Can an independent broker/dealer avoid paying a multi-million-dollar FINRA arbitration award by transferring virtually all of its registered reps and clients to another firm?
A case winding its way through federal appeals court in Georgia is challenging a move that some investor advocates characterize as a “road map” for IBDs to avoid paying damages awarded by the self-regulatory organization's arbitration panels: simply close the shop and move the business—the independent registered reps and their clients—to another registered firm.
The Public Investors Advocate Bar Association (PIABA) in June filed an amicus brief in Loving et al v. Kovack Securities, supporting plaintiffs who’d previously won a multi-million-dollar FINRA arbitration award against the Georgia-based brokerage firm Resources Horizons Group (RHG), but were unable to fully collect—the year after that award was granted, RHG President Kelly Miller allegedly struck a deal that led to most of the firm's reps and client accounts transferring to the Ft. Lauderdale, Fla.–based Kovack Securities, an independent broker/dealer established in 1997, according to its FINRA BrokerCheck profile. (RHG's FINRA broker/dealer registration was terminated in early 2015, according to its BrokerCheck page.)
In response, the recipients of the FINRA award sued Kovack Securities, arguing that the new firm housing the old firm's reps should be on the hook to make the harmed clients whole.
But industry advocates like the Financial Services Institute (FSI) are supporting Kovack, arguing a ruling against the firm would have “substantial ramifications” for the b/d industry.
“More broadly, the decision would have a ‘chilling’ effect on the transfer of financial advisors and the customer accounts they service to new broker-dealers when a broker-dealer becomes insolvent,” attorneys for the institute wrote.
The dispute originated in 2013, when elderly investors Ronald and Freda Loving “entrusted the investment of their life savings” to Robert Gist, who was operating as a registered rep at RHG and working with clients via his investment firm, Gist, Kennedy & Associates.
According to charges from the Justice Department, Gist misled the Lovings and more than two dozen other clients who’d invested more than $6.8 million with him. Gist assured clients he’d make conservative investments in corporate bonds and other securities, but instead used their funds for personal expenses, to fund business ventures and pay other clients to keep the scheme running, with victims eventually losing all their investments, according to the DOJ.
Gist, who'd met many of his clients due to working as a sports agent representing professional athletes, pleaded guilty to charges of wire fraud in August 2016, and was sentenced to five years in prison that December.
But the Lovings had nevertheless lost "substantially all of the money they had given Gist to invest," according to their eventual complaint against Kovack. The Lovings, along with Delutha King, Lois King, Kristie Taylor and the estate of Cecil and Mabel Keck, brought a FINRA arbitration case against RHG and eventually won more than $3.8 million in damages.
The FINRA award exceeded RHG’s net capital reserves, and it was required to end operations as a b/d, with its registered reps needing new affiliations in order for them to be able to work with clients, according to a brief later filed by Kovack Securities in its own defense.
During the arbitration proceedings, Miller spoke with Kovack Securities President Brian Kovack about “selling” the firm’s assets, “including its customer accounts,” according to later accusations from Loving and the other victims.
But after the blockbuster FINRA judgment, the two brokerage firms “colluded to hide from FINRA regulators” that they’d considered a sale of “assets,” later telling regulators that RHG’s registered reps and client accounts weren’t “assets” since reps and customers can “choose to do business with any brokerage firm they wish,” according to Loving’s subsequent suit against Kovack. At the time, RHG had 3,341 brokerage accounts with $326 million AUM, and more than 48,800 direct business accounts with AUM of $1.185 billion, according to that original complaint.
RHG and Kovack Securities allegedly agreed on a “negative consent” process to transfer reps between the firms, where reps and clients had 30 days to opt out of the transfer (about 180 of RHG’s 210 reps eventually registered with Kovack Securities). The reps and accounts transferred in July 2015 without Kovack paying money, according to Loving and the other victims; Kelly Miller joined Kovack Securities, where she continues to work, according to her BrokerCheck profile.
In an interview with WealthManagement.com, Hugh Berkson, an executive vice president at PIABA and senior attorney at the Cleveland-based firm McCarthy Lebit, called RHG’s actions a “concerted effort” to avoid paying a legitimate award. Moving the business “for no or inadequate consideration” was simply an “improper escape route” for RHG, according to PIABA’s brief.
In response, Loving and the others sued Kovack Securities, arguing they’d violated Georgia’s Uniform Fraudulent Transfer Act, which says that if an “asset” produces an income stream, it holds value. Adam Rubenfield, a partner at Hungeling Rubenfield in Atlanta and counsel for the plaintiffs, said the transfer of client accounts and reps from RHG to Kovack was “fraudulent” under state law.
“The key issue is whether books of business constitute assets,” he said. “We argue they do.”
But U.S. District Court Judge Steve C. Jones disagreed, ruling in favor of Kovack Securities in September of last year before the case proceeded to trial. In his decision, he argued that RHG’s clients, not the brokerage firm, owned and had the right to manage their own accounts, and even while Kovack and RHG profited off commissions from those accounts, they could not autonomously sell or transfer them like an owner could.
“Under its IBD structure, RHG could not dispose or transfer these accounts without some form of consent from the customers, whereas customers could terminate or transfer these accounts at will,” Jones wrote.
(Attorneys for Kovack Securities declined to comment for the story, pointing to the arguments included in the motion for summary judgment as well as their brief during the subsequent appeal).
But Loving and the others appealed, bringing the case to the 11th U.S. Circuit Court of Appeals, where groups like PIABA and the FSI are now having the chance to weigh in.
In Kovack Securities’ response to the plaintiffs’ appellate brief, they agreed that Loving and the others had a right to RHG’s owned assets, noting they’d already collected more than a million dollars from the defunct firm.
“They have no right to treat customers and accounts RHG did not own as chattel or to collect from another broker-dealer simply because customers chose to do business there after RHG’s collapse,” Kovack’s attorneys wrote. “What Plaintiffs seek is not justice, but to hold innocent third parties responsible for the losses caused by a criminal.”
Rubenfield acknowledged they were surprised by the ruling in favor of Kovack, saying if the case had gone to trial, the question of the transfer’s true value could have been better litigated.
“Like any other asset of a business, they’re going to get valued for whatever they're transferring or selling, and in this case we believe Kovack Securities should have paid fair value for what it received,” he said. “I think any objective person would agree there’s value in the right to manage those customer accounts even if the customers are ultimately the ones who own the accounts.”
The Cornell Securities Law Clinic filed its own brief supporting Loving and the others, arguing that the vital point was not who legally owned the accounts but whether those accounts had a value in a way that RHG should have received compensation for transferring them to Kovack.
Berkson argued that the dispute exemplified a recurring industry problem that was indicative of broader industry issues with unpaid arbitration awards, in which firms saddled with high penalties shut down operations rather than pay the fines, reopen with a new name and registration, and continue to do business “with no repercussions or liability.”
“Should the decision be overturned, as we think it should be, it’s a clear message to the industry that these sorts of games should not be tolerated, and this should not be a way to avoid liability,” Berkson said.
But the FSI disagreed that the unpaid arbitration awards issue was the industry scourge that PIABA and Cornell claimed, going as far as to say that their use of certain statistics without context had been “potentially misleading.”
To the institute (which advocates and lobbies for the b/d industry) the broker/dealer business model was built on “flexibility and freedom,” which would be under attack if the court decided that a firm’s assets also included customer accounts and relationships. Nor would the impact of the ruling be limited to Georgia, FSI argued.
“Creditors would use this holding to attack any operating broker/dealer that facilitates and or accepts the transfer of retail customer brokerage accounts from an insolvent broker/dealer, whether or not consideration is paid for such a transfer,” the institute’s brief read.
The court is currently awaiting a reply by the plaintiffs to Kovack’s brief in support of its case, which is due by Sept. 12.