In a Financial Industry Regulatory Authority (“FINRA”) Arbitration Statement of Claim filed in November 2010, Claimant asserted quite the laundry list of causes of action in connection with an investment in Canyon Creek Financial, LLC/Cottonwood Senior Living Property, LP.(a private placement):

• excessive and unsuitable investment in a private placement;
• false and misleading statements;
• negligent misrepresentation;
• breach of fiduciary duty;
• breach of the covenants of good faith and fair dealing;
• negligent supervision;
• breach of conduct;
• violations of section 20 of the 1934 Act; and
• respondeat superior.

Claimant sought at least $400,000 in compensatory damages, fees, and costs. At the close of the hearing, Claimant asked for $373,500 in restitution.  In the Matter of the FINRA Arbitration Between The William Dale Kelly and Joan Hull Trust, Claimant, v.  Investment Security Corporation and Lawrence Benjamin Miller, Respondents (FINRA Arbitration 10-05028, September 30, 2011).

Respondent Investment Security Corporation generally denied the allegations and asserted various affirmative defenses.

Decision

The FINRA Arbitration Panel dismissed all of Claimaints claims. 

SIDE BAR: Okay, that’s fine — as far as that goes, but as with many FINRA Arbitrations, just what the hell was this case about?   The Panel dismissed Claimant’s claims about what? Apart from the kitchen sink of allegations, we’re pretty much in the dark about the precise nature of the dispute. 

Spoiler Alert

As will readily become apparent, this case appears to be yet another dispute about what has become known as a Tenants In Common (“TIC”) real estate investment. 

SIDE BAR: TIC investments became increasingly popular as a way for a seller of real estate to qualify for a so-called 1031 Tax Free Exchange via the acquisition of an ownership interest in another property.  Sales of fractional ownership interests to sellers of appreciated realty became an attractive business for many FINRA brokerage firms, who marketed this transaction as a way to preserve the tax-free status of a property exchange.

However, as with most flavor-of-the-month investment ideas, TIC transactions have seen their share of consumer complaints.  Among the most common source of friction is the alleged lack of adequate pre-sale due diligence by the brokerage firm, and the failure of the firm to reasonably monitor ongoing developments at the subject properties.  A cursory glance at the litigation in this area shows disagreements between claimant investors and respondent brokerage firms as to the quality of the latter’s review of financial statements; the thoroughness of background checks involving promoters; and the validity of any appraisals done on the property in dispute. 

The Past That’s Now The Prelude: Read this helpful 2005 commentary by the NASD (now FINRA): Private Placements of Tenants-in-Common Interests: NASD Issues Guidance on Section 1031 Tax-Deferred Exchanges of Real Property for Certain Tenants-in-Common Interests in Real Property Offerings (Notice to Members 05-18, March 2005)

Whodunit?

A good mystery should never telegraph until the end who the killer is.  However, FINRA Arbitration Decisions ought not aspire to compete with Whodunits – the undertaking here is not mass-market fiction but a thoughtful explanation about the factual nature of a dispute and the rationale for the ensuing ruling. 

In this FINRA Arbitration, we’re hit with a surprise ending when we learn — albeit by implication and inference — that the dispute involved a TIC.  Notwithstanding, this Arbitration Panel does redeem itself, albeit belatedly, in a thoughtful explanation of the rationale for its ruling:

1. Although the suitability of investing in tenant in common (“TIC”) interests by seniors can be questioned, and the customer care by the stockbroker and his principal could have been better, the Panel found that in this case the TIC investment in question was an acceptable alternative given that:

a. The Claimant had already invested a much larger amount in two real estate TICs with another broker and from the very beginning of their relationship with Respondents expressed a strong desire to make a third TIC investment;

b. The expected short to medium term duration of the investment was suitable; and,

c. The generous level of income expected to be received was also suitable.

The Panel’s Deliberation Algorithm

When focusing on the “suitability” of a given investment, FINRA arbitrators often start with macro considerations and then examine the more micro facts in a particular case.  Here we see that the panel was indeed troubled about the larger issue of the appropriateness of senior citizens investing in TICs. Also, in this particular arbitration, the arbitrators questioned the level and degree of “customer care” that was extended to the Claimant – and the Panel’s disapproval was clearly conveyed through the characterization that the care “could have been better.” 

So, even before coming to the plate, Respondents seem to have been penalized with two strikes.  Nonetheless, the Panel still went beyond those typically preliminary factors and looked into the more dispositive guts of this case. To this Panel’s credit, it offered a fairly substantive rationale for why it overcame its initial bias about the TIC transaction for the older Claimants and deemed the investment suitable. 

For starters, the arbitrators examined the threshold issue of whether this TIC was a virgin investment in a new product by unsophisticated investors.  The Panel noted that the customers had previously invested in two real estate TICs with another broker, and that the invested sums exceeded the dollars at risk in the investment disputed in this case.  Moreover, in addition to a prior history with the same investment product, the customers did not come off as disinterested investors who were overly amenable to their broker’s recommendation.  To the contrary, the Decision characterized the customers as having “expressed a strong desire to make a third TIC investment.”  Further, arbitrators deemed the expected short to medium term duration of the TIC in dispute as suitable. 

Finally, the Panel asked one more critical question: Was the anticipated reward worthwhile in terms of the likely risks?  In deeming the expected income as “generous,”  it appears that the arbitrators ultimately weighted the scales in favor of the overall suitability of the TIC.

Industry participants should note the algorithmic nature of the FINRA Arbitration Panel’s inquiry into the suitability of this investment and guide their customer dealings accordingly.  A practice pointer would be to ensure the memorialization of all discussions and considerations about the factors cited in the Decision.  Having such records could tip in your favor any doubts about what you told your customers and what they understood.

For public customers, an investment that’s suitable for you shouldn’t mean one that is generically suitable for investors in general. Suitability should be achieved based upon your unique circumstances of age, sophistication, net worth, income, etc.  Demand a recommendation that’s “best” for you.  A lazy stockbroker might put a smorgasbord of suitable investments before you and try to push you into purchasing the one that pays the highest commissions or fees, or is a house-product that the employing firm prefers to move.  Be careful. Ask questions.  Insist upon what’s best for you and you alone.