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What Constitutes Investment Fraud

Legal grounds for investment fraud include unsuitability, violations of State Securities Acts, breach of fiduciary duty, negligence, and common law fraud.

If an investor is a victim of investment fraud, he/she may have a claim against his/her financial advisor, stock broker, and/or brokerage firm in arbitration or court under the following legal causes of action:

A. Securities Fraud and Unsuitable Recommendations.

Many state securities acts provide for recovery of damages, attorneys fees, and interest. The majority of state securities acts are based upon the Uniform Securities Act which holds a person civilly liable 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 the 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.

Federal securities fraud under Section 10(b) of the Securities Exchange Act of 1934 is defined as (1) material misstatements or omissions, (2) indicating an intent to deceive or defraud, (3) in connection with the purchase or sale of a security. Brown v. E.F. Hutton Group, Inc., 991 F.2d 1020 (2nd Cir. 1993). An unsuitability claim is a subset of 10(b) securities fraud with the following elements to be proved:

(1) that the securities purchased were unsuited to the buyer's needs; (2) that the defendant knew or reasonably believed the securities were unsuited to the buyer's needs; (3) that the defendant recommended or purchased the unsuitable securities for the buyer anyway; (4) that, with scienter, the defendant made material misrepresentations (or, owing a duty to the buyer, failed to disclose material information) relating to the suitability of the securities; and (5) that the buyer justifiably relied to its detriment on the defendant's fraudulent conduct. Banca Cremi, S.A. v. Alex. Brown & Sons, Inc.132 F.3d 1017, 1032 (4th Cir. 1997).

For Rule 10(b)(5) purposes, scienter includes recklessness. Breard v. Sachnoff & Weaver, Ltd., 941 F.2d 142, 144 (2nd Cir. 1991).

FINRA Conduct Rule 2111 was adopted in 2012 to update Suitability obligations, including specifically referring to investment strategies.  The Rule states:

“A member or an associated person must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer's investment profile. A customer's investment profile includes, but is not limited to, the customer's age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation.”

A recommendation has been further defined by the NASD (now FINRA) in NASD Notice to Members 96-60 as follows:

"a broad range of circumstances may cause a transaction to be considered recommended, and this determination does not depend on the classification of the transaction by a particular member as solicited or unsolicited. In particular a transaction will be considered to be recommended when the member or its associated person brings a specific security to the attention of the customer through any means, including, but not limited to, direct telephone communication, the delivery of promotional material through the mail, or the transmission of electronic messages."

B. Breach of Fiduciary Duty.

As set out by the 11th Circuit Court of Appeals: [t]he law is clear that a broker owes a fiduciary duty of care and loyalty to a securities investor. Gochnauer v. A.G. Edwards & Sons, Inc., 810 F.2d 1042, 1049 (11th Cir. 1987).

A stockbroker is an agent who owes his principal a duty to act only as authorized. Merrill Lynch v. Cheng, 901 F.2d 1124, 1128 (D.C. Cir. 1990). As an agent, he has a duty to deal in the principal's interest. Moreover, he has a duty to give his principal information which is relevant to affairs entrusted to him of which he has notice. Id. The fiduciary responsibilities of a broker to his customer are more specifically set out as follows:

(1) the duty to recommend a stock only after studying it sufficiently to become informed as to its nature, price, and financial prognosis; (2) the duty to carry out the customer's orders promptly in a manner best suited to serve the customer's interests; (3) the duty to inform the customer of the risks involved in purchasing or selling a particular security; (4) the duty to refrain from self-dealing or refusing to disclose any personal interest the broker may have in a particular recommended security; (5) the duty not to misrepresent any material fact to the transaction; and (6) the duty to transact business only after receiving prior authorization from the customer. Lieb v. Merrill Lynch, Pierce, Fenner and Smith,461 F.Supp. 951, 953 (E.D.Mich. 1978) (citations omitted).

The fiduciary duties of a broker who is utilizing discretionary authority over a client's account are broader:

Unlike the broker who handles a non-discretionary account, the broker handling a discretionary account becomes the fiduciary of his customer in a broad sense. Such a broker, while not needing prior authorization for each transaction, must (1) manage the account in a manner directly comporting with the needs and objectives of the customer as stated in the authorization papers or as apparent from the customer's investment and trading history; [citation omitted] (2) keep informed regarding the changes in the market which affect his customer's interest and act responsively to protect those interests; [citation omitted] (3) keep his customer informed as to each completed transaction; and (4) explain forthrightly the practical impact and potential risks of the course of dealing in which the broker is engaged. Leib v. Merrill Lynch, Pierce, Fenner & Smith,461 F.Supp. 951, 953 (E.D.Mich. 1978), affirmed, 647 F.2d 165 (6th Cir. 1981).

C. Negligence.

As set out in Merrill Lynch, Pierce, Fenner & Smith v. Cheng, 697 F.Supp. 1224, 1227 (D.D.C. 1988): It is clear from the case law that a stockbroker can be held liable to his client for negligence. The Cheng court went on to state that although it did not find a private right of action based upon NASD rules, a violation of the NASD rules would be a factor for consideration by the jury as to whether [the broker] acted as a reasonable person in his conduct... Id.

D. Churning.

Churning is a subset of federal securities fraud and is defined as follows by the U.S. Court of Appeals for the Fourth Circuit:

Churning occurs when a broker exercising control over the volume and frequency of trading, abuses his customer's confidence for personal gain by initiating transactions that are excessive in view of the character of the account. Its hallmarks are disproportionate turnover, frequent in and out trading, and large brokerage commissions. It is a deceptive device made actionable by Ǡ10(b) of the Securities Exchange Act and S.E.C. Rule 10b-5. Carras v. Burns, 516 F.2d 251, 258 (4th Cir. 1973).

The factors to be considered in a churning case are alternatively defined in the case of Bergen v. Rothschild, 648 F.Supp. 582, 585 (D.D.C. 1986):

(1) the number and frequency of the trades; (2) the amount of in and out trading; (3) the amount of commissions generated by the trading both in dollar terms and as a percentage of the brokers salary; (4) the investor's objectives in the market and his level of business sophistication; and (5) the degree of control exercised by the securities dealers over the investment account. Horne v. Francis I. du Pont & Co.,428 F.Supp. 1271, 1274 (D.D.C. 1977)).

To establish control, [t]he account need not be a discretionary account whereby the broker executes each trade without the consent of the client& [T]he requisite degree of control is met when the client routinely follows the recommendations of the broker. Mihara v. Dean Witter & Co., Inc.,619 F.2d 814, 821 (9th Cir. 1980).

by W. Scott Greco
The above is intended as a helpful summary for investors, but may not fully set out all relevant factors involved. This article is not intended as legal advice and does not create an attorney-client relationship. If you think that you may have a claim, you should consult with an attorney.