Recovered for Investors
Selling away is the inappropriate practice of selling securities not held or offered by the firm with whom the broker is affiliated. Brokers typically engage in selling away i n order to avoid the scrutiny of the firm’s compliance department and/or to obtain commissions on products that have not been approved by the broker’s fi rm.
Consider the following common fact pattern:
A client once came into an attorney’s office complaining that her financial adviser with a well-known brokerage firm had recommended that she invest $100,000 in a promissory note issued by Company ABC. A promissory note is a type of security in which a company or individual promises to pay a certain amount of interest to an investor over a prescribed period of time. In this example, Company ABC promised to pay the investor 20 percent in interest at the end of a 12-month period. At the end of the 12-month period, Company ABC promised to pay the investor back 100 percent of her principal plus 20 percent.
At the time that the broker recommended the promissory note, the financial adviser was managing the investor’s entire portfolio through the brokerage fi rm. The investor was looking for safe, income-producing investments, and the broker represented that the promissory notes were guaranteed. The financial adviser’s brokerage firm, however, did not permit its brokers to sell promissory notes. The broker failed to mention this important fact to the investor and invested his client’s $100,000 into the promissory note anyway. Needless to say, at the end of 12 months, the investor did not receive back her $100,000 or any interest payment.
FINRA Rule 3270, formerly known as NASD Rule 3030, provides, in part, that “[n]o registered person may be an employee, independent con- tractor, sole proprietor, officer, director or partner of another person, or be compensated, or have the reasonable expectation of compensation, from any other person as a result of any business activity outside the scope of the relationship with his or her member fi rm. . . .” NASD Rule 3040 adds that “[n]o person associated with a member shall participate in any manner in a private securities transaction except in accordance with the requirements of this Rule. . . .”
Selling-away cases often raise the issues of failure to supervise and vicarious liability. As such, claimants typically prove liability for selling away through finding and exploiting “red flags” in the brokerage firm’s compliance. According to the SEC Division of Market Regulation, Staff Legal Bulletin No. 17 (Remote Office Supervision) (March 22, 2004), red flags include:
Selling-away cases are brought under the state and federal securities laws as well as under common law fraud, breach of fiduciary duty, and/ or negligence claims.
Firms argue that they cannot be liable for failing to supervise a broker who was acting without the firm’s permission. Firms also argue that they cannot be held liable under the theory of vicarious liability when the broker actually violated the firm’s own policies by selling unapproved or unauthorized securities. Selling-away cases typically turn on whether the firm adequately supervised the broker. If the firm knew or should have known about the broker’s conduct, then success on this claim is more probable. Proving that the firm knew or should have known of the selling away may be difficult. It is important to request all forms of communication between the broker and the firm, all communication between the broker and client, and all records of the firm’s supervisory activity relating to the broker.
A common legal question that arises in selling-away cases is whether the brokerage firm is required to arbitrate the dispute with the investor. In the example above, this issue would likely not arise because there was no question that the investor was a customer of the brokerage firm at the time that the broker made the recommendation to invest in the promissory note. In that context, there would likely be a written agreement between the brokerage firm and customer, providing that all disputes or controversies be resolved in arbitration sponsored by FINRA.
What if the financial adviser had recommended the promissory note to an investor who had not formally opened an account with the broker-dealer? Would the broker-dealer still be required to arbitrate the dispute before FINRA?
The answer is not clear. FINRA Rule 12200 states:
Parties must arbitrate a dispute under the Code if:
Arbitration under the Code is either: (1) Required by a written agreement, or (2) Requested by the customer;
The dispute is between a customer and a member or associated person of a member; and
The dispute arose in connection with the business activities of the member or the associated person, except disputes involving the insurance business activities of a member that is also an insurance company.
FINRA’s rules do not define a “customer” as anything more than “a customer shall not include a broker or dealer.”
In general, courts have been liberal in defining the “customer” of a broker-dealer for the purposes of analyzing whether disputes should be resolved in arbitration.