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Common Forms of Stockbroker Misconduct
By Brian N. Smiley, Partner
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:
-
The duty to recommend a stock only after studying it sufficiently
to become informed as to its nature, price and financial
prognosis;
-
The
duty to carry out the customer¹s orders promptly
and in a manner best suited to serve the customer¹s
interests;
-
The duty to inform the customer of the risks involved
in purchasing or selling a particular security;
-
The
duty to refrain from self-dealing;
-
The
duty not to misrepresent any material fact to the transaction;
and
-
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:
- recommending
excessive positions in speculative "tech" stocks
to investors whose primary objective is preservation of
principal;
- failing
to provide a prudent and diversified portfolio for retirees;
- 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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