Selling Away: You and Your RR Can Both Be Honest and Still Be Liable to Someone Who is Not

Joseph R. Soraghan

By Joseph R. Soraghan

“Selling away”, as you know, occurs when an RR invests his client’s money without doing so at or through the brokerage firm at which he is employed. Although it occurs in all types of brokerage situations, it occurs most frequently in non-traditional, generally off-site situations. According to the NASD, selling away is the most frequently committed violation by off-site RRs. For example, RRs who also sell insurance products frequently operate in off-site locations, and selling away frequently occurs on the part of independent insurance agents registered only as Series 6 investment company and variable contract products representatives. These RRs are frequently targeted by issuers, promoters and marketing agents to sell variable contracts and promissory notes to their customers. In many instances these products constitute securities, but their promoters market them to RRs as non-securities products that do not have to be sold through the RR’s broker-dealer.

“Selling away”, also known as “private securities transactions”, is a violation by the RR of his obligation to submit to the supervision of his BD, and to allow it is a violation by the BD of its duty to supervise all securities transactions by the RR. “Selling away” is easy to do even without knowing it.

For example, the RR may innocently (he thinks) encourage friends and relatives, including some who do not have accounts with the RR or his BD but know he works for you, the BD, to loan some money to a real estate agency being started by the RR’s brother, and from which the RR may even derive no benefit. Believing the ventures to be unrelated to his day-to-day responsibilities as a RR, the RR does not advise his BD of these transactions. As luck would have it, the start-up real estate agency soon goes “belly up”, and those who made the loan – – i.e., invested in it – – lose their money. Of course, they are upset and some sue the RR. For the BD, the worst is yet to come: the investors in the real estate agency also sue you, the BD, and you learn that the law makes the claimants customers of your BD firm despite their never having an account with you. (This level of innocence by the RR is rare, but it happens. More often, of course, the RR intends that the client believe that he is operating for his BD.)

The unfortunate investors can sue the BD based on two theories: (a) the securities law requirement that a BD supervise the activities of its RRs, including establishing a reasonable supervisory system to detect an RR’s improper activities away from the BD firm; and (b) the agency theory of “respondeat superior,” which makes employers liable for the actions of their employees, including independent contractors, because they clothed the employee with the “apparent authority” to engage in these outside business activities. (Courts and arbitrators usually hold that only the claim of failure to supervise is available to customers of BDs, but some have given recovery under the doctrine of respondeat superior. “Selling away” also subjects BDs and RRs to sanctions by regulators, but that is not the topic here.)

However, the BD will not be liable for the RR’s actions if the BD “has established procedures, and a system for applying such procedures, which would reasonably be expected to prevent and detect…such violations…” and has reasonably implemented those procedures. The BD must vigorously investigate “red flags,” i.e. suggestions of irregularity or unusual trading activity.

Of course, the standard techniques for supervision and investigation of RRs will disclose many, if not most, indications of the possibility of past or future “selling away” by an RR. Examples of general methods include, prior to employment of the RR, detailed review of the RR’s U-4s and U-5s, followed after employment by generation and review of exception reports, questioning customer complaints, large number of elderly customers, etc. However, some techniques can be used to focus specifically on “selling away,” such as credit checks to determine when an RR is in a precarious personal financial situation (which may be reduced by revenue generating outside activities not requiring him to reimburse the brokerage firm), checks concerning a life style seemingly not supported by the RR’s production through the BD, detailed reviews of the RR’s correspondence, personal and otherwise, surprise inspections (particularly at off-site and other non-traditional locations), in-person interviews of not only the RR, but also the RR’s assistant or support staff about the office’s business and any unusual evidence of activity in the RR’s office or of outside activities not disclosed to the BD (typically found in surprise inspections), dramatic decrease in the funds of customers, showing their withdrawal of funds to purchase investments being “sold away” from the BD, dramatic declines in RR production as the assets under the BD’s management decline through the customers’ purchase of outside investments, the appearance in the RR’s personal account of investments not sold through the BD, and review of all e-mails received and sent by the RR. If suspicious activity is found, follow-up could include more intense review, such as monitoring usage of the firm’s stationery (which the RR may use with customers to falsely indicate he is operating with, or that the outside investment has the approval of, the BD), directing the RR’s secretary or assistant to assist in monitoring, checking the office of the Secretary of State to determine if any entities have been created using the RRs name or names similar to it, or if his/her name appears as on officer of any such entity, etc.

Obviously, determining whether “selling away” has occurred is very difficult and the investigations therefore must be sophisticated. Also they may, of necessity, be more intrusive than investigations of other violations. Of course, every BD’s operations are different, and a thorough analysis thereof will indicate “selling away” determination methods better than, or in addition to, those above.

Reprinted from The St. Louis Broker-Dealer newsletter, April 2006.

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