Theories of Stockbroker and Brokerage Firm Liability

ver a lifetime, even modest savings, contributions to an IRA, or partici- By Robert C. Port pation in an employee pension plan can result in significant accumula- O tions of wealth.1 However, many individuals have neither the interest nor the desire to learn about financial markets and investments, nor do they have the

time necessary to monitor their investments on an ongoing basis. Their aversion to and

confusion about financial matters has been further accentuated by the “irrational exu-

berance”2 of the “Internet bubble” of the late 1990s, and subsequent significant decline

in the value of technology and telecommunications stock. As a result, many individuals

turn to stockbrokers, investment advisors, financial planners, insurance agents, and oth-

ers claiming to have the knowledge and experience to offer investment advice. Stockbrokers and other financial advisors are highly motivated to cultivate their clients’ trust and allegiance, and clients who lack knowledge and sophistication on financial matters have powerful incentives to believe that such advisors are trust- worthy and acting solely in the customer’s best interests.3 This trusting relationship creates an opportunity for exploitation by the advisor, which may form the basis for a variety of legal claims. Common fact patterns associated with broker misconduct include misrepresentation, churning, unsuitable recommendations, unauthorized trading, and failure to supervise. Outright misrepresentation and fraud may also be practiced on the unsuspecting and trusting client. Federal and state securities statutes and state common law typi-

12 Georgia Bar Journal cally govern civil liability in con- ates or would operate as a fraud inexcusable negligence, but an nection with losses arising from the or deceit upon any person, in extreme departure from the stan- purchase and sale of securities. The connection with the purchase or dards of ordinary care, and that self-regulatory rules of the sale of any security.6 present a danger of misleading National Association of Securities The essential elements of a Rule buyers or sellers which is either Dealers and the New York Stock 10b-5 claim are: (1) a misstatement known to the defendant or is so Exchange are also relevant to the or omission; (2) of a material fact; (3) obvious that the defendant must issue of whether a broker or finan- made with scienter, (4) upon which have been aware of it.”15 cial advisor owed or breached a the plaintiff relied; (5) that proxi- The plaintiff’s reliance must have duty to the customer. The follow- mately caused the plaintiff’s loss.7 been reasonable or justified.16 ing is a brief overview of common The standard for determining Relevant factors include: (1) the legal theories of liability that apply materiality is whether “there is a sophistication and expertise of the to broker misconduct.4 substantial likelihood that a reason- plaintiff in financial and security able shareholder would consider it matters; (2) the existence of long FRAUDULENT MIS- important” or “a substantial likeli- standing business or personal rela- REPRESENTATIONS hood that the disclosure of the omit- tionships between the plaintiff and ted fact would have been viewed by the defendant; (3) the plaintiff’s AND OMISSIONS the reasonable investor as having access to relevant information; (4) Material misrepresentations and significantly altered the ‘total mix’ the existence of a fiduciary relation- 8 omissions made in connection with of information made available.” ship owed by the defendant to the the purchase or sale of a security can “To constitute fraud, a misrepre- plaintiff, (5) concealment of fraud by violate federal and state securities sentation generally must relate to the defendant; (6) whether the plain- 9 statutes. Such claims may also pro- an existing or pre-existing fact.” A tiff initiated the stock transaction or ceed as common law fraud claims. misrepresentation of future profit sought to expedite the transaction; generally cannot constitute fraud, and (8) the generality or specificity Section 10(b) of the as it is a type of opinion and predic- of the misrepresentations.17 Securities Exchange Act tion of future events.10 “[O]utra- To prove the causation element, of 1934 and Rule 10b-5 geous generalized statements, not a plaintiff must prove both “trans- making specific claims, that are so action causation” and “loss causa- Section 10 of the Securities exaggerated as to preclude reliance tion.”18 Transaction causation is a Exchange Act of 1934,5 is an anti- by consumers” generally will be synonym for reliance, and is estab- fraud provision prohibiting the use deemed “puffing” rather than lished when the misrepresentations “in connection with the purchase fraud.11 Furthermore, the “in con- or omissions cause the plaintiff “to or sale of any security . . . any nection with” requirement in Rule engage in the transaction in ques- manipulative or deceptive device 10b-5 is not satisfied by any misrep- tion.”19 Loss causation is more dif- or contrivance.” Rule 10b-5 prom- resentations or omissions that occur ficult to prove: the misrepresenta- ulgated by the Securities Exchange after the claimant purchases or sells tion must have caused the loss suf- Commission amplifies these prohi- the security in question.12 fered by the claimant. Loss causa- bitions by making it unlawful: The Supreme Court has express- tion is satisfied “only if the misrep- (a) To employ any device, ly left open the question of whether resentation touches upon the rea- scheme, or artifice to defraud, the scienter requirement encom- sons for the investment’s decline in (b) To make any untrue state- passes not only intentional con- value.”20 Proof of loss causation is a ment of a material fact or to omit duct, but also reckless conduct.13 statutory requirement.21 to state a material fact necessary The rule in the 11th Circuit is that a in order to make the statements Section 12(2) of the showing of “severe recklessness” made, in the light of the circum- satisfies the scienter requirement.14 Securities Act of 1933 stances under which they were “Severe recklessness is limited to Section 12(2) of the Securities made, not misleading, or (c) To those highly unreasonable omis- Exchange Act of 1933 provides that engage in any act, practice, or sions or misrepresentations that any person who offers or sells a course of business which oper- involve not merely simple or even security by use of an oral or written

April 2004 13 communication that contains an ments made, in the light of the cir- municate. “The obligation to com- untrue statement of material fact or cumstances under which they are municate may arise from the confi- omits to state a material fact neces- made, not misleading.”25 Liability dential relations of the parties or sary in order to make the statement will not be found however, if “(1) from the particular circumstances not misleading is liable to the pur- [t]he purchaser knew of the untrue of the case.”32 Under Georgia law, chaser, unless the seller can show statement of a material fact or omis- “a confidential relationship impos- that he did not know and in the sion of a statement of a material fact; es a greater duty on the parties to exercise of reasonable care could or (2) [t]he seller did not know and reveal what should be revealed, not have known of the untruth or in the exercise of reasonable care and a lessened duty to discover omission.22 Scienter is not an ele- could not have known of the untrue independently what could have ment of a Section 12(2) claim. statement or misleading omission.”26 been discovered through the exer- Although the scope of liability The remedies provided under the cise of ordinary care.”33 under Section 12(2) is potentially Georgia Act are available only to a Not all representations by a bro- broad, its reach for broker miscon- buyer of securities.27 Because there ker are actionable by an investor. duct nonetheless is limited by four is very little case law construing the For example, an investor is not jus- factors. First, the claimant is limited Georgia Securities Act, the courts tified in relying upon representa- to rescission or rescessionary dam- often look to analogous federal tions consisting of mere expres- ages (the purchase price of the secu- statutes for interpretive assistance. sions of opinion, hope, expectation rity, plus interest, less income For example, although the language and puffing.34 Thus, speculations received thereon) and must tender of the Georgia statute does not or puffing as to future performance the security back to the seller. If the appear to require scienter, courts and statements that a particular claimant no longer owns the securi- have construed the section in accor- security is a “safe investment” are ty, he may seek damages represent- dance with Rule 10b-5 as requiring generally not actionable.35 ing the difference in the purchase proof of scienter.28 One of the price and the sale price. Second, only advantages of a claimant proceeding CHURNING purchasers may assert claims under under the Georgia Act, however, is “Churning occurs when a securi- Section 12(2), and they may assert provision for recovery of attorney’s ties broker buys and sells securities 29 them only against sellers and per- fees, interest, and court costs. for a customer’s account, without sons who control them. A “seller” is Common Law Fraud regard to the customer’s investment one who either transfers title to the interests, for the purpose of generat- Under Georgia law, fraud is security or who solicits the sale and ing commissions.”36 Churning is a shown when (i) a representation of receives a benefit from doing so or violation of Section 10(b) of the material fact is made (or there is a acts with the intent to benefit the Securities Exchange Act of 1934 and 23 failure to disclose a material fact); owner of the security. Third, the Rule 10b-5 promulgated thereun- (ii) that was known or should have statute of limitations is a substantive der.37 Similarly, Georgia’s “Blue been known to be false (or should element of the claim and compliance Sky” regulation promulgated under have been disclosed); (iii) that was must be affirmatively pled. Fourth, the Georgia Securities Act authoriz- made (or omitted) for the purpose Section 12(2) applies only to initial es the Georgia Commissioner of of being relied upon by another; public offerings by means of a for- Securities to take action against bro- (iv) that was in fact relied upon; (v) mal offering document (not private kers who “induc[e] trading in a cus- that caused damage.30 Under placements or secondary market tomer’s account which is excessive 24 Georgia law, a “promise to perform transactions). in size or frequency in view of the some future act is not fraud unless Georgia Securities Act financial resources and character of made with the present intent not to the account.”38 Violation of this rule The Georgia Securities Act pro- perform or with a present knowl- is an “unlawful practice” under the vides a cause of action against a sell- edge that the future event will not Georgia Securities Act39 and may er of securities for making “an untrue take place.”31 allow the buyer to invoke a statuto- statement of a material fact or Nondisclosure may provide the ry rescessionary remedy in a civil omit[ing] to state a material fact nec- basis for constructive fraud where a action against the seller.40 essary in order to make the state- party is under an obligation to com-

14 Georgia Bar Journal Proving a and faith in a broker and routinely The account maintenance cost, Churning Claim follows the advice of his broker. also known as “equity mainte- Whether a broker has acquired con- nance factor” or the “cost-equity The essence of a churning claim trol over the account is a fact-based ratio,” is a computation of the rate is that the broker has used his con- inquiry. The factors used in evaluat- of return the client must earn on trol over an account to generate ing control include: 1) the age, edu- the account to pay the commissions excessive commissions, “while at cation, intelligence, and investment and other trading fees (such as the same time leading his customer and business experience of the cus- margin interest) caused by churn- to believe that he is attempting to tomer; 2) the relationship between ing. For example, if an account fulfill the customer’s investment the customer and the account exec- with average annual equity of objectives.”41 Churning requires utive; 3) the customer’s knowledge $100,000 generates $25,000 in fees proof of three elements: (1) control of the market and the account; 4) the and commissions in a year, the over the account by the broker; (2) regularity of discussions between investor would have to earn a 25 trading in the account that is exces- the account executive and the cus- percent annualized return just to sive in light of the customer’s tomer; 5) whether the customer break even. A high account mainte- investment objectives; and (3) the actually authorized each trade; and nance cost indicates that the broker’s intent to defraud or his 6) who made the recommendations account has been excessively trad- willful or reckless disregard of the for trades.45 ed not for the client’s benefit, but customer’s interest.42 49 Excessive Activity for the benefit of the broker. Control of Churning may also be suggested Courts examine various factors to Account by Broker by an analysis of the period of time determine whether there is exces- a security is held from the date of The broker’s control may be sive activity indicative of churning, purchase to the date of sale. Very shown either by (i) the customer’s including the rate of turnover in the short holding periods, with the sale express grant of discretionary trad- customer’s account, account main- ing authority over the account, or (ii) tenance costs, the holding periods the broker’s acquiring de facto con- for the securities in the customer’s trol over the account by, for exam- account, and the significance of the ple, gaining the customer’s confi- fees generated to the broker. dence and inducing the customer to The turnover ratio is a statistical engage in excessive trading. measure of how many times in a given period the securities in a cus- Express grant tomer’s account have been of discretionary power replaced by new securities recom- In a discretionary account, the mended by the broker. “Excessive customer gives the broker discre- trading is generally held to exist tion as to the purchase and sale of when there is an annual turnover securities, including selection, tim- rate in an account in excess of ing and price to be paid or six.”46 The turnover ratio is the received. Any formal grant of dis- cost of all purchases for the rele- cretionary control given to a bro- vant period divided by the average ker must be in writing.43 A broker monthly account value for that or his representative who exercises period. Whether a particular discretionary authority over an turnover rate is excessive depends account owes his client “the high- on the investment objectives of the est obligation of good faith and customer. In long term accounts, a fair dealing.”44 lower turnover rate may be 47 De facto control deemed excessive. In trading A broker may exercise de facto accounts, a higher turnover rate is 48 control if an investor places his trust expected.

April 2004 15 proceeds immediately reinvested Unsuitable recommendations or breach of fiduciary duty. Under in other securities, may be indica- may also give rise to state law caus- Georgia law, a confidential, fiduci- tive of churning activity.50 If a sin- es of action under theories of breach ary relationship exists between a gle customer’s account provides a of contract, breach of fiduciary broker and his client.64 significant portion of the commis- duty, and negligence. The Georgia A broker’s violation of his regu- sions earned by a broker or the Blue Sky Regulations prohibit a latory duties, while generally rec- branch office in which that account broker from recommending a secu- ognized to not give rise to a private is located, this may be additional rity transaction “without reason- right of action, may provide evi- evidence of churning.51 able grounds to believe that such dence in evaluating whether the transaction or recommendation is broker properly exercised the UNSUITABLE suitable for the customer based required degree of care in his deal- RECOMMENDATIONS upon reasonable inquiry concern- ings with a customer.65 Securities ing the customer’s investment statutes and conduct rules also Unsuitable recommendations objectives, financial situation and require broker/dealer to reason- can encompass a variety of factual needs, and any other relevant infor- ably supervise their brokers “with circumstances, including over mation known by the [broker].”58 a view to preventing violations [of concentration or failure to diversi- Violation of the rule is a violation of the securities law].”66 52 53 fy, use of excessive margin, the Georgia Securities Act.59 A number of courts have held 54 failure to use hedge strategies, that a violation of regulatory rules and mutual fund or annuity UNAUTHORIZED may be the basis of a claim sound- 55 switching. NASD Conduct ing in negligence.67 Rules allow a broker to recom- TRADING mend a securities transaction only A broker is prohibited from exe- SELLING AWAY if the broker has “reasonable cuting a trade in an account unless “Selling Away” describes instances grounds for believing that the rec- the client has approved and author- where a broker sells securities outside ommendation is suitable for such ized the trade, before the trade has of the firm with which he or she is customer” based on “the facts, if been made, either by written discre- associated.68 NASD Conduct Rules any, disclosed by such customer tionary authority given to the bro- 3030 and 3040 prohibit, respectively, as to his other security holdings ker (such as a Power of Attorney), unapproved outside business activi- and as to his financial situation or by oral “time and place” discre- ties and private securities transac- and needs.”56 tion granted to the broker.60 tions. The ability of a broker to engage To prove a Rule 10b-5 cause of Unauthorized trading occurs when in “selling away” may be indicative of action for unsuitability, the plain- a broker effects trades in a client’s the brokerage firm’s failure to ade- tiff must show (1) that the securi- account without having either writ- quately supervise its brokers. ties purchased were unsuited to ten or oral authority to do so.61 Securities firms have been held customer’s needs; (2) that the bro- Generally, the courts have con- liable for the activities of their broker knew or reasonably believed cluded that unauthorized trading, kers in selling away under the “con- the securities were unsuited to by itself, does not constitute a viola- trol person” liability imposed by the customer’s needs; (3) that the tion of Rule 10b-5.62 However, Section 20 of the Securities and broker recommended or pur- unauthorized trading may be suffi- Exchange Act.69 The fact that the chased the unsuitable securities cient to maintain state law claims of firm had “potential control” over for the customer anyway; (4) that, breach of contract, breach of fiduci- the conduct giving rise to the viola- with scienter, the broker made ary duty, and negligence. Georgia’s tion is generally sufficient to impose material misrepresentations (or, Blue Sky Regulations also prohibit liability.70 Additionally, respondeat owing a duty to the customer, unauthorized trading.63 superior provides a basis for recov- failed to disclose material infor- ery in such circumstances, since the mation) relating to the suitability STATE COMMON broker conducted the transactions of the securities; and (5) that the LAW CLAIMS in the apparent ordinary course of customer justifiably relied to its business of that broker.71 detriment on the broker’s fraudu- Claims may also be brought lent conduct.”57 against brokers based on negligence 16 Georgia Bar Journal VIOLATION the contract with the customer.74 ker/dealer has “some indirect Therefore, violations of industry means of discipline or influence” OF MARGIN rules and regulations by the bro- over them.77 REGULATIONS ker/dealer or registered represen- The Georgia Securities Act also tative may give rise to a breach of provides for liability of “control 72 Rule 10b-16 provides that it is contract claim if damage results. persons,” subject to a “good faith unlawful for a broker to extend Additionally, there is implied in all defense.”78 Liability under the credit to a customer in connection contracts the duty of good faith statute is predicated on control of with any securities transaction and fair dealing.75 the agent, and habit and course of unless the broker has established a dealing may be considered in procedure to assure that the cus- CONTROL determining control.79 Further, a tomer received, at the time he PERSON LIABILITY controlling person may be deemed opens his account, a written disclo- to have ratified the unauthorized sure regarding interest and other Under Section 20(a) of the act when facts put him on notice of charges. There is a division of Securities and Exchange Act, any the act and he takes no steps to opinion on whether there is an person who directly or indirectly further investigate or return pro- implied private right of action controls any person who is liable ceeds from the act.80 A controlling 73 under Rule 10b-16. for selling securities in violation of person may escape liability by the Act is liable to the same extent showing that “he did not take an BREACH OF as the seller, unless he acted in active part in the violation, that he CONTRACT good faith and did not directly or did not know of the violation and indirectly induce the conduct at that as a reasonably prudent man Most customer agreements and issue.76 A broker/dealer may be he would not have discovered the trade confirmations incorporate liable as a “controlling person” for violation.”81 industry rules and regulations into the acts of its brokers if the bro-

April 2004 17 RESPONDEAT and, where appropriate, punitive Robert C. Port is a part- damages. Such person shall also ner with Hassett Cohen SUPERIOR/AGENCY recover attorneys’ fees . . . and costs Goldstein Port & PRINCIPLES of investigation and litigation rea- Gottlieb, LLP, in Atlanta, sonably incurred.“89 where he practices com- Under common law agency prin- mercial litigation. He is a ciples, the principal (the FAIR BUSINESS member of the board of directors of broker/dealer) is liable for the torts the Sole Practitioner/Small Firm of its agents (its registered represen- PRACTICES ACT Section of the Atlanta Bar, and an arbitrator with the National tatives) done within the scope of the The Fair Business Practices Act, Association of Securities Dealers. He principal’s business.82 Under this O.C.G.A. § 10-1-390 et seq. has been received his J.D., with honors, from theory, broker/dealers typically are found not to apply to securities or the University of North Carolina in held responsible for a representa- commodities transactions. In con- 1983. tive’s unintentional acts in handling sidering the question, the court con- a customer account as well as some cluded that “where a consumer Endnotes intentional actions taken within the remedy exists, with no need to fill in 1. A 2003 study by the Internal scope of handling the account, such a legal gap or create a consumer Revenue Service concluded that at the end of 2002, $2.3 trillion was as churning and placing unautho- right, and where the industry which invested in IRA assets, compared rized trades. Georgia law has codi- is the subject matter of the situation to $637 billion invested at the end fied a number of duties of the agent explicitly defines wrongful conduct of 1990. For the year ending in to his principal, including: (1) the or unfair and deceptive practices, 2002, 46 percent of those IRA 90 assets were in mutual funds, 34 duty to exercise ordinary care, skill the FBPA has no application.” percent were in securities held in and diligence respecting the business brokerage accounts, 11 percent of his principal;83 (2) the duty to fol- CONCLUSION were held in bank deposits, and low his principal’s instructions;84 (3) the remaining 9 percent were held Bank robber Willie Sutton is pur- in annuities at life insurance com- the duty not to sell to or purchase ported to have said that he robbed panies. Peter Sailer & Kurt Gurka, from his principal for his own banks “because that’s where the Internal Revenue Service, account without first disclosing all of Accumulation and Distributions of money is.” The many trillions of Retirement Assets, 1996-2000-Results the facts;85 (4) the duty to account to dollars invested annually in stocks, from a Matched File of Tax Returns his principal for all profit he makes mutual funds, money market and Information Returns, available at 86 http://www.irs.gov/pub/irs- from his principal’s property. accounts, and other investment soi/03pete.pdf (2003). RICO vehicles provides numerous 2. Federal Reserve Chairman Alan opportunities for unscrupulous Greenspan, The Challenge of Central As a result of the Private stockbrokers and other financial Banking in a Democratic Society, Address at the American Securities Litigation Reform Act of advisors to devise schemes to part Enterprise Institute for Public 1995, conduct which could have investors from their hard earned Policy Research Annual Dinner been pursued under the federal money. A variety of legal claims and Francis Boyer Lecture securities laws cannot now be used can flow from negligent, reckless, (December 5, 1996) available at http://www.federalreserve.gov/b 87 as predicate acts for federal RICO. or fraudulent acts of financial advi- oarddocs/speech- The Georgia RICO statute, on the sors who have caused their cus- es/1996/19961205.htm. other hand, specifically provides tomers harm. Familiarity with 3. Donald C. Langevoort, Selling Hope, Selling Risk: Some Lessons for that “racketeering activity” includes these various legal theories of Law from Behavioral Economics committing, attempting to commit, recovery can provide counsel with About Stockbrokers and Sophisticated soliciting, coercing, or intimidating the means and opportunity to Customers, 84 CAL. L. REV. 627 another person to commit a willful recover losses a client has experi- (1996). 4. Since the Supreme Court’s 1987 violation of the Georgia Securities enced not because of the natural decision in Shearson/American Act of 1973, O.C.G.A. § 10-5-24.88 fluctuations of the marketplace, but Express Inc. v. McMahon, 482 U.S. Under Georgia’s RICO Act, the because of the unscrupulous or 220 (1987), the overwhelming claimant is entitled to recover “three unlawful conduct of a stockbroker majority of disputes between indi- vidual investors and their stock- times the actual damages sustained or financial advisor.

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Lawyers Direct is underwritten by Professionals Direct Insurance Company, a licensed and admitted carrier rated A- (Excellent) by A.M. Best. brokers have been resolved by 1983); Troyer v. Karcagi, 476 F. (providing a statutory basis for compulsory arbitration under the Supp. 1142, 1148 (S.D.N.Y. 1979). fraud claims). auspices of the NASD, NYSE, 13. Ernst & Ernst v. Hochfelder, 425 34. GCA Strategic Inv. Fund, Ltd. v. AMEX, or other self-regulatory U.S. 185, 193 n.12, (1976). Joseph Charles & Assocs., 245 Ga. organizations. The decisions 14. McDonald v. Alan Bush Brokerage App. 460, 464, 537 S.E. 2d 677, 682 reached by arbitration panels, Co., 863 F.2d 809, 814 (11th Cir. (2000). though publicly available, do not 1989). 35. Bogle v. Bragg, 248 Ga. App. 632, generally give a written rationale 15. Broad v. Rockwell International 637, 548 S.E.2d 396, 401 (2001) (not- for the decision, and are deemed Corp., 642 F.2d 929, 961 (5th Cir. ing that the statements were made final and not subject to appeal or 1981) (en banc). by an attorney who owed no duty judicial review except in very lim- 16. Bruschi v. Brown, 876 F.2d 1526 to the investor). ited circumstances. See, e.g., 9 (11th Cir. 1989). 36. Thompson v. Smith Barney, Harris U.S.C. § 10 (setting forth grounds 17. Id. at 1529. Upham & Co., 709 F.2d 1413, 1416 vacating an arbitration award); 18. Robbins v. Koger Props., 116 F.3d (11th Cir. 1983); see also McNeal v. O.C.G.A. § 9-9-13 (Supp. 2003) 1441 (11th Cir. 1997). Paine, Webber, Jackson & Curtis, (same). Nor do such arbitration 19. Id. (quoting Currie v. Cayman Inc., 598 F.2d 888, 890 n.1 (5th awards have the precedential Resources Corp., 835 F.2d 780, 785 Cir.1979. value of a court decision. See, e.g., (11th Cir.1988)). 37. See Hecht v. Harris, Upham & Co., El Dorado Technical Services, Inc. 20. Huddleston v. Herman & 430 F.2d 1202, 1206-1207 (9th Cir. v. Union General de Trabajadores MacLean, 640 F.2d 534, 549 (5th 1970); Armstrong v. McAlpin, 699 de Puerto Rico, 961 F.2d 317, 321 Cir. 1981), aff’d in part, rev’d in part F.2d 79 (2d Cir. 1983). (1st Cir. 1992). As a result, the on other grounds, 459 U.S. 375 38. GA. COMP. R. & REGS. r. 590-4-2- development of the law in this (1983); see also Currie v. Cayman .14(1)(a)(2). area has been stagnant, since it is Resources, 835 F.2d 780, 785 (11th 39. O.C.G.A. § 10-5-12(a)(1) (2000) not subject to the continued refine- Cir. 1988); Rousseff v. E.F. Hutton, (providing that it is “unlawful for ment, analysis, and appellate 843 F.2d 1326, 1329 (11th Cir. any person . . . [t]o offer to sell or review that would otherwise have 1988). to sell any security in violation of . occurred in litigated claims. 21. 15 U.S.C. § 78u4(b) (2000). . . any rule [or] regulation . . . 5. 15 U.S.C. § 78j(b) (2000). 22. 15 U.S.C. § 77l (2000). promulgated or issued by the 6. 17 C.F.R. § 240.10b-5 (2000). 23. See Pinter v. Dahl, 486 U.S. 622 [Georgia Commissioner of 7. See Gochnauer v. A.G. Edwards & (1988); Ryder International Corp. Securities].” ). Sons, Inc., 810 F.2d 1042, 1046 v. First American Nat’l Bank, 943 40. O.C.G.A. § 10-5-14(a) provides that (11th Cir. 1987); McDonald v. Alan F.2d 1521 (11th Cir. 1991). “[a]ny person [committing an Bush Brokerage Co., 863 F.2d 809 24. Gustafson v. Alloyd Co. Inc., 513 unlawful practice under O.C.G.A. (11th Cir. 1989). U.S. 561 (1995). § 10-5-12(a)] shall be liable to the 8. TCS Industries, Inc. v. Northway, 25. O.C.G.A. §§ 10-5-12(a) (2000); 10-5- person buying such security.” Inc., 426 U.S. 438, 449 (1976); see 14(a) (2000). 41. Manela v. Garantia Banking, Ltd., also SEC v. Carriba Air, Inc., 681 26. O.C.G.A. § 10-5-14(a) (2000). 5 F. Supp. 2d 165, 173 (S.D.N.Y. F.2d 1318, 1323 (11th Cir. 1982) 27. Kirk v. First Nat’l Bank, 439 F. 1998). (“The test for determining materi- Supp. 1141, 1145 n.1 (N.D. Ga. 42. See, e.g., Arceneaux v. Merrill ality is whether a reasonable man 1977); Collins v. Norton, 136 Ga. Lynch, Pierce, Fenner & Smith, would attach importance to the App. 105, 220 S.E.2d 279 (1975). Inc., 767 F.2d 1498, 1501 (11th Cir. fact misrepresented or omitted in 28. Currie v. Cayman Resources Corp, 1985). determining his course of action.”). 595 F. Supp. 1364 (N.D. Ga. 1984), 43. NASD Conduct Rule 2510(b), 9. Miller v. Premier Corp., 608 F.2d aff’d in part, rev’d on other grounds, NASD Sec. Dealers Man. (CCH) 973, 981 (4th Cir. 1979). 835 F.2d 780 (11th Cir. 1988); GCA R.2510 (2002); NYSE Rule 408(a), 2 10. Id.; see also Bogle v. Bragg, 248 Ga. Strategic Inv. Fund, Ltd. v. Joseph N.Y.S.E. Guide (CCH) P2408 App. 632, 637, 548 S.E.2d 396, 401 Charles & Assocs., 245 Ga. App. (1996). A broker may also be given (2001) (finding a statement that 460, 464, 537 S.E.2d 677, 682 (2000). oral “time and price” discretion to security was “a safe investment” to 29. O.C.G.A. § 10-5-14(a) (2000). sell a specified quantity of securi- be an opinion, not actionable 30. See, e.g., Fuller v. Perry, 223 Ga. ties. NASD Conduct Rule fraud). App. 129, 131, 476 S.E.2d 793, 795 2510(d)(1); NYSE 408(d). Unless 11. Cook, Perkiss & Liehe, Inc. v. (1996); Oklejas v. Williams, 165 Ga. provided otherwise in writing, Northern California Collection App. 585, 586, 302 S.E.2d 110, 111 such “time and price discretion” is Service Inc., 911 F.2d 242, 246 (9th (1983). generally understood to be limited Cir. 1990) (quoting Metro Mobile 31. Simpson Consulting v. Barclays to the day it is granted. See, e.g., CTS, Inc. v. NewVector Bank PLC, 227 Ga. App. 648, 651, Hanford v. Marion Bass Securities Communications, Inc., 643 F. Supp. 490 S.E.2d 184, 188 (1997). Corp., NASD No. 98-01422 1289, 1292 (D. Ariz. 1986), rev’d 32. O.C.G.A. § 23-2-53 (1982). (August 12, 1999). without opinion, 803 F.2d 724 (9th 33. Hunter, Maclean, Exley & Dunn, 44. Pierce v. Richard Ellis & Co., 310 Cir. 1986)). P.C. v. Frame, 269 Ga. 844, 848, 507 N.Y.S.2d 266, 268 (N.Y. Civ. Ct. 12. See Shamrock Assocs. v. Moraga S.E.2d 411, 414 (1998); see generally 1970). Corp., 557 F.Supp. 198, 203 (D. Del. O.C.G.A. § 23-2-51 to § 23-5-55 45. M&B Contracting Corp. v. Dale,

20 Georgia Bar Journal 601 F. Supp. 1106,1111 (E.D. Mich. sions earned by the broker on which the position can be sold 1984), aff’d, 795 F.2d 531 (6th Cir. plaintiff’s account exceeded the during a specific period of time. 1986); accord Leib v. Merrill, Lynch, commissions earned on all but 11- Another strategy is to create an Pierce, Fenner & Smith, Inc., 461 F. 14 of the other 8,000-9,000 accounts “equity collar” using both put and Supp. 951, 954-55 (E.D. Mich. in that office and amounted to 39 call options, which establishes both 1978), aff’d, 647 F.2d 165 (6th Cir. percent of all security commissions a floor on the stock’s value, and a 1981); Nunes v. Merrill Lynch, generated by the broker). cap on future price appreciation. Pierce, Fenner & Smith, Inc., 635 F. 52. See, e.g., Robertson v. Central 55. A broker looking to improperly Supp. 1391, 1393-94 (D. Md. 1986). Jersey Bank & Trust Co., 47 F.3d increase his commission may rec- 46. Moran v. Kidder Peabody & Co., 1268, 1275 n.4 (3rd Cir. 1995). ommend that his customer sell a 609 F. Supp. 661, 666 (S.D.N.Y. (“Diversification is a uniformly mutual fund he owns, and pur- 1985), aff’d, 788 F.2d 3 (2d Cir. recognized characteristic of pru- chase a fund offered by a different 1986); see also Freundt-Alberti v. dent investment and, in the mutual fund company. Switching Merrill Lynch, Pierce, Fenner & absence of specific authorization to can generate significant commis- Smith, Inc., 134 F.3d 1031 (11th Cir. do otherwise, a trustee’s lack of sions and sales charges benefiting 1998). diversification would constitute a the broker. Many funds impose a 47. See, e.g., In re Thomson McKinnon breach of its fiduciary obliga- surrender charge, typically one Securities, Inc., 191 B.R. 976, 983- tions.”). Commentators agree that percent, if the fund was not held 84(Bankr. S.D.N.Y. 1996) (finding it takes at least ten, and usually fif- for a minimum period (usually six that a turnover rate of 2.22 creates teen to twenty, non-correlated months or one year). Every switch a question of fact for a jury to securities to achieve adequate is a sale and purchase of securities, decide if activity was excessive). diversification and thereby reduce so it must pass suitability require- 48. See, e.g., Thompson v. Smith nonsystematic risk. See EDWIN J. ments. Switching may not place Barney, Harris Upham & Co., 539 ELTON & MARTIN J. GRUBER, the investor in a better mutual F. Supp. 859 (N.D. Ga. 1982), aff’d, MODERN PORTFOLIO THEORY AND fund, and may in fact place the 709 F.2d 1413 (11th Cir. 1983) INVESTMENT ANALYSIS 31 (3d ed. investor in a lesser known, lower- (Plaintiff who was aware that his 1987). “Diversification does reduce quality fund. options account was being con- risk, and the reduction can be 56. NASD Conduct Rule 2310(a), stantly traded, who had financial greater, the wider the range of pos- NASD Sec. Dealers Man. (CCH) R. acumen to determine his own best sible investments.” WILLIAM F. 2310 (2002). interests, and who desired fre- SHARPE, INVESTMENTS 115 (1978). 57. Brown v. E.F. Hutton Group, Inc., quent trading could not establish 53. In re Laurie Jones Canady, 991 F.2d 1020, 1031 (2d Cir. 1993). excessive trading.) Securities Exchange Act Rel. No. 58. GA. COMP. R. & REGS. r. 590-4-2- 49. See, e.g., Cmty. Hosp. of 41250, 1999 SEC LEXIS 669, *30 .14(1)(a)(3). Springfield & Clark County, Inc. v. n.27 (Securities Exchange 59. O.C.G.A. § 10-5-12(a)(1). Kidder, 81 F. Supp. 2d 863 (S.D. Commission Apr. 5, 1999) 60. See, e.g., NYSE Rule 408, 2 N.Y.S.E. Ohio 1999). (“Trading on margin increases the Guide (CCH) P 2408 (1996); NASD 50. See, e.g., Hecht v. Harris, Upham & risk of loss to a customer for two Conduct Rule 2510, NASD Sec. Co., 283 F. Supp. 417, 435-36 (N.D. reasons. First, the customer is at Dealers Man. (CCH) R.2510 (2002); Cal. 1968), modified on other risk to lose more than the amount Glisson v. Freeman, 243 Ga. App. grounds, 430 F.2d 1202 (9th Cir. invested if the value of the security 92, 99 532 S.E.2d 442, 449 (2000); 1970); Mihara v. Dean Witter & depreciates sufficiently, giving rise Gochnauer v. A.G. Edwards & Co., 619 F.2d 814, 819 (9th Cir. to a margin call in the account. Sons, Inc. 810 F.2d 1042, 1049 (11th 1980) (finding that excessive trad- Second, the client is required to Cir. 1987). ing was established where, among pay interest on the margin loan, 61. NYSE Rule 408(a); see also NASD other facts, fifty percent of the adding to the investor’s cost of Conduct Rule 2510, NASD Sec. securities were held for less than maintaining the account and Dealers Man. (CCH) R. 2510 fifteen days). increasing the amount by which (2002). 51. See, e.g., Smith v. Petrou, 705 F. his investment must appreciate 62. Brophy v. Redivo, 725 F.2d 1218, Supp. 183 (S.D.N.Y. 1989) (noting before the customer realizes a net 1220 (9th Cir. 1984); Kayne v. that commissions generated in the gain. At the same time, using mar- PaineWebber, Inc., 703 F. Supp. customer’s account represented a gin permit[s] the customers to pur- 1334, 1340 (N.D. Ill. 1989); Baker v. substantial portion of the broker’s chase greater amounts of securi- Wheat First Securities, 643 F. Supp. income); Stevens v. Abbott, Proctor ties, thereby generating increased 1420, 1432 (S.D.W.V. 1986); & Paine, 288 F. Supp. 836 (E.D.Va. commissions for [the salesper- Bischoff v. G. K. Scott & Co., Inc., 1968) (finding that the registered son].”) 687 F. Supp. 746, 750 (E.D.N.Y. representative derived 40 percent 54. For example, an advisor represent- 1986). of his income from commissions ing a client with a concentrated 63. GA. COMP. R. & REGS. r. 590-4-2- from customer’s account); Hecht v. position in one security may rec- .14(1)(a)(4). Harris, Upham & Co., 283 F. Supp. ommend the purchase of a put 64. See, e.g., E. F. Hutton & Co. v. 417 (N.D. Cal. 1968), modified on option to protect against a continu- Weeks, 166 Ga. App. 443, 445, 304 other grounds, 430 F.2d 1202 (9th ing decline in value. The put S.E.2d 420, 422 (1982) (“[T]he bro- Cir. 1970) (noting that commis- option fixes the minimum price at ker’s duty to account to its cus-

April 2004 21 tomer is fiduciary in nature, result- dence of negligence.”); Lang v. H. provides: APPLICABLE LAW, ing in an obligation to exercise the Hentz & Co., 418 F. Supp. 1376, RULES AND REGULATIONS. All utmost goodfaith.”); Minor v. E.F. 138384 (N.D. Tex. 1976) (NASD transactions shall be subject to the Hutton & Co., 200 Ga. App. 645, Rules provide evidence of the stan- applicable laws, rules and regulations 409 S.E.2d 262 (1991). The dard of care that a member should of all federal state and self-regulatory Securities & Exchange Commission receive.); see also O.C.G.A. § 51-1-6 authorities, including, but not limited (“SEC”) also concludes that the (2000) (“When the law requires a to, the rules and regulations of the common law of agency, coupled person to perform an act for the Board of Governors of the Federal with the rules of the self-regulato- benefit of another or to refrain Reserve System and the constitution, ry agencies such as the NASD and from doing an act which may rules and customs of the exchange or the NYSE, also give rise to a fidu- injure another, although no cause market (and clearing house) where ciary duty owed by brokers. See, of action is given in express terms, such transactions are executed. In re E.F. Hutton & Co., Exchange the injured party may recover for 75. O.C.G.A. § 11-1-203 (2002); Jackson Act Release No. 25,887 [1988-89 the breach of such legal duty if he Electric Membership Corp. v. Transfer Binder] Fed. Sec. L. Rep. suffers damage thereby.”); Georgia Power Co., 257 Ga. 772, (CCH) § 84,303 (July 6, 1988); O.C.G.A. § 51-1-8 (2000) (“Private 364 S.E.2d 556 (1988); see also accord, Restatement (Second) of duties may arise from statute or Restatement (Second) of Contracts Agency § 425 (agents who are from relations created by contract, § 205 (“Every contract imposes employed to make, manage, or express or implied. The violation upon each party a duty of good advise on investments have fiduci- of a private duty, accompanied by faith and fair dealing in its per- ary obligations). damage, shall give a right of formance and its enforcement.”). 65. See, e.g., Allen v. Lefkoff, Duncan, action.”). But see Lake Tightsqueeze, Inc. v. Grimes & Dermer P.C., 265 Ga. 374, 68. See, e.g., Martin v. Shearson Chrysler First Fin. Servs. Corp., 453 S.E.2d 719 (1995) (finding that Lehman Hutton, Inc., 986 F.2d 242 210 Ga. App. 178, 435 S.E.2d 486 the violation of a Bar Rule is not (8th Cir. 1993). (1993) (“[T]he failure to act in good determinative of the standard of 69. 15 U.S.C. § 78t(a) (2000). faith in the performance of con- care applicable in a legal malprac- 70. See, e.g., Martin v. Shearson tracts or duties under the Uniform tice action, but it may be a circum- Lehman Hutton, Inc., 986 F.2d 242, Commercial Code does not state stance that can be considered, along 244 (8th Cir. 1993); Harrison v. an independent claim for which with other facts and circumstances, Dean Witter Reynolds, Inc., 79 F.3d relief may be granted.”). in determining negligence). 609, 614 (7th Cir. 1996). 76. 15 U.S.C. § 78t(a) (2000). 66. Securities Exchange Act of 1934, 15 71. See, e.g., Hunt v. Miller, 908 F.2d 77. Harrison v. Dean Witter Reynolds, U.S.C. § 78o (b)(4)(E) (2000); See 1210 (4th Cir. 1990). Inc., 79 F.3d 609, 614 (7th Cir. also NASD Conduct Rule 72. 17 CFR 240.10b-16 (promulgated 1996); see also Hollinger v. Titan 3010(b)(1), NASD Sec. Dealers under the Securities Exchange Act Capital Corp., 914 F.2d 1564 (9th Man. (CCH) R. 3010 (2002); NYSE of 1934). Cir. 1990) (en banc) (finding con- Rule 405(2), 2 N.Y.S.E. Guide 73. See, e.g., Greenblatt v. Drexel trol where the primary violator (CCH) P 2405 (1996); GA. COMP. R. Burnham Lambert, Inc., 763 F.2d was a registered representative of & REGS. r. 590-4-2-.08(1). 1352, 1358 n.8 (11th Cir. 1985); the firm). 67. Quick & Reilly, Inc. v. Walker, Angelastro v. Prudential-Bache 78. O.C.G.A. § 10-5-14(c) (2000). 1991 U.S. App. LEXIS 5472, at *8 Securities, Inc., 764 F.2d 939, 950 79. DeBoard v. Schulhofer, 156 Ga. App. (9th Cir. 1991) (NASD “suitability” (3rd Cir. 1985); Robertson v. Dean 158, 159, 273 S.E.2d 907, 909 (1980). rules were relevant to “establish Witter Reynolds, Inc., 749 F.2d 530, 80. Id. the standard of care to which rea- 534-39 (9th Cir. 1984); Liang v. Dean 81. Gilbert v. Meason, 137 Ga. App. 1, sonable broker must adhere,” and Witter & Co., 540 F.2d 1107, 1113 n. 5, 222 S.E. 2d 835, 838 (1975); see the jury found broker negligent.); 25 (D.C. Cir. 1976). But see Bennett v. also Hamilton Bank & Trust Co. v. Miley v. Oppenheimer & Co., 637 United States Trust Co., 770 F.2d 308 Holliday, 469 F.Supp. 1229, 1244 F.2d 318, 333 (5th Cir. 1981) (2d Cir. 1985) (holding that no pri- (N.D. Ga. 1979). (Industry rules are “excellent tools vate right of action exists under 82. O.C.G.A. § 51-2-2 (2000). against which to assess in part the Securities Exchange Act of 1934, 83. O.C.G.A. § 10-6-22 (2000). reasonableness or excessiveness of Section 7, which controls the 84. O.C.G.A. § 10-6-21 (2000). a broker’s handling of an amount of money a brokerage firm 85. O.C.G.A. §10-6-24 (2000). investor’s account.”); Merrill may lend its customers); Walck v. 86. O.C.G.A. §§10-6-25 (2000); 10-6-30 Lynch, Pierce, Fenner & Smith, Inc. American Stock Exchange Inc., 687 (2000). v. Cheng, 697 F. Supp. 1224, 1227 F.2d 778 (3rd Cir. 1982) (holding that 87. 18 U.S.C. § 1964(c) (2000). (D.D.C. 1988) (finding that a viola- no private cause of action exists for 88. O.C.G.A. § 16-14-3(9)(A)(xxi) tion of a NASD rule provided evi- violations of Sections 6 and 7 of the (2003). See O.C.G.A. § 10-5-24(a) dence of broker’s negligence); 1934 Act.); Stern v. Merrill Lynch, (2000) (providing that a willful vio- Kirkland v. E.F. Hutton & Co., 564 Pierce, Fenner & Smith, Inc., 603 lation of the Act is a felony). F. Supp. 427 (E.D. Mich. 1983); F.2d 1073 (4th Cir. 1979) (holding 89. O.C.G.A. § 16-14-6(c) (2003) Piper, Jaffray & Hopwood, Inc. v. that no private right of action exists (emphasis added). Ladin, 399 F. Supp. 292, 299 (S.D. for violations of Regulation T). 90. Taylor v. Bear Stearns & Co., 572 F. Iowa 1975) (NYSE and NASD suit- 74. For example, the Customer Supp. 667, 675 (N.D. Ga. 1983). ability rules “are admissible as evi- Agreement of a major brokerage firm

22 Georgia Bar Journal