Table of Contents
Liability of Stock Brokers and their Supervisors
Stock brokers are usually held liable for investor losses under five legal theories:
Misrepresentation in connection with the purchase or sale of a security;
Selling an unregistered security;
Churning the investor’s account;
Advising the investor to buy stocks that are not suitable for the investor; and
Breaching the fiduciary duty owed to the investor.
Since stock brokers often do not have the resources to reimburse the investor, it is usually important to find the broker’s employer or supervisor also liable to the investor. This is called “secondary liability” and is predicated primarily on the failure of the broker-dealer to supervise the stock broker.
Liability for misrepresentation is premised under rule Securities Exchange Act of 1934 10-b (5) and the federal court cases implying a private remedy. This theory of liability is usually not applicable to brokers unless they sell a security without the approval of the broker-dealer with which they are licensed (selling away). This usually happens with an investment which its promoters claim is “not a security.” Under federal law, most passive investments whether described as a loan, equity investment, business investment, business opportunity, or some contract which costs money and offers a profit, are “securities.”
Oregon and Washington have state securities laws that often make misrepresentation easier to prove than the federal statute.
Generally, all securities must be registered by filing full disclosure documents with the Securities and Exchange Commission (SEC). There are narrow exceptions allowing sales where there is little reason to require the issuer to undergo the expense of registration. These generally deal with small offerings under circumstances where the investor has the ability to protect herself. Many promoters attempt to stretch these exemptions from registration and can find themselves and the persons who sold them liable to the investor because the security is unregistered.
The transaction must also be registered under state laws where the investor resides. Thus valid exemptions are the “least common denominator” between state and federal exemptions. This often is the Achilles heel of unwary promoters and their deals.
Churning is the name given to overtrading of a stock account. The broker increases his commissions to the investors detriment. A stock broker and her firm are generally compensated on a commission basis. The greater the number of transactions, the greater the income. Thus there is often a systematic tension between the broker’s goals and the goals of the customer.
Churning is a deceptive device under Section 10 (rule 10-b(5)). It also may be a violation of state suitability and fiduciary duty standards. The volume of transactions may not be suitable given the investment goals of the customer and the broker could be breaching his fiduciary duties by putting his own interests ahead of the investor’s.
Churning can be measured by the turnover rate. This rate is determined by adding the total number of purchases in an account (ignoring sales) during a twelve month period. This sum is divided by the average equity in the account. If the quotient is greater than six, the account is probably churned according to courts that follow this analysis. As an example, assume $20,000 placed in an account and total purchases in a twelve month period exceeding $120,000. This means that on average the stocks are turned over every two months.
The turnover rate of six approach has been followed by some federal courts but has been criticized as to rigid. The critics contend that the courts should focus more on the needs and objectives of the investor. For example, a study of mutual fund trading showed that the turnover ratio where there is no incentive to make commissions is often below one.
Other measuring tools include the commission-to-equity ratio and evaluation of in-and-out-trading in the same stocks. Churning cases turn into battles of the experts with each side offering expert testimony supporting their positions.
The key to finding the broker liable for churning is to establish that the broker controlled the account. Often the broker will call the client urging stock purchase and then obtain the client’s approval. The broker will then claim that the client approved all transactions and controlled the account. Courts will look at the investment experience and sophistication of the investor. The age, education, financial expertise, investment objectives and the degree of reliance on the broker’s recommendations. There is probably no liability if the investor had the ability to evaluate the broker’s recommendations but turned a “blind eye” to the trading.
Federal law imposes a scienter (bad intent) requirement. This is easily inferred by the actions the broker took in trading the account.
FINRA Rule 2310 (formally Article III, Section 2 of FINRA Rules of Fair Practice) is the basis for the definition of suitability. It provides:
(a) 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.
(b) Prior to the execution of a transaction recommended to a non-institutional customer, other than transactions with customers where investments are limited to money market mutual funds, a member shall make reasonable efforts to obtain information concerning:
(i) the customer’s financial status;
(ii) the customer’s tax status;
(iii) the customer’s investment objectives; and
(iv) such other information used or considered to be reasonable and by such member or registered representative in making its recommendations to the customer.
The federal courts in Oregon and Washington have upheld the suitability duty under the previous version of this rule. In Erdos v. SEC, 742 F.2d 507 (1984), the Ninth Circuit affirmed an SEC decision holding that the rule had been violated by a broker who did not ascertain his client’s age and financial situation:
The NASD’s [former name for FINRA] suitability rule is not limited to situations where comprehensive financial information about the customer is known to the dealer. . . . [The broker] had a duty to act with caution and to make recommendations based on the concrete information that he did have rather than on his speculations about [the client’s] situation.
This FINRA rule does not provide civil liability to the customer but is evidence of negligence and breach of fiduciary duty.
In March of 1996, the SEC issued a Suitability Interpretation which stated in part:
The two most important considerations in determining the scope of a member’s suitability obligations in making recommendations to an institutional customer are the customer’s capability to evaluate investment risk independently and the extent to which the customer is exercising independent judgment in evaluating a member’s recommendation. A member must determine, based on the information available to it, the customer’s capability to evaluate investment risk. In some cases, the member may conclude that the customer is not capable of making independent investment decisions in general. In other cases, the institutional customer may have general capability, but may not be able to understand a particular type of instrument or its risk. This is more likely to arise with relatively new types of instruments, or those with significantly different risk or volatility characteristics than other investments generally made by the institution. If a customer is either generally not capable of evaluating investment risks or lacks sufficient capability to evaluate the particular product, the scope of a member’s customer-specific obligations under the suitability rule would not be diminished by the fact that the member was dealing with an institutional customer. On the other hand, the fact that a customer initially needed help understanding a potential investment need not necessarily imply that the customer did not ultimately develop an understanding and make an independent investment decision.
The factors that the broker should consider according to the SEC were:
The customer’s use of consultants, investment advisers, or bank trust departments.
The customer’s general level of experience in financial markets and specific experience with the type of investment under consideration.
The customer’s ability to understand the economic features of the security.
The customer’s ability to independently evaluate how market developments would affect the security.
The complexity of the security.
Relevant considerations that would affect the broker’s determination that a customer is making independent investment decisions include:
Any written or oral understanding between the broker and the customer regarding the nature of their relationship and the services to be rendered by the broker.
The presence or absence of a pattern of acceptance of the broker’s recommendations.
The customer’s use of ideas and information obtained from other brokers or market professionals, particularly relating to the same type of securities.
The extent to which the broker has received from the customer current information concerning its portfolio and its investment objectives.
The New York Stock Exchange has a “know your customer” rule which requires NYSE members to use “due diligence to learn the essential facts relative to every customer [and] every order.” (NYSE rule 406) This rule is broader than the FINRA suitability standard because it applies to orders placed by the customer even without a broker recommendation.
Suitability claims may be brought under 10-b(5) either on the theory that the brokers unsuitable recommendations were deceptive practices or that the broker misrepresented (or omitted to disclose) material facts. There is a split of authority whether proof of scienter requires intentional conduct or recklessness in suitability cases.
Under state law, suitability claims may be brought under common law as negligence (like malpractice) and breach of fiduciary duties (broker is agent). Oregon makes unsuitable recommendations a deceptive practice under its Blue Sky law by administrative rule (OAR 441-205-0140). Washington has a more detailed administrative rule (WAC 460-21B-060) but civil liability is limited (Brin v. Stutzman, 89 Wn. App. 809, 951 P.2d 291 (1998) ).
Breach of Fiduciary Duty
Most courts have been unwilling to apply a fiduciary relationship to all broker-customer relationships. These courts require additional facts such as a discretionary account or known reliance on the broker’s skills when the investor is unsophisticated.
Oregon has applied fiduciary duties in absence of a discretionary account where the investor was relying on the advise of the broker. Berki v. Reynolds Sec., Inc., 277 Ore. 335, 560 P.2d 282 (1977); Wallace v. Hinkle Northwest, Inc., 717 P.2d 1280, 1282 (Or. Ct. App. 1986)
Secondary Liability of the Broker-Dealer
The company for which a broker works can be liable under federal law through the provisions of both the Securities Act of 1933 and The Securities Exchange Act of 1934. If the broker has violated a law or rule and has liability to an investor, the broker-dealer can be liable for failure to supervise. The liability of the broker is termed “primary liability” and the liability of the firm “secondary liability.”
Section 15 of the Securities Act makes any person who controls a person who violates certain sections of the Act (11 or 12), liable jointly and severally “with and to the same extent as the controlled person.” Section 20 (a) of the Exchange Act makes anyone who directly or indirectly controls any person who has liability under the Exchange Act also jointly and severally liable.
Both the Securities Act and the Exchange Act have the similar defenses to secondary liability. The Securities Act exempts those who have “no knowledge of or reasonable grounds to believe in the existence of the facts by reason of which the liability of the controlled person is alleged to exist.” The Exchange Act exempts controlling persons who “acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action.” Although not expressly provided by either the Securities Act or the Exchange Act, courts have implied private causes of actions against control persons.
Courts have applied these provisions to require that broker dealers maintain proper systems of supervision and internal controls over their registered representatives. This is consistent with Section 15(b)(4)(E) of the Exchange act which requires the Securities Exchange Commission (SEC) to discipline broker-dealers who fail “to reasonably supervise, with a view to preventing violations ….” This section provides a defense if a reasonable system of supervision is in place and the system was followed. FINRA has expanded the requirement to require reasonable investigation of vigorous response to indications of wrongdoing by brokers (FINRA Conduct Rule 3010).
The SEC applies the same duty of supervisor regardless of the location of the broker or his employment status. The registered representative in a remote office must be supervised at least as much as the broker in the home office and arguably more often because of the lack of moral restraint created when one goes to work each day with supervisors. The is no difference in supervisory responsibility if the broker is an employee or independent contractor (e.g. In re William V. Giordano, Rel. No. 34-36742, 61 SEC Docket 345 (January 19, 1996). The supervision required depends on the facts. For example, a broker with past disciplinary history should be supervised more than one with a clean record.
One common problem broker-dealers face is “selling away,” the selling by brokers of products not approved by the firm and unknown to the firm. FINRA Rule 3040 requires that a broker obtain written approval for all sales of securities. Notice to Members 01-79 interpreted FINRA rule 3030 to mean that a registered representative must report in writing to the broker-dealer all business intended to be conduct outside of the firm. The violation of these rules by the broker does not relive the firm of its duty to supervise or provide a defense to controlling person liability.