Following are the most common kinds of broker and investment-advisor misconduct. Each type of wrongdoing gives the investor the right to bring an arbitration claim against the investment professional who committed the wrongdoing.

Breach of Contract

     An investor has grounds for bringing an arbitration claim when her stockbroker breaches the broker–client investment agreement. If the contract requires the client’s written authorization but the broker sells a security based on a phone call, for example, that violates the contract.

Example: The decision In re N.Y. Stock Exch. Arbitration Between Barbier v. Shearson Lehman Hutton Inc., 948 F.2d 117 (2d Cir. 1991) involved two investors whose accounts were depleted by their brokers’ unauthorized trading. The court determined that that had breached the brokerage agreements, which required investor approval for each transaction, and so the investors were awarded $104,516.

Example: In Flickinger v. Harold Brown and Co., Inc., 947 F.2d 595 (2d Cir. 1991) a plaintiff had signed an investment agreement with a broker to purchase certain stocks, but though the plaintiff had paid for the stocks they were never transferred to him. The United States Court of Appeals for the Second Circuit entered judgment for the plaintiff for breach of contract against both the broker and the company that executed and cleared the broker’s trades.

Breach of Fiduciary Duty

     A fiduciary duty is a high standard of care that one person owes to another in certain situations. Thus, a lawyer, doctor, or trustee each owes a fiduciary duty to her client, patient, or trust beneficiary. If a fiduciary relationship exists between a stockbroker or investment advisor and a customer—which is not always the case—the relationship can make the investment professional liable for conduct that would otherwise be acceptable, because it holds her to a higher-than-normal standard of care.

     Ordinarily an investor and her broker or investment advisor do not have a fiduciary relationship, though even so, those professionals must behave with good faith and reasonable care toward their client. But a broker–client fiduciary relationship arises when an account is discretionary. When a stockbroker or investment advisor is authorized to trade securities on the client’s behalf without the client’s express consent, the client has a discretionary account and the investment professional is the client’s fiduciary. In that case, the broker or investment advisor must act only in the client’s best interest, keeping abreast of market changes that may affect the client’s investment and informing the client about each transaction.

     A fiduciary relationship can also arise if a court imposes an overarching fiduciary duty for a non-discretionary account on an investment professional because she has willingly taken on more responsibilities than the law requires.

     Non-discretionary accounts still impose duties on a broker or investment advisor. They include performing sufficient research to give the client adequate advice, carrying out the client’s instructions in a timely manner, and alerting the client to potential investment risks. And even with a non-discretionary account, the broker must not engage in self-dealing, or in misrepresenting or withholding material facts.

Example: A particularly distasteful breach of fiduciary duty is described in the Crain’s article Elderly Widow Wins $1.1M Judgment Against Wm. Blair1. Investment advisors created an e-mail address in an elderly client’s name and only sent transaction statements to that address, though the client was unaware of the e-mail address and did not own a computer. That allowed the advisors to engage in widespread churning of the client’s account by taking advisory fees. She was awarded $1.1 million by an arbitration panel in November 2009, after it determined that the investment advisors had breached their fiduciary duties.

Broker or Investment-Advisor Ignorance

     Ignorance on an investment professional’s part occurs when the broker or investment advisor misjudges the risk of a new investment product or trading strategy and misinforms her client about that risk.

Example: The danger of broker ignorance was brought home by “Black Monday,” October 19, 1987, when the exchanges experienced their largest single-day percentage declines in U.S. stock-market history. Black Monday followed the rise of “program trading,” which automatically required brokerage firms’ computers to sell securities if certain events occurred. A 1988 Fortune article entitled The Battle Over Market Reform2 stated, “come Black Monday, program trading and portfolio insurance worked together at times to speed the downward spiral.” Many economists believe that the Black Monday decline resulted from brokers’ overuse of program trading, which caused computers to make “decisions” to sell securities en mass that human oversight would have avoided. So Black Monday showed the need for investment professionals to study securities and be personally acquainted with the market before giving investment advice.

     An investor is entitled to rely on her broker’s or investment advisor’s expertise, so a lapse in judgment or miscommunication may be actionable as broker or investment-advisor ignorance.

Churning

     A stockbroker who trades a security solely to earn a commission, instead of to help her client, churns. The practice’s hallmark is excessive trading in light of the client’s financial means and goals.

     Three elements must be established to prove churning: that the broker (1) controlled the trading; that she (2) traded excessively, which is usually shown by examining the cost of securities purchased during a given period divided by the amount invested (the turnover ratio); and that the broker(3) acted with intent to defraud.

     Churning will sometimes be obvious to a lay person who scrutinizes her monthly portfolio statements, but it can also be complex and require an accountant to spot it.

Example: One investor, featured in a 2000 article from Forbes.com entitled Taking Your Broker to Task, discovered that his broker had churned when the investor returned home from a business trip to find a mailbox full of trading statements. His broker had been trading excessively on the account while he was away.

Example: In June 2009, the Securities and Exchange Commission charged Aura Financial Services and six of its brokers with churning. The SEC alleged that Aura had used high-pressure sales tactics to enlist customers simply so that Aurora could trade on those new customers’ accounts to earn commissions. That produced $1 million in unjust enrichment to the firm in the form of commissions and fees, according to SEC Press Release 2009-134.

ERISA Responsibilities

     The Employee Retirement Income Security Act of 1974 (ERISA) makes anyone who manages an employee-retirement plan a fiduciary for plan beneficiaries. Brokers and brokerage firms often become fiduciaries under that act, because anyone having discretion to trade without express authorization from the beneficiaries becomes a fiduciary. An investment professional who advises how plan assets should be invested but lacks trading discretion, also incurs fiduciary responsibilities.

Example: The decision Metzner v. D.H. Blair and Co., Inc., 663 F. Supp. 716 (S.D.N.Y. 1987) discussed a broker’s fiduciary duty under ERISA. There a broker had ignored instructions to liquidate two securities-trading accounts that held employee-pension funds under ERISA, and had instead continued to invest the funds in inappropriate high-risk securities. The court held that such actions stated a claim for breach of fiduciary duty under ERISA.

Failure to Supervise and Respondeat Superior

     A firm can be liable for its broker’s misconduct if it did not supervise the broker properly and that helped cause the misconduct. The firm may also be liable under a theory of respondeat superior, because the broker was employed by the firm when the misconduct occurred and the questionable actions fell within the scope of the broker’s employment.

Example: In June 2009, the Securities and Exchange Commission (SEC) charged Aura Financial Services, Inc. and three of its senior officers with failure to supervise, because six of Aura’s brokers had engaged in widespread churning that had caused $1 million in excess commissions and fees. Explaining the failure to supervise, SEC Press Release 2009-134 said, “Aura and the three managers failed to adopt appropriate procedures, failed to enforce rules, failed to conduct branch office inspections, and failed to maintain files of and follow up on customer complaints.”

Example: The New York Stock Exchange (NYSE) censured UBS Financial Services, Inc. in 2006 for failure to supervise. Brokers in several UBS branch offices had engaged in deceptive market timing, and the firm was held liable for failure to supervise because it had not had procedures in place to allow other employees to alert management when such prohibited practices occurred. The firm had also failed to keep proper records of trades. NYSE Hearing Panel Decision 06-5 (12 January 2006).

Forgery

     Broker forgery usually occurs when a broker signs her client’s name to a document without her client’s consent. But it is also forgery for a broker to fill in options and blank spots on a new-account form after the client has signed it, if the client did not consent to that.

Example: As reported in the Los Angeles Times article Bad Sign: Forgery Is a Common Customer Complaint, but Probes Are Rare, at least three customers won arbitration awards for forgery claims against a Paine Webber broker. One customer was awarded $72,576 because his broker had forged his signature in order to engage in unauthorized options and margin trading.

Example: A broker faced criminal forgery charges in 1999, as reported in the Boston Herald article Former Peabody Broker Charged with Defrauding Elderly Client, for forging a ninety-year-old client’s signature in order to liquidate her account and pocket $150,000 of her assets.

Frontrunning and Insider Trading

     A broker or brokerage firm who trades securities for itself on the basis of a customer’s order but before executing the order, is frontrunning. Signs of it include (1) a firm’s buying an unpopular security and then advising its customers to buy it; and (2) a firm’s buying a stock just before the issuing company will make an independent public offering (IPO).

Example: The United States Supreme Court case of Carpenter v. United States, 484 U.S. 19 (1987) involved frontrunning by a journalist who wrote an influential investment column. He let certain brokers see his column before it was printed, which let them trade on information in the column before it affected the markets. The Supreme Court held that that violated both the securities laws and the wire and mail-fraud laws.

Example: Another instance of frontrunning occurred in 2005, when seventeen specialist traders were charged with that wrong by the Securities and Exchange Commission; the New York Stock Exchange was also censured for failure to supervise the traders’ activities. The news broadcast World Today reported on April 13, 2005 that the traders had made nearly $25 million by trading ahead of customer orders at a lower price, and then filling the orders at a profit.

     Insider trading resembles frontrunning: a party trades securities based on advance information that is not yet public.

Example: Cooking and crafting guru Martha Stewart was famously convicted of insider trading in 2004. She received advance information from her broker that the value of her shares in a pharmaceutical company were about to plummet because of an adverse Food and Drug Administration ruling. So she sold all her shares in the company which, according to SEC Press Release 2003-69, avoided losses of $45,676 by illegally selling ahead of the market. Stewart served a prison term, and was prohibited from being an officer of a public company for five years.

Margin Accounts and Overleveraging

     A client buys a security on margin when she makes part of the purchase with money borrowed from her brokerage firm. The firm may then sell the security if its price drops so far that the loan is no longer fully collateralized. Because margin buying exposes an investor to large losses if the leveraged stock’s price declines, it is risky and should be limited to sophisticated investors. The Great Crash of 1929, indeed, was partly caused by widespread margin buying.

     Therefore, a broker or investment advisor who urges an unsophisticated investor to buy securities on margin, or who fails to explain the risks of margin borrowing, may commit actionable misconduct.

     An investor can also recover from her brokerage firm if it improperly liquidated (that is, sold) securities that she bought on margin. That can occur if (1) the firm liquidated the stocks before the purchaser’s margin debt came due; (2) the firm did not let the investor choose which stocks to liquidate; (3) the firm liquidated too late, or liquidated too many securities; or (4) the firm liquidated after the investor’s broker had assured her it would not.

Market Manipulation and Price Manipulation

     Market manipulation occurs when a party interferes with the normal operation of the stock market by misrepresenting the price or demand for a security. It can take various forms. A party may place orders for a stock in order to manipulate its price, or she may trade near the end of the day to influence a stock’s closing price. Other forms of market manipulation include “wash trades,” in which a security’s buyer is also its seller; and pre-arranged trades, which are transactions that the buyer and seller agree to reverse later. A broker’s disseminating unrealistically favorable information about the demand for a stock, or deliberately spreading a rumor to drive a stock’s price down, also constitute market manipulation.

     Price manipulation is a kind of market manipulation. Brokers and brokerage firms may not influence a security’s price by any other means than by disseminating accurate information and buying and selling securities normally. So a broker or firm who tries to influence a security’s price in some other way engages in price manipulation. Examples include driving a security’s price down to encourage others to buy it; refusing to sell a customer’s stock in order to inflate it’s price; and creating a false impression that a particular security is being actively traded when it is not.

Example: Price manipulation occurred in the 2000 DMN Capital Investments, Inc. scandal, in which New York mob families strong-armed a brokerage firm into inflating stocks’ prices. As described in Organized Crime on Wall Street: Hearing Before the H. Subcomm. on Finance and Hazardous Materials3, the mob established sham companies, convinced brokers to hype and sell stock in the companies, and then dumped the stock once its value increased. That caused $50 million in losses to legitimate investors.

Example: The Guinness Share Trading Scandal was another case of price manipulation. The brewer allegedly orchestrated purchases of its own stock in order to inflate the stock’s price temporarily, to allow Guinness to win a bid to take over another company. See New York Times article Guinness Ousts Head in Scandal.4

Example: Hollywood has famously portrayed market manipulation in the films Wall Street (1987) and Boiler Room (2000). The former depicts a ruthless investor whose motto is “greed is good.” He uses various illegal trading methods, such as coaxing a trader into becoming a janitor in order to read confidential files, and enlisting friends to serve as “straw buyers” so as to buy stocks and inflate their prices.

Boiler Room shows market manipulation through a “pump and dump” scheme. Brokers create artificial demand for stock in defunct companies and sell the stock at prices set by the firm, charging large commissions for each trade. The investors are then left empty-handed because there is no legitimate market for the stock in bogus companies that they bought.

     Market manipulation, including price manipulation, is prohibited by the Securities Exchange Act of 1934.

Misrepresentations and Omissions

     An investor must often rely on her broker’s or investment advisor’s evaluation of the risks involved in an investment because she cannot gauge the risks herself. An investment professional therefore has a duty to disclose all relevant facts about a particular investment, and if she misrepresents or withholds information she breaches that duty.

Example: More than 400 defendants were charged in Operation Malicious Mortgage, A June 19, 2008 Federal Bureau of Investigation Press Release said that brokers had marketed investments in two hedge funds as being “low risk,” while knowing that the funds were near collapse. When they did collapse, investors lost some $1.4 billion. Other defendants had engaged in mortgage-lending fraud by misrepresenting borrowers’ financial status in order to gain loan approval, and in foreclosure fraud by collecting foreclosure-prevention fees from financially distressed homeowners.

Order Failure

     This occurs when a broker does not enter a customer’s order or enters it incorrectly. A broker should effect the “best execution” of every order, which means that she should obtain the best price for the desired security and buy or sell as quickly as possible. So if a broker does not execute a customer’s order to the best of her ability, she may commit order failure.

Example: In 2004, the Securities and Exchange Commission censured a dozen brokerage firms for violating the best-execution rule. At issue were the firms’ methods for processing Nasdaq-listed orders in the morning that were received after closing the previous day: the firms favored themselves over their customers by not obtaining the best prices for the customers. A New York Times article entitled S.E.C. Is Said to Examine Stock Pricing by Big Brokers5 said the investigation served to put traders and brokerage firms’ executives on notice that the SEC will enforce the best-execution rule.

Overconcentration

     A broker or investment advisor has a duty to ensure that her client’s risk of loss is appropriate to her financial situation and investment goals, and one of the best ways to fulfill that duty is to diversify the client’s a portfolio. That way, risk is spread over a wide variety of investments, so if one investment goes bad it will not endanger the whole portfolio. A broker or investment advisor who concentrates a portfolio in too few areas, therefore, may give rise to a claim against herself for overconcentration if she causes client losses.

Example: The 2000 articleTaking Your Broker to Task at Forbes.com reported that an investor lost $97,000 on a single stock in less than two years after his broker overconcentrated half his assets in just two stocks. New York Stock Exchange arbitrators ordered the brokerage firm to cover the investor’s losses.

Ponzi Schemes

     A Ponzi scheme’s promoters pretend that an investor’s funds will be invested, when in fact no real investment is made and the funds are paid to other investors, to create the illusion that the investors have made a profitable investment. The promoters profit by keeping a portion of the capital that the duped investors entrust to them.

Example: Ponzi schemes gained worldwide notoriety with the 2008 Bernard Madoff scandal, history’s largest Ponzi scheme. According to SEC Press Release 2008-293, Madoff paid fake “returns” to senior investors from principal received from junior investors, while in reality Madoff’s firm was insolvent and no real investments were made. That caused at least $50 billion in investors’ losses when the market dropped. Madoff was sentenced to 150 years in prison.

Selling Away

     A broker must get approval from her firm for each trade that she makes, so if she trades without that approval or trades without her firm’s knowledge, she may be “selling away.” The misconduct often involves fraud.

     Thus, an investor whose broker advised her to engage in “secret” trading without the brokerage firm’s knowledge, and who suffered losses as a result, should be able to recover her losses from the broker. The brokerage firm may also be liable if it did not supervise the broker properly or ignored warning signs of broker misconduct.

Example: A claim was filed with the Financial Industry Regulatory Authority against a Melville, New York broker who had recommended a high-risk Chinese investment product. The broker had persuaded his clients to take out home-equity credit lines in order to buy the product, which he characterized as “the best investment available.” The broker was charged with selling away because he had traded an unregistered security and done so without his firm’s knowledge.

Unauthorized Trading

     A broker must obtain her client’s approval before trading for her client’s account. And even if the broker has written consent to trade without express approval, she must stay within the scope of that consent and make only suitable investments. A broker who trades without the client’s consent or who trades outside the scope of the consent, therefore, commits unauthorized trading.

Example: Australian broker Kym Andrew Sellers sold twelve clients’ shares without their consent to fund his gambling addiction, according to an April 10, 2008 report by the Australian Securities and Investment Commission. Sellers reportedly established an account in a friend’s name and sold shares that were held in trust for clients by his firm. When the fraud was discovered, Sellers’ firm was forced to repurchase the shares for nearly $500,000, and Sellers was “permanently banned” from providing financial services.

Example: The Securities and Exchange Commission charged Aura Financial Services, Inc. with unauthorized trading in June 2009. An Aura broker had allegedly traded on an account after the death of the account’s trustee, according to SEC Press Release 2009-134.

Unregistered Broker or Security

     An investor may be able to recover losses, interest, and attorney’s fees if (1) her broker was unregistered or if she traded an unregistered security, and (2) the investor’s state requires broker or security registration and recognizes a private cause of action for unregistered trading. New York State does not recognize that cause of action, but other states do.

Unsuitability

     Unsuitability claims are among the most common investor’s causes of action against brokers and investment advisors. The claim arises when the investment professional choose an incorrect investment given the client’s investment goals, risk tolerance, and financial situation.

Example: In Louros v. Kreikas, 367 F. Supp. 2d 572 (S.D.N.Y. 2005), the plaintiff brought an unsuitability claim against his broker when he suffered losses from his broker’s recommending vertical bull spreads and put options. The plaintiff had traded options before, and thus had some understanding of them. But a federal court held that just because the plaintiff was sophisticated enough to understand options trading did not necessarily mean that he grasped vertical bull spreads and put options. The court therefore held that the defendant’s recommending those advanced trading vehicles stated an unsuitability claim, because a broker must choose investments that are appropriate in light of her customer’s trading sophistication.

Example: As reported in the 2002 Wall Street Journal article Broker Complaints Proliferate, but Few Investigations Will Collect, an elderly couple was awarded $176,575 in an unsuitability claim. The spouses were in their seventies and neither had gone beyond elementary school, but their broker had nonetheless recommended high-risk securities, which had caused their account’s value to plummet.

___________________________

[1]  18 Nov. 2009.
[2]  01-FEB-1988.
[3]  Serial No. 106-156 (2000).
[4]  an. 14, 1987.
[5]  08-NOV-2004.

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