Securities Law

Introduction

This information is in response to common inquiries regarding whether or not a client in a specific situation might have a chance to recover all or a portion of their losses from their broker/dealer.
Generally an investor is responsible for his or her own investment decisions and losses. However, the investor has the right to expect that the broker/dealer and its salespersons deal fairly and put the customer’s interests before those of the broker/dealer and the salesperson. This includes making recommendations concerning investments and investment strategies that are suitable for the investor based upon the investor’s age, financial status and resources, income, investment horizon, investment objectives, tax status, risk tolerance and financial needs.
The investor also has a right to expect accurate and honest analyses from the broker/dealer and accurate, current and complete information from his broker/dealer and representative regarding the recommended investment decisions. Further, a broker/dealer and/or the salesperson may not commit frauds or engage in fraudulent acts and practices in connection with the transactions, and the broker/dealer is required to supervise the salespersons to prevent such fraudulent conduct.
This is not a detailed discussion of the federal and state securities laws- the primary focus is the conduct of broker/dealers and their salespersons.

Background

The actions to recover losses experienced by investors are generally based upon the federal securities laws, the state securities laws, certain Financial Industry Regulatory Authority (FINRA) and other Self Regulatory Organizations’ (SRO) rules that demonstrate the standards of the securities industry and state laws concerning breach of contract and common law fraud. Because of the Arbitration Clauses placed in most account agreements, virtually all actions are brought before the FINRA Dispute Resolution Arbitration Panels.
The basic fraud law and regulation is found under Rule 240.10b-5 promulgated under Section 10(b) of the Securities Exchange Act of 1934. This rule has been codified in the securities laws of the various states and is followed by FINRA.
Rule 10b-5 states that it shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange:

  • to employ any device, scheme or artifice to defraud;
  • 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
  • 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.

A multitude of case rulings have been issued and rules and regulations promulgated to define what this law means. Again this memorandum does not discuss each and every case ruling, law or regulation that might be the basis of an action by one who suffered a loss in the stock market. The purpose is to discuss and explain common broker/dealer and salesperson actions that may have caused losses in connection with your investments so that you may decide whether or not to seek the advice of counsel experienced in federal and state securities laws, the Rules of FINRA and other SROs and securities arbitration procedures.
The most fundamental rule governing the conduct of broker/dealers and their salespersons is described in case law as the “Shingle Theory”. It states that when a broker-dealer hangs out his shingle he implicitly represents that he will deal fairly with the public. The duty to treat the customer fairly and to put the customers’ interests and transactions before those of the broker-dealer and the representatives is a fundamental requirement found in most securities laws and regulations. Any obvious violation of that duty is a basis for additional inquiry.

Fraud by Conduct

Fraud by conduct of a broker/dealer or its salespersons includes, but is not limited to, churning accounts, switching mutual funds, twisting variable insurance products, and recommending unsuitable investment strategies.

Churning

Churning occurs in accounts holding traditional securities or exchange traded funds.
Churning of an account by a broker is a species of fraud. Churning occurs when a broker directing the volume and frequency of trades abuses the customer’s confidence for the broker’s own personal gain by initiating transactions that are excessive in view of the account’s character and its investment objectives as expressed to the broker. While an essential element of churning is the broker’s control of the customer’s account, the control need not be written discretionary control. It can be “de-facto” control of the account by the broker, in which the customer generally follows the recommendations of the broker or allows the broker to habitually make unauthorized transactions in the customer’s account, informing the customer later.
Churning more often occurs in margin accounts than in non-margin accounts because the calculation of the turn over rate, under most theories, is based upon the net assets in the account. As a rule of thumb, a net equity turn over rate of 6 times or more per year indicates churning. The required rate may be lower or higher depending on the character of the account and the investment objectives of the customer. Some customer margin accounts are funded by the deposit of large positions of investment stock or mutual funds, which are used as collateral to
borrow money for the trading activity. In certain of these cases, the rate of turn over may be calculated using the trading portion of the account.
Churning is also characterized by in-and-out trading in the account, short holding periods, high turnover, high commissions, and high margin interest. A customer need not lose money in the account for the account to be churned.
An account that does not meet all of the criteria of churning, (i.e., the salesman did not control the account) may still need to be analyzed for suitable use of margin, suitable investment strategies and/or suitable recommendations.

Switching

Switching of mutual funds or variable annuities for the benefit and profit of the broker/dealer and its representative contrary to the best interest of the customer is conceptually the same as churning. Switching occurs when the salesperson recommends or effects the sale of one mutual fund or annuity to provide funds for the purchase of another mutual fund or annuity in order to create commissions, not for the best interest of the customer.
Switching of mutual funds and variable annuities is characterized by a recommendation to redeem a loaded mutual fund or annuity four years or less after its purchase and/or when the customer experiences a surrender charge to generate funds to purchase a new mutual fund or annuity with a new front load or rear end surrender charge. Unless there is a clear and demonstrated need for the switch based upon changed investment objectives and/or needs of the client and/or problems with the original mutual fund or annuity, the transaction should be examined.
Because most mutual fund families have a wide range of funds with different investment objectives and policies and allow interfamily switches at no or low commissions, any switches between fund families, even due to a change of the customer’s investment objective, should be questioned if the customer experiences additional or new commissions or charges.
The NASD and SEC are looking very closely at the marketing of variable annuities. Because a characteristic of variable annuities is the ease of the exchange of investment portfolios within the annuities at little or no cost, a switch between variable annuities is hard to justify on the basis of a changed investment objective. In light of the fact that the separate accounts of the various portfolios are kept separate from the general assets of an insurance company and that the underlying investments are held at the mutual fund companies, it is difficult to justify a switch of a variable annuity based upon the financial status of the insurance company. Switches between variable annuities are often subject to question.

Twisting

Twisting is an insurance term for dishonest conduct in replacing insurance policies and traditional annuities by recommending the redemption of policies and using the proceeds to purchase a similar insurance policy or annuity with another company. It is similar in conduct to switching of mutual funds. Like churning and switching, these transactions may be for the purpose of generating commissions for the salesperson and may not be in the best interest of the customer.

Other Fraud by Conduct
  1. Other frauds by conduct include, but are not limited to:
  2. Unauthorized transactions in the customer’s accounts;
  3. Borrowing money from a customer;
  4. Loaning money to a customer;
  5. Sharing profits in customer accounts;
  6. Nominee accounts (salespersons using customer names or aliases to open accounts);
  7. Receiving or intercepting customer correspondence;
  8. Joint ownership in customer accounts;
  9. Using customer accounts to effect manipulative acts and practices such as controlling the float (stock available for trading) of a stock;
  10. Cross trading; and
  11. Undisclosed principal trading.
Fraudulent Acts and Practices

Overlapping fraud by conduct are fraudulent acts and practices that are more closely related to

false and misleading statements. Such acts and practices that might be apparent when reviewing

your accounts include the following:

  1. The frauds by conduct listed just above;
  2. Inconsistent recommendations and recommendations without a reasonable basis. One of the must fundamental duties of a broker/dealer and its representatives is to know their products, their customers, and to make recommendations to their clients based upon current product and customer information, which is to be documented in the firms due

    diligence files; further

    • This duty is currently a “hot spot” in the securities industry. In many brokerage firms, analysts compose recommendation lists to be used by managers and the sales force. The recommendation lists typically set out those stocks that the firm’s registered representatives may recommend their clients purchase, hold or sell, assuming all other suitability requirements are met;
    • Recent news stories indicate that certain firm’s analysts did not have a reasonable
    • Those customers who purchased and/or held the securities based upon the firm’s
    • A more common fraud of this nature is the recommendation that one customer basis for their recommendation that customers purchase and/or hold the securities of companies in which the firms were making a market and/or the firms had underwritten. Statements in the articles indicate the analysts were making contrary in-house recommendations support the concern that the analysts’ recommendations were not made in the best interest of the clients; salesmen recommendations, which were in turn based upon such an analysts’ report, may have a claim for any damages experienced as a result of following such recommendations; sell a stock while recommending a similarly situated customer purchase the same stock, often leading to cross trading;
  3. Guarantees against losses;
  4. Failing or refusing to promptly execute sales orders
  5. Representing that a market in the security will be established (common in private placements);
  6. Representing that the security will be subject to an increase in value;
  7. Claims that the salesperson has inside, private, or other material information that would impact the value of the security;
  8. Charging excess commissions and/or markups/downs (the NASD guideline is a maximum of 5% commission or markup/down, assuming no special circumstances; if the transactions involve a sale to provide funds for a related purchase, the maximum includes both sides of the transaction);
  9. Recommending a margin trading account without disclosing the rate of return required to pay the costs of margin and commissions and the risks necessary to achieve those rates of return compared to other investment strategies;
  10. Making recommendations to purchase beyond the customer’s capability to meet the financial commitment (this may occur in connection with the excessive use of margin when a customer cannot meet margin calls, in connection with option purchases, and other futures transactions);
  11. Failure to deliver a prospectus at or prior to the purchase of a security in any initial offering including mutual funds, variable annuities and variable life insurance;
  12. Contradicting or negating the importance of any information contained in a prospectus;
  13. Highlighting any provision in a prospectus;
  14. “Boiler room” tactics, such as stating that the customer must purchase immediately and the failure to provide written documentation of claims, upon request, of claims made;
  15. Failing to disclose the broker/dealers bid and ask price of a particular security at the time of the solicitation;
  16. Recording a solicited transaction as unsolicited on the trade ticket and/or confirmation;
  17. False and misleading statements in connection with the recommendation to purchase or sell a security, which include but are not limited to the following:
    • a. Unfounded claims that a mutual fund or insurance company is in trouble to induce
    • The failure to disclose the risks and economic reality of investing in margin a redemption and a new purchase;
    • The failure to disclose the risks and economic reality of investing in margin accounts;
    • The failure to disclose the risks of purchasing and selling options;
    • The failure to disclose the risks of concentrating ones investment in a limited
    • False claims concerning the company’s products, assets; sales, earnings, financial
    • Claims of private non-public information concerning the companies at issue; and
  18. Allowing a customer to invest inappropriately.
Suitability

The failure to make suitable recommendations is the most common basis for claims against a broker dealer and its’ representatives.
A broker/dealer and its representatives have a duty to exercise the utmost good faith and to act in the customer’s best interest in connection with the purchase and sale of securities in the customer’s account. This duty includes having a reasonable basis for recommending that an investment strategy and/or a particular transaction and/or a particular investment decision is suitable for the customer based upon the clients age, financial status and resources, investment horizon, income, investment objectives, tax status, risk tolerance and financial needs.
The basis for this duty is found in the antifraud provisions of the federal and state securities laws, numerous cases, the NYSE’s Know Your Customer Rule and the NASD’s Suitability and Fair Dealing with Customer Rules.
Examples of transactions and/or trading strategies that may be unsuitable include, but are not limited to, the following:

  1. Recommendations to purchase a high risk stock, mutual fund, or variable annuity portfolio to the following investors:
    • A person whose investment objective does not include high risk or speculative investments, including wealthy clients. (A wealthy person has as much a right to suitable recommendations as anyone else.) A customer may have different investment objectives for different accounts or investments and the customer’s particular investment objective must be followed in making recommendations for each account and/or investment;
    • A person who does not have the ability to recover from a substantial loss, which may include:
      • A retired person;
      • A person with limited income;
      • A person with limited assets; and
      • A person who needs the money in a short time (limited investment horizon);
    • A person with a low risk tolerance;
    • A person whose investment objective is asset preservation and/or growth;
    • A person who can not afford to lose the money; and
    • A person who has been a CD investor and does not understand the risk.
  2. Recommending the purchase of a variable annuity in an IRA or other tax deferred account (there may be an acceptable reason, but it would be an exception);
  3. Trading in mutual fund shares (mutual funds are not normally proper trading vehicles, therefore such activity on its face may raise questions of propriety);
  4. Recommending the use of a high level of margin to a customer who does not have the capacity to meet margin calls;
  5. Recommending the use of margin in accounts where the objective is long-term, investment, asset preservation, and/or income;
  6. Recommending a trading account to a person who does not have the knowledge and/or the time to participate in the investment decisions on a constant basis;
  7. Recommending a high yield bond fund (junk bond fund) and or junk bonds to an investor whose objective is asset preservation;
  8. Recommending municipal bonds to persons who have little or no taxable income;
  9. Recommending tax shelters to persons who have little or no taxable income;
  10. Recommending the purchase of illiquid investments (i.e., limited partnerships, investment trusts and restricted securities) to persons who need access to their money; and
  11. Recommending a trading strategy that has elements of churning except the customer participated in investment decisions (i.e., even though it is not churning, it may be an unsuitable strategy that benefits only the salesperson and the broker/dealer).

    Unregistered Securities

  12. In addition to the issues of suitability and liquidity mentioned above, the offering, purchase and sale of unregistered securities have raised many issues and have caused substantial losses to investors through the years. While private investments have proven to be very successful for some, unregistered private placements have also been disasters for many unsophisticated, unknowledgeable investors.
  13. The types of deals seem to change, but the basic concepts of bad deals stay the same. Generally, the bad deals are copycats of what is hot in the market or are offering something too good to be true. Historically we had tax sheltered real estate limited partnerships, other tax sheltered deals, mining deals, new age medical products, and high tech deals, among many others.
  14. Currently, as a result of the low interest rates for income investments, many of the private offerings promise high rates of return from various investment trusts or partnerships. These are often marketed with claimed safeguards or other assurances against loss and are targeted at older persons who seek high rates of interest.
  15. The various problems and issues involved with unregistered securities are too numerous and complicated to cover on a website. It is suggested that any losses suffered by a client through investments in unregistered securities should be referred to an attorney knowledgeable in the area for review.
Conclusion

The purpose of this website is to aid securities investors in deciding whether or not the investment losses they suffered may be recovered by contacting experienced securities counsel.