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Compass Law Group Resources:

Types of Securities Fraud
There are several types of fraud which result in claims by investors against their stockbrokers and other investment advisors. These include:

Margin Account Fraud
Unauthorized Trading
Breach of Fiduciary Duty
Mutual Fund Fraud

Compass Law Group offers a free initial consultation to any investor who believes he or she may have a claim against a stockbroker or brokerage as a results of these types of fraud. Simply call 888.854.4002.

Margin Account Fraud
"The imposition of a duty to investigate the financial capability of an investor entering a margin transaction and to inform that investor of the implications of a margin purchase can also be justified as part of a stockbroker's professional responsibility." Piper, Jaffray & Hopwood, Inc. v. Ladin, 399 F. Supp. 292; 1975 U.S. Dist. LEXIS 16441 (S.D. Iowa August 26, 1975).

Even many experienced investors do not understand margin accounts. When you purchase securities on margin, your brokerage firm is lending you money to pay for these securities. Initially, you may use cash equal to half the securities purchased, or pledge certain fully paid securities. Either way, you owe the brokerage firm, or most likely its clearing agent, the debit balance, or the amount borrowed to pay for these securities.

Trading on margin increases the risk of loss to a customer for two reasons. First, the customer is at risk to lose more than the amount invested if the value of the security depreciates sufficiently, giving rise to a margin call in the account. Second, the client is required to pay interest on the margin loan, adding to the investor's cost of maintaining the account and increasing the amount by which his investment must appreciate before the customer realizes a net gain. At the same time, using margin permits the customer to purchase greater amounts of securities, thereby generating increased commissions for the salesperson.

In general, unless you purchase more securities or pay down the balance, the debit or the amount borrowed does not change. Stock prices, however, change and if the market value of the securities in your account declines in value, you will be required to meet margin calls and will be called upon to deposit additional cash, or fully-paid securities, into your account. If you fail to meet a margin call, or if your account falls below minimum maintenance levels, even in the absence of notice of a margin call, by contract, your broker is able to liquidate your investments. Under most circumstances, such conduct is not actionable.

However, many unscrupulous brokers use margin to increase the purchasing power in your account in order to facilitate excessive activity or churning. Aside from this practice, unless you are able to make and meet margin calls, and have the financial ability to satisfy the debit balance in your account, based on your overall financial condition, you may be unsuited for a margin account.

While a broker may have no duty or liability with respect to purely unsolicited transactions, the purchase of a security, on margin, even without any recommendation by the broker is actionable. 17 CFR Part 275 SEC Release No. IA-1406; File No. S7-8-94)(Suitability of Investment Advice) 59 FR 13464 (March 22, 1994).

With the advent of on-line discount brokers, the NASD has become increasingly concerned about the extension of credit, particularly with respect to "unsolicited" transactions on margin. According to the NASD, "[t]he recent growth in the level of customer margin account balances, coupled with the increase in customer inquiries and complaints to NASD Regulation and SEC staffs relating to the handling of margin accounts, has raised concerns as to whether investors understand the operation and risks associated with margin trading. NASD Regulation believes that investors' misconceptions about margin requirements, particularly with respect to maintenance margin, may cause them to underestimate the risks of margin trading." [Release No. 34-44223; File No. SR-NASD-00-55].

In fact, NASD Regulation is particularly concerned that:
Certain firms may arrange for and/or facilitate loans between customers that are used to finance securities trading and/or meet margin requirements. Customers borrowing funds may incur additional finance charges when credit is arranged by the member, and customers lending funds may face additional, and perhaps undisclosed, credit risks when they extend credit to other customers. NASD Regulation believes that questions arise regarding investor protection and disclosure practices when members become involved in the extension of credit between customers. In addition, such lending activities can result in a conflict of interest between the customer and the member, particularly when such lending activities allow customers to continue to trade when they would not otherwise be in a financial position to do so, thereby generating more commission income to the member. [NASD Notice to Members 01-06 (emphasis added)].

If your broker has placed your account on margin, and you do not understand, or are unwilling to trade on margin, you should have your account evaluated by a professional. Such practices are usually the warning sign of other inappropriate activity in your account.

Unauthorized Trading
Unless you have signed discretionary papers giving your broker permission to trade your account without your authorization, your broker is required to obtain your permission before buying or selling securities in your account. Many unscrupulous brokers place transactions in customer accounts without authorization, and when the client calls to complain, they may convince you to retain the shares because they have increased in value, or will increase in value. Sometimes, this activity may be also blamed on a "computer error." In either event, if your broker has entered unauthorized transactions in your account, chances are you have fallen prey to other fraudulent devices by this person. If you have been the victim of unauthorized trading, take action. The failure to act may be deemed tacit approval of these acts, and you cannot be said to have complained later, knowing that you own a particular security, when its price goes down.

Breach of Fiduciary Duty
The relationship between a broker and his customer is one of principal and agent by virtue of which a broker is subject to certain fiduciary obligations to the client. Securities brokers are fiduciaries that owe their customers a duty of utmost good faith, integrity and loyalty. A fiduciary relationship exists between a securities broker and customer because broker is a licensed professional who holds himself out as a trained and experienced person to render a specialized service. A a securities broker has a fiduciary duty to customer where broker knows or should have known that trust has been placed in him); See Gouger v. Bear , Stearns, 823 F. Supp. 282, 288 (E.D. Pa. 1993) ("the broker handling account has an unequivocal fiduciary duty to the customer with respect to the broker's investment activities and to any facet of their relationship that pertains to the customer's money"). The court in Lieb v. Merrill Lynch, 461 F. Supp. 951, 953 (E.D. Mich. 1978), enumerated a number of duties of a broker maintaining an account:

Such a broker. . . must (1) manage the account in a manner directly comporting with the needs and objectives of the customer as stated in the authorization papers or as apparent from the customer's investment and trading history [citation omitted]. (2) keep informed regarding the changes in the market which affect the customer's interest and act responsively to protect those interests [citation omitted]; (3) keep his customer informed as to each completed transaction; and (5) [sic] explain the practical impact and potential risks of the course of dealing in which the broker is engaged.

Moreover, the duty of loyalty and good faith is further enhanced where, as here, there is a pre-existing personal relationship between the broker and the customer such that the broker knows that the customer will likely be less skeptical than in a traditional, arms-length, broker/customer relationship. These duties include:

  • The duty to recommend a stock only after studying it sufficiently to become informed as to its nature, price and financial prognosis.
  • The duty to inform the customer of the risks involved in purchasing and selling particular securities.
  • The duty not to misrepresent or omit any fact material to the transaction.
  • The duty to study, analyze, and/or otherwise become informed as to the nature, price, and/or financial prognosis of the stocks purchased for Claimant's account.
  • The duty to inform Claimant, and indeed misrepresenting the risks involved in purchasing and/or selling speculative securities.
  • The duty to follow Claimant's expressed investment objectives and conservative investment strategy.
  • The duty not to engage in speculative trading or fail to properly diversify.
  • The duty not to place putting their own financial interests above those of their clients.

Mutual Fund Fraud
It is a fraudulent and deceptive practice to engage in the sale of back-end loaded, Class "B" mutual fund shares, where a customer would otherwise be entitled to quantity discounts or "breakpoints" from the sale of front end loaded Class "A" shares.

For example, if a client purchased five different funds totaling $100,000 within any particular family of funds, by investing $25,000 in each fund, in Class B Shares, the broker will receive fees or commissions of typically 5 percent or $5,000. Should the client sell these Class B shares, there is a surrender penalty associate with the sale of these securities, and this penalty decreases each year. Typically after 5 years, there is no penalty. However, the broker gets paid upon the initial purchase of these shares, in this example, $5,000 or the 5 percent commission.

Had this same customer purchased $100,000 of Class A shares, and sought to purchase five different funds, within a particular family of funds that customer would otherwise be entitled to quantity discounts, or "break-points" and could pay a commission, albeit front end loaded of less than 2 percent or in our example, $2,000.

In an effort to maximize commissions, at the expense of a customer, a broker may purchased back-end loaded or "B" shares, as opposed to front-end loaded "A" shares, where the customer would be eligible to earn "break-points." This practice has been declared "fraudulent and deceptive," per se, by securities regulators. (See, e.g. NASD Press Release, June 25, 2003 ("NASD Brings Enforcement Action For Class B Mutual Fund Share Sales Abuses")).