What Types of Investment Losses are Recoverable?

Recoverable investment losses generally fall under one of three categories. They are excessive trading also known as churning, misrepresentations or omissions, and unsuitable investments.

Churning

Excessive trading, sometimes known as churning occurs when a broker, exercising control over the account engages in transactions that are excessive in size and scope to the needs and objectives of the client for the purpose of generating commissions. Churning generally occurs in accounts where the broker has discretionary authority, or authorization to make transactions without first consulting with the client. Excessive trading also occurs in accounts where a client does not follow the trading closely. This gives unethical brokers an opportunity to make excessive and inappropriate transactions. You can prevent excessive trading by always opening your mail from the brokerage firm, and closely reviewing the monthly statements for signs of trades you did not authorize.

A rule of thumb to measure churning is the generally accepted “Six Times Turnover” Rule. If an account’s equity has been turned over six times in the course of a year, with the broker making all or most of the transactions, there is a presumption the account has been churned.

Unauthorized Trading

Unauthorized trading also falls under the classification of misrepresentations and omissions. Unless a power of attorney has been given to the broker, all trades must be approved prior to their execution. If you spot unauthorized trades in your account, make sure to ask for an adjustment immediately. Put your request in writing. Make sure you contact the branch manager and demand the transaction be rescinded, or you risk ratifying the transaction.

A close relative of unauthorized trading is the “failure to execute.” Often an investor will instruct a broker to sell an investment when it is up (to take profits) or when it is down (to cut losses.) A broker may be reluctant to do this when the firm is holding a large position in the stock for fear it will depress the price. Again, timely complaints in writing to the branch manager are essential to establishing this claim.

Unsuitable Investments

The third area of concern is unsuitable investments. FINRA requires that investment professionals make recommendations and investments that are consistent with their clients’ investments needs and objectives. This rule also exists, via case decisions, in virtually every state. In addition, many states consider financial planners who are paid to sell investments to be fiduciaries, an even higher standard to uphold. An example of an unsuitable investment is where the bulk an elderly, income dependent client’s irreplaceable assets are sold, and the proceeds used to purchase high-risk investments. A close relative of unsuitability is over-concentration. When a broker concentrates your account in shares of a single stock, or puts a large percentage of the account into high-risk stocks or illiquid investments, the account could be considered to be over-concentrated. To prevail on a case for over-concentration you must establish that the concentration was inconsistent with your investment objectives.

From time to time a financial advisor may suggest an investment carries some form of protection from loss. FINRA rules expressly prohibit the making of guarantees, either verbally or in writing. There are no guarantees in life or in the stock market. Don’t be lead to believe there are guaranteed investments unless your advisor is talking about an FDIC insured C.D. (and even then….) Also, be mindful of an advisor downplaying or glossing over the risks of an investment. If you are concerned, make sure you quantify the risks before you commit to the purchase. The only way to do this is by asking that the risk be spelled out, preferably in writing, before making the investment.

Common Types of Losses

Some of the more common types of losses occur in the scenarios below:

Ponzi Schemes: A Ponzi scheme is an investment that depends on the fund raising prowess of the promoter rather than on the success of the underlying investment program. In a Ponzi scheme an investor is typically promised large returns which are paid from money raised from new investors. Eventually the promoter runs out of new investors, and the Ponzi scheme collapses.
Direct Participation Programs: Although a legitimate form of operating entity, these programs have been used by many unscrupulous operators to siphon fees and large commissions from investors. “DPPs” offer some of the highest commission payouts to brokers. Unfortunately, these investments are usually long term and illiquid. This means investors are stuck with these investments for five or ten years. Typical DPP investments include REITs, oil and gas programs and equipment leasing investments.
Promissory Notes: Many start-up and small companies issue promissory notes or “investment notes” as a means of raising capital. These small offerings have long been the means of support for brokers who can’t qualify for, or who have lost other securities licenses. These investments typically promise high rates of return to compensate for the high (and often undisclosed) risks of investing.
Selling Away a/k/a Outside Business Activities: “Selling away” describes when a registered representative with a brokerage firm sells an investment to a client that is not transacted through the firm. In a typical situation a registered rep will introduce his client to a “great opportunity,” and advise him to “get in on it.” The client will then write the broker a check and the rep will invest the money directly in the program. Selling away is a violation of FINRA rules.
Margin Abuse: When a client opens a “margin” account he is allowed to borrow money from the brokerage firm to buy investments. Federal regulations limit how much an investor can borrow, and require a client to maintain a certain percentage of the account value as collateral. The risk of using margin is that if the investment purchased with borrowed money declines in value, an investor may be required to deposit additional funds into the account to “cover” a margin “call.” Margin allows the broker to maximize commissions by providing additional capital for purchases. Highly volatile stocks should not be purchased on margin, except for the most risk tolerant investor.