Secondary Liability and “Selling Away” in Securities Cases

By Raymond W. Henney and Andrew J. Lievense

Introduction theories of secondary liability. Under Michi- Based on media accounts, there appears to be gan law, when an investment is truly “sold an increase in the number of Ponzi schemes away” from the brokerage firm, the firm po- and other fraudulent investments. The rise of tentially can be held liable pursuant to claims these nefarious ventures may be explained, of vicarious liability, apparent authority, neg- in part, by an investment public that is weary ligence couched as a failure to supervise, and of the volatility of traditional markets and is “control person” liability under the Michigan susceptible to projects promising safety, sta- Uniform Securities Act. Moreover, liability bility, and reliable investment return. may arise in more uncommon circumstances. Generally, for a registered securities For example, a brokerage firm can be liable brokerage firm to market investments for for the broker’s conduct even after the bro- purchase directly from the issuer, the firm ker leaves a firm. This article discusses each is obligated to conduct an investigation or of these theories and when, under Michigan due diligence of the investment opportuni- law, a brokerage firm can be liable for such 3 ties.1 Consequently, perpetrators of these claims. ruses typically seek to avoid this scrutiny and do not sell their projects as approved Vicarious Liability and Apparent investments through brokerage firms. These Authority schemes instead are sold directly by the issu- The initial question in “selling away” cases er to the investor and not through a market or is the scope of the securities brokerage firm’s an exchange. On other occasions, these coun- liability for the actions of its broker under terfeit schemes appear as corporations that theories of vicarious liability and apparent sell stock on the over-the-counter markets. authority. The brokerage firm, obviously, These stocks normally are priced extremely cannot be vicariously liable unless its broker low, are thinly traded, and are not approved is found to be primarily liable.4 The broker for solicited sale by brokerage firms. probably cannot be found primarily liable Nonetheless, individual securities brokers based solely on the fact that he or she vio- affiliated with a brokerage firm often will in- lated industry rules or the brokerage firm’s troduce their clients to such fraudulent in- policies prohibiting selling away activities.5 vestments even though the investment is not Consequently, an investor seeking to hold a through the brokerage firm with whom they brokerage firm liable must first establish that are associated. On those occasions, when the the broker is liable under some actionable investment is solicited and/or sold without claim, such as misrepresentation or malfea- the approval of, and not through, a securities sance.6 brokerage firm, the investment commonly is Further, the brokerage firm may not be known as being “sold away.” Various secu- vicariously liable for the selling away activi- rities industry rules prohibit brokers from ties of its broker where the firm was unaware “selling away” regardless of whether the bro- of the activity, and the broker acted outside ker receives any compensation for the trans- the scope of his or her association with the action.2 Moreover, brokerage firms virtually brokerage firm and for the broker’s own pur- always have their own policies that prohibit pose. For example, in Smith v Merrill Lynch “selling away” activities and procedures for Pierce Fenner & Smith,7 a customer brought a preventing the activity. claim under a theory of respondeat superior Brokerage firms, however, cannot simply against a brokerage firm for the employee rely on these rules and internal procedures stockbroker’s failure to repay a personal to avoid potential liability in the event their loan from the customer to the stockbroker. brokers violate the rules and “sell away.” The Michigan Court of Appeals held that Brokerage firms can be liable for the “selling the brokerage firm was not liable as a mat- away” actions of their brokers under certain ter of law where the stockbroker was “acting 49 50 THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010

to accomplish a purpose of his own” because piece of paper authorizing any unexplained the firm “could not be held vicariously liable transaction. for [the stockbroker’s] independent action.”8 Similarly, in Kohn v Optik, a non-Michigan Additionally, courts have recognized that vi- case,16 the court made it clear that “where the carious liability is inappropriate where the irregularity on the actions of the employee broker’s conduct violates industry rules and provide notice to the third party that the the brokerage firm’s own policies.9 Logically, employee is acting outside the scope of the in such circumstances, the broker could not employee’s employment, the employer is not be deemed to be acting on behalf of the bro- bound by the employee’s action as no ap- 17 kerage firm, so the brokerage firm could not parent authority exits.” In dismissing the be vicariously liable. investor’s agency law claim, the court noted Claimants frequently confuse vicarious that: liability with apparent authority by arguing it is uncontested that Plaintiff did that vicarious liability applies because the not open a regular account with [the broker was selling a security and the broker- brokerage firm], that Plaintiff did not age firm authorized the broker to sell securi- send her checks to the brokerage, and ties. But in typical situations, the brokerage that Plaintiff never received a single firm did not actually authorize the broker to receipt, statement, or other com- While sell the investment away from the firm, in- munication bearing [the brokerage firm’s] name. Thus, the irregularity Michigan stead the broker was acting beyond the scope of his or her authority, which negates a claim of the transaction at issue provided notice to Plaintiff that [the registered courts have of vicarious liability.10 representative] was acting outside Moreover, just because a brokerage firm clearly set the copy of his employment.18 authorizes the broker to sell securities does In Harrison I, the court delineated addi- forth the not mean the broker has the apparent au- tional factors important in analyzing a claim requirements thority to sell all securities, such as unap- under an apparent authority theory: to show proved securities. “[A]pparent authority must be traceable to the principal and cannot Here the undisputed facts show Har- rison did not open an account with apparent be established by the acts and conduct of the Dean Witter but, instead, transferred authority, agent.”11 Consequently, courts must analyze money to Kenning and Carpenter for the surrounding facts and circumstances of few Michigan them to place in Carpenter’s employ- the sale to determine if liability for apparent ee account at Dean Witter for subse- courts have authority may exist.12 Those facts and circum- quent investment. In so doing, Har- stances include the supervision activities of applied the rison expected to enhance his return the brokerage firm and the objective reason- requirements by paying the lower commission ableness of the investor’s belief that the sale in the charged Dean Witter employees, was through and approved by the brokerage although he was not an employee 13 securities firm. Thus, courts look to more than just the entitled to the benefit. It is clear nei- context. relationship between the brokerage firm and ther Kenning nor Carpenter had the the broker when considering claims under authority, actual or apparent, to use an “apparent authority” theory. Courts also the account thusly; Dean Witter’s look to the details of the transaction between rules expressly forbade it, as would 14 the claimant and the broker. ordinary prudence.19 While Michigan courts have clearly set The Harrison I court concluded that no “rea- forth the requirements to show apparent au- sonably prudent person” could conclude that thority, few Michigan courts have applied the employees had the authority because the the requirements in the securities context. In investment transactions “were not regular on one such case, Carsten v North Bridge Holdings, their face and could not appear to be within Inc,15 the investor did not know the broker the ordinary course of business.”20 had left the brokerage firm. The court found Thus, a claimant asserting a claim against that the broker was not acting with the ap- a brokerage firm for vicarious liability and parent authority of the brokerage firm in part apparent authority based on the actions of because the broker had left the firm, the bro- a broker must allege more than simply that ker was not authorized to sell unapproved there was an employment relationship be- securities, and the investor did not rely on tween the brokerage firm and the broker. The the brokerage firm when she signed a blank claimant must allege facts, and come forward SECONDARY LIABILITY AND “SELLING AWAY” IN SECURITIES CASES 51 with evidence, that the brokerage firm was that it will result in a significant increase in aware of, was involved in, or benefited from the cost to invest. the transactions at issue. Also, under the Michigan Uniform Secu- rities Act, a brokerage firm can be held liable Failure to Supervise and Control for the sale of unregistered securities by one Person Liability of its brokers, the sale of securities by a bro- Michigan courts recognize a claim against a ker who is not properly registered, or for the brokerage firm based on the firm’s supervi- misrepresentation of its broker, if the broker- sion, or failure to supervise, a broker. The age firm is a “control person.”26 A brokerage claim is couched either as a negligence claim firm typically, but not always, is considered for the failure to supervise21 or as a claim for a “control person” for a broker it licenses and “control person” liability under the Michigan supervises as it typically “directly or indirect- 27 Uniform Securities Act.22 ly controls” its brokers. The brokerage firm, Michigan courts recognize a failure to su- however, can avoid liability if it “sustains the pervise claim arising from a duty to supervise burden of proving that the controlling person based on the special relationship between an did not know, and in the exercise of reason- individual (such as an investor) and another able care could not have known, of the exis- entity or person (such as a brokerage firm).23 tence of the conduct by reason of which the 28 This duty comes from the securities regula- liability is alleged to exist.” In the brokerage Michigan firm context, the reasonable care or “good tions, such as NASD Rule 3010(a), which pro- courts vides that broker dealers “shall establish and faith” defense essentially concerns a broker- maintain a system to supervise the activities age firm’s “failure to supervise” a registered recognize of each registered representative, registered representative, and thus overlapping with 29 a failure to principal, and other associated person that the failure to supervise claim. Accordingly, is reasonably designed to achieve compliance a brokerage firm generally is not liable for supervise the underlying violation if it establishes that with applicable securities laws and regula- claim arising it maintained “a reasonable system of super- tions, and with applicable NASD Rules.”24 vision, enforced that system with reasonable from a duty Thus, a failure to supervise claim coinciden- diligence, and that the [brokerage firm] did tally embodies a similar standard for super- to supervise not directly or indirectly induce the viola- vision as the criterion set forth in the rules of tions by its [registered] representative.”30 based on the securities regulators. Courts consider many factors to determine the special In analyzing the duty imposed on bro- whether the good faith defense bars “control kerage firms, the standard is reasonable, not relationship person” liability, such as: to whom and where perfect, supervision. As stated by one regula- the investor sent checks, whether the invest- between an tory body: ment procedures were typical, and whether individual The standard of ‘reasonableness’ is the investment procedures were part of the (such as an determined based upon the circum- broker’s efforts to circumvent compliance stances of each case…. The burden is efforts by the brokerage firm.31 Courts also investor) and on the staff to show that respondent’s consider the rules and procedures in place to another entity procedures and conduct were not prevent the underlying violation, the broker- reasonable….It is not enough to dem- age firm’s implementation of those rules, and or person onstrate that an individual is less than a whether the brokerage firm had actual notice (such as a model supervisor or that the supervision or should have known of the underlying vio- 25 brokerage could have been better. lation—meaning whether “red flags” were From the regulators’ point of view, as well present and investigated.32 firm). as a court’s, a reasonableness standard is Again, the decision in Kohn33 is instruc- desirable for at least two reasons. First, the tive. In Kohn, the court ruled, as a matter of reasonableness standard provides flexibility law, that no “control person” liability existed in evaluating different circumstances and against the brokerage firm.34 In reaching that factual situations. Second, the required level conclusion, the Kohn court considered numer- of supervision must consider the cost to ous factors, such as: whether the fraudulent consumers for access to the capital markets. investments were even available through the Supervisory costs necessarily are reflected in brokerage firm; whether the broker disclosed brokerage firms’ commissions and fees. Per- his affiliation with the brokerage firm to the fect or near perfect supervision will require investors; whether the brokerage firm autho- the expenditure of such significant resources rized the broker to solicit for the investments; 52 THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010

where the investor sent investment checks; can be liable to another brokerage firm if it whether the investor received receipts, ac- stays silent even though it knows that there count documents, account numbers, corre- is a reasonable possibility that the broker has spondence, confirmation slips, or monthly engaged in, and may continue to engage in, statements from the brokerage firm; and the unlawful activity at a subsequent bro- whether any documents even mentioned the kerage firm. While, no Michigan court has brokerage firm. The Kohn court concluded addressed this issue directly, courts applying that: statutes and regulations substantially similar Plaintiff was not reasonably relying to those enacted in Michigan have done so, on [the broker] as a [broker] of [the and brokerage firms must be cautious not to brokerage firm], but was placing run afoul of these requirements. her money with him for purposes The seminal case for imposing liability on other than investment in markets to a brokerage firm for the conduct of a former which he had access only by reason broker is Twiss v Kury.37 In Twiss, defendant of his relationship with [the broker- E.F. Hutton (“Hutton”) learned that its sales age firm]; it is uncontested that [the representative, Kury, was involved with out- investment] was not traded on any side business activities in violation of securi- market to which [the broker] had ties laws and regulations. In response, Hut- Beyond being access solely because of his relation- ton requested and received Kury’s resigna- ship with [the brokerage firm] and tion. Hutton then filed with the regulators a liable for that [the brokerage firm] did not Form U-538 incorrectly stating that the termi- the actions manage the purchase transaction.35 nation was voluntary and failing to disclose Thus, courts have ruled against claimants its investigation and the probable violations of a current asserting failure to supervise and control committed by Kury. Kury remained in the broker, some person claims in “selling away” cases when securities industry and, four years later, was courts have the broker controls the transaction and the found to have sold interests in what turned brokerage firm receives no benefits from the out to be a $2.4 million Ponzi scheme. recognized transaction.36 The plaintiffs in Twiss were all persons that, under It is evident from the above discussion who became Kury’s clients after his resigna- that whether a brokerage firm may be liable tion from Hutton. The plaintiffs asserted neg- certain as a “control person” and whether the “good ligence claims, alleging that Hutton breached circumstances, faith” defense applies is a fact-intensive in- a duty to Kury’s then and future custom- a brokerage quiry. As a result, even in “selling away” ers when it misrepresented the reasons for cases where a brokerage firm was complete- Kury’s termination and failed to submit a firm can be ly mislead by its broker, it can be difficult proper and accurate Form U-5 to the regula- liable for the to convince a court to dismiss an investor’s tory authorities. On appeal, the court found actions of a claim on the pleadings and some discovery that Florida law imposed a duty “to report likely will be warranted. the fact of [Kury’s] termination to the [state former broker agency], to accurately state the reason for even after Liability For Foreseeable Harm such termination, and to specify any illegal After Termination or unprofessional activity committed…then the broker Beyond being liable for the actions of a cur- known by Hutton. The rule required Hut- is no longer rent broker, some courts have recognized ton to make the report to the Department by 39 associated that, under certain circumstances, a broker- filing a form U-5.” Thus, Hutton was liable age firm can be liable for the actions of a for- to the plaintiffs even though they had never with the mer broker even after the broker is no lon- been Hutton’s customers. brokerage firm. ger associated with the brokerage firm. For Like Florida, the NASD bylaws impose example, imagine a situation where a bro- the same duties to file and later correct Form kerage firm discovers its broker is violating U-5 disclosures.40 In a Notice to Members is- the rules or is engaged in some other activity sued in 1988, the NASD explained that one that could potentially harm investors (such purpose of the obligation to provide accu- as engaging in unreported outside business rate information on the Form U-5 is that the activities or selling away) and then fails to “[f]ailure to provide this information may [] take steps to remedy the harm or to notify subject members of the investing public to other brokerage firms that may be looking to repeated misconduct and may deprive mem- hire the broker engaged in the wrongful con- ber firms of the ability to make informed hir- duct. In this circumstance, a brokerage firm ing decisions.”41 Subsequently, in 2004, the SECONDARY LIABILITY AND “SELLING AWAY” IN SECURITIES CASES 53

NASD reinforced the importance of filing If an agent registered under this timely and accurate Form U-5’s, and cor- act terminates employment by or rections when necessary, by increasing the association with a broker-dealer or NASD’s enforcement options for the failure issuer,…the broker-dealer, invest- to timely submit amendments to the U-5.42 ment adviser, or federal covered The Twiss claim, however, is not an effort investment adviser shall promptly to imply a cause of action under the Florida file a notice of termination. If the reg- securities act or the NASD/FINRA rules. istrant learns that the broker-dealer, Rather, the reporting requirements of the issuer, investment adviser, or federal Florida act, as well as the NASD and FINRA covered investment adviser has not rules, inform the common law malfeasance filed the notice, the registrant may claim in defining the class of individuals to file the notice. whom the brokerage firm is liable for the The prior version of the Michigan Uniform subsequent misconduct of its broker. For ex- Securities Act contained a similar provi- ample, Twiss relied upon Palmer v Shearson sion.47 Lehman Hutton, Inc,43 where the court stated: Pursuant to MCL 451.2408(1), the state ad- The violation of a duty created by ministrator has adopted Form U-5, the Uni- statute is recognized at common law form Termination Notice for Securities Industry as satisfying the duty of care require- Registration, as the appropriate form to satisfy the In other ment in a negligence action, pro- requirements that the brokerage firm file a notice 48 words, a vided the injured party is in the class of termination. Thus, a brokerage firm has a the statute seeks to protect and the duty to file a U-5 with the State of Michigan brokerage injury suffered is the type the statute on the termination of its broker’s connection firm can was enacted to prevent. with the brokerage firm. A brokerage firm be liable …. also is under a continuing obligation to cor- rect a U-5 to include matters that occur or …A statute creates a duty of care to another become known after the initial submission of upon one whose behavior is the sub- the form.49 brokerage ject of the statute to a person who is Further, in another context, Michigan firm that in the class designed to be protected courts have followed the reasoning in Palmer hires the by the statute, and that such duty that statutory obligations can inform and will support a finding of liability for identify the class of individuals who can broker in negligence when the injury suffered bring a common law malfeasance claim. For question for by a person in the protected class is example, in Transportation Dep’t v Christian- that which the statute was designed sen,50 the defendant was driving a flatbed negligence for 44 to prevent. truck loaded with machinery. The height of violating its Thus, the enactments and rules that re- the machinery was above the legal limit and duties. quire a brokerage firm to file a properly struck a highway overpass. The machin- completed Form U-5 inform the common ery was knocked off the truck and onto the law malfeasance claim of the parties who highway where it struck plaintiff’s vehicle. can bring a Twiss claim against the broker- The court noted that the “legal effect of [the age firm. Those parties are clearly investors defendant’s] violation of the statutory duty who are harmed by the broker’s subsequent of care, standing alone, would be enough to conduct. But other brokerage firms that hire establish a prima facie case of negligence.” the broker with no knowledge of the broker’s The court further explained, however, that prior wrongful activity may be as well be- this “presumption of negligence” could be cause one purpose of Form U-5 is to permit rebutted by applying the “statutory purpose subsequent employers to make informed hir- doctrine.” Under this doctrine, the court con- ing decisions.45 Thus, brokerage firms also sidered whether the statute was intended may be able to bring and prevail on claims to protect against the result of the violation, pursuant to Twiss.46 In other words, a broker- whether the plaintiff was within the class age firm can be liable to another brokerage intended to be protected by the statute, and firm that hires the broker in question for neg- whether the violation was the proximate con- ligence for violating its duties. tributing cause of the plaintiff’s injuries.51 Michigan law imposes the same duties These principles also would apply to a found in the Florida act and the NASD rules. brokerage firm accused of failing to complete For example, MCL 451.2408(1) states: an accurate Form U-5. The claimant’s com- 54 THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010

mon law negligence claim would be informed particularly challenging because the activ- by the statutory violations, and the success ity is necessarily done outside the brokerage or failure of such a claim would depend, in firm and typically done clandestinely. Ulti- part, on an analysis of whether the claimant mately, the incentives are clear, but no sys- is within the class of individuals protected by tem of supervision is bullet-proof—and the the statute. Other courts have either followed law does not require such a system, only a Twiss, reached a similar result, or endorsed reasonable one. its reasoning.52 To be clear, a Twiss claim properly un- derstood is not simply the failure to report suspected or actual wrongdoing. Liability also can arise from the failure to take correc- NOTES tive action. A Twiss claim is grounded in a 1. See, e.g., NASD Notice to Members 03-71. Due common law malfeasance claim for failure to diligence obligations likely developed after the adoption of Section 11 of the Securities Act of 1933. A brokerage supervise. The malfeasance can be evinced in firm may not be liable under Section 11 of the Securities two different ways, each of which may be ac- Act of 1933 for misstatements or omissions of material tionable. First, the brokerage firm may have fact in a securities offering registration statement if it can prove that it had “after reasonable investigation, reason- had actual knowledge of a violation and took able grounds to believe and did believe” there were no no corrective action, thereby permitting the misstatements or omissions of material fact. violation to continue after the broker left the 2. For example, Financial Industry Regulatory Agen- brokerage firm. Second, the brokerage firm cy (“FINRA”) Rule 3040 prohibits associated persons from “participat[ing] in any manner in a private securi- may have knowingly failed to disclose the ties transaction” unless the associated person discloses to, activity on broker’s Form U-5 or otherwise and obtains approval from, the licensing brokerage firm. as required by the NASD/FINRA rules and This Rule distinguishes participation with or without compensation to the associated person. If the associated state regulation. person is to receive compensation, then he or she must Consequently, the first and fundamental have prior written approval of the licensing broker- element is that the brokerage firm knowingly age firm. If the associated person is not to receive any compensation, then he or she needs to provide written permitted the broker to engage in improper disclosure of their contemplated participation to his or conduct without taking steps to gain compli- her licensing brokerage firm prior to involvement in the ance. If the brokerage firm is guilty of such transaction. The purpose of prior notification is to allow the brokerage firm to prohibit or regulate the activity. conduct, then the brokerage firm may be lia- 3. Where appropriate, this article will cite federal ble for malfeasance. Further, while terminat- case law in addition to Michigan law because in many ing a broker may be a proper remedial action contexts, such as the Michigan Uniform Securities Act, for selling away activities, termination alone Michigan law is the same as or similar to federal law. Kirkland v EF Hutton & Co, 564 F Supp 427, 446 (ED is not sufficient. The focus is on the disclo- Mich 1983); Pukke v Hyman Lippitt, PC, No 265477, sure (or lack of disclosure) of the broker’s im- 2006 Mich App LEXIS 1801 (June 6, 2006). proper conduct on his Form U-5. A broker- 4. The pre-condition for such secondary theories of liability as vicarious liability is that there first is a finding age firm’s failure to disclose the real reason of primary violation. PR Diamonds, Inc v Chandler, 364 for the termination on the Form U-5 (instead, F3d 671, 696-97 (6th Cir 2004); Southland Secs v Inspire giving the broker a clean bill of health), can Ins Solutions, Inc, 365 F3d 353, 383 (5th Cir 2004) (“Control person liability is secondary only and cannot be the basis of liability. But it must be re- exist in the absence of a primary violation.”); Heliotrope membered that liability is not limited simply Gen, Inc v Ford Motor Co, 189 F3d 971, 978 (9th Cir to improper disclosure on the Form U-5. It 1999) (secondary liability as a controlling person cannot exist without a primary violation); SEC v First Jersey Secs, is first predicated upon the knowing failure Inc, 101 F3d 1450, 1472 (2d Cir 1996) (In order to find to take corrective action when the brokerage secondary liability, plaintiffs must show a primary viola- firm learns of the improper conduct. tion by the controlled person whom the controlling per- sons control.); Behrens v Wometco Enters, Inc, 118 FRD 534, 539 (SD Fla 1988) (“As with all secondary liability Conclusion under the securities laws, a primary violation of those In most cases, brokerage firms already take laws must first be found.”). great care to prevent their brokers from sell- 5. There can be no primary liability for any violation of regulatory rules because the courts generally have held ing away, and for good reason. Not only that there is no private right of action for violations of does selling away expose brokerage firms such rules. See, e.g., Vennittilli v Primerica, Inc, 943 F to possible secondary liability, but any cus- Supp 793, 798 (ED Mich 1996) (the “Sixth Circuit has held that there is no private cause of action for violation tomer funds that are invested in unapproved of National Association of Securities Dealers rules.”) investments necessarily are not invested in (citing Craighead v EF Hutton & Co, 899 F2d 485, 493 approved investments, which generate com- (6th Cir 1990)); Lantz v Private Satellite Television, 813 F Supp 554, 556 (ED Mich 1993) (“the Sixth Circuit missions for the brokerage firm. Supervision has held that these rules [NYSE and NASD] do not pro- and prevention of selling away activities is vide a private right of action.”). SECONDARY LIABILITY AND “SELLING AWAY” IN SECURITIES CASES 55

6. For examples of causes of actions against brokers trol) and with Mosley v American Express Financial Advi- under Michigan law, see R. Henney & M. Hindelang, sors, Inc, 256 Mont 27, 38, 230 P3d 479 (2010) (weigh- Investor Claims Against Securities Brokers Under Michigan ing Martin, Hollinger, and Hauser and concluding that Law, 28 Mich Bus L J 50 (Fall 2008). “as a general rule a broker-dealer controls its registered 7. 155 Mich App 230 (1986). representatives, whether directly or indirectly”). 8. Id. at 236. See also Cocke v Trecorp Enters, Inc, 28. Id. It may be questioned whether the disagree- No 198201, 1998 Mich App LEXIS 2311, *14 (Feb 20, ment noted in footnote 24 regarding whether a broker- 1998) (“summary disposition is appropriate ‘where it age firm is a “control person” of its brokers is really an is apparent that the employee is acting to accomplish a application of the “good faith” defense. The cases do not purpose of his own.’”). always make it clear. 9. Harrison v Dean Witter Reynolds, Inc, 974 F2d 29. See, e.g., Hunt v Miller, 908 F2d 1210, 1214 873, 891 (7th Cir 1992) (Harrison I) (dismissing inves- (4th Cir 1990). The analysis for “control person” liabil- tor’s vicarious liability claim because “[the brokerage ity is similar under both federal securities laws and under firm’s] rules expressly forbade” the acts in question). Michigan securities law. Kirkland v EF Hutton & Co, 10. Grewe v Mt Clemens Gen Hosp, 404 Mich 240, 564 F Supp 427, 446-47 (ED Mich 1983); Pukke v 253, 273 NW2d 429 (1978). Hyman Lippitt, PC, No 265477, 2006 Mich App LEXIS 11. Meretta v Peach, 195 Mich App 695, 698-699, 1801, *13 (June 6, 2007). 491 NW2d 278 (1992). 30. Harrison v Dean Witter Reynolds, Inc, 79 F3d 12. Id., at 699. 609, 615 (7th Cir. 1996) (Harrison II) (requiring a showing that the fraudulent activity was so obvious that 13. Sanders v Clark Oil Refining Corp, 57 Mich App the control person must have been aware of it). 687, 691, 226 NW2d 695 (1975) (“plaintiff’s belief in the agent’s authority ‘must be a reasonable one’”). 31. Harrison I, 974 F2d at 881. 14. See Harrison I, 974 F2d at 881 (dismissing 32. Id. See also Mosley, 356 Mont at 39 (ruling investor’s vicarious liability claim because “[the broker- after trial that no “control person liability existed and age firm’s] rules expressly forbade” the acts in question considering whether the broker acted in his role as a and because no “reasonably prudent person [could] nat- representative of the brokerage firm when he sold the urally suppose that [registered representative] possessed investment, whether the investment had any relation- the authority” for the acts in question). See also Sanders, ship to the brokerage firm or was an authorized product, 57 Mich App at 691-92. whether the purchase of the investment required access to a market through the firm, and whether the invest- 15. 2006 Mich App LEXIS 230 (Jan 24, 2006) ment was “the kind of investment for which a customer 16. 1993 US Dist LEXIS 7298 (CD Cal, Mar 30, typically relies on a broker with access through his firm 1993). to a stock exchange,” whether the investor received a 17. Kohn, 1993 US Dist LEXIS 7298 at *17. statement from the brokerage firm, whether the investor 18. Id. ever invested money through the brokerage firm, wheth- 19. 974 F2d at 884. er the investor was told it was an authorized product, 20. Id. and whether the brokerage firm had knowledge of or a 21. While there is no case in Michigan based on a financial interest in the investment). failure to supervise in the securities broker context, there 33. Kohn. are cases in the employer/employee context generally (see 34. Id. at *7-8 generally Millross v Plum Hollow Golf Club, 429 Mich 35. Id. at *8. 178, 192, 413 NW2d 17 (1987)), and other states have 36. See Harrison I; Harrison II; Kohn; Bradshaw v applied the doctrine to brokerage firms in the securities Van Houten, 601 F Supp 983, 906 (D Ariz 1985). context. Burns v Rudolph, 2005 Ohio App LEXIS 6222 37. 25 F3d 1551 (11th Cir 1994). (Ohio App 9 Dist, Dec 28, 2005). 38. A form U-5 is a disclosure required of brokerage 22. MCL 451.2509(7) (“The following persons are firms on the termination or departure of a broker. The liable jointly and severally with and to the same extent as form requires the brokerage firm to disclose (a) if the persons liable under subsections (2) to (6): (a) A person termination was for cause and why, (b) if the brokerage that directly or indirectly controls a person liable under firm was aware of any wrongful conduct of the broker at subsections (2) to (6), unless the controlling person sus- the time of the broker’s termination, or (c) if the broker- tains the burden of proving that the controlling person age firm was conducting an investigation of the broker at did not know, and in the exercise of reasonable care the time of his termination. could not have known, of the existence of the conduct by reason of which the liability is alleged to exist”). 39. Id. at 1556. Significant amendments to the Michigan Uniform 40. NASD Bylaws, Art. V, sec. 3(a) & (b) (note that Securities Act went into effect in 2009. See Public Act this rule remains applicable to brokerage firms after the 551. The previous “control person” liability statutes was FINRA merger); see also Andrews v Prudential Secs, Inc, MCL 451.810. 160 F3d 304, 305-06 (6th Cir 1998). 23. Mason v Royal Dequindre, Inc, 455 Mich 391, 41. NASD Notice to Members 88-67 (emphasis 397, 566 NW2d 199 (1997) (stating that a special supplied). relationship gives rise to an exception to the general 42. NASD Notice to Members 04-77. rule that there is no duty to protect someone from third 43. 622 So2d 1085, 1090 & n. 8 (Fla App Dist 1, parties). 1993). 24. NASD Rule 3010(a) (emphasis supplied). 44. Palmer, 622 So2d at 1090; see also Twiss, 25 25. In re William Lobb, NASD Compl. No F3d 1556 (examining whether plaintiffs “were within 07960105, p 5 (4/6/00) (emphasis supplied). the class of persons these provisions were designed to 26. MCL 451.2509(7). protect”). 27. Id. Compare Martin v Shearson Lehman Hutton, 45. See NASD Notice to Members 88-67. Inc, 986 F2d 242, 244 (8th Cir 1993) (status as employ- 46. See also Prudential Securities, Inc v Am Capital er of broker was sufficient to establish it as control Corp, 1996 US Dist LEXIS 7196 (NDNY May 15, person); Hollinger v Titan Capital Corp, 914 F2d 1564, 1996) (holding that a brokerage firm’s claim against 1573-76 (9th Cir 1990) (same) with Hauser v Farrell, another brokerage firm for having “violated its duty to 14 F3d 1338 (9th Cir 1994) (recognizing that a broker’s inform defendant of” factors leading to its employee’s conduct is not always within the brokerage firm’s con- termination on the Form U-5, and that “it would not 56 THE MICHIGAN BUSINESS LAW JOURNAL — SUMMER 2010

have registered [the employee] as its representative, and Raymond W. Henney is a hence would not have incurred liability…,” is arbi- partner of Honigman Miller trable). Schwartz and Cohn LLP and 47. MCL 451.601(b) of the previous version of the securities act stated: “When an agent begins or ter- is Co-Chair of the firm’s Secu- minates a connection with a broker-dealer or issuer, or rities and Corporate Gover- begins or terminates those activities that make him or nance Litigation Group. her an agent, the agent as well as the broker-dealer or issuer shall immediately notify the administrator in writ- ing on a form prescribed by the administrator.” 48. MCL 451.2605 delegates to power to issue form to the administrator. the Department of Energy, Labor & Economic Growth’s website contains the Form U- 5. Under the former securities act, § 451.601(b), the administrator had adopted Rule 451.602.2(2), which Andrew J. Lievense is an stated that: “A notice of agent termination shall contain the information specified in U-5.” This Rule is still in associate of Honigman Mill- effect while the state agency adopts new rules imple- er Schwartz and Cohn LLP menting the updated securities act. and concentrates his prac- 49. See the Instructions to the Form U-5. Also, tice in general commercial MCL 451.603 of the former securities act stated that “If litigation, including repre- the information contained in any document filed with senting securities brokerage the administrator is or becomes inaccurate or incomplete in any material respect, the registrant shall promptly firms in disputes with investors in federal file a correcting amendment unless notification of the court, state court, and FINRA arbitration correction has been given under section 201(b).” While proceedings. this language appears to have been removed from the updated securities act, brokerage firms are still under an obligation to disclosure new information and file an amended U-5. 50. 229 Mich App 417, 420 (1998). 51. Id. 52. See, e.g., Prymak v Contemporary Fin Solutions, 2007 US Dist LEXIS 87734 (D Colo Nov 29, 2007) (recognizing a negligence claim against a securities dealer based on its failure to fulfill its statutory duty of filing a truthful Form U-5, but rejecting a private right of action for a violation of the requirement); SII Investments, Inc v Jenks, 2006 US Dist LEXIS 51753 (MD Fla July 27, 2006) (affirming arbitration award where SII failed to make numerous required disclosures on a Form U-5 relating to its employee who later sold unregistered secu- rities to claimant); Palmer v Shearson Lehman Hutton, Inc, 622 So2d 1085 (Fla App Dist 1, 1993). One state court has rejected Twiss where a state statute existed that expressly “prohibits the recognition of an private-party state law statutory civil tort liability.” Ugarte v Atlas Sec, Inc, 2004 Cal App LEXIS 1721 *18 (Cal App 3 Dist, Apr 1, 2004).