Author(s): Stephen E. Csajaghy
Published: 07/24/2009
Few issues can be more mystifying to a brokerage firm than being sued in a Financial Industry Regulatory Authority ("FINRA") arbitration by a person the firm has never heard of, who is not a client of the firm, who has never been a client of the firm, and who claims he invested in a product that the firm has never approved and never sold. Worse yet, the person suing ("Claimant") is exceedingly sympathetic— she just retired from her 35-year career running an inner-city soup kitchen, and was planning to use the money she lost in the investment to supply shoes to homeless children in Central America during her retirement years. This is the world of "selling away"—the colloquial term for private securities sales by a broker away from, and outside the purview of, a brokerage firm, sales that all too often involve investment scams.
But there is good news. The firm's registered representative who sold the product (such as an investment in a mare breeding program in Kentucky) to the Claimant was specifically told not to sell that product, promised in writing that he would never sell the product, never disclosed to the firm that he had sold the product, and had no record of selling unapproved products away from the firm. Additionally, the firm reviewed the rep's sales practices in regularly scheduled annual reviews and during unscheduled office examinations. It also checked all of the rep's correspondence with actual and prospective clients. The firm never found any evidence suggesting that the rep had been selling unapproved items either to clients of the firm or to nonclients. No red flags.
No problem. Defensible case. Or is it?
Oftentimes in selling-away cases, these favorable facts are not enough for the FINRA arbitration panel to exonerate (and find for) the brokerage firm. In fact, it seems as if there exists a presumption of guilt bordering on strict liability for the firm. In today's regulatory environment, it has almost become the firm's responsibility to prove a negative—that there is nothing else that could have been done to prevent its registered representative from selling the unapproved product. For example:
Of the firm that reviewed all of a rep's email communications by reviewing his work and personal email accounts on a daily basis, the arbitration panel may ask:
But what steps did you take to ensure that the rep did not open a Hotmail account through a fictitious name?
To the firm that monitored a rep's use of fax machines by requiring log-in codes before any fax is sent, the Claimant's attorney poses the issue as:
But what did you do to ensure that the rep was not sending faxes from his friend's personal fax machine?
About the firm that monitors all incoming and outgoing telephone conversations, the arbitration panel wonders:
But what did you do to ensure the rep was not meeting in person with the Claimant outside of regular business hours?
While these may be extreme examples, it seems as if an unfortunate burden shift to the brokerage firm is taking place in today's regulatory environment. Brokerage firms are sometimes required to prove that they did everything possible to prevent a sale away from the firm. The mere fact that the sale of a dubious product took place often focuses the evidence in the arbitration on whether something—anything— could have been done to prevent the sale.
But it is unfair and contrary to settled law to presume the "guilt" of a brokerage firm in a selling- away case simply because a Claimant is sympathetic or because the product is substandard. It is true that a brokerage firm must remain vigilant and carefully monitor the activities of its registered representatives. It must monitor the rep's communications with the public. It must ensure that the products the rep is selling are suitable for the client's investment needs. It must do what is reasonably possible to ensure that these back-alley sales do not happen. Nevertheless, a firm's liability is not strict simply because a product that everyone agrees is unsuitable was sold in a back alley on a rainy, dark night.
There are several steps a firm can take to prevent this subtle burden shift during a FINRA arbitration. First, to support the argument that selling- away cases do not involve strict liability, refer the arbitration panel to FINRA Conduct Rules 2110, 3030, and 3040. These rules address factors that regulators should consider when determining what penalties to impose against a rep who engaged in selling away. Emphasize that FINRA itself asks regulators to consider whether the rep misled his brokerage firm about his outside activities, or whether the rep took steps to conceal those activities from the firm. Make the arbitration panel aware that FINRA itself analyzes whether the rep was instructed by the firm not to sell the type of product involved or to discontinue selling the precise product that was sold.
Second, minimize the potential damages award by advising the arbitration panel early in the process of the need to assess liability on a percentage basis to all potentially responsible parties, including the rep, the Claimant, and the firm. Many state laws require finders of fact (such as an arbitration panel) to assess fault on a percentage basis to all potentially liable parties, even if they are not named as a defendant (respondent) in the arbitration. If the rep hid his outside activities from the firm, a strong argument can be made that a large percentage of the fault should be assessed to the rep and not to the firm.
These are the first steps that can be taken to combat the burden shift that has unfortunately become common in selling-away actions. It is time to place the burden back on a Claimant to demonstrate that the monitoring of a rep was substandard. Only then can brokerage firms battle the "presumption of guilt."
Stephen E. Csajaghy is an associate in the Denver office. His practice focuses on complex civil litigation and arbitration. His experience includes defending broker-dealers in FINRA actions and defending clients in SEC actions. Mr. Csajaghy can be reached at 303-628-9512 or by e-mail at scsajaghy@rothgerber.com.