The Securities Litigation Expert Blog

Robinhood Recommendations - Rise of the Machines

Posted by Jack Duval

Feb 9, 2021 7:42:31 AM

accelerant jack duval robinhood litigation - hal 9000 image

Your broker will see you now.

In my first two posts in this series, here and here, I focused on Robinhood's trading restrictions and the potential litigation from those actions.

In this post, I want to shift focus to examine potential liability that could arise from Robinhood's business model and use of algorithms.

This potential liability revolves around Robinhood’s communications to its clients and if those communications constitute recommendations.


Does Robinhood make recommendations to its clients?

At first blush, the obvious answer is “no”. Robinhood is an online broker-dealer that facilitates its clients making self-directed trades through an app. There is no traditional human broker making recommendations to the client, so how could a recommendation have been made?

Upon deeper inspection, the obvious answer is very likely incorrect.


First, it is important to review how FINRA defines a "recommendation".

FINRA Notice to Members (“NTM”) 01-23 - Online Suitability, gives clear guidance about what constitutes a recommendation. FINRA writes: 

The determination of whether a "recommendation” has been made, moreover, is an objective rather than a subjective inquiry. An important factor in this regard is whether - given its content, context, and manner of presentation - a particular communication from a broker/dealer to a customer reasonably would be viewed as a "call to action", or suggestion that the customer engage in a securities transaction...


Another principle that members should keep in mind is that, in general, the more individually tailored the communication to a specific customer or a targeted group of customers about a security or group of securities, the greater likelihood that the communication may be viewed as a "recommendation".[1]

To simplify, there are two criteria that must be met to satisfy FINRA's definition of a recommendation:

  1. A suggestion to transact, (the “call to action”); and,
  2. Specificity to the customer.

For context, NTM 01-23 arose from the proliferation of online brokerage firms during the technology bubble in the late 1990's. These firms would frequently publish "Top 10" stock lists and other types of equities hyping on their websites.

The “Top 10” lists and similar communications clearly meet the call to action prong of the FINRA criteria - the firm was suggesting its clients invest in the listed securities. However, those lists clearly failed the specificity prong - the lists were posted on the firm’s website and were not specific to any individual client.

In a sense, these communications were like billboards on a highway.   Anyone driving down the highway could see them, not just one person or one group of person that had been targeted because of their specific traits.

Importantly, NTM 01-23 specifically addresses “electronic” recommendations, meaning those made by a computer and not by a human speaking to the customer. FINRA writes: 

… NASD Regulation believes that the suitability rule applies to all “recommendations” made by members to customers – including those made via electronic means – to purchase, sell, or exchange a security. Electronic communications from broker/dealers to their customers clearly can constitute “recommendations.” The suitability rule, therefore, remains fully applicable to online activities in those cases where the member “recommends” securities to its customers.[2] (Emphasis added)

Electronic communications to clients is an integral part of Robinhood’s business model and strategy. As will be discussed below, Robinhood did not use the “billboard” approach to its electronic communications. It targeted specific customers (based on their unique traits) with specific suggestions

Robinhood's Business Model

First and foremost, Robinhood is a technology company. It has applied a number of social media business techniques to a broker-dealer business and the results have been spectacular.

The Massachusetts’ Securities Division, filed a complaint against Robinhood (“MA Complaint”) in December 2020. The MA Complaint describes the firm’s business model and growth: 

Robinhood is a broker-dealer that offers commission-free trading for stocks and options. In lieu of commissions and fees, Robinhood earns revenue through a process known as payment for order flow. Payment for order flow is a process in which market makers or exchanges pay broker-dealers to route trades to the market maker or the exchange for execution. Therefore, the more trades Robinhood customers execute, the more revenue Robinhood receives from market makers or exchanges.[3]


Robinhood's stated mission is to 'democratize finance for all'. In its attempt to 'democratize' investing, Robinhood has targeted younger individuals with its advertising, many of whom have limited or no investment experience. According to Robinhood, the median customer age is 31 years old.[4]


Since its founding in 2013, Robinhood has experienced a rapid growth in its customer base. Between 2016 and October 2018, Robinhood grew its customer accounts from approximately one million to approximately six million, a 500% increase. Between the end of 2019 and May 2020, Robinhood grew its customer accounts from approximately ten million to approximately thirteen million, an increase of 30% in only a few short months. [5]


During this period of exponential growth, Robinhood used advertising and marketing techniques that targeted younger individuals, including Massachusetts residents, which little, if any, investment experience. The median age of a Robinhood customer has been reported as 31 years old and approximately 68% of Massachusetts customers approved for options trading on the Robinhood platform identified as having no or limited investment experience.[6]

Perhaps the social media technique most heavily used by Robinhood is that of gamification.


“Gamification” is the use of elements typical in game playing to encourage engagement with a product or service.[7] The MA Complaint states that Robinhood: 

(Used gamification) to encourage and entice continuous and repetitive use of its trading application.[8]


Once individuals become customers, Robinhood relentlessly bombards them with a number of strategies designed to encourage and incentivize continuous and repeated engagement with its application. The use of these strategies is often referred to as gamification: the application of typical elements of game playing to other activities, typically as a marketing technique to boost engagement with a product or service.[9] (Emphasis added)

Robinhood’s “strategies designed to encourage and incentivize continuous and repeated engagement with its application” includes the following: 

Robinhood sends push notifications to customers to encourage interaction with the application and trading.[10]


A customer that has not yet traded in their account may receive a push notification that states: 'Top Movers: Choosing stocks is hard. [flexing bicep emoji] Get started by checking which stock prices are changing the most'. Upon clicking on the push notification, the customer redirects to the aforementioned Top Movers list.[11] (Emphasis added)


Customers may also receive a push notification that states, 'Popular Stocks: Can't decide which stocks to buy [thinking emoji] Check out the most popular stocks on Robinhood.' Upon clicking on the push notification, the customer redirects to the aforementioned 100 Most Popular list.[12]

Robinhood’s Recommendation Engine

I believe the push notifications were recommendations and the algorithms Robinhood used to communicate with the firm’s clients constitute a recommendation engine.

It is almost certain that all the push notifications sent by Robinhood to its clients are tailored to groups that meet specific criteria, such as having not made a trade after opening an account. This is not “billboard” advertising. This was specific communication sent to specific clients based on specific traits they shared.

By suggesting trades to specific clients based on their specific account traits, the communication meets both prongs of the FINRA definition of a recommendation.

Most troublesome is that a push notification based on the number of times the client has traded is not based on information that would enable one to determine client suitability, such as the client’s risk tolerance and investment objective.

The Best Interest Standard

I have written extensively on SEC Regulation Best Interest (“RBI”) and will only review the basics here. In short, RBI requires a broker-dealer to know both the client and the investment in order to make a best interest recommendation. In the final RBI release, the SEC wrote: 

… when making a recommendation to a particular retail customer, broker-dealers must weigh the potential risks, rewards, and costs of a particular security or investment strategy, in light of the particular retail customer’s investment profile. As discussed above, a broker-dealer ‘s diligence, care, and skill to understand the potential risks, rewards, and costs of a security or investment strategy should generally involve a consideration of factors, depending on the facts and circumstances of the particular recommendation and the particular retail customer’s investment profile…[13]

As discussed in the MA Complaint, Robinhood’s recommendation engine appears to have failed to know the investor or the investment in any meaningful way.

First, if an algorithm bases its trade recommendation to a client off of the client's previous number of trades, the recommendation is based off of factors that have nothing to do with the client's investment objective, risk tolerance, and other relevant facts and circumstances, and thus did not consider the investment profile of the clients it made recommendations to.

Second, if the algo is suggesting trades in stocks that have the biggest daily percent change or are the most heavily traded on the platform, the algo only knows those stocks in the most trivial manner (ultra short-term performance and popularity), and in ways that cannot be used to evaluate their appropriateness for each client.

Any recommendation made in ignorance of the investor and investment completely fails the RBI standard of care.

Conflicts of Interest

Another relevant part of RBI that is violated in this scenario is the conflict of interest obligation, which states, in part: 

The broker or dealer establishes, maintains, and enforces written policies and procedures reasonably designed to:


(B) Identify and mitigate any conflicts of interest associated with such recommendations that create an incentive… to place the interest of the broker, dealer, or such natural person ahead of the interest of the retail customer.[14]

If Robinhood’s algorithms were making recommendations based on the number of trades (or lack thereof) a client had made, then the recommendations were made purely to generate revenue for the firm. This is a blatant conflict of interest.

Indeed, it’s just a form of high-tech churning with bots making the recommendation instead of brokers.


If Robinhood has been making blatantly conflicted and demonstrably unsuitable recommendations to its clients via push notifications, and those clients have lost money on the recommended trades, it would appear the firm has significant liability under RBI.

Furthermore, unlike traditional cases where the broker and client typically give conflicting testimony about what was said as part of the recommendation, or if there was a recommendation at all, there will be none of that here.

The algorithms are likely very simple: 

  1. Call the number of trades for all accounts;
  2. Filter for accounts that have not traded since opening; and,
  3. Send push notification to the filtered list account holders.

The algorithm will establish the basis of the recommendation to each client. The push notifications will establish what was “said”. The statement records will show if the client traded those securities after the push notification was received and the profit and loss on those recommended transactions.

The algorithms, push notifications, and statements should all be discoverable and would establish a causal chain from Robinhood’s selection of the clients for the push notification to the profit and loss of those recommended transactions.



[1]      FINRA Notice to Members 01-23; Online Suitability; 2. Available at:; Accessed February 4, 2020.

[2]      Id. FINRA use to be known as “NASD”.

[3]      In the Matter of: Robinhood Financial, LLC; Administrative Complaint; Docket No. E-2020-0047; 8. Available at:; Accessed February 4, 2020; In Massachusetts, a broker-dealer is a fiduciary. The MA Complaint was filed on December 16, 2020, before the short squeeze mania.

[4]      Id. at 9.

[5]      Id. at 3.

[6]      Id.

[7]      See Merriam-Webster; s.v. “gamification”. Available at:; Accessed February 5, 2021. I am paraphrasing above.

[8]      Id. at 2.

[9]      Id. at 4.

[10]    Id. at 13.

[11]    Id. at 14.

[12]    Id.

[13]    17 CFR Part 240; Regulation Best Interest: The Broker-Dealer Standard of Conduct; 270. Available at:; Accessed February 8, 2021.

[14]    17 CFR Part 240; Regulation Best Interest: The Broker-Dealer Standard of Conduct a(iii)(B); 765-8. Available at:; Accessed February 8, 2021.


To learn more about suitability and fiduciary expert Jack Duval, click here.


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Topics: FINRA, Conflicts of Interest, suitability, securities litigation, investment recommendation, SEC Regulation Best Interest, Robinhood

GameStop Litigation - Part 2

Posted by Jack Duval

Jan 29, 2021 3:46:12 PM

This is the second post in my series on potential litigation arising from the trading restrictions imposed by Robinhood and other firms on GameStop and other securities involved in the recent short squeezes. The first post can be found here.

Broker-Dealer Risks

Broker-Dealers (“BDs”) can get burned by margin clients blowing up. But that’s not what happened to Robinhood or any other BD yesterday.

As of 10am Thursday morning, every owner of Robinhood stock and call options (what the Redditors were buying) was profitable because the stock was at an all-time high.

The risk to a BD is that their margin customers take large losses in excess of the equity in their accounts. In these instances, the BD has to make up the difference to their clearing firm, if that amount is greater than the firm’s equity, it is bankrupt.

The way BDs manage this risk is to change client margin requirements to increase their client's account equity and/or to sell out client positions if their equity falls below a certain level.

Robinhood did increase the margin requirements on GameStop and the other names that were part of the ongoing short squeeze on Wednesday, January 27th.[1]

Clearing Firm Margin Requirements

BDs, like their clients, are subject to their own margin requirements from their clearing firms. Also just like their clients, BD margin requirements change, typically under a formula that includes volatility as an input. As volatility increases, so does the margin requirement of the BD.

When a BD's margin requirement increases, it must post more collateral with its clearing firm.

Robinhood CEO Vlad Tenev said in a CNBC interview this morning that the firm tapped its bank credit lines proactively, meaning that it did so before it received margin calls from the Robinhood’s clearing firms.[2] Further, Tenev stated that Robinhood had “no liquidity problem, and that: 

By drawing on our credit lines, which we do all the time, as part of normal day-to-day operation, we get more capital that we can deposit with the clearinghouses. And that will allow us to enable ideally more investment with fewer restrictions.[3]

If there was no liquidity problem and Robinhood drew on its credit lines to bolster its capital position with its clearing brokers, there should have been no reason to restrict trading in GameStop and the other short squeeze names.

GameStop Volatility

There is no doubt that GameStop volatility has been rising, but it had already risen significantly by Wednesday, January 27, and trading had not been stopped. Again, if Robinhood had bolstered its capital position on January 27th and 28th, why restrict trading yesterday?

Chart 1: GameStop 10, 30, 90, and 120 Day Historical Volatility

accelerant jack duval GME historical volatility chart

 Furthermore, overall market volatility, measured by the VIX Index fell from 37.21 on Wednesday to 30.21 on Thursday, a decline of 18.8 percent.[4]

This is important, because Robinhood clients hold many more securities that GameStop and the other short squeeze names. Thus on an aggregate basis, it is possible that the volatility on the combined Robinhood securities declined on January 28th.

In short, it would appear that Robinhood's proactive trade restrictions were implemented not because the firm had run out of money, but because the firm was worried about running out of money.

However, Robinhood was fully capitalized Robinhood and acted on these worries by preventing its clients from purchasing GameStop and other short squeeze names and only allowing closing transactions.

While it is certainly prudent for Robinhood to act proactively to protect its business it cannot be reckless or negligent in how it does so.

As can be seen in Chart 1, above, the volatilities of GameStop had been rising starting on January 13th, when the 10 day volatility spiked from 100 to 258.

On January 26th, the 10-day volatility spiked again from 308 to 394. Ultimately, the 10-day volatility peaked out at 688, nearly a 10x increase from the January low of 77.

However, Robinhood had lived through other 10x increases in single stock volatility.

Chart 2: Tesla 10, 30, 90, and 120 Day Historical Volatility

accelerant jack duval tesla historical volatility chart


Chart 2, above, shows the 10-day Tesla stock volatility increasing from 18 to 210 in the three months leading to the climax of the COVID selloff in March 2020. Furthermore, this was a time when all equity volatilities were spiking to extreme levels.

In order to protect the firm, prudent risk management would dictate that Robinhood:

  • Raise the margin requirements on its clients in the short squeeze names;
  • Bolster the firm's capital position by drawing on bank lines; and,
  • Raise additional capital from its backers (which have included some bold-faced venture capital names that surely had cash available on short notice).

Robinhood did all three, but not before it helped manipulate a catastrophic decline in the GameStop stock price.

Impact of Broker-Dealer Trading Restrictions

Robinhood implemented its closing-position only trading restrictions at 10am yesterday, January 28th, 2020.

During the day, the SEC halted trading in GameStop 19 times.

These two factors appear to have panicked investors into selling (which is, of course, the only option they had at many BDs yesterday).

Chart 3: January 28, 2021 GameStop Intraday Price Chart

accelerant jack duval GameStop Intraday Chart

Yesterday from 10am to 11:24am, GameStop stock declined by nearly 77 percent.

What's more instructive is that the price was effectively "limit down" multiple times from 10am after almost every trading halt through 11:24am.

This means it was very difficult to sell the stock. It essentially went like this:[5]

  • 10am, Robinhood told clients they could only close out positions (i.e. sell stock or long call options, or buy back short positions), this caused the stock to decline;
  • 10:03am the SEC implemented the first trading halt in GameStop;
  • 10:08am the trading halt was lifted;
  • 10:16am the stock had declined by over eight percent;
  • 10:17am the SEC implemented the second trading halt in GameStop;
  • 10:22am the trading halt was lifted;
  • 10:39am the stock declined by roughly 11 percent; and,
  • 10:40am the SEC implements the third trading halt.

 This cycle repeated seven more times until 11:24am, when the stock has an intraday peak to trough decline of almost 77 percent.

Client Losses

It is not clear how much money was lost during the one hour and 24 minutes that encompassed the 77 percent decline.

However, it is certain that some investors experienced large losses, especially those that had purchased call options over the past few days.


There have already been two class-action cases filed against Robinhood, including Nelson v. Robinhoood Financial et al in the Southern District of New York.

There are many issues involved. On Thursday, Robinhood management pointed to their own margin calls from clearing firms, but this morning said there was no liquidity crunch. If the firm implemented the trading restrictions when it did not need to, under the perception that it might face a cash crunch at some later date, that is problematic.

Instead of restricting trading due to a potential problem, Robinhood should have bolstered its capital and/or undertaken other measures in advance of those potential needs. The firm had plenty of notice as the short squeezed stock appreciation gathered pace over the past month.

Finally, Robinhood claims to have raised an additional $1 billion from its existing backers (in addition to the reported $200 million in bank line draws). If that’s true, why is the firm only allowing the purchase of one additional GameStop share as of 3:15pm today.[6] Something doesn’t add up there.

For attorneys contemplating bringing a complaint, it is good to keep in mind that Robinhood has plans to IPO this year at a price that would value the firm at around $20 billion. The firm has already had regulatory issues and had to pay an SEC fine of $65 million on December 17, 2020 for violations of FINRA's Best Execution rule.

Robinhood will not want to IPO under a cloud of litigation uncertainty and may be more willing to settle cases because of that.


What would the Redditor/Robinhood story be without a good conspiracy? This one is brought to you by Congressman Paul Gosar, D.D.S.:

Melvin Capital Management is owned by the parent company “Citadel, LLC” which, according to a Bloomberg Report, gave Robinhood roughly 40% of their revenue (through payment for order flow). Knowing the involvement Citadel has with Robinhood, it is clear that the actions taken today were motivated by anti-competitive reasons not for concerns of volatility claimed by Robinhood. Because of this blatant conflict of interest and obvious monopolistic activity, I am calling on an immediate investigation by the U.S. Department of Justice into Robinhood and the hedge fund of Citadel, LLC.[7]

 Let the investigations begin.



[1]      Robinhood ramps up margin requirements on zooming GameStop, AMC; Matt Egan; CNN Business; January 27, 2021. Available at:,initial%20margin%20requirement%20and%20maintenance; Accessed January 29, 2021.

[2]      Robinhood CEO: Tapping Credit lines proactive, not a sign of cash crunch in GameStop frenzy; Kevin Stankiewicz; CNBC; January 29, 2021. Available at:; Accessed January 29, 2021.

[3]      Id.

[4]      Source: Bloomberg.

[5]      Bloomberg News reported the Robinhood trading restrictions at 9:43am on January 28, 2021, however the New York Times reported on after-hours trading restrictions the night before at 6pm. See, Trading platforms are limiting trades of GameStop and other companies; Gillian Friedman and Tara Siegel Bernard; The New York Times; January 27, 2021. Available at:; Accessed January 29, 2021. SEC Trading Halts obtained from Available at:; Accessed January 29,2021.

[6]      Robinhood raises $1bn from investors and taps banks at end of wild week; Michael Mackenzie, Eric Platt, James Fontanella-Khan, and Philip Stafford; Financial Times; January 28, 2021. Available at:; Accessed January 29, 2021.

[7]      Letter of Paul A. Gosar, D.D.S. to Activing Attorney General Monty Wilkinson; January 28, 2021. Available at:; Accessed January 29, 2021.

To learn more about suitability and fiduciary expert Jack Duval, click here.


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Topics: FINRA, securities litigation, Bantam Inc., GameStop, Trading Restrictions, Trading Halt, Reddit, Robinhood

GameStop Litigation

Posted by Jack Duval

Jan 28, 2021 11:51:17 AM

Yesterday and this morning, TD Ameritrade, Robinhood, and other firms restricted trading in GameStop, AMC, and other heavily shorted stocks that have been undergoing tremendous short squeezes over the past few weeks.

GameStop Chart

Jack Duval Accelerant GameStop litigation image

Source: Bloomberg

Regulatory Halts v. Trading Restrictions

For clarification there is a difference between a Regulatory Halt, which can be issued by FINRA or the SEC, and a broker-dealer ("BD") restricting trading in a security.  The former is common and happens every day, usually due to a large move (up or down) in a stock.  The regulator typically contacts the issuer to see if there is news that needs be be disclosed and will remove the halt after their questions have been answered.  (Frequently, there is no news from the company.)

A BD-initiated trading restriction is much less common.  When they do happen, they are usually for clients a firm wants to fire.  They ask the client to leave and tell them they will only accept closing orders, i.e. sales of securities held long, or purchases of securities held short.

This morning, Robinhood announced it would accept only closing orders for GameStop, AMC, and other securities.  They had already raised the margin requirements for these securities.

Robinhood Customer Agreement

The Robinhood Customer Agreement explicitly allows for the firm to "prohibit or restrict" trading in securities, without notice.

Robinhood Customer Agreement Extract

robinhood account agreement

Litigation Implications

While Robinhood, and most likely all BDs, have the ability to restrict client trading in securities, doing so raises a host of issues.  Some of those include:

  • Was the implementation of the trading restriction commercially reasonable?
  • If the BD allowed the clients to buy the security and then only allowed sales of the same security, are they engineering a decline in the security?  That is, if owners can only sell a security and no one can buy, there is only one way for the security to trade - down.
  • If all BDs implement closing-only restrictions, they themselves are engaging in market manipulation, guaranteeing a price decline and losses for investors.
  • If a client has an open options position, is the BD preventing the client from hedging their position via an opening transaction in the underlying or another option?
  • It is likely that FINRA has been in consultation with the BDs about these restrictions, which would seemingly raise the same liability issues for the regulator.
  • Are these restrictions being applied to institutional investors as well as retail investors?  For instance, are the options market makers able to trade in these names freely?  What about hedge funds and other institutions?
  • If the restrictions have not been implemented uniformly, it raises serious self-dealing issues.  FINRA's members are BDs and are heavily connected to institutional investors such as hedge funds.  If the regulator coordinated a member-wide closing trade only restriction for retail investors, it would benefit the hedge funds (who have been short) at the expense of the retail investors.

As I was writing this, it would appear that the trading restrictions have negatively affected the GameStop stock price.  It has declined by 67 percent from the peak today (from roughly $450 to about $126).

GameStop Intraday Chart

gamestop intraday chart

Source: Bloomberg

I'll have more on this as developments continue.


To learn more about suitability and fiduciary expert Jack Duval, click here.


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Topics: FINRA, securities litigation, Bantam Inc., GameStop, Trading Restrictions, Trading Halt

The Firm of Wal and Mart: When you're not betting the company

Posted by Jack Duval

Oct 16, 2020 2:34:59 PM

Most of you know about my RIA firm, Bantam Inc.

I just published a post on The Bantam Blog that I thought you would find of interest.  It's about the implications of nonlawyer ownership of law firms (which is already here and will be in every state in a few years).

If you're interested in that content, please sign up for The Bantam Blog, because I won't be posting them here as well.


To learn more about suitability and fiduciary expert Jack Duval, click here.


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Topics: Bantam Inc.

Dear "Prudent": The DOL Proposal

Posted by Jack Duval

Sep 24, 2020 8:56:32 AM

NOTE: Since the DOL Fiduciary Rule has been dead for two years, I have provided a review of events since then, primarily focused on Regulation Best Interests and the new DOL proposed class exemption.

If you are familiar with those, skip to the “Prudence - and the Prudent Expert” section for the good stuff.


SEC Regulation Best Interest ("RBI") went into effect on June 29, 2020. I've written extensively about RBI and the implications for broker-dealer obligations to clients and won’t cover that here.

Instead, I want to focus on the Department of Labor (“DOL”) proposed class exemption (“DOL Proposal”) that was also released on June 29, 2020.

While much ink has been spilled on RBI and its implementation, on the same day it went into effect the Department of Labor released a proposed update to the Employee Retirement Income Security Act of 1974 ("ERISA").[1]

The DOL Proposal has received much less focus. It shouldn't have. This potential change to ERISA could make almost anyone advising on IRA rollovers, and their investments, a fiduciary.

Indeed, the release appears to be a Trojan horse for the broker-dealer community. It allows for a host of prohibited transactions (welcomed), but will hold those making the recommendations to the prudent expert standard, the highest fiduciary standard in the land (most unwelcomed).

As will be discussed below, many of those criticizing the DOL release, including the Public Investors Advocate Bar Association (“PIABA”)[2] and the State of California Attorney General,[3] (who is leading a coalition to oppose the DOL proposal), appear to have not understood the entirety of the DOL's proposal, or at least not fully understood its terms.


Before reviewing the DOL Proposal, it is helpful to review a quick timeline of how we got here. Additionally, you can access all my writings on the original DOL Fiduciary Rule here.

In 2010, the DOL began work to clarify that anyone advising on IRA rollovers and their assets was subject to ERISA and thus a fiduciary. Six years later, in 2016, the DOL published its final Fiduciary Rule.

The Fiduciary Rule was vigorously opposed by the broker-dealer community, which sued and won a Fifth Circuit Court of Appeals ruling in 2018. This vacated the Fiduciary Rule.

In the mean time, the SEC undertook to create a heightened standard of care for investment professionals dealing with retail clients, Regulation Best Interest (“RBI”). In 2019 it finalized RBI, which requires a neither-fish-nor-fowl "best interest" standard that lies between the FINRA suitability standard and the Investment Advisor fiduciary standard. (Notably, the SEC could not find the spine to define what "best interest" actually means.)

In June, the DOL quietly proposed changes to ERISA that would provide exemptions from prohibited transactions, and also significantly clarified the "five-part test" for fiduciary status. There was a short one-month comment period that has now come and gone.

The DOL Proposal

The DOL Proposal provides prohibited transaction exemptions for IRA rollover accounts:[4] 

This exemption permits Financial Institutions and Investment Professionals who provide fiduciary investment advice to Retirement Investors to receive otherwise prohibited compensation and engage in riskless principal transactions and certain other principal transactions (Covered Principal Transactions) as described below.


This exemption permits Financial Institutions and Investment Professionals, and their affiliates and related entities, to engage in the following transactions, including as part of a rollover for a Plan to an IRA as defined in Code section 4975(e)(1)(B)... (Emphasis added)

IRA accounts are significant because roughly 40 percent of U.S. household assets are held in them. According to IRS data, at year-end 2017, there were $9.4 trillion in IRA assets for 60.3 million taxpayers.[5] Furthermore, rollovers are a significant source of new funds for brokers and investment advisors. In 2017, there were 4.7 million rollovers totaling $478 billion in assets.[6]

These trends will almost certainly accelerate as increasing numbers of Baby Boomers retire and roll over their pensions, which were the dominant saving vehicle at the beginning and middle of their careers, and 401(k) accounts, which became popular in the later part of their careers.

Importantly, the DOL proposal also reverses a key 2005 ruling, and now requires the advising broker to satisfy the Impartial Conduct Standards and other conditions.

Reversing Advisory Opinion 2005-32A the "Deseret Letter”

The DOL has specifically put rollovers into fiduciary play by reversing a 2005 ruling known as the “Deseret Letter”, writing:[7] 

In light of potential conflicts of interest related to rollovers from Plans to IRAs, ERISA and the Code prohibit an investment advice fiduciary from receiving fees resulting from investment advice to Plan participants to roll over assets from a Plan to an IRA, unless an exemption applies. The proposed exemption would provide relief, as needed, for this prohibited transaction, if the Financial Institution and Investment Professional provide investment advice that satisfies the Impartial Conduct Standards and they comply with the other applicable conditions discussed below. (Emphasis added)


In particular, the Financial Institution would be required to document the reasons that the advice to roll over was in the Retirement Investor's best interest. In addition, investment advice fiduciaries under Title I of ERISA would remain subject to the fiduciary duties imposed by section 404 of that statute.


In determining the fiduciary status of an investment advice provider in this context, the Department does not intend to apply the analysis in Advisory Opinion 2005-23A (the Deseret Letter), which suggested that advice to roll assets out of a Plan did not generally constitute investment advice. The Department believes that the analysis in the Deseret Letter was incorrect and that advice to take a distribution of assets from an ERISA-covered Plan is actually advice to sell, withdraw, or transfer investment assets currently held in the Plan. A recommendation to roll assets out of a Plan is necessarily a recommendation to liquidate or transfer the Plan's property interest in the affected assets, the participant's associated property interest in the Plan investments, and the fiduciary oversight structure that applies to the assets. (Emphasis added)


Typically the assets, fees, asset management structure, investment options, and investment service options all change with the decision to roll money out of the Plan. Accordingly, the better view is that a recommendation to roll assets out of a Plan is advice with respect to moneys or other property of the Plan. Moreover, a distribution recommendation commonly involves either advice to change specific investments in the Plan or to change fees and services directly affecting the return on those investments. (Emphasis added)

The last part of this is in agreement with SEC and FINRA guidance, which note that a rollover almost always involves a securities transaction. Under RBI the SEC has written:[8] 

… it is our view that Regulation Best Interest should apply broadly to recommendations of securities transactions and investment strategies involving securities. Accordingly, the Commission is including in the rule text account recommendations as recommendations that will be covered by Regulation Best (sic). “Account recommendations” include recommendations of securities account types generally (e.g., to open an IRA or other brokerage account), as well as recommendation to roll over or transfer assets from one type of account to another (e.g., a workplace retirement plan account to an IRA). (Emphasis added)

Similarly, FINRA has put its members on notice that:[9] 

a broker-dealer’s recommendation that an investor roll over retirement plan assets to an IRA typically involves securities recommendations subject to FINRA rules.

Critically, the IRA rollover recommendations and subsequent investment recommendations would enjoy the exemptions from prohibited transactions only if the broker (and broker-dealer) met the Impartial Conduct Standards.

The importance of this language cannot be overstated.

The Impartial Conduct Standards

The DOL proposal would require broker compliance with the Impartial Conduct Standards, which have three components:[10] 

  • Providing advice that is in Retirement Investors’ best interest;
  • Charging only reasonable compensation, and;
  • Making no materially misleading statements about the investment transaction and other relevant matters.

Furthermore, the DOL proposal would require:[11] 

Financial Institutions, prior to engaging in a transaction pursuant to the exemption, to provide a written disclosure to the Retirement Investor acknowledging that the Financial Institution and its Investment Professionals are fiduciaries under ERISA and the CODE, as applicable.


The disclosure also would be required to provide a written description, accurate in all material respects regarding the services to be provided and the Financial Institution’s and Investment Professional’s material conflicts of interest. (Emphasis added)

Critics of the DOL proposal have taken aim at the best interest element of the Impartial Conduct Standards. For instance, PIABA, in its comment letter, wrote:[12] 

The first prong of the Impartial Conduct Standards, the best interest obligation, is to be interpreted and applied consistent with the best interest standard as defined by the Commission’s recently enacted Reg. BI.

While PIABA quote the DOL Proposal accurately, the spirit of the DOL Proposal reflects stronger medicine:[13] 

This proposed best interest standard is based on longstanding concepts derived from ERISA and the high fiduciary standards developed under the common law of trusts, and is intended to comprise objective standards of care and undivided loyalty, consistent with the requirements of ERISA section 404. (Emphasis added)

This DOL Proposal language echoes the language propounded in the Impartial Conduct Standard in the proposed Best Interest Contract Exemption on April 8, 2016. At the time, the DOL wrote: 

(the Impartial Conduct Standards) are fundamental obligations of fair dealing and fiduciary conduct, and include obligations to act in the customer’s best interests, avoid misleading statements, and receive no more than reasonable compensation.[14]


The Impartial Conduct Standards represent fundamental obligations of fair dealing and fiduciary conduct. The concepts of prudence, undivided loyalty and reasonable compensation are all deeply rooted in ERISA and the common law of agency and trusts.[15] (Emphasis added) 

Prudence - and the Prudent Expert


“Prudence” is a word that appears throughout ERISA and the DOL Proposal. However, it was assiduously removed from the originally proposed RBI and did not make the final rule.[16] It’s appearance in the DOL Proposal provides an important distinction between RBI and ERISA.

Critically, the DOL’s version of fiduciary conduct contained within the Impartial Conduct Standards is the prudent expert standard, the absolute highest fiduciary standard in the land.

ERISA Section 404(a)-1 Investment duties, lays out the prudent expert standard:[17] 

… a fiduciary shall discharge his duties with respect to a plan with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims. (Emphasis added)

The DOL Proposal reiterates the prudent expert standard language, essentially verbatim from ERISA Section 404(a)-1:[18] 

Investment advice is, at the time it is provided, in the Best Interest of the Retirement Investor. As defined in Section V(a), such advice reflects the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person, acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor, and does not place the financial or other interests of the Investment Professional, Financial Institution or any affiliate, related entity, or other party ahead of the interest of the Retirement Investor, or subordinate the Retirement Investor’s interest to their own. (Emphasis added)

After the 2016 DOL Fiduciary Rule was vacated by the Fifth Circuit, the DOL issued Field Assistance Bulletin (“Bulletin”) No. 2018-02 that kept the Impartial Conduct Standards in effect. The current DOL Proposal describes the Bulletin guidance:[19] 

In the FAB, the Department stated it would not pursue prohibited transactions claims against investment advice fiduciaries who worked diligently and in good faith to comply with “Impartial Conduct Standards” for transactions that would have been exempted in the new exemptions, or treat the fiduciaries as violating the applicable prohibited transaction rules. (Emphasis added)

The Impartial Conduct Standards discussed in the Bulletin were originally articulated in the Best Interest Contract Exemption proposal, the language of which will by now be familiar:[20] 

As defined in the (Best Interest Contract) exemption, a Financial Institution and Adviser act in the Best Interest of a Retirement Investor when they provide investment advice that reflects the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor, without regard to the financial or other interests of the Adviser, Financial Institution or any Affiliate, Related Entity, or other party.” (Emphasis added)

Thus, the Impartial Conduct Standards from the now-vacated Fiduciary Rule/Best Interest Contract Exemption have been in effect under the May 7, 2018 DOL temporary enforcement policy, and would remain in effect under the DOL Proposal.

The point of tracing this language back to the original ERISA text is to show the continuity of the prudent expert standard. It has not changed. From ERISA Section 404(a)-1, to the Fiduciary Rule/Best Interest Contract Exemption, to the Bulletin, to the new DOL Proposal, the prudent expert standard has remained intact.

Shifting the Burden of Proof

PIABA and others were correct to flag the adoption of the RBI version of “best interest” in the DOL Proposal. PIABA summarized it well:[21] 

None of the foregoing obligations actually requires the firm to place the customer’s interests ahead of the adviser’s. Instead, Reg BI states that the advisor cannot “place its own interests ahead of the customers’ interests. Consequently, Reg BI allows the adviser to put its own interests on equal footing with the customers’ interests. In baseball terms, a tie goes to the adviser. This is contrary to the fundamental premise of a fiduciary duty: that the investors’ interests must always come first. Similarly, the Department has said that the Impartial Conduct Standard will only require that the Investment Advice Fiduciary may not place their interests ahead of the retirement investors’ interests. (Emphasis added)

There is no doubt that the RBI “best interest” language is less rigorous than the fundamental fiduciary duty that the client’s interests must always come first, which has always existed under ERISA and the Investment Advisors Act. There are no “ties” of interest with the traditional fiduciary duty, the client’s interests win every time.

However, I believe PIABA (and the other critics) have missed the significance of the prudent expert standard, which imposes an even more rigorous standard by:

  1. Holding the advice to the standard of what a third-party expert fiduciary would do in the same circumstances, and;
  2. Without regard to their own financial interests.

These elements of the prudent expert standard raise the bar exceedingly high, much higher than the suitability standard, higher than RBI (which has a version of the prudent expert standard) and arguably higher than even the fiduciary standard of an investment advisor.

Chart 1: The Shrinking Universe of Investment Options

 accelerant jack duval - dol proposal - prudent expert - investment strategy chart

Chart 1, above, shows how the available investment options shrink under successively more exacting standards, with the prudent expert standard being the most rigorous.

Where PIABA is worried that the DOL Proposal allows for the interests of the advisor and client to be pari passu, that potential fails under the prudent expert standard.

No prudent expert, giving advice without regard to their own financial interests, would recommend an investment or investment strategy that put their own interests equal with their clients. This is simply due to the simple math of compensation: all broker compensation comes at the expense of the client.

The Defense Will Have to Make Its Case

In the typical lawsuit, the plaintiff is required to prove their case against a standard. That will change under the DOL Proposal.

At a hearing, a defendant fiduciary will have to prove they met the prudent expert standard, including:

  • Proving the contemporaneous application of care, skill, prudence, and diligence that a prudent expert would have undertaken in a similar situation for a similar client, and;
  • Proving that the recommendations made were consistent with what a prudent expert would have made without regard to their own remuneration.

This is a completely different context than what has existed for broker-dealer clients under the suitability standard, more rigorous that what exists under RBI, and possibly more rigorous that what exists under the Advisers Act.

Changing the Arbiter

Under FINRA’s Suitability Rule 2111, the standard of care is that the broker must have a reasonable basis to believe the recommendation made was suitable for the client. The rule is from the perspective of the broker. Under this rule, the broker is the arbiter of the reasonableness of the recommendation.

Under the DOL Proposal, the rule is from the perspective of an impartial prudent expert observer. That third-party prudent expert is the arbiter of whether skill, care, prudence, and diligence were applied in the making the recommendation.

This shift is enormous. The arbiter is no longer the broker but an expert fiduciary. The standard is not determined by the broker but by the expert fiduciary. The standard is no longer subjective, but objective.

Even more stark is that “reasonableness” is an opinion. It requires no evidence. In contrast, the application of skill, care, prudence, and diligence is objective and requires contemporaneous evidence. (A broker can claim to have come to an opinion about reasonableness with nothing in her files, however, she cannot credibly claim to have applied skill, care, prudence, and diligence in the manner of a prudent expert with an empty file.)

Additionally, how thorough the work was undertaken is objective and the conclusions drawn from that work can be easily weighed.

In most securities litigations I’ve been involved with, the defense has been something like this: the client wanted growth and the broker gave them growth investments, therefore they were suitable. This argument was made with a straight face no matter how expensive, illiquid, speculative, and tax-inefficient the “growth” investment was.

Under the FINRA Suitability Rule, virtually any vaguely plausible investment and/or investment strategy could be argued to be “suitable”, although those arguments frequently failed in arbitrations and in SRO disciplinary proceedings.[22]

Under the DOL Proposal they will be per se deficient.

The burden of proof will shift from the client having to prove that the investments recommended to her were unsuitable, to the broker having to prove that she undertook the required care, skill, prudence, and diligence, and after that work determined the investments recommended were in the client’s best interest. Even more daunting, the broker will have to prove that a prudent investment expert, acting without concern for her own remuneration, would have made the same recommendation, in the same situation, for the same client.

In my experience, the vast majority of “vaguely plausible” investment defenses will wither in the face of the prudent expert standard. Fiduciary defendants will not be able to demonstrate the contemporaneous “care, skill, prudence, and diligence” required to have met the standard, nor will they be able to show their recommendations would have been the same if they had been advising without regard to their own compensation.

Indeed, in the majority of cases I have participated in, brokers typically have very few notes and no evidence of any care, skill, prudence, and diligence being applied to their investment recommendations. Frequently, there is absolutely nothing in the record except the trade confirmation, sent to the client after the trade.

This fact pattern will epically fail the prudent expert standard.

Additionally, accounts that get loaded with multiple “product of the month” type of investments, including (but not limited to): new issues such as closed-end funds, as well as structured products, high fee and high load mutual funds, and insurance products will also fail to meet the prudent expert standard.

In almost all instances the investment thesis behind any high-fee and/or illiquid products can be expressed in low (or no) fee products and/or by shifting the asset allocation of an account.

While brokers are certainly entitled to reasonable compensation, the prudent expert standard shifts the arbiter from the profit maximizing broker to an impartial prudent expert fiduciary deciding without regard to her own remuneration.

These standards are worlds apart.

Once the rigor of the prudent expert standard is established, I would expect IRA-related securities litigations to settle, and for higher percentages of claimed damages.

I would also expect this to further accelerate the shift away from charging commissions on products to fee-based accounts where no product commissions are charged. The later generally eliminate the conflicts of interest inherent to commission-based broker compensation and greatly reduce the required supervisory effort.

Supervisory Impacts

To meet the prudent expert standard, broker-dealers will need to create policies and procedures to ensure that their brokers are undertaking and documenting the necessary care, skill, prudence, and diligence for each recommendation.

While this will require more oversight, the costs should not be large. In my experience of reviewing the compliance and supervisory systems of broker-dealers of all sizes and geographies, even the smallest firms have the supervisory, CRM, and other systems in place to implement the required policies.

While the capital expenditure required will likely be small, the supervisory effort will be larger.

As always, the real issue with broker-dealer policies and procedures is not their existence (every broker-dealer has them, and all but a few are sufficient), but their implementation.

In my next post, I will examine the DOL’s clarification of the five-part test to determine fiduciary status and how it will make almost all brokers fiduciaries when recommending rollovers and the reinvestment of the proceeds.



[1]      29 CFR Part 2550 [Application No. D-12011] ZRIN 1210-ZA29; Improving Investment Advice for Workers & Retirees. Available at :; Accessed August 14, 2020.

[2]      Public Investors Advocate Bar Association; Comments Letter RE: Application No. D-12011. Available at:; Accessed August 21, 2020.

[3]      Attorney General Becerra Opposes DOL Proposal; August 6, 2020. Available at:; Accessed August 21, 2020.

[4]      29 CFR Part 2550 at 40862.

[5]      IRS; SOI Tax Stats – Accumulation and Distribution of Individual Retirement Arrangements (IRA); Available at:; Accessed August 21, 2020.

[6]       Id.

[7]      29 CRF Part 2550 at 40839.

[8]       Federal Register; 17 CFR Part 240; Release No. 34-86031; Regulation Best Interest; 33339. Available at:; Accessed August 21, 2020.

[9]       FINRA Regulatory Notice 13-45; Rollovers to Individual Retirement Accounts; December 2013; 2. Available at:; Accessed August 21, 2020.

[10]     29 CFR Part 2550 at 40842.

[11]     Id.

[12]     PIABA Letter at 6. XXX

[13]     29 CFR Part 2550 at 40842.

[14]      29 CFR Part 2550; [Application No. D-11712]; ZRIN 1210-ZA25; Best Interest Contract Exemption; 21007. Available at:; Accessed August 21, 2020.

[15]      Id. at 21026.

[16]      17 CFR Part 240; Release No. 34-86031; Regulation Best Interest: The Broker-Dealer Standard of Conduct; 247. “… in response to comments, we are revising the Care Obligation to remove the term “prudence”.

[17]      29 CFR Section 2550.404a-1 – Investment duties. Available at:,like%20capacity%20and%20familiar%20with; Accessed September 9, 2020.

[18]      29 CFR Part 2550 at 40862.

[19]      29 CRF Part 2550 at 40835.

[20]      Id.

[21]      PIABA Letter at 8.

[22]      See, for instance, FINRA RN 12-25 – Suitability; Acting in a Customer’s Best Interest. This Regulatory Notice, gives six examples of fact patterns where FINRA and SEC regulators have found investments and/or investment strategies that might have been “vaguely plausible” to have not met the suitability standard if they were not consistent with the customer’s best interests. Available at:; Accessed September 24, 2020.

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Topics: Investment Suitability, dol fiduciary rule, prudent expert standard, fiduciary duties, SEC Regulation Best Interest

Coronavirus Cases

Posted by Jack Duval

Mar 24, 2020 9:23:37 AM

This is the first post in a series on the securities litigation likely to arise from the recent market declines.

Since the Global Financial Crisis ("GFC") in 2008-9, the Federal Reserve has keep interest rates at extremely low levels.

Indeed, at the end of 2007, the yield on the 10-year U.S. Treasury note was 4.0232 percent and at the end of 2011 it was 1.8762 percent.[1]  As I write this, it is at 0.69 percent.[2]

This has lead brokers and advisors to “reach for yield" for their investors.  Of course, they were able to grasp it, primarily by reducing high quality equity and fixed income investments and increasing:

  • Equity allocations;
  • Equity “bond proxy” allocations, and;
  • Low-quality fixed income allocations.

Over time, these combined shifts have led to an increasing amount of risk in investor's portfolios, even if the equity allocation did not increase (or even decreased).  Indeed, many investors have seen their portfolios become predominately equity exposed, greatly increasing their risk.  Table 1, below offers a comparison.

Table 1:  Typical Pre- and Post-GFC Portfolio Composition


Typical Pre- and Post-GFC Portfolio Composition

Table 1, above, compares typical investor portfolios from the pre- and post-GFC periods.  The yellow banded rows highlight investments with equity or equity-like exposure (even if they are bonds).

The pre-GFC portfolio has a 55/35/10 (stocks/bonds/cash) asset allocation, and is heavily skewed to quality on both the equity and fixed income sides.  The post-GFC portfolio has a 65/30/5 asset allocation, but has added 15 percent of equity “bond proxies” and lower quality fixed income.  (Equity bond proxies include equity investments such as traditional infrastructure, utilities, REITs, MLPs, and other higher yielding equities.)

Importantly, the direct equity exposure only increased from 55 to 65 percent, however, the total equity and equity-like investments increased from 60 to 85 percent.  From a risk perspective, the post-GFC portfolio is 85 percent in equities.

This is a significant increase.  And a bad trade.

In the 10-year rolling periods from January 2001 through June 2018, a traditional 60/40 portfolio returned an average annual 6.56 percent, whereas an 85/15 portfolio returned an average annual 7.13 percent, or 57 basis points higher.[3]

However, the increase in risk is dramatic.  Over the same period, the 60/40 portfolio had a standard deviation of 9.19 percent compared to 12.84 for an 85/15 portfolio.[4]

In percentage change terms, by shifting the equity (and equity-like) allocation from 60 to 85 percent, an investor gets an approximate nine percent increase in expected return, but a 40 percent increase in expected risk.  This is what made it a bad trade.

Worse still is the max drawdown risk of the two portfolios.  The 85/15 portfolio has significantly more drawdown risk.  Those risks are now being felt as the typical post-GFC portfolio proves to be much more highly correlated (i.e. where almost all the assets decline simultaneously) than most investors thought.

Hidden Fixed Income Risks

The litigations arising from the recent declines will likely have a common theme that was not present in those arising in post-GFC litigations:  hidden risks in investor’s fixed income investments.  All the risky fixed income investments that investors have been put into as part of the reach for yield are declining similar to equities, and in some cases more than equities.

These risky fixed income investments include those investing in the following underlying investments and/or strategies:[5]

  • Corporate bonds (which were typically around 50 percent in BBB rated bonds);
  • High yield “junk” bonds;
  • High yield municipal bonds;
  • Leveraged closed-end funds;
  • Convertible bonds;
  • Preferred stocks (almost all preferred stocks are issued through trusts which buy a note from the issuer and then sell interests in the trust);
  • Commercial mortgages;
  • Asset-backed securities;
  • Leveraged loans;
  • Collateralized loan obligations, and;
  • Emerging market bonds;

Table 2:  Bottom Decile One-Month Fixed-Income Mutual Fund Returns through March 20, 2020[6]

Bottom Decile one-month fixed-income mutual fund returns

The full list can be downloaded here.

Table 2, above, shows that the fixed income funds with the worst one-month performance through March 20, 2020, also generally had high, double-digit total returns in 2019.  These funds have fallen in-line with the S&P 500, which was down about 29 percent over the same period.

When reaching for yield, the handhold is risk.  The 2019 returns were the yield part, the previous months performance is the risk part.

In my experience, when bonds decline like equities, litigation ensues.

In subsequent posts, I will examine other aspects of increased risk-taking over the past 11 years.




[1]      Source: Bloomberg.

[2]      Id.

[3]      Goldman Sachs; Diversified Investment Allocation Tool.  Available at:;  Accessed March 20, 2020.  Dataset is the 91 10-year rolling periods from January 01, 2001 to June 30, 2018.

[4]      Id.

[5]      This list is by no means exhaustive.  All kinds of risky fixed income products have been invented over the past 11 years.

[6]      Source: Bloomberg.  Performance data for U.S. domiciled fixed income mutual funds with $500 million or more in assets, through March 20, 2020.


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Topics: collateralized loan obligations, securities litigation, fixed income, Investment Suitability, commercial mortgages, CLO

Lost Gains Cases: The Broker Appropriation Fact Pattern

Posted by Jack Duval

Mar 6, 2020 6:59:31 AM

This post is the second in a series exploring Lost Gains securities arbitration cases.

In my previous post, I defined “Lost Gains” cases as those where the claimant has no investment loss and possibly even a small gain, but has not participated in the upside that was available in the market.

I identified two common fact patterns in those cases:[1]

  • Broker appropriation of investment gains, and;
  • Failure to follow instructions.

Here I will examine the broker appropriation fact pattern.

Broker Appropriation of Investment Gains

Broker appropriation of investment gains is the most common type of Lost Gains case, and I have been involved in a number of these.

In my experience, broker appropriation cases have a typical fact pattern involving a client who has, or should have, a long-term buy-and-hold approach to investing.  This is the vast majority of clients, since most clients don’t have the time or inclination to follow the markets closely, and (as will be discussed below) want to avoid short-term capital gains and the accompanying taxes.

The second part of the typical broker appropriation fact pattern is the purchase of high commission investment products such as: new issue closed-end funds, preferred stocks, UIT's, and other products with high up-front commissions, and their subsequent sale after a short period.  This purchase-and-sale pattern is repeated with the client’s cash (from securities sales) serving as an evergreen source of funds.

This behavior is a form of churning, but is not as obvious as the rapid fire buying and selling of stocks to generate commissions.

The difference is that the commissions are hidden inside the purchase price of the newly issued securities, so the client does not see them.  In theory, the client could discover these hidden commissions if she read the prospectus for each product that was sold to her.  In my experience, almost no client reads prospectuses, or if they do, they give up after reading one and never venture back, especially when they receive multiple prospectuses every month.

I’ve written about this as it relates to Complexity Risk, and how clients are highly unlikely to understand the language in a prospectus, even if they do read it.  Indeed, often the brokers selling complex investments don’t understand them.

Importantly, FINRA has been crystal clear that delivery of a prospectus does not cure an otherwise unsuitable recommendation and that there can be no disclaiming of any responsibilities under the suitability rule (by prospectus delivery or any other method).[2]

Multiple Fee Layers

In broker appropriation cases it is also not uncommon to see multiple fee layers.  That is, there will often be three discrete charges assessed against the client, including:

  • Commissions charged on the investment product(s) upon sale to the client (1 to 7 percent);
  • Annual internal management fees inside the product(s) sold (1 to 3 percent), and;
  • Annual account asset-based fees on the same assets (1 to 2 percent).

This “triple dipping” is especially pernicious.  Furthermore, it is, in my experience, never explicitly disclosed to the client.

In aggregate, these commissions, internal fees, and account asset-based fees can easily add up to three to seven percent (or more) of an account’s assets each year.

When this is the case, the abusive nature of the investment strategy becomes clear.[3]

Dividing (Potential) Gains

An example is instructive.  Assume a long-term oriented client has a 60/30/10 (stocks/bonds/cash) asset allocation and the expected returns are 10 percent for the stocks, three percent for the bonds, and one percent for the cash.  The blended expected return for the portfolio is thus seven percent.

If the aggregate annual commissions and fees are even three percent, they will consume 43 percent of the expected return, over time.

One way to think about this is that the client takes 100 percent of the risk, but will only get 57 percent of the return.  Of course, no one would knowingly accept such a strategy, and it cannot be said to be suitable.


Another issue in broker appropriation cases is the tax implications of short investment holding periods.  Short-term capital gains are taxed at the investor’s ordinary income rate.  For most investors, this rate is at or close to 40 percent (combining federal, state, and local taxes).[4]

Thus, the various government entities take 40 percent of these gains, despite (like the broker) taking none of the risk.  In the business, this is known as a bad trade.  While there can be instances where taking a short-term gain is the appropriate action, it should not be the norm for a long-term investor.

Going back to our seven percent blended return example, if the broker is taking three percent off the top through fees and commissions, and short-term capital gains taxes are consuming 40 percent of the remaining four percent gain, that leaves only 2.4 percent for the investor on a net, after-tax basis.

This 2.4 percent net, after-tax, return is roughly 34 percent of the original seven percent gross return.  A long-term investment strategy which can be reasonably expected to leave only 34 percent of potential returns for the client is abusive and cannot be said to be suitable.

In my next post, I will examine the failure to follow instructions fact pattern in Lost Gains cases.



[1]      Lost Gains Securities Arbitration Cases; Jack Duval; February 26, 2020.  Available at:; Accessed March 4, 2020.

[2]      See “Understanding FINRA Suitability Rule 2111 – Prospectus Delivery and Suitability”; Jack Duval; December 19, 2013.  Available at:;  Accessed February 18, 2020.

[3]      It is important to remember that under FINRA Rule 2111, an investment strategy recommended to a client must be suitable.  If the costs of a strategy will consume the lion’s share of the expected returns, then that strategy cannot be said to be suitable.

[4]      For instance, the 2020 federal short-term capital gains tax rate is 37 percent for a married couple, filing jointly, with over $622,051 in income.  Of course, state and local taxes would be added to this.  See “Capital Gains Tax Brackets 2019 and 2020:  What They are and Rates; Robert Farrington; The College Investor; March 1, 2020.  Available at:; Accessed March 4, 2020.

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Topics: Investment Suitability, Lost Gains Cases

Lost Gains Securities Arbitration Cases

Posted by Jack Duval

Feb 26, 2020 9:15:30 AM

This post begins a series exploring Lost Gains securities arbitration cases.

A record eleven-year (and nearly uninterrupted) bull market has caused a decline in the number of FINRA securities arbitration claims.  In short, very few investors have lost money during this period.  Indeed, on a calendar year-end basis, the worst annual decline in the S&P 500 price index has been 6.25 percent, in 2018, and this would be even less if dividends were included.

Chart 1:  S&P 500 v. FINRA Annual Arbitration Claims[1]

jack duval accelerant finra suitability fiduciary expert - S&P 500 v. Arbitration Claims chart

In Chart 1, above, it can be seen that since the end of 2008, the S&P 500 price index (green line) has increased by 258 percent and the number of FINRA arbitration claims (red line) has decreased by 47 percent.  These trends are certainly well known to securities litigators.

After this record-setting bull market, one would suspect there would be some FINRA arbitration cases arising from customer accounts that did not appreciate, i.e. that the client lost out on the gains that were to be had.  However, these claims have not been prevalent.[2]

In this post, I will explore some reasons why Lost Gains cases are not more common, as well as the common types of Lost Gains cases that I have seen brought.

First, I need to make a distinction, most claimant’s attorneys make lost gains claims, but tend not to bring lost gains cases.

Lost Gains Claims

In a typical FINRA customer arbitration, the brokerage client has lost money in her account.  The claimant will usually plead damages from the principal (out-of-pocket) loss and what the account would have made if it had been invested suitably, this is known as the market-adjusted damage (“M-AD”).

The M-AD damage is a lost gain claim.  In essence, the claimant is saying, but for the unsuitable recommendations of the broker, her principal would, first, not have declined, and second, it would have appreciated.

Lost Gains Cases

Lost gains cases are different from lost gains claims because, in them, the claimant did not lose money on her investmentd.  That is, the account was profitable (or flat) over the period at issue.

Thus when a lost gains case if brought, it only contains the lost gain damage claim, there is no out-of-pocket loss claim.

Reticence to Bring Lost Gains Cases

I believe attorneys are reluctant to bring Lost Gains cases for a number of reasons, including the following:

First, the claimants are perceived to be unsympathetic.  They either didn't lose money or actually made money, just not as much as they could have but for the allegedly unsuitable investment recommendations or other violative behavior by the broker.

Second, because there are no out-of-pocket losses, the damage claim rests entirely upon the market-adjusted damages theory.  While panels frequently award market-adjusted damages, they are less common than awards of out-of-pocket losses.

Third, since Lost Gains cases are perceived to have the headwinds described above, they are typically only brought for large clients who can make seven- or eight-digit damage claims.  Since fewer investors have accounts large enough to support such claims (likely $10 million or more), this necessarily reduces the number of potential claims.

Despite these issues, lost gains cases are brought, and can be won.

Two Common Fact Patterns in Lost Gains Cases

Although there are many fact patterns that could give rise to a Lost Gains case, I want to discuss two types that I have had experience with.  Importantly, they both involve abusive behavior and are not of the sour grapes variety, i.e. where the market was up 20 percent and the client was only up 17.

Those types are:

  • Where the broker appropriates the investment gains for herself through abusive commissions and/or fee structures, (“broker appropriation”), and;
  • The failure of the broker to follow client instructions (“failure to follow”).

In my next post, I will explore these fact patterns in more detail.



[1]      Data obtained from Bloomberg and FINRA.

[2]      This is anecdotal as FINRA arbitration statistics do not track Lost Gains claims.  To get a sense of these case filings, I have surveyed a number of securities litigators across the country.


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Topics: Investment Suitability, Lost Gains Cases

The Decline of FINRA Membership and the Litigation Implications

Posted by Jack Duval

Feb 7, 2020 8:52:25 AM

In the six years ending in 2018, the number of broker-dealers ("BDs") shrank by 13.5 percent.  Over the same period, the number of SEC Registered Investment Advisor ("RIA") firms increased by 19.7 percent.[1]

Chart 1: FINRA Broker-Dealer and SEC Registered Investment Advisor Firms[2]

FINRA Broker-Dealer and SEC Registered Investment Advisory Firms - Fiduciary Duties

I expect these trends to continue, if not accelerate.

Firms and/or brokers shifting from BDs to RIAs reflect the trends in the market and what business models are sustainable.  The business model based on generating commissions from transactions in customer accounts is losing to the business model of asset management fees based on the amount of assets in the client's account.  This trend has been in place for well over a decade.

At the same time, both of these business models are under attack by the index investing trend.  However, the RIA model is less subject to declines from indexing because an RIA firm can charge the same fees whether it invests in index funds or actively management funds.

Indeed, many RIA firms are disintermediating asset managers by using index ETFs that the RIA selects.

Something that is hidden in the data in Chart 1, above, is that most BDs are dually registered (meaning they are also RIA firms) so they are acting as fiduciaries for a significant percentage of clients.  This, as will be examined below, is showing up in FINRA arbitration statistics, and has important implications for securities litigations, in-house counsel, and compliance and supervisory implementation.

Changing Trends in Securities Litigation

The decline in the number of broker dealers and the increase in the number of RIA firms would suggest that securities arbitrations will shift from being primarily suitability driven to being primarily fiduciary duty driven.

The shift from BDs to RIAs will also entail a shift in securities arbitrations from being overwhelmingly heard in FINRA forums to those of AAA, JAMS, and other forums.

This will have a number of impacts on attorneys and their clients.

Obviously, the fiduciary standard is much higher than the suitability standard.  (I have written about fiduciary duties extensively here.)  This will benefit claimants and make respondent's cases harder to defend.

For respondents, one offsetting factor could be the fact that BD cases with breach of fiduciary duty claims will be heard in FINRA forums.  FINRA arbitrators who have years of experience hearing suitability claims may not fully appreciate the difference between the suitability and fiduciary standards, even when it is explained to them.

If the cases are in AAA or JAMS forums, the costs will almost certainly be higher than at FINRA.  This comparatively higher cost may be well worth it for claimants (not that they have a choice in most instances) because many AAA and JAMS arbitrators are former judges (and if not, almost always attorneys) who are well versed in the weight and import of fiduciary duties.

Trends in FINRA Arbitration Claim Types

FINRA publishes statistics on arbitration case filings and has broken out customer case filings (that is, excluding cases between member firms) since 2013.

The trends in types of controversy are indicative of the falling number of BDs and rising number of RIA firms and RIA services provided by dually registered BDs.

Table 1:  FINRA Arbitration Claims by Type of Controversy[3]

FINRA Breach of Fiduciary Duty Table

Table 1, above, shows that Breach of Fiduciary Duty claims now comprise 86.9 percent of all customer cases filed, up from 75.9 percent in 2013.  Suitability claims have risen even more, to 66.9 percent in 2019 up from 52 percent in 2013.[4] 

Importantly, these types of claims are not exclusive of one another, and in my experience, almost all Breach of Fiduciary Duty claims will also have a Suitability claim attached.

Trends in FINRA Arbitration Resolutions

It would appear that the increasing number of Breach of Fiduciary Duty claims (and the higher hurdle to defending them) is showing up in FINRA arbitration settlements.

Table 2:  FINRA Arbitration Case Settlements[5]

FINRA Arbitration Settlements Table - Fiduciary Duties

Indeed, in 2019 69.4 percent of arbitrations settled, up from 58.9 percent in 2013.[6]

The correlation between the 17.8 percent rise in settlements and the 14.5 percent rise in Breach of Fiduciary Duty Claims over the same period can be seen clearly in Chart 2, below.

Chart 2:  FINRA Breach of Fiduciary Duty Claims and Case Settlements[7]

FINRA Breach of Fiduciary Duty claims and Case Settlements chart

The Long-Term Effects of a Shift from BDs to RIAs

While the number of FINRA Arbitration claims has fallen to the 3,400 to 4,000 per year range during the post-GFC bull market,[8] the types of claims have shifted, with a notable rise in Breach of Fiduciary Duty claims.

Breach of Fiduciary Duty claims must be prosecuted and defended differently than suitability cases.  As I have written about here and here, the difference is profound.  In short, the defenses to suitability claims will generally fail if a fiduciary standard is operative.


The increase of Breach of Fiduciary Duty claims and the shift from BDs to RIAs, are trends that are almost certain to continue, if not accelerate.  They require changes in all aspects of BD compliance, supervision, education and training, and business structure.  BDs doing fiduciary business must be built to do that type of business.  That structure is fundamentally different from the old BD brokerage/suitability structure.


For BDs doing an increasing amount of RIA business, being a FINRA member firm will become less and less attractive as their brokerage revenue declines and FINRA membership becomes a source of expensive regulatory oversight.


Needless to say, with Breach of Fiduciary Duty claims comprising nearly 87 percent of Customer claims, securities litigators should be honing their chops on fiduciary duty case construction and prosecution.



[1]      Investment Advisor Association; “2018 Evolution Revolution: A Profile of the Investment Adviser Profession”; 38.  Available at:;  Accessed January 30, 2020.

[2]      Id.

[3]      FINRA Dispute Resolution Statistics;  Available at:;  Accessed December 31, 2019.

[4]      Id.  I have excluded the other types of controversy for this analysis.

[5]      Id.  “Settled via Mediation” means cases settled with a FINRA mediator.  In the vast majority of instances, “Direct Settlement by Parties” involves a mediation with a third-party, non-FINRA mediator.

[6]      Id.

[7]      Id.

[8]      Id.


To learn more about fiduciary expert Jack Duval, click here.


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Topics: supervision, Investment Suitability, Securities Exchange Commission, fiduciary duties, Breach of Fiduciary Duty Claims

SEC Regulation Best Interest - FINRA RN 19-26

Posted by Jack Duval

Aug 8, 2019 8:16:52 AM


This blog post continues my series on SEC Regulation Best Interest ("RBI") and the DOL Rule.


FINRA RN 19-26 Image

Yesterday, FINRA published its first Regulatory Notice related to RBI, RN 19-26.  This Notice was relatively unremarkable and essentially set the table for further FINRA guidance on RBI.

FINRA has created a webpage of RBI content for member firms.  Of note was FINRA's hinting at future rule changes:

As with other SEC rules, FINRA will examine for and enforce compliance with Reg BI and, in doing so, FINRA will adhere to SEC guidance and interpretations. FINRA staff expects to work with SEC staff to ensure consistency in examining broker-dealers and their associated persons for compliance with Reg BI. In addition, FINRA will review FINRA rules to see whether changes are needed to align FINRA rules with the SEC’s rulemaking. Any proposed changes to FINRA rules will be filed with the SEC for public comment and available on FINRA’s website.1  (Emphasis added)

I suspect changes will be coming to FINRA Suitability Rule 2111, which I wrote about here.



1.          FINRA SEC Regulation Best Interest website.  Available at:  Accessed August 8, 2019.

To learn more about fiduciary expert Jack Duval, click here.


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Topics: supervision, Investment Suitability, Suitability Expert, Securities Exchange Commission, Regulation Best Interest, FINRA RN 19-26

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