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Protecting Your Financial Future Part 2: Types of Investment and Advisor Misconduct

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Regardless of the title used by an investment professional, the fact of the matter is that most investors place substantial confidence in their own advisor. They rely on him or her to manage the investor’s account in a professional and prudent manner to maximize the amount that will ultimately be available for retirement. But there are a wide range of issues that arise with both investment professionals and with the investments themselves that can rob the investor of both his or her past efforts as well as his or her future. They range from the negligence and incompetence of the advisor to outright fraud and theft. Conflicts of interest are frequently a problem. There are a variety of illegal market manipulation schemes that cause stock prices to rise and then collapse.

These losses often go unreported. Investment professionals may blame losses on market conditions, or they may engage in creative accounting to hide the losses. After a significant loss, they may tell the investor that “now” is the time to invest. They may begin buying stocks on margin to maintain the appearance of a higher account value. Other times, rising market conditions can hide investment advisor negligence or misconduct. Despite mismanagement or fraud, an account may gain value in times of rising market conditions. If an account gains 5 percent in value over a period of time when the market has gained 20 percent, that discrepancy could indicate a problem.
In order to protect yourself, it is necessary to understand some of the more common types of investment advisor misconduct.

1. Types of Investment Advisor Misconduct

Financial frauds have existed ever since financial systems have been created and, unfortunately, new fraud schemes arise almost continuously. One must understand that many investment “professionals” have no education in the area of finance and are drawn to the field by the huge commissions they can generate. For many, the goal is to maximize the amount of funds under management so that they can maximize their commissions. The real talent that many have is their ability to gain people’s trust and sell them products. Likeable, charismatic salesmen and saleswomen can and do make fortunes in the investment industry; frequently, with little understanding of what they are selling. For the ethically challenged individual, there is no limit to the amount of money he or she can generate.

While the list below is not all inclusive, it does present some of the more common types of investment misconduct.

a. Churning

Churning refers to the practice of buying and selling securities for the purpose of generating commissions. Simply put, some brokers and advisors will buy stocks and then sell them off only to buy the same stocks later. Superficially, the practice appears to cause no harm to the investor because, at the end of the day, the only thing he or she has lost is a “small” commission; however, churning is illegal and unethical. It violates both Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) rules. It also harms the investor by charging him or her excessive fees for trades that are unwarranted and unnecessary. The practice may also subject the investor to greater taxation.

There is not a hard and fast rule as to when churning exists or becomes actionable. In order to determine if churning has occurred or is occurring, it is necessary to examine the reasons for a particular series of trades. The focus should be on whether the trade(s) were in the investor’s best interest or the advisor’s best interest. Churning, even if unintentional, may be a sign of defective investment strategy or negligence.

b. Boiler Rooms

Boiler room operations are another illegal type of investment advisor misconduct and ranks among the worst type of conduct present today. The hallmarks of a boiler room operation are the use of high pressure sales tactics and cold calls to sell stocks sold on Pink Sheets or an over-the-counter bulletin board. The boiler room operation is akin to a telemarketing scam and the people making the calls are telemarketers, not investment professionals. Their goal is to sell as much worthless stock as possible at extraordinarily high commissions. Often these types of operations use impressive sounding names and office addresses and sometimes overseas offices. The reality, however, is that these operations are typically run out of low rent buildings using banks of phones and telemarketers.

Boiler room operations will frequently promise extraordinary results and tell the person answering the phone that he or she has to purchase the stock right then and there. When the investment collapses, which it inevitably will, they may bully the investor into doing nothing or buying more stock.
Beware of unsolicited calls and high pressure sales tactics.

c. Breach of Contract

In the investment context, contracts can be formed between an investor and an advisor in writing, orally or even be implied from the circumstances. The written documentation prepared by an advisor and signed by the investor constitutes a written contract that contains certain implied terms and conditions—i.e. an implied condition of good faith and fair dealings. However, an oral contract can also be formed between an advisor and the investor—“I will always put your interests first,” “I will not invest in high risk stocks,” “You will only be invested in [Fortune 500 companies][domestic companies], etc.” These representations may form the basis of a contract, and when they are not honored, the broker may be liable for violating his or her promises. This would be a breach of contract.

Breaches of contract, especially oral contracts, may be difficult to prove; however, this does not mean that they do not exist or that they are less important than a written contract. A valid oral or implied contract is just as enforceable as a written contract. If you discover that your investment advisor is not investing your funds as previously agreed or that he acted in a manner not consistent with what you understood the relationship to be, the advisor may have breached an oral or implied contract. You should seek competent legal advice immediately.

d. Elder Abuse

Unfortunately, instances of elder abuse are becoming more and more common. When we typically think of elder abuse, we may think of nursing home or caregiver abuse or neglect (such as the physical abuse that comes from being struck by a caregiver or the bedsores and mal-nourishment that come from neglect). A more insidious and more difficult form of abuse comes from the investment professional who seeks to take advantage of the elderly client. The elderly, as a group, tend to be more susceptible to high pressure sales tactics, more trusting of well dressed “professionals” and less understanding of securities transactions. They also tend to blame themselves when their accounts incur losses. Even if they suspect fraud or misconduct, embarrassment or fear may prevent an elderly individual from informing family members.

All of the categories of fraud and misconduct discussed herein occur with the elderly. In addition, they are frequently the targets of thefts and embezzlements. They may be sold unnecessary or inappropriate financial products such as insurance or other investments that simply do not make sense. For the vast majority of the retired population, appropriate investments would include diversified mutual funds or money market accounts, bonds, certificates of deposits, etc. Excessive trading is almost never appropriate.

A variety of state and federal laws do exist to protect the elderly from abuse; the problem comes in knowing if abuse has occurred. There are certain warning signs that the elderly investor and their family should look for. Some of the questions that should be asked are:

  • Are there any sudden or unexplained losses?
  • Does the investor use high pressure sales tactics?
  • Is the investor receiving regular statements? Do the statements make sense?
  • Is the investment advisor making frequent and unnecessary visits?
  • Does the investment advisor say that the investments or investment strategy are too complex to understand?
  • Are there any unusual investment products?
  • Is the investment advisor a member of the elderly investor’s church, temple, synagogue, mosque, etc., and is that the reason the investor chose that particular investment advisor?

There is a common type of fraud called “affinity fraud” that is common within certain social groups and which relies upon strong religious or other social bonds to perpetrate frauds or schemes. Some of the most common groups targeted by these types of fraudsters are Evangelical Christian Groups, Anabaptist Groups (Amish and Mennonites) and Jewish Groups. Many times, the perpetrators of these affinity fraud schemes will enter a congregation and target its elderly members. Their lack of sincerity usually only becomes apparent after people have lost money.

Because the elderly are vulnerable and frequently the target of unscrupulous investment professionals, they need to be protected. The elderly investor and his or her family and friends need to be vigilant to protect the investor. If there is a problem or a question, an investment fraud attorney should be consulted quickly.

e. Breach of Fiduciary Duty

The relationship between an investment professional and an investor is a relationship based upon trust. The professional knows intimate financial details about the investor, and the investor relies upon the expertise and advice of the professional. The investment professional always has a duty of good faith and fair dealings toward the investor. The nature of the investment relationship may give rise to an even higher duty—a “fiduciary duty.”
Fiduciaries are individuals who have an obligation to act in the best interest of another person or entity and to put the interests of that other person above his or her own. Corporate directors have a fiduciary duty to the corporation’s shareholders. Trustees have a fiduciary duty to the trust and the trust beneficiaries. Lawyers have a fiduciary duty to their clients. Investment professionals may have a fiduciary duty to their investors.

When a fiduciary duty exists, the investment professional must do the following:

  • place the investor ahead of the investment professional or the brokerage firm.
  • monitor changing markets to protect the client from changing market conditions.
  • inform the investor of all transactions that affect his or her interest.
  • advise the investor of the risks and benefits of the investment advisor’s advice.

The breach of a fiduciary duty is a very serious matter. When a breach occurs, the investment advisor and the brokerage firm will normally be required to restore all of the investor’s losses.

f. Fraud

Federal and state laws prohibit deceptive practices associated with the sale of a security. Most commonly, the deceptive practice at issue will involve a false statement by an investment professional or brokerage firm. It may relate to either a particular security or an investment practice. Securities fraud also includes other types of illegal conduct, including embezzlement, theft, stock manipulation, insider trading, false statement of financial reports to auditors, etc. The sale of high risk securities to unsophisticated investors who cannot afford the loss may also constitute securities fraud.

Securities fraud is a serious crime. For the victims of fraud, it is devastating. When securities fraud occurs, an experienced securities fraud lawyer will know how to analyze the case and how to obtain recovery. Often times a brokerage firm will try to avoid responsibility for the conduct of the investment professional in an attempt to avoid responsibility and leave the innocent investor stuck with the loss. An attorney with knowledge of this practice area can help the investor avoid this pitfall and establish a failure to supervise.
If you suspect you are the victim of securities fraud, you should seek help immediately.

g. Misrepresentation

Misrepresentation is a type of securities fraud where an investment professional makes a false or misleading statement in relation to the sale of a security. The false statement may relate to a particular stock, an account or an investment practice. Misrepresentation may involve a false statement about a stock’s prior performance. The investment professional may reference market research that does not exist or imply inside information that is not available. Sometimes, the investment professional will create “statements” that misstate the actual account value. He or she may be using margin accounts and then mislead the investor as to the use of a margin account.

Misrepresentations may be made orally or in writing. Whenever a brokerage statement differs from a statement from an investment professional or the investment professional tells an investor he or she does not need to see a statement, the investor should consult an investment fraud attorney. The longer a fraud is permitted to persist, the more difficult it is to obtain a full recovery.

h. Negligence

Negligence is a failure to use due care under the circumstances. In the context of a securities case, negligence is a failure to exercise the care required of a reasonable investment professional under the circumstances. In most cases of investment or securities fraud or misconduct, the investor must prove that the investment advisor intended the conduct that caused the loss. To prove negligence, it is not necessary to prove intent. The investor need only prove that the investment advisor was careless or negligent. One example of investment advisor negligence may be the recommendation of investment in a stock that turns out to be a fraud. A reasonable investment advisor would investigate a stock before recommending its purchase. Another example of negligence might be the failure to diversify a client’s portfolio since most investment advisors would agree that a diversified portfolio is safer than a portfolio over concentrated in one or two stocks.

Negligence is a cause of action normally joined with other causes of action. It could be that an investment advisor engaged in intentional misconduct. However, if intent cannot be proven, the advisor’s negligence may, nevertheless provide a basis for recovery.

i. Failure to Execute Trades

There are times, when for one reason or another, an investment advisor fails to execute an order. Most often the failure to execute is the result of negligence: an order may be lost or misinterpreted. There are also times when the investment advisor believes that a particular purchase or sale is unwise. Although the investment advisor has an obligation to advise the investor, in most circumstances, the advisor must execute the investor’s orders. If the failure to execute a trade results in a loss to the investor, the investment advisor may be liable for that loss.

j. Failure to Supervise

FINRA has enacted a series of rules that require brokerage firms to supervise the brokers that work for them. Firms have a duty to ensure that brokers are properly licensed and trained. Periodically, brokers are required to review an investor’s investment and financial circumstances and to review investment strategy. Brokerage firms must ensure this review takes place. Investment firms must also monitor the communications between a broker and the investor. In fact, if a broker engages in fraudulent or unauthorized activities with an investor’s funds, the brokerage firm may be liable for failure to supervise.

k. Overconcentration

One of the most common types of investment advisor misconduct is “overconcentration.” Overconcentration occurs when an investment advisor places too much of an investor’s portfolio into a single industry or single company. The old saying “don’t put all of your eggs in one basket” applies to investments just as it applies to other aspects of life. If an investment advisor places an investor’s portfolio into a narrow segment of the market, or worse yet, into a single company, and the sector or the company decline in value, an investor will lose a significant portion of his or her investment, even if the market as a whole increases in value. The safe and more professional approach to investing is to have a well diversified portfolio. That way, if one sector or one company suffers a significant set back, the portfolio as a whole will not be harmed.

If an investment advisor over concentrates an investor’s portfolio and the portfolio suffers a decline in value as a result, the investment advisor may, at the very least, be liable for negligence and overconcentration.

l. Unsuitability

Investment advisors have an obligation to “know the customer” and to make “suitable” investments on behalf of their clients. Not all investments are reasonable investments for all investors. People have different financial circumstances and risk tolerances. They are at different stages in life with different investment goals. Generally speaking, elderly investors tend to want to preserve their estates. Younger investors tend to be less risk averse. Some investors are investing a small part of their net worth; others are investing almost everything. For an investment advisor to render appropriate investment advice, he or she must ask sufficient questions from the investors to understand their investment goals. They must then use that knowledge to recommend investments that are consistent with the investor’s objectives.

“Unsuitability” claims are usually joined with other claims such as negligence or breach of fiduciary duty. If you or a family member believe that your investment advisor has placed you in an investment that you do not understand, you may have suffered from an “unsuitable” investment. You should contact a lawyer knowledgeable in this practice area. A successful claim requires a careful review of the records of the investment advisor and the investment firm. Do not delay.

m. Unauthorized Trades

FINRA rules specifically prohibit brokers or investment advisors from making discretionary trades without the express written permission of the investor. FINRA also requires brokers to maintain a list of individuals with discretion to trade. If an investment professional fails to secure written permission before executing discretionary trades, those trades are considered “unauthorized.” The unauthorized trading of securities is a form of securities fraud, and brokers and investment professionals may be held liable for unauthorized trades.

Even if written permission to trade has been secured by the investment professional, the trade may still be “unauthorized” if the investment professional used manipulative, deceptive or fraudulent practices to secure the authorization.

Typically, unauthorized trading will occur with other violations of securities law, such as breach of fiduciary duty, negligence, unsuitability and selling away. If determining whether a particular trade, or series of trades has been authorized, investment fraud attorneys will examine the documentation signed by the investor. Even if the signed document exists, the attorney should examine the circumstance surrounding the execution of the authorization. Were any promises made to secure the signature? Were any predictions made? Did the investment professional outline any particular investment strategy? Even if a trade has been authorized, the investment professional may still be held liable for unsuitability, negligence, breach of fiduciary duty or some other securities law violation.

n. Selling Away

“Selling away” occurs when a broker who is a registered agent of a brokerage firm sells securities that are not authorized to be sold by the brokerage firm. Brokerage firms maintain an approved products list that, in theory, constitutes products that have been subject to the broker-dealer’s due diligence and approved for sale by its registered agents. By “selling away,” the broker avoids the scrutiny of the brokerage firm and invests his or her client’s money in questionable or speculative investments. In some instances, investor funds have been put in unregistered private placements where the broker had a personal interest. Other types of questionable investments, the broker collects an unusually large commission. By “selling away,” a broker can cause significant damage to the investor.

“Selling away” is most common among smaller offices involving independent contractors that are far removed from the compliance departments of brokerage firm. The lack of oversight may be a basis for the brokerage firm’s liability. If you suspect that your broker has been “selling away” from the broker’s brokerage firm, you should consult knowledgeable counsel immediately.

o. Pyramid Schemes

A pyramid scheme is a type of securities fraud where a company will recruit “investors” who buy into the company for a certain amount of money. These investors then recruit other investors who pay them for the investment. A portion of this investment is then payed back to the company founders. This process then continues to third and fourth and eventually fifth level investors until, ultimately, there is no more money to be made. The founders typically make the most money and first generation investors make the second largest amount from the investment. Eventually, lower level investors do not even break even, and below that, investors lose significant amounts of money. A pyramid scheme is never an acceptable investment.

Often times, pyramid schemes are sold as multi-level marketing businesses. While multi-level marketing business are not usually suitable investments, they are not illegal. In a multi-level marketing business, the company actually has a product that it sells to the public. The “investor” collects a commission on the products that he or she sells, and that commission may be shared with a long line of previous “investors” to the point where the return on effort is miniscule, but the “investor” is not asked to pay to join the company, and the return involved is the return on the sale of a product, not a return on investment.

There is no legitimate reason for an investment advisor to recommend an investment in a pyramid scheme. Recommending involvement in a pyramid scheme would likely involve a number of other types of misconduct which may include: fraud, misrepresentation and unsuitability. Prompt legal action must be taken to minimize the damage and to obtain a recovery.

p. Ponzi Schemes

A Ponzi scheme is one of the most common types of investment or securities fraud. In a Ponzi scheme, a stockbroker or investment advisor promises a higher than usual return; however, there is almost always no investment activity. The perpetrator of a Ponzi scheme uses funds from new investors to pay off old investors. This scheme can last for a very long time, as long as there are new investors to keep paying the old investors, the scheme will continue. In the case of Bernie Madoff’s Ponzi scheme, his lasted for decades and ended up costing 4,800 investors more than $68 million. A Ponzi scheme is a serious violation of federal law.

So how can an investor or a potential investor recognize a Ponzi scheme? There are some indicators. Which include:

“Guaranteed” high returns. Legitimate investment advisors can never guarantee a consistently high return. Stock prices fluctuate with market conditions, and no one is good enough to always be correct in his or her investment advice. Certificates of deposit or treasury bonds may come with guaranteed returns, but the returns are low.

Consistent high returns. If an investment advisor indicates that he or she has produced consistently high returns for several years or more, the statement should be greeted with skepticism.

Hidden investments. Any legitimate investment advisor or brokerage firm should be able to provide details on investment strategies and actual investments. If an investment advisor is unable or unwilling to provide this information, one should suspect a Ponzi scheme. The failure to provide this information would tend to indicate that no such information exists and that the returns are fraudulent.

Unregistered securities. In the United States, securities most often have to be registered with the SEC and are subject to laws and regulations concerning their offer and sale to the public. Since a Ponzi scheme is premised upon extraordinarily high rates or returns, the perpetrators of the scheme cannot rely upon publicly available data to further the scheme. They will therefore frequently say that they base their success on an unregistered security. (Example: an interest in a South African diamond mines or Ecuadorian gold mines).

Pressure to reinvest. The Achilles heel of a Ponzi Scheme is the removal of funds from the scheme. As long as the investor is willing to keep his or her investment with the Ponzi Scheme, he or she will receive periodic statement showing extraordinary growth. When the investor removes money from the investment, the scheme is weakened. If too many investors seek to remove their account values at once, the Ponzi scheme will be quickly uncovered. In order to keep the scheme going, the perpetrators of the scheme will pressure the investor to reinvest.

A Ponzi Scheme is a particularly dangerous type of securities fraud. Usually, by the time the scheme has been discovered, all of the money will be gone. Although the perpetrators often end up in prison, they are usually not in a position to make meaningful restitution to their victims. Therefore, in looking for responsible parties, the claimant’s counsel should look to see if other parties were complicit in the scheme. Frequently, brokerage houses, audit firms and law firms will be involved in the facilitation of the scheme, and in some circumstances, they may be held liable for a victim’s loss.