Your Client Suffered Substantial Losses in the Stock Market: Can He Recover?
Written by David R. Chase, P.A.
While you are meeting with your client discussing the subject matter of your representation, he mentions that he lost a substantial sum of money in the stock market. Your initial reaction is likely to be that he is in good company, as most investors lost money in the bear market (probably including yourself), and thus there is likely no legal basis upon which he could recover his investment losses. Think again. While it is true that in many cases investor losses are simply due to the general decline in the financial markets, there are numerous instances where stockbroker fraud and/or mismanagement are the direct cause. In the latter case, wronged investors have recourse to prosecute their claims in an effort to recoup their investment losses.
How then, as counsel, can you determine whether your client's situation involves a pure market loss or, rather, some form of stockbroker misconduct upon which recovery may be had? While each case is unique and will largely depend upon its particular facts, there are three main categories of stockbroker misconduct (although there are more) that, if proven, will form the basis for a valid claim against the financial professionals involved. They are as follows:
Unsuitable Investment Recommendations
When a stockbroker recommends an investment to his client, he has an obligation under securities industry rules and regulations to ensure that the recommendation is appropriate and suitable given the client's financial situation, investment objectives, economic needs, risk tolerance and level of financial sophistication. The stockbroker also has a duty to ensure that any speculative or risky investment is suitable for the client, and that the client fully understands and is willing to undertake the risks associated with the investment. A classic example of an unsuitable investment recommendation is where the stockbroker places the proverbial elderly and unsophisticated widow -- who requires steady monthly income -- into high-risk, speculative investments, such as technology stocks on margin or illiquid private placements or limited partnerships. Another example of unsuitability is where the stockbroker recommends a portfolio that is concentrated in just one or two individual stocks, or in just one sector (i.e., technology). This over-concentration dramatically increases the risk of loss and denies the investor the benefit of diversification where risk is mitigated by being spread over several asset classes. The stockbroker's unsuitable investment recommendation may be driven by his own financial self-interest (in some cases the sale of speculative equity investments may generate a higher commission payout than a more appropriate, conservative one), or may be the result of simple negligence, where the stockbroker fell in love with a particular stock or sector and failed to exercise reasonable care.
In order to assess whether your client's stockbroker made an unsuitable investment recommendation, you must understand your client's financial situation, investment objectives, level of sophistication and risk tolerance and then evaluate the nature of the investments recommended in light of those factors. In many cases, counsel may find consultation with an experienced securities litigation counsel or an expert securities witness helpful in making this inherently subjective determination.
Churning
"Churning" is where a stockbroker engages in excessive trading in an account he controls for the purpose of generating commissions. If the stockbroker is consistently buying, selling and then re-purchasing securities in your client's account on a short-term basis, generating substantial commissions in the process, and there does not appear to be any benefit derived by the client, the stockbroker may be churning the account. There are various ways to prove that the trading is excessive, including the use of certain ratios that measure the amount and frequency of the trading, as well as other ratios that measure the cost of the trading relative to the equity in the account. I typically use a firm that is in the business of analyzing investors' accounts to determine whether the trading is excessive and contrary to the investor's financial interests. Control of the account by the broker can be demonstrated, in part, by your client's testimony, his relative lack of investment experience and sophistication thus demonstrating his reliance upon the stockbroker's advice, and trading records evidencing that the stockbroker's other clients were purchasing and selling the same securities at or about the same time. Churning has been described as: "A particularly vicious and fraudulent course of conduct . . . deserving of the severest condemnation. Its very nature brands it as one of the most injurious types of fraud possible. Its perpetrators prey on unwary and inexperienced investors." Newsom v. Dean Witter Reynolds, Inc., 558 So.2d 1076 (Fla. 1st DCA 1990).
Unauthorized Trading
With minor exception, before a stockbroker can place a trade, he must have your client's express permission and consent to do so. This is true unless the stockbroker has previously been provided with written authority allowing him to exercise his discretion in determining what securities to purchase and sell, and when. In the event your client's stockbroker has purchased and sold securities without his prior knowledge and consent, he may have violated securities industry rules and may be liable for the losses resulting from those unauthorized trades. Typically, unauthorized trading violations are difficult to prove as it often comes down to the testimony of the broker versus the investor. However, in the event the investor timely complains in writing about the unauthorized trade(s), a case is more easily proven. If no such written complaint is timely made by the investor, or the investor does not take reasonable efforts to notify management at the brokerage house about the broker's misconduct soon after becoming aware of the unauthorized trade(s), then it is quite possible that this delay will be viewed as a ratification or tacit approval of the subject trades.
The three categories of stockbroker misconduct identified above are not the only grounds for a claim against financial professionals. Other wrongful conduct includes the making of material misrepresentations and omissions in connection with the offer and/or sale of a security, theft of funds or failing to timely execute orders.
In almost all cases, investors sign binding arbitration agreements with the brokerage house requiring their claims to be brought through either the National Association of Securities Dealers or the New York Stock Exchange. These arbitrations are designed to be less costly and more efficient than state or federal court litigation, and typically do not involve depositions, extensive written discovery or numerous appearances by counsel (all pre-hearing matters are conducted telephonically). The legal claims asserted in these cases typically consist of: breach of fiduciary duty, negligence, breach of contract, securities fraud under Florida Statute Chapter 517 and Section 10(b) of the Securities Exchange Act and Rule 10b-5 thereunder, and common law fraud. I have found that a securities expert witness is often useful to help educate the arbitration panel on applicable industry standards and practice, as well as on the more subtle forms of financial fraud.
The next time your client (family member or friend) mentions that he lost money in the markets, you may be providing a valuable service to him by inquiring into the circumstances surrounding the loss to determine whether it was market driven or the result of wrongful conduct. Not all investors should have lost money (or suffered the extent of losses they did) in the bear market.
Mr. Chase is a former United States Securities and Exchange Commission Prosecutor, Co-Chairman of the Dade County Securities Litigation Committee and Principal of the law firm of David R. Chase, P.A., located in Hollywood, Florida. His practice focuses upon the representation of individual investors in securities litigation and arbitration matters, and the defense of securities professionals and companies in securities regulatory investigations and enforcement actions involving the Securities and Exchange Commission, the New York Stock Exchange and the United States Attorney's Office . He can be reached at: 954-889-5120 or david@davidchaselaw.com.
