Investor lawyers for the past year have been taking UBS to task for selling Lehman Brothers debt with such reassuring names as “100 percent principal-protected notes” that promised robust returns with no risk of loss. These Lehman-issued notes were largely wiped out when the U.S. investment bank went bankrupt in September 2008.

A string of arbitration losses over the past year may soon be followed by a round of state lawsuits, class actions and possibly intervention by the Securities and Exchange Commission and the Financial Industry Regulatory Authority.

“UBS is something of a house on fire right now,” said Jacob Zamansky, a New York lawyer who helped a South Carolina woman win the first Lehman note arbitration case last year. “They’re doing poorly in arbitration. What happens when FINRA and the SEC get involved?”

After Lehman, UBS was the largest seller of Lehman protected notes — zero-coupon Lehman debt linked to an index or a basket of other securities. These so-called structured products offer limited gains with the assurance that investors would get their money back if the linked securities fell.

UBS sold more than $1 billion of these structured notes.

Unfortunately for investors, these notes were ultimately just unsecured Lehman debt. UBS brokers continued to sell these notes to retail investors through 2008 even as Wall Street grew worried about Lehman’s financial strength.

“What we’ve learned is there were serious concerns inside UBS about these things, certainly during the spring of 2008,” said Phil Aidikoff, whose law firm Aidikoff, Uhl & Bakhtiari has represented investors.

FOLLOWED THE RULES

Lawyers representing dozens of cases and a few state officials contend the notes were unsuitable for small investors, who were lulled by the “principal protected” name.

UBS said it was “following all regulatory requirements, well-established sales practices and client disclosure guidelines” when it sold these notes. “Any client losses were the direct result of the unexpected and unprecedented failure of Lehman Brothers.”

So far, it appears arbitrators are siding with investors, who have prevailed in five of six rulings, according to FINRA arbitration documents.

In some cases investors are receiving full restitution — a rarity — and even legal and expert fees. Lawyers said UBS is now settling more of these cases outside of arbitration.

Soon, state and federal groups will join the fray.

The Swiss bank in its latest quarterly financial report warned it is named in class-action suits and “numerous” investor arbitrations, while also receiving inquiries from “state regulators and FINRA.”

New Hampshire led the charge in June 2009 when it became the first state to allege “unfair sales practices” and “recommending unsuitable investments” to more than 40 state residents.

“We believe ‘principal protection’ meant one thing to investors, but something entirely different to UBS,” Kevin Moquin, a New Hampshire attorney, said at the time.

Missouri, which took a lead role pursuing auction rate securities complaints, is one of several states that are also probing UBS and its Lehman note sales, Missouri Securities Commissioner Matt Kitzi said.

“These are complex products that investors are expressing some concern and confusion over,” said Kitzi.

Industry watchdogs have been slower to respond. FINRA in December advised brokers that promotional materials must not overstate the level of protection, though it stopped short of banning use of the term “principal protected.”

SEC staffers last month began examining how banks described risks of structured note offerings and whether “principal protection” was deceptive.

IMPACT

The potential damage to UBS could be significant in terms of both financial burden and reputation.

UBS recorded $900 million in charges related to auction rate securities, long touted as a high-yielding cash equivalent. These securities, of which UBS sold $22 billion, became impossible to sell when markets seized up in 2007.

State regulators two years ago said UBS continued selling these securities even as the bank’s executives privately worried markets were crumbling. UBS, like other banks, was forced to repurchase these securities from investors.

So far arbitrators seem to be taking a stern view of UBS. Notably, one investor received full restitution of $432,000 plus $53,000 in attorney fees.

“This was the panel’s way of telling UBS this was an egregious situation,” said Seth Lipner of Deutsch & Lipner, whose Garden City, New York, firm represented that investor and has filed more than a dozen cases.

Beyond the financial burden, the Lehman notes may put further strain on a brokerage hard hit by a series of market missteps and regulatory run-ins.

UBS suffered $52 billion of losses on ill-timed U.S. subprime markets, the biggest losses by a European bank during the credit crisis. UBS had to be bailed out by Switzerland.

Then there was news that U.S. authorities accused UBS of helping Americans hide assets overseas and avoid taxes, and clients left in droves.

The question is whether the Lehman cases will further strain a brokerage force that lost more than a thousand advisers over the course of a year, driven away by round after round of bad news.

“With UBS, it’s just one thing after another,” said Zamansky. “They’re like the BP of Wall street.”

Rex and Sherese Glendenning, of the Celina area in Texas, originally sought $1.4 million in the case they filed in February 2009, against Raymond James & Associates, a unit of Raymond James Financial Inc. (RJF) and Larry Milton, a broker associated with the firm in Fort Worth, Texas. They alleged breach of fiduciary duty, misrepresentation and civil fraud, among other things, according to a ruling by a Financial Industry Regulatory Authority arbitration panel.

The Finra panel ordered Raymond James and Milton to pay the Glendennings $925,000 in a ruling dated Aug. 20. The Glendennings must then sign the securities over to Raymond James, according to the ruling.

One of the three arbitrators on that panel that heard the case disagreed with the size of the award. “I believe the award to the Glendennings should be $1,400,000 instead of $925,000,” he wrote. Arbitration rulings, however, are generally still effective, as long as two of the three arbitrators agree.

The panel found both Raymond James and Milton liable for the couple’s damages, but didn’t include a reason for the decision–a practice that’s typical of arbitration rulings.

“We’re glad that the panel found Raymond James and Mr. Milton liable, but wish the majority would have agreed with the dissenting arbitrator in terms of the money awarded,” says Howard Klatsky, a Dallas-based lawyer who represented the Glendennings. The couple, he says, opened a Raymond James account to consolidate funds in numerous certificates of deposit. An estate planner suggested the strategy to make their finances easier to manage, he said.

Milton, the broker, purchased the auction rate securities, consisting of sewer revenue bonds, on behalf of the Glendennings in January, 2008, according to Klatsky. The couple never discussed auction rate securities or sewer bonds with the broker and spoke only about their preference to invest their money in CDs, he says.

A Raymond James spokeswoman declined comment. Milton didn’t immediately return a call requesting comment.

The auction rate securities market froze in February, 2008, leaving many investors stuck with illiquid investments that they initially thought were cash-like.

Dissents in which arbitrators object to not awarding investors 100% of the amount they claimed happen “from time to time,” says Philip Aidikoff, a Los Angeles-based attorney who represents investors.

It’s unusual, however, to find a broker liable in an auction rate case, says Aidikoff. His firm typically doesn’t name brokers in auction rate cases, he says, because many didn’t know the full story behind what they were selling, he says. The ruling against Milton could reflect possible actions that were revealed through testimony, he says.

The case marks the second time in slightly more than a month that Raymond James was ordered to buy back auction-rate securities. A Finra arbitration panel on July 19 ordered the firm to buy back $2.5 million in auction-rate securities from a customer who was acting as trustee for a revocable trust.

The clients had accused the New York-based bank’s global markets unit of breaching fiduciary duty and other misconduct tied to their investments in funds known as MAT Five and MAT Three, according to an Aug. 23 Financial Industry Regulatory Authority award. The three-member arbitration panel didn’t explain its reasoning for the ruling.

“The fund was represented by Citigroup to its brokers as a fixed-income alternative,” Ryan Bakhtiari, an attorney for the claimants at law firm Aidikoff, Uhl & Bakhtiari, said in a statement. “In truth, evidence at the hearing demonstrated that MAT was a risky investment.”

The ruling “is inconsistent with other decisions and we are disappointed that these claims were not dismissed,” Citigroup spokesman Alexander Samuelson said

In May, arbitrators dismissed a $1.5 million claim brought by another investor in the funds, according to decisions posted on Finra’s website. In two other rulings that month, arbitrators ordered the company to pay plaintiffs a total of more than $2 million.

This month, an investor arbitration panel awarded a California family $2.1 million, the full amount of its losses on a $3 million investment in a fund sponsored by First Republic Securities Co., formerly owned by Merrill Lynch & Co.

In May and June, three groups of investors in funds sold by Citigroup Inc. won a total of $2.1 million in separate arbitration proceedings. A spokesman for Citigroup, the largest sponsor of such funds, notes that three other investor claims were denied, which “supports our view the investments were appropriately sold.”

The awards are another indication of the protracted and costly cleanup under way on Wall Street in the aftermath of the financial crisis. These messes involve highly leveraged investments, which amplified losses when financial markets turned rocky.

Some of the cases raise a familiar question in many of the continuing investigations of Wall Street before and during the financial crisis: Were disclosures to investors by securities firms adequate?

The funds at issue were constructed by issuing tax-exempt short-term debt to buy longer-term municipal bonds that offered higher tax-exempt yields. The funds offered investors yields higher than municipal bonds by a few percentage points, according to lawyers for the investors. Then they attempted to use derivatives such as interest-rate swaps to hedge against adverse moves in both short- and long-term interest rates.

The Securities and Exchange Commission is examining the issue of whether fund sponsors including Citigroup understated the funds’ risk, according to people familiar with the situation. Federal prosecutors in the Eastern District of New York also are looking at the funds’ disclosures, according to people familiar with that probe. Spokesmen for the SEC and federal prosecutors declined to comment.

A spokesman for First Republic, which was sold by new Merrill owner Bank of America Corp. in a management-led buyout, said: “We strongly disagree with this finding, which is inconsistent with other legal decisions on this matter. We believe proper disclosure was made about the risks and rewards.” First Republic also noted that investors were experienced enough to understand the risks involved.

Still, when First Republic lawyers raised that argument in the arbitration, the hearing panel criticized the “glibness” of the funds’ managers and defense witnesses for their awareness of the fund’s “upsides,” such as higher yield and higher fees, without “any realistic advance recognition [of] any specific risks or patterns of risk.”

In marketing materials prepared for brokers and investors in 2006, Citigroup indicated its funds could invest $8 for every $1 put into the fund by its investors by borrowing the additional $7. The funds could borrow at a short-term rate of 3.3%, with the proceeds invested at the rate of 4.2% paid by long-term bonds. The strategy could boost investor returns to 8.6%, the marketing materials indicated.

Citigroup compared the funds’ risk to other bond “alternatives” such as high-yield or emerging-market bonds. But another page labeled “risk vs. reward” indicated that the strategy was three times as risky as a bond-market index and even riskier than a stock-market index.

Funds using such borrowing tactics controlled roughly $250 billion in municipal bonds by early 2008, according to Matt Fabian, an analyst at Municipal Market Advisors. At their peak, such funds owned roughly 10% of the $2.6 trillion in muni bonds outstanding, and routinely snapped up as much as one-third of all new issues, Mr. Fabian estimates. “They were able to buy bonds at more aggressive levels than anyone else,” he says.

The First Republic fund raised $34 million and acquired about $200 million of bonds, said Cary Lapidus, a San Francisco lawyer whose clients won the $2.1 million award.

One series of Citigroup funds raised $1.9 billion from investors between 2002 and 2007, invested in an estimated $15 billion in bonds and lost between 70% and 97% of their asset value by the end of February 2008, according to company documents. Citigroup stepped in to rescue the funds by investing more than $650 million of its own capital.

Counting quarterly distributions, representative investors had losses of 15% to 72% through March 2009, according to a person familar with the funds.

Bob Selan, a Calabasas, Calif., magazine publisher, invested $1 million in a Citigroup fund in 2006 through a broker at Smith Barney. Mr. Selan said it was presented as “a safe alternative” to bonds.

“The way it was explained to me, they were going to buy triple-A bonds and you were going to get a couple of extra percentage points,” Mr. Selan recalls.

But when the subprime crisis struck the bond markets in February 2008, municipal-bond prices plummeted amid forced sales. Leveraged funds had to post more collateral against the falling market prices of the bonds. Some funds were forced to liquidate.

By mid-2008, Mr. Selan noticed that his fund was down 15%. Eventually, he lost more than 50%. In May, an arbitration panel awarded him $550,504.96 plus interest-enough to make him whole on the investment.

Philip Aidikoff, a lawyer for Mr. Selan, said the firm has more than three dozen clients who had combined losses of more than $100 million in the Citigroup funds. Craig McCann, an expert witness who has testified for investors in a dozen such cases, estimates that Citigroup will have to pay out tens of millions in losses from such claims.

An Alabama state court has denied a request by Morgan Keegan & Co. to fully overturn a securities arbitration award entered in favor of an investor, disagreeing with the company’s arguments that an arbitrator was allegedly biased.

Judge Nicole Gordon Still, a civil division judge in Birmingham, affirmed a $220,000 award in favor of United Prison Ministries International in Verbena, Ala., which distributes free bibles and religious books to prisoners and their families. A Financial Industry Regulatory Authority arbitration panel awarded the sum in July 2009.

The claim was related to a family of bond funds steeped in mortgage-related holdings that suffered sizable losses in 2007 and 2008 when the housing bubble burst.

Morgan Keegan & Co., a unit of Birmingham-based Regions Financial Corp. (RF), filed the court case seeking to appeal the award shortly thereafter, as previously reported by Dow Jones Newswires. The brokerage argued that the panel’s chairwoman, who previously sat on another panel that ruled against Morgan Keegan, should have been recused, according to court documents.

Judge Gordon Still disagreed in a ruling made on Tuesday, saying there was “no specific instance” of the chairwoman “showing bias or prejudice against Morgan Keegan.”

“The mere fact that she has served on arbitration panels of Morgan Keegan, and has ruled against Morgan Keegan in the past, is not enough to establish bias or prejudice,” the judge wrote in an opinion.

Arbitration awards are typically binding. Federal arbitration law gives parties the right to appeal awards only under very limited circumstances, such as when arbitrators clearly ignore established law. Appeals are rarely granted, say lawyers.

The court did, however, agree to overturn a $20,000 award for expert fees that was calculated in error, according to the ruling.

“It’s a good victory,” says Debra Brewer Hayes, a lawyer in Houston, who represented the investor. “It’s very affirming that the judge did the right thing.”

Philip Aidikoff, a securities lawyer in Beverly Hills, Calif., says the arguments of alleged bias are “absurd.”

“It’s not unusual for a person on one panel to be chosen to sit on another panel,” he says, especially in a situation that involves so many investor claims. About 700 claims are pending against Morgan Keegan. “There is a limited number of people in each geographic pool to be selected for arbitration panels,” he says.

A Morgan Keegan spokeswoman says five awards appealed by the company have been decided. Courts have overturned awards in three of those cases, she says.

“Morgan Keegan appealed the case because we believed the panel was biased and that the award was inaccurately computed,” she says. “The court found our submission compelling and reduced the judgment rather than ordering a retrial.”

Mat Three was a leveraged municipal arbitrage hedge fund launched by Citigroup Global Markets, Inc. and sold through Smith Barney, part of Citigroup’s (NYSE: C - News) Global Wealth Management Group in February 2006 and was marketed only to high net worth clients of the firm.  The fund imploded in February 2008 causing catastrophic losses to investors.

“Despite widespread evidence of material omissions, Citigroup elected to employ the “blame the customer” defense which the FINRA panel rejected.  The award is the second significant investor win in a Mat case for clients of our firm in the last 2 weeks,” according to Philip M. Aidikoff.

“The fund was represented by Citigroup to its brokers as a fixed income alternative with the volatility of the Lehman Brothers Aggregate Bond Index,” stated Ryan K. Bakhtiari who added “In truth, evidence at the hearing demonstrated that Mat Three was a risky investment which subjected investors to a 100 percent or more loss of principal.”

The FINRA arbitrators also assessed the cost of the hearing against Citigroup Global Markets, Inc.

BEVERLY HILLS, Calif., May 12, 2010 - A Los Angeles based Financial Industry Regulatory Authority (FINRA) arbitration panel awarded more than $1.7 million to three clients of Aidikoff, Uhl & Bakhtiari and Maddox, Hargett and Caruso, P.C. in connection with their purchases of Mat Five.

Mat Five was a leveraged municipal arbitrage hedge fund launched by Citigroup Global Markets, Inc. and sold through Smith Barney, part of Citigroup’s (NYSE: C - News) Global Wealth Management Group in February 2007.  Mat Five was marketed only to high net worth clients of the firm.  The fund imploded one year later causing catastrophic losses to investors.

Despite widespread evidence of material omissions, Citigroup elected to employ the “blame the customer” defense which the panel rejected.  When confronted with evidence that Citigroup misrepresented Mat’s risk level to their brokers who passed the misleading information on to their clients, a high ranking Citigroup official said that it would be “unwise” for customers of the firm to rely on what their broker told them about a recommended investment.

“This award represents a return of our clients’ losses plus interest and is the first significant investor win in a Mat case,” according to Philip M. Aidikoff.

“The fund was represented by Citigroup to its brokers as a fixed income alternative with the volatility of the Lehman Brothers Aggregate Bond Index and LIBOR,” stated Ryan K. Bakhtiari who added “In truth, evidence at the hearing demonstrated that Mat Five was a risky investment which subjected investors to a 100 percent or more loss of principal.”

“Despite the representations to our clients, the evidence established that Mat Five was 2.5 times more volatile than the S&P 500 and 7.8 times more volatile than a traditional portfolio of municipal bonds.  This was not what our clients were told by their brokers,” according to Steven B. Caruso.

The FINRA arbitrators also assessed the entire cost of the hearing against Citigroup Global Markets, Inc.

The law firms continue to investigate and pursue FINRA arbitrations on behalf of investors who suffered losses in fixed income alternatives, including Mat/ASTA.

LPL Investment Holdings Inc. and Pacific Life Insurance Co. are staring each other down over which firm will have to pony up the potentially millions of dollars in claims stemming from fraud suits against a rogue broker from one of the three independent-contractor firms LPL acquired from Pac Life two years ago.

Veiled references to the quarrel first surfaced this month in official filings.

Last week, in its quarterly earnings report to the Securities and Exchange Commission, LPL said that it was in dispute with an unnamed third-party indemnifier “in connection with various acquisitions.”

Until now, the report said, the “indemnifying party” defended and paid “for certain legal proceedings and claims.”

The LPL report said that it received a written notice Oct. 1 from an unnamed third party saying that “under a certain purchase and sale agreement” the third party “is no longer obligated to indemnify the company for certain claims” under the agreement.

LPL “believes that this assertion is without merit and intends to vigorously dispute it,” the report said.

One source close to Pacific Life, who asked not to be identified, said the unnamed third party was “absolutely” Pacific Life.

Recent changes in LPL’s clearing agreement with the former Pac Life reps could have triggered the dispute, industry observers said.

In 2007, LPL paid around $97 million for the three firms - Mutual Service Corp., Associated Securities Corp. and Waterstone Financial Inc. - which at the time had a combined 2,200 reps and advisers generating $350 million in gross revenue.

Those three broker-dealers maintained clearing platforms of their own, at first with Pershing LLC and then with a combination of Pershing and LPL’s proprietary platform, BranchNet.

That all changed in September, when LPL moved the remaining 1,700 reps and advisers from those three firms off that platform and solely onto its own self-clearing platform.

That shift of brokers on to the LPL platform may have triggered the legal salvo from Pacific Life, industry observers maintained.

The claims that Pacific Life wants to have off its books involve former Associated Securities broker Jeffrey Forrest, who lost an $8.8 million arbitration claim earlier this year.

The attorney for the plaintiffs in that case, Philip Aidikoff, said that over the summer he filed two more claims totaling $10.5 million against Mr. Forrest, who has been barred from the securities business.

Asked last spring about the company’s liability for Mr. Forrest, a company spokesman, Tennyson Oyler, made it very clear that Pac Life was responsible.

“As is customary in transactions of this type, Pacific Life has agreed to indemnify LPL for certain liabilities related to pre-close activities,” he said.

Today, Mr. Oyler did not return a phone call seeking comment.

An LPL spokesman, Joseph Kuo, said, “As a matter of policy we have no comment beyond the disclosure in our” quarterly report. “We have a long-standing and productive relationship with Pacific Life.”

Forrest, who owned WealthWise LLC, and Associated Securities, an El Segundo-based broker-dealer with which his firm had been registered to sell securities, abandoned their appeal of the judgment in federal court, according to Phil Aidikoff, a Beverly Hills attorney representing the group of WealthWise investors.

“I can only tell you that they saw the error of their ways and felt that by appealing further, it wouldn’t accomplish anything,” Aidikoff said.

A Southern California attorney representing Associated Securities did not return a call Monday afternoon. Forrest acknowledged in an e-mail to The Tribune that the investors have been paid.

However, he declined to comment on the appeal, which had been filed with the U.S. Court of Appeals for the Ninth Circuit on April 22 and dismissed Aug. 4. Forrest noted that WealthWise LLC is defunct “and is no longer in the business of rendering investment advice.”

The U.S. Securities and Exchange Commission this spring charged the San Luis Obispo man with fraud and barred him from acting as an investment adviser.

A panel of the Financial Industry Regulatory Authority (an independent regulator of U.S. securities firm) found in March that Forrest, who had been a broker with Associated Securities from 1989 through 2007, had steered clients to the APEX Equity Options Fund, a highly speculative investment worth about $40 million that he touted as providing safety, security and liquidity of investor principal.

Investors - representing about 16 county households - lost millions when the fund collapsed in August 2007. Some of the investors - among them a retired nurse, stay-at-home mom and a quadriplegic man - had invested their savings and in some cases borrowed against the value of their homes.

Three other arbitration cases have settled and clients have received damages, although the amount of damages is unknown because of confidentiality agreements reached as part of the settlements.

Two additional cases have been filed by Aidikoff’s firm related to investors in Arizona and Utah.

The number of arbitration claims filed with the Financial Industry Regulatory Authority has surged in the first seven months of 2009.

Through July, investors filed 4,481 claims, as compared to 4,982 claims during all of last year. That’s a 71% increase in the number of new case filings over the same period in 2008, according to Finra statistics.

Mutual funds were part of more than a thousand of this year’s claims. There were 1,061 arbitration cases involving mutual funds through July. In 2008, there were 930 such claims.

Finra does not break out the exact types of arbitration claims involving mutual funds, says spokesman Herb Perone.

“I think the system is still trying to digest the subprime-related arbitration claims, concentrated very heavily still against Morgan Keegan, Schwab, Oppenheimer and a few others,” says Andrew Stoltmann, a Chicago attorney who represents investors in securities fraud litigation and arbitration. “There are still people just realizing how much money they’ve lost in what were supposed to be conservative bond funds. I think we’re going to see the same surge for the rest of the year.”

Total arbitration claims may reach 9,000 or 10,000 this year, estimates Stoltmann. That would make 2009 a record-setting year. In the last decade, 2004 had the highest number of arbitration claims filed, 8,201.

Claims against mutual funds probably will peak this year and decline in number in 2010, Stoltmann says. About 90 of his current 130 arbitration cases involve mutual funds, specifically bond funds managed by Schwab, Morgan Keegan, Oppenheimer and Evergreen that had severe losses during the downturn, he says.

Meanwhile, the percentage of cases for which customers were awarded damages has increased to 45% thus far in 2009, or 160 cases. Last year, customers were awarded damages in 42% of cases, or 199 cases. The increase this year may be the result of changes to the arbitration process to make it more investor friendly.

In one notable example, an arbitration panel in July awarded an investor $157,498, or 100% of the losses she had suffered in Schwab’s YieldPlus fund, plus expert witness costs of about $16,000, according to Ryan Bahktiari, partner at Aidikoff, Uhl & Bakhtiari, which represented the investor.

The claim was brought against Charles Schwab on the basis of how the fund was marketed to the investor. This is “very unusual” in that arbitration claims are usually brought against the broker that sold the fund, says Bakhtiari.

“This was more of a systemic, institutional problem than a broker-specific problem,” says Bahktiari. The firm has filed more than 100 similar claims against Charles Schwab on behalf of investors all over the country who claim the YieldPlus fund was sold to them as a conservative investment akin to a money market fund, he says.

“I think because of the number of cases that my firm has filed… that Charles Schwab wanted to test us, frankly,” says Bahktiari when asked why Schwab did not settle the case instead of going through the arbitration process.

Schwab did not immediately return a request for comment yesterday.

Like Stoltmann, Scott Silver, managing partner at Coral Springs, Fla.-based Blum & Silver, says he has also seen a number of arbitration claims brought against brokers who sold bond funds. Silver also represents investors in arbitration claims.

The arbitration claims his firm is working on that involve mutual funds fall into two categories, he says. The first are those involving investors who bring claims against brokers for selling proprietary funds, such as the Morgan Keegan funds and the Schwab YieldPlus fund.

The second category of arbitration claims are those in which investors bring claims against brokers for selling them unaffiliated funds. Many of these claims were brought against brokers that sold the Oppenheimer Rochester municipal bond funds, he says.

In addition, almost 180 arbitration claims filed in 2009 involve auction rate securities, down from 299 in 2008. Auction rate securities “are among the main components of the surge in filings,” says Howard Suskin, a partner in Jenner & Block’s litigation department. Suskin has experience as an arbitrator for several self-regulatory organizations, including Finra.

And the sale of leveraged exchange-traded funds has also spurred some arbitration claims, according to Silver. His firm represents investors in five such claims. But since Finra and the Securities and Exchange Commission have said the product is rarely suitable for retail investors, there won’t be a significant increase in claims in the months to come, he says.

A total of 2,454 arbitration claims have been closed this year. About 25% of those claims were decided by arbitrators; 45% of cases were resolved through direct settlement by the parties; 16% were withdrawn; and 5% were settled by mediation. The remaining 9% of arbitration claims were closed by stipulated award, bankruptcy of a critical party or a stayed court action, among other reasons.

There are currently 6,156 Finra-qualified arbitrators, according to Finra’s Perone. This is somewhat fewer than the number Finra had last year because it culled the list over the past few years, eliminating arbitrators who had not completed mandatory training, he says.

The Financial Industry Regulatory Authority awarded the Everett Ross family trust 100 percent of its losses plus expert witness costs.

“Although Charles Schwab recommended the purchase of the Schwab YieldPlus Fund Select Shares and the Schwab YieldPlus Investor Shares as safe, conservative cash alternatives to investors, the evidence established that the YieldPlus funds were over concentrated in toxic mortgage-backed securities,” said the Ross’ attorney, Ryan K. Bakhtiari.

The brokers who sold the Schwab YieldPlus Fund are not targets of investor claims, attorneys said. A representative from Charles Schwab did not return a call seeking comment.

A San Luis Obispo man charged with fraud by the U.S. Securities and Exchange Commission has been barred from acting as an investment adviser.

Jeffrey Forrest, owner and principal of WealthWise LLC, will not be allowed to associate with any broker-dealer or be an investment adviser for five years, at which time he will be able to reapply with the SEC or the Financial Industry Regulatory Authority (an independent regulator of U.S. securities firms) to work for a broker-dealer or investment adviser.

Forrest also has agreed to a permanent injunction ordered by a federal court, which prevents him from committing acts of fraud in the future, according to the commission.

Forrest did not return calls or respond to an e-mail message from The Tribune on Monday. But Andrew Petillon, regional director for the SEC, said Forrest’s consent to be barred from practicing as an adviser and prohibited from violating federal securities laws is bringing to a close the commission’s case against him. The federal courts must still decide on a monetary judgment, which could go to investors.

“The final money amount has to be determined,” Petillon said. “That will be up to the court to set a schedule for that.”

What he did

Forrest had recommended that more than 60 of his clients, including dozens of county residents, invest

$40 million in the Apex Equity Options Fund, a highly speculative investment that promised to protect investor principal while generating

3 percent monthly returns, according to the SEC.

Among the investors was a quadriplegic man, a retired nurse, a stay-at-home mom, a software consultant, a retired telecommunications technician and practicing physicians. They invested their savings, in some cases borrowing against the value of their homes. The investors allege that Forrest repeatedly assured them that the principal invested was safe in a money market account.

But Forrest failed to properly disclose that he had a “significant conflict of interest” in recommending the investment to clients, SEC documents state. Forrest entered into a “side agreement” with the president of Salt Lake City-based Thompson Consulting, a hedge fund manager, in which he would receive a portion of the performance fees from Thompson, according to the SEC.

Investments from WealthWise clients made up more than 90 percent of Apex’s assets, and between April 2005 and September 2007 the firm received more than $388,000 in fees from Thompson, according to SEC documents.

The Apex fund collapsed in August 2007 as a result of “TCI’s risky trading strategy,” the commission said, causing local investors, many of whom had invested considerable savings, to lose millions of dollars.

Judgments reached

More than $8.8 million was awarded in March to a group of investors (about 16 local households), primarily in San Luis Obispo County. A FINRA panel found that Forrest, who had been a broker with El Segundo-based Associated Securities, steered clients to the Apex fund, misrepresenting the safety and liquidity of their investments in that fund.

“The arbitration panel gave them 100 percent of their Apex losses and also found fraud,” said Phil Aidikoff, an attorney for the Beverly Hills law firm Aidikoff, Uhl & Bakhtiari, which represented the investors. “And that is a clear indication that the system works.”

Associated Securities and Forrest filed a petition to vacate on that case, but the petition was dismissed by a federal court judge in June, Aidikoff said. Forrest has filed an appeal of the denial, but Aidikoff expects the court to throw it out.

Three other arbitration cases have settled, and clients have received damages, Aidikoff said, noting that he cannot comment on the amount of damages because of confidentiality agreements reached as part of the settlements.

The Securities and Exchange Commission on Thursday filed fraud charges against 10 former brokers for Brookstreet, an Irvine, Calif., brokerage that collapsed in scandal in 2007. It said the brokers falsely marketed investments in derivatives of mortgage-backed securities as safe and appropriate for investors with conservative goals, including retirees. In many cases, they allegedly told investors the securities were backed by the U.S. government. The Financial Industry Regulatory Authority, or Finra, also charged six Brookstreet brokers in a parallel enforcement action.

The brokers raked in more than $16 million in commissions between 2004 and 2007, the SEC says, while their clients collectively hemorrhaged almost $40 million in margin account deficits. Some of the brokers told clients that margin would be used sparingly, and with little or no risk to their principal, according to the SEC complaint.

Stuart D. Meissner represented three investors in arbitrations against two of the brokers. He says investors who purchase certain bonds or exotic instruments are often unaware of markups, which is the difference between what the broker pays for the security and what the investor pays.

Many investors only learn of the markup much too late - when filing an arbitration claim.

“It’s certainly something that one is entitled to know, especially if it’s not a traditional investment,” says Meissner.

Furthermore, being told about the markup may not mean understanding it, notes Theodore G. Eppenstein, a New York-based attorney who represents investors in securities arbitrations. “You need a forensic accountant to take apart the statements. Even a sophisticated investor can’t figure it out,” he says.

Deborah Meshulam, a former SEC assistant chief litigation counsel who now chairs DLA Piper’s SEC practice in Washington, says brokerages typically comply with securities laws that require disclosure of their compensation and conflicts of interest - but the catch is whether the disclosure is adequate.

The Brookstreet brokers misrepresented how margin accounts would be used, the SEC says, and some told clients that they would be taken off margin but weren’t. Many investors aren’t even candidates for margin accounts - particularly if their goals are conservative.

Jill I. Gross, director of the Investor Rights Clinic at Pace Law School in New York, says that, during the last two decades, margin accounts have been extended to customers who lack the financial sophistication to use them prudently. Regulators, she says, should consider imposing requirements for margin accounts, such as standards for net worth or knowledge level.

Some investor advocates say that compensating brokers based on the performance of client portfolios would prevent misconduct. But Philip M. Aidikoff, a Los Angeles-based securities attorney, is concerned the model would push brokers toward high-risk strategies. “A broker who isn’t making anything on the portfolio may figure he has nothing to lose,” he says.

Keeping track of rogue brokers is a tricky business, particularly when they leave or are booted from the confines of the securities industry, but keep peddling financial products.

Take, for example, Jeffrey Forrest, who no longer sells securities through a broker-dealer.

His broker-dealer asked him to leave in 2006 after he had made improper sales of a hedge fund that spurred lawsuits from investors.

Two years later, the Securities and Ex-change Commission sued Mr. Forrest for failing to disclose hundreds of thousands of dollars in fees he gained from the hedge fund, which blew up in 2007.

The SEC suit sought to stop him from working in the investment advisory business.

Yet, Mr. Forrest is licensed to sell insurance in California and continues to run a registered investment advisory firm, WealthWise LLC of San Luis Obispo, Calif., which manages $26 million in assets.

Regulators are taking action against him, but the case is moving slowly and may go unnoticed by investors.

Mr. Forrest’s story highlights a host of vexing issues in securities regulation that interferes with its primary goal: protecting investors.

“If you’re kicked out of one channel, you should be bumped from all,” said Richard Nummi, a director with Accounting and Compliance International of New York. “I don’t think [advisers] should be allowed to shop for venues.”

Insurance companies, in particular, haven’t been aggressive in kicking producers with potentially problematic histories to the curb, industry executives and lawyers said.

For example, despite the SEC’s action against Mr. Forrest and a recent loss of an $8.8 million securities arbitration claim against him, major insurance companies such as Pacific Life Insurance Co. of Newport Beach, Calif., have licensed him to sell life insurance.

In fact, Pacific Life, which owned the broker-dealer, Associated Securities Corp. of El Segundo, Calif., where he worked when he sold his clients the volatile hedge fund, authorized him to sell insurance in January, a month before the SEC issued a preliminary judgment to stop him from working in the industry.

When contacted, Pacific Life said it is reconsidering its relationship with Mr. Forrest.

“I appreciate you letting us know that there is still an appointment out there for Jeffrey Forrest,” said Tennyson Oyler, a Pacific Life spokes-man.

TAKING ACTION

“We are taking steps to make sure that we revoke Mr. Forrest’s appointment to sell any and all Pacific Life products,” he said.

Additionally, a handful of other major insurance companies in 2007 and 2008 gave Mr. Forrest the authority to sell life insurance, including Aviva Life and Annuity Co. of Des Moines, Iowa, Genworth Life and Annuity Co. of Richmond, Va., Lincoln National Life Insurance Co. of Hartford, Conn., and Prudential Annuities Life Assurance Corp. of Shelton, Conn.

That was well after he left Associated Securities in October 2006, when executives simply “asked [him] to move on,” according to transcripts from the arbitration hearing.

In a statement, Aviva said, “While we cannot discuss issues concerning specific individuals, we are currently reviewing the circumstances around this situation.”

A spokeswoman for Prudential said that the company continues to monitor and review disciplinary actions against agents who sell Prudential products.

Securities regulators recognize that there is often a shortfall of information for investors when it comes to ex-brokers like Mr. Forrest.

Just last month, Financial Industry Regulatory Authority Inc. chief executive Rick Ketchum said that the Washington- and New York-based self-regulator needs to expand its effort to keep public the records of rogue brokers.

As it now stands, the records of brokers usually are pulled from the Finra database two years after they leave the business, regardless of how good or bad their history is.

Mr. Ketchum has estimated that the records of more than 15,000 brokers who left the securities business because of trouble with regulators are not publicly available to investors. He also said that some of those brokers have been involved in the frauds that have come to light during the market’s recent collapse.

“Individuals previously barred by Finra and other securities regulators have surfaced in a number of recent frauds [and are] responsible for millions lost by unsuspecting investors,” Mr. Ketchum said in a published statement.

Meanwhile, Mr. Forrest’s records are not on Finra’s website under its BrokerCheck service.

Finra has filed a proposal with the SEC to expand the service.

BOGUS HEDGE FUNDS

Mr. Forrest’s scheme appears similar to the dozens of bogus hedge funds and Ponzi schemes that began to blow up in 2007, most notably, of course, the $65 billion fraud committed by Bernard L. Madoff. Un-scrup-u-lous advisers held out the phony investments as dependable, predictable and with little or no volatility.

In 2005 and 2006, Mr. Forrest, who was a top producer with Associated Securities, advised 60 clients to invest $40 million in a hedge fund that collapsed the next year.

According to a recent arbitration decision in which he and Associated Securities were found liable, Mr. Forrest pitched the fund, the Apex Equity Options Fund, as a safe, secure and liquid investment.

A three-person Finra panel in March decided that Mr. Forrest defrauded and deceived investors in that transaction, in which he collected hundreds of thousands of dollars in fees.

Associated Securities was deemed liable because it allegedly did not properly supervise him. The firm has appealed the arbitrators’ decision, and that appeal will be decided by a federal judge on June 1.

Securities arbitration awards are almost never overturned on appeal, according to securities lawyers.

Mr. Forrest did not return phone calls to comment.

The Financial Industry Regulatory Authority, or Finra, is conducting a sweep of broker-dealer sales and promotion practices related to non-exchange-traded and private REITs, according to industry sources. Both instruments are sometimes also called unlisted REITs.

Finra, in a letter dated March 20, requests information such as sales figures, incentive payout schedules for registered representatives, blank customer applications and risk-monitoring reports. It gave broker dealers until April 13 to respond.

Tim Pedregon, a Dallas compliance consultant and former examiner for Finra, says the regulator is likely concerned about how these types of REITs are marketed to seniors. Private REITs, in particular, often rely on Regulation D, an SEC regulation that provides an exemption to registration. But the securities can be marketed and sold only to certain types of investors - usually those earning more than $200,000 annually and who have a minimu m $1 million net worth including houses.

Declining real-estate values could mean that some investors, particularly seniors on fixed incomes whose net worth falls below $1 million, are no longer considered qualified for certain investments.

Securities-arbitration attorneys say many investors in non-traded REITs don’t understand - or aren’t told - that the securities are illiquid. Some commissions on the securities are as high as 7%, according to Philip M. Aidikoff, a securities-arbitration attorney in Beverly Hills, Calif.

Non-exchange-traded REITs are registered with the Securities and Exchange Commission but don’t trade on national stock exchanges. Private REITs are similar, but aren’t registered with the SEC.

Ron Kuykendall, a spokesman for the National Association of Real Estate Investment Trusts, or Nareit, a trade group, says non-traded and private REITs appeal to many institutional and high-net-worth investors because they don’t fluctuate with market volatility, unlike publicly traded REITs, whose daily changing values are known to investors.

The securities often restrict redemptions by investors for the first 12 to 18 months. Kuykendall says the time frame helps accumulate a fund that trust managers use to buy real estate.

Other restrictions are common. For example, some investments allow only quarterly redemptions. And some non-exchange-traded REITs can deny redemption requests if too many investors want to redeem at once, says Lawrence L. Klayman, a securities-arbitration lawyer in Boca Raton, Fla., who represents investors.

Randall C. Place, an attorney in Southern Pines, N ..C., says he is aware of a case where a broker recommended non-traded REITs to an investor but didn’t explain that they were illiquid. The problem became apparent only when the investor tried to liquidate his portfolio. The investor is now trying to recover the value of the illiquid funds, Place says.

Klayman says the securities, while non-traded, could be easily affected by declines in real-estate values. That could prompt many investors to request redemptions at once, he says.

Steven B. Caruso, a New York-based securities attorney, says non-exchange-traded and private REITs remind him of the limited partnerships marketed by Prudential Securities and Payne Webber during the late 1980s and early 1990s. The investments were marketed as safe but turned out to be risky and illiquid, resulting in a spate of regulatory enforcement cases.

Valuation is also a concern, says Caruso: The same security purchased through d ifferent brokerages can have different values. Finra issued valuation guidance to brokerages about non-exchange-traded and private REITs in February.

Because the securities trade privately, the size of the market and the level of interest among current investors are murky. SecondMarket, a New York-based marketplace for illiquid assets, has noticed a “smattering of interest” in recent months from investors interested in selling unlisted REITs, according to Jeremy Smith, chief strategy officer. The company doesn’t currently offer a marketplace for unlisted REITs, he says.

Aidikoff, who recently settled several claims brought by investors involving nontraded REITs, describes them as having a potential for abuse.

“From the perspective of a normal retail customer, I can’t imagine why anyone would buy them,” he says.

More than $8.8 million has been awarded to a group of San Luis Obispo County investors - clients of Jeffrey Forrest of WealthWise LLC in San Luis Obispo - who lost millions in what amounted to a risky hedge fund that Forrest claimed was safe.

A panel of the Financial Industry Regulatory Authority (an independent regulator of U.S. securities firms) found that Forrest, who had been a broker with El Segundo-based Associated Securities, steered customers to the APEX Equity Options Fund. That was a highly speculative investment that he promoted as providing safety, security and liquidity of investor principal, according to attorneys representing 16 local households.

The fund, worth more than $40 million, was wiped out in 2007 with massive losses after making speculative investments.

Forrest’s representations to his clients about the “safety and liquidity of their investments in APEX, in light of what Forrest knew and understood from the written offering documents constitutes fraud or deceit within the meaning of California law,” said Phil Aidikoff, an attorney for Beverly Hills law firm Aidikoff, Uhl & Bakhtiari, which represented the investors.

But Forrest told The Tribune Monday that he was “greatly disappointed with the findings of the panel,” saying that its decision was not “based on the evidence but was determined by the irrational business climate of today.”

“I am considering my options, including an appeal to the state courts to set the award aside, as it is flawed,” Forrest said.

He also noted that he was pleased that the panel “fully exonerated me on claims that I was wrong in advising my clients to buy Florida Capital, San Luis Trust Bank, Kennedy Clubs and Estate Financial.” Forrest had recommended those investments to clients, and only a small percentage of them chose to participate. The panel denied requests for damages in those instances.

Kennedy Clubs refers to the group of health clubs operating in San Luis Obispo County. Estate Financial Inc. was a Paso Robles-based lender who took investors’ money and lent it to developers, with the promise that the investments would generate double-digit interest. The principals of that firm are now in County Jail awaiting trial on charges of defrauding investors. The company’s future is being determined in U.S. Bankruptcy Court.

In the APEX investment, the panel said that Forrest, who earned undisclosed fees of more than $800,000 in the two years that he promoted the APEX fund, touted his expertise with options trading, saying to one client that she should ignore the disclaimers about APEX’s risk because it was “legalese.”

“Forrest then went on to tell her that he rated the risk of investing in APEX on a scale of 1 to 10 (with one being the “safest”) as a two or three notwithstanding that options trading, especially naked options trading, as was done here, is probably a nine or 10 on that same 10-point scale,” according to the panel. Forrest also encouraged some of his clients to borrow money against their homes to invest in APEX, the panel said.

As well, the arbitration panel found that Associated Securities was also jointly and severally liable (plaintiffs may collect their entire judgment from Forrest or Associated Securities) for Forrest’s conduct because it had a responsibility to supervise his conduct and failed to do so, Aidikoff said.

Aidikoff said the award represents 100 percent of the money the firm’s clients had invested in the APEX fund, and that it’s unusual for a panel to offer full damages.

Forrest and Associated Securities could file a petition to vacate in state court, and if so, it could result in a 90-day delay.

“The panel gave them 100 percent of their money back,” said Aidikoff. “A fraud is a fraud. Regardless of their financial savvy, the panel understood that you’re not permitted to defraud any customer irrespective of their experience or education about the markets.”

Forrest declined to say whether he had the money on hand to pay the judgment.

He had a different view of the panel’s conclusions, noting that it found that “the claimants were sophisticated, experienced investors who heard from the APEX fund managers directly that their investments would be safe.”

“I am faulted for repeating what the fund managers told me and my clients,” Forrest said. “The panel also correctly notes that theft of the money by APEX fund managers caused the losses, but then blames me for recommending that the investments be made.”

Two additional arbitration hearings have been scheduled, one April 13 and another May 5, Aidikoff said. The remaining client losses amount to about $5.1 million. Another arbitration case was settled for an undisclosed amount last year.

A civil trial against Forrest by a Huntington Beach property developer is also pending in federal court. The Securities and Exchange Commission also has charged WealthWise and Forrest with fraud.

A group of San Luis Obispo County investors – clients of Jeffrey Forrest of WealthWise LLC in San Luis Obispo who had lost millions in the failed APEX Equity Options Fund - has been awarded more than $8.8 million in damages by the Financial Industry Regulatory Authority, an independent regulator of U.S. securities firms.

The FINRA arbitration panel found that Forrest, who had been an Associated Securities broker, was liable for selling what amounted to a risky hedge fund to clients, according to attorneys representing the 16 households involved in the case. The fund, worth more than $40 million, that collapsed in August 2007.

Forrest's representations to his clients about the “safety and liquidity of their investments in APEX, in light of what Forrest knew and understood from the written offering documents constitutes fraud or deceit within the meaning of California law,” said Phil Aidikoff, an attorney for Beverly Hills law firm Aidikoff, Uhl & Bakhtiari.

Due diligence, fiduciary duty, transparency, risk management, oversight. It’s all part of the sacred bond of trust between financial services firms and the investors who entrust them with their money. Somehow, the lines of that trust became increasingly blurred when it concerned investing with Bernie Madoff and his allegedly corrupt hedge fund scheme.

Long before Madoff’s arrest Dec. 11, rumors and speculation ran rampant on exactly how Madoff could guarantee such high and consistent returns for investors. These weren’t just annual returns; they were monthly. If pressed for an explanation about his money-making performance, Madoff remained silent. At best, the former Nasdaq chairman offered vague responses of investing in blue-chip stocks and hedging them in the options market. Such explanations, no matter how you look at it, are not what one expects from a supposed legitimate money manager who has the best interests of clients at heart, and is therefore committed to providing any and all information about the inner workings of their investments.

A number of hedge fund firms and money managers took the bait, however, and eagerly sent money - investors’ money - to Madoff. In doing so, highly respectable, sophisticated institutions failed their clients miserably. They neglected to perform the basic premise of Investing 101: know who or what you are doing business with.

One such firm is the Brighton Co. of Beverly Hills. In a lawsuit filed Dec. 15 in the U.S. District Court for the Central District of California, Brighton founder Stanley Chais is accused of defrauding investors and using Brighton as an “alleged feeder fund” to channel investors’ monies to Madoff.

According to the complaint, investors were under the impression that Chais had invested their money in currencies, stocks and other securities; Madoff’s name was never mentioned during his tenure as their adviser. Even more troubling: The Securities and Exchange Commission and the California Department of Corporations can find no records of Chais even registering as an investment adviser or as a broker.

Millions of dollars in life savings have now vanished. And, as if to commiserate with those who were allegedly scammed, Chais said his own foundation, the Chais Family Foundation, also suffered in the Madoff scandal. On Dec. 15, the foundation, which gives away about $12 million annually to various Jewish causes, officially closed its doors after losing 100 percent of its money to the disgraced money manager.

The demise of the Chais Family Foundation, while devastating to the causes that benefited from its support, is yet another indicator of ineffective oversight. The foundation of a professional financial adviser’s relationship with his or her clients is built on trust - trust that the person handling your money will perform the necessary legwork to ensure investment decisions are appropriate to meet individual financial goals. By steering investors’ money into Madoff’s funds without thoroughly understanding how such positive returns were generated month after month, many advisers failed to perform adequate due diligence.

Making matters worse, a number of feeder funds raked in hefty fees from investors totaling billions of dollars for their services.

The damage is done. The list of investors who lost some $50 billion because of Madoff’s alleged actions continues to grow by the day. More than just investors, the entire hedge fund industry is now marred - much like what happened in the case of Michael Milken and the junk bond market.

Investor confidence in Wall Street is at an all-time low, with the Madoff affair serving up the final icing on the cake. If money managers and hedge funds ever hope to repair the fractures that have cracked the foundation of trust among themselves and their clients, then it’s time to revisit the concepts of due diligence and fiduciary duty - and fast.

Ryan K. Bakhtiari is a securities lawyer for the L.A.-based firm Aidikoff, Uhl & Bakhtiari.

The federally mandated SIPC has a narrow requirement as to what it covers — generally theft in brokerage accounts.

Furthermore, securities attorneys say the nonprofit organization, which is supported by brokerages’ membership fees, has a miserly track record of paying out claims and its current reserves may not be nearly big enough to handle potential losses from the Madoff case.

On Monday, SIPC started the process of liquidating Bernard L. Madoff Investment Securities LLC. The case is by far, the biggest one that SIPC has ever handled. Madoff reported that it held more than $17 billion at the start of this year.

Indeed, since its creation by Congress in 1970, SIPC has had to spend only $508 million to reimburse investors after recovering assets. The Madoff case alone is likely to dwarf that.

Ceiling on Coverage

SIPC covers losses up to $500,000 per customer, which includes $100,000 on claims for cash.

Virtually all broker dealers registered with the Securities and Exchange Commission are required to have SIPC coverage, and most brokerage firms carry excess coverage for losses above this amount.

When a brokerage firm files for bankruptcy, SIPC will typically step in to help transfer investors’ holdings to another firm. With Madoff’s firm, however, it’s not likely that SIPC and the trustee will be able to transfer the customers accounts to a solvent brokerage firm. That means that it could be months, even years, before SIPC starts paying out claims, experts say.

“We don’t have any faith or reliability in the firm’s statements,” says SIPC’s president and chief executive Steve Harbeck.

“The individual victims will have to file claims asserting and proving what they gave to Madoff securities, and we’ll have to compare that to records that we have on hand,” Mr. Harbeck says. “We don’t know how much people gave to this organization, and we don’t know how much realistically they think they’re owed.”

Losses from theft and proven unauthorized trading are generally covered. Losses from fraud, churning or manipulation of stock prices are usually not. SIPC also doesn’t cover investment losses or some holdings, such as currencies, hedge funds and limited partnerships not registered with the SEC.

“Our job is really elegantly simple: It’s to return the contents of your account,” says Mr. Harbeck.

Securities attorneys say SIPC often takes a narrow definition of what is covered by its statute, the Securities Investor Protection Act. “Literally, you have to prove that someone reached into your brokerage account and wrote a check to themselves,” said Robert Uhl, a securities attorney in Beverly Hills, Calif.

Mark Maddox, an Indianapolis attorney, has represented about 300 investors from 1997 to 2001 who struggled to get SIPC to pay their claims after they lost money when the Stratton Oakmont brokerage firm filed for bankruptcy in 1997. Of those clients, he says that SIPC initially denied about 90% of his claims, forcing him to file appeals. In most cases, SIPC took the position that it would be responsible only for losses up to its $100,000 cash limit.

“SIPC doesn’t like to pay claims and when they do pay a claim, they try to pay as little as possible,” he says.

SIPC says only 349 customers through 2007 have failed to get their entire portfolios back.

Some industry watchers question whether SIPC has enough in reserves to cover potential claims in the Madoff liquidation. Currently, the SIPC Fund has about $1.6 billion to cover potential claims and SIPC can borrow up to $1 billion from an international consortium of banks and another $1 billion from the Securities and Exchange Commission.

“There are so many different things that we don’t know that it’s impossible to determine what the SIPC exposure is,” says Mr. Harbeck.

Annual Fee: $150

SIPC’s reserve is funded by its member brokerage firms, which all pay a flat fee of $150 a year. SIPC used to charge an assessment fee based on the firm’s net operating revenues but moved to a flat annual fee of $150 in 1996 after its fund hit $1 billion.

SIPC’s reserves are tiny compared to what’s held by the Federal Deposit Insurance Corp., which covers bank deposits up to $250,000. The FDIC’s reserves totaled $34.6 billion as of the third quarter. But SIPC says its coffers don’t need to be big because brokerage firms are supposed to keep investors’ stocks and bonds segregated from the firms’ assets.

Banks, by contrast, lend out customers’ money to other customers, who might default on those loans.

Now that SIPC has started the liquidation process, the court-appointed trustee will compile a mailing list of the company’s customers. After the court has approved the claim forms and authorized the publication of notice, the trustee will mail out the claim forms to customers.

Investors will typically have six months to file their claims, which must be sent by certified mail, from the time the notice is published. Eventually, the trustee will set up a Web site with more information.

For now, any investors with brokerage accounts at Mr. Madoff’s firm should save any documentation, such as monthly statements and investor reports going back as far as possible, says Steven Caruso, a securities attorney in New York.

“Those statements show what was supposed to be in your account or what the value was,” says Mr. Caruso, who worked with about 500 investors to file claims with SIPC in the Stratton Oakmont case.

In many of those cases, his clients had to provide detailed paper trails — such as documentation proving that they complained to the firm about unauthorized trades at the time of the trade — in order to show that their trades were unauthorized.

One of the largest financial scams to hit Wall Street has investors wondering if they’ll ever get their money back.

Bernard L. Madoff, a former chairman of the Nasdaq Stock Market, is accused of running a “giant Ponzi scheme” that is estimated to have defrauded investors of as much as $50 billion. While the details of the alleged scheme are still murky, some investors may recover at least part of their losses through an entity that insures brokerage accounts.

The following examines some of the questions the investors might have.

Is my account covered?

That depends. If you have a brokerage account with Mr. Madoff’s securities firm, then you may have some protections under the Securities Investor Protection Corp., the industry-funded nonprofit membership corporation that steps in when a brokerage firm fails. If your accounts are with Mr. Madoff’s investment-advisory business, then you’re probably out of luck since those accounts won’t qualify for SIPC coverage.

What does SIPC cover?

SIPC covers losses that are related to theft and proven unauthorized trading. Incidents of fraud, churning or manipulation of stock prices don’t qualify. Ordinary market losses, and some holdings, such as currencies, hedge funds and limited partnerships not registered with the SEC, also don’t qualify for SIPC coverage. If the firm doesn’t have the funds and securities to repay any customer obligations in a bankruptcy, then SIPC will step in to cover losses up to $500,000 per account, including $100,000 for claims for cash.

Would SIPC coverage apply to “Ponzi schemes”?

It’s likely, say securities attorneys. “If it’s a true Ponzi scheme — that is, if you take my money without my permission and give it to a prior investor as a profit — then I would certainly categorize it as a theft,” which should be covered under SIPC, says Robert Uhl, a securities attorney in Beverly Hills, Calif.

Does SIPC have enough money to cover all of the potential claims?

It may not if it has to cover losses as high as $50 billion. As of Dec. 31, 2007, the SIPC Fund had about $1.5 billion to cover potential claims. While the Securities and Exchange Commission can make another $1 billion in loans to them, it would probably have to go back to Congress for more money, says Steven Caruso, a partner at Maddox Hargett & Caruso PC, a New York law firm. “We’d be looking at another bailout, only this time it would be SIPC and not the auto industry,” he says.

Should I hire a lawyer?

Probably not. Even if you hire a lawyer and sue Mr. Madoff, it’s very likely there won’t be any significant money left — either in his business or personal assets. “Proving liability in true Ponzi schemes is the easy part of lawsuits,” says Mr. Uhl. “But who’s going to write the check at the end of the day?”

What are other options?

Wait to file a claim with the SEC. When the SEC collects whatever assets are left, it will eventually make some pro-rata distribution of those assets to investors. At some point, it will start notifying investors and requesting that they file claim forms documenting the amount of their investment, any returns on the investment and the dates of the investments. Typically, after several years, investors may get some fraction of what they’ve invested.

At its peak in May 2007, the Schwab YieldPlus Fund had more than $13 billion in assets.

From that point through Oct. 10, the fund lost more than 30% of its value and saw its assets drop 95% to $432 million.

One recent arbitration award for an investor in a claim against Schwab may be a bellwether for other cases, according to attorneys handling investors’ claims in the matter.

On Oct. 2, an arbitration panel of the Financial Industry Regulatory Authority Inc. of New York and Washington ruled that San Francisco-based Schwab and one of its representatives were liable for $542,340 in an investor claim against them.

The investor, Jeffrey Nielson, alleged that Schwab and the rep, Darin Beckering, duped him - prior to his purchase of the YieldPlus Fund - by not disclosing its exposure to the subprime-mortgage market and the fact that it is a proprietary fund.

“This arbitration award may in fact be significant,” said Jacob H. Zamansky, an attorney in New York who represents investors in securities arbitration claims. He said that half a dozen investors have contacted him recently about YieldPlus.

Back-of-the-envelope math translates into potentially steep claims against Schwab, plaintiff’s attorneys said.

And the attorneys like their chances. The YieldPlus claims are “among the best product cases I’ve seen in the past 10 years,” said Ryan Bakhtiari, a partner with Aidikoff Uhl & Bakhtiari of Beverly Hills, Calif.

The compelling reason is the profile of investors who bought the fund, he said. Typically, they were seeking protection of their investment principal, were retired and living on a fixed income, Mr. Bakhtiari said.

“Many had [certificates of deposit] and were convinced by a Schwab rep that the YieldPlus was as safe as a CD,” he said.

Mr. Bakhtiari has filed between 50 and 75 claims against Schwab over the fund and has other claims in various stages.

So far, the claims he has filed total $10 million, with another $5 million to $10 million in the pipeline, he said.

The claims range between $10,000 and $2 million, Mr. Bakhtiari said.

“I think it’s a sign of things to come for Charles Schwab,” he said.

Mr. Bakhtiari added that he has spoken to former Schwab employees, as well as advisers who keep assets under custody at Schwab Institutional of San Francisco, who are upset over the matter. “They’re sending us clients,” he said.

YieldPlus is an ultrashort-bond fund that offered yields about half a percentage point higher than such investments as CDs.

Along with the arbitration claims, a potential class action over the YieldPlus Fund is also making its way through the courts, observers noted.

Industry attorneys, however, noted that, despite the investor’s recent win, plaintiff’s lawyers have a difficult road ahead with the spate of claims over the YieldPlus Fund. Finra arbitration decisions set no precedents. and each claim is decided on its merits.

Schwab doesn’t “like to comment about pending litigation,” said David Weiskopf, a spokesman for the firm, who added that it will “continue to vigorously defend” itself in all cases.

Mr. Bakhtiari noted that Schwab may have its hands full as more claims go to arbitration.

It usually takes a claim about a year to work its way through the Finra system and be heard by arbitrators, he said. Since the YieldPlus Fund saw its drop this spring, arbitrators could hear many claims beginning in April.

The SEC charges are based on the failure of WealthWise principal Jeffrey Forrest to disclose to his clients that he had a conflict of interest in recommending a high-risk hedge fund investment called the APEX Equity Options Fund.

The SEC says that Forrest encouraged clients to invest in APEX and did not disclose an agreement he had with the fund’s manager, Thompson Consulting Inc. of Salt Lake City, to give him money for directing clients into the APEX fund. Thompson Consulting gave WealthWise about $390,000 in illegal kickbacks, the SEC alleges.

APEX collapsed in August 2007 with massive losses after making undisclosed sub-prime and other speculative investments. But that came after Forrest had persuaded more than 60 of his clients to invest about $40 million in APEX from April 2005 to August 2007, according to SEC allegations.

The clients - among them a quadriplegic man, a retired nurse, a stay-at-home mom, a software consultant, a retired telecom technician and practicing physicians - had invested their savings, in some cases borrowing against the value of their homes, according to attorney Philip Aidikoff of Beverly Hills-based Aidikoff, Uhl & Bakhtiari, a law firm representing some WealthWise investors. The firm filed arbitration cases against Forrest with the Financial Industry Regulatory Authority starting last October.

Forrest could not be reached Monday for comment.

A financial adviser practicing for 30 years, Forrest established his firm Wealth Enhancement and Preservation, which provided financial planning and portfolio management services, in 1994; the business was registered with the SEC as WealthWise in 1997.

The company had six to 10 employees, 301 accounts and $68 million in assets under management, according to SEC filings in 2007. It also operated branch offices in Ogden, Utah; Westlake Village and San Diego, according to the SEC complaint.

Forrest told WealthWise clients that APEX would protect their principal while at the same time generate for them monthly interest of 3 percent - a total of 36 percent in annual interest - through a purportedly innovative options-trading method.

However, as a result of its risky trading strategies, the APEX fund collapsed in August 2007, causing Forrest’s clients to lose most, it not all, of their money, the SEC said in its complaint. Forty-seven WealthWise clients had invested from 25 percent to 100 percent of their portfolios in the fund.

In March, the Securities and Exchange Commission charged Thompson Consulting with investment fraud, saying the firm engaged in much riskier trading strategies than what was described to investors.

The SEC’s complaint formally charges WealthWise and Forrest with violating the antifraud provisions of the Securities Act of 1933, the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940.

The federal regulatory agency seeks an injunction, an accounting of the total amount of performance fees that WealthWise received from Thompson Consulting, discharge of those fees and undisclosed financial penalties.

The new program is aimed at quelling rising criticism that having even a single industry panelist unfairly biases the arbitration process against investors. Surprisingly, though, the new plan seems to have sparked opposition on both sides of the equation: Those in favor of empaneling the industry arbitrator are predictably against this new idea, but even longtime critics of the industry-panelist concept-including the Public Investors Arbitration Bar Association (PIABA) and the state regulators who belong to the North American Securities Administrators Association (NASAA)-have shown little enthusiasm for the plan. Both sides say the new system will take too long, and will likely produce inconclusive results. And attorneys who defend financial advisors, of course, worry the new rule will have long-term negative implications for their clients.

But FINRA says the goal here is to provide options. The two-year program will take 40 cases from the five major wirehouse firms-Merrill Lynch, Citi Global Wealth Management, UBS, Wachovia Securities, Morgan Stanley-plus 10 from Charles Schwab each year. In each case, the investor will choose whether or not to include an industry arbitrator as one of the panelists. “This pilot will give investors greater choice when selecting an arbitration panel,” says FINRA Chief Executive Mary Schapiro. “Additionally, [we’ll] see if a change in the way arbitration panels are selected is a better way to serve and protect the interests of investors.”

FINRA will compare the results against existing metrics, such as the percentage of cases that settle before award, the length of the hearings, use of expert witnesses and the end results of the cases.

Executives at both PIABA and NASAA say the effort to address the issue is long overdue. Both believe that a mandatory industry panelist is inherently unfair and biased against the investor. “The basic problem is the industry arbitrator has a conflict of interest, and a built-in bias: an inclination to support the industry position,” says attorney Larry Schultz of Driggers, Schultz & Herbst in Troy, Mich., and president of PIABA.

Pete Michaels, a Boston-based attorney who represents advisors, argues that the accusations of bias against industry arbitrators are flawed. Sure, he says, with two public arbitrators and one industry arbitrator, it’s always two against one-but in number only. “It is false that the industry arbitrator is rigged for the industry. I sit as an industry arbitrator and I am incredibly skeptical of registered reps’ claims. If you have one person [who always sided] for the industry and two for the clients, the registered reps would lose every single case. And that’s not what happens. That’s the fault of their logic.”

But Schultz and other investors’ attorneys contend that bias becomes a growing concern in the face of industrywide scandals.

“It’s even more of a problem where we’re seeing systemic fraud-auction-rate securities being the most recent example-because firms are dealing in the same types of products and the same type of misrepresentation,” Schultz says. “The arbitrator who works for a firm selling a lot of variable annuities is going to have a hard time sitting on a variable annuity case,” he says.

FINRA tacitly recognized this conflict, Schultz adds, when the regulator finally decided to ban from cases involving auction-rate securities any industry arbitrator whose firm had ever handled those products. That effectively eliminated arbitrators who worked for any major wirehouse. As far back as May, PIABA had objected to industry arbitrators sitting on these cases, but, Schultz recalls, FINRA had refused to step in, saying that its rules prevented any remedial action. But after a series of settlements in cases brought against the industry by state regulators, including New York State Attorney General Andrew Cuomo, FINRA changed its position.

Expertise: Helpful or a Hindrance?

But PIABA and NASAA don’t simply want industry arbitrators pulled from the most high-profile system wide cases as well as the pilot program. Both groups say they’d rather see FINRA simply propose a new rule to the Securities and Exchange Commission to eliminate the industry arbitrator from the panels altogether.

Another contention is that the fluid employment market-and the takeovers of Dean Witter, Prudential Securities, A.G. Edwards, Paine Webber and Bear Stearns-opens another door to industry arbitrators’ bias. “Yesterday’s A.G. Edwards branch manager is today’s Wachovia employee,” says Brian Smiley, the incoming PIABA president and partner at Smiley Bishop & Porter in Atlanta. “That has to put pressure on industry arbitrators sitting in judgment of firms that could well be their future employer.” He adds that there are many industry arbitrators to whom he doesn’t object. His real concern, he says, is the industry panelist’s mandatory presence. Finally, PIABA and other critics object on the grounds that even though industry arbitrators work in the business, they are not necessarily experts in the issue at hand.

“FINRA materials say the industry [panelists] are there to provide expertise on policies and procedures and standards of conduct of the securities industry. But you never know what they’re telling the other arbitrators-whether it’s right, wrong, or indifferent,” says Stephen Caruso, PIABA’s past president and a partner at Maddox Hargett & Caruso in New York. That leads to the potential for bias or improprieties, he says. He and Smiley each say that an arbitration case is supposed to rise and fall on proof that the parties submit to the arbitrators. But that can often be undermined behind closed doors by an industry arbitrator who may or may not know the law.

“Having the industry arbitrator give his or her own views of what the case is about denies me of the opportunity to present my own proof and my own case. They sometimes disregard what I present,” Caruso says. “What if you get a bozo industry arbitrator who says, ‘This is how they do it at my firm [and we] sell auction-rate securities the same way.’ It may or may not be true. You don’t get a chance to sit down with an industry arbitrator to get their views on industry practices. I could do a two-week hearing on industry practices and general mispractices and all my proof and theories could be negated by an improper or misguided industry arbitrator, which I’ll never know about.”

Smiley agrees, adding that if an industry arbitrator negated his expert witness, he wouldn’t have the chance to cross-examine the arbitrator to find out the basis for the opinion, including the possibility that the arbitrator is simply defending a practice from which his or her firm profits.

Michaels scoffs at the notion that industry arbitrators might be more of a hindrance than a help to the public arbitrators. He’s seen a retired firefighter and the owner of a printing franchise sit cheek-by-jowl with attorneys and professors. “You need an industry person to tell them what’s going on; and some of these cases are very complex. They don’t get training on how to be a securities arbitrator; they get mechanical training on how to read the script [to investors] and are told not to talk in the bathroom. They’re not trained in the industry. They don’t know what options are, or short sales. So you need the industry person to explain the intricacies of the industry to the laypeople.”

Caruso dismisses this argument, noting that juries in murder trials are made up of ordinary citizens. “In a capital case with life-and-death stakes, there’s no requirement that there be expertise on that jury. If we can entrust people’s lives to everyday people, it defies common sense that in the securities arena some expertise is needed.”

Michaels fears the ultimate result will be “a dumbing-down” of arbitration panels, which “will adversely impact the ability of investment professionals to get a fair hearing.” True or not, the two sides are divided about whether the industry arbitrator should be explaining securities law in the first place. “My job is to explain the facts of the case to them, not to educate them on the securities industry,” Michaels says. But the PIABA attorneys say they’d rather lay out everything for the public arbitrators, without any help from the industry arbitrator.

Schultz says the pilot program is flawed because the industry can “rig the results.” Wirehouses are likely to settle the cases in which the customer has a good chance of winning and will only take the cases they feel confident about to arbitration. “That way, they can show that the panel without industry arbitrators ruled against investors in a large number of cases,” Schultz says, adding that he expects far fewer than 400 decisions, with the vast majority of cases settling.

Michaels also thinks the plan is ill-advised because of the length of time and the unlikelihood of a clear outcome. “This is a knee-jerk reaction by FINRA to a lot of external pressure and not very well thought out. At best it’s not going to be fair to anybody. If people think the system is broken, this won’t help. It’s going to complicate things.” Highly technical cases, he says, will require extra days to explain complex issues to a panel of laypeople. That, he says, “costs more money and clogs up the system.” One key benefit of arbitration is that it’s supposed to allow investors with relatively small claims to be heard. The alternative is a court of law, where attorney fees can cost $30,000, and cases can get thrown out.

“FINRA’s wacky pilot project doesn’t seem to me to suit anybody’s interest,” Michaels says. “It’s not going to make people [who are] unhappy with arbitration happy either. If you want to get rid of arbitration, get rid of it and we’ll all go to court. But in 10 years, you’ll come back and say ‘That’s not fair for investors either.”

Both sides agree that the two-year pilot will likely take far longer to play out. In fact, Schultz says it may be five years before we see a resolution: two years’ worth of cases will take three years to wind through the system, plus two more years for the SEC to deliberate over FINRA’s rule proposal.

Decisions All Over the Place

Schultz and other observers say it’s difficult to cite specific cases in which the industry arbitrator swung the decision against the investor. It’s impossible to know what was said behind closed doors.

But, incoming PIABA president Smiley and Philip M. Aidikoff, a leading investors’ attorney in Beverly Hills, Calif., say that suspiciously low judgments for clients can be red flags of an industry arbitrator using undue influence. Smiley says that many awards appear to be the product of compromise. One arbitrator may feel the investor is entitled to full damages, while the industry member may not see anything worthy of condemnation or any recovery at all. “That’s when the third arbitrator plays Solomon and splits the difference,” Smiley says. “That may explain the fairly low recovery rates when people win and they don’t win much.”

According to a survey of 3,000 investors who have been through arbitration, more than 62% believed the process was unfair, 60% had an unfavorable view of arbitration and 70% were dissatisfied with the outcome. Schultz notes the results were hardly surprising, since more than half of the investors who took their cases to arbitration received a zero award. Plus, based on another PIABA study of awards made in 2006, those who do recover are awarded an average of just over 10% of the amount claimed-which may not even offset the fees arbitrators sometimes assess that can run into several thousands of dollars.

One attorney, who requested to speak off the record because of fear of damaging his client’s case with arbitrators, recalls a case in which the client was awarded $100. This same attorney, who has served as a public arbitrator, reports that industry arbitrators can sometimes become apologists for industrywide abuses to his fellow panelists. “The industry member will say, ‘This just isn’t that unusual. Sure, the regulators believe in this, but they don’t live in the real world.’”

Aidikoff gives examples of seemingly random awards and fee assessments. He note that in court, the winning party never pays costs. In one case filed in May 2001, the claimant asked for $2.6 million in damages and received $2.1 million. The client paid out $2,200 in fees but was reimbursed $1,200. In a case filed in October 2005, a client seeking damages of $202,000 was awarded $60,000, but had to split the costs with the broker, each paying $6,300 in forum fees to FINRA. (Aidikoff says that it was not FINRA that levied that fee, but the arbitration panel.) In another case, filed in December 2002, the claimant had asked for $518,000; the panel awarded $334,000, but assessed the entire forum fee against the broker, a sum of $29,700. “It’s all over the place,” Aidikoff says. “You win and you have to pay on some and not on others? It’s completely on the panel. Gee, if there weren’t an industry member on these panels, do you really think a winning claimant would be assessed forum fees?”

California-based New Century’s stock rallied on Coren and Nannizzi’s research note to investors, rising 3% in afternoon trading on Thursday March 1, 2007, to close at $15.78.

In April 2007, a month after the analysts issued their somewhat upbeat report, New Century filed for bankruptcy protection due in large part to the massive number of borrowers who were defaulting on their loans.

The move by Coren and Nannizzi, as well as an analyst at UBS who, in February 2007, also upgraded the mortgage company’s stock, to lead investors into believing that New Century was undervalued and on solid footing underscores how little Wall Street has learned since Enron imploded in a wave of accounting scandals in 2001.

The historic, unprecedented federal bailout of Bear Stearns, Freddie Mac, Fannie Mae, and the dissolution of Lehman Brothers, came as these companies engaged in questionable trading practices and allegations that it failed to inform investors the true financial condition of its subprime investment business. There is abundant evidence of Bear Stearns’ controversial trading practices in the subprime mortgage industry while investigations continue into Fannie, Freddie, and Lehman’s trades.

The collapse of Fannie, Freddie, Lehman, Bear, and others like them, represents the failure of federal regulators to enact reforms in the $6.5 trillion mortgage securities market, an industry far bigger than the United States treasury market.

“The regulators are trying to figure out how to work around it, but the Hill is going to be in for one big surprise,” said Josh Rosner, a managing director at Graham-Fisher & Company, an independent investment research firm in New York, and an expert on mortgage securities, in an interview with The New York Times in November. “This is far more dramatic than what led to Sarbanes-Oxley,” he added, referring to the legislation that followed the WorldCom and Enron scandals, “both in conflicts and in terms of absolute economic impact.”
Federal regulators have been slow to act, despite the obvious warning signs (an increase in foreclosures and loan defaults), because the housing market drove the economy over the past five years and Bear Stearns led the pack as one of Wall Street’s top underwriters of mortgage backed securities. That meant that Bear’s financial stability–as well as other banks–was tied directly to the repayment of loans at the mortgage firms it was underwriting.

Indeed, what Coren and Nannizzi’s research note on New Century didn’t say was that Bear Stearns was one of the Wall Street banks that financed New Century’s mortgage operation. Their positive report on the company seemed to be about protecting Bear’s investment and the bank’s bottom line than it was about providing investors with sound financial advice.

As with Enron and WorldCom, sell-side firms such as Bear Stearns issued biased stock recommendations during the housing boom in the hopes that they would win investment-banking business. And when the bubble burst the banks continued to reassure investors until dozens of mortgage companies such as New Century closed their doors or ceased making loans available, which lead to a massive sell-off of banking stocks.

William Galvin, Massachusetts’ secretary of the commonwealth, subpoenaed Bear Stearns and UBS just two weeks after Coren and Nannizzi issued their report on New Century in March 2007, demanding the firms turn over their research documents into New Century. Galvin alleged that Bear and UBS violated a 2003 global research settlement following the Nasdaq crash of 2000 in which Wall Street firms paid hefty fines and promised to keep their sell-side away from the investment banking side after regulators accused analysts of writing biased research reports in order to win lucrative investment deals from the companies the analysts covered.

“Recent revelations that research analysts issued positive reports on mortgage lenders…even as those companies faced more and more defaults suggests that the commitment of 2003 has not been met,” Galvin said in a prepared statement at the time. Glavin had worked closely with then New York Attorney General Eliot Spitzer on the settlement. Spitzer resigned as governor of New York last week after he was alleged to have been a customer of an escort service.

Still, at least one savvy trader saw through Coren and Nannizzi’s overly optimistic report on New Century and acted accordingly. Last March, the trader commented on a popular financial message board last year that Bear Stearns was “trying to cover its own behind with that upgrade.”

“The question on everyone’s mind should be, “How much are they on the hook for?” the commenter asked, before signaling that he intended to short Bear’s stock. No doubt that the savvy trader is a very rich person today. Bear was sold to JPMorgan Chase for $2 a share last weekend in a deal brokered by the Bush administration.

In November, Glavin reemerged accusing Bear Stearns of an inherent conflict-of-interest when it engaged in trading with two hedge funds the firm managed that specialized in mortgage securities that suffered $1.6 billion in losses and eventually filed for bankruptcy.

Glavin filed a civil complaint against the bank saying it violated securities laws and its own internal regulations by failing to inform the hedge funds’ independent directors that it had traded mortgage securities from its own accounts with hedge funds that it also advised. Glavin claims Bear Stearns violated the US Investment Advisers Act of 1940, which bars such transactions unless hedge fund clients receive prior notification in writing about self-dealing and agree to the transaction. That case is still pending.

“This begins to explain how the subprime genie got out of the bottle,” Galvin told the Associated Press in an interview. The meltdown in the mortgage industry “happened in part because there was a seemingly limitless amount of capital put in the hands of people who had conflicts of interest that weren’t disclosed,” he said.

The hedge funds–Cayman Islands-based Bear Stearns’ High Grade Structured Credit Strategies Fund and the Enhanced Leverage Fund - bet wrongly on securities that were backed by subprime loans for home buyers with poor credit ratings. When homeowners defaulted, losses at the hedge funds mounted. Bear Stearns then informed its investors that their investments were worthless..

In December, investors filed a new round of legal claims against Bear Stearns claiming the bank mismanaged the hedge funds and concealed the condition of the funds until it was too late.

“Officials at Bear Stearns engaged in a concerted effort to conceal the true state of affairs at both of these hedge funds for an extended period of time before they imploded,” attorney Steve Caruso of Maddox, Hargett & Caruso in New York, one of four firms representing plaintiffs, said in December.

Another plaintiffs’ attorney, Ryan Bakhtiari of Beverly Hills, said Bear Stearns used the hedge funds “as a dumping ground.”

“Given Bear Stearns’ dominance in the mortgage-backed securities underwriting market, they knew or should have known how much subprime exposure both of these hedge funds faced,” Bakhitari said in December. “We’re finding, in our investigation of these funds, that many investors in these funds simply were unaware of what was being held in their portfolios because it was not adequately disclosed.”

In March, a lawsuit was filed against Bear Stearns on behalf of investors alleging the company issued materially false and misleading statements regarding its financial condition.

Striking it rich on the blunders of the financial world: The lawyers who represent investors looking to sue their brokerage firm.

“Bad markets expose bad portfolios,” says Vincent Imbesi, who handles securities cases at the New York law firm Napoli Bern Ripka LLP. “When the market goes down, our business goes up.”

Lawyers who specialize in representing investors in securities arbitration were swamped even before market-rocking news this week that included the bankruptcy of Lehman Brothers Holdings Inc. All year, bruised investors have been filing complaints with the Financial Industry Regulatory Authority, or Finra, after purportedly safe investments such as auction-rate securities turned out to be anything but.

“I now have more claimants than at any time in my career,” says Charles M. Thompson, a plaintiffs’ lawyer in Birmingham, Alabama, who has been practicing law for 35 years. Most of Thompson’s cases involve retirees who thought they were buying low-risk bond funds that turned out to be heavily invested in mortgage and equipment-leasing obligations.

With Lehman’s bankruptcy filing, the Merrill Lynch & Co. fire sale to Bank of America Corp., and American International Group Inc. facing a doubtful future, financial markets plunged, unearthing fresh examples of mismanaged portfolios.

“In 2007, we probably averaged four calls a week,” says Imbesi. “Now I’m getting about 20 calls a day.”

No Choice

Investors with a complaint have no choice but to use Finra’s arbitration system, because brokerage firms insist that customers sign agreements that they will forgo court in a dispute. Finra received 3,011 new arbitration requests through the end of August this year, up 39 percent from the same period in 2006.

Lawyers say that number will only get bigger before the year ends: “This isn’t the tip of the iceberg anymore,” says Philip M. Aidikoff, a lawyer at Aidikoff, Uhl & Bakhtiari in Beverly Hills, California. “Now the iceberg is out there — it’s big and everyone can see it.”

Not all unhappy investors are calling a lawyer looking to file a claim. Many are calling local securities regulators, trying to get a handle on trouble that might be ahead. In Massachusetts, “We are getting calls from nervous investors asking `Are my Neuberger Berman funds safe? What happens to my Merrill account when the companies merge? I have an annuity with AIG — should I worry?” says Bryan J. Lantagne, director of the state’s securities division.

`No Real Downside’

Aidikoff says that, with the precipitous declines of shares of Fannie Mae and Freddie Mac this year, he is hearing from investors who contend they were sold the shares even though they were unsuitable for their investment profile. On Sept. 15, Aidikoff reviewed account documents for a retired man whose broker talked him into using proceeds from a maturing certificate of deposit to purchase shares of Fannie and Freddie.

“The broker told him it’s government-backed,” says Aidikoff. “He told him there was upside and no real downside.”

Jake Zamansky, a lawyer in New York, says he has been talking to investors who were advised to buy the preferred stocks of Fannie, Freddie and other financial institutions. “A lot of these preferred holders were your proverbial little old ladies and retirees who were moved into preferreds by brokers seeking higher commissions,” he says.

Investors’ lawyers may be getting more cases that look like winners, but that doesn’t mean they have confidence that their clients will actually be made whole. Steve Gard, a lawyer in Ponte Vedra, Florida, says his phone has been ringing with clients who worry that they might win their arbitration hearing, but not be able to collect. With Lehman seeking bankruptcy protection, who knows which firms might be next?

“After being in this line of work for 30 years, I could paper my wall with arbitration awards and judgments that my clients were unable to collect,” he says. Even a lawyers’ bull market comes with its risks.

Good luck, Mr. Federal Reserve chairman. If integration, broker oversight or speedy reporting of trouble are among the goals you’re shooting for, you had better brace yourself. The lobbying locomotive known as America’s financial industry was armed and already doing battle over a plan for stricter rules before you hopped that plane for the Fed’s conference at Jackson Hole, Wyoming.

The Financial Industry Regulatory Authority, formed when the New York Stock Exchange and NASD merged their regulatory units in July 2007, is in the midst of rewriting the rules that govern brokerage firms. The two sets of rules used by Finra have been partially cut back, partially merged, and, in some cases, reworked into proposed new rules. It’s the proposals for new rules that have some financial bosses morphing into candidates for anger-management class.

For a flavor of the industry’s reaction to the proposals, consider these choice observations made in the letters sent by banks, insurance companies, brokerage firms and their related lobbying groups this summer: Finra’s proposals were “overly burdensome,” “inappropriate,” “unnecessarily bureaucratic,” and would doom financial firms to new exposures to lawsuits.

“Finra has taken the position, which I support, that somebody’s got to be responsible,” for the mass of banking, insurance and securities products all being sold under one roof, says Philip M. Aidikoff, a Beverly Hills, California, lawyer who represents investors. “The pushback is from folks who don’t want to be regulated.”

Taking Offense

Among the offending suggestions Finra has floated is that brokerage firms establish a system “to supervise the activities of each associated person” in order to comply with securities laws. A regulator suggesting that brokerage employees be regulated? No wonder the firms are up in arms.

The rules now refer narrowly to an obligation to supervise registered representatives and registered principals — employees who have licenses granted by Finra. The feared “associated persons” category would take in others, including unlicensed partners, officers, directors and sole proprietors of brokerage firms. We wouldn’t want to pester them with rules, would we?

Nor would we want to make the bosses responsible for the stuff that the brokers were selling — at least if the “stuff” wasn’t officially overseen by securities regulators. Finra suggested that firms designate a registered principal to supervise “each type of business in which it engages.”

What Gall

Terrible idea, wrote Robert Keenan, chief executive officer of St. Bernard Financial Services Inc. in Russellville, Arkansas. “Finra has absolutely no basis, nor logic, to attempt to force broker/dealers like us to supervise non-security activities of our representatives.”

“We fear regulatory overlap and redundancy” if principals get that sort of authority, wrote James Livingston, CEO of National Planning Holdings Inc., in Santa Monica, California. The company has four brokerage subsidiaries.

Securities firms are equally galled that Finra is suggesting that firms hold on to customer complaint letters for four years, up from the three now; that firms send a written report to Finra within five business days of completing an internal investigation; and that offices be inspected every three years, something that’s way too costly given “today’s challenging economic environment,” in the view of the Securities Industry and Financial Markets Association, a trade group for the brokerage industry.

`Untenable Position’

ING Advisors Network, an Atlanta-based network of independent brokers, wrote to oppose record-keeping requirements that were “in addition to Securities and Exchange Commission rules.”

Firms also groused about Finra’s proposal to get tough about “outside business activities” of brokers, which can range from legitimate selling of insurance products to off-the-wall Ponzi schemes. Finra suggests that brokers get written permission from their firms before they engage in outside activities, and that brokerage firms be responsible for overseeing those activities once they approve them.

Bad idea, wrote J. Peter Purcell, CEO of Purshe Kaplan Sterling Investments in Albany, New York. It would put Finra members “in the untenable position of directly or indirectly supervising” registered investment advisers who weren’t Finra members, he said.

Piecemeal Regulation

Finra’s critics are technically correct that it is encroaching on other regulators’ territory. In practice, though, there’s a whole lot of business going on that isn’t getting scrutinized when a financial employee sells products and services subject to piecemeal, uncoordinated regulation.

In Bernanke’s “macro” regulated financial world, rules like the ones Finra is suggesting could be just the thing to shut down the industry weasels who parse every rule looking to avoid accountability. For a real understanding of where the loopholes are, the Fed chairman might sit back with a stack of those comment letters and compare them with the firms’ disciplinary records.

Purshe Kaplan Sterling was censured by Finra earlier this year because it hadn’t set up procedures for special supervision of brokers after customers filed complaints.

Financial Network Investment Corp., a broker-dealer in the ING Advisors network, was censured and fined by Finra in 2004 for being late in filing 130 amendments related to customer complaints, terminations, regulatory actions and criminal disclosures in its brokers’ records.

SII, one of National Planning Holdings’ subsidiaries, was censured and fined by Finra three times for supervisory problems over the past eight years. Kansas censured the firm for supervisory violations in 2004. Wisconsin censured and fined it for failure to physically visit its branch offices for compliance reviews in 1993.

These guys are complaining that Finra wants to make the rules tougher? Of course they are. Now let’s see if policy makers have the muscle to stand up to them.

Citi said earlier this month that it will buy back $7.5 billion in ARS from retail investors, small businesses and charities within three months, but will use only its “best efforts” to repurchase $12 billion from institutional holders by the end of 2009.

Just last week, Merrill Lynch, Goldman Sachs and Deutsche Bank settled with regulators, agreeing to buy back the securities from smaller investors but only to help large institutional investors find markets for their holdings.

It stands to reason, given the impetus, one securities lawyer said. “Remember that attorneys general are elected by voters, not corporations,” said Columbia University professor John Coffee, referring to New York’s Andrew Cuomo, who has been investigating the collapse of the ARS market. The Securities and Exchange Commission is also investigating the failure of the ARS market.

Some banks have mentioned specific redress for institutions. In its settlement announced Aug. 8, UBS said $10.3 billion will be set aside for them, but the bank has until June 2010 to pay up. Wachovia gave itself until the end of June 2009 to buy back $3.1 billion from such investors.

But until then, an estimated $100 billion to $150 billion in ARS remains on the books, leaving companies saddled with the illiquid securities facing uneasy choices: trying to make a deal with brokers, arbitration or litigation, selling or holding on.

Some say deals are taking place.

“There are a number of conversations,” said Tim Batchelor, a managing director at investment banking and financial advisory firm Duff & Phelps. “We’re seeing a higher percentage of activity. I have half a dozen conversations every day with one side or the other.” He said that some clients are receiving 90 cents on the dollar, above what they could get in the open market.

And terms may even improve, since the firms are under pressure. “The genie is out of the bottle,” said Adam Dean, president of SVB Asset Management. “Sooner or later, brokers will have to make [institutional] clients whole or face further legal pressure. They’re thinking now, “Who’s going to sue us, and how bad is it going to be?’”

Mr. Dean said he advises his clients to hold on to the securities if they can afford to, and wait for a decent offer.

When it comes to negotiations, companies may have the upper hand, given the amount of business they do with their brokers, Mr. Coffee said. “Often a company will have a strong economic relationship with the broker-dealer. They have a lot more negotiating leverage.”

When asked about negotiations with institutional clients, a spokeswoman at Wachovia said she could not comment beyond the press release. A Citi spokeswoman wrote in an e-mail that the bank “will continue to marshal its resources to work diligently with issuers and regulatory authorities to provide liquidity solutions for all holders of auction rates.”

The ARS market fell apart in February, when banks that had been buyers of last resort abandoned it. In recent weeks, banks have pledged to buy back a total of about $35 billion.

According to Tony Carfang, co-founder of Treasury Strategies, just having some of the supply taken out is a good sign for the market. “What you have is a smaller problem, and more liquidity.” he said. “Overall, that’s bullish. It increases the likelihood that some of these auctions may begin clearing.”

But no matter what course a company decides on, the first step is writing a letter to let the brokers know you’re not happy, Mr. Carfang said. “Say, “I’m damn pissed off, and you pay me off first.’ Then you have something to wave around later.”

Mark Conner, owner of Corporate Treasury Investment Consulting, agrees. “I’m advising companies to prepare for arbitration, while they monitor other developments, because I think that’s how it’s going to turn out,” he said.

Since the market seized up, more than 200 ARS arbitration cases have been filed with the Financial Industry Regulatory Authority, according to FINRA spokeswoman Nancy Condon.

Arbitration is the most common route because it’s a cheaper and more informal process, Mr. Coffee of Columbia explained. Also, companies usually have a securities arbitration agreement with their broker that restricts them to settling disputes in this manner.

Since the market is still frozen, selling should be an option only for the most cash-poor, market participants agree, since they’d be selling at a steep discount.

Prices depend on the type of underlying asset behind ARS, according to Barry Silbert, CEO of Restricted Stock Partners, which operates an electronic trading marketplace for illiquid assets. Discounts are about 50% for ARS backed by collateralized debt obligations; 2% to 8% for municipals; 5% to 15% for closed-end funds’ auction-rate preferred securities; and 20% to 30% for student loans.

Some who are less sanguine about the ARS market are advising their clients who need cash to sell, then file an arbitration. “I tell my clients to get what they can and then go after the haircut,” Philip Aidikoff, a securities lawyer in California, said.

Mr. Silbert said he’s seen an uptick in the number of sales done on his Restricted Securities Trading Network, up from about 10 a week in April to more than 40 a week currently. Most sellers are wealthy individuals, he said, but more companies are joining in now.

No matter what a company decides to do with its ARS, FASB’s FAS 157 requires that companies mark to market their ARS on the books each quarter. Some who are in the valuation business say that even for private companies, determining the fair value may be a worthwhile exercise to help evaluate what the options are.

“What we’re doing right now is helping corporations and institutions understand what the underlying economics are, and where they stand, and more importantly, what the potential financial risk is given the current market,” Mr. Batchelor of Duff & Phelps said. “The devil’s in the nuances. [Fair value] really depends on the type of ARS that the company has.”

If companies can afford to hold on and see how the market shakes out, thoroughness and patience are probably the best course, Mr. Carfang suggested. “Mark to market, and over-disclose. And don’t enter into any rash transactions.”

Citi, for example, said in its announcement last week of a $7.3 billion settlement that it “will use its best efforts to facilitate issuer redemptions and/or to resolve its institutional investor clients’ liquidity concerns.”

Securities lawyers weren’t impressed.

“I’m very uncomfortable with the ‘best efforts’ language,” said Philip Aidikoff, a securities lawyer and litigator in Los Angeles. “If you’re the CEO of a corporation, how do you read that? My corporate clients are completely in the dark as to what the treatment they receive will be.”

Mr. Aidikoff said he is recommending that if his clients need the cash, they sell at a loss, then seek securities arbitration to “go after the broker-dealer for the haircut.”

Depending on the type of instrument involved, that haircut can be steep. According to Barry Silbert, CEO of Restricted Stock Partners, which operates an electronic trading marketplace for illiquid assets, the discounts on ARS at the time of sale are about 2% to 8% for municipals; 5% to 15% for closed-end funds ARPs; 15% to 30% for student loans; and in excess of 50% for CDOs.

Mr. Silbert said he’s seeing selling from two types of institutions: those that need the money now and those that simply want a higher yield on their investments. He said the number of deals done has gone from about 10 a week in early April to 40 or more a week now.

“The volume’s definitely increasing,” Mr. Silbert said, but the pace is “choppy.” Buyers include hedge funds and foreign investors, he noted.

Many companies have delayed cashing out their auction-rate securities because they put the matter on hold after a painful first quarter of valuations and write-downs, said Tony Carfang, co-founder of Treasury Strategies, a treasury management consultancy.

After the first quarter, “many hunkered down, hoping for a solution,” he said. But managers at those businesses also focused on more pressing business matters. “From a financial and accounting standpoint, that makes a lot of sense.”

Mr. Carfang said he sees the banks’ settlements as good news for the companies involved. With each settlement, “The problem gets smaller; the cash available to solve the problem goes up.”

He added that “the more liquidity there is, the more likely that there will be opportunities to get out at or near par value.”

It’s also in the best interests of broker-dealers to come through for clients, said Adam Dean, president of SVB Asset Management. “It could be a long, winding path for them to be unwound, but ultimately, [ARS] will be replaced.”

Joe Morgan, chief investment officer at SVB, added, “From a business perspective, [Wall Street firms] have damaged a very important client constituency. It’s to their benefit to try to get that goodwill back, and the only way to do that is to make those clients whole, or as close as possible.”

By early 2007, FinanSure had exited home mortgages completely (its Illinois residential mortgage license was revoked that August). In February 2007, FinanSure syndicated its first student loan master trust, $925 million backed by government-guaranteed educational consolidation loans. It also attracted a $30 million investment from British private equity firm Cambridge Place Investment Management LLP. FinanSure Student Loans’ name began appearing on both recommended lending lists of colleges and consumer lists, decrying its aggressive boiler-room telemarketing practices.

In the fiscal year ended Sept. 30, FinanSure held almost $800 million in government-guaranteed student loans, according to the independent educational lending Web site FinAid.org. FinAid.org listed FinanSure in the top 20 of student loan consolidators for that fiscal year.

Less than a year later, it’s as though FinanSure never existed. Its staff is gone, its loan portfolio sold. The Cambridge Place executive who had publicly talked up the FinanSure investment suddenly left his firm. (When asked whether the executive was fired for his role in FinanSure, a spokesman for the firm said he wouldn’t comment on personnel matters.) In recent months, the only trace of FinanSure’s CEO, Evan Silverman, can be found on John McCain campaign contribution rolls. Silverman is listed as the managing director of something called Sunnyside Capital Partners, which operates from his Highland Park, Ill., home with an unlisted telephone number.

That about sums up how it’s gone in the student loan industry. Primed by congressional fiat and government subsidies, propelled by fast-rising tuition costs, student lending rode high through the first half of 2007. Unknown lenders such as FinanSure mushroomed. Established players such as SLM Corp., commonly known as Sallie Mae, accumulated huge war chests and gobbled up competitors. One private student loan provider, Nelnet Inc., came out of nowhere, acquired 13 companies in a five-year period ending 2006 and emerged with more than $26 billion in assets. Major consumer-lending institutions such as CIT Group Inc. paid generously for companies that would give them a piece of the action. Student loans became a large and integral part of the market in asset-backed securities.

For the past several months, however, the industry has lurched from one crisis to another. It’s been blasted for making subprime loans, buffeted by corruption-related scandals and clipped by angry legislators. The collapse in securitization and auction-rate securities brought critical parts of the student lending process to a screeching halt. A few educational-lending concerns have gone bankrupt. Others are teetering. Some of the biggest names in student finance have walked away from the industry. Others say they will reduce lending to schools with higher default rates, affecting the neediest, lowest-income students. Investor and consumer lawsuits abound.

Student lending suffers from many of the problems that beset the mortgage industry and, if anything, may be even more complex, though it’s received less publicity and even less understanding by the public. “Federal intervention is essentially the same [as mortgages],” says Barmak Nassirian, the associate executive director of the American Association of Collegiate Registrars and Admissions Officers. “The secretary of education is a cut-rate ATM for every bank.”

In fact, the entire industry came close to buckling earlier this summer before Congress and then the Department of Education intervened with temporary fixes. Most significantly, the Education Department announced in late May that, until Sept. 30, 2009, it will buy educational loans from originators at cost plus a small fee, ensuring a secondary market. The department is also offering to act as a lender of last resort to guaranty agencies, and said it was doubling the money available for direct educational loans, anticipating a spike in that program.

Since then a few private and state lenders, which had announced a moratorium on new federally guaranteed loans, have crept back. Hundreds of colleges and universities have shifted funding sources from private lenders to the government.

However, these remedies are at best provisional. The Department of Education’s bailout lasts for a year. And its implementation rules leave many in the industry unenthusiastic. “Less than satisfactory,” says Richard George, president and chief executive of Great Lakes Educational Loan Services Inc., the nonprofit agency that acts as guarantor for education loans in Wisconsin, Minnesota, Ohio, Puerto Rico and the Virgin Islands. George, whose agency has suspended its federal default fee waiver, says delinquencies and defaults will “significantly increase” under the new rules. Lenders need to advance money before the government reimburses them. The availability and cost of bridge loans necessary to originate loan packages “may prove difficult for many,” he says.

“This is a one-year Band-Aid, not the best Band-Aid, but it will keep it together for next year,” adds FinAid.org founder Mark Kantrowitz.

“This ensures students will get loans and there won’t be too much chaos, but it’s not a long-term solution.”

This is normally the time of year students and their parents scramble to pay tuition and fees. Many families confront what seems a financial black hole. To bridge it, they must maneuver through complex loan programs. The direct lending program offers lower-cost loans both backed and administered by the U.S. government. The Federal Family Education Loan Program, or FFELP, is privately issued but backed by government guarantees. Other loans are completely private and have no government backing. “What we have is breathtaking in its needless complexity,” says Nassirian, an outspoken critic of the student lending industry. “It didn’t happen by accident.”

A college or university may select one approach or the other and, many times, favor one lender over others. Until they came under investigation by New York State Attorney General Andrew Cuomo and other states’ law enforcers, some colleges and universities not only pushed for certain private lenders but acted as co-lenders with them. Educational institutions “became intermediaries,” says Nassirian. “It was systemic co-option. Institutions were asking lenders, ‘What can you do for me if I hand over the borrowers to you?’ ”

The stakes are high, the amounts staggering. Last academic year, FFELP loans totaled $54.7 billion, while direct loans amounted to $13.6 billion. Commercial lenders peddled more than $20 billion in private loans. Loans consolidating previous borrowings amounted to $40 billion more.

Student lending is a classic story of financial excess, with a few critical twists. Markets were from the beginning massaged and manipulated. Congressional largess primed student lenders with government subsidies and guarantees. Specially crafted legislation dictated everything from interest rates to marketing competition. Like the mortgage industry, education-related lenders got fat this decade on cheap money and the seemingly insatiable appetite of investors for securitized assets. Most student loans had the added incentive of government guarantees. There were both yield guarantees and credit guarantees. “Because the loan is guaranteed, it was very easy for investors to understand,” says Richard Fried, a New York partner with Stroock & Stroock & Lavan LLP. Fried specializes in structured finance.

When both securitization and securities auctions collapsed, lenders were stuck. State agencies issuing bonds were stuck. And investors holding the instruments were stuck. When these tools of modern finance get unstuck is anyone’s guess. “The auction-rate market is dead,” declares Philip Aidikoff, a Beverly Hills, Calif., lawyer, who represents investors.

Nonetheless, demand for loans remains strong. This isn’t the same as the housing crisis, where home sales and easy mortgages are tightly interwoven. In ever-greater numbers, students are enrolling in college. Tuitions continue to rise. Students and parents still need to figure out how to pay for this steadily mounting educational adventure.

The dislocation of the past several months in the student loan industry may prompt a major increase in the level of direct government lending. But because so many private lenders have dropped out, the crisis could also end up consolidating lending in fewer hands. Most notably, Sallie Mae remains weakened. But it could emerge more dominant, even if far less profitable. “They’ll probably have an increased market share, but of a much less valuable market,” Kantrowitz says.

The industry landscape has already changed dramatically. In early 2005, for example, CIT paid $318 million for Education Lending Group. After CIT gained control, its management more than doubled the student loan portfolio in the renamed Student Loan Xpress Inc., largely through aggressive marketing of consolidation loans. By the end of March, its student loan portfolio totaled $12.6 billion. But the company since the fall had been hammered by everything from government fines to the collapse in asset-backed securities. In April, as the market began to shut down, CIT announced it would stop originating student loans, effectively shuttering the unit. CIT has already taken more than $300 million in impairment charges.

A CIT spokesman says the company wouldn’t make available anyone to speak about its experience.

Student Loan Xpress wasn’t the only one to give up. Comerica Bank, HSBC Bank, TCF Bank, M&T Bank and a host of smaller banks have exited the market. So did nonbank lenders including the once-aggressive Goal Financial LLC. Bank of America NA, one of the biggest industry players, no longer offers private loans. Sovereign Bank offers only private loans. Kantrowitz estimates that 120 lenders have either suspended or exited student lending.

For others in the industry, the consequences have been graver. One private loan guarantor, The Educational Resources Institute, or Teri, declared Chapter 11 in April after witnessing a spike in defaults and anticipating many more.

Teri guaranteed loans from First Marblehead Corp., which in turn provided claims management, marketing and origination services on behalf of the actual lenders, including Bank of America and J.P. Morgan Chase Bank NA. Not only will First Marblehead have difficulty collecting almost $20 million Teri owed before filing, but its various service agreements with Teri were terminated in bankruptcy court, potentially depriving it of more than $100 million a year in revenue. This is a stunning reversal. As one of the country’s largest service providers of private student loans — including securitization — the company’s earnings “stair-stepped to heaven in recent years,” Barron’s gushed in April 2007.

Little more than a year later, First Marblehead lost $229 million for the quarter ended March 30, 2008. It can’t securitize. Big clients such as BofA have pulled out of private student loans. Goldman Sachs Capital Partners has delayed an agreed-upon equity investment. The company has cut its workforce by more than half. And its share price is down more than 90%.

There has always been a problem with student lending: the borrowers. Student lending has been woven tightly into the fabric of for-profit educational and vocational establishments. Lenders largely catered to less affluent students and flourished on the backs of both government-guaranteed and private loans, even though borrowers were often high risk. “On the face of it, it looked odd,” Nassirian says. “Historically, we know the lifetime default rates approach 50% for vocational, for-profit [schools].” But because lenders could so easily offload loans, they could play fast and loose with creditworthiness. “The lender didn’t assume the risks.”

Sallie Mae played a major role in this sector. “We were seeing Sallie Mae issue a pretty high rate of loans to those with either little credit or poor credit histories,” says Robert Shireman, executive director of the Project on Student Debt.

This year, the contradictions surfaced and lenders turned off the taps. The for-profit chain Corinthian Colleges Inc. reported that early this year Sallie Mae notified it that it would stop issuing subprime loans. Last year 75% of Corinthian’s private loans were rated subprime; Sallie Mae issued almost all of them.

The ease students had in obtaining private loans for all kind of vocational programs created an environment ripe for abuse. For example, a rapidly expanding chain of flight schools called Silver State Helicopters LLC filed for Chapter 7 bankruptcy in February in Nevada. The decision to liquidate came after Citigroup Inc. ended its loan program to the school’s students.

New York private equity firm Eos Partners LLP acquired a 60% interest in Silver State last year for $30 million. That investment is now worthless.

Silver State required students to produce almost $70,000 in fees up front. Students, who typically borrowed heavily to attend, discovered to their dismay that lenders — notably KeyBank NA of Cleveland — still demanded repayment even though there was no longer a school to attend. What’s more, a provision slipped into the 2005 bankruptcy act made private student loans impossible to discharge, even in bankruptcy. This extraordinary fillip to the industry gave private student lenders rights no other unsecured creditor has.

“It’s just an abomination,” says Andrew August, a partner with the San Francisco-based Pinnacle Law Group, which has filed a class action on behalf of former Silver State students against KeyBank NA, Student Loan Xpress and other lenders. August alleges fraud and unfair trade practices. The lawsuit calls the school “a Ponzi scheme that enabled its owner and CEO and his partners to siphon off millions of dollars for their own personal use.” The school lacked adequate equipment, instructors and maintenance necessary for students to gain pilot ratings, the lawsuit alleges.

Laura Mimura, a spokeswoman for KeyBank, says the bank “won’t comment on any legal proceedings as a matter of policy.” She says the bank “has worked with and will continue to work with individual student borrowers on repayment and has considered them on a case-by-case basis,” but would not go into further detail. She says that although the bank still participates in federal guaranteed student loan programs, it exited lending to for-profit schools in 2005.

The no-discharge provision illustrates the power the industry has wielded. Stalwarts such as Sallie Mae have underwritten political campaigns and poured millions into lobbying efforts, not unlike the lobbying of other government-sponsored enterprises such as Fannie Mae and Freddie Mac.

Today’s gargantuan student-loan apparatus traces to 1965, when the federal government began guaranteeing and offering interest rate subsidies on student loans issued by banks and other private lenders. To ensure a working secondary market, Congress in 1972 created Sallie Mae, then known as Student Loan Marketing Association. This so-called GSE acted as a buyer of last resort of student loans; for years, it was the only secondary market.

The system evolved rapidly in the 1990s. Private lenders gained government subsidies, notably an insured yield. In 1993, the Clinton administration initiated a direct-lending program designed to bypass private lenders and cap subsidies. Mid-decade, however, the White House and a newly Republican-controlled Congress butted heads over direct lending, which had been designed to handle 60% of student loans by 1999.

What emerged was a compromise that created an odd kind of competition: The Department of Education offered subsidized loans, with interest rates set by Congress. Private companies could also offer these loans. The Education Department not only guaranteed the loans, but gave private providers subsidies to administer and service them. The government also agreed not to market its own loan program and was bound by law to charge an interest rate banks could discount and levy certain fees private lenders could waive. “The banking industry did a fabulous deal for themselves … not putting any money at risk,” says Michael McPherson, the president of the Spencer Foundation, which funds education-oriented research.

Individual colleges and universities could decide whether to use the direct lending program or FFELP. Several hundred chose direct lending. “We were overwhelmingly surprised at how wonderful it was,” says Roberta Johnson, director of the office of student financial aid at Iowa State University and the chair of the National Direct Student Loan Coalition. Iowa State was an early convert to direct loans.

As of last year, about 1,100 colleges and universities had signed up for the direct-lending program. That’s still less than one-third of all institutions. The government proved no match for private lenders, which gained the lion’s share of government-guaranteed loans through aggressive marketing, an anti-bureaucracy backlash and inducements to financial aid offices.

Many of those in the industry maintain this kind of dual system has kept prices down. “It’s good that we have both direct and federally guaranteed loans,” says Sandra Baum, an economist at Skidmore College, an authority on the economics of higher education and an adviser to the College Board. “It’s a more efficient system.”

However, taxpayers have borne the brunt at what one critic called “corporate socialism.” According to a 2005 Government Accountability Office study, direct loans cost the government $2.5 billion in subsidies. FFELP loans cost $36.6 billion. Put another way, FFELP required a 9.2% subsidy, while direct loans needed only 1.7%.

In some years, direct lending actually resulted in a surplus to the Treasury, as loan repayments and interest payments outweighed the costs of the loans themselves.

The intricacies of federal loan programs aren’t the only factors in this equation. Runaway tuition plays a major role as well. The cost of tuition has skyrocketed over the past 15 years, fueled in part by the amount of money available to students. But the amount of government-sponsored, low-cost loans to students has remained roughly the same since 1993. That mismatch created a huge, and increasing, demand for supplemental loans. Consumer lenders jumped at the opportunity, enticing students and parents with tens of thousands of dollars. Last year, private loans eclipsed $20 billion, a 25% gain. Private lending has jumped more than 10-fold since 1996.

Fifteen years ago, private loans were “negligible,” says Baum. “Now they’re 20% of the total. That’s a problem.”

It’s certainly been an acute problem for the less affluent. According to an Institute for Higher Education Policy study, students from families making less than $40,000 a year accounted for 27% of the private lending market in 2004. If anything, that percentage rose in the three years following the study.

The era of low-cost funds primed the flow of private, nonguaranteed student loans. Banks and nonbank financial institutions alike added these products to their consumer-lending arsenals. These nonguaranteed student loans were marketed heavily on everything from television commercials to telemarketers to Internet pop-up ads. The ads promised loans of tens of thousands of dollars with little more than a signature or two. One study indicated that at least one in 10 borrowers availed themselves of higher-cost loans even before they maxed out on subsidized loans.

Another facet was consolidation loans, which became one of the biggest money earners for private lenders. Until July 2006, government-guaranteed student loans carried variable interest rates. As rates fell, borrowers were eager to consolidate their loans — it was like refinancing — and private lenders obliged, since they could exploit government subsidies. But under another strange provision of the Higher Education Act, a borrower could consolidate only once, so lenders were under pressure to be as aggressive as possible. By the fiscal year ended Sept. 30, 2006, that market expanded to almost $90 billion.

Lenders chased big money. Colleges and universities became a favored way of gaining access to that market. Meanwhile, higher education institutions faced unrelenting financial pressures, so it isn’t surprising school financial aid offices fell prey to various deals lenders offered. The scandals that broke last year involving favors and kickbacks to financial aid officers were only the most dramatic examples of the abuse.

Since most lenders offered both government-subsidized and private loans, students and their parents faced a confusing array of choices. Understandably, financial aid offices became the sources for guidance on those loans.

In turn, those schools that opted for private originators of government loans would almost inevitably compile a list of preferred lenders. Corruption seeped in.

Some of these lenders showered financial aid officers with favors ranging from dinners to free trips. Sallie Mae and Nelnet employees staffed call centers for college financial aid offices. In the most egregious example, New America Foundation’s Higher Ed Watch discovered college aid officials had picked up stock options in Education Lending Group as compensation for sitting on an advisory board. Last year, The Chronicle of Higher Education, using data from Student Marketmeasure Inc., reported more than 500 colleges had a single lender making all federally guaranteed loans. Roughly 900 more had one lender making at least 80% of the volume.

Private lenders used a variety of techniques to entice universities. Private student loans were branded with the university’s name but were actually made by lending institutions. A financial institution would extend a line of credit to a university, which would use the money to make loans. The university would then sell back the loans to the institution but keep the premium for itself.

Some financial institutions offered revenue-sharing agreements, in which schools got to keep a small percentage of the loans in return for recommending a lender. Other lenders gave colleges access to so-called opportunity loans, packages to students who wouldn’t otherwise qualify for subsidized loans, in return for giving the lender preference status.

Some lenders devised ways to link with other university entities. Alumni associations could get a cut on every consolidation loan referred. Nelnet, for example, had agreements with 120 different alumni associations. “The profiteering that was occurring was milking students,” Laird argues.

Congress finally banned revenue sharing and gifts as part of the student loan overhaul package passed late last month.

State government entities got involved as well. When the federal government set up the lending program, each state designated either a state agency or a nonprofit corporation to act as a secondary market. Banks would make loans, then sell the loans to these entities. The state agencies needed to maintain liquidity, however. So they would issue bonds. These AAA-rated instruments not only found favor among investors seeking a slightly higher yield, but became a source of income for the states. Pennsylvania educational scholarship programs last year received $61 million from the Pennsylvania Higher Education Assistance Agency, the state’s educational bond-issuing authority, which lent $500 million in student loans and purchased an additional $2.5 billion on the secondary market.

Securitization was an enabler of all these programs. Simply put, student loans were sold to a trust that issued bonds backed by the loans. The system made perfect sense. These are long-term instruments with short-term funding needs. The government guaranteed the loans 97 cents on the dollar and offered subsidies to boot. But holding the loans wasn’t really an option for originators. They needed ever more capital to make ever more loans. So, they’d bundle them and sell them off, packaging the instrument as almost as good as a Treasury bill with slightly higher interest rates. Or they’d sell them to state guarantors, which would, in turn, bundle the loans and issue bonds.

According to the Bond Market Association, by 2005, of the $800 billion worth of asset-backed securities offered, almost $63 billion were student loan-backed.

Auction-rate securities provided another mechanism to ensure liquidity. State agencies especially would refinance through these auctions, with interest rates resetting every seven 14, 28 or 35 days, obtaining, in effect, long-term funds at short-term rates. Institutions provided buying power. In the last year or so of this churn, however, broker-dealers began enticing retail investors as well, promising “cashlike equivalents.”

As the industry developed, major student-lending players identified various growth avenues that had in the past been the domain of niche operators. This included state and regional lenders, servicing groups and collection agencies. Aggressive mergers and acquisitions followed.

Most notable: Sallie Mae, by far the biggest player, with $124.1 billion in loans held as of Dec. 31, 2007, about 60% of which were consolidation loans. This odd beast — government sponsored, publicly traded — began to privatize in 1997, a process completed in late 2004. From 1999 to 2006, Sallie Mae made 12 major acquisitions. These included several regional lenders, a debt collection agency and UPromise, an affinity marketing and credit card company tied to a college savings plan. “We are engaged in every phase of the student loan life cycle,” the company boasts in its latest annual report.

For years, SLM minted money; it posted $1.16 billion in net income in 2006. Private equity salivated. In April 2007, a consortium that included JC Flowers & Co. LLC, Friedman Fleischer & Lowe LLC, J.P. Morgan Chase & Co. and Bank of America Corp. agreed to pay $25.3 billion to take Sallie Mae private.

Then the sky fell. Already weakened by scandal and punishment by politicians, student lenders found themselves hostages to the shift in the overall credit market. Here’s a recap of what’s happened:

Led by Cuomo, several state attorneys general investigated student-lending practices, threatened suits and extracted fines and behavior codes from lenderss and universities alike, ending the most egregious practices.

Last September, President Bush signed into law the College Cost Reduction and Access Act. This cut private-sector subsidies by about $21 billion over five years, shifting money to grants for low-income students and reductions in rates on subsidized loans. The law trimmed subsidies to private-sector lenders from 50 to 85 basis points, depending on the loan.

The well-heeled and normally politically powerful student loan industry was suddenly hobbled in its ability to counter the legislation, since congressional action followed consent decrees from a number of lenders over dubious lending practices. “Because of Cuomo, it was harder for the industry to fight back,” says the Project on Student Debt’s Shireman.

The law yanked subsidies on consolidation loans as well by 55 basis points. Even before congressional action, however, this market had been losing steam simply because variable rates disappeared. Since July 2006, borrowers of federally guaranteed student loans now pay a fixed rate. With the reduction in subsidies, consolidations “made were very close to underwater,” FinAid.org’s Kantrowitz says.

Lenders like to blame congressional action for their woes. The fact is, reductions in subsidies may have hurt the bottom line, but the liquidity crisis was the real killer.

In August 2007, auctions sputtered and gasped. Weaker players like FinanSure dashed for the exits. Others held their breath. Industry stalwarts hoped the dislocation would be short-lived. After all, most student loan notes were backed by government guarantees, and unlike mortgages, there was no rapidly weakening market to contend with. “For a while we thought student loans might be immune,” says Stroock & Stroock’s Fried. “But then a tidal wave of a liquidity crisis swept away everyone.”

The student loan securitized market seized up. This followed the downgrading in mid-January by credit agencies of monoline insurer Ambac Financial Group Inc., which suffered big losses insuring structured products backed by home mortgages as well as bonds backing student loans. With investors spooked that Ambac itself might lack the resources to step in and cover losses, any residual interest in securitized educational loan products disappeared.

The student loan securitization market had $86 billion outstanding at the start of 2008. Nothing much has moved since, penalizing issuers and investors. Nonbank lenders regularly borrowed to issue loans, but without securitization, they were stuck. Waco, Texas, nonprofit Brazos Higher Education Service Corp. acquires, originates and services student loans. Its spokesman says Brazos is sitting on $7 billion in loans and paying $11 million more a month in interest.

The collapse of auction-rate securities also hurt. A typical provision in these securities states that if an auction fails, the interest rate paid to the holder of the underlying security drops to zero. As auction failures dragged on, many players announced loan program suspensions or terminations. State agencies from Pennsylvania to Arkansas, Massachusetts to Michigan, said they could no longer offer new federally guaranteed loans, since they had no ability to either hold them, auction them or securitize them.

Major banks displayed little appetite, either. And those that did got pickier about which schools they would service. Citigroup subsidiary Student Loan Corp. said in mid-April that it was suspending loans at “certain schools where loans with lower balances and shorter interest-earning periods result in unsatisfactory financial returns.”

That was code for community colleges and for-profit schools.

Even the original lender of last resort is pulling back. “Sallie Mae has lent too much money to students who have gone to schools without very good graduation records,” CEO Albert Lord said in a conference call earlier this year.

That’s the least of the company’s problems. Last fall, its presumptive acquirers bailed, citing a dramatic change in the market. They offered Sallie Mae $21 billion. Lord refused and took Flowers and the others to court to collect a $900 million breakup fee. The lawsuit ended when Bank of America and J.P. Morgan Chase agreed with syndication partners to provide a $30 billion financing line.

Even that may not have been enough to keep the company humming. In April, Sallie Mae hinted that it, too, might have to stop processing new loans. Kantrowitz believes this wasn’t an idle threat. “Sallie Mae was one or two months away from running out of liquidity,” he says.

Some critics believe lenders played chicken with the government and won. They say the government could have taken over with its direct lending program. Already, about 350 colleges and universities have either switched entirely from FFELP to direct or added direct loans as a backstop. The Education Department doubled the capacity of direct lending to $30 billion.

Others argue the dislocation would have been monumental had FFELP suddenly ended. “There was a concern that you could turn off the switch and leave schools in the lurch,” says Tim Guenther, the CFO at the Pennsylvania Higher Education Assistance Agency.

Lawmakers didn’t want to take the chance. Congress passed the Ensuring Continued Access to Student Loans Act on May 1. In late May, Education and Treasury announced a bailout that included paying private lenders a fee for administering government-guaranteed loans and acting as the lender of last resort.

Unlike the melodrama that ensued after Treasury announced a backstop facility for Freddie Mac and Fannie Mae, this plan generated little attention and no popular upheaval. Maybe that’s because students and parents alike are already suffering from tuition shock. That said, no one really knows what next year will bring as the much-needed industry tries to reinvent itself on a new economic basis.

The Financial Industry Regulatory Authority, a non-governmental regulator for securities brokers and dealers, said Thursday that qualifying investors will have the option of having their claims heard by a three-person panel of arbitrators, none of whom are affiliated with a firm that recently sold auction-rate securities.

The new process stems from one Finra developed for the Securities and Exchange Commission’s settlement with Citigroup Inc. (C), in which the bank agreed to buy back about $7.3 billion in illiquid auction-rate securities, and pay $100 million in civil penalties, with $50 million going to the state of New York.

“The auction-rate securities matter is more widespread than other issues that have developed in the arbitration forum, and we wanted to make sure that any investor, whether in the Citigroup settlement who elects to have a three-person panel, or any other case related to ARS, all got the same treatment,” said Linda Fienberg, president of Finra Dispute Resolution. “This will apply to all auction-rate securities cases that are in our forum whether it’s part of a settlement or not.”

Finra will put the process in place as soon as possible, Fienberg said.

Thus far, Finra has confirmed that more than 170 cases involving auction-rate securities have been filed in its Dispute Resolution forum, but there may be as many as 200, Fienberg said.

The announcement was welcomed by Laurence Schultz, president of the Public Investors Arbitration Bar Association, a national association of attorneys which represent investors in securities disputes, and which has been pressing for change in the arbitration process.

“This is precisely what we’ve been asking for,” said Schultz, of Driggers, Schultz & Herbst in Troy, Mich. “We’re pleased that they have stepped up to this problem and recognized that arbitrators who are associated with firms that were issuing auction-rate securities cannot participate in these panels.”

Typically, for claims of more than $50,000, the three-member panel of judges must include two public members, who may have limited industry connections, and an industry representative. In the process announced Thursday, arbitration panels will continue to have that makeup, but individuals who since Jan. 1, 2005, have either worked for a firm that sold auction-rate shares or supervised someone who sold them will not appear on the lists of non-public arbitrators from which panel members are selected for current and future auction-rate arbitration cases, Finra said.

Arbitration Pilot Program Planned

Schultz said that the flood of auction-rate arbitration claims has helped to emphasize the flaws in the process.

In a May 7 letter to Fienberg, he wrote, “Every investment bank or brokerage firm which originated or sold these securities, either in the original offering or secondary market, is implicated in this wrongdoing. The conflicts of interest are obvious. No prospective ARS arbitrator associated with a firm involved in these activities can avoid the taint of bias or at the very least the appearance of bias.” As a result, any potential arbitrator associated with such firms must be disqualified from serving on any arbitration panel, he wrote.

PIABA believes that industry-connected arbitrators should be banned in all cases, Schultz said.

“We have always opposed the mandatory industry arbitrator on security arbitration panels, and we continue to oppose that,” he said. “This is a perfect example of why the industry arbitrator should not be required.”

Philip Aidikoff, an attorney with Aidikoff, Uhl & Bakhtiari in Beverly Hills, Calif., who is handling some auction-rate securities-related cases, agreed that Finra needs to go further.

“It’s a small step in the right direction,” he said. “I’m pleased, but I would be more pleased if there were no industry arbitrators on these or other cases. I think that customers deserve a completely fair shake, and that there shouldn’t be anybody on a panel with any contacts in the securities industry.”

Aidikoff said the process Finra has put in place won’t ensure that investors receive an unbiased decision. “It simply suggests that those who sold or supervised those who sold them won’t be on a panel, but that doesn’t address the larger issue - they should all be public members.”

As an example, he said, imagine if you were presenting a bad faith insurance claim against an insurer as a result of a flood or a fire and you were told that one of the people on the panel would be an insurance adjustor.

“How would you feel?”

Arbitrators with securities-industry connections may be biased even though they didn’t sell auction-rate securities, he said. “That person, even though they didn’t sell the product, might be more friendly to a broker-dealer just because they’ve worked in the industry their whole lives.”

Fienberg said Finra works to eliminate conflicts of interest in all arbitration cases. It will exclude an arbitrator if it identifies a conflict, an arbitrator may recuse themselves or an attorney or investor may bring a challenge if they feel there is a conflict, she said.

Finra plans to undertake a two-year pilot project, which will begin Oct. 6, in which some cases will be heard before an all-public panel if an investor chooses. The pilot will involve at least 466 cases, but Finra hopes to include more, Fienberg said.

The regulator will gather data to determine possible future options for arbitration, she said.

“Reports of the imminent demise of the auction market seem to be greatly exaggerated, again,” analyst Kevin Conery wrote in a Feb. 8 research note. “We continue to be impressed by the auction market’s resiliency.”

The remarks show Merrill's researchers were “co-opted” during a seven-month drive by the New York-based firm’s sales force to prevent a meltdown in the $330 billion market, Massachusetts Secretary of State William Galvin alleged Thursday in an administrative complaint filed in Boston. As the sales desk pushed analysts to publish upbeat notes, managers used gallows humor to complain about a ”collapsing” market and the end of $2,000 dinners.

“Come on down and visit us in the vomitorium!!” the auction-rate desk's managing director, Frances Constable, wrote to a co-worker in August, as demand began to dry up. “Market is collapsing,” another executive cited in Galvin's complaint said in a November 2007 personal e-mail. “No more $2K dinners at CRU,” a Manhattan restaurant where the wine list includes dozens of bottles for more than $1,000.

Galvin, 57, wants the third-largest U.S. securities firm to “make good” on sales of now-frozen holdings, compensate investors who disposed of their bonds or shares at a loss and pay an unspecified fine. He has already filed a related claim against Zurich-based UBS, and is still probing Bank of America.

SIGNIFICANT DANGER

“Research analysts routinely soft-pedaled significant negative events affecting liquidity in the auction markets,” he said in the complaint. At the same time, managers knew “the auction markets were not functioning properly and were in fact in significant danger of collapsing,” he said.

Conery, 47, received a “six-figure” bonus for 2007 after his year-end review credited him for “proactive and timely interchange” with the sales desk and clients, according to the complaint. “Ultimately, his work contributed to better liquidity and lower inventory levels in the marketplace,“ the reviewer said.

“The influence that the supposedly independent research analysts were subjected to was extraordinary,” said Philip Aidikoff, a partner with Aidikoff, Uhl & Bakhtiari, a Beverly Hills, Calif.-based law firm that specializes in securities arbitration and litigation.

SECOND COMPLAINT

Merrill denied that its analysts acted improperly in recommending auction-rate securities, also known as ARS.

The analysts mentioned in Galvin's complaint “are men of integrity and intellectual honesty. They called the ARS market as they saw it, not the way anyone else did,” Merrill spokesman Mark Herr said. “Nothing the sales desk could do or couldn't do affected how much these analysts earned or their standing in our research department.”

Auction-rate securities are long-term bonds or preferred shares with interest rates adjusted typically every seven, 28 or 35 days through a dealer-run bidding process, providing them with the characteristics of money-market investments. Firms historically supported the auctions, without contractual obligation, when demand waned.

Merrill is the second bank to face a complaint by Galvin after brokers stopped supporting the auctions in mid-February as losses from securities tied to subprime mortgages mounted. Massachusetts last month filed a complaint against UBS, Switzerland's biggest bank.

SEPARATE SETTLEMENT

UBS said it will contest the allegations. The bank agreed Wednesday to pay $1 million to settle a separate complaint filed by Massachusetts Attorney General Martha Coakley over the marketing of auction-rate securities to 20 towns and public agencies in the state. UBS also agreed to pay $38.5 million to the municipalities.

February's meltdown began in July 2007, when MBIA and Ambac Financial Group, the two largest insurers of auction-rate debt, reported lower profits because of losses on securities backed by subprime mortgages. Losses at the insurers prompted auctions for $1.8 billion of their own securities to fail, according to Fitch Ratings.

That month, Constable, 51, objected to an analyst's report, which noted auction-rate bonds lack a so-called “hard put,” like some other variable-rate securities, which obligate the issuer to arrange a purchaser for any unwanted securities when rates reset.

‘MISPLACED CONCERNS’

The reference was misleading, she said, because the report focused on municipal bonds and those instruments weren't yet failing. When the analyst, Martin Mauro, refused to retract the note, Constable sent an e-mail to colleagues within the firm.

“I HAD NOT SEEN THIS PIECE UNTIL JUST NOW AND IT MAY SINGLE HANDEDLY UNDERMINE THE AUCTION MARKET,” she wrote in capital letters, according to Galvin's claim.

The research department withdrew the report a day later, Galvin said. While a revised version still included information on the hard put, it also recommended auction-rate securities, saying concerns were “misplaced” and they may offer good value.

“The same facts contained in the first report were all retained in a longer, fuller and clearer version,” Herr said.

Constable, Conery and Mauro, all located in New York, have no comment, he said, declining to make them available. They aren't named as defendants in Galvin's complaint.

Constable's objections had a lasting effect, according to Galvin. When an analyst drafted a report on the securities the following January, he asked his colleague for advice before publication.

“I want to make sure that research cannot be accused of causing a run on the auction desk,“ the analyst, who wasn't named, wrote in an e-mail.

The flood of auction-rate claims against brokerage firms points up, again, how badly the deck is stacked against you in securities-industry arbitration. For claims exceeding $50,000, your three-member panel of judges must include an industry representative, plus two “public” members who also can have industry ties.

The industry rep is there to explain the industry’s point of view to the other panelists — effectively, a Wall Street mouthpiece, sympathetic to the very products and practices you’re complaining about. As an “expert,” his or her opinion carries extra weight.

For years, the lawyers representing customers have pressed to get rid of this fifth-columnist on arbitration panels. The industry always stonewalled.

Then, in 2007, a bill called the Arbitration Fairness Act appeared in Congress, containing a clause requiring all three panelists to be from the public. Coincidentally — I’m sure — the Financial Industry Regulatory Authority (Finra), which runs securities arbitrations, decided to hedge its position.

Last week, Finra announced a two-year pilot project, allowing as many as 420 cases to be heard by an all-public panel. Customers’ lawyers welcomed the pilot, tepidly, as a baby step in the direction of fairness.

The Boot

Then, fairness got the boot.

Last May, the Public Investors Arbitration Bar Association wrote to Finra about the problem of conflicted panelists on the auction-rate cases. PIABA President Laurence Schultz, of Driggers, Schultz & Herbst in Troy, Michigan, asked that potential panelists be excluded from the hearings if they worked for firms that originated or sold auction-rate securities. After private talks, PIABA expected a yes.

Finra said no, in a letter that Linda Fienberg, president of Finra Dispute Resolution, sent to Schultz last week. Arbitrators will simply be required to make additional disclosures if, after Jan. 1, 2005, they worked for firms that sold auction-rate securities, sold them themselves or supervised anyone who did.

It will then be up to the lawyers (or to the customers, if they’re representing themselves) to decide whether to take those arbitrators as panelists. “The steam is coming out of my ears,” says Philip Aidikoff of Aidikoff, Uhl & Bakhtiari in Beverly Hills, California.

Staying Involved

To understand the steam — and why Finra is still being pressed to change its mind — you need to know how arbitration panels are chosen. The parties to the dispute get three lists of eight names, chosen randomly by computer from the arbitrator pool. There’s one list of industry panelists and two for the two public members. Each side strikes as many as four names on each list, for any reason at all, then ranks the rest in order of preference. Finra names the panel, choosing the arbitrators most acceptable to both sides.

By keeping the people involved with auction-rate securities in the panelist pool, Finra forces customers’ lawyers to use up their challenges to get rid of them. If four challenges aren’t enough, they’re stuck.

They will also use up challenges that might have been needed for other reasons, such as bouncing an arbitrator whose awards consistently skew in favor of the industry. Arbitrators can also be challenged for cause — meaning direct and definite bias or interest in the outcome — though that’s hard to show.

Everyone’s Involved

What makes this especially unfair is that arbitration issues have changed, says Brian Smiley of Smiley Bishop & Porter LLP in Atlanta. “The cases used to be about isolated broker misconduct,” he says. “Now we’re seeing institutional misconduct — the perversion of Wall Street research during the tech bubble, selling fraudulent and unsuitable variable annuities, abuses in the securitization of subprime products and, lately, auction-rate securities.” All the big firms are involved.

Say that you have an auction-rate case against UBS AG and get stuck with a Merrill Lynch & Co. branch manager as your required industry panelist. How can that Merrill manager bring in a large award, or indeed any award? His own firm is up against the same charges. He might worry that if he finds for you, it could cost him his promotion or even his job.

Whatever the reason, the win rate for consumers has been spiraling down. They won 53 percent of their arbitrated cases in 2001 but only 36 percent in 2007, according to the Securities Arbitration Commentator in Maplewood, New Jersey, which tracks awards. (So far this year, they’re running at 47 percent, says SAC Managing Editor Richard Ryder.)

Paltry Returns

Even with wins, you don’t get much money back. In a study of arbitration covering 1995 through 2004, attorneys Daniel Solin and Edward O’Neal, of the Securities Litigation & Consulting Group in Fairfax, Virginia, combined win rates with awards to create an “expected recovery rate.” It peaked in 1998, at 38 cents on the dollar, falling to 22 cents in 2004.

More cases settle than go to arbitration, but those low recovery rates “knock down the settlement offers you get,” says attorney Theodore Eppenstein of New York.

When trying to remove Wall Street’s thumb on the scale during arbitration, “you’re up against some of the best funded lobbying in the country,” Aidikoff says. “Where are the people who speak for individual investors?” Where, indeed.

The hedge funds, managed by United Capital Asset Management, an affiliate of United Capital Markets, were pronounced dead by Devaney in a letter to his investors Wednesday. According to Devaney, about 150 investors, including some from his hometown of Key Biscayne, have lost about $510 million.

Devaney himself has lost more than $100 million, he said. His losses amount to about half his net worth, he added. But he still has a 126-foot yacht, the Dorothy Ann — a present to his mother — moored behind his Key Biscayne home.

The failed funds — Horizon Fund, Horizon ABS Fund, Horizon Fund III and Horizon ABS Master Fund — invested in junk bonds, which have collapsed in value over the past year amid unprecedented turmoil in the credit markets.

United Capital denied the assertions made in three separate arbitration claims over the past year, according to records at FINRA, the Financial Industry Regulatory Authority, which regulates the brokerage industry.

In an interview Thursday, Devaney, 38, who was at Sardy House, his 16-bedroom Victorian vacation home in Aspen, Colo., declined to comment specifically on the arbitration claims. But he said the majority of his investors have stood by him during this difficult time, with only a few complaining about their losses.

“More of the individuals sent my wife and I flowers and cards . . .,” Devaney said.

The collapse of Devaney’s funds was all the tight-knit community of Key Biscayne talked about Thursday.

“Everybody knows what’s been going on with Mr. Devaney,” said Alexander Avila, the publisher of Key Biscayne Magazine, a glossy monthly highlighting luxury living on the island.

“Those who invested made a lot of money when it was going good. When it went bad, they lost,” said Robert Vernon, Key Biscayne’s mayor. “I don’t know how much of that money belonged to Key Biscayne residents.”

Devaney acknowledged that some of his investors are angry: ‘They won’t accept responsibility for an investment and they say, ‘Hey, this guy still has a waterfront home.’ ”

But he said all his hedge fund investors were institutions or high-net-worth individuals savvy enough to know the risks.

One unhappy investor, Stuart Hayim, who lives in New York and Key Biscayne, filed an arbitration claim with the American Arbitration Association in June, seeking to recover the $1.8 million he says he lost. According to his attorney, Lawrence A. Kellogg, of Tew Cardenas in Miami, Hayim was assured he could withdraw funds whenever he wanted, but instead found himself locked in a frozen fund that spiraled downward.

“We will be looking to collect from the broker dealer and from Mr. Devaney personally because of the assurances he made to my client,” Kellogg said.

Last July, Devaney took the unusual step of halting withdrawals to prevent an exodus of investors spooked as subprime mortgage woes began to unfold. He said he wanted to avoid selling at depressed prices, with the hope that the market would rebound.

But it has not.

On Thursday, Devaney said the fund had lost about 90 percent of its value by September 2007.

“It was hanging on to the side of a building by fingernails,” he said.

The death blow came late last month when Deutsche Bank, the funds’ main lender, issued a margin call — a demand that the funds put up additional collateral to back their loans. When the funds couldn’t meet the margin call, the bank declared the loans in default and auctioned off the funds’ bonds. A second lender, Pershing, a unit of Bank of New York, then terminated its lending lines to the funds.

Devaney’s firm is facing a second arbitration claim filed in December by Beverly Hills, Calif., attorney Philip M. Aidikoff and Miami co-counsel Mark F. Raymond of Broad and Cassel on behalf of a Southern California investor who declined to be identified and who seeks the return of about $350,000.

A third complaint, filed with FINRA in February, seeks $6 million in damages on behalf of three hedge fund investors.

Devaney said warnings that the full principal can be lost were prominent in all the funds’ disclosure documents.

“All investors were put through net-worth tests, screenings and a cooling-off period before they could invest,” Devaney said. “Anyone investing in a fund making 40 percent return a year had to have a lot of disclosure about the risks.”

How much is your investment worth?

That might seem like a simple question on Wall Street, where the price of everything from Apple to zinc flickers across computer screens every day. But inside Bear Stearns, the answer was anything but clear last spring for investors who put their money into two giant, but ultimately doomed, hedge funds.

Two executives who oversaw the funds, Ralph R. Cioffi and Matthew M. Tannin, did not disclose that the funds were plunging in value until it was too late, the authorities say. On Thursday morning, the pair surrendered to federal agents and were charged with nine counts of securities, mail and wire fraud.

Whatever the outcome, the case spotlights one of the most vexing problems confronting Wall Street as the credit crisis plays out: How to value tricky investments linked to subprime mortgages and other risky debt.

As the mortgage market slumped last spring, authorities say, Mr. Cioffi valued one of his funds as having lost 6.5 percent in April. But colleagues at Bear placed far lower values on investments in that fund. They said the fund had lost 18.97 percent.

All across Wall Street, similar battles are playing out inside banks, albeit without the legal drama. Many banks are struggling to value the assets they hold, raising doubt among many investors about those companies’ financial health.

“It’s a humongous problem for Wall Street,” said Michael Young, a lawyer with Willkie Farr & Gallagher. “These days these valuation obstacles are at the core of the write-downs.”

Mr. Cioffi and Mr. Tannin are the first Wall Street executives to face criminal charges linked to the credit mess. But many other bank executives are grappling with far bigger financial worries. Worldwide, banks have written down the value of assets by $380 billion, as high-flying markets have crashed back to earth. Some banks suggest that the write-downs have been conservative and that some assets may be written back up in the future. Others say the bill will keep mounting.

Bankers like to say that valuing complex investments is part art and part science, but four large firms have said recently that some employees have not been honest.

In February, Credit Suisse found a group of employees who had bumped up the value of mortgage assets by $2.65 billion during the fourth quarter last year and through the start of this year. The employees were fired.

In March, Lehman suspended two traders on its equity derivatives desk for overpricing bets in the market by tens of millions of dollars. In May, Merrill Lynch disclosed a similar incident that cost it about $18 million.

Morgan Stanley was the latest to find misconduct. On Wednesday, the investment bank said it had lost $120 million this year because of a rogue trader. The trader, Matt Piper, is British and has worked for Morgan Stanley in London for four years. He was suspended while Morgan Stanley continued investigating his trades in credit-index options.

“In this sort of environment of stressed markets, one would expect to see people trying to behave improperly,” said Colm Kelleher, Morgan Stanley’s chief financial officer, on a conference call. “We’re very angry about it.”

The level of losses industrywide is sure to raise questions about how values were assigned in the first place. Banks generally look at prices in the market first. But when no market price is available, they turn to internal computer models. The practice is similar at hedge funds, though in some instances, banks give pricing out to hedge funds, allowing price levels to trickle through in nebulous asset classes like mortgage bonds.

Now, bank executives are increasingly scrutinizing their employees and trying to catch them if they are too optimistic - or downright dishonest - about valuations.

But it is not simply a question of catching rogue traders. Marking the book, as the industry calls the pricing process, has become one of the more controversial topics among finance executives, even in instances where no fraud has been alleged. On Thursday, the chief financial officer of Citigroup said the company would use internal models to price mortgage bundles known as collateralized debt obligations rather than use the dismally low market prices as the only factor. On the other end of the spectrum, firms like Goldman Sachs say that market prices should be the driving factor in pricing.

Different computers models often use different data and produce different valuations. Investors have complained recently that Wachovia and Washington Mutual are modeling values with a housing price index that is more optimistic than the index used by their competitors.

“There’s almost a definitional issue of what you mean by value,” said Rick Antle, an accounting professor at the Yale School of Management. “You’re really kind of behind the eight ball.”

Away from Wall Street, plaintiffs’ lawyers are circling. Suits over losses in funds like Charles Schwab’s YieldPlus Select assert that managers were irresponsible in not knowing how risky the mortgage assets would turn out.

A spokesman for Charles Schwab said the company does not comment on pending legal cases.

“I don’t know if I could tie it to some kind of widespread conspiracy. Certainly the fact that the write-downs have been so massive would mean that somebody was optimistic,” said Ryan Bakhtiari, a lawyer who has filed an arbitration on behalf of investors against Schwab. “It was true from the beginning to the end of the food chain: everybody made inflated money.”

Banks are sometimes forced into write-downs because of selling in the market. Lehman Brothers, for instance, said that the collapse of the hedge fund Peleton Partners in February forced Lehman to write down the mortgage assets it owned similar to ones held by Peleton. Some banks say the write-downs caused by fire sales may be overkill.

“There is a bit of this atmosphere that says, ‘Let’s just mark it down, no one is going to question it if we mark it down,’ ” said Christopher Hayward, the finance director at Merrill Lynch, at a recent industry conference.

Not all banks are eager to take their hits. In the fall, for example, a large city in the Southeast asked Bank of America to write down the C.D.O.’s the city held, said Mr. Bakhtiari, who represents the city but was not authorized to identify it.

Bank of America refused to mark down the C.D.O.’s, Mr. Bakhtiari said, because it did not want to create a mark-down domino effect in its other holdings. A spokesman for Bank of America declined to comment Thursday.

Investors are increasingly complaining that banks have become too opaque about the assets they own and the trades that make - or lose - them money. Financial companies flocked en masse in recent years to trading assets that are far harder to value than, say, shares of Microsoft.

And the problem may be exacerbated by the way traders are compensated. Bank employees from lowly associates to chief executives are paid bonuses each year based on performance. But there is little recourse if their bets lose money the following year, so long as the employee is deemed to have made an innocent mistake.

Some banks are considering expanding the period in which traders are evaluated to longer than a year, said Chip MacDonald, a partner in the capital markets group at the law firm Jones Day.

“We have our health and families,” Cioffi told fellow portfolio manager Matthew Tannin and two other co-workers the next day. “We are not a 19-year-old Marine in Iraq.”

It was the first monthly loss in the 3 1/2 years that Cioffi had managed the Bear Stearns High Grade Structured Credit Strategies funds, which he founded in October 2003. Even as Cioffi celebrated, he worried in an e-mail that a “meltdown” was coming in the subprime mortgage market.

By June 2007, the funds collapsed, touching off broader subprime mortgage-related losses that now total $396.6 billion worldwide. Cioffi and his deputy Tannin were arrested yesterday and charged with mail and securities fraud. The indictment portrays a pattern of misleading investors as losses mounted. Civil suits further allege incomplete record-keeping and conflicts of interest going back to the summer of 2006.

Attorneys for Cioffi, 52, and Tannin, 46, said their clients were guilty of no wrongdoing.

“Because his funds were the first to lose might make him an easy target, but doesn’t mean he did anything wrong,” said Cioffi’s attorney, Edward Little.

The nine-count indictment filed in New York by U.S. Attorney Benton Campbell adds detail to the Bear Stearns manager’s unsuccessful efforts to rescue the funds. He allegedly transferred $2 million of his personal wealth out of the fund three weeks after the vodka salute.

Massachusetts Suit

The criminal complaint shows “damning evidence,” says lawyer Ryan Bakhtiari, whose Beverly Hills, California, law firm of Aidikoff, Uhl & Bakhtiari represents hedge funds and institutional investors that allegedly lost tens of millions of dollars after putting money into Cioffi’s funds in March 2007.

The two Bear funds filed for bankruptcy in July 2007, at a cost to investors of $1.6 billion, according to a securities- fraud lawsuit filed in U.S. District Court for the Southern District of New York by Barclays Bank Plc against Cioffi, Tannin and Bear Stearns. The London bank helped finance the funds.

The Massachusetts Securities Division, the first regulator to act, alleges in a November administrative complaint that the Cioffi-managed funds pushed through thousands of trades without legally required approvals and documentation. Many of the transactions were Bear Stearns investments and other deals Cioffi managed.

Independent Directors

By September 2006, Cioffi’s bet on subprime mortgage securities was falling short of the 10 to 12 percent annual returns he’d promised, and he faced the threat of investor withdrawals, according to the federal lawsuit.

That month, Cioffi carved off 37 percent of the fund’s $1.53 billion in assets into the newly created Enhanced Leverage fund, according to the Barclays suit.

“What I was thinking was to build up six (months) of returns and then send a letter to all the remaining investors and tell them we are closing the (high-grade fund) and ask everyone to convert to the Enhanced Fund,” Cioffi said in a Sept. 17, 2007, e-mail to Tannin that is included in the Barclays lawsuit.

Almost immediately, Cioffi discovered he didn’t have the independent directors needed to sign off on some of the related- party trades he wanted to make, according to e-mails attached to the Massachusetts complaint.

The state alleges that the directors hired by the Cioffi funds, Scott Lennon and Michelle Wilson-Clarke, both senior vice presidents at Walkers Fund Services Ltd. in the Cayman Islands, routinely approved trades for which Cioffi and his staff produced insufficient documentation, often after the fact.

Related-Party Transactions

“The Walkers directors approved more than 165 related-party transactions whose applications were incomplete or were submitted after the transactions were completed,” according to the state.

Massachusetts enforcement attorney Michael Regan says in the complaint that the directors “do not appear to have been entirely independent.” They didn’t comply with a civil subpoena, contending the state lacked jurisdiction in the Cayman Islands, Regan says.

“The independent directors properly reviewed every trade that was presented to them,” said spokesman Michael Robinson, a senor vice president at Levick Strategic Communications LLC in Washington, in an e-mail. The directors offered to meet with Massachusetts officials and remain available, he said.

The Barclays lawsuit outlines why the alleged conflicts might be important. It alleges that Cioffi’s employer, Bear Stearns, used the Enhanced Fund “to dump” hundreds of millions of dollars of its riskiest assets, sometimes with no independent third party to value them.

`Awesome Opportunity’

According to the federal complaint, Cioffi e-mailed an unidentified colleague on March 15.

“I’m fearful of these markets,” Cioffi said in the e-mail. “Matt said it’s either a meltdown or the greatest buying opportunity ever. I’m learning towards the former.”

Publicly, he was more upbeat.

“We have an awesome opportunity,” Cioffi told a Bear Stearns co-worker on March 7, according to the criminal complaint. The colleague allegedly had more than 40 clients invested in Cioffi’s two subprime mortgage-dominated hedge funds.

Then, on March 23, Cioffi began transferring a third of his $6 million personal investment to another Bear Stearns vehicle, federal prosecutors say.

Rather than disclose the funds’ growing losses and shut them down, Cioffi and Tannin misled investors into June, according to the federal criminal complaint.

By June 9, 2007, Cioffi may have resigned himself to an unpleasant end. The federal complaint says Cioffi told a confidante then that if he couldn’t turn around the funds, “I’ve effectively washed a 30-year career down the drain.”

Instead, some regulators and investors’ lawyers argue, brokerage firms are responsible. The firms had a bird’s-eye view of the now-frozen auction-rate securities market and should have foreseen the failure, they believe.

Also, some say, it is reasonable to expect brokers to rely on their firms’ descriptions of products; they aren’t obligated to research an investment if their firms had explained it to them.

“The brokerage firms bear the responsibility, and they know it,” says Phil Aidikoff, a Beverly Hills, Calif., lawyer who is former president of the Public Investors Arbitration Bar Association. “I don’t think the industry representatives understood the risk. I think [they] simply told customers what they were told by the firm.”

Even if brokers are legally blameless, their reputations may be tarnished. As the business attempts to shift to a more-relationship-based model, many investors are disappointed that their financial advisers were caught off guard by the collapse of the auction market.

The market was estimated at $330 billion, held by individuals and institutions, when it collapsed in February. Many individual investors say they received no disclosure of risks when they purchased these products. Brokers never gave them prospectuses to read, they say, and they were never told auctions could fail.

“Our investigation indicates that officials at Bear Stearns engaged in a concerted effort to conceal the true state of affairs at this hedge fund, for an extended period of time before it imploded and that the victims of this nefarious scheme included both individual investors and professional money managers from around the world,” said Steven Caruso of Maddox Hargett & Caruso, one of the law firms.

The claims were filed with the Financial Industry Regulatory Authority on behalf of investors in Bear Stearns’ High Grade Structured Credit Strategies Fund. Last summer the fund failed along with the company’s High-Grade Credit Enhanced Leveraged Fund, costing investors $1.6 billion.

Since then, a variety of entities have started investigations, or filed suit alleging malfeasance, including the Securities and Exchange Commission and the states of New York and Massachusetts.

Representatives of Bear Stearns and J.P. Morgan Chase & Co., which closed its $1 billion acquisition of the brokerage last week, were not immediately available for comment.

The proposed rule, released April 24, would require reporting of an unnamed broker if his or her identity can be deduced from the arbitration or court filings. The firm employing the unnamed broker would have 30 days to make the disclosure to the Central Registration Depository (CRD) on forms U4 and U5, the standard securities industry registration forms.

Philip M. Aidikoff, an attorney with Aidikoff, Uhl & Bakhtiari in Beverly Hills, CA, said the rule proposal would close a “huge loophole” that should “provide more transparency in the dispute resolution process” for investors and regulators.

According to Aidikoff, his firm and many others tend to name only the securities firm as the party because it has a duty to supervise. Also, not naming the broker can expedite reaching settlements, he said.

Steven B. Caruso, an attorney with Maddox, Hargett & Caruso in New York, explained that his firm does not name the broker to avoid having to face additional lawyers and because it is more efficient for the arbitration process.

The rule proposal should give investors and regulators a “much more complete picture,” Caruso said.

FINRA said it was hard to reconcile requiring named brokers to be reported but not unnamed brokers whose identity could be ascertained because, in both situations, a sales practice violation is at the heart of the complaint.

“[T]his reporting inconsistency, FINRA said, “raises practical concerns because the practice of making a firm the sole respondent in an arbitration claim is becoming more prevalent in circumstances where the allegations involve sales practice violation(s) against a registered person.”

FINRA is seeking comment on the proposed rule change. The comment period is open until May 27.

Published last week by the Financial Industry Regulatory Authority, or Finra, the rule would require brokers to include on their records arbitration claims that allege misconduct in how they sold products - even if the brokers themselves aren’t specifically named in the complaints.

The change would reconcile an inconsistency that has existed for years. Presently, if a customer lodges a written complaint about sales practices to a firm but doesn’t name the broker involved, the firm must try to identify the employee involved, and that complaint then goes on the broker’s public record. Currently, if an arbitration claim doesn’t name a broker - even if it refers to the broker’s bad behavior - there’s no need to put the complaint on the broker’s record.

The timing of the proposed rule change is causing some consternation among brokers who worry that it may be hard to draw a distinction between claims alleging sales practices complaints and those alleging product failures, such as the rising tide of complaints caused by the failure of the auction-rate securities market.

In 2001, 25% of arbitration complaints didn’t name brokers, according to Finra. Now that number is closer to 50%.

The change is due to legal strategy, according to people who represent different sides in customer disputes. The idea is that making a broker a respondent ropes in a person who may fight aggressively to prevent a black mark from appearing on his or her record. A firm on its own may be more willing to offer a settlement for the sake of expediency.

Those who favor the rule change say that legal strategies shouldn’t impede public disclosure.

The fact that “it’s more efficient for an investor to get something resolved if the representative isn’t a party shouldn’t dictate whether other investors should know there was a complaint,” said Melanie Lubin, Maryland securities commissioner.

Investors’ advocates argue that full disclosure gives investors access to information that can help them pick a broker. Some brokers are upset by the potential change, saying that putting allegations on their records results in an “innocent until proven guilty” standard.

But with waves of arbitration claims over auction-rate securities coming in, some brokers and the lawyers who represent them are even more nervous than they would otherwise be.

“It’s not fair to mark up a broker’s record in a toxic product case, if the broker is as ignorant as you are,” said David Robbins, a Manhattan lawyer who represents both brokers and investors in arbitration claims. “Under this rule, it will.”

Because brokers are the customer’s main contact at a firm, they were the ones who sold auction-rate securities to their clients. But some industry observers argue that the on-the-ground sales team wasn’t responsible for the market’s collapse, and had no way of knowing it would occur. Brokers don’t want to see their records marred for selling what they say they understood to be perfectly safe products.

Even some investors’ advocates who think the rule serves an overall good acknowledge that it could prove unfair to brokers when it comes to product failure cases.

“I have no problem pointing fingers at brokers when I believe there has been wrongful conduct ,” said Phil Aidikoff, an investors’ attorney in Beverly Hills, Calif.,who said he’s spent the last six weeks working on auction-rate securities claims. But “when it’s a massive product failure, it’s rarely if ever the fault of the broker.”

Regulators point out that brokers have an opportunity to share their side of the story on their public records. And Lubin said the new version of the paperwork that brokers and firms must fill out would specifically ask whether the broker was alleged to have been involved in sales practices violations. That leaves room for brokers and firms to determine whether a case is ultimately a sales practice issue.

“The question dictates what needs to be disclosed,” she said. “They parse very carefully whether or not a yes answer is appropriate.” When it comes to how to categorize auction-rate securities complaints, she said, “It’s going to take a while to unwind.”

Finra is accepting comments on the proposed rule until May 27.

That’s the hard lesson learned by thousands of consumers just now finding their savings are irretrievably stuck in something called auction rate certificates, or ARCs.

They were told the obscure investments were as safe and liquid as money markets, T-bills and CDs, but with bigger returns. Now they’re wondering if they’ll ever seen their money again.

We’re talking lots of money - $330 billion to be exact - much of it not even earning interest. This could be the next big shoe to drop on an already stumbling economy.

“It’s a huge problem,” said Philip M. Aidikoff, past president of the Public Investors Arbitration Bar Association, one of dozens of lawyers hearing from desperate consumers.

Missouri is one of nine states that are part of a regulatory task force now investigating whether consumers got duped.

Once again you can thank in part big Wall Street brokerage houses that helped turn the subprime mess into a national calamity by slicing up high-risk loans and selling them like securities.

Auction rate certificates are basically long-term bonds of 20 to 30 years. They’re issued by municipalities and institutions, including hospitals and state student loan agencies.

But they are sold as short-term investments at weekly or monthly “auctions,” where investors can sell certificates they own or buy more, depending on the prices set at the auctions.

Many consumers were sold ARCs through their local bank. Because of the frequent auctions, the banks touted ARCs as being safe and liquid. And customers could squeeze a little more out of their investment.

For instance, a money market might return 3.5 percent in interest, while an ARC might return 4 percent.

Couples used ARCs as a way to save up for taxes or to buy a house. Congregations relied on them to save contributions to remodel their churches. Small businesses invested their payrolls.

But the promise of liquidity proved fleeting - and illusory. In reality, the auctions were little more than some big Wall Street banks getting together and trading paper, officials say.

Sales “depended on a few banks trading these investments back and forth,” said Kansas City investment attorney Diane Nygaard. Without the banks propping them up, there could be no auctions.

So when Wall Street experienced its own liquidity problems in 2007, the big brokerage banks began pulling out of the auctions.

Some auctions failed last fall. But most failed in February, when consumers started receiving letters saying, in essence, oops, your money is no longer available to you - at least not for 20 to 30 years.

And by the way, your account is losing value and your interest has dropped, too.

Some lucky consumers were able to sell off their ARCs. But attorneys and experts estimate that, with the auctions now all but dead, 50 to 80 percent of consumers are stuck.

Some Kansas City customers have seen interest rates on their ARCs fall from 4.78 percent to a flat zero. As the accounts lose value, some banks are even assessing customers a custodial fee.

So, should brokers and bankers have known better? There’s evidence to think so.

Back in May 2006, the Securities and Exchange Commission alleged that 14 brokerage firms had added capital to hide risks that the auctions could freeze up. The firms paid $13 million in fines, without admitting wrongdoing. Indeed, even as the auctions began failing last year, banks sent promotional letters to customers touting ARCs as “ultra high quality investments” for “your liquid funds.”

A secondary market has started to develop to buy ARCs from consumers - but at 50 to 80 cents on the dollar.

Consumers also have the option of suing or seeking redress through arbitration proceedings, experts say. There are already a couple of class-action lawsuits brewing. Congress is sure to notice, too.

Rest assured there is more to this story.

“We are investigating the decline of fixed income portfolios that Citibank sold. The Falcon, ASTA and MAT funds employed leverage to purchase municipal bonds,” said attorney Ryan K. Bakhtiari of Aidikoff, Uhl & Bakhtiari. “Falcon appears to have lost more than 30% of its value while ASTA and MAT appear to have suffered losses in the range of 60% to 80%.”

The lawyers have established a website, www.subprimelosses.com, to explain the implications for investors who have been hurt in the subprime crunch.

“Many investors relied on Wall Street and the rating agencies assignment of investment grade relative to these investments prior to investing,” the firms say. “The Wall Street underwriters and the teams they assembled in the structuring, rating, accumulating collateral and managing the investment pools which make up these investments may be liable to investors under a number of legal theories including but not limited to: negligence, breach of fiduciary duty, breach of contract, violation of state and federal securities laws and fraud.”

Citigroup reportedly placed $661 million in ASTA and MAT hedge funds in recent weeks and devised a restructuring plan that would allow investors potentially to recoup some of their money.

Attorney Phil Aidikoff, whose Beverly Hills firm is representing San Luis Obispo County investors who were clients of Forrest and lost millions in a failed equity investment fund, said the first hearing begins Dec. 1 in Los Angeles.

The claims are being sought against Forrest and Associated Securities, an El Segundo-based broker-dealer with which Forrest was registered until last year.

Investors claim Forrest —charged in the civil cases with breach of fiduciary duty and fraud— told them the principal they invested in the APEX Equity Options Fund, a $46 million equity fund, would be protected. Attorneys say that wasn’t the case and allege Forrest sold investments in several businesses that were unsuitable for some of his clients.

The first claim, filed with the Financial Industry Regulatory Authority in October 2007, represents seven households that collectively invested $5 million in the APEX Equity Options Fund, which was wiped out in August 2007.

In all, the losses stemming from the four claims now total nearly $24 million, Aidikoff said. In some instances, clients had used their savings or borrowed against the value of their homes to invest, according to legal documents.

Keith L. Griffin, of Maddox, Hargett & Caruso PC, said in a telephone interview on Monday [Feb. 18] that the firm is aware of the difficulty that pension funds and other institutional investors have had finding law firms both willing and qualified to file lawsuits against such
institutions.

Mr. Griffin said that he had seen a column on the subject in the Financial Times last week. According to that column, which cited unnamed sources: “At least three big London law firms have turned away clients seeking to recover money they put into complex derivative products that later lost money. Though the would-be plaintiffs are mid-sized institutions that regularly hire London law firms, their potential targets are the leading international banks on which the biggest law firms depend for their daily bread.”

U.S.-based securities lawyers reached over the weekend on the subject of the FT column generally agreed that the author was on to something - at least in the specific context of the London bar, where bankers and securities lawyers are part of a close-knit community disinclined to the sort of rift that accepting such a client would require.

Some U.S. lawyers said that although the point was a valid one in the context of the United Kingdom, it doesn’t extend to the United States, where there are smaller but high-quality securities firms that don’t rely upon good relations with the large banks or broker- dealers and where the class-action lawsuit provides another format for airing such grievances.

Other U.S. lawyers, though, said that the problem also exists on the western shore of the North Atlantic. One of them compared a lawsuit by a securities lawyer against a broker-dealer to a claim of legal malpractice - such claims do get brought, but rarely, because there is
a powerful stigma that works against it.

Maddox, Hargett & Caruso, Mr. Griffin’s law firm, is one member of a new alliance of firms that propose to represent institutional investors harmed by the subprime crisis and the collapse of mortgage-backed securities. The other firms involved are Aidikoff, Uhl & Bakhtiari of Beverly Hills, Calif.; Page Perry LLC of Atlanta; and David P. Meyer & Associates Co., of Columbus, Ohio.

In a statement issued Friday [Feb. 15], the members of this alliance made special reference to the fact that Citigroup Inc., New York, has stopped investor redemptions in its London-based hedge fund, CSO Partners.

Steven Caruso, one of the named partners of MH&C, said investors in the CSO Partners hedge fund investors “may have a variety of remedies that they should discuss with qualified counsel.”

The list of people who got caught up in the mutual fund debacle unfolding at the Memphis-based brokerage firm has included retirees, institutional investors, the well-to-do and small-business owners, to give but a few examples. The latest addition to that list: Morgan Keegan employees themselves.

Over the past several months, scores of lawyers from around the country have sought out and researched claims from one investor after another, nearly all of whom have told variations of the same story.

Whether it was their retirement nest egg, rainy-day savings or large chunks of their net worth, much of it that was tucked away in the RMK funds seemed to evaporate overnight.

Now, those same lawyers are hearing from clients who were exposed to the RMK funds in a different way. Some of the affected mutual funds were part of the Morgan Keegan employees’ pension plans, meaning that a number of employees have now found themselves in the same boat as the unlucky investors.

A figure as high as $10 million has been mentioned as the amount of employee money invested in the group of RMK funds that sustained massive losses over the course of 2007. One of the reasons for the large losses is the funds’ over-concentration of investments in a small number of industries, according to various lawsuits that have since been filed in West Tennessee.

“We’ve been speaking to employees of Morgan Keegan who may have (Employee Retirement Income Security Act) claims against Morgan Keegan for the handling of their retirement funds,” said attorney Ryan Bakhtiari, a partner at Aidikoff, Uhl & Bakhtiari in Beverly Hills, Calif.

More disclosure needed?

The Employee Retirement Income Security Act of 1974, or ERISA, is a federal law that sets minimum standards for pension plan management in the private sector. Bakhtiari said his firm is considering filing a class action suit representing Morgan Keegan employees who lost money in their pension plans because of the RMK exposure.

His firm is not the only one. A cursory check revealed at least a handful of other law firms from around the country who’ve announced similar investigations.

“The company owes the employees a fiduciary duty to manage the plan in a prudent manner, the same way the company owes a fiduciary duty to customers of Morgan Keegan,” Bakhtiari said.

“And as part of that fiduciary duty, the company would have to tell the truth to its employees, to not make any misstatements or hold back any material information in connection with the investments in the plan.

“We believe that Morgan Keegan didn’t tell people about the true nature of the risks of these particular funds.”

That’s a claim individual investors are continuing to lodge against the brokerage firm, where the mutual funds in question are overseen by Jim Kelsoe. He’s a once-high-flying money manager who’s responsible for about $3 billion worth of assets at Morgan Keegan.

More suits coming

The credit crunch that knocked the economy back on its heels starting last year did the same to several of the funds Kelsoe manages. One of those mutual funds, the RMK Select High Income Fund, lost more than 60 percent of its value in 2007. The fund already is down 13 percent this year.

Four separate lawsuits are pending in the U.S. District Court for the Western District of Tennessee. They were filed on behalf of investors from across the country whose portfolios took varying degrees of loss in the RMK funds.

A similar complaint also was filed recently in Shelby County Chancery Court. Memphis attorney Scott Beall, representing three local-area family trusts, filed suit Tuesday against Regions Financial Corp., the parent company of Morgan Keegan, according to The Daily News Online.

Also named in the suit is David Franks, a senior vice president and regional trust manager for Regions in Memphis. The basic argument in the Chancery suit is that the family trusts originally had been managed by Union Planters Bank, which was acquired by Regions in 2004.

Within months of Regions’ taking over management of the trusts, according to the suit, the bank began selling off some of the trusts’ existing assets to generate cash that was then used to buy into the volatile RMK funds. Those purchases were made for the benefit of Regions rather than for the trust beneficiaries, according to the suit.

A Morgan Keegan spokesman declined to comment on the mutual fund situation. On a conference call with analysts last month, Regions’ chief financial officer Al Yother said the bank had made a recent investment in two of the RMK funds to provide some liquidity to support them.

Like many aspects of the debate over arbitration, the argument over explained decisions presents a juxtaposition between efficiency and fairness. While arbitration is meant to be faster and cheaper than the court system, many have argued that those advantages have eroded over the years. At the same time, some say they wish arbitration had some characteristics of court that they view as more fair.

Into the fray comes new numbers from a survey released last week in which 55% of customers and nearly 44% of non-customers said they’d like to understand the reasoning behind their arbitration awards. The study was commissioned by the Securities Conference on Arbitration, and more than 2,000 people answered the question about explained awards.

But a pending rule proposal to do just that has drawn protests from both sides, who argue that explanations could open the door to endless appeals, eliminating the efficiency that even critics see as a benefit to arbitration.

An explanation “lets the parties know…why it turned out that way,” said Tom Fehn, a Los Angeles lawyer who represents brokers and firms. “When people can understand things without an aura of mystery, they feel better.”

In 2005, the National Association of Securities Dealers - a predecessorto the Financial Industry Regulatory Authority, which now runs the industry’s arbitration forum - sent a rule to the Securities and Exchange Commission that if passed would require arbitrators to provide a written explanation of their decisions if either side requests it. The proposed rule drew nearly 200 comments, and is still pending as Finra reviews the responses, a spokeswoman for the self-regulator said.

Currently, arbitration awards must contain only basic information: the parties’ and lawyers’ names, a summary of issues, the damages and other relief requested and awarded and similar information.

Another pending Finra rule would require arbitrators to provide an explanation in instances where they grant a defense motion to dismiss before the claimant makes his case. But if the SEC approves the rule, arbitrators would only be able to grant such motions for three fact-based reasons, so the explanation wouldn’t provide great insight into the panel’s thinking.

It is rare for arbitrators to explain their decisions. Even though Finra has made awards publicly available online, the limited information that arbitrators typically include makes it difficult to glean any telling information from them.

“You need to know how the sausage is made,” said David Robbins, a New York City lawyer who represents investors and brokers in arbitration claims. “Cases aren’t black and white, cases are gray. You have a right to know” how the decision came to be.

Both investor and industry advocates acknowledge that it can be frustrating to receive an award that bears no resemblance to a party’s understanding of the case.

But some argue that providing explanations for awards, even if it made participants in arbitration feel better, wouldn’t necessarily improve the process.

“It’s understandable, it’s human nature” for people to want to have awards explained, said Kevin Carroll, managing director and associate general counsel at the Securities Industry and Financial Markets Association. “But the costs of implementing it are just too high.”

Chief among detractors’ concerns is the prospect of the losing party appealing - or threatening to appeal - a ruling. The grounds for which someone can appeal an arbitration award are narrow, but include an arbitration panel’s manifest disregard for the law. Large numbers of appeals would slow down the resolution of arbitration cases, negating the speed that is a key benefit of arbitration compared to courts of law, critics fear.

A written explanation “creates more opportunities for broker-dealers to file petitions to vacate, not because they know they’re going to win, but they can use it as a negotiation tool,” said Phil Aidikoff, an investors’ lawyer in Beverly Hills, Calif.

Along the same lines, Sifma’s Carroll and others are worried that arbitrators - who aren’t necessarily lawyers - wouldn’t know how to write explanations that could withstand legal scrutiny.

But Robbins sees a simple solution to that potential problem: training. Also, Fehn argues that the risk of endless appeals isn’t so daunting.

“If it seems clear they made a mistake, shouldn’t it be corrected?” Fehn asked. “Is the god of finality superior to the devil of wrongness? I don’t think so.”

There are a lot of portfolios - held by non-profits, governments and companies - with bonds backed by subprime mortgages.

With the burst housing bubble and subprime meltdown roiling the markets, Maddox and his partner Tom Hargett think there will be a lot of come-to-Jesus moments.

They’ve already had success in a case involving the Indiana Children’s Wish Fund and its investment adviser, Morgan Keegan.

Hargett filed an arbitration claim to recover nearly $50,000 the wish fund said it lost when it switched investments on the advice of Morgan Keegan.

The case closed late last month when Morgan Keegan agreed to pay the fund an undisclosed sum.

“Eight months ago, Mark and I saw the rumblings of this avalanche coming from the subprime loan mess,” Hargett said.

Maddox, Hargett and New York-based partner Steven Caruso have made a name for themselves in arbitration cases against brokers.

Maddox was Indiana securities commissioner under Gov. Evan Bayh, while Hargett worked as a stockbroker before becoming a lawyer. Caruso was general counsel for a national brokerage.

They’ve had some big wins in arbitration cases, but the subprime problem is so big and so new, they decided not to go it alone.

Over four days in August, Maddox and Hargett hammered out an unusual alliance between their firm and three others that specialize in securities law. The new affiliation “makes a lot of sense,” said Craig McCann, an expert witness in securities cases across the country.

“I don’t know of any other group that has organized the way these guys have,” he said.

It would be hard for the firms to take on the cases individually, McCann said, but together they can.

The other firms are Aidikoff, Uhl & Bakhtiari in Beverly Hills, Calif.; David P. Meyer & Associates in Columbus, Ohio; and Page Perry in Atlanta. They launched a Web site, www.subprimelosses.com, and then filed a lawsuit against New York-based Bear Stearns, which has lost billions on the loans.

Regular investors soon will see the problems that big investment banks like Bear Stearns have had since last fall. “There are a lot of people who don’t see the problem yet,” Hargett said. “But trust me, its coming.”

Those come-to-Jesus moments, that is.

Terms of the settlement between Morgan Keegan & Co. and the Indiana Children’s Wish Fund, a group that grants wishes to children with terminal illnesses, include a payment by the firm to the charity. That payment, the amount of which remains private, was made a little more than a week ago.

The Indiana charity, which lost almost $50,000 investing in the Regions Morgan Keegan Select Intermediate Bond Fund, was one of the first investors in the group of bloodied RMK funds to file a claim or lawsuit recently saying the funds’ volatility had not been fully disclosed.

Morgan Keegan spokeswoman Kathy Ridley could not be reached for comment.
Other investors in the various RMK funds followed soon after the Indiana charity. Two separate lawsuits were filed in U.S. District Court for the Western District of Tennessee in December alone, both making claims similar to the charity’s.

For its part, Morgan Keegan denied the notion it glossed over risks associated with the charity’s investment in an October letter sent to the group’s executive director. That letter also included an offer to settle the claim for a little less than $15,000.

The 23-year-old, wish-granting charity turned that offer down but now has agreed to a new deal.

“I’m informed that the parties have agreed to settlement terms including confidentiality,” said Ryan Bakhtiari, a partner at the Aidikoff, Uhl & Bakhtiari law firm in Beverly Hills, Calif.

A loose affiliation of lawyers from across the country, including Bakhtiari, is currently investigating the performance and management of the six RMK funds whose values plummeted this year partly as a result of the mortgage market meltdown. More suits and investor claims are expected to be filed soon.
By way of highlighting the effect of the RMK losses for investors on an individual level, Bakhtiari said the nearly $50,000 loss the Indiana charity took from its mutual fund investment could have funded about 10 wishes of children the group serves.

For some San Luis Obispo County investors who collectively lost millions of dollars in an equity investment, 2007 meant dealing with financial trouble.

Many clients of Jeffrey Forrest and Wealth Wise LLC had used their savings and, in some cases, borrowed against the value of their homes to invest in the APEX Equity Options Fund, a $46 million fund that was wiped out in August, according to legal documents.

Three arbitration cases have been filed with the Financial Industry Regulatory Authority against Forrest and Associated Securities, an El Segundobased broker-dealer, and a fourth case is under way, said Phil Aidikoff, an attorney with Aidikoff, Uhl & Bakhtiari in Beverly Hills. A civil suit has been filed as well by a Hunting-ton Beach investor.

Attorneys are also pursuing Associated Securities, where Forrest had been registered until this year, for not supervising or controlling his actions, which is required by the regulators.

Investors allege that Forrest, who is charged in the cases with breach of fiduciary duty and fraud, assured them that the principal they invested in the APEX fund would be protected. But attorneys say that wasn’t the case. They also allege that Forrest sold investments in five businesses -Kennedy Club Fitness, San Luis Trust Bank, Florida Capital Real Estate, BOOMj, an online social networking site for baby boomers, and Estate Financial, a hard-money lender based in Paso Robles - that were unsuitable for some of his clients.

Aidikoff said an unsuitable investment does not mean that the investment itself is of poor quality; rather, it’s an investment that may not be advisable for some people. According to the case filings, Forrest had a responsibility to know his clients’ goals and risk tolerance, and to act in their best interest.

Aidikoff said FINRA will appoint arbitration panels, and hearing dates will be set. The first hearing could be in the fall, Aidikoff said.

Forrest was reached by The Tribune on Wednesday, but he declined to comment.

Calls are coming in from investors who have lost millions of dollars in the battered funds. And attorneys with the four-firm legal team such as Ryan Bakhtiari expect to file a flurry of lawsuits soon on behalf of some of those investors.

“I would guess the (collective) losses of people we’ve been speaking to may be north of $15 (million) or $20 million right now,” said Bakhtiari, a partner at Aidikoff, Uhl & Bakhtiari in Beverly Hills, Calif. “I don’t know if we’ll take all the cases. But I can tell you I think, right now, that we’ve spoken to investors who have lost somewhere in the neighborhood of $15 (million) to $20 million.”

Values plummeting

The funds are overseen by Morgan Asset Management, a Memphis-based arm of Morgan Keegan & Co. Since the beginning of 2007, the values of at least six of the company’s mutual funds have been hit especially hard because of their inclusion of assets tied to the subprime mortgage market. Once the mortgage meltdown unfolded late this summer in full force, those values plunged further still.

One of the six Regions Morgan Keegan funds that has seen the sharpest loss is the RMK Select High Income Fund. To use that fund as one example, it most recently reported assets valued at $190 million, according to data from Chicago-based Morningstar Inc.

At the beginning of this year, the value of its assets topped $1 billion.

“That fund’s return through (Tuesday) was a loss of 56 percent,” said Morningstar analyst Lawrence Jones, “which is about as bad as you’re ever going to hear in the bond market.”

Now, the lawyers are circling. Already, almost a dozen people have retained the four-firm team, which includes Aidikoff, Uhl & Bakhtiari; Maddox, Hargett & Caruso PC, which has offices in Indiana and New York; Page Perry LLC, of Atlanta; and David P. Meyer & Associates Co. LPA, of Columbus, Ohio.

That team is expected to file several complaints in the near future contending that, among other things, the risks associated with the various Regions Morgan Keegan funds were not fully spelled out to investors. Bakhtiari recalled one man he spoke to in the last few days who said he’d lost $600,000 of his retirement savings in one of the funds.

The funds’ performance since the beginning of this year has led to several recent actions. Morgan Properties LLC, a subsidiary of Morgan Keegan, recently gave two of the funds some much-needed cash when it bought about $55 million of securities in the RMK Select High Income Fund in the third quarter.

Morgan Properties also bought about $30 million of securities in the Select Intermediate Bond Fund, according to Region’s most recent quarterly report.

Action taken

Last month, an Indiana charity filed an arbitration claim with the Financial Industry Regulatory Authority against one of the funds. The Indiana Children’s Wish Fund said in the claim it filed that the group lost about $50,000.

Meanwhile, a federal lawsuit has been filed by two investors in Memphis, according to The Daily News Online. The lawsuit filed in U.S. District Court for the Western District of Tennessee seeks to become a class action covering investors who bought shares of the Regions Morgan Keegan Select Intermediate Bond Fund and Select High Income Fund between Dec. 6, 2004, and Oct. 3, 2007.

“It’s going to take a lot for these funds to come back,” Bakhtiari said. “It’s going to take a miracle, in my opinion.”

Jim Kelsoe, the chief fixed income investment officer of Morgan Asset Management who manages the funds in question, sounded a similar note in a recent update to shareholders.

“During my 20-year career,” he wrote, “these are truly unprecedented times.”