I am fond of saying that, at least generally speaking, the most important document in a customer arbitration alleging unsuitable recommendations is the new account form. If the NAF is in good shape, i.e., it is accurate, it is complete, it is up-to-date, it doesn’t have any changes or white-outs, then I am free to argue that my client was 100% entitled to rely on the information disclosed there by the customer in framing recommendations for securities transactions to that customer. Particularly because the NAF is signed by the customer. And even better if I have a copy of the obligatory 17a-3 letter sent to the customer after the account was opened instructing the customer to advise the BD of any incorrect information on the form, coupled with the lack of a response from the customer.
Faced with such a wondrous document, claimants’ counsel are reduced to making one or more of the usual silly arguments to reduce the impact on the case of a strong NAF: the customer signed it in blank, or it was magically altered after the customer signed it, or the signature was forged, or the customer did not speak/read/understand English, or the 17a-3 letter was never received, or whatever. Arbitration panelists are not perfect, but they typically are clever enough to understand that these arguments are pretty unpersuasive, and discount them out of hand.
But, what happens if there are issues with the NAF? What if there are blanks? What if there are changes that are not initialed by the customer? What if there is an unexplained and strange discrepancy between the date that the customer signed vs. the date the account was approved by a supervisor? What if the information is just janky? In those cases, you can bet your mortgage that the NAF will become Claimant’s Exhibit 1, and will be blown up to gargantuan proportions in order for counsel to better highlight the jankyness. And while the issues with the NAF may have zero actually to do with specific complaint being raised, it is inevitable that counsel will argue that because my client is sloppy with its handling of the NAF, it necessarily follows that my client is sloppy, period, thus opening the door for the panel to decide there were supervisory lapses.
So, hopefully you agree that NAFs are super important documents that can dramatically impact the outcome of many cases. But don’t take my word for it. Let’s look at a complaint recently filed by the State of Massachusetts against Fidelity Brokerage Services. And let’s be very clear: it is important to understand that any complaint, including a regulatory complaint filed by a state securities regulator, even one as renowned as William Galvin, contains nothing but allegations. Unproven allegations that may amount to nothing. With that said . . . there are still lessons to be learned from complaints. I am not here to throw stones at Fidelity, but this complaint does show that the devil really is in the details when it comes to NAFs.
There is nothing sexy about paperwork. The folks who toil in the “back office” have none of the glamour, get none of the attention, and certainly not the compensation reserved for the “frontline” sales people. But, if the back office doesn’t do its job, then the whole thing can come crashing down. That is precisely what Massachusetts alleges happened at Fidelity. Specifically when it came to the approval of new account forms for option and margin accounts.
According to the complaint, Fidelity’s retail business simply exploded during the pandemic. As of September 30, 2021, Fidelity had a total of 30.9 million retail brokerage accounts, a 22.9% increase from a year earlier. Supposedly, “[y]ounger customers were responsible for opening a substantial number of these new retail brokerage accounts,” and at least some of those customers were seeking the ability to trade in “meme stocks,” such as AMC Entertainment Holdings, Inc. (“AMC”), BlackBerry Limited (“BB”), and Nokia Corporation (“NOK”).
Faced with that paperwork onslaught – and I use paperwork here a bit euphemistically, as Fidelity allowed customers to submit applications on paper or electronically – Fidelity, according to the complaint, simply could not keep up, and so lots of questionable NAFs for options or margin accounts were approved. What made them questionable? Principally, the State alleges that the problem arose when some customers who submitted applications that were rejected, or approved for trading at a risk level lower than requested, would proceed, almost immediately, to submit “successive” applications, with different information than had been disclosed on the rejected application. Fidelity purportedly failed to notice, and ultimately approved the accounts.
Here are the pertinent allegations regarding the supervisory framework in which this matter arose:
- In July 2016, Fidelity created a policy that instructed the folks approving option account applications to “be alert to a customer initiating a pattern of reapplying for options approval by frequently increasing his or her financial or experience information in order to meet the approval standards.”
- But, no Fidelity agent or employee ever specifically informed the people responsible for actually approving option accounts about the policy, “let alone provided them with guidance as to what constitutes a ‘pattern’ or how to identify one.”
- Fidelity never required the account approvers to review the policy, “so they never had an opportunity to discover and read [it] for themselves.”
- While Fidelity’s computer system provides access to information about every prior options and margin application that a retail brokerage account has ever submitted, Fidelity’s review process never required account approvers to look beyond the single application in front of them.
As a result of these alleged supervisory shortcomings, options accounts were approved under the following factually challenging circumstances:
- Customer 1:
- He was a recent high school graduate who worked at an automobile oil change station at the time. Fidelity “failed to detect, let alone investigate,” the fact that he listed his occupation merely as “Job.”
- His initial application to trade options at “Level 3” was rejected, but approved at Level 1 (a level that did not permit particularly risky trades). Within a month, customer submitted three more applications to trade options at Level 2; the first two were rejected but the last one – the fourth in all – was approved, but the approver was apparently unaware of the three prior rejections.
- Fidelity “failed to detect, let alone investigate,” the fact that in the one day between the submission of his third and fourth applications, the customer asserted that his annual income had increased from between $20,001 and $50,000 to $100,001 or more, and that his liquid net worth had increased from between $30,001 and $50,000 to between $100,001 and $500,000, with no corresponding change in occupation.
- Customer 2:
- Customer 2 applied for Level 3 options trading, but was only approved for Level 1. The very next day, Customer 2 applied again for Level 3, and was denied again. Later that same day – so this would now be the third application in a two-day time period – he applied again for Level 3 and was approved.
- What changed? In less than one day, Customer 2 increased his annual income from between $20,001 and $50,000 to between $50,001 and $100,000, added three years to his experience in trading stocks, two years’ experience in trading options, four years’ experience trading equity options, and five years’ of experience trading index options.
- Customer 3:
- Basically the same story, only this time there were five options applications submitted in less than three weeks, the last of which resulted in the customer being approved for a higher level of risk than had been initially approved.
- Customer 4:
- Apparently saving the best for last, Massachusetts alleged that in less than a month, this customer submitted a total of 13 applications for options trading – 11 in one week alone – after the first one was approved but not at the customer’s desired level of risk. As with the other customers, the applications reflected unexplained, undetected and uninvestigated changes in the customer’s finances and trading experience.
Remember, these are just allegations, so we will see what happens. (I can tell you that it’s been reported that, in response to the complaint, Fidelity said, “We disagree with the characterizations of FBS contained in the complaint, believe that we have effective due diligence processes, and look forward to addressing and resolving this matter through the administrative process.”) Regardless, the complaint provides a valuable lesson here, underscoring the absolute truth of what I said at the outset of this post: as a defense lawyer, a new account form can become your best friend or your worst enemy.
To ensure that they remain the former, it is essential that you review the customer’s disclosures very carefully, looking for inconsistencies with what you already know about the customer (oftentimes from earlier NAFs you have on hand). Do not approve such an account without taking the time to investigate them, and document your efforts. Any firm whose account approval process has devolved simply into rubber-stamping is taking on completely avoidable and unnecessary risks. And I get it that Fidelity was swamped with account applications, reducing the amount of time available to vet those applications. That’s still not an excuse. Never was and never will be. Cut corners at your own risk when it comes to NAFs.
 The complaint alleges that Fidelity expects that the individuals responsible for rendering the final decision on options and margin applications “review paper applications at a rate of approximately 12 per hour and electronic applications at a rate of approximately 300 per hour. A CRT member might spend as little as a single minute reviewing an electronic application.”