What Types of Investment Losses are Recoverable?
Recoverable investment losses fall broadly under one of three categories (sometimes, with several overlapping.) These categories are excessive trading also known as churning, misrepresentations or omissions, and unsuitable investments ("suitability claims.")
Excessive trading, frequently called "churning" occurs when a broker, exercises control over a client's account, and engages in transactions that are excessive "in size and scope" to the needs and objectives of the client. Churning generally occurs in accounts where the broker has discretionary authority, authorization to make transactions without first consulting with the client, or where the client "habitually follows" the advice of the broker. Excessive trading usually occurs in accounts where a client does not follow the trading closely. You can prevent excessive trading by always opening your mail from the brokerage firm, and closely reviewing the monthly statements for signs of trades you did not authorize.
A rule of thumb to measure churning is the "Six Times Turnover Rule.” If an account’s equity has been turned over six times in the course of a year, with the broker "controlling the account", courts have ruled that there is a presumption the account has been churned.
Unauthorized trading is where a financial advisor enters into transactions without first obtaining permission from the client. Unless a properly authorized and signed power of attorney has been given to the broker, all trades must be approved prior to their execution. Clients that spot unauthorized trades in their accounts should make sure to ask for an adjustment immediately, preferably in writing. It is also best to contact the branch manager and demand the transaction be rescinded. Otherwise, you risk the defense that you "ratified" the transaction.
Close kin to unauthorized trading is the “failure to execute.” The brokerage firm profiled in the Leonardo DiCaprio movie "Wolf of Wall Street" Stratton Oakmont brought this unethical practice to an art form. After pumping up a stock, Stratton’s brokers would simply stop answering their phones, preventing desperate clients from selling their crashing stocks. Or, if a client was lucky enough to get through, the brokers would simply ignore orders to sell.
Brokerage firms may be reluctant to sell when the firm is holding a large position in the stock for fear it will depress the price. Again, timely complaints in writing to the branch manager, and even securities regulators like FINRA or the SEC are essential to establishing this claim, and to slavaging what remains in your account.
Misrepresentations (and omissions) come in many forms; the most common one in the investment context is the "guarantee against loss." There are no guarantees in life or in the stock market. Incredibly, many brokers pitch investments to retirees using some form of guarantee; either “avoid stock market risk” or “at the end of five years you will get your money back.” Equally misleading is leaving a client with the impression that the investment is somehow guaranteed, or insulated against market or structural risk. Don’t be lead to believe there are guaranteed investments unless your broker is talking about an FDIC insured C.D. Also, be mindful of a broker downplaying or glossing over the risks of an investment. If you are investing in a private placement, like a REIT or oil and gas program, make sure to review the private placement memorandum prior to investing. And, make sure to quantify the risks before you commit to the purchase. The only way to do this is by asking for the risks to be spelled out, preferably in writing before making an investment.
By far, the most common claim in the FINRA arbitration forum are those for “suitability.” FINRA requires that investment professionals make recommendations and investments that are consistent with their clients’ investments needs and objectives, and in line with their risk tolerances. This rule also exists, via case law, in virtually every state. In addition, many states consider financial planners that are paid to sell investments to be fiduciaries, who have a duty to put their client’s needs in front of their own, and to make recommendations in the best interests of their client.
A textbook example of an unsuitable investment is where the majority of an elderly, income dependent client's assets are sold, and the proceeds used to purchase high-risk investments. A close relative of unsuitability is over-concentration. When a broker concentrates a client’s investment account in shares of a single stock, or puts a large percentage of the account into high-risk stocks or illiquid investments like REITs, the account is likely over-concentrated. To prevail on a case for over-concentration a customer must establish that the concentration was inconsistent with his or her investment objectives and risk tolerances.
A “ponzi scheme” is an investment that depends on the fund raising prowess of the promoter rather than on the success of the underlying investment program. In the typical ponzi scheme, an investor is promised large returns which are paid from money raised from new investors. Eventually the promoter runs out of new investors and the ponzi scheme collapses.
Many ponzi schemes start out as legitimate business enterprises that experience a bad quarter or bad year. Rather than address this with investors, the owner covers up the losses by using funds in a manner inconsistent with sound business practices. One bad business decision leads to another, then many, and, as was the case with the Bernie Madoff ponzi scheme, the lies snowball, and what was once a legitimate business, becomes nothing more than a fund raising vehicle to pay off older investors.
Direct Participation Programs
Although a legitimate form of operating entity, these programs have been used by many unscrupulous operators to dump bad investments (office buildings, dry hole wells) onto unsuspecting investors. They are also set up to siphon fees and pay large commissions to the selling broker dealers. In addition to being long term and illiquid, they make little financial sense. A big red flag is why the supposed experts running the company are raising money from mom and pop, instead of borrowing it from a bank. And why are they paying 15% off the top to raise the money?
Consider a REIT that raises $100 million and pays the typical 15% in offering costs. In order to raise the $100 million, the REIT promises an 8% annual return to investors. But after offering costs it only receives $85 million. Yet, it is obligated to pay investors 8% on $100 million. This puts the actual payout at over 10%. Earning a 10% return entails significant risk, and an investor should question why the supposed experts running the REIT are stuck paying 10% to mom and pop investors, rather than paying five or six percent to a lending institution.
Typical DPP investments are REITs, oil and gas programs and equipment leasing investments.
Many start-up and small companies issue promissory notes or “investment notes” as a means of raising capital. While a legitimate source of funding, especially when used to raise funds from family and friends, these small offerings have long been the means of support for brokers who have lost their securities licenses. Promissory note investments typically promise high rates of return to compensate for the high (and often undisclosed) risks of investing.
“Selling away” is a term used to describe when a registered representative employed with a brokerage firm sells an investment to a customer, and that transaction is done “away from” the firm. It is also referred to as “outside business activity.” In a typical situation a registered rep will introduce his client to a “great opportunity,” and advise him to “get in on it.” The client will then write the broker a check and the funds will be invested directly into the program. Because a registered rep must transact all business with customers though the firm he is licensed with, “selling away” is a violation of FINRA rules.
When a client opens a “margin” account he is allowed to borrow money from the brokerage firm to buy investments. Federal rules limit how much an investor can borrow, and require a client to maintain a certain percentage of the account value as collateral. The use of margin is risky because if an investment purchased on margin declines in value, an investor may be required to deposit additional funds into the account to “cover” a margin “call.” Margin allows the broker to maximize commissions by providing additional capital for purchases. Many accounts that are “churned” see high levels of margin use.
The Law Office of David Liebrader