Theories of Stockbroker and Brokerage Firm Liability

• Jurisdiction: United States,Federal
• Citation: Vol. 9 No. 5 Pg. 0001
• Pages: 0001
• Publication year: 2004

Georgia Bar Journal Volume 9.

GSB Vol. 9, No. 5, Pg. 1. Theories of Stockbroker and Brokerage Firm Liability

Georgia State Bar Journal
Vol. 9, No. 5, April 2004

"Theories of Stockbroker and Brokerage Firm Liability"

By Robert C. Port

Over a lifetime, even modest savings, contributions to an IRA, or participation in an employee pension plan can result in significant accumulations of wealth.1 However, many individuals have neither the interest nor the desire to learn about financial markets and investments, nor do they have the time necessary to monitor their investments on an ongoing basis. Their aversion to and confusion about financial matters has been further accentuated by the "irrational exuberance"2 of the "Internet bubble" of the late 1990s, and subsequent significant decline in the value of technology and telecommunications stock. As a result, many individuals turn to stockbrokers, investment advisors financial planners, insurance agents, and others claiming to have the knowledge and experience to offer investment advice

Stockbrokers and other financial advisors are highly motivated to cultivate their clients' trust and allegiance, and clients who lack knowledge and sophistication on financial matters have powerful incentives to believe that such advisors are trustworthy and acting solely in the customer's best interests.3 This trusting relationship creates an opportunity for exploitation by the advisor, which may form the basis for a variety of legal claims. Common fact patterns associated with broker misconduct include misrepresentation, churning, unsuitable recommendations unauthorized trading, and failure to supervise. Outright misrepresentation and fraud may also be practiced on the unsuspecting and trusting client

Federal and state securities statutes and state common law typically govern civil liability in connection with losses arising from the purchase and sale of securities. The self-regulatory rules of the National Association of Securities Dealers and the New York Stock Exchange are also relevant to the issue of whether a broker or financial advisor owed or breached a duty to the customer. The following is a brief overview of common legal theories of liability that apply to broker misconduct.4

FRAUDULENT MISREPRESENTATIONS AND OMISSIONS

Material misrepresentations and omissions made in connection with the purchase or sale of a security can violate federal and state securities statutes. Such claims may also proceed as common law fraud claims.

Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5

Section 10 of the Securities Exchange Act of 1934,5 is an anti-fraud provision prohibiting the use "in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance." Rule 10b-5 promulgated by the Securities Exchange Commission amplifies these prohibitions by making it unlawful: (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.6

The essential elements of a Rule 10b-5 claim are: (1) a misstatement or omission; (2) of a material fact; (3) made with scienter, (4) upon which the plaintiff relied; (5) that proximately caused the plaintiff's loss.7

The standard for determining materiality is whether "there is a substantial likelihood that a reasonable shareholder would consider it important" or "a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available."8 "To constitute fraud, a misrepresentation generally must relate to an existing or pre-existing fact."9 A misrepresentation of future profit generally cannot constitute fraud, as it is a type of opinion and prediction of future events.10 "[O]utrageous generalized statements, not making specific claims, that are so exaggerated as to preclude reliance by consumers" generally will be deemed "puffing" rather than fraud.11 Furthermore, the "in connection with" requirement in Rule 10b-5 is not satisfied by any misrepresentations or omissions that occur after the claimant purchases or sells the security in question.12

The Supreme Court has expressly left open the question of whether the scienter requirement encompasses not only intentional conduct, but also reckless conduct.13 The rule in the 11th Circuit is that a showing of "severe recklessness" satisfies the scienter requirement.14 "Severe recklessness is limited to those highly unreasonable omissions or misrepresentations that involve not merely simple or even inexcusable negligence, but an extreme departure from the standards of ordinary care, and that present a danger of misleading buyers or sellers which is either known to the defendant or is so obvious that the defendant must have been aware of it."15

The plaintiff's reliance must have been reasonable or justified.16 Relevant factors include: (1) the sophistication and expertise of the plaintiff in financial and security matters; (2) the existence of long standing business or personal relationships between the plaintiff and the defendant; (3) the plaintiff's access to relevant information; (4) the existence of a fiduciary relationship owed by the defendant to the plaintiff, (5) concealment of fraud by the defendant; (6) whether the plaintiff initiated the stock transaction or sought to expedite the transaction; and (8) the generality or specificity of the misrepresentations.17

To prove the causation element, a plaintiff must prove both "transaction causation" and "loss causation."18 Transaction causation is a synonym for reliance, and is established when the misrepresentations or omissions cause the plaintiff "to engage in the transaction in question."19 Loss causation is more difficult to prove: the misrepresentation must have caused the loss suffered by the claimant. Loss causation is satisfied "only if the misrepresentation touches upon the reasons for the investment's decline in value."20 Proof of loss causation is a statutory requirement.21

Section 12(2) of the Securities Act of 1933

Section 12(2) of the Securities Exchange Act of 1933 provides that any person who offers or sells a security by use of an oral or written communication that contains an untrue statement of material fact or omits to state a material fact necessary in order to make the statement not misleading is liable to the purchaser, unless the seller can show that he did not know and in the exercise of reasonable care could not have known of the untruth or omission.22 Scienter is not an element of a Section 12(2) claim.Although the scope of liability under Section 12(2) is potentially broad, its reach for broker misconduct nonetheless is limited by four factors. First, the claimant is limited to rescission or rescessionary damages (the purchase price of the security, plus interest, less income received thereon) and must tender the security back to the seller. If the claimant no longer owns the security, he may seek damages representing the difference in the purchase price and the sale price. Second, only purchasers may assert claims under Section 12(2), and they may assert them only against sellers and persons who control them. A "seller" is one who either transfers title to the security or who solicits the sale and receives a benefit from doing so or acts with the intent to benefit the owner of the security.23 Third, the statute of limitations is a substantive element of the claim and compliance must be affirmatively pled. Fourth, Section 12(2) applies only to initial public offerings by means of a formal offering document (not private placements or secondary market transactions).24

Georgia Securities Act

The Georgia Securities Act provides a cause of action against a seller of securities for making "an untrue statement of a material fact or omit[ing] to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they are made, not misleading."25 Liability will not be found however, if "(1)[t]he purchaser knew of the untrue statement of a material fact or omission of a statement of a material fact; or (2)[t]he seller did not know and in the exercise of reasonable care could not have known of the untrue statement or misleading omission."26

The remedies provided under the Georgia Act are available only to a buyer of securities.27 Because there is very little case law construing the Georgia Securities Act, the courts often look to analogous federal statutes for interpretive assistance. For example, although the language of the Georgia statute does not appear to require scienter, courts have construed the section in accordance with Rule 10b-5 as requiring proof of scienter.28 One of the advantages of a claimant proceeding under the Georgia Act, however, is provision for recovery of attorney's fees, interest, and court costs.29

Common Law Fraud

Under Georgia law, fraud is shown when (i) a representation of material fact is made (or there is a failure to disclose a material fact); (ii) that was known or should have been known to be false (or should have been disclosed); (iii) that was made (or omitted) for the purpose of being relied upon by another; (iv) that was in fact relied upon; (v) that caused damage.30 Under Georgia law, a "promise to perform some...