Selling Away Claims - A Killer
Selling Away claims are a firm-killer. They can and do cause the demise of broker-dealers - we have seen it many times. Some principals feel as though they know their reps very well, their reps's ethics, and just do not feel vulnerable to these claims. Reps can become friends, they may sit on an advisory board or committee or be a trusted top producer without a blemish on their long record. It is next to impossible for a firm to prevent and detect it (until it's too late). Yet that is exactly what FINRA expects and requires a firm to do and holds a firm responsible for failing to do so. The exposure from selling away claims is the biggest blind spot, by far.
To be sure, reps do not get into the business with the goal to sell away or be lax within the regulatory framework. It does not start out that way. Things change, circumstances evolve. Sometimes it is greed. Sometimes the rep does not want to "color inside the lines." Fairly often, it is simply desperate people doing desperate things - money troubles, divorce, or an expensive side gig.
Here are a few scenarios
- Some reps have good intentions but fall for the story "it's not a security, you don't have to tell your broker-dealer."- Other reps have asked the BD to approve a product but have been told no yet proceed to sell it anyway.
- Other reps create their own "product" and outright steal from the clients, manufacture statements on their laptops and the firm only finds out when a client calls the home office to complain about something.
- Still, others create a selling away claim when an "investment" is tied to their approved outside business activity.
Here are a few real claim examples
- Reps ask their BD if they can sell Woodbridge. BD says no, they sell it anyway because it is touted as not being a security.
- Rep has a coffee bean business - an approved outside business activity. This rep sits on the board of the firm, is a long-time confidant of the principals, and is a top producer. The rep allowed friends, who are also clients of the broker-dealer, to invest in the coffee bean business. The business fails, clients sue.
- Rep is establishing a winery - an approved outside business activity. Family and friends are in this business together with the rep. The contractor who built the fencing around the winery wanted to invest. Ultimately, a friend who is also a client of the BD invests. Winery fails, everyone sues.
- Rep has a catfish farm - not necessarily an approved business activity. Who knew he would be selling fish? Who knew he would allow a client of the BD to buy the fish food? Client sues.
- Rep sells many approved REITS and other real estate investments to clients of the BD. Rep decides he wants to get in on the hot home foreclosure market for his personal investing. He was doing very well and had made great contacts and had an in with the bank's asset managers. One of his clients begs him to get in on a particularly sweet deal. Instead of investing in the down payment, because that would be against the rules, the rep gives him "ownership" in the form of sweat equity the client/friend can contribute acting as the Property Manager and agreeing to pay for maintenance/repair costs. The rep and the client/friend have a falling out resulting in selling away claims.
Here is how the BD gets caught up with the liability
- FINRA rules require the broker-dealer to a. inform the rep of what selling away is and that it is not allowed, b. confirm they acknowledge it and c. have the procedures and infrastructure to conduct audits to perform those audits. The problem is when in a FINRA arbitration, the fact the firm did all that they were required to do is ignored. The pitiful investor wins. Empathy trumps facts.
- Even if the "investor" signs a document stating they understand this investment is personal, has nothing to do with the broker-dealer or the rep's business with the broker-dealer, the fact the rep is a rep makes it investment advice. The broker-dealer has strict liability for the acts of the reps.
- There is occasionally (very seldom) success in thwarting a claim or potential E&O claim IF the investor has no relationship with the current BD or any previous BD of the rep, in other words, there were no legitimate investments done with the individual. This defensive argument is most successful when it made before plaintiff attorneys get involved and it is prior to becoming a FINRA arbitration or civil matter. If a go-away settlement with full legal release can be made, it should be considered.
How does this play out in the Registered Investment Advisory environment?
Registered Representatives and Investment Advisory Reps, in practice, are held to the same standard of care when it comes to the "professional providing service and advice" to the investing client. Fiduciary versus non-fiduciary seldom plays into the calculation of a settlement or judgment that may be awarded to an injured client. Legally, technically speaking, it may matter. But we have never seen an E&O claim dismissed or lessened on the basis of it being a fiduciary or non-fiduciary relationship. When clients lose money, they have the upper hand, whether it is a legitimate service being provided or it is a selling away case.
In summary, firms must realize the magnitude of this exposure and the many ways it presents itself. Most of our clients, when the selling away event becomes known, tell us they just had a gut feeling about that rep or a particular situation. There was no evidence, nothing to point to the source of the intuition. More than anything they feel angry and hurt because they never expected it. Frustration compounds when they are held responsible for the loss when the firm took all the steps required by the regulators and then some.
Some relief can come from Selling Away Coverage that is available in some E&O policies, certain Fidelity Bonds, and potentially D&O insurance.
If given the opportunity to purchase Selling Away coverage, it should be strongly considered. Most claims are large. The perpetrators "go big or go home" because the pay-off needs to be commensurate with the risk they are taking. Most often the coverage comes with a noticeable price tag, a lower limit, and a higher deductible. Most firms do not have the capital to deploy to defend and resolve a Selling Away claim, which often results in closing the doors. If they do, surely there is a better way to deploy the capital. Furthermore, why expose the firm's capital when coverage can be obtained with the cost of that coverage being spread among the firm's many representatives.
If the E&O market turns hard, which indications are that is starting to happen, this coverage will likely be next to impossible to buy, particularly if you don't already have the coverage. As said earlier, if given the opportunity, purchasing the coverage should be strongly considered.