EVALUATING INVESTOR CASES

CONTROL PERSON LIABILITY

ATTORNEY'S FEES

DAMAGES

        POINTS OF ANALYSIS AND DETERMINATIONS

1. Client Analysis

·         Age/education/health

·         Income/source

·         Total net worth/liquid net worth

·         Investment experience

·         Investment objectives

·         Determine investors risk tolerance

·         Types of accounts and quantity

·         Any accounts with other bkge. firms

·         Margin, options or other features

·         Tenure of accounts

·         Date of last statement

·         Commission to equity ratio & cost to equity ratio (comp. to a low load M/F)

·         Turnover in account

·         Any Penny Stocks (Priced under $5 and not traded on an exchange)

·         Is a Penny Stock Disclosure form signed by client

·         Are mutual funds being switched

·         Are mutual fund shares A, B or C type

·         Determine broker’s basis for investment recommendations

·         Are the trades solicited or unsolicited

·         Does the client routinely follow the brokers advice and recommendations (de-facto broker control)

·         Does a third party have discretion

·         Concentration of speculative security(s) as a % of liquid net worth

·         Activity letters sent to client (were they negative consent type)

·         Evidence of communication between A/E and client i.e. E-Mail/letters

·         How diversified is the portfolio

·         Are insurance policies being replaced

·         Are variable annuities being sold to the elderly; within an IRA

·         Are stocks being held for term or traded actively

·         Are all trades authorized prior to trade execution

·         Did the client ratify the brokers’ activities

·         Did the client do anything to mitigate damages

·         Do the tax returns support the clients information

·         How does the client keep track of the brokers activities

·         Are any conversations between client and broker tape recorded

·         Were firm research reports or materials provided to the client

·         Were “Dealer Use Only” materials provided to the client

·         Were prospectuses receipted for by the client, prior to the trade

2. Broker Analysis

·         All names used by broker/education/years in business

·         CRD information

·         State Securities Commissioners’ information if any

·         Any complaints on file at the firm

·         Any indication of discipline by firm or regulators

·         Is the account set up on a fee or commission basis or both

·         Is the broker an RIA or Associate RIA through the firm

·         Does the broker have any financial planning designations such as CFP or IARFC

·         Did the broker do a financial plan on the client

·         Percentage of clients assets under mgmt. by broker

·         Specific client investments

·         Incentives for broker to sell proprietary products i.e. trips or extra commissions or extra sales credits

·         How did client and broker meet one another

·         Does the broker tailor products to the client or provide the same to all

·         Has the broker ever had “special supervision”

·         Does the broker engage in activities outside the brokerage firm

·         How does the broker rank in sales within branch and B/D

·         Does the broker keep notes of meetings and trades with clients

·         What specific documents did the broker ask for to “know his customer”

·         Did the broker determine if the client could afford, understand and/or tolerate the risk

·         Was the new account form in the brokers handwriting

·         What % of the brokers’ business is in proprietary products

·         Did the broker diversify the client choosing products from different asset classes, different stock exchanges and differing holding periods

·         Did the broker provide a copy of the new account form to the client

·         Is there any evidence that the broker independently did due diligence on the products sold

·         Did the broker provide firm research reports or “dealer use only materials” to the client

·         Did the broker report any trades to be unsolicited

·         Did the broker continue to monitor the account and communicate with the client after the initial products were sold

·         Does the broker buy any products sold to client

·         Does the broker’s family buy products from the broker, sold to client 

3. Supervision Analysis (Broker-Dealer and Branch Office Mgr.)

·         CRD information

·         State Securities Commissioner information

·         Does the firm consider the broker to be an employee or independent contractor.

·         What does the independent contractors’/employee agrmt. say

·         What is the chain of command in the compliance dept.

·         What is the structure of compliance i.e. active account report generation

·         How many employees are in the broker’s branch

·         How does the branch rank in terms of total production

·         Is it a satellite or office of supervisory jurisdiction (OSJ)

·         Did the Branch Office Mgr. ever talk with or write the client

·         Is there any oversight or review by peers as a disciplinary tool

·         Does the Broker-Dealer provide unannounced branch audits

·         Does the Broker-Dealer have a Compliance Review Committee

·         Does the Broker-Dealer provide annual compliance reviews

·         What does the branch office manager’s supervision show

·         What do the compliance and supervision manuals show

·         Does the Broker-Dealer have an approved product list

·         Were all products sold on the approved product list

·         Did the Broker-Dealer do research on the company’s represented by the securities sold

·         Is there a complete due diligence file on each security sold

·         Was the Broker-Dealer an Underwriter, Principal or Market Maker in the securities sold

·         Does the Broker-Dealer offer a variety of products to be sold by brokers

·         Does the Broker-Dealer offer a number of proprietary products for sale

·         Does the Broker-Dealer offer any special incentives for these products

·         Did the Broker-Dealer rate and rank the securities in question

·         How does the Broker-Dealer check or measure the accuracy of new account information taken by the broker on the new account form

·         Does the firm require receipts for prospectuses mailed to clients

·         How does the Broker-Dealer measure if the broker is meeting the clients investment objectives

·         How does Broker-Dealer monitor receipt of activity letters

·         How does the Broker-Dealer measure if its brokers are disclosing all material facts and avoiding material omissions about the securities that are sold to clients

     D.  Control Person Liability Analysis

                Normally, in securities arbitration, we seldom name the broker, directly.  The reason for this was summed up in a recent NASD arbitration where the arbitration panel assessed a sizeable award against the broker only,  and not joint and several against the broker and the firm.  This position is also because the broker, if named, will often fight any settlement to the death and usually enlist their own outside attorney.  We now face two attorneys, one for the firm and one for the broker.  Further, the arbitration panel might split the award separately between the firm and the broker leaving us with only one viable collection source.  The only exception to the above rule is when we have a financially shaky brokerage firm and there is a collectibility problem there.  Then, and only then, do we name the broker.  We also do something else at that time.  We name all of the Control Persons of the B/D. 

                In these times of economic uncertainty and volatility, it is essential to pursue claims that provide a reasonable measure of collectibility.  To pursue claims against broker-dealer firms that are not viable financially is folly indeed.  Too many of these entities have vanished, declared bankruptcy or been taken over with an "asset only purchase", leaving claimant's with an award that is uncollectable.  It is essential therefore, to consider naming "control persons" in statements of claim even if the names, by necessity will have to be furnished later.  This will usually follow the subpoena of Form BD from the NASD where the Control Persons along with their percentage ownership is indicated, relative to the time period at issue.     

                The Securities Exchange Act of 1934 was enacted to strengthen protection for individual investors.  Section 20 (a)* makes a "controlling person jointly and severally liable for the securities violations caused by those persons whom they control.  By enacting Section 20(a) of the 1934 Securities Exchange Act, Congress intended to broaden the liability of "controlling persons" to deter those in a position to directly or indirectly exert their influence over the policy and decision making process of securities firms. 

               The control person statute broadens joint and several liability for "controlling persons" for securities violations irrespective of whether the control person directly supervised the primary wrongdoer.  The importance of "controlling person" liability, as compared to respondeat superior, is the broader policy of holding those persons liable who control the policy and activities of the firm which allowed the specific wrongful conduct to occur.  As opposed to common law which does not permit liability without knowledge, federal law provides for liability with or without knowledge. 

              In order to invoke Section 20 (a) in the ninth circuit, a plaintiff must first prove that the defendant  is a "controlling person" within the meaning of Section 20 (a).  In Hollinger v. Titan Capital Corp., the ninth circuit adopted the SEC definition of control as the "possession, directly or indirectly of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities or by contract, or otherwise."

             Previous ninth circuit cases required a plaintiff to prove that the "controlling person" was a "culpable participant" in the act or omission. The language of Hollinger dispelled the notion; the court stated: "(w)e hold that a plaintiff is not required to show "culpable participation" to establish that a broker-dealer was a controlling person under Section 20 (a).  Once a plaintiff proves that a secondary actor is a "controlling person" within Section 20 (a), the burden of proof shifts to the defendant to prove that he acted in "good faith."

            Recently, in Harrison v. Dean Witter Reynolds, the seventh circuit set forth the standards for control person liability.  The circuit requires a showing similar to the ninth circuit; it mandates that a plaintiff prove: "some direct means of discipline or influence, although short of actual direction, is sufficient to hold a person possessed the power or the ability to control the specific transaction upon which the violation was predicated.  

           The tenth circuit suggests that the control person doctrine is to be interpreted liberally and only requires some indirect means of actual influence or direction by a broker-dealer to hold him liable as a "controlling person."

           In First Interstate v. Pring, the court articulated a position similar to the one set forth in the Hollinger court requiring a plaintiff to prove:  1) a primary violation and,  2) that the secondary defendant was a control person.  A control person need not have been involved in the particular transaction in issue. 

          Once the plaintiff established a prima facie case under Section 20(a), as in the ninth circuit, the burden of proving "good faith" shifts to the defendant.  To meet this burden, a defendant must prove that "he exercised due care in his supervision of the violator's activities in that he maintained and enforced a reasonable and proper system of supervision and internal control", one that was set in place to prevent violations."

·         Section 20 (a) states:  "Every person who, directly or indirectly, controls a person liable under any provision of this chapter or of any rule or regulation thereunder shall also be liable jointly and severally with and to the same extent as such controlled person to any person to whom such controlled person is liable, unless the controlled person acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action." (15 U.S. C. #78T (a) (1988).

In addition to identifying the officers and directors of the firm on the form BD, the firm's are also required to designate their "control" persons.  There is a box conveniently marked "control person" in which the firm is required to say "yes" or "no" as to each individual.  In addition, there is also a box for "ownership code" wherein the firm is required to set forth the percentage of ownership of each person listed as an officer, director or other control person.  On the reverse side of Form BD, is an instruction page which, under section 4, provides a definition of control person as follows:

               "Control - The power, indirectly or indirectly, to direct the management or policies of a company, whether through ownership of securities, by contract, or otherwise.  Any person that (i) is a director, general partner or officer exercising executive responsibility (or having similar status or functions); (ii) directly or indirectly has the right to vote 25% or more of a class of a voting security or has the power to sell or direct the sale of 25% or more of a class of voting securities; or (iii) in the case of a partnership, has the right to receive upon dissolution, or has contributed, 25% or more of the capital, is presumed to control that company. (This definition is used solely for the purpose of Form BD)"

Note that the last sentence of the definition purports to self limit the control person definition only for  the purposes of the Form BD.  Respondent's counsel will likely rely on this purported limitation to undercut claimant's counsels argument that the brokerage firm itself, in reporting to the regulatory authorities, has indicated who the control persons are.  There is no discovered case law which addresses whether or not respondent's counsel is correct in attempting to limit the definition for control person to the form and not to the statutory definition of control person.  However, an argument can be made by claimant's counsel that since the Form BD is a public document, the brokerage firm is informing the world that there are specific people at the brokerage firm who are in control of its activities.  In Gardner v. Stratton Oakmont, No. 96-02076, 1997 WL 290168, (N.A.S.D.) respondent's counsel made this precise argument which the panel rejected in awarding more than $10 million dollars in punitive and compensatory damages against four control persons.  The panel expressly found that the award was premised upon these control persons' "participation in the overall business" of the firm even though they had no direct contact with or even knowledge of the claimants account.   

                                                          ATTORNEY'S FEES

E.  The awarding of attorney's fees in arbitration.

           It is well settled, in arbitration, that there must be a legal precedent for attorney's fees to be awarded by a panel.  Typically, attorneys for claimant turn to California Civil Code # 1717 which contends that attorney's fees may be awarded only by contract.  When there is a margin agreement, signed by  claimant, that has an "attorney's fee provision", it is argued that there is an implied agreement (contract) between the brokerage firm and the claimant.  In other words, if one party has the right to collect attorney's fees, the other part has a reciprocal right.  Arbitration panels have often awarded attorney's fees to a claimant, as the prevailing party, based upon this legal precedent.  However, what if there is no margin agreement and hence no contract.

          In the United States Court of Appeals for the Ninth Circuit - 2002 U.S. App. Lexis 14924 No. 02-56016, No. 02-56052 - June 5, 2003, (Coutee v. Barington Capital Group, L.P., Morton Berale Gropper; Bruce Adam Gropper; James Anthony Mitarotonda; Jerome Snyder; John Telfer) Argued and submitted, Pasadena, California, July 28, 2003, Filed:

          The Court of Appeals reversed the district court's vacature of the attorney's fee portion of the arbitration award.  Attorney's fees were upheld for the following reasons:

          1.  The arbitrators granted attorney's fees pursuant to California Welfare and Institutions Code section 15657*, which provides that where a defendant is guilty of financial abuse toward an elder, "the court shall award to the plaintiff reasonable attorney's fees and costs."  Cal. Wel. & Inst. Code #  15657 (a).  Note - The failure to adhere to the California choice of law clause was considered a "harmless error'.  

          2.  An arbitration panel may award attorney's fees, even if not otherwise authorized by law to do so, if both parties submit the [recovery of attorney's fees] issue to arbitration.  See First Interregional Equity Corp. v. Haughton, 842 F. Supp. 105, 112-13 (S.D.N.Y. 1994).   

               Where both parties to an arbitration seek attorney's fees, courts routinely hold the parties' consensual jurisdiction to award attorney's fees, U.S. Offshore, Inc. v. Seabulk Offshore, Ltd., 753 F. Supp. 86,92 (S.D.N.Y. 1990).  In Seabulk, the Court concluded that since both parties had requested attorney's fees , the arbitrators had the power and authority, given them by the parties who both asked for them, to award legal fees and costs: If both parties sought attorney's fees, as was apparently the case here, then both parties agreed pro tanto to submit that issue to arbitration, and the arbitrators had jurisdiction to consider that issue and to award them.  Seabulk Offshore, Ltd., 753 F. Supp. at 92; accord First Interregional Equity Corp. v. Haughton, 842 F. supp. 105, 112 (S.D.N.Y.1994), citing Neuberger & Berman v. Donaldson Lufkin and Jenrette Securities corp., No. 91-16833 (N.Y. Sup. Ct., N.Y. County 1992).  In Marshall & Co., Inc. v. Duke, 114 F.3d 188 (11th Cir. 1997), the Eleventh Circuit court of Appeals reached the same conclusion, that it was sufficient support for an award of fees that the parties agreed to submit the issue of attorney's fees and expenses to the Panel so that an enforceable "bi-lateral agreement" existed.   

      *  As quoted in Section IV. G. California Welfare and Institutions Code section 15600(h) states that is is the "intent of the Legislature...to enable interested persons to engage attorneys to take up the cause of abused elderly persons..."  section 15657 of such Code in pertinent part provides:

             "Where it is proven by clear and convincing evidence that a defendant is liable for ...financial abuse as defined in Section 15610.30**, and that the defendant has been guilty of recklessness, oppression, fraud, or malice in the commission of this abuse, in addition to all other remedies otherwise provided by law:  (a) the court shall award to the plaintiff reasonable attorney's fees and costs...[Emphasis added.]

               **Section 15610.30 defines "financial abuse" as follows:

      (a)  "Financial abuse" of an elder or dependent adult occurs when a person or entity does any of the following:

               (1)  Takes, secretes, appropriates, or retains real or personal property of an elder or dependent adult to a wrongful use or with intent to defraud, or both.

               (2)  Assists in taking, secreting, appropriating, or retaining real or personal property of an elder or dependent adult to a wrongful use or with intent to defraud, or both

     (b)  A person or entity shall be deemed to have taken, secreted, appropriated, or retained property for a wrongful use if, among other things, the person or entity takes, secretes, appropriates or retains possession of property in bad faith.

               (1)  A person or entity shall be deemed to have acted in bad faith if the person or entity knew or should have known that the elder or dependent adult had the right to have the property transferred or made readily available to the elder or dependent adult or to his or her representative.  

               (2)  For purposes of this section, a person or entity should have known of a right specified in paragraph (1) if, on the basis of the information, received by the person or entity or the person or entity's authorized third party, or both, it is obvious to a reasonable person that the elder or dependent adult has a right specified in paragraph (1).

There is another theory for possible recovery of attorney's fees in arbitration.  There exists statutory grounds that provide authority for the award of attorney's fees to claimants.  The statutory grounds for attorney's fees relate to the deceptive and misleading statements of the respondent firm's broker.  The Consumer Legal Remedies Act (California Civil Code # 1750, et seq.) #1780 states: (This theory is based on the advice, rather than the securities themselves, being deceptive and misleading goods and services)

      " (a)  any customer who suffers any damage as a result of the use or employment by any person of a method, act, or practice declared to be unlawful by Section 1770 may bring an action against that person to recover or obtain any of the following:

          (1)  Actual damages, but in no case shall the total award of damages in a class action be less than one thousand dollars ($1.000).

          (2)  An order enjoining such methods, acts or practices.

          (3)  Restitution of property.

          (4)  Punitive Damages.

          (5)  Any other relief that the court deems proper. 

     (d)  The court shall award court costs and attorney's fees to a prevailing plaintiff in litigation filed pursuant to this section."    (Emphases added).

     California Civil Code #1770 makes it unlawful to use unfair or deceptive methods of competition.  The following are certain enumerated deceptive and unfair methods of competition:

          "(5)  Representing that goods or services have...characteristics...uses, [or] benefits...which they do not have...

           (7)  Representing that goods or services are of a particular standard quality, or grade or that goods are of a particular style or modes, if they are of another.

          (16)  Representing that the subject of a transaction has been supplied in accordance with a previous representation when it has not.

         (17)  Representing that the consumer will receive a rebate, discount, or other economic benefit, if the earning of the benefit is contingent on an event to occur subsequent to the consumption of the transaction." 

              The statute describes the exact nature of misrepresentations made by a broker to his client.  California case law supports the theory that claimant's are entitled to attorney's fees.  The California Supreme Court recently held that claimant's that prevail under the Consumer Legal Remedies Act in arbitration would be entitled to costs and attorney's fees.  Broughton v. Cigna Healthplans of California,  21 Cal. 4th 1066 (1999).  The Broughten court states in pertinent part:

          "We agree with plaintiffs that the availability of costs and attorney's fees to prevailing plaintiff's is integral to making the Consumer Legal Remedies Act (CLRA) an effective piece of consumer legislation increasing the financial feasibility of bringing suits under the statute (See enrolled Bill Rep, on Assem. Bill No. 3756 (1987-1988 Reg. Sess.) p.3.)..." Broughten  at page 1087. 

                                                      DAMAGES

F.  Damages Analysis  - The following methodologies were taken in large part from a 2000 Practising Law Institute article by Mary Calhoun and Ross Tulman.   My own comments and relevant case citings are added, when applicable, and where the experts disagree, I have added my own thoughts, selected a preference and taken certain editorial liberties.  

                                       MARKET ADJUSTED DAMAGES   

               Market adjusted damages calculations adjust the gain or loss in the account to a market-based equivalent.  In other words, they calculate what the account would have earned had it been invested in some other investment alternative or equivalent such as the S&P Composite Index or composite of mutual funds with a growth or growth and income objective.  

             The proper measure of damages in California for breach of fiduciary duty is to put the Claimant in the position he would have been in if not for Respondent's conduct.  (Twomey v. Mitchum, Jones & Templeton, Inc. (1968) 262 Cal. App. 2d 690, 730.)  The Federal standard is in accord.  Medical Associates of Hamburg v. Advest, Inc. (W.D.N.Y. (1989) 1989 U.S.D.C. Lexis 11253.)  In fact, Hamburg held that when unsuitable transactions are involved, the proper measure of damages is to assume that the funds had been placed in suitable indexes.  See Rolf v. Blyth, Eastman Dillon & Co., Inc., 570 F. 2d 38, 48-50 (2d Cir. 1978) (stating that the proper method of calculating damages is to take the initial value of the claimants' portfolio, adjust by a percentage change in an appropriate index i.e. the Standard & Poor's 500 Composite Index, during the relevant period, and subtract the value of the portfolio at the end of the period.  See also Randall v. Loftsgarden, 478 U.S. 647, 661-62 (1986) (stating that ordinarily "the correct measure of damages...is the difference between the fair value of all that the plaintiff received and the fair value of what he would have received had there been no fraudulent conduct").  The "well-managed" account" theory of damages was approved in the case of Miley v. Oppenheimer & Company, 637 F.2d 318, 326 (5th Cir.) Rehearing denied, 642 F.2d 1210 (5th Cir. 1981).  The proper measure of damages in California and federal law, is spelled out in Civil Code section 3333 as follows:  "For the breach of an obligation not arising from contract, the measure of damages, except where otherwise expressly prohibited by this Code, is the amount which will compensate for all the detriment proximately caused thereby, whether it could have been anticipated or not."  The California court of appeals held in Walsh v. Hooker & Fay (1963) 212 Cal. App. 2d 450, that out-of-pocket damages are not the proper measure in a fiduciary breach situation.  In addressing the fiduciary relationship with a broker, the court said:  "An exception to the foregoing rule is recognized where a fiduciary relationship exists between the fraudulent and the defrauded parties... as to such cases the much broader provisions of Section 3333 and 1709 of the Civil Code are applicable."  (Id. at pp. 458-459; Twomey, supra, 262 Cal. App. 2d 690, 731.)  The court went on to make it clear that in the case where a party is entitled to recover damages from a fiduciary, the proper damages are all damages suffered or all detriment proximately caused by the breach of fiduciary obligation.   In the final analysis, the law clearly recognizes that a brokerage firm's client is entitled to the "benefit of the bargain" or "properly managed account" damages.  See Levine v. E.F. Hutton & Co., 636 F.Supp. 899-900 (N.D. Ill. 1986) (plaintiffs recovered the difference between losses incurred on the sale of speculative securities and the greater amount plaintiffs would have received had they not been defrauded); Hatrock v. Edward d. Jones & Co.,750 F.2d 767, 773-774 (9th Cir. 1984)(investor may recover the decline in value of the investor's portfolio in an amount equal to "the difference between what [the plaintiff] would have had if the account ha[d] been handled legitimately and what he in fact had at the time the violation ended").   Lastly, in applying the benefit of the bargain rule, it doesn't matter whether the investment markets are ascending or declining during the relevant time frame.  See Medical Associates v. Advest, and Rolf v. Blyth, Eastman Dillon & Co. Inc., mentioned above.  Also see Salahutdin v. Valley of California, Inc., 24 Cal. App.4th 555 (1994), citing Walsh v. Hooker & Fay, 212 Cal. App. 2d 450, 458-459 [fiduciary relationship between stockbroker and client made application of benefit of bargian rather than out of pocket rule appropriate].

              The case-law basis for market adjusted damages is simply that they provide an automatic adjustment for any market-based activity, such as “crashes”, that were not caused by the respondent’s wrongdoing.  In other words, even if the claimant’s investments declined along with the general market, they would not have declined as much as they did in speculative, heavily-margined securities.  Thus, market-adjusted damages avoid what is sometimes called in the case law “unjust compensation” received by the investor, who presumable assumed the general risk of investing in the market, but not the specific risk of investing in unsuitable securities or investing on margin. 

               Thus, in a falling market, market-adjusted damages reduce the loss caused by unsuitable or otherwise improper activity; in a rising market, market-adjusted damages compensate the investor for lost total return because of improper investments.  These types of calculations go by many names:  “Miley” damages, after one of the seminal damages cases (Miley v. Oppenheimer & Co., 637 F.2d 318, 326 (5^th Cir.) reh’g denied, 642 F2d 1210 (5^th Cir. 1981), “well-managed account” damages, “properly-managed account” damages, “lost-opportunity” damages, “benefit of the bargain” damages, or “lost profits” damages.