If an investor determines that his or her account has suffered losses at the hands of a broker or advisor, it may be time to move ahead with legal proceedings. This article will outline the options available to you for moving ahead with your claim, as well as what you should expect at each step. (Prior to actually filing a claim, there are a few steps to take to ensure the case will proceed smoothly. Read When A Dispute With Your Broker Calls For Arbitration for more information.)

Arbitration Vs. Litigation
There are two available paths: arbitration and the court system. While the processes differ significantly between the two venues, the preparation and time commitments are similar. Which path you will take will be determined by the regulatory agency that oversees the particular financial services company:

  • Stockbrokers and brokerage firms will be pursued via arbitration coordinated by FINRA. Even though brokers can use titles such as "financial planner" or "advisor," they are regulated under FINRA. While FINRA has designed its process to be handled by a non-legal entity, most people seek legal assistance at some point in the process.
  • For the majority of other types of disputes with fee-based advisors, mutual fund companies or trust companies regulated by the SEC or state regulators, the customer will pursue the dispute through the court system as plaintiffs. (Read about how FINRA and the SEC protect your account in Who's Looking Out For Investors?)

Before Filing a Claim
Prior to filing a claim, and after exhausting all avenues within the company involved in the dispute, the case should be evaluated for validity. During the evaluation, it's important to note that merely losing money in an investment account, whether a brokerage or managed account, is not always grounds for arbitration, mediation or litigation. (For more on why your broker may not be at fault, read Don't Blame Your Broker.)

Considering the volatility of investments and varied time horizons, investors have historically experienced investment losses over some periods of time. If the customer has already used legal assistance at this point, the legal team will most likely retain an expert witness and look for clues. The witness (who is typically an analyst with an accounting and financial background) will be looking for tell-tale signs of unsuitability, churning, failure to supervise or negligence. Finding footprints of at least one of these violations is essential to defining a valid case. The use of an expert witness is vital in determining the measurement of recovery and setting forth the fact of damage. (Read about more signs of a bad broker in Is Your Broker Acting In Your Best Interest?)

Basis for a Claim
The most common theories of liability by arbitration claimants or securities-fraud plaintiffs are common-law fraud or violation of the Securities Exchange Act of 1934.

The claimants will pursue one of two avenues: seeking out-of-pocket losses or rescinding the actual transaction as a resolution. Each avenue can lead to similar settlements, and for the inexperienced it's best to let the legal team decide the path.

Unsuitability is one of the most common allegations, but one of the more difficult to prove due to its subjective nature. The plaintiff/claimant alleging unsuitability sets forth the fact that the broker or advisor knew, or should have known, that the trading patterns and/or type of security was inconsistent with the planned objectives. There is a significant amount of qualitative information to evaluate, as opposed to the quantitative evidence when investigating churning.

The evidence trail starts with documentation beginning at when the account was opened. The account-opening documents will most likely contain a risk profile of some sort defining the customer's risk tolerance and time horizon. These documents have evolved into more detailed formats to better profile the customer in case of events like this.

A common practice is to rank a customer's risk level from one to five, with a rank of five designating a high level of risk tolerance. If unsuitability is going to be pursued and a substantial amount of money has been lost in risky types of investments, it would be best if the profile was a low number. For example, a customer claiming unsuitability who has a tolerance profile of five would be hard-pressed in a proceeding to prove that the investment-loss claim was anything more than a "sore loser" complaint. (Read more about what constitutes a legitimate complaint in Don't Take Broker Excuses At Their Word.)

Churning is one of the strongest allegations and one of the easiest to prove. It implies that the account was traded in excessive amounts and requires a certain level of broker control over the funds in order to be validated. In other words, just proving excessive trading is not sufficient evidence to claim churning, especially if the customer was instigating the trades on his or her own agenda.

Because of the nature of the dispute, churning is most common in transaction- or commission-based relationships. Also known as "excessive trading," it can be used as a separate claim where the commissions accumulated during the trading are requested as a recovery, or in conjunction with other claims where losses and commissions are the target of recovery. Either way, the calculation uses basic math and is easily understood by courts and arbitration panels.

The formula divides the total amount of transactions (buys and sells) by the unleveraged account market values over monthly or annual time periods (monthly calculations are more accurate). While there are many opinions on how much trading is excessive, four to six times turnover has been recognized as an excessive amount in many cases. (For more on why churning happens and what you can do to protect your account, read Understanding Dishonest Broker Tactics.)

When using the churning approach, it is important to remember that the defense will present contrasting evidence. If the client was making money during a previous time period, the defense will present the trading patterns during that time and request that the gains offset the losses.

Negligence and failure to supervise are not as frequently used, due to their subjectivity, but they can be strong components if proven. They tend to go hand-in-hand: if allegations of negligence are proved, there is usually a manager who has failed to act dutifully to supervise his or her employees. (For tips on finding a financial professional who will work in your best interest, read Find The Right Financial Advisor.)

Like churning, a certain amount of control needs to be present for negligence to take place. If the advisor controlled a significant number of trades and was negligent in execution, security selection, etc., then the case will have a basis.

Legal Proceedings
In many cases, class-actions suits can occur simultaneously with individual suits. There are many benefits to pursuing claims with class actions, but for parties with unique claims, independent claims provide better control of the proceedings. The caution here is that individuals can exclude themselves inadvertently by filing a class-action suit first. Luckily, class-action filing papers provide a clear reference to this issue and offer an opt-out for those parties that plan to pursue their claims independently. Just like with all legal proceedings, the time frames need to be in perspective, as the courts have long waiting lists.

Just like in sports, legal proceedings are best approached with a strong team. Having a professionally trained legal staff adds depth to the case and provides additional backing for seeking a settlement. Selecting an attorney and an expert witness early in the process can change the direction of the proceedings early on. (To learn more, read How To Pick The Right Lawyer.)

As the markets ebb and flow, so do the attorneys who move in and out of the securities-litigation area. Personal-injury and trial lawyers have good crossover skills and are usually well positioned to handle court cases where trial experience is a must. Either way, it is important to use an attorney with at least some experience in the securities industry, as you can guarantee that the defending parties will be well informed.

As in any legal proceeding, it is important to set expectations reasonably, especially as concerns costs:

  • If your legal team decides your case is strong enough and large enough, it will most likely work on a contingency and share a percentage of the restitution.
  • If the team feels the case is borderline, you can expect to retain the team and prepay the expert between $2,000-$6,000 to prepare the case.
  • In addition, there are fees to be paid to FINRA for filing and fees associated with court proceedings.

You should be prepared to be grilled in cross-examination in either venue by experts on the other side of the table. Firms take allegations seriously and have deep pockets to defend themselves. Also be prepared to accept any possible scenario, from winning the case with no compensation to losing the case and being held responsible for the entire cost of the court and legal fees.

FINRA has outlined the steps for filing a claim via arbitration on its website, and the average person can get a good start in the process. If litigation is the path, the SEC website can provide some basic information, but this would be a good time to hire an attorney.

For related reading, see Broker Gone Bad? What To Do If You Have A Complaint and Get A Hold On Mishandled Accounts.

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