Financial abuse of the elderly is reaching epidemic rates as stockbrokers and financial advisors take advantage of the complicated financial landscape to convince older persons to take on risky, high-commission investments and investment strategies.
This article does not discuss pyramid schemes or scams that amount to outright fraud or theft. Rather, it explains rights and remedies for investors who believe they have been harmed by engaging in securities transactions with registered and licensed stockbrokers. Retirees and the elderly have, generally, a much more conservative risk tolerance, which means the scope of investments that are appropriate for them is much narrower than for other investors.
How Financial Abuse Occurs
The following example is fictional but realistic. For the Smiths, the rewards of 30 years of hard work vanished in a matter of months. Mr. Smith worked on a farm, and Mrs. Smith was a local elementary-school teacher. They trusted their stockbroker would keep their retirement money safe by directing them to conservative investments with modest returns designed to keep up with inflation. Instead, the Smiths’ broker – also a family friend and fellow parishioner – lured the Smiths into risky investments, the primary benefit of which was handsome commissions for the financial advisor.
There are several techniques the broker could have used to persuade Mr. and Mrs. Smith: 1) paying for a steak dinner held at a local venue; 2) exerting pressure in face-to-face meetings; 3) promising good returns with a guarantee that Mr. and Mrs. Smith’s money would be waiting for them at the end; and 4) promising that Mr. and Mrs. Smith could get out of the investments at any time.
The broker’s assurances were completely false. It turns out the Smiths invested in some of the riskiest investments available and their investments predictably collapsed. Most of their retirement money is now gone.
This hypothetical is not an exaggeration. These details are grim reality for hundreds of thousands of American investors. Most investors, knowing little about investing, listen to their brokers and do not realize, until their investment is worthless, that they have been taken.
Jeffrey M. Salas, DePaul 2006, is a founding partner of Salas Wang LLC, headquartered in Chicago. He concentrates his practice in securities arbitration and litigation and has represented clients in a variety of securities, financial fraud, corporate governance, breach of fiduciary duty, and breach of contract actions in state and federal courts around the country.
There are remedies for individuals who, like the Smiths, are harmed by making legal, but risky, investments. In the author’s estimation, however, approximately 90 percent of meritorious cases are not brought because 1) they are not recognized as such, or 2) investors decide to ignore possible claims.
Often, investors are embarrassed that they lost money, and blaming the market is an easy way for them to justify the losses. Also, they might believe that their brokers are “nice guys” who were trying their best. Both of these comforting explanations are usually false.
Neither embarrassment nor politeness should discourage individuals from seeking relief if they believe they have been steered to inappropriate investments. This article describes some remedies, available under Wisconsin law and the Financial Institution Regulatory Authority, for investors who have lost money as a result of broker misconduct.
What Investors Can Do
Brokers and broker-dealers are regulated by the Financial Industry Regulatory Authority (FINRA), which, according to its website, “is the largest independent regulator for all securities firms doing business in the United States. FINRA’s mission is to protect America’s investors by making sure the securities industry operates fairly and honestly. All told, FINRA oversees nearly 4,460 brokerage firms, about 160,485 branch offices and approximately 629,520 registered securities representatives.”1
FINRA has a dispute-resolution division, where most customer claims are brought via arbitration. (In the vast majority of situations, the forms used to open accounts indicate that signing of the form constitutes agreement to submit disputes to arbitration.) Usually, claims are brought for violations of FINRA’s customer-friendly rules. But, investors can also bring state common-law claims in FINRA for breach of fiduciary duty, negligence, and so on.
Claims an Investor Can Assert
The most common type of misconduct is when brokers recommend unsuitable investments. This deals with the risk related to a particular investment or investment strategy. As a corollary, unsuitability can be shown by excessive trading, also known as “churning.” Both are discussed below.
Claims for Unsuitability. When unsophisticated investors – especially elderly persons – are considering investing money, they need professional advice to adequately achieve their goals. This is common sense. In turn, “[a] stockbroker’s recommendations must be suitable for the client in light of the client’s investment objectives, as determined by the client’s financial situation and needs.”2 Brokers must “tailor [their] recommendations to the customer’s financial profile and investment objectives.”3 A broker’s recommendations are actionable when they conflict with the customer’s interests.4 Indeed, even in situations in which investments are arguably in line with investment goals, if there is a better, readily apparent strategy, a broker must disclose existence of the better strategy.5
“The single historical constant in suitability evaluations is the assessment of risk.”6 This forms the entire basis for regulation because “‘[u]nsuitable’ recommendations are, at the baseline, those that are deemed excessively risky.”7
Indeed, the most prevalent claim is for violation of FINRA’s “suitability rule,” meaning that investments were too risky (or in some circumstances, too conservative) for the investor. Under FINRA rules, “The suitability rule is fundamental to fair dealing and is intended to promote ethical sales practices and high standards of professional conduct.”8 Specifically, FINRA rule 2111 requires brokers to ensure that a recommended investment must, at least, satisfy three types of suitability “obligations.”
First, it must satisfy “reasonable basis suitability,” which means that the broker must – based on reasonable diligence – have a reasonable basis to think the recommendation is suitable for some investors.
Identifying a Possible Case
The number of possible investments on the market is overwhelming. Lawyers who have no financial training can easily overlook claims, but certain activities and investments are red flags:
- Stockbroker “seminars” or “luncheons”
- Increasing trade confirmations
- Private placements (investments that are not publicly traded)
- Real estate investment trusts
- “High-yield” funds
- Foreign, developing, or emerging markets funds
- “Short” funds (funds that bet against the stock market or a particular index)
- Trading “on margin” (meaning that the trades are made with borrowed money)
- Trading in stock options or other derivatives
- Multiple variable annuities
Every investor who has lost money should have a portfolio review to determine if there are claims, simply because stockbroker misconduct is so widespread.
Accordingly, the broker must first evaluate the overall quality of a particular investment. Indeed, “[a] broker-dealer must have an ‘adequate and reasonable basis’ for any recommendation that he [or she] makes.”9 The reasonable-basis concept concerns whether the recommendation for the investment itself is suitable for anyone; it is not customer specific.10 So, the broker must first determine if the investment is suitable for anyone.11 This reasonable basis standard requires brokers and broker-dealers to vet potential investments.12 Failure to satisfy any of these requirements is sufficient to violate FINRA’s suitability rule.13
For instance, in In re Securities America,14 the broker-dealer was sanctioned for, among other things, violating FINRA/National Association of Securities Dealers (NASD)15 suitability rules for selling private placements, an inherently risky investment product. Specifically, the state of New Hampshire found that “[Securities America] ignored certain red flags in the offering that were not fully investigated and resolved.”16 Basically, because Securities America ignored that the investment lacked audited financial statements, accurate valuation of accounts receivable, and independent directors and had “the ability to invest proceeds in equity securities of all types of businesses and make risky mortgage loans to receivable sellers or other parties in the health care industry,” it was unsuitable for investors.
Second, the broker must satisfy “customer specific suitability,” meaning the broker must have a reasonable basis to believe that his or her particular client could prudently invest in the particular investment.17
This is an inquiry into a particular customer’s situation, considering details such as whether the customer is retired, elderly, a sophisticated investor, or saving for college. Very few investors have sufficient resources to gamble with their retirement fund, so risky products (although they have high commissions for brokers) should really be used only for a small percentage of investors.
Thus, a broker must assess an investment’s risk in the context of the specific investor, because “when a relatively unsophisticated buyer seeks investment recommendations from a stock broker and subsequently relies on those recommendations ... the broker knowing of this reliance owes a duty to disclose the financial implications of the particular ... transaction to the buyer.”18 Cases show that “the suitability rule will be violated by a recommendation that might be suitable for some investors but is unsuitable for a specific investor to whom the recommendation is directed.”19 Indeed, “a broker may violate the suitability rule if he [or she] fails so fundamentally to comprehend the consequences of his [or her] own recommendation that such recommendation is unsuitable for any investor, regardless of the investor’s wealth, willingness to bear risk, age, or other individual characteristics.”20
The third suitability obligation is “quantitative suitability,” which refers to the suitability of the entire portfolio and its trading frequency and strategy, without regard to a particular investment’s stand-alone suitability.21
Excessive Trading. Another common claim is for excessive trading, also known as churning. Churning “occurs when a securities broker buys and sells securities for a customer’s account, without regard to the customer’s investment interests, for the purpose of generating commissions.”22 To show churning, a claimant must show that 1) the broker controlled the account; 2) the trading was excessive in terms of the investor’s trading objectives; and 3) the broker acted with scienter (intent).23
Spotting a potential churning case is simple. Look for lots of trades. An account statement that is very thick relative to the account’s value might be a sign that churning may be occurring. Often, daily trades are taking place without the customer’s knowledge. An increase in the number of trade-confirmation receipts that a customer receives may be evidence of churning.
The crux of a churning claim is that the account is being managed to generate or maximize commissions. Indeed, “[t]he existence of churning does not turn on whether the customer lost money.”24 Most times, churning decreases “the customer’s return on her investment by increasing the commissions generated by the account.”25 But, “an account may [have been] churned even if the customer shows a profit on the excessive trading.”26 Courts have allowed recovery to investors in cases in which customers have made money on the account because damages “will have the salutory deterrent effect of inform[ing] the brokerage community that churning is a fraud that will violate the securities laws, regardless of the ultimate condition of the client’s portfolio.”27
Proof of churning is specific to the case’s facts and depends on the number of trades, the value of the account, and other factors. In general, though, daily trading, in-and-out trades, and increasing trade confirmations might signal churning.
Additional Claims Investors Can Assert
Suitability is the flagship argument that investors typically make to FINRA – that is, that their broker should never have recommended that they invest in that particular way. Any claim a person can bring in court can be brought under FINRA, so victims also have state law rights and remedies.
Wisconsin’s Uniform Securities Law. Wisconsin law recognizes a specific claim for bad investment advice that operates as a fraud, that is, “this investment is safe”:
“A person that receives directly or indirectly any consideration for providing investment advice to another person and that employs a device, scheme, or artifice to defraud the other person or engages in an act, practice, or course of business that operates or would operate as a fraud or deceit on the other person is liable to the other person.”28
Wisconsin law treats these violations seriously, providing for prevailing plaintiffs’ attorney fees and costs of bringing the action.
Breach of Fiduciary Duty or Negligence. Wisconsin common law also allows investors to recover for breaches of fiduciary duty in situations in which the investor places his or her trust and confidence in a stockbroker’s recommendations.29 When “[t]he plaintiff alleges that he [or she] sought out and obtained the defendant’s services and that as a result of the arrangement, advice was given and recommendations were made … [n]othing more is needed to establish that the defendant owed a duty to the plaintiff not to be negligent.”30 Other states have elaborated that “an inexperienced or naive customer is more likely to leave the control of an account in the broker’s hands.”31
Some courts have stated that principal/agent principles also apply in the investor/broker relationship.32 In fact, the U.S. District Court for the District of New Jersey has distinctly noted that “[a] broker/dealer owes a fiduciary duty to a retail customer.” The court explained that “the duties of a securities broker are, if anything, more stringent than those imposed by general agency law. All that is necessary [for a claim] is to hold [the] defendant to standards that would govern an agent for the sale of potatoes.”33
Depending on the case’s circumstances, lawyers should use their experience and creativity in developing a case that will best serve their client’s interests.
How the Process Works
The lion’s share of securities-arbitration claims are brought under the FINRA Code of Arbitration Procedure for Customer Disputes,34 which governs cases brought under FINRA and applies to FINRA registered brokers and broker-dealers. Investors might also be able to bring claims in state and federal courts or under the auspices of the National Futures Association, the American Arbitration Association, JAMS Arbitration, or the Commodity Futures Trading Commission’s Reparations Program.
Under FINRA rules, the investor is the claimant bringing the arbitration against the broker/broker-dealer respondent(s).35 Respondents must file an answer to the claim.36 They may file a motion to dismiss, although such motions are heavily disfavored.37 After the answer, the parties rank arbitrators.38 Once the arbitrators are empanelled, they conduct an initial prehearing conference with the parties and counsel to schedule discovery deadlines, prehearing exchange deadlines, and the final hearing.39 The rules limit discovery to document discovery.40 The final hearing on the merits is a trial, but as with all arbitration proceedings, relaxed rules of evidence apply, and can be fashioned as the arbitrators and parties agree.41
After the hearing, the arbitrators will issue a decision on the merits and award relief to the claimant, dismiss claims against the respondents, or both.
The Other Side of the Story
Stockbrokers (and the industry as a whole) sometimes argue that they cannot protect cavalier, return-hungry investors who are willing to take big gambles with their money. Although that might be a fair argument in theory, it is simply not applicable in the vast majority of cases. Industry representatives also may raise defenses based on a customer’s net worth, occupation, previous investing experience, and knowledge of the risks of the investment. There may be something to be said for this type of “buyer beware” argument; high-net-worth investors employing conservative investment strategies are often at a disadvantage in litigation because of their supposed “sophistication” (a characterization based mostly on the fact that they have accumulated wealth), regardless of the actual facts. Nonetheless, the contention that the customer “should have known” is an argument the industry often relies on.
Preventing Abuse of Customers
The FINRA website has numerous resources investors can use to locate, among other things, a broker’s history, investment scam alerts, and explanations regarding investment products. Unfortunately, many investors simply do not take the time to use these resources, and otherwise lack the sophistication to properly protect themselves from fraud and abuse. That is the heart of the dilemma, and far too often, a customer’s best bet is to bring an action in FINRA after the fact. Holding bad brokers accountable remains a strong deterrent and facilitates good regulation of the industry.
While those who would perpetrate financial fraud on elders can be cunning salesmen and women with substantial experience, there remain effective tools at the disposal of investors looking to hold advisors accountable.
2 In re Muth, File No. 3-11346, 2005 SEC LEXIS 2488, at 44.
3 In re Epstein, File No. 3-12933, 2009 SEC LEXIS 217, at 43.
4 In re Howard, File No. 3-10392, 2002 SEC LEXIS 1909, at 5-6 (“the speculative securities recommended by Howard were clearly at odds with those interests”).
5 In re Epstein, 2009 SEC LEXIS 217, at 13.
6 Rapp, Rethinking Risky Investments for That Little Old Lady: A Realistic Role for Modern Portfolio Theory In Assessing Suitability Obligations of Stockbrokers, 24 Ohio N. U. L. Rev. 189, 242 (1998).
8 Preliminary Statement as to Members’ Obligations, FINRA website, http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=3641&print=1 and Regulatory Notice 11-02.
9 In re Kaufman, 50 S.E.C. 164, 168.
12 In re Sec. Am., 2012 N.H. Sec. LEXIS 1, 11.
13 FINRA Manual, Rule 2111(a).
15 The National Association of Securities Dealers (NASD) watches over the Nasdaq to make sure the market operates correctly. In 2007, the NASD merged with the New York Stock Exchange’s regulation committee to form FINRA.
16 FINRA Manual, Rule 2111(a).
17 Id. Rule 2111(b).
18 Piper, Jaffray & Hopwood Inc. v. Ladin, 399 F. Supp. 292, 299 (S.D. Iowa 1975) (in the context of “margin” transactions).
19 In re Kaufman, 1989 SEC LEXIS 2376, at 11.
20 In re Siegel, 2008 SEC LEXIS 2459, at 28 (broker recommended that customers invest in a private company they had never heard of).
21 FINRA Manual, Rule 2111(c).
22 Olson v. E.F. Hutton & Co., 957 F.2d 622, 628 (8th Cir. 1992) (quoting Thompson v. Smith Barney, Harris Upham & Co., 709 F.2d 1413, 1416 (11th Cir. 1983)).
23 Hotmar v. Lowell H. Listrom & Co., 808 F.2d 1384, 1385 (10th Cir. 1987).
24 In re Struder, 3-11426, 2004 SEC LEXIS 2347, at 19.
27 Davis v. Merrill Lynch, Pierce, Fenner & Smith, 906 F.2d 1206, 1218 (8th Cir. S.D. 1990).
28 Wis. Stat. § 551.509(6).
29 Esser Distrib. Co. v. Steidl, 149 Wis. 2d 64, 71, 437 N.W.2d 884 (1989) (holding that common-law and statutory fraud causes of action can coexist).
30 Schweiger v. Loewi & Co., 65 Wis. 2d 56, 63, 221 N.W.2d 882 (1974); compare Merrill Lynch Pierce Fenner & Smith Inc. v. Boeck, 127 Wis. 2d 127, 377 N.W.2d 605 (1985).
31 Paine, Webber, Jackson & Curtis, Inc. v. Adams, 718 P.2d 508, 517 (Colo. 1986).
32 Fustok v. Conticommodity Servs. Inc., 618 F. Supp. 1082, 1085 (S.D.N.Y. 1985).
33 In re Merrill Lynch Secs. Litig., 911 F. Supp. 754, 768 (D.N.J. 1995), aff’d on this issue & rev’d on other grounds, 135 F.3d 266, 270 (3d Cir. 1998).
35 FINRA Rule 12302.
36 FINRA Rule 12303.
37 FINRA Rule 12504.
38 FINRA Rule 12400.
39 FINRA Rule 12500.
40 FINRA Rules 12506/12507.
41 FINRA Rule 12604.