GAMBLING WITH SECURITIES: THE (BROKERAGE) HOUSE MAY NOT WIN
Welcome to the new millennium-the lottery millennium-where Las Vegas rises from the desert like a phoenix and millions hope to get rich quick. Usually, of course, people use their own money to gamble, but what happens when someone else (e.g., a fiduciary) uses your money to place bets?
With unprecedented gains in the stock market and baby boomers rushing to Independent Retirement Accounts (IRAs) and other stock and money market programs, the opportunity for abuse by securities professionals has never been greater. Unfortunately, what often develops is gambling when people give their money to others for investment purposes.
The fact pattern of a typical securities case: A widow or divorcee or retiree gives hard-earned money to a brokerage house and its brokers for safekeeping and steady growth. Instead of insuring steady growth, the broker churns the account for commissions. The brokerage house, meanwhile, encourages or at least turns a blind eye to the broker's increased commissions and does nothing to ensure the broker is meeting the client's needs.
Suddenly the client no longer has money with which to retire or college funds for their children or grandchildren. What should this client do?
EVALUATING THE CASE
Other than initiating an investigation by a regulating body, such as the New York Stock Exchange, the only viable option for the defrauded client is a lawsuit. The less experienced your client is with the securities industry, however, the easier it will be for her to pursue claims against the stockbroker and brokerage house. If your client has a finance background or is an experienced investor the defendants will undoubtedly argue that the client somehow ratified the transactions on the account.
WHAT NEEDS TO BE PROVEN
You need to prove that the defendant stockbroker(s) and brokerage house were negligent (or worse) in managing the plaintiff's account; that the defendants failed to consider the plaintiff's investment needs and resources; and that the defendants engaged in excessive trading on plaintiff's account for the purpose of generating commissions and fees.
Potential causes of action include fraud, negligence, breach of fiduciary duty and breach of contract.
The contract in question will probably be a New Customer Agreement, a New Account Agreement, or an Adoption Agreement. This agreement should detail the client's stated account objectives, the client's financial objectives, and the client's goals for the account. The broker and brokerage house then must meet their duties under the contract, as well as their fiduciary duty to the client.
THE BROKER'S DUTIES
Under California law "the relationship between a stockbroker and his customer is fiduciary in nature, imposing on the former the duty to act in highest good faith toward his customer."1 "Churning" exists where "an account controlled by a broker" has "excessive trading done primarily to benefit the broker by generating commissions in excess of those justified."2 If plaintiff can show that the defendant broker and brokerage house churned her account or made other unsuitable investments, she can usually prove that defendants breached their fiduciary duty. 3
CLIENT'S ACCOUNT OBJECTIVE
In evaluating your client's case, the first piece of evidence to review is your client's stated account objective. The client's objective and financial situation should dictate how the broker and brokerage house should have handled the account. In reviewing your client's objective, make sure you ask your client what she understood the objective to be. You will find that clients frequently do not understand the exact terminology used in their agreement with the brokerage house.
However, your client's ignorance about terminology can help rather than hurt the case. She came to the brokerage house and broker because she could not make investments on her own and needed the guidance of defendants. The client's duty is to pay her bills. The broker and brokerage house, on the other hand, have a fiduciary duty to the client. In meeting that fiduciary duty the broker and brokerage house must do more than just carry out the stated objectives of the customer. Instead, they must "determine the customer's actual financial situation and needs."4
Once you understand your client's goals for the account you will be able to analyze the broker's wrongdoing. What you need to determine is whether the trading on the client's account was excessive and constituted churning. To determine if trading was excessive you must evaluate that trading in light of the client's financial needs, resources, and account objective.5 Once you can establish that the trading was excessive you must show that defendants engaged in the trading for the purpose of generating excessive commissions and fees.6
THE CLIENT INTERVIEW
Your initial interview with the client is very important. You must determine your client's understanding and experience with the securities industry. As noted earlier, the less your client understands about the securities industry, the easier it will be to prove her case. If you elect to team with more experienced co-counsel in securities cases, try to have your co-counsel at the client interview. This will not only be more efficient but minimize inconvenience to your client.
During the interview you should determine what documents the broker and brokerage house sent to your client, and which of those documents the client still has. In many churning cases the brokerage house will raise the defenses of unclean hands and ratification of the activity by your client. The brokerage house will use the documents sent to the client in support of those defenses. The more documents sent and the more experienced your client, the more difficult it will be to prove she did not understand the transactions on her account.
ARBITRATION OR TRIAL
During the client interview you should determine whether an arbitration clause applies to the case. Any arbitration agreement should be included in the plaintiff's New Customer Agreement or New Account Agreement with the brokerage house. Most brokerage houses have automatic, enforceable arbitration clauses.
Occasionally a brokerage house may forget to have the client sign all the paperwork necessary to enforce the arbitration clause. If you learn that this is the case for your client's account, you have won an important initial victory. This means you will have the opportunity to sue the broker(s) and brokerage house in court and have the case heard by a jury.
As in most cases, your client is usually better off with a jury than an arbitrator. If you find yourself in this unusual situation, take full advantage of it-especially if you are comfortable in the courtroom. Most attorneys retained by brokerage houses are accustomed to bringing their cases to arbitrations where they know the rules. They may well feel disadvantaged in a jury trial.
Due to the level of control the broker and brokerage house may have over your client's account, punitive damages are often justified in a stock churning or breach of fiduciary duty case. In arbitrations, however, punitive damages are unlikely. If you go before a jury, punitive damages may be your trump card. The threat of punitive damages and unfamiliarity with jury trials may turn out to be the brokerage house's best reasons to negotiate a reasonable and full settlement in your case.
DISCOVERY
REQUESTS FOR PRODUCTION
Requests for Production may be your most important written discovery option in these cases. Establishing the paper trail is critical in a securities case in order to pin down the brokers and other potential witnesses.
Account Statements
First request your client's Account Statements for the entire life of the account. The Account Statements will evidence the pattern of trading on your client's account, establishing both liability and damages.
From the Account Statements your expert will determine the turn-over ratio, commissions generated, and profit and losses on the account. It is very important that you provide your expert with the Account Statements as soon as possible because often it will take some time for your expert to completely analyze the account.
Activity Reports
The brokerage house's Activity Reports are usually generated once a month for each branch. The Activity Reports will reflect information for accounts with a certain level of trading on them in any one month. Once you receive the Activity Reports you should serve written interrogatories and ask deposition questions regarding the level of trading necessary to trigger an account's appearance on the Monthly Activity Report. This level of trading is customarily used as the brokerage house's red flag for monitoring accounts. Using this information, you may be able to establish the brokerage house's failure to properly monitor and supervise plaintiff's account.
Generally the branch manager will be responsible for reviewing the Activity Reports generated for his branch. Upon receipt of the Activity Reports you should notice the deposition of each branch manager involved during the life of your client's account. During the deposition review the Activity Reports with the branch manager and determine what action the branch manager took each time your client's account appeared on his Activity Report.
The branch manager's review of Activity Reports, in conjunction with his review of the daily transactions within the branch and monitoring of the defendant broker, may well provide the information necessary to successfully prosecute the brokerage house for failure to supervise.
In addition, most brokerage houses have a compliance department or related body that independently reviews all accounts for specific activity levels. If an account has large amounts of trading or trading that appears excessive in light of the client's stated objectives, the compliance department should send a notice to the branch manager asking the manager to evaluate the account. Upon receipt of any notices from the account department you should determine exactly what the branch manager did to follow up.
Happiness Letters
Frequently you will learn that all the branch manager did was to send out form letters that invited clients to call him if they had any questions or concerns. These letters are referred to as "happiness letters," and essentially say nothing. Through discovery ensure that you receive copies of any such letters forwarded to your client. During the branch manager's deposition ask him what he believes the letter conveyed in the way of new information to plaintiff.
Compliance Guides
The brokerage house's own Compliance Guide can support your case. If the brokerage house maintains Compliance Guides there should be one for the both the broker and the branch manager. Some brokerage houses have discontinued the use of Compliance Guides. If defendants in your case make this contention, discover the last date the brokerage house issued and distributed a Compliance Guide to its brokers and/or branch managers, and secure a copy.
Commissions
You should request any and all documents that explain or outline the formula used by the brokerage house in charging commissions. From this formula you and your experts will be able to better track and understand the commissions charged to your client by the broker and brokerage house.
Advertising
At time of trial the brokerage house's own advertising and slogans often can be used effectively against them. The cornerstone of any case against a stockbroker or brokerage house is that plaintiff put her trust in them. Frequently the brokerage house's slogan will advise your client to trust her money to the brokerage house's experience and reputation. With the right evidence you can build your opening and closing statements on the words of the brokerage house itself.
DEPOSITIONS
In prosecuting your client's case you should take the depositions of your client's stockbroker, the branch manager, and the brokerage house's representative. You should also consider taking the depositions of other support staff. Support staff members may unwittingly provide you with information showing that the broker involved did not send out as much information as he should, nor have as much client contact as claimed. If you need to depose a particular former branch manager or stockbroker and the brokerage house claims not to have his current address, you can easily get the broker's current place of employment through the Securities and Exchange Commission.
The following questions should get you started. Your review of the brokerage house's Compliance Guide, the branch's Activity Reports, and your client's Account Statements, along with other documents, should trigger more specific questions. In addition, if you have experienced co-counsel on the case and/or expert consultants, do not forget to coordinate fully with them for additional areas of questioning in your particular case.
General Questions for the Broker
- Have you ever been sanctioned by the National Association of Securities Dealers (NASD), the New York Stock Exchange (NYSE) or any related or similar entities regulating the securities industry?
- Have you ever had any complaints or claims filed against you by any other clients?
- What do you believe your duties to your clients were?
- What do you understand about the "know your customer rule"?
- Why does the "know your customer rule" exist?
- Did you maintain any notes or memos about your handling of plaintiff's accounts?
- Have you ever maintained a calendar with any information about your work as a stockbroker?
- Does the brokerage house have any particular rules regarding brokers and the maintaining of notes or memos?
- What was your client's account objective on her account?
- Did the client ever change her account objective?
- Would you consider the client's account objective conservative?
- What did you believe the client wanted from her account?
- What was your understanding of the client's financial situation?
- Do any documents exist supporting your understanding of the client's financial situation?
- If the client changed her account objectives, when did she make the change? Is there any documentation supporting the client's changed objective?
- Was the client called prior to each transaction on her account? What records exist of those conversations?
- If the client was not called prior to each transaction, did the broker and/or brokerage house have any writings permitting discretionary activity on the account?
- Are there any records of the telephone calls made to the client?
- How often did the client receive materials in the mail?
- What types of material were mailed to the clients?
- Is there a log of the materials sent by you and/or the brokerage house to the client?
- (If a Compliance Guide has been produced): Have you reviewed the Compliance Guide? When was the last time you reviewed the Compliance Guide? Does the brokerage house have any rules about maintaining and reviewing the Compliance Guide?
- How are commissions charged to the client?
- How are the commissions calculated?
- How are you paid?
- What percentage of the commissions charged to the client do you receive?
- Have you received or been eligible for any bonuses? What determines your receipt and level of bonuses?
- Have you received performance reviews by the brokerage house?
- Who conducts your performance reviews?
- How often do you receive performance reviews?
- What did your last performance review state? (And the review before that?) (And the ones during and prior to the trading in question?)
General Questions for the Branch Manager
- Do you review the transactions within the branch on a daily basis? If not, how often do you review the transactions within the branch?
- What documents regarding accounts do you review?
- Upon receipt of the daily transactions within the branch: Have you ever discussed the transactions with your stockbrokers? Have you ever independently reviewed a client's account to determine whether the trading level on the account met her account objectives? Have you ever contacted a client by telephone? By mail?
- How often do you receive Activity Reports for the branch?
- What level of trading triggers a client's account being placed on an Activity Report?
- What action do you take when a client's account appears on an Activity Report?
- Have you ever telephoned a client after their name appeared on an Activity Report? When and why?
- Is there a compliance department or other body within the brokerage house that also monitors the trading activity on client's accounts? If so, does the compliance department notify you of any potential problems on an account?
- Did you ever receive any notification of potential problems on the plaintiff's account?
- Did you review the client's activity levels in light of her account objectives?
- Have you ever spoken with a broker regarding activity levels?
- Have you ever spoken with a client regarding activity levels?
- Do you ever send letters to clients regarding the activity levels on their accounts? If so, are the activity letters sent to the client basically "form letters" or do they address specific potential problems you and/or the compliance department see in the account? Examples?
- What do you understand "discretionary trading" to be?
- Does the branch have any policies regarding discretionary trading?
- Was discretionary trading authorized on the plaintiff's account?
- What are the rules regarding discretionary trading?
- How often do you have meetings with your stockbrokers?
- Do you ever have performance reviews with your stockbrokers?
- When was your last performance review of the defendant stockbroker? What was included in your review(s) of the defendant stockbroker?
- How many accounts did the branch maintain during its handling of the plaintiff's account?
- How are commissions charged to the client? How are commissions calculated?
- How are you paid? Do you receive a percentage of the commissions charged to the clients within your branch?
- Do you receive any bonuses? What determines your receipt of bonuses?
- Does the brokerage house have any regular meetings with the stockbroker? If so, when? How often? What is the subject matter? Who conducts the meetings?
- As branch manager do you have meetings with your brokers? If so, when? How often? What is the subject matter? Who attends the meetings?
- Do you ever conduct informal reviews of the branch's accounts with your brokers?
- Does the brokerage house have any internal audit procedures? If so, when? How often? Who conducts the audits? If so, was the plaintiff's account ever audited? What records exist?
EXPERTS AND DAMAGES
EXPERTS
Review by the appropriate expert is essential to your thorough investigation of the account and prosecution of the case. Your best expert may well be a former broker or branch manager. As with most complex cases, a few well-placed calls to attorneys who practice in this area will likely result in expert candidates for your particular case.
During a recent expert search the authors noted, however, that many securities experts do not know what to expect in a non-arbitration case. This is important to keep in mind when selecting your expert. If you have the opportunity to avoid arbitration and take the case to trial, make sure you have an expert whose mind is open to an evaluation of the case by a jury of plaintiff's peers and a corresponding damage award larger than most industry arbitrators would grant.
DAMAGES
In developing damages in your case, work closely with your expert. Damages in a securities case can include:
(1) the loss in value of the plaintiff's account due to defendants' negligent and intentional mismanagement;
(2) the increased account value plaintiff reasonably would have received if her account had not been mismanaged;
(3) the disgorgement of commissions, fees and profits taken by defendants as a result of their improper trading; and
(4) punitive damages.
CONCLUSION
Churning cases have become more and more prevalent. Through proper discovery, consultation with attorneys who practice in the area, and selection of the right experts, your client can receive full entitlement for the injuries caused by unscrupulous brokers. In that way, the consumer, not the brokerage house, becomes the winner.
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Blankenheim v. E.F. Hutton & Co., Inc. (1990) 217 Cal.App.3d 1463, 1475; Duffy v. Cavalier (1989) 215 Cal.App.3d 1517, 1533-34.
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Hobbs v. Eichler (1985) 164 Cal.App.3d 174, 188.
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Id. at 189; and Twomey v. Mitchum, Jones & Templeton, Inc. (1968) 262 Cal.App.2d 690, 715.
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| 4 |
Duffy, supra at 1538. See also Twomey, supra at 719.
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Twomey, supra at 716.
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Hobbs, supra at 188. |
