Sophisticated Investor Defense Losing Steam
Dow Jones Compliance Watch
One of Wall Street’s favorite defenses against claims by unhappy investors may be losing steam.
The often-used argument that the claimant was a sophisticated investor, and thus should have understood the risks of an investment that went bad, was weakened in the 2008 financial crisis, according to experts in securities law. A lot of wealthy and supposedly smart investors suffered losses in the crisis, exposing flaws in that view.
Brokerages use the “sophisticated investor” defense against many clients who file claims that a broker sold them an unsuitable investment or was otherwise negligent. But the arbitration panels that handle investor claims are now less prone to accept it, securities lawyers say.
“The arbitrator perception of ‘sophisticated investor’ has evolved as a result of such a substantial market break,” says Edward Pekarek, a securities law professor at Pace Law School in White Plains, N.Y. “Such opaque and complex products and such questionable sales tactics associated with those products resulted in even the most sophisticated investors–institutions–being sold securities later revealed to be toxic.”
Wealth, investing experience, profession and education are all factors in who is considered a sophisticated investor. The arbitration system doesn’t have a precise definition.
Regulators require that an investor have a certain amount of wealth–$1 million, for example–to be able to purchase certain complicated securities. But “money and sophistication are not synonymous,” says John Lovi, a securities litigator and founding partner of Steptoe & Johnson’s New York office.
He uses reality television star Kim Kardashian as an example: She may have more than enough money to be considered an accredited investor by the Securities and Exchange Commission, but that doesn’t mean she is sophisticated about investing, he notes.
The panels that hear cases in the Financial Industry Regulatory Authority’s arbitration system rarely include explanations with their decisions, making it hard to know exactly how often the sophisticated investor defense succeeds or fails. But Jonathan Uretsky, a securities attorney who often represents broker-dealers, points to Finra data showing that in 2010, about 76% of customer claimant cases resulted, through settlements or awards, in monetary or non-monetary recovery for the investor.
“That’s telling of the fact that broker-dealer defendants are less likely to go ahead and say, ‘this guy was a sophisticated investor,'” he says. “It doesn’t mean we can’t win on it, it means we’re less willing to try.”
Media coverage of large losses by brokerages, such as a $54 million award against Citigroup Inc. (C) last year, makes arbitrators more aware of cases in which the sophisticated investor defense doesn’t work, Uretsky adds.
In that case, an arbitration panel ordered a Citigroup unit to pay a group of investors for losses they incurred in several municipal arbitrage funds, including one that lost about 80% during a period between 2007 and 2008.
One of the law firms which represented those investors, California-based Aidikoff Uhl & Bakhtiari, has represented a total of 17 households in cases related to the Citi funds and has won awards in all of them.
Ryan Bakhtiari, a partner at the firm, says the investors in all of the cases were sophisticated or “qualified,” meaning they had $5 million or more in liquid assets. But the outcomes show that “arbitrators don’t buy the fact that when a brokerage misrepresents an investment, a sophisticated investor should have known more,” he says.
Even traders have won these cases. In late November, an arbitration panel ruled that Citi had to pay more than $750,000 to Christopher Puglisi, a former oil trader at the New York Mercantile Exchange. Citi misrepresented the fund to its broker, who in turn misrepresented it to Puglisi, Bakhtiari says.
Even though Bakhtiari doesn’t bring claims against brokers in these cases, brokers can be held liable.
The bottom line: It doesn’t matter if your client is sophisticated or not, you have the same obligation to make sure your recommendations are suitable, Lovi says.
Brokers are required to research and know a product, he adds, and it is always a good idea to pass along all of that information to the investor.