There are three common methods of calculating damages in an arbitration before the Financial Industry Regulatory Authority (FINRA)—(1) net out-of-pocket damages; (2) trading losses; and (3) well managed portfolio damages. It is in the complete discretion of the arbitration panel to determine the appropriate measure of damages based on the specific facts and circumstances of each case. In addition, the arbitration panel may elect to enhance a damages award by adding pre-judgment interest, attorneys’ fees or punitive damages.
Net Out-Of-Pocket Damages
Net out-of-pocket damages are calculated by measuring the total principal loss in a security and reducing it by the amount of income the investor received during the life of the investment. For example, if an investor purchases a security for $10, sells it at $5 for a principal loss but receives $2 of income, they have a net out-of-pocket loss of $3. In this scenario, the investor is simply put back in the same position they were in prior to making the investment. Of the methods for calculating damages, this is the most favorable for the brokerage firm.
Trading losses reflect the actual principal loss realized by the investor. Using the same example above, if an investor purchases a security for $10, sells it at $5 for a principal loss but receives $2 of income, they still have trading losses of $5. In this instance, the arbitration panel compensates the investor for the principal loss they incurred and does not offset the damages by the income received. The damages awarded to the investor are $5 under this scenario. The investor also keeps the $2 of income. Of the methods for calculating damages, this is more favorable for the investor.
Well Managed Portfolio Damages
Well managed portfolio damages is a legal theory that is predicated on the idea that investors are entitled to receive a return on their investment that is commensurate with a well-allocated and diversified investment portfolio; hence the name “well managed portfolio.”
For example, it is generally unsuitable for an investor to be overconcentrated in a limited number of investments. Under this scenario, an investor could present the arbitration panel with a well-managed portfolio damages model that hypothetically assumes that the investor held a more suitable allocation, consisting of 50 percent in stocks listed on the S&P 500 and 50 percent in investment grade bonds. The well managed portfolio model would generate a beginning and end portfolio value, the difference of which would be deemed recoverable damages. Put another way, if my Financial Advisor would have recommended a suitable portfolio, my account value would be $500,000 instead of $300,000; thus my damages are $200,000.
Interest, Attorneys’ Fees and Punitive Damages
In FINRA arbitration, arbitrators have the discretion to award pre-judgment interest and punitive damages.
Pre-judgment interest seeks to compensate the investor for the “loss of use” of their money during the time period they held the unsuitable investment and assumes the investor would have otherwise earned a reasonable rate of return on that money had it been suitably invested in the first instance. The arbitration panel has the discretion to determine the beginning and end point for the assessment of pre-judgment interest. Typically, arbitration panels will award pre-judgment interest, beginning on the date of the misconduct and ending on the date that the arbitration award is entered or paid.
Punitive damages are not commonly awarded in FINRA arbitration and are reserved for egregious, reckless conduct by the brokerage firm or Financial Advisor. Examples of egregious conduct include intentional misrepresentations, theft or misappropriation. If the investor is able to prove reckless misconduct, the arbitration panel can award punitive damages in an amount that will deter the brokerage firm from engaging in the same misconduct in the future.
In most jurisdictions, the “American Rule” is applied and authorizes arbitration panels to award attorneys’ fees only if there is an agreement between the parties to the arbitration or a statute that provides for attorneys’ fees. In most FINRA arbitrations, no agreement exists between the parties to submit the issue of attorneys’ fees to the arbitration panel. Rather, the investor must rely on a state or federal statute that permits the recovery of attorneys’ fees. In many jurisdictions, the state securities laws provide for the recovery of attorneys’ fees.
Other Frequently Asked Questions:
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- How Do Arbitrators Determine Suitability?
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