The Duty of a Brokerage Firm


The Duty of a Brokerage Firm

Analysis of the duty of a brokerage firm to monitor customer accounts and to recommend account changes. 

Please note that, while this article accurately describes applicable law on the subject covered at the time of its writing, the law continues to develop with the passage of time. Accordingly, before relying upon this article, care should be taken to verify that the law described herein has not changed.
Does a brokerage firm owes its investor clients an ongoing duty to monitor the investments held in the customer’s accounts to ensure that the investments remain suitable and appropriate for the customer’s needs and circumstances? Many reported decisions and other legal authorities appear to support the finding of a duty of brokerage firms to their investment clients to monitor the clients’ accounts and the investments held in those accounts, and to recommend changes where appropriate to maintain the suitability of the accounts for the clients.

Securities brokers stand in a fiduciary relationship with their customers. Marchese v. Shearson Hayden Stone, Inc., 734 F.2d 414, 418 (9th Cir. 1984). Such a fiduciary relationship is characterized as an affirmative duty to use the utmost good faith. Id. This duty carries with it the duty to fully and fairly disclose all material facts. Id. See also Securities & Exchange Commission v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 194, 84 S. Ct. 275,284, 11 L.Ed.2d 237 (1963). Agents, as a general rule, are fiduciaries of their principal. French v. First Union Securities, Inc., Case No. 3:02-0140 (M.D. Tenn. 2002). Since stockbrokers are generally agents of the client, it necessarily follows that they are also fiduciaries. Id. ‘Thus, the investor-stockbroker relationship is an inherently fiduciary relationship.’ Id. The fiduciary obligations securities brokers owe to clients are comparable to the fiduciary obligations corporate directors owe to shareholders. O’Malley v. Boris, 742 A.2d 845,849 (Del. Supr. 12-8-1999). See also Rupert v. Clayton, 737 P.2d 1106, 1109 (Colo. 1987):
A broker who becomes a fiduciary of his client must act with utmost good faith, reasonable care, and loyalty concerning the customer’s account, and owes a duty to keep informed regarding changes in the market which affect his customer’s interests, to act responsibly to protect those interests, to keep the customer informed as to each completed transaction, and to explain forthrightly the practical impact and potential risks of the course of dealing in which the broker is engaged.
A securities broker has a continuing duty to carefully monitor his customer’s account and to advise the customer of foreseeable risks if that customer has routinely relied on the broker’s similar advice in the past and that customer is relatively unsophisticated. Vucinich v. Paine, Webber, Jackson & Curtis, 803 F. 2d 454, 460 (9th Cir. 1986). Failure to do so is tantamount to a breach of the broker’s fiduciary duty. Id. An agent breaches his fiduciary duty to the principal and is liable for damages when the agent’s lack of due professional care leads to the loss of his principal’s money. Thropp v. Bache Halsey Stuart Shields, Inc., 650 F.2d 817 (6th Cir. 1981). See United States v. Dial, 757 F.2d 163, 168 (7th Cir. 1985), cert denied, 474 U.S.838:

If someone asks you to break a $10 bill, and you give him two $1 bills instead of two $5’s because you know he cannot read and won’t know the difference, that is fraud. Even more clearly is it fraud to fail to ‘level’ with one to whom one owes fiduciary duties. The essence of a fiduciary relationship is that the fiduciary agrees to act as his principal’s alter ego rather than to assume the standard arm’s length stance of traders in a market. Hence the principal is not armed with the usual wariness that one has in dealing with strangers; he trusts the fiduciary to deal with him as frankly as he would deal with himself ‘ he has bought candor.

S.E.C. administrative decisions have gone one step further, requiring securities brokers not only to monitor investors’ portfolios, but to advise the investor against making certain investments that are unsuitable given the investor’s financial status. See Erdos v. S.E.C., 742 F.2d 507 (9th Cir. 1984), see also Clyde J. Bruff, 50 S.E.C. 1266 (1992), and Charles W. Eye, 50 S.E.C. 655 (1991), all of which impose on brokers the duty to counsel investors in a manner consistent with their financial status, even though the investor expresses an interest in speculative investments. These important decisions signify the extent of the broker’s fiduciary duty, and make clear the point that brokers need not only concern themselves with their own recommendations, but those of the investor and third parties.

In Erdos v. S.E.C., the Federal Ninth Circuit Court of Appeals upheld the S.E.C.’s order affirming NASD disciplinary penalties imposed on a broker who was found to have churned his customer’s account, and to have made unsuitable investments for the customer. Eugene J. Erdos, 47 S.E.C. 985 (1983), aff’d. Erdos v. S.E.C., 742 F.2d 507 (9th Cir. 1984). In Erdos, the defendant/broker engaged in more than 130 transactions in one year for his client who was a seventy-five year old retired widow. Erdos, 742 F.2d 507 at 508. Such trades brought significant commissions to the broker, while the account lost roughly $90,000, or most of its value due to unsuitable investment decisions by the defendant broker. Id. The broker claimed that he did not violate the NASD’s suitability rule because the investor did not divulge her age, lack of sophistication or other related facts. Id. Further, the broker maintained that he was not responsible for the losses incurred as a result of the numerous transactions on the account because the elderly investor controlled the account. Id.

The court rejected both of these defenses. Id. Regarding the first defense, the court stated, ‘The NASD’s suitability rule is not limited to situations where comprehensive financial information about the customer is known to the dealer. Erdos (the broker) had a duty to act with caution and to make recommendations based on the concrete information that he did have rather than on his speculations about her situation.’ Id. The court rejected the broker’s second defense of lack of control, deferring to the lower administrative court’s decision. Id. In the administrative opinion, the judge provided in pertinent part, ‘Even though Mrs. C (the investor) may have desired ‘quick profits’, that did not entitle Erdos to ignore her individual situation and place limited assets in risky investments.’ Eugene J. Erdos, 47 S.E.C. 985, 988 (1983). It seems the defense of ‘lack of control’ failed, not because the broker did control the account, but precisely because he did not control the account adequately. Thus, the broker was obliged to protect the investor from her own poor investment decisions.

In Charles W. Eye, the S.E.C. presided over an appeal of an NASD disciplinary proceeding in which Charles Eye, a broker for Dean Witter, was sanctioned for making unsuitable recommendations, including the use of margin in his client’s account, and for engaging in unauthorized trading. Charles W. Eye, 50 S.E.C. 655 (1991). Mr. Eye had always handled the client’s account conservatively, as she was an unemployed mother of two children, and a full time college student who had expressed an investment objective of obtaining income. Id. at 656. The Commission upheld the harsh sanctions despite evidence that the client had expressed a new objective of both ‘large cash flow’ and growth following a divorce in 1984. Id. at 658. In the opinion, the Commission stated:
Her request for a plan to increase that income was not a warrant to escalate risks unduly. If the only approach capable of producing the desired income involved significant dangers, Eye should have advised against it.
Charles W. Eye, 50 S.E.C. 655, 658 (1991).

In response to the broker’s claim that his investment decisions were justified given the fact that the client had a safety net of at least $70,000.00 in another account, the Commission opined:
Even assuming that Ramini (client) had the objectives and assets cited by Eye, our conclusion would be the same. Here Eye was dealing with a single, unemployed mother who needed income to cover living expenses. The fact that she might have possessed about $70,000 in addition to her account would not justify the exposure to heavy losses and the drain on income to which she was subjected. Moreover, regardless of whether Ramini appeared willing, or even eager, to pursue ‘growth’ as Eye understood it, it was Eye’s duty to advise her against that pursuit to the extent that it was incompatible with her acknowledged needs.
Id. at 659.

Clyde J. Bruff, 50 S.E.C. 1266 (1992) involved a broker’s appeal from a disciplinary proceeding, this time before the NYSE, in which the broker was sanctioned for improperly recommending options transactions in his clients’ joint account. His clients, an elderly couple nearing retirement, had expressed a desire for ‘long term growth’ and ‘income’. Id. at 1267. Despite his clients’ age and other circumstances warranting safety, the broker recommended that his clients engage in options trading in order to recoup certain losses they had sustained. Id. At some point soon after Mr. Patterson’s (the husband) agreement to let the broker engage in options trading in his account, he realized he lacked the expertise to monitor the account adequately. Id. at 1268. In its decision to affirm the NYSE-imposed sanctions, the Commission noted,
Whether or not the Pattersons ultimately considered options transactions appropriate is not the best test for determining the propriety of Bruff’s (the broker) conduct. Having undertaken to act as an investment counselor for the Pattersons, Bruff was required to make only such recommendations as were in their best interests. Thus, even if the Pattersons wished to engage in aggressive and speculative options trading, Bruff was obliged to counsel them in a manner consistent with their financial situation.
Id. at 1269.

Clyde J. Bruff is yet another decision which stands for the proposition that brokers are bound to protect investors from even their own poor investment decisions. Further, should a brokerage firm and stockbrokers argue that they are not responsible for any losses sustained from certain investments because they were acquired while the clients were with another brokerage firm, this argument must fail. The clients paid the respondents in return for their services as investment counselors. They were obliged to counsel their clients about all of their investments. A broker, therefore, should be held accountable for permitting bad investments to remain in their clients’ account. As Judge Posner said so poignantly of a client’s expectations, ‘‘ he trusts the fiduciary to deal with him as frankly as he would deal with himself ‘ he has bought candor.’ United States v. Dial, 757 F.2d 163, 168 (7th Cir. 1985), cert denied, 474 U.S.838.

Contrary Brokerage Firm Arguments. Brokerage firms typically argue that a stockbroker does not have an ongoing duty to keep clients apprised of information affecting their accounts where no fiduciary relationship exists between broker and client, citing Caravan Mobile Home Sales v. Lehman Bros., 769 F.2d 561, 567 (9th Cir. 1985). Generally, they argue that in regard to a non-discretionary account, a broker acts as the agent for the purposes of placing a requested order, but his agency terminates immediately following that transaction. However, while frequently cited by brokerage firms, the Caravan case is actually helpful to investors since it directly indicates that an ongoing fiduciary obligation shall be imposed upon a broker who ‘for all practical purposes controls the account.’

Caravan Mobile Home Sales involved a plaintiff/trustee who sustained significant losses in a non-discretionary account due to an extremely speculative investment in ‘Nucorp’, an oil and gas exploration concern that filed for bankruptcy protection soon after the plaintiff’s investment. Id. at 564. The plaintiff alleged that defendants (Lehman Brothers) breached their fiduciary duty and sought recovery for these losses after it became clear that a managing director of defendant Lehman Brothers, was also an outside director of Nucorp. Id. The plaintiff alleged that defendant’s failure to disclose that the company was in financial trouble was a breach of their fiduciary duty. Id. The court denied the plaintiff’s claim on the basis that the subject account was without question non-discretionary in nature, and therefore no ongoing fiduciary duty was owed. Id. at 567. The court reasoned that no continuing duty to monitor plaintiff’s account was owed because, “There was no showing that defendants exercised continuing control over Caravan’s account or acted as investment counselors.’ Id. The court continued: ‘California law imposes a fiduciary duty ‘where the agent for all practical purposes controls the account.’ Because plaintiffs have offered no evidence that Lehman Brothers owed them a continuing duty to advise them about Nucorp developments, the district court properly held that defendants were entitled to judgment as a matter of law on Caravan’s purported federal claim based on breach of fiduciary.’ Id. Accordingly, in a situation where the investor client relies upon the stockbroker, who in effect exercises control over the account, Caravan stands for the proposition that a continuing duty does exist.

Finally, other Ninth Circuit cases have been much more instructive in analyzing the fiduciary obligations of stockbrokers to monitor customer accounts. In Vucinich v. Paine, Webber, Jackson & Curtis, 803 F.2d 454, (9th Cir. 1986), for example, the Ninth Circuit court engaged in a much more extensive analysis for purposes of defining a broker’s fiduciary obligations. In the context of a broker’s fiduciary duty to explain the nature of short selling to a relatively inexperienced investor, the court provided, ‘‘if during that period she (the investor) routinely relied on his (the broker’s) advise when to close out her short positions and did not have the education and experience to decide these matter herself, Moore was in a fiduciary relation to her and had a continuing duty to advise her of the nature and risks of short selling’’ Vucinich v. Paine, Webber, Jackson & Curtis, Id. at 460.

Other Authority. On November 8, 2002, Harvey Pitt, while he was still acting Chairman of the SEC, gave a speech at the Securities Industry Association’s annual Meeting, in which he emphasized the inherent fiduciary obligations imposed on all securities professionals.[1] He stated in pertinent part:
Congress can legislate new legal standards, as it did in Sarbanes-Oxley. Government can engage in regulatory reform and strong enforcement, as the SEC has done with unprecedented vigor over the last year. But in the end, it’s incumbent upon the private sector ‘ you who are responsible for making our markets function ‘ to ensure you meet and exceed the highest standards for professional conduct. Regulation can never substitute for people doing their jobs honestly, dedicated to serving their customers as the fiduciaries they are.[2]
[Emphasis added].

In likening the industry professional’s customer to doctor’s patient, Mr. Pitt continued:
So it is for your customers. You’re charged with taking care of their financial health. Too many Americans, ‘even one is too many,’ have come to believe your industry doesn’t subscribe to or implement this premise. Too many Americans who piled into the stock at the worst possible time, lured by false expectations of sustained double-digit increases in their personal portfolios, feel fundamentally betrayed by an industry that made them believe unbelievable rises in personal wealth were possible.[3]
Mr. Pitt then discussed the concept of improving customer service in the industry when he stated:
Service excellence must be your mantra, too. Ask customers what they don’t like about how you do business, what services they’d like you to provide that you don’t. You might be surprised. Only if investors truly believe you care first and foremost about serving their needs and interests will they become customers for life. Like Sewell (referred to earlier in speech) you need to be committed to giving customers what they most want honesty, integrity and genuine concern for their welfare.[4]
[1] See copy of Speech By SEC Chairman: Remarks at the Securities Industry Association Annual Meeting, November 8, 2002, available on the SEC website.

[2] Id. Mr. Pitt’s unqualified comments regarding the fiduciary duty of securities industry professionals to their clients is particularly noteworthy given the fact that Mr. Pitt was often publicly criticized as being too industry biased, and not strong enough on protecting investors’ rights. Harvey Pitt’s candid concession that securities professionals owe a fiduciary duty to act in their clients best interests, like a doctor to his patient, is significant authority for an arbitration panel to hold brokerage firms accountable to the standard of conduct recognized and acknowledged by the former Chairman of the SEC.

[3] Id.

[4] Id.

If you have questions regarding a possible securities law matter, or to arrange for a consultation concerning your legal matter, please contact Robert Mitchell at rdm@tblaw.com or at (602) 452-2730.
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