Securities Regulation and Litigation Lawyer & Attorney : OverRegd Blog : Lindquist & Vennum Law Firm, Minneapolis and Denver

There is a long-perceived natural tension that exists between the challenging goals of revenue production, adherence to compliance and effectively serving the customer's interests. These competing forces do not necessarily have to be in conflict. Well-run organizations and dedicated sales staffs find the correct balance, identifying proper products for the appropriate customer and generating fair returns for all of the participants to the transaction—the firm, the broker and the customer.

It is only when a party's interests are diverted from this path that problems arise. Unfortunately, there have been occasions when a broker/dealer or registered representative wandered off the path of righteousness and pursued a personal agenda to the detriment of the customer. These problems may arise as a consequence of the sales of proprietary products, such as mutual funds, annuities and private placements, or distributions in which the firm is an underwriter. Improper activities have led to regulatory sanctions against firms for tying special incentives, such as trips, cash and goods to sales of the firm's proprietary products when non proprietary products were as good, if not better and cheaper, than the product touted by the firm and the sales personnel. Sanctions have also been made against individual reps for violations of the “Know Your Customer” rule.

It will generally not suffice for  a broker  to assert that she was just following orders when she sold what is an allegedly unsuitable investment to the customer. That defense hasn't worked before NASD arbitration panels in the past, and it will probably not work in the future, either.

The customer's interests must be paramount. That much we can all agree on. Clearly, if the product were inferior, the broker would not sell it, and if she were hounded by management to sell it anyway, she  would leave the firm. But let's proceed on the assumption that the product that the firm seeks to market is not defective in some sense. Rather, let's assume for the purposes of this discussion that the firm's product provides features, rates of return and fees and costs comparable to the competition.

If the product is truly competitive as an investment, all things being equal, there may be strong reasons why a proprietary product would best serve the interests of a customer, as well as the collective interests of the firm and broker. First, if the firm is sponsoring the product, it is expected to have an in-depth familiarity with the product and a reasonable expectation regarding how it will react to various market conditions. Since the firm stands behind the product, it will be motivated to provide a ready and stable market for it and to maintain its competitive position by dint of performance and fees. Second, unless the account is “overloaded” with any one company's products—especially products that would make the account illiquid or subject to high surrender costs—or is not properly diversified by sector, then there is no reason to avoid proprietary product. A broker who is meeting his or her duty to the customer will have offered the customer various alternatives, including the proprietary product, and can justify the recommendations made. Then, it's up to the customer to decide. The firm would be on very thin ice legally if it were found to have “intimidated” its brokers into pushing its product over another that was better or, worse, retaliated against a broker for acting on her conscience.

It might be advisable for a broker to put in writing the basis for your recommendations. Contemporaneous notes may act as an insurance policy, reflecting why a particular recommendation was made at an earlier time. This document may be valuable in the event the broker gets into a scuffle with the firm regarding her “loyalty” or subsequently, with an aggrieved customer, who attacks the recommendation because he was sold a proprietary product that failed to perform to expectations.

In the end, go with your instincts. It's your license and reputation that are at stake. Once they're tarnished, they're hard to restore. If the product isn't right for the customer, don't sell it.

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The long wait is over. The Supreme Court's decision in Tellabs, Inc. v. Makor issues & Rights, Ltd. ends the split among the circuit courts of appeal by defining the "strong inference" scienter element that securities fraud claims must meet in order to survive a motion to dismiss. Vacating the Seventh Circuit's decision, the Supreme Court held that to qualify as "strong within the intendment of § 21D(b)(2) ... an inference of scienter must be more than merely plausible or reasonable - it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent." Boiled down, this means that courts "must not only consider inferences urged by the plaintiff, as the Seventh Circuit did, but also competing inferences rationally drawn from the facts alleged." To assist the district courts, the Supreme Court laid out a tripartite test for use when deciding the "strong inference" element of a securities fraud claim on a motion to dismiss. Courts must 1) accept all factual allegations in the complaint in the complaint as true, 2) consider the complaint in its entirety, as well as other sources courts ordinarily examine when ruling on 12(b)6 motions to dismiss, and 3) take into account plausible opposing inferences as well as inferences to be drawn in support of the allegations.

Chalk this up as a victory for the Defense Bar. The stakes for securities fraud plaintiffs to get into federal court have just been raised. Now, only time will tell whether a split among the circuits will arise as to what the Supreme Court meant by requiring that an inference of scienter be "cogent."

 

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In dismissing a federal securities class action against Ceridian Corp. and three of its former officers, United District Court Judge Patrick Schiltz found that the hundreds of alleged accounting errors by numerous employees over many years, which led to repeated restatements of the company’s financials, simply did not amount to securities fraud under Rule 10b-5. (In re: Ceridian Corporation Securities Litigation, Case No. 04-CV-3704 (D. Minn., June 5, 2007.)

Using the colorful language he is becoming known for, Judge Schiltz states that in making their securities fraud allegations, the plaintiffs were “[s]eeing fraud where others might see incompetence—seeing Gordon Gekko where others might see the Keystone Cops.” Id. at 1. The Court here clearly saw only incompetence:

Judge Davis concluded that the plaintiffs’ original consolidated complaint did not adequately allege scienter. His conclusion is hardly surprising: Given the course of conduct described in the original consolidated complaint and the first amended complaint—a course of conduct involving dozens of employees committing hundreds of unrelated accounting errors of many different types over many different years—it seems almost inconceivable that there could have been any unifying intent behind the errors, much less an intent to defraud. The allegations in the complaint reek of incompetence, not fraud. At bottom, the plaintiffs’ allegations amount to little more than allegations that lots of accountants committed lots of GAAP violations.  Id. at 20-21.         

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Brocade Communications Systems ($7 million) and Mercury Interactive (a whopping $28 million) reached settlements late last week with the SEC over allegations of backdating at the two companies.    

Brocade and Mercury are the first companies to pay civil penalties in the SEC’s monumental backdating investigation -- until now, the SEC had only imposed penalties against individuals. SEC Commissioners were deadlocked for almost a year over whether to impose civil penalties directly against companies. The Brocade/Mercury settlements demonstrate that the SEC is now prepared to pursue civil penalties against companies as well as individuals in backdating cases. SEC Chairman Christopher Cox explained: "This enforcement action clearly demonstrates the SEC will use all the weapons in our arsenal, including significant corporate penalties, to protect investors and combat fraudulent stock option backdating."

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