I have been representing customers and brokers in securities arbitration matters since 1982. In those 35 years I have handled over 700 securities arbitration cases. Since securities arbitration is such a large part of my practice, I also survey all of the arbitration awards that are entered in matters across the country, write columns for investors and brokers on the topic, and stay well informed on developments in this unique area of law.
Today, FINRA administers virtually all of the securities arbitration disputes in this country, with the AAA and JAMS handing the remainder. From my work, and my review of the statistical summaries published by FINRA it is clear that investment disputes fall into very well-defined categories.
Naturally, the type of cases that are filed is a function of the market. Not only are there fewer arbitrations when the markets are doing well, economic factors create different types of claims. For example, when Internet stocks fell in April 2000, the arbitration forums saw a significant increase in arbitration filings, and the emergence of a new category of claim, for over-concentration, or failure to diversify.
As the markets improved in 2003, through 2007, we saw a sharp decrease in the number of arbitration filings, and less than 4,000 claims were filed in 2007. Given the fact that there are over 600,000 registered representatives in the country, the complaint-to-registrant ratio is pretty good.
The details of securities arbitration are covered in another article, Overview of the Securities Arbitration Process which explains the arbitration process itself, and Introduction to the Federal Securities Laws provides a foundational explanation of the securities laws that are applied in arbitration. The focus of this article is the type of claims or the typical complaints that customers bring in arbitration.
These categories are how the customer characterizes their claim, which may or may not be factually accurate. However, a review of these categories helps put the law into practice, and highlight what a manual of rules and compliance procedures cannot – brokers have an obligation to deal fairly, honestly and openly with their customers, and are liable for a variety of offenses if they do not do so.
That being said, the reader is cautioned that simply because portfolio has suffered losses, a broker is not necessarily liable to the customer. Any type of investment has a risk involved, and that risk is that the securities will decline in value. Similarly, simply because a broker has been accused of wrongful conduct by a customer, that is by no means the same as a finding of wrongful conduct. In fact, because of the ease at which an arbitration can be commenced and maintained, in my experience there is a higher percentage of frivolous and baseless claims brought against broker dealers than any other group of professionals. It should be further noted that approximately 50% of all customer claims that go through an arbitration hearing are actually won by the customer and approximately 75% of all customer claims are settled or resolved in mediation or arbitration.
While nearly all of the claims that a customer can assert against a broker flow from the concepts of fraud or negligence, some claims are premised on contract law. While the details of how each type of claim has evolved at the law is of great interest to lawyers and law professors, for purposes of this discussion it is important to note that brokers are NOT responsible if their investment advice turns out to be bad advice. A stock broker can never be successfully sued because an investment which he recommended, in good faith, with full disclosure, did not prove to be profitable.
While this simple concept may seem quite apparent to most people, an incredible number of arbitrations are commenced, and lost by the customer, because they are premised upon this incorrect theory.
Putting aside those types of claims, customer claims against brokers can be broken down into a few broad categories:
Churning – in a churning claim, the customer alleges that the broker purchased and sold securities solely to generate commissions, without regard to the customer’s investment objectives or goals. In the typical churning case, the customer must prove: 1) that the broker controlled the account; 2) that the trading was excessive in light of investment objectives, and 3) that the broker intended to defraud the customer or acted willfully or recklessly.
Unauthorized Trading – in a claim for unauthorized trading, a customer alleges that the broker entered transactions into the account without the customer’s knowledge or approval. Unauthorized trading allegations are common in securities arbitrations and usually turn on the timing of the customer’s complaint to the brokerage firm. Customers who first raise an unauthorized trade allegation months or years after the trade has occurred usually do not fair well in arbitrations, particularly where the customer has been receiving confirmation slips and monthly account statements.
Unauthorized trading allegations also bring into play a number of SRO regulations, including NYSE Rule 408 and Article III, Section 15 of the NASD Rules of Fair Practice, both of which require brokers to have discretionary authority in writing from the customer. Trading without the customer’s prior consent, is viewed as using discretion, and thus, a broker who engages in unauthorized activity violates Rule 408 and Section 15.
Unsuitability – unsuitability is a common customer complaint. Here the customer alleges that the broker recommended investments that were not appropriate for his investment goals, or even his age and investment objectives. Unsuitability is another problem in securities arbitrations, since the claim is typically made after the entire account loses money, rather than at the close of a truly unsuitable investment. Arbitrators often struggle with unsuitability claims, as the inquiry requires a determination, often without expert witnesses, of just what is suitable for the customer.
These claims have potential for disaster for the broker, since a customer who was perfectly well informed of the risks, and willing to take same, may later claim unsuitability. If the investment was not within reasonable guidelines for the customer, the broker may have been found to have made an unsuitable recommendation, even years after the fact, and despite similar profitable investments in the same account.
Brokers need to make sure that they understand the risks of the various products they recommend, and that the customers understand those same risks. As discussed below, account documentation can be critical in arbitrating these types of claims.
As in the case of Unauthorized Trading, SRO rules come into play in suitability claims and can lead to enforcement proceedings. NYSE Rule 405 requires that a firm use due diligence to learn the essential facts relative to every customer and every order. Article III, Section 2 NASD Rules of Fair Practice requires a member to have reasonable grounds for believing that a recommendation is suitable for the customer based on other securities holdings, the customer’s financial situation, and his investment needs.
Failure to Diversify – this claim is, in reality, a subset of an Unsuitability claim, as discussed above. As Internet and Technology stocks roared upwards in the late 1990s, more and more investors invested in those securities. Not only did they invest in them, they left other sectors of the market, and placed an increasing percentage of their assets in Internet and Technology stocks. Now, after the bubble burst, investors are filing complaints against their brokers for the over concentration of their portfolios in these sectors.
The claim is a difficult claim to prove, for the issue is nearly always that the customer expressly desired the investment in these sectors, and that given the time, and the climate, the investments were in fact suitable for the investor, as they fit the investor’s risk tolerance and investment objectives. Like most customer claims, the success of this type of claim depends heavily on the facts of the case, and the particular circumstances of the investor.
Material Misrepresentations or Omissions – here the customer alleges that the broker intentionally misled him or failed to disclose a material fact about an investment. While Courts require proof that the broker acted intentionally or recklessly, arbitration panels often use the level of sophistication of the customer in deciding whether he was misled. Here, as in most of these claims, the credibility of the customer, and the broker are crucial to the arbitration process, and, as discussed in Avoiding Customer Disputes, the documentation maintained by the parties may be determinative of the outcome.
If proven, an intentional misrepresentation claim can have serious consequences for the broker, as it is a violation of Rule 10b-5, and a matter taken very seriously by the regulators. A serious enough violation could lead to criminal charges.
Breach of Fiduciary Duty – this is what is known as a common law claim. Brokers are fiduciaries in relation to their customers, that is, they occupy a position of trust and confidence, owing the highest degree of loyalty and fidelity to his customer. In this claim, the customer alleges that the broker breached his duty to a client.
While breach of fiduciary duty overlaps some of the other claims, negligence may suffice to find the breach, and since the claim is not premised on fraud, the customer’s burden of proof (discussed below) is lower, and the claim is therefore easier to prove. Further state laws differ as to when a broker is a fiduciary and the level of conduct necessary to constitute a breach of the fiduciary duty.
Negligence – another common law claim, a claim for negligence is best described as a claim for broker malpractice, although that term is not used in the securities industry. Essentially, a claim for negligence is that the broker failed to use reasonable diligence in handling the affairs of the customer, and did not act as a reasonable and prudent broker would have acted.
Like breach of fiduciary duty, negligence claims do not require any proof that the broker acted maliciously, or intentionally. However, claims for negligence alone are not particularly strong claims, and it is the rare case where a customer prevails on such a claim without prevailing on one of the other claims discussed here.
Later revisions of this document will expand on the evidence and legal issues raised by each of these claims. For those interested in reading more about these issues, see Introduction to the Securities Laws and Overview of Securities Arbitration
Mark J. Astarita is a nationally known securities attorney with over 30 years of experience in securities arbitration, regulation and litigation. He has represented parties on over 700 securities arbitrations and countless SEC and FINRA investigations. This article was originally published in 2002, and was last updated in 2019.