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Fraud and Misrepresentation

Financial advisors have a legal and ethical obligation to disclose all material facts when making investment recommendations. The obligation of disclosure is required under federal securities laws (the Securities Exchange Act of 1934 (15 U.S.C. § 78a et seq. and Rule 10b-5), state securities laws and the rules promulgated by the Financial Industry Regulatory Authority (FINRA). The purpose of full and fair disclosure is so that investors can make informed investment decisions.

Sometimes, fraud is overt and obvious. More frequently, however, fraud is concealed. Common red flags associated with fraud are inconsistencies in statements made or information provided by your Financial Advisor, excessive trading, the sale of high commission investment products, high-pressure sales tactics and unauthorized activity in your account.

Fraud is a complex area of the law that requires a careful and effective presentation. Choosing securities fraud lawyers with experience in navigating securities fraud claims is a crucial first step in the investment loss recovery process.

Lack of Diversification and Overconcentration

Portfolio diversification is a fundamental principle of investing. Regardless of how well the stock market performs in a given year, the next downturn is just around the corner. Sectors of the market that performed well last year may perform poorly over the next several years. To smooth out the peaks and valleys in an account and avoid unnecessary volatility, it is imperative that your financial advisor recommends portfolio diversification across various asset classes, geographic regions and sectors of the economy.

While some brokers are over-confident in their assessment of market conditions, others are inexperienced, lazy or financially motivated to overconcentrate a client’s assets in a particular investment product. Brokers who fail to diversify a client’s portfolio may violate the fiduciary duty owed to that client.

Failure to Supervise

Brokerage firms make billions of dollars each year through the sale of investment products. While individual brokers are the ones to communicate with clients and recommend specific products, brokerage firms are responsible for the activities of individual brokers. The Financial Industry Regulatory Authority (FINRA) Rule 3110 requires that brokerage firms implement a reasonable system of supervision to detect and protect against unlawful sales practices by financial advisors.

Brokerage firms must look for red flags such as unsuitable investment activity, unusual withdrawals, sizable account losses and portfolio overconcentration. Brokerage firms invest a substantial amount of money in computer software to assist the management team and compliance departments in the detection of unlawful investment activity. If a brokerage firm fails to create or implement a reasonable system of supervision or ignores red flags when they arise, the firm may be in violation of FINRA rules for its failure to supervise individual brokers. In these cases, aggrieved investors may have a claim against both the individual broker as well as the brokerage firm.

Ponzi Schemes

While there are many types of fraudulent investment schemes, none are as known as the Ponzi scheme. Ponzi schemes rely on attracting new investors, often by offering high rates of return with the promise of little or no risk.

In a Ponzi scheme, the operator lures early investors in with the promise of future asset appreciation or cash flow through some legitimate means, typically product sales. To give the illusion of credibility, the operator pays early investors as promised; however, this money comes directly from new investors’ investment, rather than the legitimate source cited by the operator. Thus, when the operator can no longer convince new investors to give him their money, the scheme breaks down, leaving most investors with substantial losses. Unfortunately, many investors are unaware that they are involved in a Ponzi scheme until it is too late.

Breach of Fiduciary Duty

Financial professionals, including investment advisors, financial advisors and brokerage firms, owe a fiduciary duty to their clients. When referring to a fiduciary duty, the person or organization that owes the duty is called the fiduciary, and the person to whom the duty is owed is called the principal or beneficiary. Simply stated, fiduciaries must act in the best interest of the principal.

In 2019, the Securities Exchange Commission (SEC) implemented Regulation Best Interest (Regulation BI), which provides that brokerage firms and financial advisors may only recommend financial products to their customers that are in their customers’ best interests. Brokerage firms and financial advisors must also clearly identify any potential conflicts of interest and financial incentives the brokerage firm or financial advisor may have in selling those products. Regulation BI is an effort to codify the fiduciary duty owed by financial industry professionals to their clients. If a financial professional violates a fiduciary duty owed to an investor, the advisor may be liable for the investor’s losses.

Unauthorized Trading

Investors place a significant amount of faith in the financial professionals they trust to handle their money. Too often, investors – especially those who do not keep a close eye on the monthly activity in their account – fall victim to unauthorized trading. Unauthorized trading occurs when a financial advisor buys or sells investment products without a client’s permission. Advisors who engage in unauthorized trading do so to generate additional commissions.

Financial advisors have several different ways they can charge clients for their services. One of the common ways is to charge a client for each trade the advisor makes. Of course, a financial advisor must obtain an investor’s authorization before placing an order to buy or sell securities. If an advisor fails to get an investor’s permission before buying or selling securities, an investor can pursue a claim against the advisor to recover the losses associated with the trade, including for any commission paid.

Broker Theft

The financial industry is heavily regulated. Thus, the idea that an investment advisor or broker would engage in criminal conduct related to a client’s capital is unfathomable to many investors. Unfortunately, financial advisor theft and broker embezzlement are more common than most investors realize.

Broker embezzlement refers to any scheme in which a broker takes illicit and unauthorized action designed to steal directly from their clients. Common examples of broker theft include forging client documents, doctoring account statements, unauthorized trading or the unauthorized transfer of funds. In each of these situations, a broker violates the fiduciary duty owed to the investor, and the investor can pursue a claim to recover any losses associated with the unauthorized activity.

Churning

Even in sizable investment accounts, the aggregate cost of buying and selling securities and other products can accumulate quickly. Indeed, transaction costs can have a noticeable effect on a portfolio’s return, especially in actively traded portfolios. While financial advisors are often compensated on a per-trade basis, they are also required to put the financial interests of their clients ahead of their own. Churning, or excessive trading, occurs when a financial advisor recommends or places trades that do not have a material benefit for the client. The financial advisor’s sole focus is generating additional fees or commissions.

A financial advisor who engages in excessive trading relies on the fact that most investors only care about how much their portfolio has increased in value. Thus, investors who are most at risk for churning are those who do not carefully follow daily transactions in their account. These advisors often make short-term trades for marginal gains and emphasize monthly or quarterly returns, instead of long-term performance, in an effort to minimize the overall cost of transactions.

Margin and Other Securities-Based Lending

Margin refers to a loan that a customer of a brokerage firm takes against the value of the securities held in the account. The margin loan can be used to purchase securities, or the money can be withdrawn from the account to meet personal expenses. The brokerage firm charges interest on the amount of margin used. Financial advisors are often compensated, in part, based on the amount of assets they have under management, which includes asset values enhanced by the use of margin.

Investors who use margin to purchase securities have the opportunity to enhance their investment returns. However, margin carries significant risks. If the value of the underlying collateral securing the margin loan falls below a certain level due to general market volatility, the brokerage firm will issue a margin call. If the client does not meet that margin call through the deposit of additional assets, the brokerage firm can liquidate securities in the account.

Margin carries significant risks and is not suitable for all investors. All risks associated with the use of margin must be disclosed prior to an account being approved for margin, and the client must have the willingness and financial ability to absorb a loss of principal. A brokerage firm’s failure to discharge its disclosure and suitability obligations regarding the use of margin may subject the brokerage firm to liability for attendant losses.

Elder Abuse

Dishonest financial advisors use a variety of tactics to bilk unsuspecting seniors of their money. Most often, advisors will attempt to foster an unusually friendly relationship with a prospective investor, hoping to gain their trust. However, once the deceitful advisor has a senior’s money, the advisor’s true intentions come out. Frequently, this takes the form of one or more of the following:

• Charging the investor excessive fees
• Engaging in churning to increase the amount of commission paid by the investor
• Buying and selling investment products without obtaining an investor’s consent
• Placing an investors capital in unsuitable products

Seniors who are the victim of financial exploitation can pursue a claim against offending financial advisors and the brokerage firms that fail to supervise them.

Unsuitable Investments

Suitability is the bedrock principle of investing. Financial advisors must take an investor’s needs and objectives into account and make suitable investment recommendations. Every investor’s situation is unique. For example, younger investors may be willing to take additional risks for the prospect of a higher annual return. However, older investors generally opt for more conservative investments that will preserve their capital, allowing a stable flow of income throughout their retirement.

Financial Industry Regulatory Authority (FINRA) Rule 2111 governs suitability and provides that a financial advisor must consider the following factors when making investment recommendations to a client:

• Age
• Other investments
• Investment objectives
• Risk tolerance
• Tax status
• Investment experience
• Liquidity needs
• Time horizon

Selling Away

Selling away refers to the practice by a financial advisor of recommending securities to a customer that are not offered or vetted by the brokerage firm that employs the financial advisor. Often, the financial advisor has a personal interest in the outside investment being offered. The Financial Industry Regulatory Authority (FINRA) has promulgated Rules 3030 and 3040, which set forth the standard of conduct relative to private securities transactions.

Rule 3030 requires that financial advisors disclose their association with any outside businesses or entities so that the brokerage firm can supervise their activities and ensure compliance with the securities laws. Rule 3030 applies to any business, even if it does not relate to the sale of securities.

Rule 3040 directly relates to outside private securities transactions. If a financial advisor is engaged in the sale of securities, separate and apart from their association with the brokerage firm, the brokerage firm is obligated to supervise those private securities transactions and record them on the books and records of the brokerage firm.

Advisors usually sell away from their firm for one of two reasons. The first reason is to make a commission. The second reason a broker may sell away is to recommend an investment in their own business or a business owned by a friend or family member. In each of these cases, selling away is a violation of FINRA rules and may be the basis for a legal claim against the advisor and employing brokerage firm.

The purpose behind the prohibition against selling away is to ensure that financial advisors do not offer securities to clients of the brokerage firm that have not been vetted or approved by the brokerage firm. Approved products have typically undergone thorough due diligence screenings to ensure that they are sound financial products.