Specific Securities Fraud Questions

Where Can a Customer of a Securities or Commodity Brokerage Firm Bring a Claim Against the Firm and His Broker?

Typically, when a customer opens an account with a brokerage firm, he signs a Customer Agreement that contains an arbitration clause. Most arbitration clauses state that if a customer wants to bring a claim against his brokerage firm, it must be arbitrated before a forum such as the National Association of Securities Dealers, Inc. (NASD), National Futures Association (NFA), or New York Stock Exchange (NYSE). If the customer has not signed an agreement that includes an arbitration clause, he may file a lawsuit against his brokerage firm and his individual broker in state or federal court, depending on the nature of his claims. If the customer prefers arbitration, he may still bring his claim to any forum where the brokerage firm is a member (e.g., the NASD or NYSE)--whether or not he has signed an agreement with an arbitration clause. This would include claims against the customer's individual broker. Alleged violations of the Commodity Exchange Act may be filed before the Commodity Futures Trading Commission (CFTC) where they would be heard as reparations claims before an Administrative Law Judge. Usually, a customer will base his complaint on several legal theories (e.g., fraud and breach of fiduciary duty). Because the CFTC will only adjudicate claims under the Commodity Exchange Act, many customers prefer the NFA as a forum for their commodities disputes.

What Types of Things Can't a Broker Do?

  • A broker cannot make recommendations to a customer for the purchase or sale of a security that is not suitable for his customer, given his customer's age, financial situation, investment objectives and investment experience
  • A broker may not purchase or sell securities in a customer's account without first contacting his customer and obtaining specific authorization for the sale or purchase. An exception to this rule is if the broker has received written discretionary authority to effect transactions in an account, or if the broker was given discretion as to a particular price and time to buy a particular security
  • A broker cannot switch a customer from one mutual fund to another, when there is no legitimate investment purpose to do so
  • A broker may not intentionally misrepresent or fail to disclose material facts concerning an investment. An example of a material fact would be to accurately present the risks involved in a particular investment, the charges or fees involved to purchase an investment, the company's financial information and any technical or analytical information, such as bond ratings
  • A broker may not remove funds or securities from a customer's account without the customer's prior written authorization
  • A broker may not charge a customer excessive mark-ups, markdowns or commissions on the sale of securities
  • A broker may not guarantee to his or her customer that they will not lose money on a particular securities transaction. The broker may not make specific price predictions, or agree to share in the losses in their customer's account
  • A broker may not engage in a private securities transaction with one of his or her customers, which may violate any NASD rules. This is particularly true where such transactions are done without the knowledge and permission of the broker-dealer employing the representative
  • A broker is prohibited from using any manipulative, deceptive or other fraudulent device or contrivance to effect any transaction, or to induce a customer to purchase or sell any security.

This list does not encompass all of the conduct prohibited by the rules of the National Association of Securities Dealers. If you have questions regarding the conduct of your representative and/or broker-dealer, you are urged to contact a qualified attorney or other trusted professional.

What Are Some of the Duties That My Stockbroker Owes to Me as His Customer?

First and foremost, a stockbroker has a duty to treat his customers in a fair manner, which is characterized by high standards of honesty and integrity. The NASD Rules of Fair Practice impose the following standards upon members of the securities industry: A member, in the conduct of his business, shall observe high standards of commercial honor and just and equitable principles of trade.

A broker also owes his customer a duty of loyalty. Brokers should always place the interest of their customers before their own. We all know that many (not all) brokers earn their living through commissions on the transactions they execute on behalf of their clients. Accordingly, this creates a very delicate relationship between the broker's interest and the interest of their customers. Frequent trading in a customer's account should be considered a red flag as the broker is required to recommend trades which meet the needs of the customer. The broker is prohibited from engaging in frequent trading for the purpose of generating commissions for himself. This activity is known as "churning".

A broker is required to make recommendations to customers for the purchase or exchange of any security only if he or she has reasonable grounds for believing that the recommendation is suitable for the customer. This belief must be made upon the basis of the facts disclosed by the customer regarding any other security holdings and his or her financial situation and needs.

The brokerage firm is required to maintain a watchful eye over its registered representatives. The brokerage firm must maintain a system to assure that its brokers are in compliance with all of the relevant securities rules and regulations. As a result, the brokerage firm can be just as liable as the representative in securities arbitration actions.

Customers should expect to be treated by their broker and brokerage firm in accordance with the high standards imposed upon them by the brokerage securities profession. A good broker is cognizant of the fact that his client is putting his financial well being in their hands and should act only with the customer's best interests at heart.

What Does a Customer Have to Prove to Establish Fraud?

Generally, to prove fraud a customer must show that the broker intentionally or recklessly made a misrepresentation or omission of material fact that the customer justifiably relied upon and then suffered damages as a direct result of his reliance on the misrepresentation or omission of material fact.

To Bring a Federal Securities Fraud Action, Must an Investor, Before a Stock Purchase, Actually Take Time to Read the Prospectus That Contains Fraudulent Misrepresentations or Omissions?

When a federal securities fraud action alleges that the defendant made a positive misrepresentation, proof of reliance by the plaintiff on the misrepresentation is required. This reliance can be established by direct or indirect evidence. For example, when a prospectus states that the issuer has a lucrative contract that the issuer in fact does not have, the plaintiff may be able to directly establish that he or she relied to his or her detriment on this misrepresentation in making the purchase decision.

Proof of reliance can also be established indirectly pursuant to the fraud-on-the-market theory. Under the fraud-on-the-market theory, proof of subjective reliance on a particular misrepresentation is not required to establish a securities fraud claim. Rather, the courts recognize that the misrepresentation served to artificially inflate the price of the stock, and the plaintiff is permitted to indirectly prove reliance by virtue of his or her dependence on the market to set the stock price. Because the misrepresentation affected the stock price, and the plaintiff bought the stock based on the affected price, the plaintiff indirectly relied on the misrepresentation that misled the market as a whole. In such case, the defendant can try to disprove the plaintiff's case by showing that the misrepresentation was not material or did not affect stock prices. The defendant can also attempt to show that the individual plaintiff knew that the statement was false or would have bought the stock even if he or she had known of the falsity of the statement.

When a federal securities fraud action alleges that the defendant defrauded the plaintiff securities purchaser by failing to include material information in the prospectus, the plaintiff cannot and need not prove actual reliance on the omitted information. For example, if a prospectus omits notice to prospective investors that the issuer's patent on its primary product is being contested in court, it would be difficult for the plaintiff to prove that he or she specifically relied on the missing information. The courts have decided that if the omitted information constitutes material facts that reasonably could be expected to influence an investor's purchase decision, positive proof of reliance is not required. Rather, reliance is presumed to exist. The defendant can rebut this presumption of reliance by showing that the plaintiff's purchase decision would not have been affected even if the defendant had disclosed the omitted fact. Under the facts presented, the defendant may be able to establish this defense by pointing out that the plaintiff's decision would not have been affected by a litigation disclosure section in the prospectus if the plaintiff did not read the prospectus.

Should I Attempt to Resolve a Dispute about My Investment Account with My Broker?

Investors can file an informal complaint with the firm themselves without seeking legal counsel. However, be aware that the time spent investigating will most likely result in a denial of recovery of funds for the investor, as brokerage firms are very aware that the arbitration process is in place to pursue recovery of funds. Also, while the brokerage firm investigates, the "eligibility" time to file a complaint in arbitration or the "statute of limitations" to file a complaint in court is running (see below, "Is it too late to take action...?"), and the investor may be foreclosed from pursuing other complaints.

Is it Too Late to Take Action to Protect My Investment?

There are legal time limitations that exist for an investor to file a securities fraud claim. The period in which to file an arbitration claim is called the "eligibility" period, and, to file a formal lawsuit, the time period is called the "statute of limitations." If an investor wants to file a claim, he or she should act as soon as possible to prevent these time limitations from barring his or her claim. The lengths of eligibility and statute of limitations periods vary, as they are contingent upon the facts of each case. A qualified securities law professional can better assist an investor in discussing how much time is available to file a claim for recovery.

What Types of Misconduct Are Brokerage Firms Guilty of Today?

Analyst Claims A.k.a. Conflict of Interest

These are claims that are now being filed that relate to misrepresentations made by Wall Street analysts including Jack Grubman, Henry Blodget and others. In order to win investment banking business, investment firms issued positive stock research when the stocks were not doing well. Basically, research was being manipulated for profit. An example of this would be WorldCom, which was touted by Jack Grubman of Salomon Smith Barney.

It is legal for companies to seek analyst coverage for their stock. It is even legal to promise investment banking business in return for this coverage. However, it is not legal for companies to provide false information to analysts or to request favorable coverage that is not justifiable.

Breach of Fiduciary Duty

This means a broker or advisor put the needs of the firm ahead of the needs of the client. For example, an investment firm may have had a stake in the success of a stock it was pushing.

Unsuitability

This means a broker or advisor invested a client's money into stocks that were clearly unsuitable for that client's circumstances, for example, taking a retiree's life savings and investing in high-risk stock options.

Over Concentration/Negligence

This means non-diversification. Brokers need to make sure investors have a well-balanced portfolio (unless otherwise directed by the client).

Misrepresentation/High Pressure Sales/Omission

This means a broker or advisor did not adequately disclose the risks involved in purchasing a particular type of stock.

Failure to Supervise

This means an investment firm failed to keep an eye on what their brokers or advisors were selling.

Churning

This means excessive trading of a client's securities to generate commissions for the broker.

Unauthorized Trades

This means any trading of stocks not authorized by the client either directly or through a written discretionary agreement.

Spinning

This means offering hot initial public offerings (IPO) to personal brokerage accounts of executives who are also the investment firm's clients. This practice leaves small investors out of the IPO while benefitting corporate executives.

IPO (Initial Public Offerings) Laddering

This refers to a broker's analysts overstating research reports in an attempt to win investor-banking business. Brokers offer IPOs in exchange for the promise of purchasing future shares when trading begins after the IPO. This type of stock manipulation hurts the average investor because it artificially inflates the price of a stock in the open market. The secondary market is where the ordinary investors buys and at top market price. Unfortunately for the investor, the stock price tends to fall shortly thereafter.

I recently lost a lot of money on a stock my broker recommended. Do I have any basis to sue?

Like all professionals, stockbrokers are required to act reasonably in making investment recommendations to clients. A failure to act reasonably, such as the recommendation of an unsuitable investment, may result in liability for negligence. Ordinarily expert testimony is required to establish this type of liability.

My broker works out of a small brokerage house. Does that impact my ability to recover?

The large brokerage houses have committed fraud many times and caused huge losses to investors. The plus-side to this is that large houses have the financial resources to pay monetary damages to defrauded investors. However, it only takes a modest amount of money to open up a small brokerage house, which may be staffed by as little as one person. Small brokerage houses unfortunately are capable of doing a huge amount of financial harm to customers, and many times sleazy investment promoters will use these small houses to distribute investments that the larger brokerage houses would never touch. An investor dealing with a small brokerage house should consider the reality that the house may not have the financial resources to respond to a substantial damage claim in the event of fraud.

What are the benefits of a securities class action?

A securities class action provides small shareholders with the ability to litigate on an equal playing field with the large, well-funded corporations who have allegedly violated the securities laws and have a lot of money to spend on defending lawsuits directed at those violations. A class action allows many people who would never have brought an individual action against a company to seek recovery from the company without having to individually retain a lawyer and incur a legal fee.

What are the shortcomings of a class action?

Large-scale securities fraud cases typically involve hundreds, if not thousands, of investors and huge sums of money. Although class action settlements often range into the millions, or hundreds of millions, of dollars, the amounts paid to individual investors in class settlements are often only a fraction of actual investor losses. A $100 million settlement, where the losses are several times this amount, might net pennies on the dollar for class members. Accordingly, investors who have been the victims of a clear case of fraud should seriously consider hiring their own private lawyer to prosecute the case in court, rather than passively relying upon the outcome of a class action matter.

What are the advantages of arbitration?

The main advantage of arbitration is that the case usually will take less time for the investor, since depositions are not generally allowed and strict time limitations are often placed on the length of hearings and other proceedings. Hearings are usually held over the telephone or in the vicinity of the investor's residence. Hearings are conducted in an extremely informal atmosphere, usually in a hotel meeting room. There is usually considerable flexibility shown for scheduling matters. Disputes between the attorneys are typically resolved over the telephone, with the chairperson issuing rulings by letter. After the panel issues an award, there really is no practical method of appeal for either side. The arbitration award can be filed with the Court and has the same legal significance as a Court judgment. Although losing customers are sometimes ordered to pay large arbitration fees to the NASD, apparently the NASD never reports the non-payment of these fees to credit agencies, and it has an unwritten policy of not following up with legal collection actions against customers - probably because of the negative publicity this could generate.

What are the disadvantages of arbitration?

The NASD has recently raised its filing fees. A fee between $1,000 and $2,250 is now required to start a case. Additional fees are charged as the case progresses. Total fees for a typical case might range from $2,000 to $15,000 or more. The panel has discretion to award these fees to either party, or require both sides to share the cost. As a rule, the arbitrators who are retained by the NASD to preside over arbitration hearings are not judges. A panel of three arbitrators will have one panelist who is actively employed by a brokerage house, who is called the "industry arbitrator." Many times this person is a stockbroker or an executive with a brokerage house. The two other arbitrators are called "public arbitrators," but they may have some degree of affiliation with the financial services industry. Public arbitrators are often lawyers, but usually not the type that represent customers. Being an NASD arbitrator is not a full-time occupation and the arbitrators invariably have full-time day jobs. Accordingly, they may be tired or pressed for time and have little patience for protracted cases. Arbitrators are not required to follow any particular law. Although customers are awarded money in roughly 50% of the cases, large awards are rare and many times the amount awarded is significantly less than the losses incurred.

Will the Results of Arbitration Be Favorable for Me, and How Much Might I Recover?

It has been reported by the Securities Arbitration Commentator, a periodical that studies the statistics of securities arbitration cases, that 80% of all investor cases settle before trial with some recovery of funds for the investor. Also, 55% of claims that go to a hearing in arbitration result in a favorable recovery for the investor. Though no attorney can guarantee a favorable recovery, investors have been awarded out-of-pocket losses, compensation for what an account should have generated absent a broker's mismanagement, reasonable attorney fees and interest on the losses, and, in some egregious situations, punitive damages.

Is Pursuing a Claim in Arbitration Going to Consume My Life and Cause Me Undue Stress?

Filing a claim in arbitration is a procedure that is designed to be faster and more efficient than filing a formal legal complaint, often with a conclusion between 12-16 months after an investor's first consultation with an attorney. By consulting with an experienced securities law attorney, an investor can be assured that the claim is given serious consideration and the investor's decision to pursue recovery is in capable hands.

What Happens If the Company I Own Stock in Goes Bankrupt?

What happens when a public company files for protection under the federal bankruptcy laws? Who protects the interests of investors? Do the old securities have any value when, and if, the company is reorganized? Federal bankruptcy laws govern how companies go out of business or recover from crippling debt.

A bankrupt company might use Chapter 11 of the Bankruptcy Code to reorganize its business and try to become profitable again. Under Chapter 11, management continues to run the day-to-day business operations but all significant business decisions must be approved by a bankruptcy court.

Under Chapter 7, the company stops all operations and goes completely out of business. A trustee is appointed to "liquidate" (sell) the company's assets and the money is used to pay off the debt, which may include debts to creditors and investors.

Most public companies will file under Chapter 11 rather than Chapter 7 because they can still run their business and control the bankruptcy process.

In most bankruptcy cases, the role of the SEC is limited. The SEC will review the disclosure document to determine if the company is telling investors and creditors the important information they need to know, and to ensure that stockholders are represented by an official committee, if appropriate.

Although the SEC does not negotiate the economic terms of reorganization plans, they may take a position on important legal issues that will affect the rights of investors in other bankruptcy cases as well. For example, the SEC may step in if they believe that the company's officers and directors are using the bankruptcy laws to shield themselves from lawsuits for securities fraud.

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