Common Fact Patterns of Stockbroker Fraud and Misconduct

• Publication year: 2002
• Pages: 0001

Georgia Bar Journal Volume 7.

GSB Vol. 7, No. 6, Pg. 1. Common Fact Patterns of Stockbroker Fraud and Misconduct

Georgia State Bar Journal
Vol. 7, No. 6, June 2002

"Common Fact Patterns of Stockbroker Fraud and Misconduct"

By Robert C. Port

Until recently, it seemed as though everyone had heard of a "friend of a friend" who made a "killing" in the stock market. The late 1990s were especially good to investors, with double digit returns seemingly the norm Financial newspapers and magazines offering investment advice were everywhere, and Internet bulletin boards and chat rooms were filled with people claiming to have identified the next Microsoft, Yahoo or Cisco

In this environment, investors easily fell prey to dishonest stockbrokers, investment advisors, financial planners insurance agents and others claiming to have the knowledge and experience to offer investment advice. Certainly, no one has a crystal ball, and not every loss results from actionable activity by a broker. Even supposedly "rock-solid" blue-chip stocks experience significant declines from time to time. However, in many instances, the actions of a broker or investment advisor can form the factual basis for a variety of legal claims

Federal and state securities statutes and state common-law typically govern civil liabilities arising out of the purchase and sale of securities.1 This article first reviews the duties a broker owes to his client, and then provides an overview of reoccurring fact patterns and circumstances often found when an investment advisor has engaged in actionable activity.

STOCKBROKER AND BROKERAGE FIRM DUTIES TO THE CUSTOMER

Pursuant to Sections 15A and 19 of the Securities Exchange Act of 19342, Congress has authorized the establishment of "self-regulatory organizations" (SROs) such as the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX) and the National Association of Securities Dealers (NASD). Each of these SROs have promulgated rules which are, inter alia, "designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation and coordination with persons engaged in regulating, clearing, settling, processing information with respect to, and facilitating transactions in securities, to remove impediments to and perfect the mechanism of a free and open market and a national market system, and, in general, to protect investors and the public interest. . . "3 Rules promulgated by the various SROs are sent to the Securities and Exchange Commission for review and approval, following publication and an opportunity for public comment.4

The failure of a broker to comply with the SRO rules does not give rise to a private right of action.5 However, a violation of the SRO rules can provide critical evidence that a broker or brokerage firm failed to exercise the requisite degree or standard of care owed their customer.6

The Duty to Know the Customer and to Recommend Suitable Investments.

Among the most fundamental of SRO rules are the "Know Your Customer" and the "Suitability" rules. The "Know Your Customer Rule"7 places a duty upon brokers to acquire an understanding of their customer's financial needs, investment objectives and other pertinent information before making a recommendation to purchase or sell a security.

Working hand-in-hand with the "Know Your Customer Rule," the "Suitability Rule"8 requires that the broker have a reasonable basis for believing that a securities transaction recommended to a customer is suitable for the customer, in light of the customer's financial and other circumstances. NASD has made it clear that a "recommendation," and hence the applicability of the "suitability requirements," is a fact specific inquiry. In particular, the NASD has advised that "a transaction will be considered to be recommended when the member or its associated person brings a specific security to the attention of the customer through any means including, but not limited to, direct telephone communication, the delivery of promotional material through the mail, or the transmission of electronic messages."9 The NYSE has adopted a similar approach. For purposes of these standards, the term "recommendation" includes any advice, suggestion or other statement, written or oral, that is intended, or can reasonably be expected, to influence a customer to purchase, sell or hold a security. 10

By regulation, the Georgia Securities Commissioner has promulgated rules that similarly obligate a broker operating in Georgia to investigate the client's circumstances and only recom- mend investments suitable in light of those circumstances.11 Violation of these rules is a violation of the Georgia Securities Act.12

The Duty of Good Faith, Fair Dealing and Loyalty.

Various SRO and state regulatory pronouncements require brokers and brokerage firms to act with the utmost good faith, fair dealing and loyalty toward their customers.13 These obligations mirror those imposed by Georgia common-law and statute upon parties to a contract.14

The Duty to Supervise Brokers.

Brokerage firms have a statutory obligation, under both federal and state law,15 to supervise their brokers to prevent violations of the securities laws. The SROs have imposed similar obligations by rule-making.16

Brokers Owe Their Customers a Fiduciary Duty.

Under Georgia law, a confidential, fiduciary relationship exists between a broker and a client.17 As a fiduciary, the broker has a legal obligation to act in the "utmost good faith."18

As set forth by the 11th Circuit, the fiduciary duties of an investment broker include: (1) the duty to recommend investments only after studying it sufficiently to become informed as to its nature, price and financial prognosis; (2) the duty to perform the customer's orders promptly in a manner best suited to serve the customer's interests; (3) the duty to inform the customer of the risks involved in purchasing or selling a particular security; (4) the duty to refrain from self-dealing; (5) the duty not to misrepresent any material fact to the transaction; and (6) the duty to transact business only after receiving approval from the customer.19

COMMON PATTERNS OF MISCONDUCT

Although each case presents a different set of facts and circumstances, there are a number of common themes and fact patterns giving rise to claims against stockbrokers, brokerage firms and investment advisors. Most of these claims arise from the inherent conflicts created when a broker's income is commission based, and thus directly tied to the volume of transactions generated. Among the more common improper activities are the following:

Churning/Excessive Trading.

Churning "occurs when a securities broker buys and sells securities for a customer's account, without regard to the customer's investment interests, and for the purpose of generating commissions."20 The broker churns an account by exercising control over it, either as a result of having been given express discretionary authority to trade, or by developing a relationship of trust and confidence with the client such that the client follows almost every recommendation the broker makes. Churning can be a violation of Section 10(b) of the Securities Act of 193421 and Rule 10b-5 promulgated thereunder.22 It also is a violation of the Georgia Securities Act.23 Churning may also provide a basis for claims based upon breach of fiduciary duty,24 breach of contract,25 negligence,26 and respondent superior liability.27

Several objectively measurable factors may suggest that an account has been churned. One widely accepted indicator is the turnover ratio. "Turnover rate is the ratio of the total cost of purchases made for the account during a given period of time to the amount invested."28 The courts generally recognize an annual turnover rate in an investment account of 6, or a ratio of purchases to the amount invested of 6:1, excessive as a matter of law.29 Whether a particular turnover rate is excessive depends upon the investment objectives of the customer. In long-term accounts with conservative objectives, a lower turnover ratio may be deemed excessive.30 In trading accounts and accounts with options transactions, a higher turnover ratio is expected.31

Another factor to consider is the "account maintenance cost," also known as the "equity maintenance factor" or the "cost/equity ratio." This is the rate of return the customer must earn on the account to pay the commissions and other trading fees (such as margin interest). It is calculated by adding all fees and commissions and expressing the total as a percentage of average annual equity. A high account maintenance cost is indicative f an account that has been traded not for the customer's benefit, but for the benefit of the broker.

Also considered is the period of time a security is held from purchase date to sale date. Short holding periods, with the proceeds immediately reinvested in other positions, may be indicative of churning.32 Another indicator of churning is a comparison of the total commissions generated by the account as compared to total commissions earned by the broker and/or the branch.33

Fraud and Misrepresentation.

A broker may induce a customer to buy or sell a stock by making statements or representations of material fact that are known by the broker to be untrue, or that are made with a reckless disregard for the truth, and that are relied upon by the customer following the broker's recommendation. Also a broker can commit fraud by an "omission" - failing to reveal material facts that would have been important to the customer in making the investment decision....