By Gerald D. Jowers, Jr.
Originally published in The South Carolina Lawyer, November 2003

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Who hasn’t lost money in the stock market?   Just a few years ago it seemed no one could. The mid-1990s saw enormous growth across the entire market, but most notably in the technology sector.  Internet startups and IPOs were the news of the day and everyone, it seemed, was getting in on the action.  The champions of the “new economy,” the Wall Street analysts, the media, and the public cheered as the markets reached unprecedented levels and ignored those who warned that prices were unsustainable. 

On January 14, 2000, the Dow Jones Industrial Average reached its all time high at 11,723.   The NASDAQ, fueled in large part by the technology sector, reached 5,048.62 on March 10, 2000. However, in 2002 the bulls made way for the bears and “irrational exuberance” gave way to sobering reality.   At market close on October 9, 2002 the Dow Jones was at 7,286.27, 37.8% down from its peak.  That same day, the NASDAQ closed at 1,114.11, 77.9% less than its high.  Today, the Dow has returned to the 9000 level, yet the NASDAQ is still below 2000. 

In the aftermath of the 2002 decline, investors are closely scrutinizing their portfolios- wondering where things went wrong.  The bursting of the technology bubble and the recent Wall Street scandals draw attention not only to the fundamental risk involved in stocks, but also to the fact that, in some cases, the individual investor is headed for financial disaster from the outset.

While everyone knows the stock market has risk, fewer know that the securities laws impose legal duties on brokers and provide rights to investors.  It must be recognized that most brokers are ethical and want to do what is best for their customer; however, the brokerage industry is a business of inherent conflicts of interest.  Brokers are compensated by commission.  Promotions are largely dependant on a broker’s revenue, and firms provide incentives to brokers to sell certain investment products.  Inevitably, there will be those whose professional ethics give way to self-interest.  This article provides an introduction to the state and federal securities laws, two common forms of broker misconduct, and investors’ available remedies. 

Disputes Must Be Arbitrated

In virtually every case, investor disputes with brokerage firms must be arbitrated.  In 1987, the U.S. Supreme Court handed down Shearson/American Express, Inc. v. McMahon, 482 U.S. 220, 237 (1987), holding that claims based on the federal securities laws and other federal statutes may properly be decided in arbitration.  Soon after McMahon, the Court held in Rodriguez de Quijas v. Shearson/American Express, Inc., 490 U.S. 477, 481-82 (1989), that predispute arbitration clauses in standard brokerage contracts are enforceable.   Thus an investor who is a party to such an agreement is precluded from bringing her dispute in court.  Naturally, the brokerage industry responded by including predispute arbitration clauses in their standard account opening agreements.  The result has been that so long as the contract is valid, the investor must submit all disputes to binding arbitration.

Securities arbitrations are most commonly conducted by the securities industry self- regulatory organizations (SROs).  SROs are private organizations to which Congress, through the securities laws, has delegated authority to make and enforce rules governing their members’ conduct.  The largest SROs are the National Association of Securities Dealers (NASD) and the New York Stock Exchange (NYSE).  Each of these organizations sponsors its own arbitration forums to which disputes involving their members may be submitted.

The choice of arbitration forum is usually left to the investor.  However, the choice of forum may be limited to the SROs in which the brokerage firm is a member, or by a forum selection clause in the contract.  Of course, in some cases a claimant’s choice of arbitration forum may be made for strategic reasons as there are some differences between them.  

The advantages of arbitration over litigation in most contexts are well recognized. Arbitration is less expensive and disputes are resolved faster. In the securities context, arbitration begins with the filing of a Statement of Claim and from that point the case is typically resolved in less than one year.  The swift resolution and reduced expense is due, in large part, to limitations placed on the two time consuming and expensive features of litigation- discovery and motion practice.  Another advantage of arbitration is the finality of the award.  Arbitration awards may be overturned by the courts only on very limited grounds.  See Upshur Coals Corp. v. United Mine Workers of Am., Dist. 31, 933 F.2d 225, 228-29 (4^th Cir. 1991); Remmey v. Painewebber, Inc., 32 F.3d 143 (4^th Cir. 1994).  Additionally, SRO rules require prompt payment of awards by members and impose severe penalties for nonpayment.

Securities arbitration is not without its disadvantages.  Because arbitration is less expensive and disputes are resolved quickly, defendants are less likely to settle.  Another disadvantage is that while arbitrators are expected to be guided by the law, unlike the judiciary, they are not bound by existing precedent.  As a result, there is some degree of uncertainty and a potential for inconsistent results.  Lastly,  there is a perception of bias because securities arbitrations are sponsored by the industry. 

Information on securities arbitration law and procedure is abundant.   The websites of the NASD and the NYSE contain a wealth of information for both the practitioner and the investor.  Additionally, a number of books on the subject are available.  First among them is Securities Arbitration Procedure Manual by David E. Robbins, published by LEXIS Publishing.  This book, now in its fifth edition, is considered indispensable by most practitioners.  Likewise, an excellent book written for investors is Does Your Broker Owe You Money? by Daniel R. Solin.                                     

Federal Securities Law

The primary federal securities laws are the Securities Act of 1933 and the Securities Exchange Act of 1934.  The 1933 Act requires that all securities sold within the U.S. be registered and contains provisions prohibiting fraudulent and deceptive practices in connection with their sale.  The 1934 Act established the Securities and Exchange Commission (SEC) and charged it with the enforcement of the federal securities laws and delegated to it the power to make rules pursuant to those laws.  Additionally, the 1934 Act expanded the fraudulent and deceptive practices prohibited by the 1933 Act. 

While both Acts contain antifraud provisions, the classic securities fraud claim is based on section 10(b) of the 1934 Act and SEC Rule 10b-5 enacted pursuant to that section.  Interestingly, neither section 10(b) nor Rule 10b-5 provides a private cause of action.  However, the courts have uniformly implied one. See e.g. Ernst & Ernst v. Hochfelder, 425 U.S. 185, 196 (1976) (“the existence of a private cause of action for violations of the statute and the Rule is now well established.”).

To prevail on a claim brought pursuant to this implied cause of action, one must show 1) a misstatement, omission, or other fraudulent act; 2) the fact misstated or omitted was material; 3) it was made in connection with the purchase or sale of a security; 4) with scienter (intent to deceive, manipulate, or defraud); 5) justifiable reliance on the part of the plaintiff; and 6) damages proximately caused by the act.  Norman S. Poser, Broker-Dealer Law & Regulation §3.01(D) (2d ed. 2001.).

Notably, some courts have held that “recklessness” is sufficient to meet the scienter requirement. Gochnauer v. A.G. Edwards & Sons, Inc., 810 F.2d 1042, 1047 (11^th Cir. 1987). The statute of limitations for actions brought under section 10(b) and Rule 10b-5 is 1 year after discovery of the act or omission giving rise to the claim, but no later than three years after the act. Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson, 501 U.S. 350, 364 (1991).  A noteworthy drawback to 10(b) and 10b-5 claims is the unavailability of punitive damages. Carras v. Burns, 516 F.2d 251, 259 (4^th Cir. 1975).

South Carolina Securities Laws

South Carolina has its own securities laws codified in Title 35.  Among other things, the state securities laws provide a private cause of action in section 35-1-1490.  Subsection 1 provides a private remedy for violation of the state registration requirements and subsection 2 contains the antifraud provisions.  Subsection 2 provides a buyer a cause of action when:

Any person who offers or sells a security by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they are made, not misleading, the buyer not knowing of the untruth or omission, and who does not sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of the untruth or omission.

Section 35-1-1490 also lists the damages available to the buyer.  In addition to losses sustained by the buyer, damages include costs and reasonable attorney’s fees.  If the buyer has not sold the security, this statute entitles him to recover the consideration paid for the security plus interest at six percent per year less any income received from the security.  Section 35-1-1530 allows investors three years from the sale of the securities at issue in which to bring a claim.

While the language is similar to section 10(b) and Rule 10b-5, the state law carries a longer statute of limitations, does not require proof of reliance, and  would likely be found not to require scienter. See e.g. Gochnauer, 810 F.2d at 1046 (scienter not required under Florida’s similar statute.).  Another benefit of the state law is the availability of attorney’s fees, costs, and, in some cases, recovery of the purchase price of the security plus interest.  Moreover, punitive damages are not prohibited under state securities laws as they are under the federal laws.

Common Law Causes of Action

In addition to federal and state statutes, the common law provides investors with remedies for brokerage firm misconduct.  Theories commonly employed are: breach of contract, negligence, common law fraud, and breach of fiduciary duty.  Breach of fiduciary duty is probably the most important common law remedy available to investors.

In South Carolina, a fiduciary relationship exists “when one imposes a special confidence in another, so that the latter, in equity and good conscience, is bound to act in good faith and with due regard to the interests of the one imposing the confidence.” Island Car Wash, Inc. v. Norris, 358 S.E.2d 150, 152  (Ct. App. 1987).  “The law is clear that a broker owes a fiduciary duty of due care and loyalty to a securities investor.” Gochnauer, 810 F.2d at 1049.  The nature and extent of the broker’s fiduciary duties depends upon the type of account the investor has.

In Leib v. Merrill Lynch, Pierce, Fenner & Smith, 461 F. Supp. 951 (E.D. Mich. 1978), the district court describes three types of brokerage accounts and sets forth the duties owed to an investor for each.  A brokerage account may be discretionary, nondiscretionary, or hybrid account.  A discretionary account is one in which the broker has authority to conduct trades without prior approval of the customer.  A nondiscretionary account requires the customer’s approval before trades may be made.  A hybrid account is “one in which the broker has usurped actual control over a technically nondiscretionary account.”  Id. at 954. 

In a discretionary account the broker “becomes a fiduciary of his customer in a broad sense.”  Id. at 953. As such, the broker’s duties are: 1) to  manage the account in a manner directly comporting with the needs and objectives of the customer; 2) to keep informed of the changes in the market and react to those that may affect his customer’s interests; 3) keep the customer informed as to each transaction; and 4) explain the impact and risks of the course of dealing in which the broker is engaged.  Id.

On the other hand, in a nondiscretionary account, “all duties to the customer cease when the transaction is closed.”  Id. at 952.  In this type of account, the broker’s duties are: 1) to recommend a stock only after becoming informed as to its nature, price, and financial prognosis; 2) to carry out the customer’s requests promptly; 3) to inform the customer of the risk involved in purchasing or selling a security; 4) to refrain from self-dealing or refusing to disclose any personal interest the broker may have in a recommended security; 5) to not misrepresent any fact material to the transaction; and 6) to transact business only after receiving prior authorization from the customer.  Importantly, here the broker does not have “a continuing duty to keep abreast of financial information which may affect his customer’s portfolio or to inform his customer of developments which could influence his investments.”  Id. at 953.

A hybrid account is a creation of the courts.  A hybrid account may be found if the facts and circumstances indicate that the broker has actual control over a nondiscretionary account.  In such cases, the broker’s influence and control transforms the nature of the account from nondiscretionary to discretionary.  Accordingly, “the broker owes his customer the same fiduciary duties as he would have had the account been discretionary” from the beginning.  Id. at 954.

Broker control is likely to be found in cases where the customer’s age, education, and  investment experience are such that he relied on his broker for advice and routinely followed it. Id. at 954-55; Hatrock v. Edward D. Jones & Co., 750 F.2d 767, 775 (9^th Cir. 1984); Carras v. Burns, 516 F.2d 251, 258-59 (4^th Cir. 1975).   Control is also likely to be found in cases where the broker is socially or personally involved with the customer.  Leib, 461 F.Supp. at 954. Further, if the broker engaged in unauthorized trading, itself actionable, a court will likely find the broker usurped control of the nondiscretionary account.  Id.; Davis v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 906 F.2d 1206, 1217 (8^th Cir. 1990).  However, a customer who frequently initiated contact with the broker to discuss the account and purchases made will more likely be found to have retained control. Leib, 461 F.Supp. at 954-55.

While extended discussion is beyond the scope of this article, it must be mentioned that an arbitration award against a broker individually is an undesirable result.  Thus, it is important that liability for the broker’s misconduct attach to the brokerage house.  This can be accomplished under several theories.  The most familiar are the principles of agency law and respondeat superior.  Johns Hopkins Univ. v. Hutton, 422 F.2d 1124, 1130 (4^th Cir. 1970); Marbury Mgmt. v. Kohn, 629 F.2d 705, 714-15 (2^nd Cir. 1980).  Other theories include controlling person liability under the federal securities laws, aiding and abettor liability, and joint and several liability under section 35-1-1500 of the South Carolina securities laws.  Of course, each theory has different elements that must be considered in determining which is applicable in light of the facts of each case.

Churning

Churning is perhaps the most overt form of broker misconduct.  Churning is simply excessive trading in an account carried out for the purpose of generating commissions. To establish churning, a plaintiff must demonstrate that: 1) the trading was excessive in light of his investment objectives; 2) the broker exercised control over the account; and 3) the broker acted with intent to defraud or with willful and reckless disregard for the interests of his customer.  Hatrock, 750 F.2d at 775. For a particularly egregious example of churning, see Rizek v. SEC, 215 F.3d 157 (1^st Cir. 2000).

Excessive trading can be shown by several different means. The most apparent is by demonstrating in-and-out trading.  In-and-out trading is a pattern of selling all or part of a portfolio with immediate reinvestment of the proceeds in other securities, only to repeat the pattern a short time later. Marilyn Blumberg Cane & Patricia A. Shub, Securities Arbitration: Law and Procedure 144 (1991).  In-and-out trading gives rise to an inference of churning. Id.   Another commonly used method is the turnover ratio.  This ratio is a calculation of the total cost of purchases divided by the average equity in the account. The higher the number, the greater the likelihood of a finding of excessive trading.   Another useful tool for determining excessive trading is the commission-equity ratio.  This ratio calculates the rate of return an investor’s account would have to realize just to break even with transaction costs.  Id.  Again, the higher the commission-equity ratio, the more likely a finding of excessive trading.

Control is a frequently litigated issue in securities cases.  The first point of inquiry is into the account designation: discretionary or nondiscretionary.  As discussed above, control is clear in the case of a discretionary account.  However, in the case of the nondiscretionary account, control may be established based on the factors courts have used to find the existence of a hybrid account.  The typical claim is that the account holder is an unsophisticated investor. Generally, this is an investor whose age, education, and/or limited investment experience causes them to rely on their broker for advice and routinely follow it.

Once the first two elements of a churning claim are established, the third element generally falls into place. A broker who engages in excessive trading in an account under his control clearly does so with intent or with reckless disregard for the interests of his customer.  The very nature of the conduct tends to satisfy the third element and as such this element is rarely litigated.           

Churning is actionable under the federal securities laws.   “Churning is a species of fraud prohibited by Section 10(b) and 10(b)-5.” Davis, 906 F.2d at 1218-9. In addition, “the investor will, in most or perhaps all cases, be entitled to hold the broker liable under a pendant state claim for breach of fiduciary duty.” Miley v. Oppenheimer & Co., Inc., 637 F.2d 318, 324 (5^th Cir. 1981).  Churning is also  actionable as common law fraud.

There are two potential measures of damages in a churning case. The first is the amount of excess commissions paid to the broker.  Second is the portfolio’s decline in value due to the excessive trading.  Id. at 326 (the investor “may lose the benefits that a well managed portfolio in long term holdings might have brought him.”) In Miley, the Fifth Circuit suggests that it may be appropriate in some cases for such losses to be calculated by reference to the performance of the Dow Jones or another market index to measure how the account would have performed absent the misconduct. See also Hatrock, 750 F.2d at 774.  However, it is not necessary to a finding of churning that the account lost money.  In fact, that an account has made money is neither a bar nor a defense to a churning claim. See Davis, 906 F.2d at 1218 (Churning not excused by the fact that the account made a profit).

The Suitability Doctrine

A less overt, but more common, source of investor disputes involves unsuitable recommendations.  The suitability doctrine requires that a broker who makes recommendations to an investor recommend only those investments that he reasonably believes are suitable for that particular investor.  Investments can be unsuitabile as to all investors or unsuitable as to a particular investor. 

Suitability is determined primarily by an investor’s age, education, investment sophistication, risk tolerance, and financial goals.  These are matters that should be discussed at the initial meeting with the broker.  The account opening forms require the investor to select his or her risk tolerance and investment objectives.  Recommendations by the broker must correspond with the stated objectives and risk tolerance.

A suitability claim may arise in relation to a single investment or as to an entire course of investing.  An example of the latter is over-concentration.  Over-concentration occurs when a portfolio is disproportionately weighted in one asset class, such as equities, or when holdings in an asset class are concentrated in a particular sector.  A timely example of the latter is an account with all or nearly all of its holdings in stocks and with those holdings dominated by internet and technology stocks.  Before the 2002 decline it was not uncommon to see a portfolio with excessive concentration in this area.  These portfolios were subjected to great risks, risks that could have been offset through diversification.

The Securities Industry Association (SIA) website details several model portfolio allocations.  According to the SIA, the classic portfolio consists of 60% stocks, 30% bonds, and 10% cash or cash equivalents.  Of course, an investor’s allocation is dependant upon his stage in life and risk tolerance. Their website suggests that a young person just starting out may have as much as 90% of their portfolio in stocks, while someone nearing retirement would want to reduce their stocks holding to 40%, while increasing their bond holdings to reduce volatility.  Many would suggest that 40% is still too high for someone approaching retirement. 

Most of the major brokerage houses publish their own model portfolio allocations.  One would be well served to compare their own or a potential client’s holdings to the brokerage house’s model portfolio or to that of the SIA.  If there is a substantial deviation, the reason for that deviation needs to be explored.  The question of whether the deviation was the result of independent choices of the investor or recommendations of the broker needs to be answered.

It is surprising how many portfolios apparently cast aside asset allocation and diversification principles during the recent bull market.  Many investors whose stage in life would call for low risk investments found themselves over-concentrated in stocks, often in the most speculative sectors of the economy.  For these investors, the true picture of their risk exposure became clear only through catastrophic loss of principle.  In some cases, these investments were the result of unsuitable recommendations by a  broker.

The suitability doctrine derives from the rules of the National Association of Securities Dealers (NASD) and the New York Stock Exchange (NYSE).   NASD rule 2310(a) provides as follows:

In recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.

Rule 2310(b) further requires that prior to executing a recommended trade, a broker shall make reasonable efforts to obtain information concerning 1) the customer's financial status; 2) the customer’s tax status; 3) the customer’s investment objectives; and 4) any other information used or considered to be reasonable in making recommendations to the customer.          

Similarly, NYSE rule 405, often called the “know your customer rule,” requires members to “use due diligence to learn the essential facts relative to every customer, every order...”  Although these two rules impose specific standards of conduct, neither provides for a private cause of action.  Kaufman v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 464 F.Supp. 528, 539 (D. Md. 1978).  Instead, the SRO rules are viewed as standards to be applied in determining suitability claims brought under existing causes of action.

Suitability claims may be brought under section 10(b) and Rule 10b-5, state securities laws, or as common law breach of fiduciary duty.  Perhaps, the preferred theory of liability will be for breach of fiduciary duty.  A broker’s fiduciary duties are clearly set forth in the case law.  Further, breach of fiduciary duty is easier to establish than violation of Rule 10b-5.   

A typical defense is  that the customer was a  “sophisticated investor,” and, as such, the broker was not a fiduciary but instead merely an order taker.  Other typical defenses are that  even if the recommendations were unsuitable, the customer ratified them by failing to object, or that the customer should be barred from asserting a claim by estoppel or laches.  The success of these defenses depends largely on the knowledge and experience of the investor.  Id. at 534-35.

A successful claimant can recover commissions paid to the broker for the unsuitable investments, losses associated with the investment, and under Miley, a measure of damages representing what a “well managed account” could have earned during that time.  Depending on the theory of recovery, costs and attorney’s fees may be available.  While punitive damages may be possible under state law in suitability cases, arbitration awards of punitive damages are extremely rare; some states even prohibit arbitrators from awarding them.

Of course, not every investment loss is the result of broker misconduct.  Some losses are the result of decisions made by the investor, others result from unforeseeable events outside the control of either the broker or investor.   However, inevitably, there will be those whose losses are attributable to unsuitable recommendations, churning, or other misconduct.  For those investors who truly have been wronged, the law provides remedies and the possibility of recovering their losses. Unfortunately, few investors are aware of their broker’s legal obligations, the inherent conflicts of interests in the broker-customer relationship, and the protections afforded to them by state and federal law. 

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