10-15% immediately upon purchase. Along with substantially lower purchase fees, in Mr. Thomas' view, non-traded REIT managers should only be paid for transparent operational revenue success, as oppose to a murky fixed management fees and a host of other opaque charges for things such as general operations and property transactions. Mr. Thomas sees this list of best practices, along with genuine transparency, as a necessary "evolution" of the non-traded REIT sector.

Transparency, short-term life cycle, no excess fees, and consistent distributions from FFO, all sounds like a fantastic wish list, but these features are not beyond the realm of possibility, particularly as market and regulatory forces appear to be insisting these firms reform or perish. If over-valuation of shares and over-leveraging of assets to pay dividends are the means by which investors are duped into buying illiquid shares, non-traded REITs must remake themselves to be smarter, leaner, and more short-term oriented, or the market will rightfully attach a permanent stigma to the sector. What is meant here by "short-term orientation" is that the overall goal of the non-traded REITs should be to develop or acquire high-quality performing assets, and enter the public securities market as expediently as possible. This is different from the pyramid type non-traded REIT model, where debt and offering proceeds are used to fund future distributions, instead of FFO. If a non-traded REIT faces the prospect of open market trading (and the related price discovery) in 3 years or less, or asset liquidation to pay back shareholders, there would be a greater level of investor confidence for non-traded REITs. More so, if a non-traded REIT successfully transitions to the public market in a reasonably short time period, subsequent offerings of similar ilk will enjoy improved investor confidence.

Darwin or Dodo?

In today's economic climate, with large scale fraud and investor abuse souring the public's perception of Wall Street, the non-traded REITs currently holding some $84 billion in assets, will wither on the vine absent meaningful legislative, regulatory and/or internal reform, as market forces will cause the beleaguered sector to go the way of the Dodo bird. The reform ingredients identified above, combined with short-term oriented business models that lead to publicly held shares, could result in the transformed and legitimized non-traded REIT sector Mr. Thomas envisions. If these changes do not occur in short order, already eroded investor confidence will continue to wane, and the sector may someday soon face extinction with an ice age of investor rejection.

Mr. Pekarek is a Visiting Professor of Law and Supervising Attorney at Pace Law School, who also serves as Assistant Director for the non-profit Pace Investor Rights Clinic of John Jay Legal Services, Inc. He is a former Marketing Manager for Developers Diversified Realty Corp., a publicly traded REIT (DDR: NYSE).

Mr. Haimi is a 2012 Pace Law School graduate and student-intern for the non-profit Pace Investor Rights Clinic, as well as Managing Editor of the Pace Environmental Law Review and a member of the national championship team of the 2011 FINRA/St. John's Securities Dispute Resolution Triathlon. Mr. Haimi is also the recipient of the 2012 Adolph Homburger Humanitarian Award, and is the managing member of Direct Title, LLC, a Boston-based title examination firm.

About May 2012

This page contains all entries posted to Securities Litigation and Arbitration in May 2012. They are listed from oldest to newest.

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