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Settling Investment Casesby Fredrick D. Huebner The litigation and arbitration of investment cases — investor claims against securities and commodities brokers; investment advisers; ERISA and private trustees; and sellers of stock, debt, and alternative investments for loss of capital — are on the rise again. Three broad trends, especially the current, ongoing credit and housing crises, have caused this to happen. First, most large corporate employers and many public entities no longer provide defined benefit pension plans to their employees and instead provide or contribute to a variety of self-directed 401(k) and IRA retirement savings accounts and plans. This shift places the burden of investment research, investigation, and decision on people who may be completely unprepared to cope with it. Even highly skilled, well-educated executives and professionals may be ill-prepared to make investment decisions, especially if they assume their competence in their chosen field translates into skill in selecting investments. Second, the increasing concentration of wealth in America has created a much larger class of individual investors with significant investments. Corporate compensation plans emphasize stock options, stock grants, and deferred compensation accounts that can make lucky employees wealthy at a surprisingly young age. The expansion of computing, the Internet, and biotechnology businesses over the past 20 years has created an entrepreneurial class that makes millions, but sometimes suffers major losses in reinvesting capital gains after their company, product, or invention has been sold. Third, and most importantly, there has been a significant increase in the volatility of the financial markets. Volatility breeds litigation. Even during the booming 1980s and 1990s — the 1987 market crash, the commercial real estate bust of 1989–92, the 1998 "Russian Summer" currency crisis, and the credit crunch following the failure of hedge-fund long term capital management(1) — each triggered a significant number of investment lawsuits. The March 2000 dot-com bust(2) generated more than 20,000 claims nationwide. The current credit crisis is unrivaled since the 1930s, and has the potential to unleash even more investor cases. It has destroyed Lehman Brothers, Bear Stearns, and Washington Mutual, battered Wachovia and Morgan Stanley, and all but ruined AIG and Merrill Lynch. Although rooted in the residential housing bust,(3) this crisis has spread because unregulated hedge fund, dark pool, and credit-swap transactions displaced open-market transactions. The Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) were directed by Congress not to regulate new financial instruments, but also loosened regulations on existing markets. The Federal Reserve took little note of vastly increased leverage at investment and commercial banks.(4) There is so little transparency in the derivatives world that even the United States Treasury cannot tell us what the assets held by many surviving financial institutions are worth. As a result, investments long thought of as "conservative" — mortgage-backed bonds, auction-rate securities, bank stocks, Fannie Mae and Freddie Mac common and preferred stock — have lost as much as 99 percent of their value. No one knows where future losses will be incurred. We do know that investment failures become investment lawsuits. Investor claim filings are rising again. For example, FINRA Dispute Resolution Inc., the primary arbitration forum for claims against securities brokers, has logged a 46 percent increase in case filings for the first nine months of 2008 over the same period in 2007.(5) Investment cases tend to be difficult and expensive to prosecute and defend. Although securities brokerage and some bank-related cases are governed by pre-dispute arbitration agreements, the practical reality is that FINRA Dispute Resolution, Inc., and other financial arbitration forums have become alternate court systems with many of the same cost drivers — burdensome discovery, large volumes of documents to review and analyze, the need for expert witnesses, and frequent motion practice — as traditional courtroom litigation. The 15-day, $500,000 legal fee securities arbitration, once unheard of, is now common. Difficult cases should prompt the parties to settle. Yet despite the costs and risks of these cases, settlement rates remain relatively low compared to personal-injury-insured claims. Approximately 95 percent of insured personal-injury claims settle prior to hearing,(6) but only 57 percent of FINRA investor claims are resolved by settlement.(7) The Impediments to Settlement of Investment Cases Why don't more investment cases settle? Based on my own experience, and on the experience of fellow lawyers(8) who regularly represent plaintiffs, defendants, or both in investment cases, I believe there are six primary impediments to settlement. 1. Difficulty in accurately defining and demonstrating damages The courts have approved a wide variety of damage theories in investment cases: out-of-pocket loss, disgorgement of commissions, and the "properly managed portfolio" theory that adjusts damages up or down based on market movements during the time period when the plaintiff investor's assets were managed by the defendant. Some statutes, such as the Washington Securities Act, provide an explicit formula for calculating damages — but the formula contemplates rescission of a single typical face-to-face sale or purchase of a security, not the behavior of an investment portfolio over time.(9) All of the damage formulas for investment portfolio cases attempt to separate the damage caused by misconduct from the losses caused by market movement. They define damages by comparison to the hypothetical proper course of conduct that should have, but did not, happen: for example, the suitable, risk-appropriate investment portfolio versus the churned, unsuitable portfolio. Damage-calculation issues become even more difficult and contentious in cases where complex options trading, or collaring a concentrated equity position, is involved. For example, in a case alleging a failure to collar,(10) the parties' experts will vehemently disagree on whether and when a collar strategy could be employed, the cost of collar strategy, the level of protection that could have been provided, and the damages that could have been avoided. Because portfolio damage calculations are inherently hypothetical and potentially so uncertain, the parties have difficulty defining a sensible range for negotiations. 2. Failure to recognize the emotional aspects of financial loss Investment and financial cases are sometimes thought of as cold "numbers cases." In reality, they involve surprisingly deep emotions on both sides. Investors who have suffered financial loss often have feelings of betrayal, personal inadequacy, shame, and fear. Stockbrokers and investment advisers and their firms frequently believe they are being unfairly penalized for market movements beyond their control. Investment-firm managers fear that agreeing to settle a case may result in adverse publicity, a stain on their supervisory record,(11) or even end their careers. The emotions on both sides may prevent one or both parties from moving forward from the loss. 3. Hoarding information for perceived tactical advantage at trial In any form of negotiation, case-assessment information must be exchanged between the parties, or the negotiation will decline into a sterile, probably fruitless, haggle. Yet the desire to hoard information in order to gain or preserve a perceived tactical advantage at trial inhibits both parties from exchanging information that might lead to settlement. This is especially true in securities arbitration, where discovery is somewhat limited, depositions are not taken, and wise lawyers on both sides gather as much information as they can from searching publicly available, but unexpected, data sources such as trade and service-mark applications, press articles, blogs, personal websites, court files, tax records, divorce filings, and testimony in other cases. The paradox is that by hoarding information for trial, counsel may diminish the prospect for settlements. 4. Failure to manage client expectations Lawyers who defend investment cases frequently assert that the plaintiffs' counsel routinely inflate client expectations, leading to unreasonable, rigid demands. Lawyers who represent investors say that financial-institution defendants habitually undervalue claims and fail to negotiate in good faith. The core of the problem lies in lawyers on both sides failing to manage client expectations through early and candid discussion of the range of potential outcomes with the client.(12) 5. Reactive devaluation Reactive devaluation is a psychological phenomenon that frequently creates a barrier to effective negotiation. Humans are cantankerous animals. Receiving a proposal from an adversary diminishes its value or appeal — especially when the information is coupled with the express or implied assertion that listener's case lacks merit. Reactive devaluation lies at the heart of two of the most common stumbling blocks in negotiations: the irritation felt by the negotiators when each receives the "high-ball" and "low-ball" offers at the beginning of a negotiation, and the anger and fatigue that clients develop late in the process at what they perceive to be a string of insulting responses. 6. Fear of setting a precedent Both sides in investment cases fear that settlements may become precedents. Many cases involve the failure of a particular type of investment product — auction rate securities, illiquid limited partnerships, structured notes. Plaintiffs' counsel fear that a less than optimum settlement in one case will hurt other clients they represent with the same types of investments, often involving the same financial institution. Defense counsel heeds the client's command that they not recommend even reasonable settlements if the ultimate effect is to "turn us into an ATM." The result is stalemate — and as financial institutions' balance sheets continue to be stressed, the problem will grow worse. Strategies for Overcoming Impediments to Settlement of Financial Cases 1. Understand and be prepared to effectively present the economic basis for your damage claims or defenses. The advocate's best and most effective tool in settling investment cases is a detailed, accurate damage analysis based on sound legal theory and reflecting economic reality. For example, in an investment suitability case, effective damage presentations must rest on a detailed reconstruction of the investment portfolio, and incorporate reasonable assumptions about investment objectives, the appropriate comparison portfolio, and the performance of the market during the same time period. It is simply not persuasive to pump up damages by claiming, for example, that a client with substantial wealth, an acknowledged speculative investment objective, and a lengthy history of personally trading risky stocks on margin should, in retrospect, have held only short-term U.S. Treasuries during a market crash. Similarly, defense-suitability analyses based on the assumption that retirees of limited means can accept market risks that would make Warren Buffet tremble because they had a $1,000 per-month Social Security benefit will not persuade opposing counsel, the mediator, or the judge. In larger, more complex cases, it may be well worth the expense for the parties to bring their expert to the mediation to better articulate their damage claims and defenses. 2. Confront the emotional aspects of financial loss. The emotions raised in investment cases do not simply go away. It is important for counsel on both sides to be prepared to deal with them. Counsel representing investors should discuss, assess, and understand their client's emotional state prior to the negotiation. Has a friendship between the client and the investment adviser been ruptured? Has the loss caused a rift between spouses? Is the client so fearful of the future because of the loss that he cannot envision moving forward with his life? Defense counsel should not ignore a plaintiff's emotional distress — it will damage the chance to gain a reasonable settlement. For example, I represented a securities brokerage firm that had the misfortune to employ a salesman who secretly sold his customers an outside "prime bank" fraud and concealed the scheme from my client. I made a point of being polite and greeting the lead plaintiffs and their counsel at each court hearing, and taking pains in court arguments to acknowledge that plaintiffs were good people who had been defrauded — though not by my client. As part of the settlement negotiations, my client offered to pursue their former employee into bankruptcy and collect what it could for the benefit of the plaintiffs — a way of acknowledging their loss. The case settled with relative ease, at reasonable cost, and with courtesy and respect on both sides. 3. Use, don't hoard, information. Lawyers on both sides need to be realistic. Most investment cases eventually do settle — although settlement on the eve of trial is likely to be less satisfying and useful to the clients because of litigation costs. The chance that a particular piece of hoarded information is going to create a decision-changing surprise at trial is generally small. Moreover, the best types of information to use in settlement negotiations — objective facts, documents containing written admissions, or evidence from outside sources that contradict the opposition's story — don't lose their trial value by being disclosed in negotiations. Selective disclosure of information to the opposing parties in mediation is an effective form of advocacy. Sometimes the simplest bits of evidence can be effective: phone records can prove that a claimed phone conversation never took place. A tax lien against a broker's house can demonstrate a need for cash — and a motive for excessive trading. Contrary testimony from a prior case may damage an expert's qualifications and credibility. Creating uncertainty for your adversary by carefully using your hoarded facts moves the settlement range in your favor. 4. Overcome fixed client expectations by focusing on the reasonable settlement range. Clients who are not prepared for the mediation process and arrive with fixed, high expectations often speak in the language of combat: we need to be aggressive, we need to crush them, we aren't getting their respect, we look weak, I won't settle for anything less than a victory. The best means for dealing with the client-expectation problem is to shift the focus of discussion from the language of combat to the language of range. This can be done through mediator suggestions and questions rather than an outright statement that "this case should settle between x and y." Most importantly, by focusing both parties on defining an acceptable range for negotiation, the mediation dialogue begins to focus on problem-solving rather than the perception of victory or defeat. 5. Let the mediator use his or her tool kit to overcome reactive devaluation. Every effective mediator has a personal tool kit he uses to break through impasse. The common purpose of all these tools — mediator questions about the facts, delivery of new evidence, blind bids into the box, suggestions for a reasonable settlement range, and the ultimate tool, the mediator proposal — is to minimize the reactive devaluation problem, because the information comes from a neutral, and hopefully credible, source. The respectful mediator will not use these tools without permission and agreement from counsel. Counsel, in turn, should give a bit of latitude to the mediator so that the ultimate gap — from the parties' own best numbers, to the number that will settle the case — can be bridged. 6. Be honest — if you can't settle the case for fear of setting a precedent, say so. But beware of what happens if verdicts or awards stack up. Assess the scope of the client's problem and deal openly with the client. Frankly, the true "message" case and the precedent-setting case don't really belong in mediation. If your client wants to take the risk of drawing a line in the sand, the courthouse and the FINRA arbitration hearing room are the places to do it. But do make sure the client is fully informed of the risks of their position. In cases involving the structural failure of a financial product, a defendant may well want to consider the potentially adverse regulatory and reputation impacts as well as the immediate financial impact of risking the settlement course. In such cases, a proactive plan for early dispute resolution may save money, salvage an institution's public image, and reduce exposure to future regulatory sanctions.
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