Holmes v. Grubman
| Jurisdiction | Georgia,United States |
| Citation | Vol. 16 No. 5 Pg. 0020 |
| Pages | 0020 |
| Publication year | 2011 |
A Look at the Law
The Supreme Court of Georgia Balances Financial Advisor Common Law Liability and Investor Protection
by Robert C. Port and Jason R. Doss
It is no surprise that the stock market has a long history of volatility that can send wild speculators to yacht dealerships and conservative retirees back to the workforce. The recent downturn of 2008 is no different. In 2008 alone, America suffered a historic loss in wealth totaling approximately $10.2 trillion.[1] Over $6 trillion of that amount was attributed to losses in the stock market.[2]
Typically, American investors hire financial professionals (commonly referred to as stockbrokers or financial advisors) to make sound investment decisions. The nature of the relationship between a stockbroker and a client is one based on a trust in that professional's perceived financial acumen. In fact, brokerage firms aggressively market themselves as skilled advisors competent to handle every aspect of their clients' financial life, from investments to mortgages, life insurance, long-term care, estate planning and charitable giving.[3] Furthermore, brokerage firms often advertise that their financial advisors will monitor investments after a recommendation to purchase by Robert C. Port and Jason R. Doss a security to ensure that the investor meets his or her long term investment goals.
Studies in behavioral finance demonstrate that securities brokers are highly motivated to cultivate their clients' trust and allegiance, and clients have powerful incentives to believe that such advisors are trustworthy and acting solely in the client's best interests.[4]Obtaining a client's trust and confidence, and convincing the client that he or she should rely upon the investment advice given, is at the heart of the brokerclient relationship.
As a result, Georgia courts have long held that under Georgia common law, a stockbroker's duty to account to its customer is fiduciary in nature, so that the broker is obligated to exercise the utmost good faith. Requirements of good faith demand that in the principal's interest, it is the agent's duty to make known to the principal all material facts that concern the transactions and subject matter of his agency.[5]
In an attempt to limit these common law fiduciary obligations and limit liability for unsuitable or inappropriate investment advice, the financial services industry created discretionary and nondiscretionary accounts for its retail investor customers. A discretionary account is one in which the financial advisor has full discretion to make investment decisions without obtaining prior approval from the customer.[6] A non-discretionary account, which is by far the most common type of investment account, is one in which the financial advisor is required to get prior approval from the customer before making a trade in an investment account.[7] By implementing this approval process, a brokerage firm argues that in a nondiscretionary account, it does not owe a fiduciary duty to the customer and that the firm is merely an "order taker" because the customer—who had the right to follow or reject the broker's recommendation — was the one who actually made the investment decision. Furthermore, even though the brokerage firm may advertise to the contrary, it will typically argue that it has no continuing legal duty to monitor its customers' portfolios in nondiscretionary accounts and that its legal duty (if any) does not extend beyond the recommendation to purchase the security.
Investor advocates have long criticized the use of nondiscretionary accounts to limit liability. Studies have shown that investors are not aware of the distinction between discretionary and nondiscretionary accounts and also believe that their financial advisor is acting in a fiduciary capacity.[8] After all, the type of account does not change the trust relationship that typically exists between financial professional and investor customer. As a result, the approval process described above is in large part meaningless to the investing public because a trusting investor typically does not have the ability to evaluate independently the broker's recommendations, and will simply follow the stockbroker's investment recommendation without question with the belief that it is appropriate.[9]
Stock market crashes like the one in 2008 are often sudden and dramatic. For example, the S&P 500 Index, a stock index comprised of 500 large cap common stocks actively traded in the United States, fell more than 52 percent between October 2007 and November 2008, which was the largest decline since the Great Depression.[10] When these types of events occur, retail investors frequently contact their
financial advisors looking for advice on how to stem the losses. The typical response by the financial professional is to hold on and "stay the course" and wait for the stock prices or investment values to come back. This recommendation to "hold" is often made without any analysis by the financial advisor regarding whether a customer's investment portfolio is suitable for their current investment objectives and risk tolerance.
Indeed, recommendations to hold sometimes may be the correct and suitable course of action. After all, the stock market has proven to be resilient and with every downturn there is typically an equally large, if not larger, upturn.[11] On the other hand, these statistics represent the performance of the broadbased stock market over time and do not reflect the performance of individual stocks. There are certainly a large number of individual stocks that have not bounced back. Furthermore, it is certainly possible for an investment to be suitable at the time of purchase and then become inappropriate for that investor due to a change in circumstance for the investor (e.g. health problems, death of a spouse, etc.), or change of circumstance for the investment (e.g., loss of a large contract, a product recall or change of investment strategy for a mutual fund). As a result, the recommendation to hold may not be appropriate.
When does the recommendation to hold become the wrong investment recommendation? Does a financial advisor have a duty to monitor investments after a recommendation to purchase to ensure that the investor meets his or her long term investment goals? What legal claims and remedies are available to investors to recoup losses stemming from an improper recommendation to hold a particular stock or overly risky portfolio?
With regard to federal securities laws, the answer to the last question is that there is no viable claim or remedy. This is because Section 10(b) of the Securities Exchange Act affords investors a securities fraud claim based on misrepresentations or omissions made only in connection with the purchase or sale of a security, not a recommendation to hold a security.[12]
Without a remedy under the federal securities laws, does an investor have a viable claim under Georgia common law against a stockbroker or the brokerage firm for an improper recommendation to hold a security? As described in more detail below, the Supreme Court of Georgia recently addressed this issue in Holmes v. Grubman, and held that aggrieved investors, subject to some limitations, can maintain common law tort claims such as fraud and negligent misrepresentation based on an improper recommendation to hold a security.[13] The Supreme Court of Georgia also re-affirmed that the relationship between a financial professional and customer is fiduciary in nature and that the brokerage firm and the investment professional will owe a heightened duty to the holder of a security even if the account is nondiscretionary.[14]Each of these holdings furthers the protection of public investors who rely upon brokerage firms to provide them sound investing advice and recommendations.
Factual Background and Procedural History of Holmes v. Grubman
Appellant William K. Holmes and his four entities controlled by him (Holmes) had nondiscretionary accounts with Citigroup Global Markets, Inc. f/k/a Salomon Smith Barney & Co., Inc. (SSB).[15] As of June 1999, Holmes "owned 2.1 million shares in Worldcom, Inc., the major telecommunications company which went bankrupt after the revelation of massive accounting fraud in 2002."[16] Holmes brought an action against SSB as well as its well-known telecom analyst, Jack Grubman, alleging that Holmes verbally ordered his broker at SSB to sell all shares in Worldcom stock, which was at that time trading at approximately $92 per share. Holmes further alleged that his SSB broker convinced him not to sell, based on recent research reports by SSB's Grubman. The suit further alleged that SSB and Grubman were operating under a conflict of interest because they promoted Worldcom, although knowing that it was grossly overvalued, in order to retain Worldcom's lucrative investment banking business. Instead of selling, Holmes purchased additional shares as the stock price declined. In October 2000, Holmes was forced to sell all WorldCom shares in order to meet margin calls, resulting in an alleged loss of nearly $200 million.[17]
In 2003, Holmes filed for bankruptcy and brought this action for damages under Georgia law. The case was transferred to the U.S. District Court for the Southern District of New York and the district court dismissed the complaint, which brought claims based on fraud, negligent misrepresentation, negligence in making disclosures, and breach of fiduciary duty. On appeal, the U.S. Court of Appeals for the Second Circuit certified the following questions to the Supreme Court of Georgia that are pertinent to this article:[18]
1. Does Georgia common law recognize fraud claims based on forbearance in the sale of publicly traded...
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