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.