Herald Tribune (March 4, 2011 12:00 am) — Ewald Groetsch was lonely after his wife died in 2003. Mr. Groetsch, a retired grocery wholesaler who had dementia, struck up a relationship with a broker from Securities America and eventually agreed to put the bulk of his portfolio into a risky security usually reserved for experienced investors.

The broker, he said, portrayed the investment as “safe and secure.” But the company Mr. Groetsch bought into, Medical Capital Holdings, turned out to be a fraud, wiping out his entire investment.

While Mr. Groetsch, who is 85, has an outstanding arbitration claim against the brokerage firm, he is quickly losing hope of recovering his $500,000. Legal wrangling may cap the amount that can be recouped by him and other investors – who collectively lost $400 million – at around 10 cents on the dollar.

At issue is whether investors’ complaints should be resolved in arbitration, as is typical in the securities industry, or whether the claims should be rolled into two existing class-action lawsuits against Securities America, a unit of one of the nation’s largest advisory firms, Ameriprise Financial.

Arbitration is the preferred route for many of the investors. While it is never a sure bet, the forum proved successful for at least one Securities America client. In January, a regulatory panel awarded Josephine Wayman nearly $1.2 million, a sum that included roughly $730,000 of investment losses plus punitive damages.

But the class-action lawyers – who represent a group of brokerage clients with similar complaints – argue that the arbitration claims could threaten the financial position of Securities America and its ability to pay for a proposed settlement. The plaintiffs’ lawyers say that reasoning is misleading, given the brokerage firm’s deep-pocketed parent.

The closely watched case, the next round of which is set for March 18 in federal court in Dallas, could have serious implications. If the judge finds in favor of the class-action lawyers, financial firms could decide to use similar tactics to circumvent arbitration proceedings and limit their liability in securities cases, plaintiff lawyers and regulators say.

Regulators also worry the ruling may hamper their ability to sue Wall Street firms. Authorities in Montana and Massachusetts have brought separate actions against Securities America, claiming that the firm described the investments as conservative, even as an internal committee raised red flags about the risks. The class-action lawyers are asking the judge to also bring an end to the states’ cases, arguing that they could similarly drain the settlement fund.

“The federal government should not be pre-empting the states from protecting our citizens and enforcing the law,” said William F. Galvin, the chief financial regulator in Massachusetts. “We intend to fight it vigorously. It has the potential to set a very bad precedent.”

Securities America said it supported the settlement. “We are pleased that the judge is willing to consider the agreement reached by the parties,” said Janine Wertheim, a spokeswoman for the company. “We believe this represents good progress as we pursue a resolution to this matter.”

The legal drama centers on private placements, a type of corporate security that doesn’t trade on the public markets. The investments are considered riskier than regular stocks since they don’t face the same regulatory scrutiny. Brokers are supposed to sell them only to so-called accredited investors, like wealthy individuals and big institutions.

But the definition of accredited hasn’t changed much since it was first introduced by the Securities and Exchange Commission more than three decades ago. Under current rules, an investor must have earned at least $200,000 in each of the last two years or have a net worth exceeding $1 million, a calculation that includes the individual’s home.

As real estate prices inflated, the group expanded significantly. Some brokers, academics and lawyers say, exploited the situation to sell risky products to unsophisticated investors, particularly among the retired. The S.E.C. is considering raising the minimum level for the net worth requirements.

“We are seeing private placement being sold to retail investors that barely meet the standard that was set in 1982,” said Jennifer Johnson, a professor at Lewis & Clark Law School in Portland, Ore., who was called as an expert witness in one of the state regulatory cases. “Oftentimes, the investors are retired, not financially savvy and are solicited by brokers.”

Mr. Groetsch bought the private placements on the recommendation of his Securities America broker, Ron Carazo. The financial adviser, Mr. Groetsch said, described them as good alternatives to traditional fixed income products. Mr. Carazo continued to sell the securities to Mr. Groetsch, who has Alzheimer’s disease, even after his family asked the broker to stop, said Mike Groetsch, the son of Mr. Groetsch.

A lawyer for Mr. Carazo, Bruce Bettigole, said in a statement that Mr. Groetsch was a “high net worth accredited investor who evidenced his understanding of the risks involved.”

Other Securities America advisers are accused of making similar pitches about Medical Capital. The company, which billed its mission as “financing the future of health care,” purported to lend money to troubled hospitals, clinics and nursing homes. As brokers noted, investors would earn regular interest, not unlike a bond. In one marketing piece, Securities America called the investments “The Missing Piece That Should Be Included In Your Fixed Income Arsenal!” according to the Massachusetts complaint.

The brokers sold the products, even as an internal due diligence committee at Securities America raised concerns. In a 2005 e-mail, one executive at the brokerage firm worried that Medical Capital, which had issued $1.7 billion of securities, lacked audited results, according to the complaint. “At this point, there is no excuse for not having audited financials,” the executive wrote.

to produce such documents. “We simply have to tell them that if they don’t have the financials” by a certain date “we will stop distributing the product.” Securities America continued to sell the private placements for several more years, according to the complaint.

In 2009, the S.E.C. charged Medical Capital with fraud. Among other allegations, the agency claimed the company misappropriated funds. The court-appointed receiver for Medical Capital found that some of the money was invested in a yacht, named the Home Stretch; an Internet pornography company; and “The Perfect Game,” a movie about a Mexican little league team, starring Cheech Marin.

Now, investors’ fate is in the hands of the judge – and the early indications are not favorable.

In a Feb. 18 ruling, Judge Royal Furgeson halted three arbitration cases against Securities America. “If the arbitration were to proceed,” he wrote, “it would expend funds for legal defense that would otherwise be made available to class members.”

The Financial Industry Regulatory Authority, Wall Street’s self-policing organization that oversees the arbitration process, declined to comment.

The worry is that the firm won’t have the money to cover the class-action settlement and additional arbitration claims.

But plaintiffs’ lawyers say the judge should take into account the financial standing of the parent, Ameriprise. The financial firm, which was spun off from American Express in 2005, notched profits of $1.1 billion in 2010 on revenue of nearly $10 billion.

On March 3, Ameriprise agreed to add $27 million to the settlement fund, bringing the total to $48 million. A spokesman, Paul W. Johnson, said Ameriprise was “pleased to have reached an agreement.”

That $48 million pot, estimate plaintiffs’ lawyers, amounts to what Securities America collected in commissions on the private placements.

“These people have lost millions of dollars,” said Mr. Groetsch’s lawyer, Joseph C. Peiffer. “Now they are going to end up with virtually nothing, and Securities America gets to continue to operate as if this never happened.”