“Selling Away” –
Can FINRA brokerage firm’s be held responsible for the investment losses incurred on investments sold directly by their agent/advisor to the client even if the investment was not authorized by the firm?
The following is a brief discussion on what has become known as “selling away” – when a licensed securities agent sells an investment to his/her client that was not approved by their employer and whether despite doing so without the awareness of the employer/broker-dealer, whether the broker-dealer can still be held responsible for failure to properly supervise the agent.
As the brokerage firm industry migrates away from the traditional wirehouse model to the “independent model,” selling away has become an increasing problem as advisors (who are often less supervised than under the wirehouse model) look to maximize their income by selling products that may or may not be disclosed to their employer and also may or may not be approved by their employers.
A good starting point in determining whether brokerage firms can be held responsible when a financial advisor “sells away,” is the case Lustgraaf v. Behrens, 619 F. 3d 867 (8th Cir. 2010). Lustgraaf held that broker-dealers are liable for the acts of their registered representatives because they control them, and are required to supervise them. As such, even if a brokerage firm had no knowledge of nor “culpable participation” in a fraudulent investment scheme, it can still be liable for the broker’s “selling away.”
This argument essentially acknowledges that the broker is acting as an agent of the broker-dealer and the firm is therefore liable for the actions of its agent based on basic agency principles, also known as respondeat superior.
Under the doctrine of respondeat superior, “an employer is vicariously liable for the torts of its employees committed within the scope of the employment.” (Lisa M. v. Henry Mayo Newhall Memorial Hospital (1995) 12 Cal.4th 291, 296, 48 Cal.Rptr.2d 510, 907 P.2d 358.) An employee’s actions need not benefit the employer (Id., at p. 297, 48 Cal.Rptr.2d 510, 907 P.2d 358; Bailey v. Filco, Inc. (1996) 48 Cal.App.4th 1552, 1560, 56 Cal.Rptr.2d 333).
And “an employee’s willful, malicious and even criminal torts may fall within the scope of his or her employment for purposes of respondent superior, even though the employer has not authorized the employee to commit crimes or intentional torts.” (Lisa M., supra, at pp. 296-297, 48 Cal.Rptr.2d 510, 907 P.2d 358.) “The employer is liable not because the employer has control over the employee or is in some way at fault, but because the employer’s enterprise creates inevitable risks as a part of doing business. [Citations.] Under this theory, an employer is liable for ‘the risks inherent in or created by the enterprise.’ ” (Bailey, supra, at p. 1559, 56 Cal.Rptr.2d 333.)
In this context then, the basic question is whether the action taken by the broker was within the reasonable scope of his employment.
“Conduct committed within the scope of employment for purposes of respondeat superior liability requires “a nexus between the employee’s tort and the employment to ensure that liability is properly placed upon the employer.” (Bailey v. Filco, Inc., supra, 48 Cal.App.4th at p. 1560, 56 Cal.Rptr.2d 333.)
“The nexus required for respondeat superior liability-that the tort be engendered by or arise from the work-is to be distinguished from ‘but for’ causation. [Fn. omitted.] That the employment brought tortfeasor and victim together in time and place is not enough…. [T]he incident leading to injury must be an ‘outgrowth’ of the employment [citation]; the risk of tortious injury must be ‘ “inherent in the working environment” ‘[citation] or ‘ “typical of or broadly incidental to the enterprise [the employer] has undertaken” ‘ [citation].” (Lisa M. v. Henry Mayo Newhall Memorial Hospital, supra, 12 Cal.4th at p. 298, 48 Cal.Rptr.2d 510, 907 P.2d 358.)”
Therefore, the caselaw suggests that if the action at issue is that the broker (who is employed to sell investments) is selling an investment (regardless of whether the firm is aware of the investment or not) his/her actions would generally fall within the scope of his/her employment resulting in the broker-dealer being responsible for those actions under respondeat superior liability.
FINRA Rule 3270
In the securities/investment context, FINRA Rule 3270 governs the duty of brokerage firms to supervise outside business activities (these would be disclosed activities as opposed to undisclosed), and the supplementary materials say the following:
Upon receipt of a written notice under Rule 3270, a member shall consider whether the proposed activity will:
(1) interfere with or otherwise compromise the registered person’s responsibilities to the member and/or the member’s customers or
(2) be viewed by customers or the public as part of the member’s business based upon, among other factors, the nature of the proposed activity and the manner in which it will be offered.
*Based on the member’s review of such factors, the member must evaluate the advisability of imposing specific conditions or limitations on a registered person’s outside business activity*, including where circumstances warrant, prohibiting the activity.
A member also must evaluate the proposed activity to determine whether the activity properly is characterized as an outside business activity or whether it should be treated as an outside securities activity subject to the requirements of Rule 3280.
Not only does the rule govern the approval of disclosed outside business activities, though, it also establishes and obligation for the broker-dealer to supervise those activities. This obligation, based on respondeat superior can then be further extended to demonstrate that FINRA brokerage firms have a general obligation to supervise their agents activities regardless of whether they are disclosed or not.
SEC Rule 206(4)-7(a)
SEC Rule 206(4)-7(a) is also analogous. It says that an registered investment advisory (RIA) firm is under an obligation to have policies and procedures in place reasonably designed to prevent violation of the Act or SEC rules adopted under the Act.
This duty would therefore apply to outside business activities that could present opportunities to engage in fraudulent activity, or violations of the fiduciary duty. Accordingly, the rule does seem to require RIAs to supervise any activity that could cause a violation, which would include selling investments regardless of whether they are approved or not or disclosed or not.
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