• March 19, 2020
• Investor Education

On February 19, 2020, the Dow Jones Industrial Average (“Dow Jones”) and the S&P 500 indices—the two primary benchmarks for measuring the performance of the United States equities market, closed at 29,348 and 3,386, respectively. As of March 18, 2020, both the Dow Jones and S&P 500 indices had declined nearly 35%. During this time, the equities markets have experienced record breaking point and percentage declines. The market volatility is likely here to stay for the foreseeable future.

While the catalyst of this stock market crash may very well have been associated with the combination of the Coronavirus pandemic (COVID-19) and the war over oil production between Russia, Saudi Arabia and, indirectly, the United States—there is another story lying beneath the surface that deserves attention.

Trillions of dollars in wealth was lost in the month of March 2020. While volatility is inherent in the marketplace, a suitable and well-constructed portfolio is designed to withstand volatility. Here is the thing—over the last several years, many Financial Advisors have touted the positive performance in customer accounts as if their investment acumen is the primary reason why their clients’ accounts have been profitable. Truth be told, from 2009-2019, there were very few “losers.” Financial Advisors had to try very hard to be unsuccessful. Warren Buffet eloquently stated that “only when the tide goes out do you discover who’s been swimming naked.” The coming months will reveal that a lot of Financial Advisors have, indeed, been swimming naked.

After a major market event, the immediate tendency is for the brokerage firm and Financial Advisor to point to a perceived independent catalyst (i.e. COVID-19) and proclaim that there was nothing that they could have done to prevent account losses. However, this mindset is folly. Financial Advisors are paid by their customers to manage both the upside and the downside of a portfolio. This does not require a crystal ball. However, this requires planning “for” the unknown, which is starkly different than “knowing” the unknown. This is done through appropriate asset allocation.

The next wave of FINRA arbitration claims is coming and those claims will be based on a variety of different unsuitable products and strategies, including but not limited to, securities fraud, negligence, misrepresentation, unsuitable investments, overconcentration, and failure to diversify. The Wolper Law Firm, P.A. is already hearing from a number of investors, who have been impacted by recent market events. Their complaints have fallen into the following buckets:

• Overconcentration—Asset allocation is the cornerstone of sound financial planning. A well diversified portfolio includes diversification across different securities, sectors, asset classes, geographic regions and investment strategies (i.e., value, growth, large-cap, mid-cap, etc). In recent years, many accounts have become overweight in equities and Financial Advisors were reluctant to recommend taking money “off the table” or simply ignored the account altogether. Some Financial Advisors continued to “buy the dips.” The overconcentration of assets in the equities sector will lead to disproportionate and unnecessary losses for investors, particularly those who are retired and can least afford to experience investment losses.

• Margin and securities backed lending: As of January 2020, the Financial Industry Regulatory Authority (“FINRA”) reported that retail customers across the country have total margin exposure of approximately $561 million. When the equities market crashed in March 2020, the collateral supporting the margin was significantly impaired, causing margin calls. Many customers have been forced to liquidate collateral securities at depressed prices. In many cases, brokerage firms departed from their standard practice and procedure of allowing customers to deposit additional collateral and instead forced liquidations, causing investors to realize losses.

• Liquidity—In recent years, there has been a surge in the sale of private placements, non-traded real estate investment trusts, business development companies and other alternative investments. These securities are illiquid, meaning that customers cannot sell them on demand. Many Financial Advisors assured clients that these products would provide liquidity events within a short period of time, allowing clients access to their capital. This has not occurred. As a consequence, many investors have been holding illiquid, non-traded investments for years. In light of recent market events, and the corresponding decline in investor assets, many retail investors are searching for liquidity to support their personal expenses or pay employees. That liquidity is gone because of the over-recommendation of illiquid alternative investments.

• Structured Products—Structured Products are synthetic securities constructed by brokerage firms and sold to retail customers. Structured Products are marketed and sold to retail customers as safe, income producing investment alternatives with derivaitave “put” or “call” option features that provide a customer with downside protection. Generally, Structured Products are tied to an underlying index or security. If the underlying index or security remains within a range, the customer collects an income stream. If the underlying index or security falls below a certain price, the protective barriers are broken and the customer is left financially exposed. Structured Products generally pay Financial Advisors above-average commissions, which has led to an uptick in sales over the years. In the last month, the protective barriers of many Structured Products have been broken.

• Unsuitability—Brokerage firms and Financial Advisors have a fiduciary responsibility to recommend investments that are suitable and appropriate for a particular customer. There are many facets to the suitability rule, which is codified in FINRA Rule 2111. Customer-specific suitability requires that a member or associated person have a reasonable basis to believe that the recommendation is suitable for a particular customer based on that customer’s investment profile. Among the criteria that a Financial Advisor must evaluate to satisfy his or her customer-specific suitability obligations include the investor’s:
• Age
• Other investments
• Financial situation and needs
• Tax status
• Investment objectives
• Time horizon
• Liquidity needs
• Risk tolerance
• Any other information disclosed by the customer

Financial Advisors will now have to justify the recommendations that they made over the last several years and why the recommended allocations made sense for each client given his or her specific needs and objectives. Those Financial Advisors who planned appropriately and mitigated losses during this period will avoid arbitration claims. Those Financial Advisors that left their clients’ exposed will not.

The Wolper Law Firm, P.A. represents investors nationwide in securities litigation and arbitration on a contingency fee basis. Matt Wolper, the Managing Principal of the Wolper Law Firm, P.A., is a trial lawyer who has handled hundreds of securities cases during his career involving a wide range of products, strategies and securities. Prior to representing investors, he was a partner with a national law firm, where he represented some of the largest banks and brokerage firms in the world in securities matters. We can be reached at 800.931.8452 or by email at mwolper@wolperlawfirm.com.