When is an investor responsible for his or her own investment decisions?

When is an investor responsible for his or her own investment decisions?

A recent FINRA administrative action against Merrill Lynch sanctioned the firm when “several hundred” customers of its Puerto Rico office invested in Puerto Rican government bonds and Puerto Rican closed-end funds, some using borrowed money and some buying on margin.  When the value of the securities later declined — a result of the island-commonwealth’s declining financial condition — some of the investors, approximately 25 of whom had borrowed or purchased on margin, had to meet margin calls or were sold out at a loss.  Others became overly-concentrated in Puerto Rican securities and suffered declines in value.  For these various outcomes, FINRA required Merrill to pay $780,000 in “restitution” for having failed to determine in advance whether or not the securities were suitable for the purchasers. 

As the settlement document explained, Puerto Rican bonds and closed-end funds “provide Puerto Rico residents with various tax advantages, including exemption from U.S. estate and gift taxes.” The Puerto Rican government further incentivized residents “to invest in Puerto Rican securities by establishing a Puerto Rico estate tax applicable to property held by a Puerto Rico resident outside of Puerto Rico.”  In other words, to encourage local investment, the Puerto Rico government built in a negative incentive by taxing residents on assets held off-shore.   It is very likely some percentage of Merrill’s investors, perhaps even a substantial percentage, were motivated by these incentives in making their investment decision.

The settlement document does not offer much in the way of profile information about the investors, except to note that some unspecified number of them had “modest net worth and conservative or moderate investment objectives” and that “as a result of the[ ] unique” government offered benefits described above, “many Puerto Rico customers were concentrated in” Puerto Rico securities.  Because of this outcome, Merrill was made to bear the brunt of the losses of at least 25 investors by having to pay restitution to 22 of them, after having settled with several others.

There was no allegation that anyone at Merrill encouraged or promoted any of this Puerto Rico activity, or targeted any of these investors.  In fact, the settlement makes clear that it was the Puerto Rico government that “further incentivized” investors with “unique benefits.”  Nor was there an allegation that any of these investors was incapable of determining for themselves whether the securities purchased, or the method by which they chose to pay for them, were suitable or unsuitable.  In short, FINRA’s claim that Merrill failed to determine suitability prior to each purchase transaction for these “several hundred” investors could be viewed as simply a cynical after-the-fact regulatory hook to force Merrill to refund investor losses it had no affirmative role in causing.

In the face of this glaring regulatory overreach, the question arises: when investors respond to government incentives, or are motivated by hometown loyalty, should a brokerage firm be made a scapegoat if the anticipated benefits fail to materialize?  Stated another way: when investors choose to walk past their local bank, with its offerings of savings accounts and certificates of deposit, to place their funds with a brokerage house, is it fair to assume they have made an informed decision about the greater-than-bank-offered return they are about to pursue, and understand that the pursuit of greater return comes at the greater risk of loss?  The answer depends on one’s view of regulation, however, it is certainly the case that “even a naïve investor is expected to know the risks inherent in investing in the stock market.”  Shamsi v. Dean Witter Reynolds, Inc., 743 F. Supp. 87, 91 (D. MA 1989).

During congressional debates on proposed legislation that would ultimately become the federal securities laws, following the Great Crash of 1929, opponents of regulation spoke of three types of investors.  The first type, the “investor,” was described as someone who seeks to preserve his capital and realize a reasonable return.  (pp. 200-201.)  These investors are characterized by the earnest diligence they put into evaluating an opportunity before making the decision to invest.  (Think mutual fund portfolio managers as the embodiment of this category.)  Next, there is the “speculator,” who also undertakes some degree of investigation and diligence but is primarily motivated by the opportunity for profit; something more than a reasonable return.  (Think hedge fund trader.)  Finally, there is the “gambler,” who is largely indifferent to research and evaluation, preferring headlines and market momentum.  (Think day trader.)

Of these three categories of market participants, a number of representatives and senators believed the last category, the gambler, was a “fool” undeserving of regulatory protection.  “The pending legislation is an effort to protect the fool against his folly.  I doubt if it can be done. . . . Of all ‘diseases’ suicide is the hardest to prevent.”  This may sound harsh, but it is worth remembering when evaluating whether a brokerage house should serve as guarantor for someone who willfully chooses to invest in something she knows little or nothing about, but is simply following the crowd or the day’s headlines.  Presumably, this was not the case for Merrill’s Puerto Rican investors, inasmuch as they, being residents of the island-state in whose securities they invested, were well aware of – or certainly had the means to know – the island’s financial condition and its daily and weekly fluctuations.  And because municipal bonds, i.e., fixed income securities, are not the type of investment in which one invests for unlimited upside, they are not likely to be the gamblers’ preference.  Therefore, it is unlikely FINRA’s settlement was driven by a desire to restore lost fortunes to fools and gamblers, no matter how modest their means.

The settlement agreement’s generic description of the investors as being of “modest net worth and moderate or conservative investment objectives,” probably also rules out the likelihood that they were speculators.  This is supported by the belief that any half-informed speculator, especially one who lived in Puerto Rico during 2012-2013 – the period in question – would likely have been selling Puerto Rico securities, or going short, but not buying.

Thus, we arrive at the salient question: should the brokerage industry be responsible for intervening to stop “investors” who have demonstrated prudence and diligence in their approach to investing, or who respond to governmental incentives from making what second guessers may consider an unsuitable investment?  The congressional debaters who ultimately enacted the nation’s securities laws apparently believed so.  They argued that regulation should protect investors who “tried to invest intelligently; who were thrifty and had ‘trust’ in the nation’s great financial institutions [such as municipal governments]; and who wanted an even chance in a market free of the ‘deliberate introduction of a mob psychology.’”  (p. 190.)

This objective is certainly laudable.  But as represented by the industry’s later developed and widely invoked suitability rule, with which FINRA tagged Merrill, it seems more a form of governmental paternalism than a process designed to ensure that investors have access to relevant and important information about the issuer and its business as would aid in making an informed decision.  Ironically, in connection with more recent federal legislation, the Sarbanes-Oxley Act, one prominent member of congress suggested that government regulation could have the perverse effect of making investors less prudent in the belief that government or regulatory oversight will protect them from loss or lessen their risk (p. 239), a belief that veers dangerously toward moral hazard.   He observed “investors are responsible for their own decisions, good or bad.  This responsibility lends them to vigorously analyze companies before they invest, using independent financial analysts.”  This is as true for government securities, like the Puerto Rican municipal bonds at issue in Merrill’s case, as it is for profit making companies since public finances and the financial condition of public entities are open to the public and readily available.

We may never know what amount of effort the 25 Merrill customers who suffered losses put into evaluating whether they should respond to Puerto Rican government incentives at a time of troubled fiscal condition, and whether they were “investors” in the traditional congressional sense.  But, we do know that investors who knowingly take on the twin risks of borrowing to invest in the securities of heavily leveraged entities are knowingly (or presumably) investing for reasons that may not be entirely consistent with, or solely for the purpose of, seeking a reasonable return; they may also be seeking a unique benefit, such as triple level tax protection, or the emotional return of supporting a local need or call to action (as with U.S. savings bonds).  And, it should be entirely their call whether or not the investment, looking forward from the time the investment is made, will achieve their goal, and therefore be suitable.



Ron Wood

Ron Wood is a partner with Brown White & Osborn LLP. A former Assistant Director in the SEC's Division of Enforcement, Executive Director in the Law Division at Morgan Stanley, and litigation partner with Proskauer LLP, he practices securities law with a focus on regulatory and enforcement matters. He also conducts internal investigations and complex commercial litigation.
Ron Wood