Warning Signs and Examples of Broker Misconduct

Warning Signs of Broker Misconduct

There are certain activities in an account that are not advisable for most investors and should be considered warning signs of broker misconduct requiring closer attention. These include:

• An unusual amount of trade confirmations sent to your home;
• A dramatic change in your portfolio’s composition;
• Pressure to act immediately on the purchase of an investment;
• A concentration of your portfolio into a single product;
• Large purchases of securities on margin;
• Switching between different mutual fund families or variable annuity contracts;
• Denied access to a branch manager or compliance officer;
• Account under-performance relative to the stock market; and
• Guarantee of investment return and protection against losses.

Examples of Broker Misconduct

Breach of Fiduciary Duty

A fiduciary duty requires a person to act in the best interest of their client, putting the client’s interests ahead of their own. It is the highest standard of duty implied by law. Investment advisers owe a fiduciary duty to their clients. Stockbrokers may owe a fiduciary duty to their customers, depending on the circumstances of the relationship.

Churning

Churning occurs when a broker engages in excessive trading in a customer’s investment account in an attempt to generate commissions.

Failure to Supervise

Brokerage firms have obligations pursuant to their own policies and procedures, as well as FINRA rules to supervise the activities of their brokers and firm. This duty includes:

• the review of each transaction submitted by the broker to place a trade in a customer’s account;
• the review of transactions in a customer’s account to determine whether the transactions are in accordance with the client’s investment objectives;
• the review of incoming and outgoing correspondences;
• the review of accounts to determine if trading in a customer’s account is excessive; and
• making sure brokers are not conducting outside securities transactions (selling away).

If the firm fails to investigate such broker misconduct and/or allows it to take place, the firm may be held liable for its failure to supervise its employees.

Margin Abuse

A customer who purchases securities may pay for the securities in full or borrow part of the purchase price from his or her securities firm. If the customer chooses to borrow funds from a brokerage firm, the customer will open a margin account with them. The portion of the purchase price that the customer must deposit is called “margin” and is the customer’s initial equity in the account. The loan from the firm is secured by the securities that are purchased by the customer. Customers generally use margin to leverage their investments and increase their purchasing power. However, customers who trade securities on margin incur the potential for higher losses. As a result, there are additional risks involved with trading on margin that brokers must disclose to their customers. For example, when the margin ratio in the account exceeds the requirements by the firm, the customer is susceptible to a margin call that could force the sale of the customers’ securities.

Misappropriation of Assets

Some signs of misappropriation of assets include money missing from your account and a broker’s request for checks being written to him or her personally instead of the brokerage firm. If your broker or financial adviser has stolen money from your account, then you may have a broker misconduct claim against both the broker and firm.

Misrepresentations and Omissions

Federal and state securities laws prohibit salespersons from making any “material misrepresentation” about investments they are selling to customers. The laws also impose upon the brokers an obligation to include any information that a reasonable investor would want to know about while making a decision to invest. A broker may be liable to a customer if a broker misrepresents or fails to disclose material facts to the investor in the sale or recommendation of an investment. This obligation requires brokers to fairly disclose all of the risks associated with an investment.

Negligence

Negligence is conduct that falls below the “legal standard” established to protect others against unreasonable risk or harm. Generally, negligence is the failure to use such care as a reasonably prudent and careful person would do under similar circumstances. If a broker is negligent in his or her dealings with a customer, then the customer may have recourse against that broker.

Over-concentration

A fundamental concept of investing is diversification. If a customer’s account is concentrated in any individual investment or type of investment, then the risk associated with their portfolio is dramatically increased. A broker should never place all of the customer’s investment “eggs in one basket.” Any broker who fails to diversify a customer’s account may be liable should the investment significantly decline in value.

Selling Away

A stockbroker is not permitted to sell investments that are not offered by their brokerage firm. Typically, these outside investments are riskier and pay a higher commission to the broker. If your broker solicits you to purchase securities away from the brokerage firm, they are “selling away,” which is a violation of FINRA Rules and state and federal securities laws. These investments are usually in the form of private placements and alternative investments. If you are a victim of selling away, you may have legal rights against your broker and the brokerage firm.

Unauthorized Trading

Unauthorized trading occurs when the broker executes transactions in a customer’s account without the customer’s permission or if the broker has not been given discretion to make such trades.

Unsuitability

A broker has an obligation to make suitable investment recommendations that are consistent with a customer’s investment objectives, risk tolerance, needs and other factors. This arises out of the concept of “Know Your Customer” in FINRA Rule 2111. An investment may be unsuitable if:

• it is not in accordance with the customer’s objectives or risk tolerance;
• the customer does not have the financial ability to incur the risk associated with a particular investment; or
• the customer did not know or understand the risk associated with the particular investment.

Ponzi Schemes

A Ponzi scheme is an investment scam that involves the payment of purported returns to existing investors from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk. In many Ponzi schemes, rather than engaging in any legitimate investment activity, the fraudulent actors focus on attracting new money to make promised payments to earlier investors and divert some of the “invested” funds for personal use.

The victims of Ponzi schemes are often confused about the nature of the fraud because the investment seemed legitimate at the outset. Representations were made about the nature of the investment opportunity that may have been inaccurate, or they may have been true at the beginning. Some Ponzi schemes are fraudulent from their inception. Others may have been legitimate investment ventures that didn’t work, so the fraudster began using new investors’ money to pay promised investment returns to earlier investors.

“Free Lunch” Seminars

Investment seminars or “free lunches” can offer a great deal of useful information. But, they also provide the opportunity for fraudulent schemes. These schemes can lead investors to lose significant amounts of money when stockbrokers or financial advisors use such events to promote fraudulent trading schemes or promote bogus investments and Ponzi schemes.

Private Placements

Private placement offerings allow companies to raise money by selling stocks, bonds and other instruments. Such offerings may be exempt from federal securities registration requirements. This exemption enables a company to raise business capital without having to comply with the registration requirements of a public securities offering. Because private placement offerings made in reliance on Rule 506 of Regulation D are not reviewed by regulators, they have become a haven for fraud. According to the most recent enforcement statistics from the North American Securities Administrators Association, private placement offerings are the most frequent source of broker misconduct cases enforced by state securities regulators.

Alternative Investments

An alternative investment is one that is not one of the three traditional asset types (stocks, bonds or cash). Most alternative investment assets are held by institutional investors or accredited, high-net-worth individuals because of their complex nature, limited regulations and relative lack of liquidity. Alternative investments include hedge funds, pension advance offerings, virtual currency, real estate investment trusts (REITS), commodities and derivatives contracts.

Many alternative investments also have high minimum investments and fee structures compared to mutual funds and traditional Exchange Traded Funds (ETFs). Moreover, the values of alternative investments indicated on brokerage statements are often inaccurate or inflated.