Arbitrators Are Recognizing That ‘Sophisticated Investors’ Can Be Defrauded

 

Wall Street’s favorite defense to investor claims, the “sophisticated investor” defense, isn’t working anymore. In almost every FINRA arbitration brought by an investor, the brokerage firm adopts the mantra that “The claimant is a sophisticated investor.” In essence, the firms argue that the customer was too sophisticated to rely on any alleged misconduct or misrepresentations. In their advertising, brokerage firms say “Trust us.” In arbitration they say, “You were too sophisticated to trust us. Even if we lied, you should never have believed us.” Recently, however, arbitrators haven’t been buying this argument (See “Sophisticated Investor Defense Losing Steam,” Wall Street Journal).

“The arbitrator perception of “sophisticated investor” has evolved as a result of such a substantial market break,” Edward Pekarek, a securities law professor at Pace Law School, was quoted as saying, adding: “Such opaque and complex products and such questionable sales tactics associated with those products resulted in even the most sophisticated investors?institutions?being sold securities later revealed to be toxic.”

In recent years, there has been a marked increase in sales of alternative investments, such as structured products, hedge funds and other exotic products. It is a common observation by industry observers that these products are pushed by sellers, not demanded by consumers, and that they are poorly understood by buyers and sellers alike.

The increasing number of very large awards in favor of high net worth individuals and corporate claimants is indicative of how unsuccessful the sophistication defense has become. Financial officers of corporations are by definition “sophisticated” in financial matters, at least in comparison to what the securities industry calls “retail” (i.e., street-level) investors. Yet there is a growing recognition that sophistication cannot be brought to bear when the material facts and risks are misrepresented or not disclosed.

The example provided in the article is the media coverage of a $54 million award against Citigroup Inc. in favor of a group of wealthy investors in several of Citigroup’s municipal arbitrage funds. These claimants alleged, and the arbitrators agreed, that Citigroup mismanaged and falsely marketed them to traditional fixed income investors as safe and sound alternatives to municipal bonds. Citigroup made much of the claimants’ wealth and sophistication. The award included $17 million in punitive damages and $3 million in attorney’s fees.

Page Perry is an Atlanta-based law firm with over 170 years of collective experience maintaining integrity in the investment markets and protecting investor rights.