Common Types of Stockbroker Misconduct

Notwithstanding the duties that brokers owe to their clients, whether because of intentional misconduct or poor training, some stockbrokers fail to meet the obligations that they owe to clients. This failure often results in mishandled client brokerage accounts, which can lead to significant investment losses. Among the most common types of broker misconduct are unsuitable investment recommendations, churning, misrepresentations and omissions, and unauthorized trading.

1. Unsuitable Investment Recommendations

Rule 405 of the New York Stock Exchange (“NYSE”), referred to as the “Know Your Client” Rule, and the rules of the National Association of Securities Dealers (“NASD”) require a broker to learn information about a client before recommending an investment. This information comprises a client’s “investor profile,” and includes the client’s age, financial status, investment experience, risk tolerance, and investment objectives. Brokers have a duty to recommend only investments that are consistent with a client’s risk tolerance, investment objectives, and needs. If a broker recommends investments that are inconsistent with the client's investor profile, the recommendations are considered to be unsuitable.

Following are three common examples of unsuitable investment recommendations:

a. Improper Asset Allocation

Asset allocation is the distribution of investments among asset classes, such as stocks, bonds, and real estate. Studies show that 90% of an investment portfolio’s performance is attributed to asset allocation rather than the selection of the “right” stock or bond. An appropriate asset allocation is based on a client’s investor profile, e.g., a retired person relying on their investments for income typically should invest primarily in conservative, bonds, rather than in risky stocks.

b. Lack of Diversification or Over-Concentration

Diversification refers to the distribution of investment dollars among different securities within an asset class. Undiversified or over-concentrated investment portfolios exist when a significant percentage of an account is invested in only one or a few stocks, one or a few bonds, or in only one sector of the economy, creating significant risk of loss. This risk of placing all of your “investment” eggs in one basket is reduced by investing in a number of securities from each of several economic sectors, such as banking, healthcare, consumer goods, and energy. When one particular security or economic sector suffers a downturn, other securities or sectors frequently experience stability or positive growth. As such, diversified portfolios are less volatile.

c. Unsuitable Margin Borrowing

“Margin” is borrowing money from a brokerage firm to buy securities. The securities in the account serve as collateral for the loan. The Securities Exchange Commission (“SEC”) requires the brokerage firm to have a margin agreement signed by the client before the broker and firm can use margin to purchase securities in a client’s account. If the securities purchased using margin borrowing drop in value, additional funds may have to be deposited into the account as collateral for the loan. Otherwise, the firm can sell the client’s securities to pay down the loan. The firm can do this without contacting the client and has the right to decide which securities to sell. If the value of all securities in the account is insufficient to pay off the margin loan, the client is responsible for the loan balance remaining after all securities in the account are sold. Because the client can lose even more money that they deposited into their account, and because the brokerage firm can force the sale of securities in the client’s margin account without first notifying the client, there is substantial risk of loss associated with investing on margin. The broker and brokerage firm are required to disclose these risks to the client.

2. Churning

Churning, also known as excessive trading, occurs when a broker makes trades for the primary purpose of generating commissions. Repeated securities purchases and sales within a short period of time are a sign of churning. In a commission-based account, the commissions charged for these unnecessary and excessive trades can make it difficult or nearly impossible for the client to obtain a long-term profit. This type of trading violates the broker’s duty to act in the best interests of the client and to refrain from self-dealing.

3. Misrepresentations and Omissions

Brokers are required to provide accurate information about investments. Federal and state laws prohibit brokers from making material misrepresentations and from omitting material information when recommending an investment. Information is “material” if a reasonable investor would consider it important in making an investment decision. Misrepresentations and omissions frequently involve incorrect disclosure or the lack of disclosure of the risks associated with a particular investment. Brokers can be held liable if they misrepresent material facts or fail to disclose material facts and the client loses money.

4. Unauthorized Trading

A broker generally must obtain the client’s approval before executing a trade. Broker’s must have a client’s written trading authority to waive this requirement. This, however, does not give the broker license to do as he pleases. Even then, a broker is required to make investments that are suitable the particular client. Trades made without the client’s prior approval and without any written trading discretion generally are held to be unauthorized. Clients can bring a claim to recover losses resulting from such trades.

5. Other Types of Broker Misconduct

Other types of misconduct, though less frequent, can occur, including market or stock price manipulation, theft of client funds, and failure to follow a client’s instructions.