Securities
"Selling Away" Liability of Broker-Dealer Firms and Securities Professionals
When a broker sells, or solicits the sale of, securities that are not authorized or sold by the brokerage firm with which he is a registered representative, he has “sold away” from his brokerage firm.
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.
When a stockbroker/registered representative sells an investment product to an investor that turns out to be a fraudulent investment scheme, and the broker-dealer firm that the broker works for has never approved of or sold the investment, does the broker-dealer firm have any liability to the investor for its representative’s “selling away?” As discussed below, in many cases the answer is yes.
What is “Selling Away”?
When a broker sells, or solicits the sale of, securities that are not authorized or sold by the brokerage firm with which he is a registered representative, he has “sold away” from his brokerage firm. Accordingly, selling away involves an investment that was not on his broker-dealer firm’s approved product list and was therefore not subjected to the firm’s due diligence processes. Often, the stockbroker/registered representative “sells away” from the brokerage firm to avoid scrutiny of questionable investment products. Many times, this type of activity takes place in satellite arrangements where firms allow small independent contractors in offices far removed from the principal broker-dealer offices or its compliance department to essentially conduct their own business with little or no day-to-day contact with the stockbroker/registered representative. This callous lack of oversight by some firms can create a situation where much damage and harm can be done to investors. Over the years, we have seen cases where stockbrokers/registered representatives have put their clients’ monies in speculative unregistered private placements in which the stockbroker had a personal financial interest, or was paid a premium commission (often not disclosed), or even where the stockbroker unlawfully borrowed monies from the clients without disclosing the regulatory impropriety of their doing so.
FINRA Regulation of Selling Away
FINRA Rules 3270 and 3040 regulate registered representatives’ outside business activities and private securities transactions. Rule 3270 provides that a registered representative must report in writing any business that he or she intends to conduct outside of the brokerage firm. Rule 3040 regulates private securities transactions which it defines as “any securities transaction outside the regular course or scope of an associated person’s employment with a member.” See Rule 3040(e)(1).
Rule 3040 provides that registered representatives shall not engage in such transactions except as permitted by this rule, which requires that the broker provide the broker-dealer firm with prompt written notice prior to participating in a private securities transaction and sets forth procedures whereby the broker-dealer firm may approve the transaction. If the broker-dealer firm approves the transaction, then it is responsible for supervising the private securities transaction as if it were executed on behalf of the firm. This supports FINRA’s general rule that FINRA member firms have a duty to supervise their brokers. See also FINRA Rule 3010.
Broker-Dealer Firm Liability in Selling Away Cases
As discussed above, “selling away” involves unauthorized and undisclosed business activities by a registered representative, which the broker-dealer firm has not approved, and often, has no knowledge of. This raises the question of whether the broker-dealer firm can be held liable for an investor’s losses when the investment was “sold away” from the firm.
Broker-dealer firms have a legal and regulatory duty to maintain proper internal controls and supervisory policies over its registered representatives. See also FINRA Rule 3010. In addition, a registered representative’s violation of FINRA Rules 3040 and 3270 does not relieve the broker-dealer firm of its duty to supervise the stockbroker/registered representative. Accordingly, a broker-dealer firm cannot simply rely on these rules to avoid potential liability arising from its representatives’ unauthorized activities. Failure to supervise is one of the predominant theories used to hold broker-dealer firms liable in selling away cases.
In assessing liability to broker-dealer firms, the focus is typically on whether the firm “should have known” about the brokers outside activities. This involves determining if the broker-dealer firm has reasonable supervisory policies to prevent and detect misconduct and more importantly, whether the firm actually implements such policies in a reasonable manner. For example, in Battle v. Northeast Securities, Inc.,
FINRA No. 06-04110 (March 18, 2008), the panel found that the broker-dealer firm had reasonable supervisory policies in place, however found that there was no evidence that the firm had reasonably implemented such policies.
Another important factor in determining broker-dealer liability is whether or not there were red-flags that should have prompted follow up investigation of potential misconduct. Broker-dealer firms may be liable for failure to supervise if there are indications of irregularities that they overlooked or ignored. For example, in Chandler v. FSC Securities Corporation, FINRA No. 05-04443 (July 2, 2007), the arbitration panel found the firm liable in a selling away case holding that it ignored and failed to investigate numerous red-flags, such as, the broker’s U5 had allegations of “bogus business” and “forgery” and he made repeated attempts to designate his office as a “branch” and his correspondence frequently suggested that it was a “branch.” Furthermore, a broker with history of discipline issues or other red flags should be supervised more than a broker with a clean record. Accordingly, a broker-dealer firm must investigate red-flags and must implement proper supervisory measures to address the situation.
Conclusion
In selling away cases, a broker-dealer may be held liable when it can be demonstrated that the brokerage firm failed to follow up on red-flags, and/or failed to establish and/or implement reasonable supervisory procedures. Moreover, certain stockbrokers/registered representatives by virtue of their backgrounds, prior discipline and legal history, may necessitate a heightened supervision by the broker-dealer.