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"Beware of the Suicidal Customer"
tockbrokers increasingly are held liable for failure to prevent clients from committing "financial suicide." These cases suggest that brokers are required to stop even savvy and wealthy customers from getting in over their heads. The awards are rooted in analogous state laws that say bartenders have a duty to cut off patrons who drink too much (though the analogy is not sound: "dramshop" cases don't protect the drunk; they protect an innocent third party from the drunk). Likewise, another imperfect analogy can be made to Dr. Kervorkian's assisting suicides: his patients want to commit suicide, but the prosecution claims that he has a legal and ethical obligation to avoid assisting.
In any event, brokers need to be aware that they are potentially liable for clients who trade aggressively, even if the broker never recommended the investment and marked the trade ticket "unsolicited." Recent arbitration cases illustrate the problems brokers face. In Oliver v. Charles Schwab, the arbitration panel found that the firm breached its fiduciary duty and awarded damages because the firm permitted the trading in the account. The arbitrators rejected Schwab's accurate claim that the firm does not solicit activity of any kind. In TNGS (Belken) v. Paine Webber, arbitrators awarded $2 million to a sophisticated customer with an MBA from Harvard, despite the arbitrator's findings that the investments were suitable and the customer understood the risks involved. The arbitration panel reasoned that the broker and the firm undertook an express duty to monitor the performance of the customer's investment selections.
Other cases help illustrate the problems faced by brokers. In Cass v. Shearson Lehman Hutton, claimant was an active investor who had transferred his account from another firm and, at the same time, opened a joint account with his wife. Following a series of losses in prior months, claimant lost approximately $1 million in the October 1987 Crash. The arbitrators expressly ruled that Shearson Lehman Hutton was not liable for any loses which occurred prior to January 1988. However, given that the customer lost $1 million in the Crash of 1987 (the bulk of his visible capital), the arbitrators found that the firm and its broker no longer had credible evidence of his suitability for options trading and margin debt. The panel stated that the firm should not have allowed the claimant to continue his "disastrous trading strategy" at that point without making a diligent inquiry into the claimant's financial resources and his suitability for continued speculative trading. The panel awarded the claimant $236,159, the loss of equity following January, 1988.
In Peterzell v. Dean Witter Reynolds, the customer lost approximately 20% of his net worth while trading with respondent. Following the losses, respondent failed to request an updated financial profile and failed to inquire into the customer's trading practices. The broker provided options research and other information directed toward soliciting business and did not properly investigate the customer's financial status and level of experience. The arbitrators further found that the firm failed to take adequate steps once it became apparent that the customer was trading inappropriately, losing large amounts of money, and putting excessive amounts of his net worth at risk. The customer was awarded $80,577 plus interest of $46,622.
The good news is that certain affirmative defenses do exist for the broker in a financial suicide claim. For instance, the broker may be able to prove ratification and estoppel. A customer ratifies an otherwise improper trade or conduct by the broker if, with full knowledge of the material facts, he or she accepts the benefits of the transaction. In Hecht v. Harris, Upham & Co., the Ninth Circuit stated that "[t]he purpose of the Securities Exchange Act is to protect the innocent investor, not one who loses his innocence and then waits to see how his investment turns out before he decides to invoke the provisions of the Act."
Another defense available to the broker is what is called in pari delicto. This equitable defense is available when 1) the customer bears at least substantially equal responsibility for the violation he or she seeks to redress and 2) preclusion of suit would not significantly interfere with the effective enforcement of the securities laws. For example, in Wolfson v. Baker, the court ruled there was no liability for the broker who failed to notify the customer of applicable securities regulations where customer also knew of the regulations.
Nonetheless, customers increasingly are prevailing on their financial suicide claims. Unfortunately for brokers, arbitrators seldom offer a rationale for their decision and are not required to do so by law. Without clear guidance by the arbitrators, an element of uncertainty is introduced for any broker, whether working at a discount or full service firm.
Brokers can take precautions to help guard against financial suicide liability. First, make sure the account application properly reflects the client's level of sophistication and experience in trading stocks. Second, if the customer does not have the appropriate investment objectives, do not let him or her make the trades. This is regardless of what the customer orally represents. Third, make a written log of any conversations with an extremely aggressive customer detailing any warnings made, and any reservations expressed about what the client is doing. Finally, make the in house compliance manager aware of any extreme activity. Any potential suspension of the client's trading account may hurt the broker's bottom line in the short-term. However, the potential prevention of a costly and time consuming arbitration in the future will make the decision much easier.
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Sponsored by James J. Eccleston, an attorney representing stockbrokers, financial planners and
investors nationwide in arbitration, litigation and regulatory matters, and a shareholder with the law firm
Shaheen, Novoselsky, Staat, Filipowski & Eccleston
P.C.(www.snsfe-law.com). This Web site contains material
of general interest. It is neither intended to, nor constitutes, either legal advice or investment advice.
Always consult an attorney and/or investment advisor when building and protecting your wealth.
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