Wrongful Management Referral
Brokerage firms can be held responsible for the failure to conduct due diligence or the recommendation of inappropriate or unsuitable third party investment advisor, hedge fund or investment manager. This is also known as a wrongful management referral. For example, if your broker recommends that you invest with Bernard Madoff, or that you invest with a particular outside money manager, or a hedge fund if this recommendation is the product of a conflict of interest or the lack of due diligence, that broker and brokerage firm may have liability for the negligence or the wrongful referral of an investment manager.
Brokerage firms and stockbrokers cannot delegate away their responsibility to recommend only suitable investment strategies or recommend outside investment managers who employ overly risky, exotic, or otherwise inappropriate investment managers, selected without reasonable due diligence.
It is well settled that such duties cannot be contracted away to non-members. See, e.g., Securities Act of 1933 § 14, 15 U.S.C. § 77n (1988); Securities Exchange Act of 1934 § 29(a), 15 U.S.C. § 78cc(a) (1988); See also, Norman S. Poser, Broker-Dealer L. & R. Sec. 2.05, Broker-Dealer Law and Regulation, PART A – Private Rights of Action (2d ed. 2001).
In cases where the Broker-Dealer recommends that the wrong advisor, liability will attach. For example, in Kaufman v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 464 F. Supp. 528 (D. Md.1978). In this case, as Respondent Merrill Lynch argued to the Court that it did more than execute unsolicited orders and that their duty to the plaintiffs was limited to faithful order execution. In Kaufman, the Court disagreed and expressly held that by placing the investment advisor on its list of advisors, and by realizing significant income and other fees from these advisors, Merrill Lynch could be held liable, directly, for the losses sustained by the customer.
Other Courts have reached the same conclusion. Rolf v. Blyth, Eastman Dillon & Co., Inc., 570 F.2d 38, 45 n.10 (2d Cir. 1978)(trading authorization maintained by a third party, such as a money manager or independent investment advisor, does not relieve a broker or his firm of their duty to the client. They must only recommend suitable money managers, continue to have an obligation to evaluate the suitability of the transactions in an account held with the firm and must not give baseless reassurances that the manager ”knows what he is doing,” lest the firm be held liable for the manager’s indiscretions), cert. denied, 439 U.S. 1039, 99 S. Ct. 642, 58 L. Ed. 2d 698 (1978)(Newburger, Loeb & Co., Inc. v. Gross, 365 F. Supp. 1364, 1371 (S.D.N.Y.1973)the question of liability is to be determined upon consideration of the particular circumstances of each case), modified on other grounds, 563 F.2d 1057 (2d Cir. 1977), cert. denied, 434 U.S. 1035) Bear, Stearns & Co. v. Buehler, 2000 U.S. Dist. LEXIS 14752 (C.D. Cal. 2000)(affirming an arbitration award against the broker-dealer for acts of the investment advisors “where there is additional involvement by the broker-dealer, a duty may be found”).
As the Court observed in Rolf, “[D]efendants are unable to point to any language in the NYSE rules which indicates that the duties of a broker are lessened when an investment adviser handles the account. Indeed, the language of Rule 405(1) which requires the broker to discover all pertinent facts with respect to the adviser indicates to this court that due diligence is required in this situation also.” See also Gochnauer v. A.G. Edwards & Sons, Inc., 810 F.2d 1042 (11th Cir. 1987)(broker’s recommendation of unsuitable money manager constituted a breach of fiduciary duty), Hanly v. SEC, 415 F2d 589, 595-597 (2d Cir. 1969); SEC v. Dain Rauscher, Inc., 254 F3d 852, 857-858 (9th Cir. 2001); SEC v. Hasho, 784 F. Supp. 1059, 1107 (S.D. NY 1992); In re Thomson McKinnon Securities, 143 B.R. 612, 619 (Bankr. S.D. NY 1992), Keenan v. D. H. Blair, 838 F. Supp. 82, 89 (S.D. NY 1993).
With these facts, liability will attach. See, Atascadero v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 68 Cal. App. 4th 445 (1999), the Court stated that “broker-dealers may find themselves subject to liability to individuals who invest through an investment advisor. The inquiry is fact-intensive and depends crucially on the broker-dealer’s level of involvement with the advisor and the advisor’s clients. Where a broker-dealer lends credibility to an investment advisor by making positive statements about his investment record and skills, without investigating the basis for the assertions, the broker-dealer may be subject to liability. See also, Bear, Stearns & Co. v. Buehler, 2000 U.S. Dist. LEXIS 14752 (C.D. Cal. 2000)(in affirming an arbitration award against the broker-dealer for acts of the investment advisors, the Court again specifically held that “where there is additional involvement by the broker-dealer, a duty may be found.”).
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AboutNicholas Guiliano, Esq.
Nicholas J. Guiliano has more than 25 years of securities related experience, and has represented more than 1,000 public customers in claims against brokerage firms for fraud in connection with the sale of securities principally in arbitration before the Financial Industry Regulatory Authority (“FINRA”) Dispute Resolution, Inc. (formerly known as The National Association of Securities Dealers (“NASD”) Dispute Resolution, and the New York Stock Exchange (“NYSE”) Department of Arbitration.LEARN MORE