The Investor's Lawyer - by Georgia Securities Lawyer Joel Beck

Don't Get Caught in the Selling Away Trap

As markets decline, alternative investments pop up, and many brokers sell these alternative investments (promissory notes, chattel mortgages, membership interests in LLCs or LLPs, and private stock offerings, to name a few) to their clients with the goal of outperforming the down market and growing their clients' assets.  Many times, these brokers sell investments that just don't work or are even fraudulent.  Why are these sells made?  From my experience as a securities regulator, I'd say that its twofold:  1) because the broker believes that the product will make money for the client and 2) because the product pays an above average commission or finder's fee to the broker for making the sale.  If the product is sold away from the firm, without their knowledge and consent, when it goes bust the firm will deny any responsibility for the fraudulent investment you purchased.  While there may be legal remedies available to you, and you may ultimately be able to recover some or all of your investment from the firm, it will be a time-consuming and costly process.  Why not avoid the problem to begin with?

Whenever a broker approaches you with an investment opportunity that requires writing a check to a company other than the brokerage firm that holds your account, check it out before you invest.  Find out why you would need to do so.  Is the product sold through the brokerage firm, or is this a product that they do not recommend and do not sell, but that the broker has independently found for you?   But don't just check with the broker, consider checking with someone at the firm, such as a branch manager or compliance officer. 

If you believe that you have been a victim of "selling away," contact a competent securities arbitration attorney today.

FINRA Affirms Bar of Broker for Unsuitable Mutual Fund Switching

Last month FINRA's National Adjudicatory Council (NAC), which is essentially the organization's appellate body for disciplinary proceedings, affirmed a hearing panel decision finding that Scott Esptein, a former Merrill Lynch employee of Marlboro, New Jersey, made unsuitable mutual fund switch recommendations to about 12 clients.  Many of these clients were elderly and/or unsophisticated, according to the NAC.

It appears that Epstein recommended that these customers sell their mutual fund position and purchase another mutual fund in a different fund family.  The replacement funds were very similar to the fund originally held by the clients, so there was no real benefit to the client by effecting the transactions, however, Epstein and the firm received a commission.  What's worse is that the customers were harmed by incurring longer periods for contingent deferred sales commissions and higher fees in several cases.  As a result of this misconduct, FINRA barred Epstein from working for any broker-dealer.  You can read FINRA's decision here).

As an investor, you need to understand what products a broker is recommending you purchase before you go along with it.  Be sure to ask questions and find out the pros and cons of the proposed transaction, including what's in it for you - and what's in it for the broker.

Churning: A Primer

Investors are oftentimes curious about what "churning" is and how it relates to a brokerage account.  Churning is a form of unsuitable recommendations and trading activity, and is also called excessive trading.    Churning occurs when a securities broker engages in securities transactions and manages a customer's account for the purpose of generating commissions, at the expense of (instead of the benefit for) the client.

Churning typically has three elements:
1.  Control.  For churning cases, the broker must control the account.  Control can be through explicit control such as a written discretionary agreement, or it can be de facto control, where the broker assumes control of the account through the client's acquiescence, trust, or reliance.  For example, if a client always follows a broker's advice, the broker may be found to have de facto control over the account.
2.  Excessive trading.  The trading in the account must be considered excessive in view of the customer's investment objectives and other suitability information.
3.  Scienter or Intent.  There typically must be some type of required mental state of the broker (an intent element) to prove churning.

How is it determined that the trading in an account is excessive?  A primary test for excessive trading is the relationship between the net amount of money invested and the transaction costs (commissions, margin interest, etc.) that are incurred.  To that end, when evaluating whether an account was churned, an expert typically reviews the account activity and determines the cost to equity maintenance factor (or break-even factor).  This demonstrates that percentage of return on the customer's average net equity needed to pay the commissions and other expenses, such as margin interest, associated with the trades. In many instances, a break-even rate of 8% may be presumed to be excessive trading, while a 12% rate is generally conclusive.  But, this factor cannot be used alone, but must be considered along with the nature of the accounts, the stated investment objectives, the control exercised by the broker over the account, and that character of the trading.  Another method used in analyzing excessive trading is the average annualized turnover rate, which measures the number of times an account turns over in a given year. 

If you think your account may have been churned, contact a competent securities attorney for an evaluation. 

Be Aware of the Switch

In "switching" cases, a broker recommends that a client sell his or her mutual fund or variable annuity and invest in a similar product.  Oftentimes, this is done solely to benefit the broker,by generating a new commission or a sales credit (commissions on variable annuities can be very high compared to other products).  The switch may be detrimental to the client because of the imposition of additional surrender penalties and sales charges.  Investors should be particularly aware of the possibility of a "switch" when a broker moves from one firm to another. 

In an enforcement case related to switching, earlier this week the SEC filed charges against a San Francisco area stockbroker for selling names and contact information of his clients to insurance agents as sales leads.  According to the SEC release , the broker sold confidential customer information to the insurance agents, to enable the agents to solicit the customers to purchase additional annuity products.   Remember, do your homework before you invest.  Determine the pros and the cons of making a move, and invest smartly. 

Investors Should Use Caution When Purchasing Promissory Notes

Investors would be wise to use caution when considering purchasing a promissory note being sold by a broker or an investment adviser.  Some brokers seek to sell these notes, which are essentially I.O.U.'s, that are usually issued by development-stage companies previously unknown to the client.  These notes may promise to pay the investor an above-market rate of return for 9-months or a year, or longer.  In many instances, these notes are not products of the broker's firm, and are sold without the knowledge of the firm.  On occasion, the issuing company turns out to be conducting a fraudulent scam (of which the broker is unaware) and investors lose all or most of their investment. 

If you consider purchasing a product like this, understand the risks.  Find out if the product is being offered by the brokerage firm or if the broker is selling these without his or her firm's permission.  Ask how much commission the broker gets for making the sale, and do your own homework on the company issuing the note.  Remember, if it sounds too good to be true, it likely is.

If you've bought a promissory note through a broker and the issuer has stopped making payments, or advised you it is going to default, you may have the ability to pursue a claim against the broker and brokerage firm involved.  There may also be other grounds for your claims in an effort to recover losses.  Because of time limitations that may be involved in situations like these, you should consult a competent securities arbitration attorney without delay. 

Common Broker Misconduct - Part 3 - Fraud (Misrepresentations and Omissions)

The third common broker misconduct area is what we call fraud, or making material misrepresentations or omissions of material fact in connection with the purchase or sale of a security. When a broker recommends an investment, he or she is obligated to disclose all material, or important, information about that investment to the client - both the good information and the bad.  Making false and misleading statements, or failing to disclose material information is considered fraud, and is prohibited by the federal securities laws, as well as other industry rules and regulations (including FINRA Rule 2110).

Examples of fraudulent statements and omissions by brokers include failing to disclose the financial condition of a company when recommending its stock.  I remember a disciplinary case I litigated against a broker when I worked for NASD.  In that case, the broker had been recommending that his clients purchase the stock of a little known, financially weak company.  The stock was a penny stock, was very thinly traded, and had no real good prospects at the time.  Nevertheless, because the firm was apparently pushing the stock, the broker "sold" it to his clients, and never bothered to tell them that the company had never made a profit in its existence, and had not real expectations of making a profit in the near future, and never told the customers that the company's largest asset was its "goodwill."   These misstatements and omissions were fraudulent conduct by the broker. 

How do investors guard against being defrauded.  First, investigate and understand the product that is being sold.  Ask the broker specific questions, and do your homework.  Many investors fail to take time to consider the recommendations made to them, and some brokers falsely encourage clients to "act now," claiming that there is no time to wait, and that this opportunity will be lost if the investor doesn't immediately purchase the stock.  Don't fall for that.  Take your time, don't act hastily, and do your homework.

If you think you've been the victim of broker fraud, contact a competent attorney who works in the area of securities arbitration. 

Common Broker Misconduct - Part 2 - Unsuitable Recommendations

A broker has an obligation to recommend that his or her client invest in only appropriate, or suitable, investments, given the client's financial condition and the objectives for the account.  In making a recommendation to a client, a broker should usually consider the client's age, net worth, investment objective, risk tolerance, and other holdings. 

An example:  A broker makes an unsuitable recommendation when he advises an unsophisticated, elderly client of limited means who wants to preserve his or her assets, to invest in a speculative investment.

So what do you do as an investor to guard against unsuitable recommendations?  First, understand the product that your broker is recommending, and investigate it yourself.  Ask your broker why the product is appropriate for you, and ask specific questions about the product.  Find out what the risks are, what the fees and charges are, how long your money may be subject to withdrawal penalties and what those penalties are.

What do you do if you think you've been placed in unsuitable investments?  Act quickly, and contact a competent lawyer that practices in the securities arbitration area to find out more.

Common Broker Misconduct - Part 1 - Unauthorized Trading

First, let me put this in some perspective:  Most brokers and investment advisers out there today work hard to provide value to their clients, and put their client's interests above their own.  But as in any profession, there are some bad apples.  So, as we explore that common areas of broker misconduct, recognize that we're talking about the bad ones, and not painting the entire industry with the same brush.  Now, onto the point.

Unauthorized trading occurs when a broker places a trade in a client's account without that client's prior authorization, unless the client has previously given the broker discretionary authority over the account, in writing.  A broker violates industry rules (FINRA Rule 2110) when he or she makes an unauthorized trades.  Securities industry regulators oftentimes sanction brokers for effecting unauthorized trades.

How do you prevent unauthorized trading?  You really can't, because its the broker who commits the act.  But, you can identify these trades by reviewing your trade confirmations and monthly account statements and ensuring that you authorized all trading activity.  If  you identify a trade that you don't recognize, talk to your broker and his or her manager.  And if that fails, talk to the firm'c Compliance Department and seek assistance.  Typically, you'd expect the trade to be canceled from your account, resulting in n profit or loss in your account as a result of the unauthorized trading activity. 

Stay tuned as The Investor's Lawyer blog will address other common broker misconduct.