Definition of Securities Fraud, Unauthorized Trading, Churning, Unsuitable Investment, Breach of Fiduciary Duty
Definitions:
What Is the Definition of Securities Fraud?
Generally speaking, Securities Fraud refers to dishonest behavior in the offer and sale of investment products. However, the legal area of securities fraud is a very conflicted and complicated area of law with a large number of contradictory and confusing rules. For a detailed discussion, click here.
What Is the Definition of "Unauthorized Trading"?
There is a type of brokerage account agreement by which a stockbroker is given "discretion" or "discretionary authority" which grants the broker the legal right to buy and sell securities at will, without first getting permission from the client. This is a managed account and normally the broker is paid a fee for advisory services. Where a broker exercises discretionary control over an account, it may be considered a fiduciary in the broad sense with affirmative duties to disclose all material facts to the customer, including all material information concerning investment risks, and to manage the account in a manner that directly comports with the customer's needs and objectives. See, Leib v. Merrill Lynch, Pierce, Fenner & Smith, Inc. 461 F. Supp. 951 (E.D. Mich. 1978).
Most of the time, however, when the customer opens up a securities account with a brokerage house, the contracts signed do not give the broker the legal right to transact securities for the customer, and in this type of account, the broker serves as an agent to take orders from the client to buy or sell securities. Many times a broker will recommend that a client buy or sell a particular stock and the customer will follow this recommendation and the broker will execute the trades that the broker in the first instance proposed. The broker in this situation has obtain the client's permission to engage in the purchase or sale transaction.
As a practical matter, however, a broker normally has the actual ability to buy or sell stocks in a customer's account without first obtaining client approval, simply because if the broker places a buy or sell order in the account, it will be processed by his firm without regard to whether the client truly approved of the transaction in advance. For example, it would be possible for a broker to execute a buy order and only after the order had been processed, call the client and recommend the transaction. So long as the client agrees to follow the recommendation, no one is the wiser and nothing untoward would likely happen to the broker. However, this would be a technical violation, even if the client retroactively gave approval to the transaction.
Trouble definitely arises when a broker engages in purchase and sale transactions in a client's account without bothering to ask for permission first from the client, or even, without ever communicating with the client about the trades. This may happen when a broker, who is paid a fee or commission for every purchase or sale of a security in the account, needs money, and in order to obtain it, engages in transactions that are not authorized by the client. This type of conduct is prohibited by the rules of major exchanges and FINRA. See, New York Stock Exchange Rule 408(a) – (c), FINRA Rule 2310-2(b)(4)(iii).
A broker may hope that the client will retroactively approve of the transactions, or not notice them, or will simply accept them without complaining (this is a defense known as "ratifying" the transactions by failing to register a protest). This last scenario is a classic case of unauthorized trading by the broker.
Federal Courts have been divided as to whether this type of misconduct violates the federal securities laws. Some have held that unauthorized trading is not actionable under Rule 10b-5 without an accompanying misrepresentation or non-disclosure. See, Rowe v. Morgan Stanley Dean Witter, 191 F.R.D. 398 (D.C.N.J. 1999). Others have held that a violation occurs because a material fact has been omitted by the broker, namely, that a trade has taken place. See, Rivera v. Clark Melvin Securities Corp. 59 F.Supp. 2d 280 (D. Puerto Rico 1999). In Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Cheng 901 F.2d 1124 (Ct. App. D.C. 1990), the Court held that a broker who has engaged in unauthorized trades has a duty to inform the client of the right to reject the unauthorized trades, and if this is not done, then the client as a matter of law cannot be deemed to have ratified the trades.
What Is Churning?
Churning occurs when a broker makes excessive trades in a customer's account to further his own interests instead of the customer's. There is no single formula for determining when churning has occurred. The amount of trading done for one customer may be appropriate based on his sophistication and understanding of what his broker was going to do, whereas the same level of trading may be inappropriate for a less sophisticated customer. Arbitration panels and courts consider objective criteria for evaluating churning claims, including turnover and commissions-to-equity ratios. Generally, churning claims may be made only when a broker has made excessive trades in a discretionary account (i.e., where the customer has given the broker a power of attorney over his account). If a customer, however, can demonstrate that the broker exercised de facto control over the account, he may be able to prove churning even though he never gave his broker a power of attorney over his account.
What Is an Unsuitability Claim?
The rules of various regulatory bodies state that a broker must attempt to learn the essential facts about each customer's needs and objectives. Thereafter, the broker is prohibited from recommending a specific trade or course of trading that is unsuitable for the customer's needs and objectives. If a broker has recommended unsuitable trades for a customer's non-discretionary account or made unsuitable trades in a customer's discretionary account, the broker may be held liable for the losses sustained.
What Is a Breach of Fiduciary Duty Claim?
It has been said that all agents owe their principals a fiduciary duty of complete fidelity, loyalty, obedience, and trust. The courts in each jurisdiction differ about when a fiduciary duty arises in a customer-broker relationship. Some jurisdictions hold that unless the customer has given his broker discretionary powers over his account, the broker does not owe the customer a fiduciary duty. Other jurisdictions find a fiduciary duty in all customer-broker relationships, but limit the brokers duties to those he specifically agreed to perform. For instance, in a typical non-discretionary account, the fiduciary duty would be limited to the execution of the customer's orders and accounting for the customer's funds. Other jurisdictions examine the facts of each situation closely to determine whether the customer reposed sufficient trust and confidence in the broker to create a fiduciary duty. A fiduciary duty is sometimes found when there is a great disparity in the expertise of the parties and the broker has been able to exert substantial influence over the customer due to his superior position. When a jurisdiction has found that a fiduciary duty exists, the customer does not have to prove that his broker intended to breach the duties he owed to him. Negligence will suffice.
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