Are you an investor who has lost money because you believe your broker made investment recommendations that were inconsistent for your age, income, investment objectives and/or investment risk tolerance? If so, you may be the victim of something called “unsuitability.”
Customer Suitability: In making an investment recommendation to a client, a broker must make recommendations that are consistent with the customer’s risk tolerance, needs and investment objectives. A broker has a duty to know his client and only recommend investments and trading strategies that are suitable for that client. An investment may be unsuitable if a customer does not have the financial ability to incur the risk associated with a particular investment, if the investment was not in line with the investor’s financial needs or if the customer did not know or understand risks associated with certain investments.
A broker has a duty to gather essential information in order to understand the risk tolerance of an investor, the tax considerations for the client, the client’s prior experiences and appetite for risk, and the level of return desired. It is the duty of a broker to make recommendations that are appropriate and suitable given his client’s circumstances. If a broker breaches those duties and makes unsuitable recommendations for a client, the broker may be liable to that client.
A broker must also have a “reasonable basis for the recommendation.” The broker’s basis for the recommendation can be the firm’s research, in which case the firm must have a reasonable basis for its own recommendation.
Quantitative Suitability: All brokers and broker-dealers must have a reasonable basis for recommending a series of transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together in light of the customer’s objectives. Thus, while a small investment in a particular product may be suitable for the investor, a large portfolio concentration in the same or similar products may be unsuitable for the same investor. In addition, the pattern and type of securities activity in the account can also be unsuitable for the investor. Factors such as turnover rate, cost-equity ratio, and use of in-and-out trading tactics indicate excessive activity that violates quantitative suitability standards
Securities fraud, also known as stock fraud and investment fraud, is a deceptive practice in the stock or commodities markets that induces investors to make purchase or sale decisions on the basis of false information, frequently resulting in losses, in violation of securities laws.
Investors are protected against fraudulent securities activities by several different civil laws. First, the Securities Exchange Act of 1934 (15 U.S.C. § 78a et seq.) and Rule 10b-5 protect investors against deceptive and manipulative acts in the purchase or sale of securities. This sweeping legislation is the cornerstone of federal securities laws. Rule 10b-5 makes it unlawful to employ a device or scheme to defraud, to make any untrue statement of material fact or omit to state a material fact not misleading, or to engage in any practice that would operate as a fraud.
Second, the vast majority of states have passed “blue sky” laws that regulate the securities industry in each state and protect investors. Even if a state has not enacted specific securities laws, an investor can still pursue a claim under theories of common law fraud.
Third, investors can pursue claims against a broker or a brokerage firm under the rules of the Financial Industry Regulatory Authority (FINRA), including its anti-fraud provisions. The FINRA rules have several provisions pertaining to fraud including IM-2310-2 (covering churning, false accounts, unauthorized trading, and misuse of customer funds) and Rule 2210 (covering communications with the public).
Churning (Excessive Trading)
Excessive trading, commonly referred to as “churning,” involves the broker trading securities in the account in an excessive manner. In this type of case, the broker places his own interests ahead of those of his customer for the purpose of generating additional commissions and fees. When brokers buy and sell securities in an account to generate commissions, they usually convince their clients of reasons the clients should quick profits. While these reasons seem valid, these are often simply excuses for the broker to charge excess commissions. Although churning often occurs by trading in and out of stocks, churning can also occur by short-term trading in mutual funds, bonds or annuities.
To establish that your broker has churned your account, we will demonstrate that the pattern of trading activity in your account was excessive. This can be done in a number of ways including calculations to determine the annualized rate of return that would be necessary to cover the commissions charged in your account; the number of times the equity in your account is turned over to purchase securities; and the purchase and sale trading activity that occurs in your account.
Churning occurs because many securities brokers play a dual role as both investment advisers and salespersons and because of the compensation system used in the securities industry.
NYSE Rule 408(a) and FINRA Rules 2510(b) and 2020 explicitly prohibit brokers from making discretionary trades in a customers’ non-discretionary accounts. The SEC has also found that unauthorized trading violates just and equitable principles of trade and constitutes violations of Rule 10b and 10b-5 due to its fraudulent nature.
There are certain exceptions. For instance, if a customer has a margin account and the value of the account falls below the brokerage firm’s requirements, the broker may be able to sell the customer’s securities without consulting the customer beforehand.
Failing to diversify your investments over asset class (type of security, i.e., stock, bond, mutual funds, cash, etc.) and sector (health care, financials, automotive, pharmaceuticals, consumer goods, technology, international, etc.), as well as “overconcentration” in any one of those areas may be the reason for your losses and an actionable claim against your broker. A broker who does not diversify his client’s portfolio is potentially liable if that investment declines in value.
Failure to Supervise
Under FINRA 3010, each brokerage firm must “design and implement written procedures” in order to properly and effectively supervise the activities of each of its brokers and other employees.
When an individual broker is negligent or acts in an unlawful manner against the interests of the client and that client suffers damages as a result of such wrongdoing, the firm may be held liable for the investor’s losses
There are also instances in which a brokerage firm may be held liable for failure to supervise without the individual broker being held responsible for damages. Brokers are required to complete standardized training and pass exams administered by the FINRA. If it is found that a brokerage firm did not properly train a broker, did not ensure the broker obtained the necessary license, or furnished the broker with false information, the brokerage firm alone may be liable for damages caused by the broker’s negligence or misconduct. In addition, brokerage firms are responsible for conducting due diligence on the securities products they sell and devising a written supervisory system to achieve compliance with the securities laws.
Misrepresentation and Omissions (Common Law Fraud)
Often the misrepresentations or omissions disguise the risk associated with a particular investment. A broker has a duty to fairly disclose all of the risks associated with an investment. A brokerage firm or broker can be held liable if that firm or broker misrepresents material facts or omits to disclose material facts to the investor regarding an investment, and that client subsequently loses money on that investment.
There are two types of misrepresentations and omissions; those that are fraudulent and those that are negligent. If the misrepresentation was not intentional a negligence claim is more appropriate.
According to the SEC anti-fraud regulations, an investor who lost money may recover damages by proving the investment recommendations made:
- was based on a misrepresentation or omission of a material fact;
- was intentional, reckless;
- was in connection with the purchase or sale of a security;
- was relied upon by investors; and
- resulted in an investment loss.
Breach of Fiduciary Duty
Financial advisors or securities firms often have fiduciary duties to their clients. A fiduciary is obligated to place the interests of the person to whom he owes the fiduciary duty (the investor) above his own interests.
When a broker agrees to execute an order, the broker and firm have a fiduciary duty of “best execution” – to not place the firm’s interest before the clients and to execute the order at the best price available in the marketplace.
When a broker agrees to manage client assets and/or obtain permission to place orders on their behalf, the brokers have additional fiduciary duties to these clients. Financial Advisors have an even greater fiduciary duty to their clients, and brokers and their firms are often considered fiduciaries to their clients when performing the same function.
Since investors are encouraged to place their trust and confidence in their broker whom they rely upon for expertise in making the investment decisions, the broker is held to an extremely high standard not to abuse that trust. Acts of fraud and misrepresentations, unauthorized trading, unsuitable trading and churning will generally also be the basis for a breach of fiduciary duty claim. A broker may also be subject to liability as a fiduciary for a pension or retirement plan account under the Employee Retirement Income Security Act (“ERISA”).
Margin Account Abuse
A “margin account” is an account offered by brokerage firms that allows investors to borrow money to buy securities. An investor might put down 50% of the value of a purchase and borrow the rest from the brokerage firm. The brokerage firm charges the investor interest for the right to borrow money and uses the securities as collateral.
While margin investing can double the gains on an investment, it also doubles the risk. In fact, because interest immediately begins to be charged to the account and a temporary drop in the stock value can cause liquidation, the danger is even greater than many investors realize.
Using margin is a high risk method of investing and is only appropriate for sophisticated investors who fully understand the risk.
Failure to Execute
Brokers have a duty to properly execute customer orders. Failure to execute trades, also known as a failure to follow directions, occurs when a broker does not execute a trade ordered by an investor. Other cases include the failure of the broker to: obtain the best possible price during an authorized trade; make the trade in a timely manner, or carry out a pre-specified action at the price the client believes it will be.
If an investor directs his/her broker to sell or buy a given security and it is not done or not done in a timely manner, the broker will be found in violation of his/her duties to the investor. Even in such cases, it can often be difficult to prove especially if the order was conveyed verbally and not followed up with a written order. For this reason, it is important that you always maintain a paper trail by issuing written orders, even after confirming your request verbally with your broker.
A broker and brokerage firm’s procedures and controls should take into consideration the age and life stage (whether pre-retired, semi-retired or retired) of their customers. Of particular concern is the suitability of recommendations to senior investors, communications targeting older investors, and potentially abusive or unscrupulous sales practices or fraudulent activities targeting senior investors. For example, certain securities such as private placements, penny stocks and other speculative securities may not be suitable for a senior investor relying on their investments for income.
Dealing with senior citizens and those approaching retirement requires special care and planning, as well as generally have special needs of liquidity, income and safety. If you find yourself having experienced greater than expected losses and you are in or approaching retirement, you may have a claim.
Pump and Dump Schemes
Pump and dump is a form of microcap stock fraud that involves artificially inflating the price of an owned stock through false and misleading positive statements, in order to sell the cheaply purchased stock at a higher price.
These schemes often occur on the Internet where it is common to see messages urging readers to buy a stock quickly. Often, the promoters or brokers will claim to have “inside” information about a development that will be positive for the stock. After these fraudsters dump their shares and stop hyping the stock, the price typically falls, and investors lose their money.