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Financial Suicide Liability:
A Broker's Duty to Refuse to "Serve the Drink"
nternet mania surely will continue, and investors surely will continue to demand those "safe, 20% returns". Even when brokers caution against such unfounded optimism, they are put in a tough spot, as two NASD enforcement decisions illustrate.
The liability doctrine of "financial suicide" is akin to the line of court opinions imposing liability upon the bartender and the bar for serving drinks to the drunk (who then leaves the bar and injures a third party) under state Dram Shop laws. The NASD enforcement decision rendered in In the Matter of Frank Mazzei (June 24, 1998), summarizes it best:
[A broker's] responsibility goes beyond mechanical obedience to all customer demands.
In Mazzei, the hearing panel assumed, for the sake of argument, that the customer had changed his investment objective from "growth and income" to "aggressive growth". But that shift in investment objective, even if true, did not relieve the broker of further obligations, such as:
Warning the customer of increased volatility;
Discussing how the customer would meet margin calls; and
Advising against high portfolio turnover (17 times annualized in one account).
In short, the broker was required to counsel against an aggressive growth objective because it was not in the customer's best interests and not consistent with the customer's financial situation. The broker was fined, suspended and ordered to pay restitution.
The second NASD enforcement decision imposing various discipline is In the Matter of Robert Kernweis et al. (February 16, 2000). Notably, there the evidence demonstrated that the customer was "a speculative investor who was willing to 'bet the ranch' on an extremely risky trading strategy". Moreover, he "appeared to understand" the risks of the recommended trading strategy, and he had a history of risky trading.
Nonetheless, the hearing panel wrote:
The SEC has made clear that even in those situations where a customer seeks to engage in highly speculative or otherwise aggressive trading, a representative is under a duty to refrain from making recommendations that are incompatible with the customer's financial profile.
As one of its authorities, the panel cited an SEC decision, wherein the SEC stated:
Whether or not the [customer] ultimately considered … [the] transactions appropriate is not the test for determining the propriety of [the broker's] conduct. Having undertaken to act as an investment counsellor (sic) … , [the broker] was required to make only such recommendations as were in their best interests.
In view of these and other decisions, what can brokers do to attempt to protect themselves? Some may suggest discussing each trade with the client. However, the NASD enforcement decision in Kernweis found that to be insufficient. Others may suggest that a "Comfort Letter" or activity letter be sent, which requires the investor to state his awareness of the following:
I am a speculative stock investor and my sole investment objective is speculation;
My account may make substantial profits or suffer substantial losses;
I will buy and sell securities or the same security often and repeatedly;
I will pay large commissions; and
If my objective changes at any time, I will notify the firm in writing.
Sufficient? Kernweis found this very letter to be insufficient.
Although there is no certain solution, I recommend the following three steps: Advise, Document, Terminate If Advisable. First, advise your branch office manager and compliance department of the situation. Then, coordinate a response to the customer in order to communicate the dangers facing him should he choose to pursue his financially suicidal strategy.
Second, document those efforts with correspondence to the customer, which he must sign and return. Additionally, document the firm's continuing objections to the customer's financially suicidal strategy by, among other things, marking each trade unsolicited.
Finally, terminate the customer relationship if advisable, and hopefully before the financial suicide occurs.
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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.
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