Contributory Negligence as a Defense to a Securities Law Claim
Contributory Negligence as a Defense to a Securities Law Claim
May securities professionals defend against claims brought by their investor clients pursuant to securities laws on the basis of the client’s contributory negligence?
Please note that, while this article accurately describes applicable law on the subject covered at the time of its writing, the law continues to develop with the passage of time. Accordingly, before relying upon this article, care should be taken to verify that the law described herein has not changed.
The weight of applicable legal authority indicates that there is no contributory negligence defense available to securities professionals in claims brought by their investor clients under the securities laws.
I. Analysis of Securities Regulations
NASD Conduct Rule 2310 and NYSE Rule 405 both govern the securities broker (and brokerage firm) conduct when the broker recommends investments to his client. These regulations require the broker to know his customer and to make suitable investment recommendations based on his knowledge of the client. The NASD Rules, including Rule 2310 are applicable not only to members of the NASD, but to all persons associated with a member. See NASD Applicability Rule 0115. Furthermore, violations of NYSE Rule 405 and the NASD Suitability Rule, are admissible as evidence of a broker professional negligence. See Piper Jaffray & Hopwood Incorporated v. Ladin, 399 F. Supp. 292, 293 (S.D. Iowa 1975). While these regulations govern the broker and firm activity as it pertains to the recommendations of investments, the client is not subject to any such rule or regulation. NASD Conduct Rule 2310 provides:
In recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.
Similarly, NYSE Rule 405 requires member organization to:
(1) Use due diligence to learn the essential facts relative to every customer, every order, every cash or margin account accepted or carried by such organization and every person holding power of attorney over any account accepted or carried by such organization.
(2) Supervise diligently all accounts handled by registered representatives of the organization.
While these rules affirmatively obligate securities professionals to make suitable investment recommendations based on their knowledge of the customer, no rule or regulation obligates the customer to act in a similar fashion. These rules recognize, therefore, that the securities professional upon whom the customer relies must answer for his professional negligence.
II. Analysis of Applicable Statutes and Case Law
Contributory negligence is not available as a defense to one who violates the securities statutes. Washington National Corp. v. Thomas, 117 Ariz. 95, 102, 570 P.2d 1268, 1275 (App. 1977). “The statutes do not require investors to act with due diligence. To the contrary, defendants have an affirmative duty not to mislead potential investors.” Trimble v. American Sav. Life ins. Co.,
152 Ariz. 548, 553, 733 P.2d 1131, 1136 (App. 1986). Indeed, even if a misguided customer wishes to speculate, but it is not suitable for him to do so, the broker is enjoined not to exacerbate the problem by making recommendations which are inconsistent with the client’s financial profile. Eugene Erdos, 47 S.E.C. 985 (1983), aff’d 742 F.2d 507 (9th Cir. 1984): John M. Reynolds, 50 S.E C. 805, 808 (1992). Arizona courts, for example, impose strict liability for those who make misrepresentations and omissions in violation of its securities statutes. Garvin v. Greenbank, 856 F. 2d 1392, 1398 (9th Cir. 1998).
An investor may succeed in a cause of action based upon the violation of Arizona securities statutes regardless of the defendant knowledge of the falsity. State v. Superior Court of Maricopa County, 123 Ariz. 324, 331 (1979). Neither is contributory negligence a defense to fraud in general. Eastern Trading Co., v. Refco, 229 F.3d 617, 625 (7th Cir. 2000). The Nebraska Supreme Court has repeatedly held that contributory negligence is not a permitted defense in fraudulent misrepresentation claims. See Douglas County Bank v. United Financial, 207 F.3f 473, 479 (8th Cir. 2000). See also Little v. Gillette, 218 Neb. 271, 276-277, 354 N.W. 2d 147 (1984) quoting Foley v. Holtry, 43 Neb. 133, 143, 61 N.W. 120, 123-124 (1894):
“We have little sympathy with the theory always advanced in such cases that the defendant should be protected from the consequences of false statements made by him for the purpose of inducing the plaintiff to act, because the plaintiff had sufficient confidence in the defendant to believe the statement and not proceed upon the assumption that he was dealing with a man unworthy of belief.”
The United States Supreme Court has indicated in numerous decisions that a “fundamental purpose” for the creation of Securities Acts generally, “was to substitute a philosophy of full disclosure for the philosophy of caveat emptor and thus to achieve a high standard of business ethics in the securities industry.” Basic v. Levinson,
485 U.S. 224, 235 (1988); SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 186 (1963) ; Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 151 (1972). “Ratification of unauthorized trading occurs only when it is clear from the circumstances that the customer intends to adopt the trade as his own. Knowledge of the pertinent facts and the clear intent to approve the unauthorized action is a precondition to ratification.” Syckle v. C.L. King & Assoc., Inc.,
Fed. Sec. L. Rep.(CCH) §97,701 at 97,261 (N.D.N.Y. May 23, 1993).
Moreover, a customer does not ratify a transaction when the manifestation of consent is obtained through misrepresentation. Eichler v. S.E.C.,
757 F.2d 1066, 1070 (9th Cir. 1985). Arizona courts recognize the “reasonable expectations” doctrine, which serves to prohibit the enforcement of unusual, oppressive or bizarre contact limitations commonly found in standard contracts, even if such terms do not go so far as to be unconscionable. Philadelphia Indemnity Insurance Co. v. Barberra, 196 Ariz. 391, 395 (App. 1999). Instead, the customer is permitted to reasonably rely on an agent verbal statements even if the customer failed to read the contradictory provisions within the standardized agreement. (See Darner Motor Sales v. Universal Underwriters,
140 Ariz. 383, 682 P.2d 388, 403 (1984), which dealt with a customer reliance upon the statements of an insurance agent). The Florida Supreme Court has held that a representee may rely on the truth of a representation, “even though its falsity could have been ascertained had he made an investigation, unless he knows the representation to be false or its falsity is obvious to him.” Besett v. Basnett, 389 So.2d 995, 998 (Fla. 1980).
In Washington National Corp. v. Thomas, the Arizona Court of Appeals rejected the Appellant attempted use of contributory negligence as a defense to their violation of an Arizona securities statute. Washington National Corp. v. Thomas, 117 Ariz. 95, 102, 570 P.2d 1268, 1275 (App. 1977). The court specifically prohibited the Appellant use of the contributory negligence defense since the Appellants breached an affirmative duty to refrain from misleading their customer as to the need for creating an inter vivos revocable trust. Id.
The court also rejected the Appellant attempt to defend on the basis that the agent who gave the bad financial advice lacked scienter, or knowledge of its falsity. Id.
The court held that knowledge of a statement falsity is not a necessary element of a cause of action based upon A.R.S. §1991. Id.
In Trimble v. American Sav. Life ins. Co.,
the court presided over an appeal from a trial court finding that the respondent had violated sections of A.R.S. §44-1991 & §44-1992 of Arizona securities statutes when they implemented a sophisticated scheme to defraud investors by inflating their company assets and by creating expectations of growth that were completely unfounded. Trimble v. American Sav. Life ins. Co., 152 Ariz. 548, 552 (App. 1986). The Defendants argued that the plaintiffs were negligent in that they failed to investigate the false representations, and that had they done so, they would have prevented the loss. Id.
at 553. The court rejected the defense and noted that the Defendants breached an affirmative duty not to mislead potential investors, in violation of the statute. Id.
The court stressed that the very nature of this affirmative duty “not only removes the burden of investigation from an investor, but places a heavy burden upon the offeror not to mislead potential investors in any way.” Id.
Thus, the issue of whether the investor was contributorily negligent was moot because, according to the court, Arizona does not recognize contributory negligence as a defense to a violation of its securities statutes.
In Garvin v. Greenbank, the 9th Circuit court of Appeals solidified the proposition that securities fraud, pursuant to Arizona securities statutes is a strict liability offense. Garvin v. Greenbank, 856 F. 2d 1392, 1398 (9th Cir. 1998). The court explained that A.R.S. §13-202 (B), is the proper statute which to refer in order to determine the level of scienter necessary for a violation. That statute provides “the offense is one of strict liability unless the proscribed conduct necessarily involves a culpable mental state.” A.R.S. §13-202(B) (1978). The Garvin court noted that since the Arizona securities statute in question did not proscribe any mental state, it is a strict liability offense. Id.
Finally, the Garvin court removed any doubt as to whether a showing of scienter is an element of an Arizona securities fraud when it pointed to a legislative amendment in 1978, pursuant to which scienter was actually removed as an element of securities fraud for purposes of criminal prosecutions. Id.
at 1397. The court, incidentally, noted that scienter was never an element of civil actions alleging securities fraud. Id.
In Besett v. Basnett
a leading Florida case dealing with the related issue of fraudulent misrepresentation, the court held that the plaintiffs, buyers of land, were entitled to rely upon the truth of the seller representation that the lot was a particular size, even though its falsity could have been discovered upon a simple investigation. Besett v. Basnett, 389 So. 2d 995, 998 (Fla. 1980). In so holding, the Florida Supreme Court provided, “Though one should not be inattentive to one business affairs, the law should not permit an inattentive person to suffer loss at the hands of a misrepresenter.” Id.
The court then adopted Section 540 of Restatement (Second) of Torts (1976) which provides:
§540. Duty To Investigate.
The recipient of fraudulent misrepresentation of fact is justified in relying upon its truth, although he might have ascertained the falsity of the representation had he made an investigation.
Finally, the court quoted a passage from Bristol v. Braidwood, 28 Mich. 191 (1873), in an attempt to demonstrate the long held policy behind its decision. In that case, the Michigan Supreme Court provided:
There may be good, prudential reasons why, when I am selling you a piece of land, or a mortgage, you should not rely upon my statement of the facts of the title, but if I have made that statement for the fraudulent purpose of inducing you to purchase, and you have in good faith made the purchase in reliance upon its truth, instead of making the examination for yourself, it does not lie with me to say to you, “It is true that I lied to you, and for the purpose of defrauding you, but you were guilty of negligence, of want of ordinary care, in believing that I told the truth; and because you trusted to my word, when you ought to have suspected me of falsehood and cunning, and you are without a remedy.”
In Nebraska, courts have long recognized that plaintiffs should not be faulted for putting their trust in their fiduciaries’ representations. In Little v. Gillette, for example, the Nebraska Supreme Court held that the plaintiff was entitled to rely on the fraudulently optimistic statements that two realtors made to him regarding the profit potential of a business he was purchasing. Little v. Gillette, 218 Neb. 271, 276-277, 354 N.W. 2d 147, 154 (1984). The court rejected the defendants’ argument that the plaintiff was partially to blame for his failure to investigate the truth of their representation. Id.
Instead, the court held that since the plaintiff would have had to conduct an independent investigation to uncover the falsehood, he was entitled to full recovery. Id.
III. Brokerage Firm Arguments and Why Not Dispositive
Brokerage firms frequently interpose the defense of ratification as a means of escaping liability for fraudulent activity such as unauthorized trading. In limited circumstances, such a defense may even prove successful to the broker. See Brophy v. Redivo, 725 F.2d 1218 (9th Cir. 1984). But it is uncontested that brokers generally may not avail themselves of the ratification defense when a customer lacks the skill or experience to properly interpret monthly statements and other related documents. See Modern Settings, Inc., v. Prudential-Bache,
936 F.2d 640, (2nd Cir, 1991).
The theory behind this added leniency in favor of the customer is that the customer is less likely to become aware of the broker unauthorized acts, and is therefore not able to notify the broker of his dissatisfaction. Karlen v. Ray E. Friedman & Co. Commodities, 688 F.2d 1193,1200 (8th Cir. 1982). Another reason that added leniency is given to the uninformed customer is that he is generally at a distinct disadvantage due to the disparity in sophistication between him and the brokerage firm. Id.
Furthermore, brokers are estopped from claiming the customer ratified a transaction where the broker deceptive acts forestall the customer notification of dissatisfaction. Cange v. Stotler And Co., 913 F.2d 1204, 1209-10 (7th Cir 1990).
In Brophy v. Redivo, the 9th Circuit court held that the plaintiff, who had 30 years of experience as a securities account holder, ratified a series of unauthorized transactions as she failed to fulfill her contractual obligation of immediately notifying the defendant brokerage firm in writing of her dissatisfaction with the transactions. Brophy v. Redivo, 725 F.2d 1218 (9th Cir. 1984). The Brophy decision did not refer to any facts that would warrant any leniency for her failure to notify the brokerage firm. In that case, the plaintiff actually profited from the unauthorized trades that were the subject of her suit. Id at 1218. Furthermore, she was a sophisticated investor who did not allege any facts that would estop the broker from alleging a ratification defense. Id.
In Karlen v. Ray E. Friedman & Co. Commodities, the 8th Circuit court upheld a jury verdict in favor of the plaintiffs on their unauthorized trading claims after it considered evidence of the plaintiffs’ inexperience and the fact that they were inundated with confusing confirmation slips. Karlen v. Ray E. Friedman & Co. Commodities, 688 F.2d 1193 (8th Cir. 1982). The defendant brokerage firm argued that even if the subject trades were unauthorized, the plaintiffs ratified them since they were given monthly confirmation slips, at least one plaintiff assented to the subject trades, and the plaintiffs continued to invest substantial amounts of money with the firm after the subject trades were executed. Id.
The court rejected all of these arguments and provided, “The question is not simply whether Karlen {plaintiff} assented to the trades; rather it is whether his apparent assent was given voluntarily and intelligently with full knowledge of the facts.” Id.
Finally, the court stated in its decision, “It has been recognized that confirmation slips and monthly statements do not enable a customer to determine his or her overall position or the total amount of real profit or loss occurring, unless the customer is sufficiently skilled to elaborate upon them to make that determination.” Id.
The court, therefore, presumptively acknowledged that monthly statements and other similar documents are confusing to customers.
III. Other Relevant Authorities
An investor is particularly justified in relying on his fiduciary to execute transactions as authorized. The broker/brokerage firm, purports to have specialized knowledge which the investor trusts will be used to his advantage. The online law dictionary “Law.com Law Dictionary” defines the fiduciary relationship as follows:
Fiduciary Relationship.Where one person places complete confidence in another in regard to a particular transaction or one’s general affairs or business. The relationship is not necessarily formally or legally established as in a declaration of trust, but can be one of moral or personal responsibility, due to the superior knowledge and training of the fiduciary as compared to the one whose affairs the fiduciary is handling.[1]
The dictionary defines “Fiduciary” as follows:
Fiduciary.From the Latin fiducia,
, meaning “trust,” a person (or a business like a bank or stock brokerage) who has the power and obligation to act for another (often called the beneficiary) under circumstances which require total trust, good faith and honesty. The most common is a trustee of a trust, but fiduciaries can include business advisers, attorneys, guardians, administrators of estates, real estate agents, bankers, stockbrokers, title companies or anyone who undertakes to assist someone who places complete confidence and trust in that person or company. Characteristically, the fiduciary has greater knowledge and expertise about the matters being handled. A fiduciary is held to a standard of conduct and trust above that of a stranger or of a casual business person. He/she/it must avoid “self-dealing” or “conflicts of interests” in which the potential benefit to the fiduciary is in conflict with what is best for the person who trusts him/her/it. For example, a stockbroker must consider the best investment for the client and not buy or sell on the basis of what brings him/her the highest commission. While a fiduciary and the beneficiary may join together in a business venture or a purchase of property, the best interest of the beneficiary must be primary, and absolute candor is required of the fiduciary. 2) adj. defining a situation or relationship in which a person is acting as a fiduciary for another.[2]
Given these definitions, the very relationship between an investor and his brokerage firm is based on trust. Surely then, an investor should not be faulted for doing exactly what is contemplated by the fiduciary relationship; trusting his fiduciary.