FinraArbitration: Is it Fair ?


Unlike a Certificate of Depositthat is bought directly from a bank, a brokered CD is sold bystock brokers (and others). And unlike a bank-bought CD, a brokeredCD is marketable on a secondary market. It is FDIC insured upto $100,000 and it is often marketed as a suitable alternativeto Treasury issues. But there are pitfalls that I discovered recentlyby bitter experience.

I bought a total of $40,000in 10-year CD's in January and February of 2003 from one of thebest known, best respected security dealers in the country (Vanguard).Before I bought, the broker assured me that if I wanted to sellbefore maturity, I could do so in the secondary market. Of course,I understood that if interest rates go up, the market value ofthese securities would go down. That is elementary to anyone whohas ever been interested in fixed-income investments.

Immediately after I bought thesesecurities, the prevailing interest rates in fact went DOWN, soI would have expected the value of the securities to go UP. Butthat is not what happened. In the secondary market, the valueof these CD's in fact went down the minute I bought them, moreor less like the value of a new car the minute you drive out ofthe dealer's lot. The immediate loss was about 6.5%, in an environmentof FALLING interest rates, i.e. in an environment in which fixed-incomesecurities appreciated in value.

After many weeks of investigatingand discussions with other people, I learned much. The bank issuingthese CDs was rated 3 stars out of five by BauerFinancial, andit seems that the secondary market doesn't like this kind of bank.Yes, these CDs were FDIC insured. But apparently the market doesn'tlike long-term CDs from banks rated lower than four stars.

At the time of purchase, I hadno idea of the risk related to the credit worthiness of FDIC-insuredbanks. The broker didn't tell me; I wasn't even aware of the systemof rating banks.

The worst part is the following:there is evidence that on the very day these securities were soldto me, I could have bought similar CDs on the secondary marketat a discount of about 6.5%. The broker didn't tell me. In effect,the broker sold me securities at 100 when the market value ofthese securities was only about 93.5. He misrepresented the valueof these securities to me.

There is another way of lookingat the broker's misrepresentation. The CD that was representedas yielding 4.15% actually yields only about 3.38%, once the immediateloss of about 6.5% is factored in.

Well, to make a long story short,I have taken the matter to NASD arbitration, and I have, of course,also complained to the SEC and the Attorney General of New York.I trust, but do not know, that these regulatory agencies willtake a serious interest. The average time for an NASD arbitrationto be decided is a year. I am in my 3rd month of submitting discoveryrequests, etc. The broker is stalling.

And here is something I foundout only very recently: For small investors in CDs, there is FDICinsurance for amounts under $100,000. But it seems that the largerplayers in the field invest much higher sums at a time. So ifthe small investor wishes to sell his $10,000's worth of brokeredCDs on the secondary market, the larger players, who seem to dominatethis market and who apparently bunch smaller amounts, would notbe very interested if the issuing bank is only so so. They wouldlook for high-ranking banks, because for large investors, theseCDs are essentially uninsured. If such players make a bid forlower-ranked CDs such as mine, they will offer less to compensatethem for the higher risk. That's why the little guy needs to lookat the credit worthiness of the issuing bank. The number of starsof the issuing bank is worth concrete dollars on the secondarymarket. If your bank has only three stars, you will lose seriousmoney if you need to sell before maturity. This is not somethingmy broker warned me about. Does your broker disclose these factsof life of the CDs he offers you ?

I do not suggest that brokeredCDs should never be bought. But I would strongly suggest thata prospective buyer inform himself of the hidden risks. By thenature of such securities, the risks are higher the longer theterm. The highest risks are for CDs running for ten or more years.

When you are offered one ofthese securities, here is what you need to do:

1. Check the rating of the bank.This can be done without cost at either of the following ratingagencies (it's best to check both, in case there is a discrepancy):

2. Get the broker to check thevalue of a similar issue on the secondary market.

3. If the secondary-market valueis less than par, offer the broker this lower price. That mayresult in a good deal for you. For instance, an issue with a couponrate of 4.15%, if it sells on the secondary market for 93.5, willyield 4.98%.


Werner Cohn

November 25, 2003


October 2006 Update

Finra Arbitration: Isit Fair ?


The arbitrator (Mr. John F.Tague III, who is currently suspended from the practice of law-- see below) decided against us in this case in the summer of2004.

I thought that our case wasclear-cut and that the facts were all on our side. It is my opinionthat the arbitrator's decision was arbitrary and capricious.

But be that as it may, the caseexposed weaknesses in procedure that should be of great concernto all customers of security dealers.

As a condition for establishingan account with a dealer, a customer is required to sign an agreementin which he waives the right to sue. All disputes are to be arbitratedunder the auspices of the National Association of Security Dealers,which has since been absorbed by the Financial Industry RegulatoryAuthority (Finra).

Arbitration awards (decisions)cannot, except in the rarest of circumstances, be appealed tothe courts.

Hearings in arbitration arenot open to the public. In my case, the arbitrator also requiredme to sign a confidentiality agreement as a condition for approvingmy discovery requests. As a result, I cannot reveal the most significantevidence that I was able to introduce at the hearing. This evidencewould be of crucial importance to anyone contemplating a businessrelationship with the dealer. After the case was decided, thetop legal officer of the company (Vanguard) sent me a letter sayingthat he "expects" me to keep the evidence from the public.I took this to be a threat to sue if I reveal what I have learnedabout the practices of his company.

In contrast, court hearingsare public as a matter of principle, and evidence introduced incourt trials almost always become public documents.

The arbitrator's decision was"bare," i.e. it consisted of the word "denied"without explanation.

In the course of the arbitrationproceedings, the arbitrator, in my view, showed disdain and discourtesyto our side. Many months elapsed between the preliminary proceduresand the scheduled date of the hearing. When this date finallyarrived, I appeared at the designated office but the arbitratordid not. Apparently he had given a few hours notice to NASD (whichwas relayed to the other side but never reached me) citing a conflictwith his schedule. He then set another date that involved yetanother delay of several months, disregarding my request for speedierproceedings. (I assume here that Finra, which has absorbed NASDarbitration, operates under the old NASD rules).

Unlike procedures in other arbitrationschemes, NASD arbitration awards cannot be appealed to a masterarbitrator.

In sum, the secretive NASD procedureconcludes with the say-so of a single person, unexplained, unappealable,unchallengeable. (In cases involving more than $50,000, more thanone arbitrator will sit in a case.) Perhaps justice is done someof the time in these procedures, perhaps it is even done mostof the time. But justice is certainly not seen to be done. Thesystem has no apparent way of avoiding bias, caprice, sloth, orworse.

NASD has not responded to mywritten suggestions for more transparency and more accountability.

On August 15, 2006, some twoyears after the events recounted here and apparently unrelatedto them, Mr. Tague, the NASD arbitrator in our case, was foundguilty of multiple breaches of fiduciary duties as well as of"the extraction of unreasonable and unconscionable compensation."He was suspended from the practice of law for a period of twoyears, commencing September 15, 2006. 2006NY Slip Op 06234



October 16, 2004

revised October 4, 2006 and(slightly) on August 12, 2007.


UPDATE, February 13, 2009:

Mr. John F. Tague III, according to the website of New York State's Attorney General, is still suspended from the practice of law.




The Behaviorof FDIC-Insured CDs in the Secondary Market


Seniors are themost vulnerable



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