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Divorced Customer Sues Morgan Stanley Over Bond Purchases
October 25, 2023
Apparently, an ex-wife didn't quite understand how her Morgan Stanley brokerage account generated income, profits, and losses. She asked for explanations. She questioned her investments in bonds. She questioned whether the investment strategy made sense. She complained about increasing losses. She argued that the stockbroker wrongfully failed to continue with the approach in place for her ex-husband. Following a FINRA Arbitration hearing, the arbitrator determined that any losses in the account were caused by rising interest rates and not the stockbroker's negligence.
Case in Point
In a FINRA Arbitration Statement of Claim filed in January 2023, public customer Claimant Arnot representing herself pro se asserted negligence. In the Matter of the Arbitration Between Jenny L. Arnot, Claimant, v. Daniel J. Baldwin and Morgan Stanley, Respondents (FINRA Arbitration Award 23-00152) https://www.finra.org/sites/default/files/aao_documents/23-00152.pdf
The FINRA Arbitration Award characterizes Claimant Arnot's cause of action as relating "to the purchase of various unspecified bonds." Claimant sought $45,000 in compensatory damages but reduced that demand at the hearing to $15,000.
Respondents Baldwin and Morgan Stanley generally denied the allegations, asserted affirmative defenses, and sought the expungement of the matter from Baldwin's Central Registration Depository record ("CRD").
Award
The sole FINRA Arbitrator denied Claimant Arnot's claims and granted the expungement based upon a FINRA Code of Arbitration Procedure Rule 12805 finding that the claim, allegation, or information is factually impossible or clearly erroneous. The Arbitrator offered this rationale:
Claimant asks this Arbitrator to assess up to $45,000 in damages against Baldwin under FINRA regulations for his alleged negligence in failing to advise her about the risks associated with investing in corporate bonds. She argues that Baldwin did not sufficiently advise her of the risks associated with bonds (i.e., that their value could fall due to a rise in interest rates) and that Morgan Stanley and Baldwin should therefore pay for the decline in value of her investment portfolio that has occurred since April 2021. Claimant testified at hearing that she has no other income and relies on her investments to support herself. She argues that if she had “continued with the strategy that [her ex-husband and her] followed for many years, I would not have lost that money.” Id. She further argues that “[a]ll of the risks associated with the junk bond purchases have materialized. My bond account value has fallen about $45,000 with the foreseeable rise in interest rates.” Id. Her claim for damages was further clarified by Mr. Smith at hearing. Mr. Smith testified that he estimated Claimant’s unrealized losses to be about $42,000 with gains of approximately $27,000. Thus, the difference is approximately $15,000 in total damages to Claimant.
Mr. Nelson testified that the bonds in Claimant’s account are municipal and corporate bonds. Baldwin also testified as such. These bonds are for a set value and pay a fixed rate of interest over the term of the bond. Id. Municipal bonds are generally exempt from taxes, whereas corporate bonds are not. Id. Corporate bonds generate higher interest payments over time (known as yields) to make up for this. Id. Baldwin testified that he always advises his clients about the potential downside of corporate bonds, all bonds in fact; that the value may decrease if there is a significant rise in interest rates. He further testified that he purchased the investments for Claimant’s portfolio to accomplish her primary investment goal, which was generating income of approximately $2,200 per month, $26,400 annually. His contemporaneous notes of that meeting state: “If current cash investments do not meet goals begin converting munis to corporates for higher cash flow. This approach will maintain benefits of tax free income and allow for increased income while keeping taxes as low as possible within the income level discussed.” Id. He testified that bonds are one of the best investment vehicles for clients who primarily need income because of the regular interest payments, and they are generally better for regular income than equities, which may pay dividends, but that such dividends are not always guaranteed.
On May 10, 2022, Claimant emailed Baldwin asking for information “detailing the reasons and parameters of all purchases since my divorce May 2021 and physical copies of the confirmations with commissions.” That same day, she sent another email asking Baldwin to provide “the reasoning for everything you bought me since my divorce. I will look at my account with confirmations with commissions on the computer late[r].” Id. Baldwin responded that same day. He said her investment goals as he understood them were “you needed the account to generate income.” Id. He further clarified:
“We discussed, and decided on, investing the idle cash into a combination of fixed rate, and fixed to floating rate corporate bonds. The bonds are taxable, and as such carry a higher coupon or interest rate. Given your relatively low tax bracket this would still yield a higher after tax return to you than tax free munis. At the same time, we discussed maintaining the existing muni bonds to preserve their tax free benefits and to keep your taxes to a minimum. We further discussed, that if this still did not generate enough cash flow to meet the desired income level we would either sell the non-Oregon muni’s or the re-refunded munis and swap then into taxable corporate bonds for a higher income stream.” Id.
He noted that none of her municipal bonds had yet been sold but several had retired (in other words, had been paid off by the holder) and that all proceeds had been reinvested as per the plan above. He advised Claimant that “[t]his approach has resulted in annual cash flow of $23,700 from the account, which is just shy of the range you provided but allows you to maintain a cash balance that you can draw on as needed.” Id. When I asked Claimant if Respondents’ Exhibit 4 accurately reflected their conversation, she testified that she thought so but did not really remember.
Claimant emailed Baldwin again on May 12, 2022, and asked him to “invest more conservatively with no more high risk and preferred stocks after understanding more about my needs. * * * Before you buy, can you give me the coupon, maturity date, and cusip of the bonds and the price?” She asked to chat “tomorrow” and they spoke for 40 minutes the next day. Neither Baldwin nor Claimant elaborated further on the substance of their discussion on May 13, 2022, other than that it occurred. Baldwin testified that after that conversation he did not change his investment recommendations nor did Claimant ever ask at that time (or since) to change her primary investment goal, which was to generate income. He further testified that even amid this litigation, he would have recommended the same investment strategy based on her primary desire of generating income. This Arbitrator takes note of the fact that notwithstanding this dispute and the unrealized losses to her accounts because of the rise in interest rates, Claimant’s investments have continued to generate income of $54,457 since May 2021.
After listening to both Baldwin and Claimant, this Arbitrator is unconvinced that Baldwin did anything wrong regarding Claimant’s investments. The losses that occurred to her accounts since May 2021 (unrealized and realized) are the result of rising interest rates affecting the bond markets, not any alleged negligence by Baldwin. As to Claimant’s requests to Baldwin for specific information regarding individual transactions, the record is replete with information provided to Claimant showing the information she requested. For example, Claimant’s Exhibit 6 lists all the information she wanted (coupon, maturity date, cusip, price). I will grant that it is a statement from August 2023, not May 2022, but I suspect and will extrapolate that any other month would have similar information in a statement regularly sent to Claimant by Morgan Stanley and Baldwin. Further, Claimant’s Exhibit 10 shows trade confirmation sheets she received for transactions made on her behalf that also contain the requested information about the bonds purchased. Claimant’s Exhibit 2 also shows several conversations after May 13, 2022, where she and Baldwin spoke or emailed and then a transaction was subsequently made. There is no evidence that Claimant ever told Baldwin to stop purchasing corporate bonds or asked that any trade be rescinded or modified. Ms. Desoto testified that Claimant never complained or raised any concerns about her account during 2021. Claimant also frequently checked on her investments.
Claimant testified that she was not sure what to do because she does not know or understand a lot about investing. I sympathize with Claimant’s predicament. Being unsure about whether certain investments are appropriate is understandable, however, Claimant also had an obligation to direct Baldwin accordingly if she felt he was not following her instructions or meeting her needs. She decided to file a lawsuit instead. The evidence presented shows that her investments were generating income, as she wished them to do, and as Baldwin had recommended and advised, notwithstanding the decline in value of the bonds generally because of the rise in interest rates since April 2021. Baldwin therefore did not violate his obligations under FINRA regulations or Oregon law.
Claimant’s claim for damages is denied.
Baldwin’s request for expungement is hereby GRANTED.
Bill Singer's Comment
Compliments to sole FINRA Arbitrator Phillip Alan Johnson for drafting a thoughtful and comprehensive rationale in support of his Award, which provides other similarly situated parties guidance as to how arbitrators process competing allegations and assertions.
Offsetting Profits and Losses
FINRA Arbitrator Johnson was presented with an allegation by Claimant that:
My bond account value has fallen about $45,000 with the foreseeable rise in interest rates.” Id. Her claim for damages was further clarified by Mr. Smith at hearing. Mr. Smith testified that he estimated Claimant’s unrealized losses to be about $42,000 with gains of approximately $27,000. Thus, the difference is approximately $15,000 in total damages to Claimant.
Many arbitrators are predisposed to off-set profits against losses in the same account. That's often a surprise to some public customer claimants, who believe that they have every right to keep their profits and recover their losses. In some cases, that discriminatory approach may be warranted, and should be forcefully argued with a clear explanation as to why such a departure is appropriate. In cases where there is evidence of fraud or a conflict of interest, customers may well be entitled to keep their profits and recover there losses. In cases where the dispute involves the strategy of a portfolio and raises considerations such as diversification or asset allocation, triers-of-fact may be more amenable to off-setting losses against profits. Keep in mind that when deciding whether to take a case on the basis of a contingency fee, many lawyers will also use a forensic approach that off-sets profits against losses to see if the risk is warranted in accordance with a likely one-third-of-damages fee proposal -- so if you're seeking out a contingency lawyer, make sure to anticipate that pushback.
The Arnot Award asserts that Claimant had initially "sought $45,000 in compensatory damages but reduced that demand at the hearing to $15,000." An unfortunate aspect of revising damages downwards during litigation (as was the circumstance in Arnot) is that such a revision may imply that the lawsuit is more about a bona fide misunderstanding rather than fraud or other misconduct by a stockbroker. Arbitrators tend to get impatient with litigants who are perceived to not have had their facts straight before filing a lawsuit. The revision of damages following the initial filing of the case is not unusual and may well be proper if predicated upon newly discovered facts. Just keep in mind that if you start lopping off zeros once you sit down at the hearing table, it's not necessarily going to make that great an impression upon those deciding your case.
A Matter of Advice
In Arnot we have a public customer Claimant who argued that if stockbroker Respondent Baldmin had “continued with the strategy that [her ex-husband and her] followed for many years, I would not have lost that money.” Additionally, Claimant alleged that "Baldwin did not sufficiently advise her of the risks associated with bonds. . ." In countering Claimant's allegations, Respondent Baldwin produced notes, emails, and other memoranda that documented his efforts to explain the strategy in the account, the attendant risks, and how he had implemented various purchases and sales. Arbitrator Johnson specifically noted in the Award that "the record is replete with information provided to Claimant showing the information she requested."
I am not unsympathetic to Claimant Arnot's plight. Widows/widowers or divorced spouses are often placed in the position of trying to understand what a former spouse's investment strategy was during their marriage. If the deceased/ex-spouse was more financially sophisticated that may put a lifetime of savings at risk when a less sophisticated accountholder is now put in the position of maintaining the investments. A takeaway from Arnot may be for the surviving/ex-spouse to promptly seek an independent review of the account's investment strategy. Among the key considerations that should follow such a review:
Maybe it makes sense to simplify the investment approach or to retain the services of someone to oversee the trading.
Maybe a brokerage account should be closed and funds transferred to a registered investment advisory firm.
Maybe your former spouse's stockbroker isn't the best choice for you going forward and you should ask the Branch Manager for a replacement.
Maybe your nephew or granddaughter with the MBA or CPA could advise you and speak with the financial professional per your authorization.
Taking Notes
In Arnot we seem to have a fact pattern where the ex-wife didn't quite understand what her former husband was doing and/or she needed to develop a better understanding of how her account generated income, profits, and losses. As Arbitrator Johnson noted: "notwithstanding this dispute and the unrealized losses to her accounts because of the rise in interest rates, Claimant’s investments have continued to generate income of $54,457 since May 2021." More critically in terms of Claimant's causes of action, the Arbitrator concluded that the losses in Claimant's accounts since May 2021 were the "result of rising interest rates affecting the bond markets, not any alleged negligence by Baldwin." Investment professionals should take note that taking notes of discussions and retaining written memoranda of same may best help to support your defenses when a customer sues. Clearly, Baldwin came loaded for bear to the hearing and the Arbitrator favorably commented upon his extensive documentation of what he was asked by the customer and what he explained. Further, many of the cited notes were of a contemporaneous nature, which enhanced their probative value.
Unsure is Understandable
Adding to the likely turmoil of adjusting from married life to divorce, Claimant Arnot seemed somewhat befuddled by what was in the account and the investing approach that was in play. In hindsight, Claimant may have fared better if she did not represent herself at the arbitration and had retained a skilled public-investor lawyer, who may well have uncovered different facts and argued a different case. Of course, the cost of retaining a lawyer may well have proven prohibitive. Further, as to whether a lawyer would have made a difference given the facts at issue is mere conjecture.
In fairness to Respondent Baldwin, Arbitrator Johnson rendered this comprehensive summation:
Claimant testified that she was not sure what to do because she does not know or understand a lot about investing. I sympathize with Claimant’s predicament. Being unsure about whether certain investments are appropriate is understandable, however, Claimant also had an obligation to direct Baldwin accordingly if she felt he was not following her instructions or meeting her needs. She decided to file a lawsuit instead. The evidence presented shows that her investments were generating income, as she wished them to do, and as Baldwin had recommended and advised, notwithstanding the decline in value of the bonds generally because of the rise in interest rates since April 2021. Baldwin therefore did not violate his obligations under FINRA regulations or Oregon law.
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