Investment fraud has robbed hard-working investors of their retirements, their savings, and their futures. While Ponzi schemes and insider trading cases are more likely to snag national headlines, these cases are far less common than instances of stockbrokers and advisors simply taking advantage of unsuspecting investors.
What are the Most Common Types of Investment Fraud?
According to FINRA, negligence is one of the most common types of investor fraud. A broker may be negligent by failing to thoroughly vet a complex product or by neglecting to research the company behind a private placement. Investors can also be negligent when they fail to sufficiently diversify the investments, thereby exposing the investor to unnecessary risks.
Churning involves excessive trading at an investor’s expense. Because brokers typically earn a commission on each trade they execute, they have a financial incentive to make trades even if the transactions do not serve their clients’ investment objectives. As the U.S. Securities and Exchange Commission (SEC) explains:
“When a broker engages in excessive buying and selling . . . in a customer’s account without considering the customer’s investment goals and primarily to generate commissions that benefit the broker, the broker may be engaged in an illegal practice known as churning.”
There are several telltale signs of churning. Along with a high volume of transactions, if you see unauthorized trades in your account, if your broker’s trading activity seems inconsistent with your investment objectives, or if the fees in one segment of your portfolio seem particularly high, these could all be signs that your broker is churning your portfolio for their own financial benefit.
Churning violates FINRA Rule 2111, which states that every trade must be quantitatively suitable to the investor. This means that brokers must consider if the number of trades will incur too many fees to provide any benefit to the investor. To determine if churning has taken place, FINRA examines the cost-to-equity ratio and the turnover rate.
If there is a cost-to-equity ratio of more than 20% or a turnover rate of more than 6, FINRA can conclude that churning has taken place.
- The cost-to-equity ratio measures how much a portfolio would have to increase to generate a return
- The turnover rate is the number of times the broker exchanged one portfolio of securities for another portfolio of securities
3. Selling Away
Selling away occurs when a broker sells securities not sold through their firm without first seeking their firm’s authorization. FINRA Rule 3210 prohibits selling away and requires brokers to seek written authorization from their member firm before opening an account outside the firm for securities transactions. Fraudulent selling away inherently presents risks for investors since the firm cannot supervise the broker’s recommendations. Brokers may be especially motivated to sell away from their firm when they want to sell a security that is too risky for their firm to approve but comes with a tempting commission.
In many cases, stockbrokers sell away to invest in private placements and other non-public offerings. Regulatory Notice 01-79 noted an uptick in brokers selling promissory notes away from their firms—notes that marketing firms insisted were not securities and therefore did not require firm authorization. According to FINRA, however, the promissory notes were securities, information which brokers are required to verify.
4. Unsuitable Investment Strategy
Investors may be surprised to learn that recommending an unsuitable investment strategy is considered a form of investment fraud. According to FINRA Rule 2111, brokers and advisors have a duty to make “suitable” investment recommendations that fit their investor’s risk tolerance and financial goals. Suitable investments also account for the investor’s age, investing experience, and liquidity needs. Brokers can be held liable for any losses suffered as a result of their unsuitable advice.
To provide suitable investment recommendations, brokers and advisors must clearly understand their clients’ financial circumstances. This means that brokers and advisors also have a duty to get to know their clients. Whether an unsuitable investment strategy results from failing to understand a client’s needs and goals or ignoring those needs, it can provide a cause of action in FINRA arbitration.
5. Unauthorized Trading
In addition to churning, making isolated unauthorized trades can also result in an investment fraud claim. Investors are only allowed to place trades without investor authorization if the firm has approved the account for discretionary trading. While some investors may be willing to trust their brokers, this prohibition is designed to ensure that brokers do not take advantage of their access to their clients’ portfolios for their own benefit.
6. Failure to Supervise
Federal laws and FINRA rules require brokerage firms to adequately supervise their personnel. FINRA Rule 3110 requires a firm “to establish and maintain a system to supervise the activities of its associated persons that is reasonably designed to achieve compliance with the applicable securities laws and regulations and FINRA rules.”
Failure to supervise is considered a form of investment fraud regardless of intent. In other words, even if a brokerage firm’s executive leadership team believes the firm’s supervisory system is adequate, the firm can still face liability in FINRA arbitration if this proves not to be the case.
7. Elder Financial Abuse
Elder financial abuse is one of the most common and most unfortunate forms of investment fraud. The U.S. Department of Justice (DOJ) reports that “[a]t least 10% of adults age 65 and older will experience some form of elder abuse in a given year,” and it notes that approximately one-third of all elder abuse cases involve financial fraud.
Brokers have misled their clients, asked them to sign documents they don’t understand, and exerted pressure to coerce them to authorize high-risk or high-cost trades. Regardless of the specific circumstances involved, elder financial abuse is never justified, and senior investors (or their loved ones) can – and should – take legal action to hold fraudulent brokers and advisors accountable.
Schedule a Consultation at Kurta Law Firm with an Investment Fraud Lawyer
If you believe that you or a loved one may be a victim of investment fraud, we encourage you to contact us promptly and learn how our investment fraud lawyer team can help you.