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SPOTTING
COMMON FORMS OF STOCKBROKER MISCONDUCT
by Brian N. Smiley
In recent
months, the brokerage industry has been the subject of scathing
headlines about fraud, corruption and conflicts of interest. The media
have reported on abuses ranging from tainted research reports to
outright theft by brokers. Investors have lost billions of dollars and
confidence in securities markets has plummeted.
Happily for investors, there
is a remedy for the client who has lost money as the result of broker or
brokerage misconduct, whether that misconduct is the result of outright
fraud or simple negligence.
Since 1987, when the U.S.
Supreme Court upheld the validity of contractual provisions requiring
arbitration of controversies between clients and brokerages, the primary
venues in which such claims are heard are the arbitration departments of
the NASD and NYSE. This article will examine several common forms of
investor claims which are heard in arbitration.
Misrepresentations and
Material Omissions
A disturbingly prevalent
form of abuse occurs when a broker either lies outright to the client or
offers up half-truths in order to induce a client to purchase or sell
securities. This is fraud, pure and simple. Common misrepresentations
and material omissions include: (1) telling a client that a company is a
"hot prospect" when it is virtually bankrupt; (2) implying
that the broker has inside knowledge about a company's plans or
prospects ("I know that the stock will double after the company
announces its new contract," etc.); (3) describing an investment as
safe, secure, guaranteed or government-backed when it is not; and (4)
recommending a stock without telling the client that the broker or his
firm is receiving "undisclosed" payments from the issuer or
others.
Not just individual brokers,
but brokerages and their analysts, can be guilty of misrepresentations.
After reports that a Merrill Lynch internet analyst was issuing
enthusiastic recommendations for Merrill's clients to buy stocks he was
deriding in his e-mail as "junk", "crap" and worse,
SEC Chairman Harvey Pitt, correctly stated, "If an analyst says 'I
think X is a good stock' but he or she really thinks X is a bad stock,
he or she has committed fraud."
False statements or material
omissions made to induce the trading of stock constitute violations of
the Securities Act of 1933, the Securities Exchange Act of 1934, and
state "Blue Sky" securities laws such as the Georgia
Securities Act, O.C.G.A. § 10-5-12(a). They may also constitute common
law fraud, deceit, or breach of fiduciary duty.
Breach of Fiduciary Duty
Controlling authorities
acknowledge that a fiduciary duty runs from the stockbroker to the
client. See Weiss, "A Review of the Historic Foundations of
Broker-Dealer Liability for Breach of Fiduciary Duty," 23 Iowa
Journal of Corporate Law 65 (1997); Rolf v. Blyth, Eastman, Dillon
& Co., 570 F.2d 38 (2d Cir. 1978); Glisson v. Freeman,
Glisson, 243 Ga. App. 92, 532 S.E. 2d 442 (2000); Beckstrom v.
Parnell, 730 So. 2d 94 (La. App. 1998). The SEC has acknowledged
that it is a "basic principle" that by holding itself out to
the public as a broker-dealer, a firm represents that it will act in the
client's best interest. In re D.E. Wine Investments, Inc. Admin.
Proceeding File No. 3-8543 Release No. ID-134, 1999 WL373279 (June 9,
1999).
A fiduciary duty is one of
the most demanding standards of care imposed by law. The fiduciary owes
the utmost good faith, competence and candor to his client. According to
an influential decision of the Eleventh Circuit Court of Appeals, the
fiduciary responsibilities of a broker include:
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The duty to recommend a
stock only after studying it sufficiently to become informed as to
its nature, price and financial prognosis;
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The duty to carry out
the customeršs orders promptly and in a manner best suited to serve
the customeršs interests;
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The duty to inform the
customer of the risks involved in purchasing or selling a particular
security;
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The duty to refrain from
self-dealing;
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The duty not to
misrepresent any material fact to the transaction; and
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The duty to transact
business only after receiving authorization from the customer.
Gochnauer v. A.G. Edwards
& Sons, Inc., 810 F.2d 1042, 1049 (11th Cir. 1987) [quoting
Lieb v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 461 F.
Supp. 951, 953 (E.D. Mich. 1978)].
Suitability
Suitability is a concept
rooted in the fiduciary nature of the broker's relationship with his
client. The basic standard of suitability is set forth in the NASD
Conduct Rule 2310:
In recommending to a customer the purchase, sale or exchange of any
security, a member shall have reasonable grounds for believing that the
recommendation is suitable for such customer upon the basis of the
facts, if any, disclosed by such customer as to his other security
holdings and as to his financial situation and needs.
Similarly, NYSE Rule 405
(the so-called "Know Your Customer Rule") requires members to
use "due diligence to learn the essential facts relative to every
customer," every order [and] every cash or margin account and as to
all accounts accepted and all trades conducted.
As stated in Norman Poser's
treatise, Broker-Dealer Law and Regulation §3.03 (3d ed. 2001
Supp.) "The [suitability] doctrine is based on a 'homely truth
about investing --investment decisions are made only in light of the
goals and needs of the person for whom they are made."
In order to comply with
these rules, brokerage firms routinely have clients sign forms when an
account is opened which discloses the client's assets, investment
experience, and investment objective. See NASD Conduct Rule 2310(b).
Careful analysis is required
to determine if a broker has made or recommended unsuitable trades. The
quality of the securities traded must be appropriate for the age,
income, financial needs, risk tolerance and investment acumen of the
client. Typical kinds of suitability violations include:
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recommending excessive
positions in speculative "tech" stocks to investors whose
primary objective is preservation of principal;
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failing to provide a
prudent and diversified portfolio for retirees;
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engaging in short term
trading, options trading or excessive trading or margin in the
accounts of persons with irreplaceable funds.
Suitability violations often
overlap with other wrongful behavior such as churning and making
fraudulent misrepresentations. For example, if a broker deceives an
elderly client with false assurances that her investment is safe when,
in fact, he is engaging in short-term trading of speculative stocks,
multiple violations occur simultaneously. It should be emphasized,
however, that merely making adequate risk disclosure does not insulate a
broker from liability for making an unsuitable recommendation. According
to an opinion of the National Adjudicatory Council of the NASD-Regulation
, "Although it is important for a broker to educate clients about
the risks associated with a particular recommendation, the suitability
rule requires more from a broker than mere risk disclosure." In
re James B. Chase, August 15, 2001 (Complaint No. C8A990081).
Indeed, even if a misguided customer wishes to speculate, but it
is not suitable for him to do so , the broker is enjoined not to
exacerbate the problem by making recommendations which are inconsistent
with the client's financial profile. Id. ; Eugene Erdos, 47 S.E.C.
985 (1983), aff'd 742 F.2d 507 (9th Cir. 1984) John M. Reynolds,
50 S.E C. 805, 808 (1992).
Another form of suitability
violation occurs when the broker makes recommendations of stocks without
having conducted a reasonable investigation of the security and its
issuer. Although brokers are not guarantors of the performance of stocks
they recommend, they have a duty to investigate the financial condition
of issuers. In re B. Fennekohl & Co., 41 S.E.C. 210, 215-17
(1962) (broker has duty to investigate issuer's financial condition
before recommending stock). The existence of a special relationship
between the brokerage and the issuer such as the brokerage serving as
the issuer's investment banker, increases that duty of investigation .University
Hill Foundation v. Goldman Sachs & Co., 422 F. Supp. 879 (S.D.N.Y.
1976).
Churning
Churning is one of the
better known forms of investor abuse. In Miley v. Oppenheimer &
Co., 637 F.2d 318, 324, reh'g denied, 642 F.2d 1210 (5th Cir.1981),
the court stated "Churning occurs when a securities broker enters
into transactions and manages a client's account for the purpose of
generating commissions and in disregard of his client's interests."
In Miley, the court
enumerated the elements of a churning case: (1) the trading in [the
investor's] account was excessive in light of his investment objectives;
(2) the broker in question exercised control over the trading in the
account; and (3) the broker acted with the intent to defraud or with
willful and reckless disregard for the investor's interests. 637 F.2d at
324.
The question of whether
churning has occurred begins with consideration of the client's
investment needs and objectives. A client who wishes to invest over the
long term for retirement or to fund a child's education would not likely
want to take the risks and bear the commission costs associated with
short term speculative trading. On the other hand, a well-heeled,
financially savvy young business person may well be willing to trade for
quick profits.
In judging whether a
claimant is an innocent dupe lured by his broker into speculative short
term trading or a modern-day riverboat gambler, factors such as the
investor's age, education and business background come into play. These
factors also play a role in determining whether the broker or the
customer controlled trading in the account. An investor's previous or
contemporaneous experience in the stock, options or commodities markets
must be ascertained.
Although churning may be
difficult to prove where the plaintiff is highly educated, as is pointed
out in Goldberg, Fraudulent Broker-Dealer Practices, §§ 5.2,
5.3 (1978), the mere fact that the customer is well-educated or is
knowledgeable about business in general does not mean that he will
necessarily be considered a sophisticated investor. What counts most is
knowledge of the securities markets. Thus, an investor who follows the
market closely by reading investment advisory services, tracks his
portfolio on the internet or participates in stock "chat
rooms" will have a hard time establishing that a high level of
trading in his account over a sustained period was contrary to his
wishes.
Churning often occurs in
accounts in which the customer gives the broker discretion (discussed
below) to execute trades without the client's prior consent. The very
fact that a client is willing to repose nearly absolute confidence in
his broker's discretion is strong evidence of his own lack of financial
sophistication. If the client routinely follows his broker's
recommendations, churning can be found even though a formal
discretionary account has not been established. Conversely, if the
broker merely acts as an order taker for the customer, the broker may
lack the control necessary to find churning.
Various cases and
commentators have suggested mathematical tests to assess whether an
account has been traded excessively. The most common is the
"turnover rate." This is measured by dividing the total dollar
cost of purchases by the account's average monthly equity. This number
is then divided by the number of months over which trading occurred and
this monthly turnover figure is then multiplied by 12 to establish an
annual turnover rate. An annual turnover rate of two or more has been
utilized as an appropriate point at which to infer excessive trading in
an account which the investor intends to use for long term investment.
For such investment accounts, an annual turnover rate of six is said by
some to be virtually conclusively excessive. Of course, a high turnover
rate does not establish churning if indeed the client's investment
objective is to trade frequently. Similarly, for very conservative
investors, a turnover rate of 2 may well be excessive. Jenny v.
Shearson, Hamill & Co., 1978 U.S. Dist. LEXIS 15077 (S.D.N.Y.
1978) (denying motion for summary judgment because a turnover rate of
1.84 might be considered excessive depending upon the circumstances.).
In analyzing a churning
case, a studied analysis should also be made of the length of time
securities are held. For example, in Hecht v. Harris Upham & Co.,
283 F.Supp. 417, 436 (N.D. Cal. 1968), modified on other grounds, 430
F.2d 1202 (9th Cir. 1970), churning was found where almost half of the
plaintiff's securities were held for less than six months and 82% were
held for less than a year. In Mihara v. Dean Witter & Co.,
619 F.2d 814, 824 (9th Cir. 1980), evidence established that 81.6% of
the plaintiffs stocks were held for 180 days or less, and during one
year, 50% of the securities were held for 15 days or less. Another
indication of churning is "in and out trading," i.e., multiple
purchases and sales of the same securities, sometimes within a matter of
days or even hours.
Since the broker's primary
motivation in churning an account is to obtain commissions, an
investigation of the account will frequently reveal that the amount of
commissions is unreasonably large, as a percentage of the value of the
investor's portfolio, or as a percentage of the broker's income.
Churning is, by its very
nature, conduct which evidences intent to defraud the investor by
over-trading his account in order to generate excessive commissions. At
a minimum, churning involves a reckless disregard for the investor's
interest. Accordingly, in Miley, the court pointed out that
churning violates Section 10(b) of the Securities Exchange Act and Rule
10b-5 as a "device, scheme or artifice to defraud." The court
also stated that churning is a breach of the broker's common law
fiduciary duty to his customer.
Rules of the NASD Regulation
and the New York Stock Exchange, Inc., which govern the brokerage
industry also prohibit churning and require that supervisory procedures
be in place to prevent this illegal practice. See, NASD Conduct Rule
2120 (prohibition of the use of any manipulative, deceptive or other
fraudulent device or contrivance); NASD Conduct Rule 3010 and NYSE Rule
405 (duty to supervise diligently). It is important to note that these
rules are often looked to by courts as evidencing the standard of care
in the brokerage business. Petrites v. J.C. Bradford, 646 F.2d
1033 (5th Cir. 1981); Lange v. Hentz, 418 F. Supp. 1376, 1383-84
(N.D. Tex. 1976); Mihara v. Dean Witter & Co., 619 F.2d 814,
824 (9th Cir. 1980).
Unauthorized Trading
Unless a client gives a
formal written grant of "discretion" to his broker, a
stockbroker is not entitled to trade in the client's account without
obtaining prior approval for transactions. NASD and NYSE rules and
industry practice require that discretionary trading authority be in
writing and that discretionary accounts be subject to great supervisory
scrutiny by management. If written discretionary authority is not given,
the broker simply has no right to trade without the investor's prior
approval of each transaction. (NASD Conduct Rule 2510 and NYSE Rule 408)
The excuses that the broker could not reach the client or that he had to
move hastily in order to avoid missing a "good deal" will
simply not suffice.
Unauthorized trading is a
form of conversion of the client's money in order to generate
commissions for the broker. Arceneaux v. Merrill Lynch, 767 F. 2d
1498 (1501) (11th Cir. 1985). In Merrill Lynch, Pierce, Fenner &
Smith, Inc. v. Cheng, 901 F. 2d 1124, 1129 (D.C. Cir. 1990), the DC
Circuit held that a client who is the victim of unauthorized trading
does not ratify the illegal transactions simply by failing to object
upon receipt of a confirmation slip. Rather, according to the court, the
brokerage had a duty to tell the client of his right to reject an
unauthorized transaction.
Liability of the
Brokerage House
The rules of the NASD and
NYSE require brokerage houses to supervise their brokers' handling of
accounts. See NASD Conduct Rule 3010 and NYSE Rule 405.
Unfortunately, these rules are often ignored by brokerages, and abuses
such as churning and trading of unsuitable stocks may go unchecked. When
this happens, the brokerage house may be held liable for the acts of its
broker under several theories. Section 20(a) of the 1934 Securities
Exchange Act and most state Blue Sky laws impose liability on persons
who "control" the actions of those who violate the Act. The
control person may escape liability for 1934 Act violations if he can
establish that he acted in good faith and did not directly or indirectly
induce the violation. However, if the firm has not established or
enforced "a proper system of supervision and internal
control," it has not acted in good faith under the statute. Moscarelli
v. Stamm, 288 F. Supp. 453, 460 n. 5 (E.D. N.Y. 1968).
Under state common law, in a
true principal/agent relationship, the principal is automatically liable
for the negligence of an agent acting with the scope of the agency. A
brokerage house may also be held vicariously liable for the torts of its
employee committed in the scope of his employment or within the area of
his apparent authority.
Conclusion
While brokers are not
guarantors of their clients' investments, neither may they treat their
license to sell securities as a license to steal. If an investor is
given a fair and unbiased evaluation of a security which his broker
recommends and which is a suitable investment for that client, the
investor will in all likelihood not have a claim for recovery of his
losses. On the other hand, if the investor has been lied to, misled, or
his account over-traded or abused, liability may be established and
recovery obtained through the arbitration process.
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