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legal causes of action against brokers and brokerage firms

Federal Securities Laws

The federal securities laws include anti-fraud provisions which contain private rights of action for defrauded investors. The federal securities laws provide a cause of action in the event that a broker engages in any scheme to defraud, makes untrue statements or material omissions or engages in any practice that deceives the investor. This covers misrepresentations or failures to disclose information necessary in the context of the statements, and numerous other instances in which a broker abuses a customer's account, such as through unsuitable trading, insider trading, stock manipulation, churning and unauthorized trading.

State Blue-Sky Laws

Many state securities laws, known as "blue sky" laws, contain anti-fraud provisions which include private rights of action. These tend to follow the federal provisions as to prohibited stockbroker activity, in particular in those states which have adopted the Uniform State Anti-Fraud Securities Act. However, it should be noted that certain states do not include a private right of action for individual investors under their state blue-sky laws. Investors in such states must rely upon the federal causes of action and common law rights.

Consumer Protection Statutes

Some state consumer protection laws cover securities investing among the protected activities. Certain states specifically include securities trading under their Unfair and Deceptive Trade Practices Act, and provide a private remedy for defrauded investors. In such states the typical claims of securities fraud against stockbrokers will generally also constitute prohibited unfair and deceptive trade practices under that state law.

Fraud and misrepresentation

A claim of securities fraud will generally include a common law claim of fraud and misrepresentation. General elements of the common law action for fraud and deceit are that there was a false representation of a material fact with knowledge of the falsity for the purpose of inducing the investor to act, and that the investor relied upon the representation as true and acted upon it to his detriment. Although there generally must be a statement or representation for fraud to occur, a "mere omission" will constitute fraud if the broker had a duty to disclose the fact omitted. A broker's recommendation of an investment without disclosing the risks would constitute a fraudulent misrepresentation. In most jurisdictions the requirement that the action was "knowing or intentional" is satisfied by reckless conduct, even if the broker did not actually know that his statements were false.

Negligence and malpractice

The cause of action for negligence or malpractice is based upon the duty owed by a broker to the customer and the breach of that duty, including the duty to exercise due care in connection with the account. Even if a broker did not have actual knowledge as to the falsity of statements which he made, his activity may constitute negligent misrepresentations. There may also be negligent management of an account, for example by failing to properly diversify a portfolio. Another example of negligence involves negligent supervision by the firm in failing to implement or enforce supervisory and compliance procedures.

Breach of contract

A cause of action for breach of contract may be based upon the New Customer Agreement or New Account Agreement which the customer signs when he opens his account with the brokerage firm. These standard forms generally require the brokerage firm to handle the account in accordance with the rules and regulations of the securities industry and self-regulatory organizations. A breach of contract claim may also be based upon a failure to follow the customer's instructions. Mismanagement of the account may also be included in a breach of contract claim based upon implied warranties to handle the account with due care and diligence. A breach of an implied covenant of good faith and fair dealing may also provide the basis of a cause of action for breach of contract.

Unsuitable trading

FINRA's suitability rule requires that the broker's recommendations must be appropriate in light of the customer's financial condition, level of sophistication, investment objectives, and risk tolerance. The suitability rule and the closely related "know your customer" rule require that the broker use due diligence to obtain information about the customer's financial situation, needs, objectives, and understanding. The standard for suitability must be considered in the circumstances of each case.

Violation of FINRA rules, including the suitability and "know your customer" rules, may be the basis for a cause of action on its own or through other causes of action. For example, the violation of the suitability rule and FINRA rules will itself constitute a basis for a breach of contract action. Unsuitable trading has also been held to constitute fraud and to constitute a violation of federal and state securities laws. A broker clearly is prohibited from recommending unsuitable investments, and there have been indications that a broker should refuse to execute unsuitable transactions even when the investment is originally the customer's idea.

Churning

"Churning" is trading at an excessive rate of frequency motivated by the broker's desire for personal gain through commissions. In order for overtrading to constitute churning, the broker must exercise control over the trading in the account and abuse the customer's trust by engaging in transactions which are excessive in volume and frequency considering the character of the account. The control of the broker may be actual or de facto, i.e. where in light of the relationship between the broker and the customer, for all practical purposes the broker is directing the trading.

Churning is generally measured by the rate of turnover in the account, frequent in and out trading, and large brokerage commissions. Another method for measuring churning is the cost-to-equity ratio, which calculates the cost of commissions (and margin interest) on the account as a percentage of the average equity, thus showing a break-even rate of return i.e., the rate of return that the account would have had to generate in order to break-even just to cover the cost of commissions and charges against the account. The turnover rate is calculated by dividing the total cost of purchases in the account by the average monthly equity. But whether a particular turnover rate or cost-to-equity ratio will constitute churning will depend upon the customer's trading objectives and experience and the level of control exercised by the broker over the trading.

A claim of churning, or excessive trading may be the basis of a legal action on its own or as part of a claim for breach of contract. Churning also constitutes fraud and a violation of state and federal securities laws.

Breach of fiduciary duty

Where there is a relationship of trust and reliance between the customer and broker, many jurisdictions hold that this gives rise to a fiduciary relationship. A fiduciary, like a trustee, is subject to a higher degree of duty that obligates the fiduciary to act in a diligent and faithful manner to further the customer's best interests. A fiduciary is held to rigorous duties of loyalty and care and must conduct himself with the utmost good faith and integrity. Since investors are encouraged to place their trust and confidence in their stockbroker whom they rely upon for expertise in making the investment decisions, the broker is held to an extremely high standard not to abuse that trust. Acts of fraud and misrepresentations, unauthorized trading, unsuitable trading and churning will generally also be the basis for a breach of fiduciary duty claim. A broker may also be subject to liability as a fiduciary for a pension or retirement plan account under the Employee Retirement Income Security Act ("ERISA").

Failure to supervise

A brokerage firm's failure to adequately supervise its broker may also result in liability for the brokerage firm. Federal securities laws and FINRA rules require brokerage firms to reasonably supervise their brokers for the purpose of preventing violations of the rules and regulations of the securities industry. In order to satisfy its obligations, a brokerage firm must show not only that they had in place supervisory and compliance rules and procedures, but also that they effectively implemented and enforced their compliance rules and procedures so as to diligently supervise the activities of the brokers. Related to the cause of action for failure of supervision is the secondary liability of a brokerage firm for the acts of their agents under the statutory "control person" provisions and the common law doctrine of respondeat superior holding the employer liable for the wrongful acts of the employee acting within the scope of employment.