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:
- 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 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 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).
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.
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.