Securities Law Enforcement Reacts to the Crisis: Congress, the Courts and the Regulators

I recently published an article discussing the reactions of each of the three branches of government to the economic crisis which became so evident in mid-2008 (Soraghan, Joseph, “Securities Law Enforcement Reacts to the Crisis: Congress, the Courts and the Regulators,” Inside the Minds, New Developments in Securities Litigation 55-76. Aspatore Books/Thomson-Reuters March 2010). The article points out that, not surprisingly, the economic crisis, highlighted by the names AIG, Lehman Brothers, Madoff and others, called to action Congress, the regulators, and possibly even the Supreme Court.

Brought before Congress since late 2008 have been proposals of huge B and not-so-huge B scope. (For example, the proposals would add more supervision and regulation of bank holding companies, the asset-backed securitization process, OTC derivative products and markets, private fund investment advisers and securities rating agencies, among many other functions.)  Most have since been adopted in bills passed separately by the Senate and the House of Representatives, and await review by joint conference committees. It is likely that most will be adopted in some form, after joint conference action, and signed into law. They will significantly affect the conduct of business in this country, and therefore how attorneys must advise their clients.

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The St. Louis Broker-Dealer: June 2010

To the St. Louis region small broker-dealers, compliance officers, legal officers and banks with securities related activities: We present the twelfth issue of our newsletter.

Social Media – Linked In, Facebook, Twitter, etc. have become a major method of communicating not only personal information, but also business information. And with so many possible clients utilizing it, small broker-dealers must consider using it in their business in order to just keep up with their competition.

But the characteristics of social media which are so positive – quickness and freedom of the user and of responses of third parties – cause difficulty in this industry, which requires control and supervision of all communications with the public. The Financial Industry Regulatory Authority (“FINRA”), in its January 2010 Regulatory Notice 10-06, guides – and restricts – broker-dealers in their use of social media.

I have asked a “guest writer” to advise on these issues: Cliff Campeau, a Partner with Evolutionize, LLC. Cliff’s statements and opinions in this piece are his, and are not necessarily mine or those of Danna McKitrick, P.C.

The “Business Memo” part of this newsletter continues the discussion of theories of, and avoidance of, liability of broker-dealers (“BDs”) and registered representatives (“RRs”). This time we analyze “unauthorized trading.”

If you would like copies of past issues or have any questions arising from the contents of this or past issues, please call or e-mail me, Joe Soraghan, at (314) 726-1000 or jsoraghan@dmfirm.com at no charge.

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Business Memo: Defending Against Allegations of Unsuitability — Part II: The Period of Limitations

The most frequent allegation brought against broker-dealers and RRs is that of “unsuitability” of recommendations. We discussed avoiding unsuitable recommendations in our July 2003, February 2004 and September 2004 issues. We discussed in our last issue, July 2007, the defenses of ratification, waiver, estoppel and laches. In this issue we will discuss the statute of limitations, or more precisely, the period of limitations.

As now implemented, the cause of action for “unsuitability” in arbitration has become a sort of “malpractice” action against broker-dealers and registered representatives, similar to negligence and recklessness malpractice actions against lawyers and doctors. That development arose out of the recent movement of disputes out of courts and into arbitration over the past, say, thirty years. The roots of the unsuitability” action, even when resolved in arbitration, are actually in the court action of securities fraud. The action was created in state and federal statutes and rules (e.g., Rule 10b-5) and cases beginning early in the last century. And the roots of its period of limitations, not surprisingly, are in that same action of securities fraud.

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Holy Moses, Batman! They’ve Stolen Our Private Placement Exemptions!

The Basic Requirements: Early History

Any sale of a security to a Missouri resident must either be registered with the U.S. Securities and Exchange Commission (“SEC”) and the Missouri Securities Commission, or have at least one specific provable exemption from each of those two requirements.

In 1953, the U.S. Supreme Court ruled that the “private offering” exemption of §4(2) of the Securities Act of 1933 (the “1933 Act”) required that the issuer prove that all “offerees” (not only purchasers) had sufficient investment sophistication and financial well-being (hereinafter “investment suitability”) to establish that they did not “need the protection of registration” under the 1933 Act. SEC v. Ralston Purina, 346 U.S. 119 (1953) But because of the illusory definition of “offerees” as including possibly every person who learned of an offering (not just those receiving an “offer” in the contract sense), the availability and thus the usefulness of the private offering exemption of Section 4(2), was thereafter seriously curtailed.

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Early Stage Financing: Offerings Exempt From Registration Requirements

I. The Requirement for Registration or Exemption

Every offer and sale of a “security” must be registered or the issuing company must bear the burden of proving an exemption from the registration requirement is available under the federal Securities Act of 1933, §5, 15 U.S.C. §77(e), and under the Missouri Securities Act, Mo. Rev. State. §409.3-301. Prima facie case for plaintiff: that he was sold a security in a transaction which was not registered.

II. What is a Security?

A. STATUTORY DEFINITION – §2(1) of the Securities Act of 1933 defines a “security” as: Any note, stock, treasurer stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, . . .investment contract, …fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege or any security, …or, in general, any interest or instrument, commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. Missouri definition virtually identical. Mo. Rev. Stat. §409.1-102(28).

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Business Memo: Defending Against Allegations of Unsuitability – Part I

As pointed out in our July, 2003 issue, far and away the most frequent allegation brought against broker-dealers and RRs is alleged “unsuitability” of recommendations by RRs. As also pointed out in that issue, a claimant alleging unsuitability must show that the securities or investment program recommended were (1) unsuitable to the investor’s circumstances; and (2) that the broker-dealer and RR held sufficient “control” over the investor.

In that issue, we discussed what aspects of the RR’s recommendations could be unsuitable. In the next two issues, i.e., February, 2004 and September, 2004, we discussed what constituted “control” and what constituted a “recommendation.” In this issue we will discuss briefly the defenses available to a broker-dealer to a claim of unsuitability.

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New NASD Code of Arbitration for Customer Disputes is Effective

The long-awaited new NASD codes of arbitration became effective April 17, 2007. They are reorganized into three different codes: member-customer disputes, industry disputes and mediation. We will discuss here the code likely to be the most used, i.e. the code for member-customer disputes.

Although the provisions for customer-member disputes were almost totally rewritten in the new rules, there are surprisingly few substantive changes in them. I have, somewhat arbitrarily, broken the more important substantive changes into categories.

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Private Placement Broker-Dealers

Both federal and state securities laws require registration of “every person engaged in the business of effecting transactions in securities . . . . ” And such registration, of course, requires that principals and RRs take initial and continuing examinations, and that firms meet net capital and extensive ongoing record-keeping and reporting requirements. The examinations require an understanding of the public securities markets, evaluation of the nature of publicly-held securities vis-à-vis the suitability of various investors, the structure of mutual funds, annuities, derivatives and other types of investments, and other concerns of full-service B-Ds.

So, you might ask, do these not simply assure that B-Ds and their RR know how to carry out their business and report their financial well-being, thereby protecting the investing public? What is the problem?

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Business Memo: Are You A Fiduciary? Why Do You Care?

A lawn care service company sells products and provides services. Registered representatives (“RRs”) and broker-dealers (“B-Ds”) also provide services and sell products (securities, etc.) to their customers. The question here is whether RRs and B-Ds have a significantly higher duty—a fiduciary duty—to their customers.

Most RRs and BDs would automatically react that they provide much more sophisticated services and products than a lawn care service and therefore treat their customers with a higher level of care. However, when that customer complains about their service, and perhaps brings a claim in arbitration or litigation, well-advised B-Ds and RRs argue that their duty was not that of a fiduciary.  Liability on such a claim frequently turns on whether, and is much more likely if, the arbitrators or court believes that the B-D and RR had a fiduciary duty to the customer.

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Recent Changes to Branch and Small Office Requirements:Getting Out in the Neighborhood

The structure of the regulation of the securities industry continues to change to accommodate changes in customer demand and technological capabilities of the industry. As discussed in detail below, the National Association of Securities Dealers (NASD), the New York Stock Exchange (NYSE) and the North American Securities Administrators Association (NASAA) have proposed, and the Securities and Exchange Commission (SEC) has approved, a new and uniform definition of “branch office” (the “Uniform Definition”) and the transition to a centralized, CRD-based branch office application system, using a new Form BR. The new Form BR will allow member organizations to submit a single filing to simultaneously fulfill the branch office registration/approval requirements of the NASD, the NYSE and most states. And, in a more recent development, the SEC has approved the NYSE’s proposed Interpretation of its Rule 342 (concerning supervision and control of offices) to permit waiver of the otherwise normally required level of supervisory qualifications of resident branch office managers for “limited purposes offices” which have more than three registered representatives (RRs).

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