Every year, investors lose billions through fraud and negligence by stockbrokers and investment firms. This article explains:

• Fraud and Negligence by Stockbrokers and Investment Firms
• How to Avoid Being Victimized
• Mediation and Arbitration.

Fraud and Negligence by Stockbrokers and Investment Firms

• Churning or Excessive Trading: Brokers live on commissions; the more trades, the more they make. More often than the industry admits, stockbrokers gin up commissions through excessive trading, called churning: trades made to generate commissions rather than to benefit the investor. This can occur with both discretionary accounts (those in which the broker may execute trades without prior approval by the investor) and nondiscretionary accounts (those requiring the investor's prior approval). In cases involving nondiscretionary accounts, it occurs when brokers trick their customers into excessive trading. Of course, it may also result from unauthorized trading.

• Unauthorized Trading: Brokers sometimes make trades without the investor's knowledge or approval. It may be churning or some other scam.

• Spinning: Investment firms and investment bankers sometimes allocate shares of an initial public offering (IPO) to insiders, usually corporate officers or others influential in steering business their way. The insiders then have an opportunity to profit by the jump in the price that often occurs during the first day or two of trading. This illegal practice, called spinning, also enables insiders to manipulate the price. The nature of this crime is such that investors are unaware that they have been cheated. If you read that the SEC or some other government agency has brought action against someone for spinning a security you invested in, investigate the case and take appropriate action.

• Mutual-Fund Switching: Mutual funds are considered good long-term investments, but from time to time, things change and it is advantageous for an investor to swap shares in one mutual fund for those in another. Since many mutual-fund companies have a host of funds with different investment objectives, they often allow investors to swap funds within their group without additional charges. But the broker doesn't make as much on a swap as would be made by switching to a fund managed by another company. A broker switching a customer for that reason is guilty of mutual-fund switching.

• Insider Trading: The law requires stockbrokers and investment firms to be upfront and transparent. In the real world, those closest to the action get information that would give them an unfair advantage if they were to act on it.

• Front Running: In volatile markets brokers trading the same stock as their customers have opportunities to gain at the expense of their investors by buying low from or selling high to their customers.

• Breach of Fiduciary Duty: The law imposes upon stockbrokers and investment firms a fiduciary duty to handle all transactions with impeccable honesty. Any violation is illegal, and could adversely effect their clients.

• Good Faith and Fair Dealing: Brokers and investment firms must not use their size, specialized knowledge, and other resources to gain advantage over their customers. This new and developing legal principle, called the obligation of good faith and fair dealing has not yet been well defined, but several of its elements have.
  1. It begins with full disclosure. The investor has a right to know about kickbacks, payments, favors, or any other thing else that might influence the broker.

  2. Secondly, the broker and firm must not use legal technicalities and lack of sophistication on the part of its customer to gain an unfair advantage over the customer.

  3. Finally, the broker and firm must warn the customer whenever it appears that the customer is going to take some ill-advised action that would put the customer in a weakened position with the broker or firm.

Negligence

Stockbrokers and investment firms owe a duty of care to their customers. Some times they slip up. Here are common problems.

Unsuitability: Each investor is unique. A sound security for one is a disaster for another. To address that, the law requires a stockbroker to consider all the investor's circumstances, including the investor's investment objectives, tax bracket, age, health, other sources of income, and tolerance for risk. A broker who negligently puts an investor into an unsuitable investment is liable to the customer.

Over Concentration: No investment is a sure thing, and it is folly for an investor to invest everything in one or only a few investments. It is the don't-put-all-your-eggs-in-one-basket principle. Brokers owe investors a duty to advise them of the wisdom of diversifying.

Due Diligence: Some investments are unsound or overpriced. While the broker does not guarantee any investment, the investor is entitled to assume the broker adequately investigated the investment.

Failure to Supervise: An investment firm is responsible for protecting its customers from misconduct by its brokers. Sometimes, the firm is liable under the doctrine of respondent superior (the employer is responsible for the torts of the employee done in the course of employment). For legally technical reasons, this rule does not always apply. However, in such cases the firm may be liable for failing to adequately supervise the broker.

How to Avoid Being Victimized

• Meet face to face with your stockbroker. Ask tough questions about his or her background, education, training, and how long the broker expects to handle your account. If the broker changes positions every two years and it's been eighteen months since the last transfer, look for someone else.

• Educate your broker. To give sound advice, the broker needs to know everything about your finances and life goals. That is a lot of personal information. Expect the broker to ask for it upfront, usually with a long questionnaire. If the broker doesn't, leave.

• Be Skeptical Invest with the understanding that risk is unavoidable. The surest advice is, If it looks too good to be true, it probably is. If your broker tells you about such a deal, you probably have made a bad choice. Although most people in the securities business are intelligent, hard working, and honest, always be on the lookout for something that is not right, and have the common sense to walk away. (There is nothing more foolish then trying to make a bad deal look good.)

• Never deal with telemarketers. Typically, they are inexperienced, desperate people making blind calls hoping to generate business. When they call, hang up.

• Seek a nearby firm. Today, investment firms are ubiquitous. Select one that is conveniently located. The industry has a special designation, called Certified Financial Planner (CFP), for brokers with extensive training and experience. It is very difficult designation to obtain, and few stockbrokers have earned it. It is a good sign that the person knows the business.

• Resist pressure. Look for a broker in whom you will have confidence. It the broker tries to fast talk you into anything, leave.

• Find a broker happy to handle your account. Ask whether your account is large enough and of the kind the broker would be challenged to handle. If your business doesn't interest the broker, find one who is.

• Decide on the type of account that will suit you. The distinction between discretionary accounts and nondiscretionary accounts is discussed above under churning. In all likelihood, a nondiscretionary account, which requires your approval for all transactions, is best for you.

• Demand the reasons behind the broker's recommendations. Never buy a pig in a poke. If the broker can't explain why a particular transaction is best for you, leave.

Keep Neat, Orderly Files Even small accounts generate a lot of paper. If a problem should develop, the burden is going to be upon you to establish what happened and when it happened, and who said what or failed to say what. Should mediation or arbitration become necessary, you will need to make all that clear to a lawyer and expert witnesses so your case can be effectively presented.

The side with the best records usually wins. Check Everything Sent You Your investment firm will send you a confirmation statement (notice of the trade, including date, price, etc.) and monthly account statements. Check them carefully for mistakes and irregularities. If something is amiss, call the broker, and if that doesn't bring satisfaction, call the broker's supervisor. Investment firms are large, busy places.

Mistakes happen. It is always easiest to correct a mistake while it is fresh. Complain in Writing If a problem is not resolved to your satisfaction, send the firm (not the broker) a letter with copies of all relevant documents. Be clear and precise. The things for which stockbrokers and investment firms are accountable are discussed above under the heading "FRAUD AND NEGLIGENCE BY STOCKBORKERS AND INVESTMENT FIRMS". Explain why your complaint fits into one or more of those categories.

Mediation and Arbitration

When investors are ready to sue their stockbroker or investment firm, they are often shocked to learn they can't. Fine print in the agreement between the investor and the investment firm requires that all disputes be resolved by binding arbitration, administered by the National Association of Security Dealers (NASD), the industry's leading trade group, or one of the stock exchanges. Mediation is also an option.

A good source of information on this is on NASD's website. Mediation Mediation is the voluntary settlement of a dispute with the assistance of a person (the mediator) knowledgeable about the industry and trained at getting two warring sides together. In complex cases where it is best to compromise, mediation often assists the parties get the dispute behind them. Where justice is clear, a mediator can sometimes explain the facts of life and devise a face-saving way out. Mediation is nonbinding, so if it doesn't work, arbitration is still available. Sometimes, the broker or investment firm stonewalls even if the case is solid. In such cases, mediation is a waste of time and money, and it is better to go straight to arbitration.

A lawyer is a good source of advice as to which is the better course. Arbitration Unlike mediation, arbitration tries the case and renders an enforceable judgment, just as a court would. The decision is almost always final; only in rare cases can an appeal be successfully taken to a court. Arbitration is done by one to three arbitrators, depending upon the size of the case. The arbitrators come from panels appointed by the NASD. It is common to find accountants, lawyers, investment advisors, and even retired judges on the lists.

The NASD claims that because their arbitrators are knowledgeable about the securities business, they provide a speedy and fair resolution of disputes. There is some truth to that, but the system does have its critics (especially among trial lawyers).

Critics point out that arbitrators are initially chosen by the very industry they are called upon to judge, and these critics accuse arbitrators of being insensitive to unfair practices in the industry.

Others disagree. They say experienced arbitrators have hands-on experience that enable them to better understand these unfair practices and render swift and sure justice.

Arbitration typically takes 12-15 months, which is much faster than courts. Because the panels are familiar with most issues, there is not as much need for expert testimony as there would be in court. That makes the process quicker and cheaper.

Nevertheless, some expert testimony is usually required. That testimony must be based on the facts. Consequently, as said above under Keep Neat, Orderly Files, the party with the better-kept files has an advantage.

Unfortunately, it is often necessary to retain a stockbroker to give expert testimony as to the standards of the profession. In the securities industry, one hand often washes the other, which makes stockbrokers reluctant witnesses. In such cases, it is usually best to approach someone who has retired.

Small investors are at a tremendous disadvantage in complex cases because there is not enough at stake to support the cost of adequate expert testimony and the legal counsel to present the case effectively. In such cases, the investor's only recourse is to complain to NASD and the state attorney general and hope someone else will carry the ball. The NASD website is the place to start.

Not surprisingly, brokerage houses, even in cases where their broker is clearly at fault, often play hardball in order to intimidate the customer (and the customer's lawyer). In almost every case, they settle on the eve of the arbitration hearing. Should you encounter that, demand a hearing as soon as possible.