I was catching up on my reading and came across a column in Investment News by Mark Schoeff  that described the results of a recent FINRA arbitration, results which I found a bit alarming.  I caution you: reading too much into any arbitration award can be dangerous and/or foolhardy since they don’t always follow – or, occasionally, even slightly resemble – the rule of law.  Indeed, screwy arbitration awards abound, and sometimes all you can say is dang, glad it wasn’t me.  That’s why, in the eyes of the law, anyway, arbitration awards, even those that are well reasoned and sensible, do not constitute binding legal precedent.

Nevertheless, this award serves as a nice cautionary tale for firms that are willing to open accounts for advisory customers but not serve as the actual advisor, which is an altogether common practice in the securities industry.  Remember: investment advisors can recommend securities transactions, but they cannot actually effect any trades.  To make a securities trade that was recommended by an IA, the customer must have a securities account at some broker-dealer.  Some advisors are dually registered, and work for a BD, and that’s where the account is generally opened.  Many other advisors, however, are not associated with a BD, so their advisory clients need a brokerage account somewhere.  Often, that somewhere is a discount BD that charges low commissions, like TD Ameritrade, the respondent in this particular arbitration.

Here is all I know about the case, which I gleaned from the award itself and the article – the author of which, Mr. Schoeff, an excellent reporter on securities matters, included several quotes from the claimant’s attorney – as well as other public sources that I have cited/linked to:

• Michael D. Bayliss used to be a registered rep, but, according to BrokerCheck, hasn’t been associated with a BD since 2004.
• According to IARD, however, he was registered as an investment advisor with his own firm through August 2016, when his registration was revoked by the State of Nevada. (In 2018, the State of Nevada also filed criminal charges against Mr. Bayliss, accusing him of having committed securities fraud.)
• Apparently, Mr. Bayliss had his advisory clients open securities accounts at TD Ameritrade.
• While I don’t know everything that Mr. Bayliss may have advised his clients to purchase, according to a Form D that he filed with the SEC, he did manage to convince 16 people to invest a total of almost $2.3 million in Wealth Strategies Opportunity Fund, a private placement he created. It is noteworthy that the arbitration award recites that the case related to the claimant’s investment in “Wealth Strategies Funds,” which I am going to presume is the same entity as that identified in the Form D.
• According to the article, the claimant, a Nevada doctor, “invested with Mr. Bayliss because of his association with TD Ameritrade.” Claimant’s attorney is quoted as saying, “In [claimant’s] mind, the fact that the accounts were at TD Ameritrade gave her confidence in the investments.”  That dovetails with another statement in the article that “[t]he arbitration case didn’t revolve around the investments in Mr. Bayliss’ fund so much as the imprimatur TD Ameritrade gave Mr. Bayliss by allowing him to operate on its platform.”
• Claimant sought $407,050 in compensatory damages and other costs; the hearing panel apparently didn’t think that was enough, and awarded her $728,816 in compensatory damages.

Let’s just take a second to review that, in case I went too fast: this is money that was awarded against TD Ameritrade, not Mr. Bayliss, and that was even though it was undisputed that (1) Mr. Bayliss, not TD Ameritrade, recommended the investment, and (2) Mr. Bayliss was never registered with TD Ameritrade in any capacity.

I have to tell you, THIS is why respondents often choose to settle arbitrations rather than take them to hearing.  Even when the facts and the law are on your side, you just never know what a hearing panel may do.  For me, I have a hard time looking at this case and figuring out exactly what TD Ameritrade supposedly did wrong.  Claimant’s attorney supposedly asserted that the firm “didn’t properly vet Mr. Bayliss or his investment fund.”  But, what was TD Ameritrade supposed to have vetted?  Let’s start with the fund.

TD Ameritrade didn’t recommend the investment.  That means under FINRA rules it had no suitability obligation, either customer specific or reasonable basis.  In other words, TD Ameritrade did not have to perform due diligence on the fund to ensure it was suitable for any human being – reasonable basis suitability – or take care that the fund was specifically suitable for the claimant – customer specific suitability.  All TD Ameritrade had to do was to maintain custody of the investment for the claimant, and it certainly seems that the firm fulfilled that duty.

What about vetting Mr. Bayliss?  Again, Mr. Bayliss did not work for TD Ameritrade, either as a registered representative or as an investment advisor; he simply had his advisory clients open accounts there so they could buy and sell the securities he was recommending and for their assets to be custodied.  In light of that, what obligation did TD Ameritrade have to do any due diligence on Mr. Bayliss?  Admittedly, there are a ton of things that TD Ameritrade would have had to do if it was looking actually to hire Mr. Bayliss in terms of reviewing his background, talking to prior employers, maybe running a credit check, etc.  But under the circumstances of this case, those obligations were not triggered.

I hope that you agree that, as I said at the outset, this award is alarming.  The hearing panel’s willingness to impose liability on a firm whose obligations to the claimant were largely, if not entirely, ministerial in nature is downright scary.  It reminds me a lot of those handful of cases in which a clearing firm has been liable for something that went wrong at the introducing firm.[1]

Those cases are few and far between, given that every clearing agreement I have ever read explicitly puts the responsibility for suitability determinations exclusively in the hands of the introducing firm.  But, there are a couple, and they stand as stark warnings – as this case does – that when it comes to arbitrations, anything can, and does, happen.

[1]It should be noted that TD Ameritrade Clearing was also named as a respondent, and the award was against both respondents jointly and severally.  So, I suppose here is one more oddball case in which a clearing firm has been made to bear the brunt of an unhappy arbitration panel for supposedly not doing something that it had no obligation to do in the first place.