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The Oregon Department of Consumer and Business Services published its Summer 2022 issue of Common Ground this week. The newsletter is available here, Common Ground Summer 2022 (oregon.gov). It includes an article about cryptocurrencies and NFTs and another about a lawsuit against Safeguard Metals, LLC and others that Oregon joined.

Regarding crypto and nonfungible tokens, DCBS writes that its Division of Financial Regulation (DFR) is “warning Oregonians to use caution when investing in cryptocurrencies, nonfungible tokens, or other new or volatile products.” And “[t]here are nearly 10,000 active cryptocurrencies and they and NFTs are increasing in popularity. Regulation of these new asset types is still evolving. While there are often promises of big returns consumers often lose money when investing in them.” According to DCBS, cryptocurrencies and digital assets topped the North American Securities Administrators Association’s (NASAA) annual list of top investor threats.

According to the article about the Safeguard Metals lawsuit, the Department joined the Commodity Futures Trading Commission (CFTC) and 26 state securities regulators in bringing claims against the precious metals dealer and its owner. The alleged scam involved $68 million taken from 450 investors, including eleven Oregon investors who were defrauded out of almost $3 million.

The Safeguard Metals article also includes a warning about self-directed IRAs. In our experience, metals dealers sometimes require investors to open a self-directed IRA to hold precious metals investments. DCBS explains, “[s]elf-directed IRAs should not be confused with traditional IRAs or other retirement vehicles. Self-directed accounts are placed with a custodian, but do not afford the investor any protections nor provide a review of the holdings or any valuations of the holdings in the account.”

The SEC Division of Examinations announced its 2022 examination priorities in late March. The announcement is available here. The priorities include a “focus on private funds, environmental, social and governance (ESG) investing, retail investor protections, information security and operational resiliency, emerging technologies, and crypto-assets.”

Regarding private funds, the Division will focus on registered investment advisers, including RIA’s fiduciary duty, compliance programs, fees, conflicts of interest, risk disclosures, and other issues.

For environmental, social and governance investing, the Division said examinations will “typically focus on whether RIAs and registered funds are accurately disclosing their ESG investing approaches and have adopted and implemented” procedures to prevent violating the federal securities laws.

For its retail investor focus, the Division will examine whether advice from broker-dealers and RIAs is in an investor’s best interest. The SEC referred specifically to registrants’ obligations under Regulation Best Interest and fiduciary standards under the Advisers Act.

The SEC said its focus on information security involves reviewing whether broker-dealers and RIAs have appropriate technology and measures in place to protect customer accounts.

Finally, for emerging technologies and crypto-assets, the Division “will conduct examinations of broker-dealers and RIAs that are using emerging financial technologies to review whether the unique risks these activities present were considered by the firms when designing their regulatory compliance programs. RIA and broker-dealer examinations will focus on firms that are, or claim to be, offering new products and services or employing new practices to assess whether operations and controls in place are consistent with disclosures made and the standard of conduct owed to investors and other regulatory obligations; advice and recommendations, including by algorithms, are consistent with investors’ investment strategies and the standard of conduct owed to such investors; and controls take into account the unique risks associated with such practices. Examinations of market participants engaged with crypto-assets will continue to review the custody arrangements for such assets and will assess the offer, sale, recommendation, advice, and trading of crypto-assets.”

President Biden signed an Executive Order on March 9, 2022, directing federal agencies to develop a strategy for regulations and policies on digital assets, which include cryptocurrencies. In a fact sheet released the same day, the White House cited survey data that the market cap of cryptocurrencies in November 2021 surpassed $3 trillion, a massive increase from $14 billion five years before. The fact sheet reports that around 40 million Americans have put money in cryptocurrencies. In explaining the basis for the executive order, the White House cited the “substantial implications” of digital assets for “consumer protection, financial stability, national security, and climate risk.”

The Order is aimed at setting the stage for regulation. The first of the objectives identified in the Order includes, in part, “We must protect consumers, investors, and businesses in the United States. The unique and varied features of digital assets can pose significant financial risks to consumers, investors, and businesses if appropriate protections are not in place.”

These risks are often not understood by investors. In our practice, we hear from investors who lost money in outright scams or who are running into issues with crypto exchanges. Some of the fraud impacting digital assets could be mitigated through regulation.

The crypto industry apparently thinks that regulation is coming and has been hiring former government officials, in the words of the Tech Transparency Project, “to help mold the policy landscape in the industry’s favor.” In a report published last month, the Tech Transparency Project said it identified “nearly 240 examples of officials with key positions in the White House, Congress, federal regulatory agencies, and national political campaigns moving to and from the industry.” This includes two former chairs of the SEC, two former chairs of the Commodity Futures Trading Commission, and a former chair of the U.S. Senate Finance Committee.

Forced arbitration is common in investor cases. If an investor has a dispute with a member of FINRA, such as a broker or brokerage firm, and the dispute involves the investment business of the broker or brokerage firm, the investor very likely is required by contract to arbitrate before FINRA. Many financial advisers and other professionals in the investment industry are not brokers and are not regulated by FINRA. Instead, they are investment adviser representatives (IARs) of registered investment advisers (RIAs) regulated by the SEC or one or more states. Many investor agreements with RIAs also force investors to litigate claims in arbitration. For example, many RIA customer agreements require arbitration before the American Arbitration Association.

Because of the Federal Arbitration Act and other laws, investors rarely have much if any say about whether to seek relief in court or arbitration. Instead, if the investor’s account agreement says the investor must arbitrate, that requirement more often than not is enforced.

A Georgia judge recently called out misconduct by Wells Fargo and FINRA in an order vacating a FINRA arbitration award in favor of Wells Fargo and against an investor. According to the Honorable Belinda E. Edwards of the Superior Court of Fulton County, “Wells Fargo and its counsel manipulated the FINRA arbitrator selection process” by removing names of potential arbitrators from what was supposed to be a randomly generated list. Judge Edwards wrote, “Permitting one lawyer to secretly red line the neutral list makes the list anything but neutral, and calls into question the entire fairness of the arbitral forum.”

Judge Edwards went on to discuss problematic decisions by the arbitrators during the arbitration. In one example, a broker testified about text messages that did not go through Wells Fargo’s compliance process. The broker testified that he knew this was a “no-no,” “a bad thing,” and a violation of supervisory procedures, but the broker testified he “did it anyway.” This testimony was interrupted by a “medical emergency.” The FINRA arbitrators, for unknown reasons, did not sequester the broker. When the broker’s testimony resumed more than 6 months later, he claimed to not recall the damaging testimony, and his testimony changed in favor of Wells Fargo.

Judge Edwards’ opinion has received national attention. In a letter to FINRA’s president and CEO, Senator Elizabeth Warren and Representative Katie Porter described Wells Fargo’s manipulation of the arbitrator selection process as “highly disturbing.” Senator Warren and Representative Porter wrote, “we have long had concerns about FINRA’s ability to effectively enforce rules against fraudulent and abusive behavior by brokers and dealers. And we have for years attempted to address the problems for consumers and workers caused by forced arbitration processes that limit their rights. This latest report brings all three problems into focus: it reveals troubling new allegations about the atrocious behavior of Wells Fargo, the inability of FINRA to effectively police the financial system, and the unfairness of the arbitration process.”

A recent Wall Street Journal article, A Couple Stored IRA Gold at Home. They Owe the IRS More than $300,000, is a reminder about what can be complex rules for using an IRA to invest in esoteric assets, such as gold, silver, platinum, and other precious metals. Precious metals tax avoidance strategies and investment scams proliferate on the internet and social media. These scams are so common that the Commodity Future Trading Commission published a fraud advisory. According to the California Department of Financial Protection & Innovation, Department of Business Oversight Sues to Stop $185 Million Coins Scam that Targeted Senior Citizens | The Department of Financial Protection and Innovation, for example, the business behind metals.com targeted senior citizens through advertisements on conservative media and websites. Metals.com, according to the state, used fear tactics to pressure seniors to purchase overpriced coins through self-directed IRAs. The promotion of self-directed IRAs to hold esoteric or alternative investments is common in precious metals investing scams. These scams often combine bad tax advice with bad investment advice. They also often charge high fees, which in some cases are not disclosed. In some instances, the people and entities behind the investments are unlicensed. The Wall Street Journal article makes it clear that an investor considering using an IRA to invest in precious metals would be wise to obtain professional advice.

The United States House Financial Services Committee recently passed the Investor Choice Act, H.R. 2620. The Investor Choice Act, introduced by Representative Bill Foster, would prohibit broker-dealers, investment advisers, and others from including mandatory arbitration clauses in their customer agreements. H.R. 2620 would also prohibit bans on class action suits in these customer agreements. The bill includes language making it retroactive, meaning if the bill becomes law, any customer agreement in effect before then that violates these prohibitions would be void. The full text of the bill is available here: Text – H.R.2620 – 117th Congress (2021-2022): Investor Choice Act of 2021 | Congress.gov | Library of Congress.

Findings in Section 2 of H.R. 2620 include, “Issuers, brokers, dealers, and investment advisers hold powerful advantages over investors, and mandatory arbitration clauses, including contracts that force investors to submit claims to arbitration or to waive the right of investors to participate in a class action lawsuit, leverage those advantages to severely restrict the ability of defrauded investors to seek redress,” and “Investors should be free too—(A) choose arbitration to resolve disputes if they judge that arbitration truly offers them the best opportunity to efficiently and fairly settle disputes; and (B) pursue remedies in court should they view that option as superior to arbitration.” No Republicans joined the seven Democrats who cosponsored the bill.

In an article about insider stock sales at publicly traded companies, the Wall Street Journal reported that the father of the CEO of Carvana, an online car dealer, sold $3.6 billion in company stock since October. Much of the sales took place while Carvana was losing money. The WSJ reported that Carvana had net losses of around half a billion dollars over the past six quarters and only reported its first quarterly profit in spring 2021. The WSJ’s article is available here.

According to the WSJ, Carvana’s ownership structure allows the family that founded the company to sell billions of dollar worth of stock but at the same time keep control. Like many other publicly traded companies, Carvana has different share classes—one available to certain insiders and another available to the public. The WSJ explained that each share held by Carvana’s CEO’s family counts for 10 votes, while each share held by members of the public is worth only one vote. Even after $3.6 billion in sales, the WSJ explained, Carvana’s CEO and his father still control more than 85% of all the voting shares.

The WSJ also reported that the CEO’s father sold the shares under what is known as a 10b5-1 plan. Often used by insiders, these plans are designed to purportedly prevent insiders from making trading decisions based on nonpublic information by automating the insider’s sale of company stock. Rule 10b5-1 creates an affirmative defense to insider trading, so long as the automated trading plan is adopted in good faith and at a time the insider does not possess material nonpublic information. Perhaps contrary to the intent of these plans, the WSJ reported that Carvana’s CEO’s father modified the plan twice over six months, while selling hundreds of millions of dollars worth of stock.

In a June 7, 2021 speech, SEC Chair Gary Gensler expressed concern about potential abuses of 10b5-1 plans. The speech can be found here. Chair Gensler said he asked SEC staff to consider “how we might freshen up Rule 10b5-1.” He raised the issue again on September 14, 2021, in testimony before the United States Senate Committee on Banking, Housing, and Urban Affairs. Chair Gensler told the committee that he asked SEC staff to recommend ways to tighten and modernize the rule “and fill perceived gaps in our insider trading regime.”

Oregon Senator Jeff Merkley and U.S. Representative Bill Foster of Illinois introduced the Investor Choice Act earlier this month. The bill would prohibit broker dealers and investment advisors from forcing investors to agree to mandatory arbitration. The bill also prevents brokers dealers and investment advisors from forcing investors to waive the right to bring a class action lawsuit. The Senate’s version of the bill is available here.

The North American Securities Administrators Association (NASAA) and Public Investors Advocate Bar Association (PIABA) endorsed the legislation. SEC Commission Chairman Gary Gensler said during his confirmation hearing that investors should be able to chose to go to court to resolve disputes.

Most agreements with individual investors in the financial services industry force customers into arbitration. Many investor advocates want investors to have the option of pursuing claims in court. Arbitration lacks the transparency of court and is sometimes cost prohibitive.

In Interactive Brokers LLC v. Saroop, No. 19-1077, 2020 WL 4668551 (4th Cir. 2020), the Fourth Circuit Court of Appeals recently confirmed that a violation of FINRA rules can be a breach of an agreement between an investor and a broker-dealer.

Three investors opened accounts with Interactive Brokers, an online broker-dealer. The investors’ agreements with Interactive Brokers had an arbitration clause. Trading on margin, a third-party investment manager invested the accounts in an exchange-traded note that moved based on the stability of the market and also sold naked call options. FINRA rules prohibit trades of some high risk securities on margin, including the exchange traded note. A large, one-day drop in the markets in August 2015 led to Interactive Brokers liquidating the accounts and a margin call.

The investors brought claims in FINRA arbitration against Interactive Brokers. The arbitration panel found for the investors. In dismissing a counterclaim brought by Interactive Brokers, the arbitrators referred to FINRA Rule 4210, which includes the prohibition against trading certain high risk securities on margin. Interactive Brokers challenged the award in federal district court.

The district court sent the case back to the arbitrators, seeking an explanation of the award. The arbitrators referred to FINRA rules in explaining the award and wrote, “To ignore a FINRA rule by the Panel would defeat the purpose of FINRA.” Interactive Brokers again moved to vacate the panel’s award. The district court did so, finding that by basing liability on FINRA Rule 4210, the arbitrators disregarded the law because there is no private right of action to enforce FINRA rules.

The investors appealed to the Fourth Circuit. The Fourth Circuit vacated the judgment of the district court and instructed the district court to confirm the arbitration award. In its opinion, Interactive Brokers LLC v. Saroop, No. 19-1077, 2020 WL 4668551 (4th Cir. 2020), the Fourth Circuit explained that the agreement between the investors and Interactive Brokers provided that all transactions were subject to rules and polices of relevant markets and clearinghouses, and applicable laws and regulation. The Court held, “[t]his, of course, includes the publicly available FINRA rules (citation omitted). As such, the clause could well be read as incorporation the FINRA rules, making a violation of the rules a breach of the parties’ contract.”