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Wall Street Litigation Opens Window on Product Sales Conflicts

Posted by Duane Thompson on June 13, 2014

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>>>The attempted defection by most of Deutsche Bank Securities’ private client group to an advisory firm last month offers a new twist to the old-fashioned tale of broker-poaching on Wall Street.

In what may be a sign of the times, Wall Street executives are now encountering a new fiduciary culture emerging within its ranks, not merely brokers jumping ship for greener pastures.

According to court documents in two lawsuits filed with the New York Supreme Court in Manhattan last month, Deutsche Bank Trust Company Americas v. HPM Partners and Pace v. Deutsche Bank Securities Inc., two of the resigning Deutsche brokers alleged that pressure by management to sell high-margin proprietary products made it impossible to fulfill their fiduciary obligations.

One of the brokers, Benjamin A. Pace III, is a frequent commentator on CNBC and was the bank’s chief investment officer for wealth management in the Americas.  The other plaintiff in the counter-suit, Lawrence B. Weissman, was head of portfolio consulting and reported to Pace.

Deutsche Bank, in turn, rejected the conflict-of-interest charges.

“Deutsche Asset and Wealth Management’s first priority is to fulfill fiduciary duties owed to clients and we reject the claims made in this complaint,” Renee Calabro, a spokesperson for the bank, told in response to the counter-suit. ]

In its original suit seeking a temporary restraining order to prevent a wholesale exit of the private client group, and a potential loss of billions in assets, Deutsche Bank claimed the resignations were a breach of fiduciary duty to Deutsche Bank, including violation of its employment policies.  Company policy requires up to 90 days’ notice prior to resignation and a ban on soliciting former customers for another 120 days.

Whether this dispute turns out to be just another ugly spat over broker poaching remains to be seen. 

Deutsche Bank directed most of its legal salvos at HPM Partners LLC, the advisory firm that DB alleged was involved “in a clearly choreographed commercial  assault…[that] raided virtually the entire senior management cadre of portfolio consultants” in its private banking business.  

There was certainly bad blood between them.  According to the brief, two years ago HPM was successful in hiring away four advisors in DB’s California office, resulting in the loss of $550 million in assets under management to HPM and forcing it to close its West Coast office. 

“This time HPM’s raid knows no limits,” Deutsche Bank’s brief stated, “and seeks to choreograph a mass exodus of key talent…resulting in a vast windfall for HPM – while HPM easily avoids the many years of marketing and investment dollars that it takes to establish and maintain those client relationships.”

In an effort to avoid DB’s policy restrictions on departing brokers, Pace and Weissman presented a novel legal argument that would not have been available to brokers simply moving to another wirehouse.  As financial advisors in the private banking group, meaning they were also affiliated with Deutsche Bank’s registered investment advisory firm, Pace and Weissman argued that the personnel policy was unenforceable because the bank’s efforts to establish a sales quota system would have “breached the Group’s...fiduciary obligations to put the customers’ needs first.”

According to court filings, they repeatedly expressed concerns with management regarding the conflict between an open-architecture platform and pressure to sell proprietary products.  In one incident, according to the counter-suit, management allegedly wanted them to place a newly developed hedge fund in customer accounts, which Pace and Weissman argued was inappropriate and unwanted by many of their retired investors, some of whom were in their 80s.  Senior executives also repeatedly requested data on their other  customer portfolio allocations to hedge funds in order to create investing targets for the private client group.

To avoid any negative perceptions by reluctant customers, Pace allegedly was urged by senior executives to create a new asset class called “long/short equity” as a way of obscuring the hedge fund investment.  According to court filings, he declined.

At other times, according to court documents, senior management asked Pace and Weissman to swap out existing outside funds in which the private client group invested with new proprietary products.  One proprietary fund allegedly pushed by management was a European fund that invested only in European Union countries and not Great Britain or Scandinavian countries; whereas the Group’s investment models required broader coverage.  Similarly, senior management wanted Pace to replace an outside Japanese equity fund with its own proprietary holding, which the counter-suit alleged would generate adverse tax consequences for its customers. 

At one point, senior management allegedly considered ways to avoid fiduciary conflicts by transferring some of the private client group to the bank’s broker-dealer, according to court documents.

In addition to arguing points of contract and employment law by both sides, the counter-suit did undertake a brief analysis of the advisors’ fiduciary duty, claiming the law was well settled in that area.  Financial advisors such as themselves [meaning Pace and Weissman acting as investment advisors] “owe the highest duty of loyalty to those on whose behalf they act,” according to their brief.  The Pace brief also noted their responsibilities under FINRA Rule 2111 to “only recommend products that were suitable for [their] client,” as well as citing other cases requiring brokers to give “honest and complete information” to their customers;  and when a fiduciary duty is lacking “use reasonable efforts to give information relevant to the affairs that [have] been entrusted to them.”

On May 30th, Justice Marcy Freidman ordered a June 24 hearing for all parties to show cause why a temporary restraining order should or should not be entered prior to entering arbitration.

Regrettably, it’s unlikely we’ll ever learn all of the facts in the case.  Ironically, FINRA’s Conflicts of Interest Report, [See attached ‘FINRA conflicts report] released last fall, highlighted many of the same problems raised in the Deutsche case.

In the report, which strongly encouraged broker-dealers to identify and mitigate firm-wide conflicts of interest, FINRA recommended that “firms’ private wealth businesses should operate with appropriate independence from other business lines within a firm.”  The report went on to say FINRA was “encouraged by the general adoption of open product architectures (i.e., the sale of third party in addition to proprietary products).”

FINRA also recommended firms develop safeguards such as the use of product review committees  to reduce “pressure to prefer proprietary products to the detriment of customers’ interests.”  This issue was particularly important, the report emphasized, when firms seek to leverage their brokerage platforms to cross-sell other products and services.  One of the allegations in the Deutsche suit was that the bank skirted its usual due diligence process for new product development.

In a statement accompanying the FINRA report, FINRA Chairman and Chief Executive Officer Richard Ketchum said that while member firms “had made progress in improving the way they manage conflicts, our review reveals that firms should do more.”

Following the June 24th hearing, it’s likely that FINRA arbitration is the next stop in the Deutsche dispute.  Whether the Court grants restraining orders or not, there is always the possibility that FINRA, the SEC or New York Attorney General could intervene by opening separate investigations.  Given the significant media attention, probably due to the fact that Pace was with Deutsche Bank for 20 years and a frequent television commentator, it seems unlikely that the case would escape regulatory attention. 

Separately, after the arbitration case is concluded, that is, if it is not settled in private between the parties, the arbitrators could also make an enforcement referral  to FINRA if they believe there were significant violations.   Even if the arbitrators reach a decision, the panel is not required to write a basis for its decision, unlike a court.

Assessing where Deutsche Bank is on the fiduciary spectrum, and HPM Partners, for that matter, is of course, problematic.  Given the discretionary management of assets and special compensation charged for advice, the private client group operated under Deutsche Bank’s RIA.  However, according to Deutsche Bank’s Form ADV, of its 4,100 employees, 3,600 are registered representatives and only 276, or roughly 7 percent, are investment adviser representatives.  In contrast, 16 of HPM Partners’ 55 employees, or  29 percent, are IARs.  Moreover, three of HPM’s 20 partners are Accredited Investment Fiduciary® designees, suggesting a strong professional interest within the firm in best practices.   HPM reported no disciplinary infractions under its advisor registration, nor did Pace and Weissman have a disciplinary history as brokers or IARs.

How this limited data set translates into a vibrant, client-first fiduciary culture is difficult to judge.  Certainly, IAR or AIF® numbers alone are not necessarily an accurate barometer of a firm’s fiduciary culture, and the disciplinary histories of small advisory firms are typically clean (or much cleaner) than a large brokerage firm with thousands of workers.  However, the sheer weight of multiple conflicts that Deutsche Bank and other large firms must avoid or manage on a daily basis suggests hard choices will have to be made as Wall Street moves forward along the fiduciary path.

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