Calculating Damages in Securities Arbitrations: How Much Money Are Wronged Investors Owed?

Introduction: When Might Investors Be Entitled to Damages in Securities Arbitrations?

Most claimants put forth a securities claim when they believe they have suffered financial harm due to a broker’s fraud or negligence. They go through the process, their attorneys by their side, because they are driven not only to see justice served and to potentially protect future investors from being harmed, but also to recover money they have lost in the form of damages. If a claimant wins, damages are carefully calculated to compensate them.

It is important to recognize the difference between losses incurred during the regular ups and downs of the stock market and losses incurred through broker fraud. In their article The Calculation of Damages in Securities Arbitration[i], experts Mary Calhoun, Norman Padgett, and Ross Tulman explained that the investor “presumably assumed the general risk of investing in the market, but not the specific risk of investing in unsuitable securities…” In addition to suitability claims, claimants might also be seeking restitution if their broker engaged in negligence, churning, failure to supervise, Ponzi schemes, or any other number of wrongful actions

Two Remedies: Net Out-of-Pocket Damages and Well-Managed Damages

At the end of an arbitration proceeding, if the arbitrators believe that the claimant’s attorneys have proven, by a preponderance of the evidence, that the respondent is liable for financial losses, then the next step is for the arbitrators to, according to the Financial Industry Regulatory Authority (FINRA), “determine an appropriate remedy.” The most common remedy is damages awarded in the form of money. How are these damages calculated? The two major ways of calculating damages are “net out-of-pocket damages” and “well-managed damages.” Let’s discuss both methods of calculating damages in securities arbitrations.

How to Calculate Net Out-of-Pocket Damages in Securities Arbitrations

According to the Arbitrator’s Guide[ii] issued by the FINRA Office of Dispute Resolution, one form of damages, net out-of-pocket damages, can be calculated two ways, depending on whether “the wrongful conduct involves one or more specific trades” or “if the wrongful conduct involves the management of an entire account.”

For specific trades, damages are calculated as follows:

1. The purchase price of the security plus commissions, minus…

2. The total value of the security on the relevant date, plus

3. Dividends or interest received

For the whole value of a portfolio account, damages are calculated as follows:

1. The initial value of the account, plus…

2. Money and securities deposited, minus…

3. Money and securities withdrawn, less…

4. Account value on the relevant date

For example, assume that a client invests $100,000 in December 2016. They subsequently receive $25,000 in dividends. In December 2017, however, they learn that the investment was a scam and is now worth $0. Their losses are $75,000.

Net out-of-pocket losses are disfavored by arbitrators. Instead, well-managed damages constitute a more appropriate method of calculating damages.

How to Calculate Well-Managed Damages

A second method of calculating damages in a securities arbitration involves comparing the claimant’s portfolio (which has incurred losses due to fraud or negligence, as described above) with a typical, suitable portfolio that acts as a model for how the claimant’s portfolio would have likely performed had there been no wrongdoing.

In their article The Calculation of Damages in Securities Arbitration, experts Mary Calhoun, Norman Padgett, and Ross Tulman explain that the purpose of presenting a Model Portfolio to an arbitration panel is to “demonstrate what the account would have earned or lost had it been invested in some other investment surrogate.” In FINRA’s Arbitrator’s Guide, the FINRA Office of Dispute resolution states, “This measure of damage allows the claimant to recover the difference between what the claimant’s account made or lost versus what a well-managed account, given the investor’s objectives, would have made during the same time period.”

Also known as “market-adjusted damages”, well-managed damages are frequently called “Miley damages” because of the seminal case Miley v. Oppenheimer & Co. (1981). This case established that claimants are entitled to damages equal to the drop in worth of their portfolio, as well as the recovery of commissions and interest paid to the broker.

Calhoun, Padgett, and Tulman assert:

In a falling market, market-adjusted damages reduce the loss caused by unsuitable or otherwise improper activity. In a rising market, market-adjusted damages compensate the investor for lost total return caused by a breach. … In most cases, the claimant’s damage calculation indicates that, had the account been suitably, or properly managed, there would have been no out-of-pocket loss. Instead, the account would have generated a positive total return. Here, the claimant seeks as damages the out-of-pocket loss plus a market-adjusted damage component.

How are well-managed damages calculated? Experts use software programs to calculate market-adjusted damages, comparing them to the average performance of the S&P 500. Mutual fund averages work well as a comparison tool for a model portfolio. Calhoun, Padgett, and Tulman go a step further and argue that mutual funds from the respondent’s own brokerage fund are a particularly effective tool in demonstrating a claimant’s losses. They argue, “By using an average fund rate of return for a particular investment objective, we avoid accusations that the surrogates have been ‘cherry-picked’ to enhance damages.”

Using the same example, assume that a client invests $100,000 in December 2016. They subsequently receive $25,000 in dividends. In December 2017, however, they learn that the investment was a fraud and is now worth $0. Assume that the S&P 500 appreciated by 10% from December 2016 to December 2017. (This is not an actual rate of return and is used for illustration purposes only). IN this case, their damages would be calculated as (100,000 * 10%) = (110,000 — [25,000 + 0]) = 85,000. Thus, the client’s damages would be $85,000.

Next Steps

Recovering lost funds in the form of damages is no easy task. For that reason, it is imperative to retain a securities attorney. Call (877) 238–4175, email info@fkesq.com, or visit www.stopbrokerfraud.com for your free case consultation with the knowledgeable and experienced securities attorneys of Fitapelli Kurta.

[i] Mary Calhoun and Ross Tulman, The Calculation of Damages in Securities Arbitration, reprinted in David E. Robbins’s Securities Arbitration 2000: Today’s Trends, Predictions for Tomorrow (PLI Corporate Law and Practice Course Handbook Series No. B-1196).

[ii] Financial Industry Regulatory Authority, FINRA Office of Dispute Resolution Arbitrator’s Guide. November 2019. https://www.finra.org/sites/default/files/arbitrators-ref-guide.pdf