Common Fact Patterns of Stockbroker and Misconduct

By Robert C. Port

ntil recently, it seemed as though everyone had heard of a “friend of a

friend” who made a “killing” in the market. The late 1990s were Uespecially good to investors, with double digit returns seemingly the norm. Financial newspapers and magazines offering investment advice were every-

where, and Internet bulletin boards and chat rooms were filled with people claim-

ing to have identified the next Microsoft, Yahoo or Cisco.

In this environment, investors easily fell prey to dishonest stockbrokers, invest- ment advisors, financial planners, insurance agents and others claiming to have the knowledge and experience to offer investment advice. Certainly, no one has a crys- tal ball, and not every loss results from actionable activity by a broker. Even sup- posedly “rock-solid” blue-chip experience significant declines from time to time. However, in many instances, the actions of a broker or investment advisor can form the factual basis for a variety of legal claims. Federal and state securities statutes and state common-law typically govern civil liabilities arising out of the purchase and sale of securities.1 This article first reviews the duties a broker owes to his client, and then provides an overview of reoccurring fact patterns and circumstances often found when an investment advisor has engaged in actionable activity. STOCKBROKER AND BROKERAGE FIRM DUTIES TO THE CUSTOMER Pursuant to Sections 15A and 19 of the Securities Exchange Act of 19342, Congress has authorized the establishment of “self-regulatory organizations” (SROs) such as the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX) and the National Association of Securities Dealers (NASD). Each of these SROs have promulgated rules which are, inter alia, “designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation and coordination with persons engaged in regulating, clearing, settling, processing information with respect to, and facilitating transactions in secu- rities, to remove impediments to and perfect the mechanism of a free and open mar- ket and a national market system, and, in general, to protect investors and the pub- lic interest. . . “3 Rules promulgated by the various SROs are sent to the Securities and Exchange Commission for review and approval, following publication and an opportunity for public comment.4

14 Georgia Bar Journal The failure of a broker to comply tion before making a recommenda- tomer through any means includ- with the SRO rules does not give tion to purchase or sell a . ing, but not limited to, direct tele- rise to a private right of action.5 Working hand-in-hand with the phone communication, the delivery However, a violation of the SRO “Know Your Customer Rule,” the of promotional material through rules can provide critical evidence “Suitability Rule”8 requires that the the mail, or the transmission of elec- that a broker or brokerage firm broker have a reasonable basis for tronic messages.”9 The NYSE has failed to exercise the requisite believing that a securities transac- adopted a similar approach. For degree or standard of care owed tion recommended to a customer is purposes of these standards, the their customer.6 suitable for the customer, in light of term “recommendation” includes The Duty to Know the the customer’s financial and other any advice, suggestion or other Customer and to Recommend circumstances. NASD has made it statement, written or oral, that is Suitable Investments. Among the clear that a “recommendation,” and intended, or can reasonably be most fundamental of SRO rules are hence the applicability of the “suit- expected, to influence a customer to the “Know Your Customer” and ability requirements,” is a fact spe- purchase, sell or hold a security. 10 the “Suitability” rules. The “Know cific inquiry. In particular, the By regulation, the Georgia Your Customer Rule”7 places a NASD has advised that “a transac- Securities Commissioner has duty upon brokers to acquire an tion will be considered to be recom- promulgated rules that similarly understanding of their customer’s mended when the member or its obligate a broker operating in financial needs, investment objec- associated person brings a specific Georgia to investigate the client’s tives and other pertinent informa- security to the attention of the cus- circumstances and only recom-

June 2002 15 mend investments suitable in light of the risks involved in purchasing such that the client follows almost of those circumstances.11 Violation or selling a particular security; (4) every recommendation the broker of these rules is a violation of the the duty to refrain from self-deal- makes. Churning can be a violation Georgia Securities Act.12 ing; (5) the duty not to misrepre- of Section 10(b) of the Securities The Duty of Good Faith, Fair sent any material fact to the trans- Act of 193421 and Rule 10b-5 prom- Dealing and Loyalty. Various SRO action; and (6) the duty to transact ulgated thereunder.22 It also is a and state regulatory pronounce- business only after receiving violation of the Georgia Securities ments require brokers and broker- approval from the customer.19 Act.23 Churning may also provide age firms to act with the utmost a basis for claims based upon good faith, fair dealing and loyalty COMMON breach of fiduciary duty,24 breach toward their customers.13 These PATTERNS OF of contract,25 negligence,26 and obligations mirror those imposed respondent superior liability.27 by Georgia common-law and MISCONDUCT Several objectively measurable 14 statute upon parties to a contract. Although each case presents a factors may suggest that an account The Duty to Supervise Brokers. different set of facts and circum- has been churned. One widely- Brokerage firms have a statutory stances, there are a number of com- accepted indicator is the turnover obligation, under both federal and mon themes and fact patterns giv- ratio. “Turnover rate is the ratio of 15 state law, to supervise their bro- ing rise to claims against stockbro- the total cost of purchases made for kers to prevent violations of the kers, brokerage firms and invest- the account during a given period of 28 securities laws. The SROs have ment advisors. Most of these claims time to the amount invested.” The courts generally recognize an annu- al turnover rate in an investment Under Georgia law, a confidential, fiduciary account of 6, or a ratio of purchases to the amount invested of 6:1, exces- relationship exists between a broker and a sive as a matter of law.29 Whether a particular turnover rate is excessive client. As a fiduciary, the broker has a legal depends upon the investment objec- tives of the customer. In long-term obligation to act in the “utmost good faith.” accounts with conservative objec- tives, a lower turnover ratio may be 30 imposed similar obligations by arise from the inherent conflicts deemed excessive. In trading 16 rule-making. created when a broker’s income is accounts and accounts with options Brokers Owe Their Customers a commission based, and thus direct- transactions, a higher turnover ratio 31 Fiduciary Duty. Under Georgia ly tied to the volume of transac- is expected. law, a confidential, fiduciary rela- tions generated. Among the more Another factor to consider is the tionship exists between a broker common improper activities are “account maintenance cost,” also 17 and a client. As a fiduciary, the the following: known as the “equity maintenance broker has a legal obligation to act Churning/Excessive Trading. factor” or the “cost/equity ratio.” 18 in the “utmost good faith.” Churning “occurs when a securi- This is the rate of return the cus- As set forth by the 11th Circuit, ties broker buys and sells securities tomer must earn on the account to the fiduciary duties of an invest- for a customer’s account, without pay the commissions and other ment broker include: (1) the duty to regard to the customer’s invest- trading fees (such as margin inter- recommend investments only after ment interests, and for the purpose est). It is calculated by adding all studying it sufficiently to become of generating commissions.”20 The fees and commissions and express- informed as to its nature, price and broker churns an account by exer- ing the total as a percentage of financial prognosis; (2) the duty to cising control over it, either as a average annual equity. A high perform the customer’s orders result of having been given express account maintenance cost is indica- promptly in a manner best suited discretionary authority to trade, or tive of an account that has been to serve the customer’s interests; by developing a relationship of traded not for the customer’s bene- (3) the duty to inform the customer trust and confidence with the client fit, but for the benefit of the broker.

16 Georgia Bar Journal Also considered is the period of evidence of unsuitable activity, as Overconcentration/Failure to time a security is held from pur- is over concentration of the portfo- Diversify. It is generally accepted chase date to sale date. Short hold- lio in one stock, group of stocks, or that risk can be reduced by diversi- ing periods, with the proceeds industry, recommendations to use fying investments among a number immediately reinvested in other excessive margin to purchase addi- of different investments (such as positions, may be indicative of tional shares, and recommenda- investments in auto stocks, tech- churning.32 Another indicator of tions to purchase unregistered pri- nology stocks, retail stocks), or by churning is a comparison of the vate placements. The broker’s fail- diversifying in different types of total commissions generated by the ure to recommend suitable invest- investments (such as stocks, bonds account as compared to total com- ments may violate Section 10b of and mutual funds).48 A broker who missions earned by the broker the Securities Exchange Act and recommends that a client place all and/or the branch.33 Rule 10b-5,39 the Georgia Securities or substantial all of his investments Fraud and Misrepresentation. A Act,40 as well as conduct rules in one or just a few securities may broker may induce a customer to promulgated by the SROs.41 not only be ignoring sound invest- buy or sell a stock by making state- Unsuitable recommendations may ment theory, but may also be vio- ments or representations of material also give rise to state law based lating a number of legal and regu- fact that are known by the broker to causes of action under theories of latory obligations owed to his cus- be untrue, or that are made with a breach of contract,42 breach of fidu- tomer. Indeed, as a fiduciary, the reckless disregard for the truth, and ciary duty,43 and negligence.44 broker may be obligated to recom- that are relied upon by the customer Unauthorized Trading. A bro- mend a diversity of investments to following the broker’s recommen- ker is prohibited from executing a his client.49 dation. Also, a broker can commit trade in an account unless the client Excessive Margin. “Margin” fraud by an “omission” — failing to has approved and authorized the refers to the situation where a cus- reveal material facts that would trade, before the trade has been tomer borrows from the brokerage have been important to the cus- made, either by written discre- firm to purchase additional securi- tomer in making the investment tionary authority given to the bro- ties, using those securities (and decision. This conduct is prohibited ker (such as a Power of Attorney), perhaps others in the account) as by Section 10(b) of the Securities or by oral “time and place” discre- collateral.50 The Federal Reserve Exchange Act and Rule 10b-5 prom- tion granted to the broker.45 Often, sets the initial ratio of margin debt ulgated thereunder34, as well as the a disreputable broker will initiate to stock value at the time of pur- Georgia Securities Act.35 Such con- trades in the account without the chase.51 A broker cannot engage in duct also can serve as the basis for a prior authorization of the client. margin trading in a customer’s claim of common-law fraud.36 Among other claims, unauthorized account unless the customer Unsuitable Recommendations. trading in an account may violate authorizes it in writing, and is A broker must only recommend Section 10b of the Securities provided with certain credit disclo- investments that are appropriate Exchange Act and Rule 10b-546, sures.52 While many account open- for the customer’s particular cir- and is a violation of the Georgia ing agreements contain a provision cumstances, in light of the cus- Securities Act.47 authorizing and allowing margin tomer’s financial condition, level of sophistication, investment objec- tives, and risk tolerance. This is known as “suitability” or “know- ing your customer.”37 A common fact pattern is the broker’s recom- mendation to purchase excessive concentrations of low priced “penny” stocks38 or other volatile shares, suggesting that a small price rise for each share will mean significant profits. Churning is also

June 2002 17 trading, sometimes an account is An unscrupulous broker or firm The ability of a broker to engage in improperly traded on margin with- sometimes refuses to do so, because “selling away” may be indicative out any prior agreement or author- a sale might push down the price of of the brokerage firm’s failure to ization from the customer. a security they are promoting. adequately supervise its brokers. Even if a customer has author- Switching of Mutual Funds. “Cold Calls.” A cold call is a tele- ized trades on margin, a broker Although mutual funds are often phone call from a broker the cus- may improperly induce the cus- viewed as an appropriate invest- tomer has never met, trying to solic- tomer to carry an unreasonably ment option, a broker looking to it business. The brokers making large margin debt. Often, a dishon- improperly increase his commis- these calls are often very convinc- est broker will recommend that a sion may recommend that his cus- ing, and portray the stock they are customer borrow heavily to pur- tomer sell a mutual fund they own, touting as no-risk opportunities for chase low-priced, risky securities. and purchase a fund offered by a big profits. The stock is described as Sometimes, the broker fails to clear- different mutual fund company. a “phenomenal opportunity,” “the ly explain margin borrowing, Switching can generate significant next Microsoft,” or “a once in a life- including the fact that the margin commissions and sales charges ben- time opportunity.” Often, such balance cannot exceed a certain per- efiting the broker. Switching may brokers claim they have “inside” centage of the account. The broker not, however, place the investor in information, claim they have made might also fail to explain that if the a better mutual fund, and may in lots of money for other people, or value of the account falls below the fact place the investor in a lesser claim that they are out to help the required percentage, a “margin known, lower-quality fund. small investor, unlike the “big call” will be made requiring the Selling Away. “Selling Away” boys” on Wall Street. Sometimes, customer to place additional money describes instances where a broker brokers will claim (usually falsely) in the account or risk liquidation of sells securities outside of the firm that they believe in the investment the account to satisfy the margin with which he or she is associat- so much, they sold some to their debt. As the SEC has observed: ed.54 As described by the NASD, mother or other relatives. The Trading on margin increas- “[these] transactions pres- NASD’s Telemarketing Rule56 lim- es the risk of loss to a cus- ent serious regulatory con- its the calling time to between 8 tomer for two reasons. First, cerns because securities may a.m. and 9 p.m. Brokers calling the customer is at risk to lose be sold to public investors must identify themselves by pro- more than the amount invest- without the benefits of any viding their name, firm name, ed if the value of the security supervision or oversight by a address or phone number. depreciates sufficiently, giv- member firm and perhaps The “Bait and Switch.” The ini- ing rise to a margin call in the without adequate attention to tial recommendations of a dishon- account. Second, the client is various regulatory protections est broker may be for the purchase required to pay interest on the such as due diligence investi- of well known, widely traded blue margin loan, adding to the gations and suitability deter- chip stocks, or other securities con- investor’s cost of maintaining minations. In some cases, sistent with the customer’s invest- the account and increasing the investors may be misled into ment objectives. After the customer amount by which his invest- believing that the associated has invested in such companies, ment must appreciate before person’s firm has analyzed the the broker will then suggest that the customer realizes a net security being offered and such companies have little growth gain. At the same time, using “stands behind” the product potential, and pressure the cus- margin permit[s] the cus- and transaction when in fact tomer to sell the blue chip stocks tomers to purchase greater the firm may be totally and invest in small, unknown com- amounts of securities thereby unaware of the person’s par- panies, which the broker claims generating increased commis- ticipation in the transaction.”55 will bring spectacular profits. sions for [the salesperson].53 NASD Conduct Rules 3030 and Improper Marking of Failure or Refusal to Execute an 3040 prohibit, respectively, unap- Confirmations as “Unsolicited” Order. A broker also has an obliga- proved outside business activities Orders. The broker may inaccu- tion to execute sell orders if given. and private securities transactions. rately state that purchases recom-

18 Georgia Bar Journal mended by the broker were “unso- investment activity, the practition- 4. 15 U.S.C. § 78s(b)(1), (b)(2). licited.” Mismarking order tickets er should carefully review the facts 5. Spicer v. Chicago Bd. of Options Exch., Inc., 977 F.2d 255 (7th Cir. is a violation of the Securities not only in light of the legal and 1992); Hoxworth v. Blinder, Exchange Act57 and rules promul- regulatory obligations imposed Robinson & Co., 903 F.2d 186, 200 58 (3d Cir. 1990); Shahmirzadi v. gated by the SROs. upon those in the brokerage com- Smith Barney, Harris Upham & Blaming Errors on “Back munity, but also to understand the Co., 636 F. Supp. 49 (D. D.C. 1985); Room” or “Administrative” economic motivations that encour- Thompson v. Smith Barney, Harris Upham & Co., 709 F.2d 1413 (11th Problems. Unauthorized transac- aged and facilitated the broker to Cir. 1983); Jablon v. Dean Witter & tions, improperly marked confir- breach the legal and regulatory Co., 614 F.2d 677 (9th Cir. 1980); Shull v. Dain, Kalman & Quail, Inc., mations, and other difficulties a duties owed to the customer. 561 F.2d 152, 160 (8th Cir. 1977). customer is having with a broker 6. Miley v. Oppenheimer & Co., 637 will often be dismissed by the bro- Robert C. Port is a F.2d 318, 333 (5th Cir. 1981) (indus- partner with Hassett try rules are “excellent tools against ker as a problem with the “back which to assess in part the reason- room,” the administrative and cler- Cohen Goldstein Port ableness or excessiveness of a bro- & Gottlieb, LLP, ker’s handling of an investor’s ical support. Atlanta, Ga., where he account”); Lang v. H. Hentz & Co., The Manager Who Promises to 418 F. Supp. 1376, 1383-84 (N.D. practices commercial “Make it Right.” Often, a customer Tex. 1976) (NASD Rules provide litigation. He is a member of the evidence of the standard of care a who has lost substantial money as Board of Directors of the Sole member should have); Kirkland v. a result of a rouge broker gets a call E.F. Hutton & Co., 564 F. Supp. 427 Practitioner/Small Firm Section of (E.D. Mich. 1983). See also, Allen v. from the “manager” of the firm, the Atlanta Bar, and an arbitrator Lefkoff, Duncan, Grimes & Dermer, offering to make things right if the with the National Association of P.C., 265 Ga. 374, 453 S.E.2d 719 customer will let the “manager” Securities Dealers. He received (1995)(violation of a Bar Rule is not determinative of the standard of handle the account. Frequently, the his J.D., with honors, from the care applicable in a legal malprac- customer will be asked to send University of North Carolina in tice action, but it may be circum- 1983. stance that can be considered, along more money, “so we can have with other facts and circumstances, something to work with.” The in determining negligence.) “manager” might claim that the ENDNOTES 7. See NASD Conduct Rule 2310(b); NYSE Rule 405(1); AMEX Rule 1. A number of theories of liability other broker was young and inex- 411. NASD Conduct Rule 2310(b) are available to a plaintiff, includ- provides as follows: perienced, or claim that the other ing claims based upon the Prior to the execution of a transac- anti-fraud provisions of the broker has been fired. This “man- tion recommended to a non-insti- Securities Exchange Act of 1934, 15 tutional customer, other than ager” is often not the manager of U.S.C. § 78j(b) and Rule 10b-5 transactions with customers where the office, but someone working in promulgated thereunder, 17 C.F.R. investments are limited to money § 240.10b-5; the anti-fraud provi- tandem with the first broker. More market mutual funds, a member sions of the Georgia Securities Act shall make reasonable efforts to often than not, this “manager” will of 1973, O.C.G.A. § 10-5-14; com- obtain information concerning: mon law fraud; breach of fiduciary lose any new funds sent in, as well (1) the customer’s financial status; duty; breach of contract; negli- (2) the customer’s tax status; as what was left in the account. gence; control person liability (3) the customer’s investment under the Securities Exchange Act, objectives; and 15 U.S.C. § 78t(a) or the Georgia CONCLUSION (4) such other information used or Securities Act 0f 1973, O.C.G.A. § considered to be reasonable by 10-5-14(c); respondent superior lia- Unscrupulous investment advi- such member or registered repre- bility; agency; and the Georgia sors are always devising new and sentative in making recommenda- Racketeer Influenced and Corrupt tions to the customer. innovative methods to part Organizations Act (“RICO”), 8. NASD Conduct Rule 2310(a). This O.C.G.A. § 16-14-4. Other federal investors from their hard earned Rule provides as follows: statutes, such as the Employee In recommending to a customer money. Many of the patterns of Retirement Income Security Act the purchase, sale or exchange of (“ERISA”) may come into play. illicit activity summarized in this any security, a member shall have Self-regulatory organization rules, article are motivated by the eco- reasonable grounds for believing such as the NASD rules or NYSE that the recommendation is suit- nomic incentives under which bro- rules, also are relevant to the ques- able for such customer upon the tion of whether the broker has kers operate: commissions based basis of the facts, if any, disclosed breached a duty owed to a cus- by such customer as to his other on trading activity. When present- tomer. security holdings and as to his 2. 15 U.S.C. § 78o-3 and § 78s. ed with a possible claim of inap- financial situation and needs. propriate or perhaps fraudulent 3. 15 U.S.C. § 78o-3(b)(6).

June 2002 19 9. NASD Notice To Members 96-60 salesmen and employees.” The It shall be unlawful for any person, (Sept. 1996) (emphasis added). Rule sets forth various procedures directly or indirectly, by the use of 10. NYSE Supplementary Material to by which proper supervision can any means or instrumentality of Rule 472, Communications With be accomplished. interstate commerce or of the The Public No. 90-5. 16. NASD Conduct Rule 3010 provides: mails, or of any facility of any 11. Ga. Comp. R. & Regs. r. 590-4-2-.14 (a) Supervisory System. national securities exchange… (1)(a)(3) of the Georgia Securities Each member shall establish and (b) To use or employ, in connec- Commission, entitled Dishonest or maintain a system to supervise the tion with the purchase or sale of Unethical Business Practices, author- activities of each registered repre- any security registered on a izes the Securities Commissioner sentative and associated person national securities exchange or any to take action against brokers who: that is reasonably designed to security not so registered . . . any recommend[ ] to a customer the achieve compliance with applica- manipulative or deceptive device purchase, sale or exchange of any ble securities laws and regulations, or contrivance in contravention of security without reasonable and with the Rules of this such rules and regulations as the grounds to believe that such trans- Association. Final responsibility Commission may prescribe as nec- action or recommendation is suit- for proper supervision shall rest essary or appropriate in the public able for the customer based upon with the member. interest or for the protection of reasonable inquiry concerning the . . . investors. customer’s investment objectives, (b)Written Procedures. 22. See Hecht v. Harris, Upham & Co., financial situation and needs, and Each member shall establish, main- 430 F.2d 1202, 1206-07 (9th Cir. any other relevant information tain, and enforce written proce- 1970); Armstrong v. McAlpin, 699 known by the dealer, limited deal- dures to supervise the types of F.2d 79 (2d Cir. 1983)(churning may er, salesman, or limited salesman. business in which it engages and be a deceptive and manipulative 12. O.C.G.A. §§ 10-5-12(a)(1). to supervise the activities of regis- action under 10b-5). Rule 10b-5, 13. See, e.g., NASD Conduct Rule 2110 tered representatives and associat- promulgated by the Securities and (Members “shall observe high stan- ed persons that are reasonably Exchange Commission pursuant to dards of commercial honor and just designed to achieve compliance the authority granted to it by and equitable principles of trade.”); with applicable securities laws and Section 10b of the Securities NYSE Rule 401 (“Every member, regulations, and with the applica- Exchange Act, provides: allied member and member organi- ble Rules of this Association. It shall be unlawful for any person, zation shall at all times adhere to NYSE Rule 405(2) provides: directly or indirectly, by the use of the principals of good business Every NYSE member shall “super- any means or instrumentality of practice in the conduct of his or its vise diligently all accounts han- interstate commerce, or of the business affairs.”); Rule dled by registered representatives mails or of any facility of any 590-4-2.14(1) of the Georgia of the organization.” national securities exchange, Securities Commission (“Every 17. E. F. Hutton & Co. v. Weeks, 166 (a) To employ any device, scheme, dealer, limited dealer, salesman and Ga. App. 443, 445, 304 S.E.2d 420, or artifice to defraud, limited salesman shall observe high 422 (1983) (“The broker’s duty to (b) To make any untrue statement standards of commercial honor and account to its customer is fiduciary of a material fact or to omit to state just and equitable principles of in nature, resulting in an obliga- a material fact necessary in order trade in the conduct of business”). tion to exercise the utmost good to make the statements made, in 14. O.C.G.A. 11-1-203; Jackson Elec. faith.”); Gochnauer v. A. G. the light of the circumstances Membership Corp. v. Ga. Power Edwards & Sons, Inc., 810 F.2d under which they were made, not Co., 257 Ga. 772, 364 S.E.2d 556 1042, 1049 (11th Cir. 1987) (“The misleading, or (1988); see also Restatement law is clear that a broker owes a (c) To engage in any act, practice, (Second) Contracts, § 231 (1986 fiduciary duty of care and loyalty or course of business which oper- App.) (“Every contract imposes to a securities investor.”); accord ates or would operate as a fraud or upon each party a duty of good RESTATEMENT (SECOND) OF AGENCY deceit upon any person, in connec- faith and fair dealing in its per- § 425 (1957) (agents who are tion with the purchase or sale of formance and its enforcement.”). employed to make, manage, or any security. But see, Lake Tightsqueeze, Inc. v. advise on investments have fiduci- 23. Rule 590-4-2-.14(1)(a)(2) of the Chrysler First Fin. Servs. Corp., ary obligations). Georgia Securities Commission, 210 Ga. App. 178, 435 S.E.2d 486 18. O.C.G.A. § 23-2-58. entitled Dishonest or Unethical (1993)(“the failure to act in good 19. Gochnauer v. A.G. Edwards & Business Practices, authorizes the faith in the performance of con- Sons, Inc., 810 F.2d 1042, 1049 Securities Commissioner to take tracts or duties under the Uniform (11th Cir. 1987) (quoting Lieb v. action against brokers who Commercial Code does not state Lynch, Pierce, Fenner & “induc[e] trading in a customer’s an independent claim for which Smith, Inc., 461 F. Supp. 951, 953 account which is excessive in size relief may be granted.”) (E.D. Mich. 1978) aff’d, 647 F.2d 165 or frequency in view of the finan- 15. Rule 590-4-2-.08 of the Georgia (6th Cir. 1981)). cial resources and character of the Securities Commission, entitled 20. Thompson v. Smith Barney, Harris account.” Violation of the Rule is Supervision of Salesmen, Limited Upham & Co., 709 F. 2d 1413, 1416 a violation of the Georgia Salesmen, and Employees, provides (11th Cir. 1983); Costello v. Securities Act, § 10-5-12(a)(1). that “(1) Every dealer and limited Oppenheimer & Co., 711 F.2d 1361 24. See nn. 19-21, supra dealer registered or required to be (7th Cir. 1983). 25. Most customer agreements and registered under the Act shall exer- 21. Section 10(b) of the Securities Act trade confirmations incorporate cise diligent supervision over the of 1934, 15 U.S.C. § 78j(b), pro- industry rules and regulations into securities activities of all of its vides, in pertinent part that: the contract with the customer. For

20 Georgia Bar Journal example, a Bear Stearns Customer acts and omissions of those over 33. See, e.g., Smith v. Petrou, 705 F. Agreement provides: whom they hold the ability to dis- Supp. 183 (S.D.N.Y 1989)(commis- APPLICABLE LAW, RULES AND cipline or influence. See, Section sions generated by account was REGULATIONS. All transactions 20(a) of the Securities and substantial portion of broker’ s shall be subject to the applicable laws, Exchange Act, 15 U.S.C. § 78t(a); income). Accord, Stevens v. rules and regulations of all federal Harrison v. Dean Witter Reynolds, Abbott, Proctor & Paine, 288 F. state and self-regulatory authorities, Inc., 79 F.3d 609 (7th Cir. 1996); Supp. 836 (E.D. Va. 1968); Hecht v. including, but not limited to, the rules Hollinger v. Titan Capital Corp., Harris, Upham & Co., 430 F.2d and regulations of the Board of 914 F.2d 1564 (9th Cir. 1990) (en 1202 (9th Cir. 1970). Governors of the Federal Reserve banc)(control found where pri- 34. The elements of a System and the constitution, rules and mary violator was a registered rep- action under of the 1934 Act are: (1) customs of the exchange or market resentative of the firm and had false representation or omission of (and clearing house) where such some direct means of discipline or a material fact; (2) made with scien- transactions are executed. influence over them). The Georgia ter - a mental state embracing an Violations of industry rules and Securities Act similarly provides attempt to deceive, manipulate or regulations by a broker/dealer or for liability of “control persons,” defraud; (3) in connection with the registered representative give rise subject to a “good faith” defense. purchase or sale of a security; (4) to breach of contract claims if dam- O.C.G.A. § 10-5-14(c). upon which the claimant reason- ages result. 28. Levin v. Shearson Lehman/ ably relied; (5) that proximately 26. A broker’s violation of regulatory American Express, Inc., [1984-85 causes damage. See Gochnauer v. duties, while generally recognized Transfer Binder] Fed. Sec. L. Rep. A.G. Edwards & Sons, Inc., 810 to not give rise to a private right of (CCH) ¶ 92,080 (S.D.N.Y. June 14, F.2d 1042, 1046-47 (11th Cir. 1987); action, may provide evidence in 1985). To calculate the annual rate Thompson v. Smith Barney, Harris evaluating whether the of turnover in an account, divide Upham & Co., 709 F.2d 1413 (11th broker/dealer properly exercised the total purchases in the account Cir. 1983); Diamond v. Lamotte, the required degree of care in deal- by the average amount invested in 709 F.2d 1419 (11th Cir. 1983). The ings with a customer. See, e.g., Allen the account. Then divide that fig- standard for determining materiali- v. Lefkoff, Duncan, Grimes & ure by the number of months in ty is whether “there is a substantial Dermer P.C., 265 Ga. 374, 453 S.E.2d the time period the account has likelihood that a reasonable share- 719 (1995)(violation of a Bar Rule is been open to determine the month- holder would consider it impor- not determinative of the standard of ly rate of turnover. Multiply that tant” or “a substantial likelihood care applicable in a legal malprac- figure by twelve (12) to determine that the disclosure…would have tice action, but it may be circum- the annual turnover. been viewed by the reasonable stance that can be considered, along 29. Freundt-Alberti v. Merrill Lynch, investor as having significantly with other facts and circumstances, Pierce, Fenner & Smith, Inc., 134 altered the ‘total mix’ of informa- in determining negligence.). F.3d 1031, 1032 (11th Cir. tion made available.” TCS Indus., A number of courts have held that 1998)(referring to benchmark Inc. v. Northway, Inc., 426 U.S. 438, a violation of regulatory rules may annual turnover ratio of six); 449 (1976); SEC v. Carriba Air, Inc., be the basis of a claim sounding in Craighead v. E.F. Hutton & Co., 681 F.2d 1318, (11th Cir. 1982) (The negligence. Miley v. Oppenheimer 899 F.2d 485, 490 (6th Cir. 1990); test for determining materiality is & Co., 637 F.2d 318, 333 (5th Cir. Arceneaux v. Merrill Lynch, whether a reasonable man would 1981) (industry rules are “excellent Pierce, Fenner & Smith, Inc., 767 attach importance to the fact mis- tools against which to assess in F.2d 1498, 1502 (11th Cir. 1985); represented or omitted in deter- part the reasonableness or exces- Mihara v. Dean Witter & Co., 619 mining his course of action). siveness of a broker’s handling of F.2d 814, 821 (9th Cir. 1980); 35. Georgia Code Section 10-5-14 pro- an investor’s account”); Lang v. H. Moran v. Kidder Peabody & Co., vides a cause of action against a Hentz & Co., 418 F. Supp. 1376, 609 F. Supp. 661 (S.D.N.Y. 1985), seller of securities for violating 1383-84 (N.D. Tex. 1976) (NASD aff’d, 788 F.2d 3 (2d Cir. 1986). Section 10-5-12 for making an Rules provide evidence of the stan- 30. See In re Thomson McKinnon Sec., untrue statement of a material fact dard of care a member should Inc., 191 B.R. 976 (Bankr. S.D.N.Y. or omiting to state a material fact have); Kirkland v. E.F. Hutton & 1996)(turnover rate of 2.2 creates necessary in order to make the Co., 564 F. Supp. 427 (E.D. Mich. question of fact for jury to decide if statements made, in the light of the 1983). See also, NASD Conduct activity was excessive). circumstances under which they Rule 2120 (“No member shall 31. See Thompson v. Smith Barney, are made, not misleading. Liability effect any transaction in, or induce Harris, Upham & Co., 539 F. Supp. will not be found however, if the purchase or sale of, any securi- 859 (N.D. Ga. 1982), aff’d, 709 F. 2d (1) the purchaser knew of the ty by means of any manipulative, 1413 (11th Cir. 1983) (plaintiff who untrue statement of a material fact deceptive or other fraudulent knew his account was being con- or omission of a statement of a device or contrivance.”) stantly traded, who had financial material fact; or (2) the seller did 27. Under common law agency princi- acumen to determine his own best not know and in the exercise of ples, the principal (the interests and who desired frequent reasonable care could not have broker/dealer) is liable for the trading, could not establish exces- known of the untrue statement or torts of its agents (its registered sive trading). misleading omission. O.C.G.A. § representatives) done within the 32. See Mihara v. Dean Witter & Co., 10-5-14. There is very little case scope of the principals business. 619 F.2d 814, 819 (9th Cir. 1980) law interpreting the Georgia O.C.G.A. § 51-2-2. Further, under (excessive trading established Securities Act. Its civil liability pro- both federal and state law, “control where 50% of securities held for visions are analogous to the feder- persons” may be held liable for the less than 15 days). al statutes. Although the language

June 2002 21 of the Georgia statute does not sufficiently to become informed as diversification and thereby reduce appear to require scienter, courts to its nature, price, and financial nonsystematic risk. See Edwin J. have construed the section in prognosis.” Gochnauer v. A.G. Elton & Martin J. Gruber, MODERN accordance with 10b-5 as requiring Edwards & Sons, Inc., 810 F.2d PORTFOLIO THEORY AND INVESTMENT proof of scienter. Currie v. 1042, 1049 (11th Cir. 1987) (quoting ANALYSIS 31 (3d ed., 1987). Cayman Resources Corp, 595 F. Lieb v. Merrill Lynch, Pierce, 49. “Diversification is a uniformly rec- Supp. 1364 (N.D. Ga. 1984), GCA Fenner & Smith, Inc., 461 F. Supp. ognized characteristic of prudent Strategic Inv. Fund, Ltd. v. Joseph 951, 953 (E.D. Mich. 1978) aff’d, 647 investment.” Robertson v. Cent. Charles & Assocs., Inc., 245 Ga. F.2d 165 (6th Cir. 1981). Jersey Bank & Trust Co., 47 F.3d App. 460, 464, 537 S.E.2d 677 44. See n. 7, supra. 1268, 1275 n. 4 (3d Cir. 1995), citing (2000). Georgia blue sky law does 45. See, e.g., NYSE Rule 408; NASD RESTATEMENT (THIRD) OF TRUSTS § not require proof of reliance. One Conduct Rule 2510, IM 2310-2(4)(iii). 229(d) (1992). advantage of a claimant proceed- Glisson v. Freeman, 243 Ga. App. 92, 50. As explained by the court in Walck ing under the Georgia Act is the 99 532 S.E.2d 442, 449 (2000)(“With v. Am. Stock Exch., Inc., 687 F.2d provision for recovery of attor- respect to a nondiscretionary 778, 780 (3d Cir. 1982), “[t]he mar- ney’s fees, interest, and court costs. account, . . . the broker owes a num- gin device permits a broker to O.C.G.A. § 10-5-14(a). ber of duties to the client, including extend credit to his customer to 36. Elements of fraud in Georgia are: the duty to transact business only finance the customer’s transac- (1) false representation of an exist- after receiving prior authorization tions, with the broker holding a ing fact or past event; (2) scienter, from the client. . . .”). At least one security interest in the securities (3) intention to induce plaintiff to court has held that basic principles purchased as collateral for the act or refrain from acting, (4) justi- of agency law required the broker to loan. The customer pays an agreed fiable reliance by plaintiff and (5) inform the customer of his right to percentage of the purchase price damage to plaintiff. See, e.g., Fuller reject unauthorized purchases. by depositing cash or other securi- v. Perry, 223 Ga. App. 129, 476 Merrill Lynch Pierce Fenner & ties, and the broker holds the stock S.E.2d 793, 795 (1996). Smith, Inc. v. Cheng, 901 F.2d 1124, purchased as collateral for the bal- Nondisclosure may provide the 1128 (D.C. Cir. 1990). ance. The broker in turn often basis for constructive fraud where 46. See n. 23, supra. See, e.g., Davis v. finances the purchase by using the a party is under an obligation to Merrill Lynch, Pierce, Fenner & securities purchased as collateral communicate. O.C.G.A. § 23-2-53. Smith, Inc., 906 F.2d 1206, 1212 for a bank loan.” The obligation to communicate (8th Cir. 1990). 51. Regulation T of the Federal may arise from the confidential 47. Rule 590-4-2-.14(1)(a)(4) of the Reserve Board, 12 C.F.R. § relations of the parties or from the Georgia Securities Commission, 220.1-18. A customer purchasing particular circumstances of the Dishonest or Unethical Business prac- stock on margin generally must case. See also O.C.G.A. § 23-2- tices, authorizes the Securities advance a minimum of 50% of the 51(b). Under Georgia law, a confi- Commissioner to take action purchase price in cash or in securi- dential relationship imposes a against brokers who “executing a ties. In addition, the NASD, NYSE, greater duty on the parties to transaction on behalf of a customer and brokerage firms set their own reveal what should be revealed, without authorization to do so.” “margin maintenance” require- and a lessened duty to discover Ga. Comp. R. & Regs. r. 590-4-2-14. ments, and in some instances, do independently what could have Violation of the Rule is a violation not permit certain securities to be been discovered through the exer- of the Georgia Securities Act, § used as collateral for margin bor- cise of ordinary care. Hunter, 10-5-12(a)(1). rowing. Currently, NASD and Maclean, Exley & Dunn, P.C. v. 48. See, e.g., Richard A. Booth, The stock exchange rules require 25 Frame, 269 Ga. 844, 847-48, 507 Suitability Rule, Investor percent margin maintenance, and S.E.2d 411 (1998). Diversification, and Using Spread to many firms require 30 percent to 37. See nn. 8-11 supra., “[T]he making of Measure Risk, 54 BUS. LAW. 1599 35 percent maintenance. recommendations for the purchase (1999) “One of the time-honored 52. 17 C.F.R. § 240.17a-3(a)(9)(iii); 17 of a security implies that the dealer investment maxims is that risk can C.F.R. § 240.10b has a reasonable basis for such rec- be reduced by diversification.” 53. In the Matter of Laurie Jones ommendations, which in turn, Burton Malkiel & William Baumol, Canady, Exchange Act Release No. requires that, as a prerequisite, he Redundant Regulation of Foreign 41250, (Apr. 5, 1999). shall have made a reasonable inves- Security Trading and U.S. 54. See, e.g., Martin v. Shearson tigation.” Distribution By Broker- Competitiveness, in MODERNIZING Lehman Hutton, Inc., 986 F.2d 242 Dealers of Unregistered Securities, U.S. SECURITIES REGULATION, 39, 45 (8th Cir. 1993). Exchange Act Release No. 4445, 1962 (Kenneth Lehn & Robert W. 55. NASD Notice to Members 85-21. WL 69442 (Feb. 2, 1962). Kamphuis, Jr. eds., 1992). “The sin- 56. NASD Conduct Rule 2211. 38. “Penny” stocks are generally con- gle most important step most 57. Securities Exchange Act, Sec. 17(a) sidered to be those whose market investors can take to immediately and Rule 17a-3(a)(6). price is less than $5.00. improve the long range perform- 58. NYSE Rule 440. 39. See nn. 23-24, supra. ance of their portfolios … is to 40. See n. 25, supra. properly diversify their common 41. See n.28, supra. stock investments.” Norman G. 42. See n. 27, supra. Fosback, STOCK MARKET LOGIC: A 43. See nn. 19-21, supra. As set forth by SOPHISTICATED APPROACH TO PROFITS the Eleventh Circuit, the fiduciary ON WALL STREET 252 (1985). There is duties of an investment broker general agreement that it takes at include “the duty to recommend least 10, and usually 15-20, non-cor- [investments] only after studying it related stocks to achieve adequate

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