How a Broker Provides Suitable Recommendations to his/her Clients
(Comparative Study between United States and Saudi Laws)
Sultan Abdulsalam Ibrahim Abdulsalam
LLM-Financial Services Law
Table of Contents
Introduction to the Topic . . . . . . . . . . . . . . . . . 5
Section 1: Background
1.1 The origin of US law and Saudi law. . . . . . . . . . . . . . . . . . 8
1.2 The history of regulators. How they acquired the authority? What is their feature in US and Saudi? . . . . . . . . . . . . . . . . . 11
A. Who are the US regulators?
1. Congress: . . . . . . . . . . . . . . . . .11
- SEC (Securities and Exchange Commission) . . . . . . . . . . . . . . . . .12
- SRO’s. . . . . . . . . . . . . . . . .12
- OTC. . . . . . . . . . . . . . . . .14
B. Who are the Saudi Regulators:
1. The Council of Ministries, Shura (Consultative) Council. . . . . . . . . . . . . . . 15
2. CMA (Capital Market Authority) . . . . . . . . . . . . . . . . .16
3. SRO (Saudi Stock Exchange) . . . . . . . . . . . . . . . . .17
1.3 Who is a broker, dealer, investment advisor or an authorized person?
A. The definition of broker in US. . . . . . . . . . . . . . . . . .17
B. The definition of dealer in US. . . . . . . . . . . . . . . . . .18
C. The definition of investment advisor in the United States. . . . . . . . . . . . . . . .18
D. The definition of broker in Saudi. . . . . . . . . . . . . . . . . .20
E. The definition of investment advisor in Saudi. . . . . . . . . . . . . . . . . .21
F. The definition of authorized person in Saudi. . . . . . . . . . . . . . . . . .21
G. The differences between United States and Saudi. . . . . . . . . . . . . . . . . .22
Section 2: Fiduciary duty of a broker dealer in US and in Saudi. . . . . . . . . . . . . . 24
2.1: Fiduciary Duty in general:
2.2: Fiduciary Duty for Brokers in United States: . . . . . . . . . . . . . . . . .26
2.3: Fiduciary Duty for Brokers in Saudi: . . . . . . . . . . . . . . . . .33
Section 3: Securities exchange act of 1934 regarding Securities Fraud and Unsuitable Recommendations, theories of liability, and precedents and the similar concepts in Saudi Capital Market Law.
A. US Securities Exchange Act of 1934
3.1: Section 10-b about anti fraud provision in securities exchange act of 1934. . . . 36
3.2: Misrepresentation theory and the components of establishing unsuitability Claim (Rule 10b-5) . . . . . . . . . . . . . . . . .36
3.3: Theories of liability for unsuitable recommendation. . . . . . . . . . . . . . . . . .37
1. Material misstatement/ Omission theory. . . . . . . . . . . . . . . . .38
2. Fraud by conduct. . . . . . . . . . . . . . . . .38
3.4: Precedents regarding unsuitable recommendation under rule 10b-5. . . . . . . . .39
B. Saudi Capital Market Law of 2004 and its Implementing Regulations. . . . . . . . 43
Section 4: Self Regulatory Organizations, and Authorized Person’s Rules about Suitability
4.1 What a broker needs to know regarding opening a client account? . . . . . . . . . . 47 . . . . .
A. Know your customer rules in Self regulatory organization in US. . . . . . . . . . . . .47
B. Know your customer rule in Saudi law. . . . . . . . . . . . . . . . .48
4.2 Suitability concept for an individual client and an institutional client
A. Broker dealer suitability obligation regarding to an individual client. . . . . . . . . 49
1. The United States rules about individual clients. . . . . . . . . . . . . . . . .50
2. The Saudi rules about individual clients. . . . . . . . . . . . . . . . .54
B. Broker dealer suitability obligation regarding to an institutional client. . . . . . . .55
4.3 Special Attention regarding Low-priced securities; start-up companies; low-rated bonds according to NASD rules and SEC rules and similar articles in the Saudi authorized person regulations. . . . . . . . . . . . . . . . .57
4.4 The use of investment advisor when a client seeks an advice under both regulations. . . . . . . . . . . . . . . . .63
Section 5: Final comparison, evaluation, and recommendations
5.1: Final Comparison and evaluation between United States and Saudi Arabia Laws. . . . . . . . . . . . . . . . .66
5.2: Recommendations. . . . . . . . . . . . . . . . .69
Introduction:
Any broker dealer who works in the financial sector has many obligations towards his/her clients. His/her clients may rely on his/her advice completely or partially. It can be discovered from many circumstances that clients provide to a broker, or it might be only a broker’s responsibility if he/she acts against the furnished information from customers that a broker knows his/her recommendation is unsuitable or he/she does not disclose risks with a transaction that must be disclosed by law to any client. This paper gains more attention especially after the occurrence of global financial crisis that have been made by using some risky financial instruments in wrong ways which bankrupted Lehman Brothers, and currently facing a case between the Securities Exchange Commission and the giant financial bank Goldman Sachs, and whether these brokers always provide suitable recommendation to their clients or not. It leads to give more attention whether the broker should give advice or leave it only to financial advisors. Thus, a suitable recommendation for each customer is not an easy job and carefully investigated especially that there are enormous numbers of current cases about unsuitable recommendations in courts located in United States and in Saudi Arabia. Otherwise, it might lead to some liability. Furthermore, the Saudi regulator is trying to convince investors to deal with authorized persons like brokers because there are enormous numbers of Saudi individual investors, who trade in the stock market with no knowledge or lack of knowledge of financial analysis, risks of investments, and so on to be mostly as an institutional market as in the United States. The US has also many experiences in non institutional investors in 1929 and 2001 about investment in technology companies that the price of its securities raised without looking to the risks and the real price of stocks due to speculation so the US market was hit badly due to these practices. These bad experiences lead the regulator to enhance the rules of suitability for investment. Here, This paper provides some of the guidelines to give an appropriate recommendation by a broker and apply the suitability approach from recent precedents or cases that expand the concept of how a broker can provide a suitable recommendation to his/her clients. Unfortunately, Saudi Court (Securities and Resolution of Securities Disputes) does not have any published precedent regarding suitability yet. Therefore, the influence of United States precedents will enhance the applicability of applying securities law in Saudi as long as it contains similar facts and laws about suitability as it will be seen later in this paper. The Saudi Capital Market Law of 2004 is the main regulation in this area. In addition, the Saudi Capital Market Authority has issued Authorized Person Implementing Regulation to organize the business of securities business professionals, who are mainly, mentioned in the suitability concept which this paper is all about. On the other hand, the situation is different in the United States. There is the securities act of 1933, the securities exchange act of 1934, and Investment advisor act of 1940. Thus, it might be difficult for ordinary customers to understand these regulations as well as some of the NASD rules regarding suitability. Regular clients need to understand at least basic rules and violations regarding securities due to some investment do not suit their financial objectives. In addition, clients have to sign risk disclosure for specific types of investment that includes the risk of losing all money. This paper has many objectives. One is improving Saudi Capital Market Law and its implementing regulations from various rules issued by American regulators. Moreover, the application of enormous numbers of precedents that mentioned unsuitable recommendations, which will be an added value to the new developed law and assist Saudi court to apply the best practices in this area. Lastly, this paper shows which is better either having one law like Saudi or different laws regarding suitability concept in US.
This paper gives clear examples about giving suitable advice for many types of investors. If ABC brokerage firm has four or more customers as the following:
I- An institutional investor, who has the ability to evaluate risks,
II- An institutional investor, who can’t evaluate risks and needs financial advisor’s help or a broker’s assistance,
III- An individual investor who wants to invest in conservative investments according to his/her investment objectives with respect to other components such as age, marital status, etc,
IV- An individual investor, who wants to invest in penny stocks, startup companies, or speculative stocks and options.
Section 1: Background
1.1 The origin of US law and Saudi law.
American law has its origin from common law. It started in England when there was no written law. All cases go to the court and then the judge decides after studying all facts to get logical judgment without referring to any written statue because they follow customs. With the accumulation of many judgments, there are enough precedents that judges must follow in their current and following cases even if there were any written laws . Common law has different names such as Anglo-American, English, judge-made. The sources of this law are case law, legislation, and the policy making role which is shared by courts to balance the power between the judicial authority and Congress. This type of law is always compared with Civil law. The latter has different sources of law such as legislation and statutes. A court in Civil law system has equal but separate power in policy making roles. Thus, the origin is differing in its development because civil law developed out from the roman of Justinian’s Corpus Juris Civilis, which is the body of civil law.
As noticed from this simple comparison, the origin of American law is considered from common law; however, there are recent changes in this area, especially after the congress has mandated the securities act of 1933, and the securities exchange act of 1934. These laws are the fundamental regulations in securities area and their professionals. Moreover, it gives the authority to the SEC to issue rules to organize the market. In addition, the SEC has the power to authorize self regulatory organizations to cooperate with SEC to improve the structure of the securities market. From this introduction, it is clear that the American system in securities area does not follow common law completely as it can be seen throughout this article in different sections ,because there are certain sections and rules which must be respected in any suitability cases. Therefore, it is considered as a combination between common law when they rely in current cases on previous cases and civil law when it mentions the violation section and rules in unsuitable recommendation from broker to his/her client for example.
In contrast, Saudi Arabia has a totally different type of organization in its shape. Saudi follows Shariah, which is commonly called Islamic law (religious law). The sources of law are Quran and others such as Hadith (Prophet Mohammed Sayings)…etc. Furthermore, courts and other government branches are subordinated to the Shariah. This is really in general. Although Saudi follows Sahriah in specific criminal cases such as manslaughter, adultery, burglary… etc, which is written in Quran and have specific punishments.Saudi has formed various laws that rely on Egyptian law, which came from French law that follows Civil law. For instance, Anti corruption law, and Companies Act. Of course, all of these laws must not breach Islamic concepts (Shariah). On the other hand, Saudi Capital Market Law, which is one of the main topic in this article implicitly follows the US securities laws even though the different concepts in some parts and the language of statue itself. Baker Mackenzie law firm, which is one of the leading American law firms, has participated with Saudi regulators to form the new law of 2004. It is also noted that some of the articles in Capital Market Law breaches Islamic principles. The regulator (Ministries Council which is similar to Congress) bears in mind the nature of dealing with securities is differ from any other area, and lets people decide whether to deal with these type of investment or not, even though it breaches Islamic principles. To clarify, regular municipal bonds which are not Islamic bonds (Sukuk) are prohibited in religion due to the fixed interest in maturity each time. Comparing to Sukuk which does not have that and it relies on sharing profit/loss that changes every year. There are other examples such as dealing with options, derivatives that do not match with Islamic principles as well. In addition, referring to Islamic rules can be noticed in some types of investment especially when there are no clear articles in law or implementing regulations. Therefore, Saudi system in securities rely mainly on its regulations and precedents, which means they follow a complicated system that follows common law, civil law, and general Islamic principles which is something that is not mentioned explicitly in its regulations, therefore it provides the flexibility to empower the law in any cases under Saudi jurisdiction.
In brief, it is implied that none of these countries rely on their own origin. They always refer to the statues, authority rules, self regulatory organization rules, precedents, or principles which mean that they mainly do not follow a specific type of law in securities area.
1.2 The history of regulators. How they acquired the authority? What is their feature in US and Saudi?
A. Who are the US regulators?
1. Congress:
The only legislative branch in the United States is the Congress. The constitution says “All legislative Powers herein granted shall be vested in a Congress of the United States, which shall consist of a Senate and House of Representatives…” Furthermore; the constitution has given the authority to the congress to issue all regulations after discussing that. According to this power stated in the constitution, which called the commerce clause the Congress has adopted the securities act of 1933, the securities exchange act of 1934, the investment advisors act of 1940, and all regulations that govern securities markets.
2. SEC (Securities and Exchange Commission)
The main regulator in the securities industry is the Securities and Exchange Commission (SEC), which is considered as a federal administrative agency. It was created under the Securities Exchange Act of 1934 by the congress during the great depression to enforce the newly-passed securities status and regulations, to promote stability in the markets and to protect investors. Furthermore, it has the authority to issue rules that interprets securities regulations. For instance, The SEC regulates disclosure to the public and protects investors against malpractice in the securities markets. Also, the SEC regulates securities brokers, dealers and transfer agents, as well as securities, transactions, and, under certain circumstances, individual investors.
3. SRO’s
Self-Regulatory Organizations. Non-government organizations that assists the SEC in regulating financial markets, particularly exchanges and companies that deal with securities and their members through the adoption and enforcement of rules of conduct for fair, ethical and efficient practices within the securities industry. To achieve these goals, the Securities Exchange Act of 1934 requires all SROs to adopt rules in an agreement with the provisions of the securities laws and to enforce compliance with those rules by SRO member firms. Moreover, SROs have the authority to regulate a wide variety of trading and sales-practice activities not specifically prohibited by the securities laws; however, it violates the essence and goals of this beneficial remedial legislation. By itself, courts have held SROs must be given broad authority in creating and enforcing their disciplinary rules. Not only theses tasks but also, it arbitrates disputes, and provides training and licensing services. Examples of SRO include National Association of Securities Dealers (NASD), the national securities like NYSE, AMEX, and commodities exchanges. In 2007, FINRA (Financial Industry Regulatory Authority) was created in 2007 by the merger of NASD and the regulatory and enforcement divisions of the New York Stock Exchange (NYSE) to become the largest self-regulatory organization (SRO) in the United States. Some of FINRA tasks include writing and enforcing rules governing the securities industry as well as enforcing federal securities laws as it mentioned above about all SROs. In addition, FINRA has jurisdiction over all broker-dealers and registered representatives, [19] and has authority to discipline firms and individuals who violate the rules. It regulates trading in stocks, mutual funds, variable annuities, corporate bonds, and futures and options contracts on securities. It also acts as the SRO for a number of securities exchanges.
4. OTC:
Over-the-counter (OTC). Securities that trade over-the-counter (OTC) are not listed on an organized stock exchange, such as the New York Stock Exchange (NYSE) or the Nasdaq Stock Market. It can be referred to stocks that trade via a dealer network as opposed to on a centralized exchange. It also refers to debt securities and other financial instruments, such as derivatives, which are traded through a dealer network. To clarify, common stocks, corporate, government, and municipal bonds, money market instruments, and other products, such as forward contracts and certain options, may trade OTC. Theses financial instrument are generally traded on the Over-the-Counter Bulletin Board (OTCBB) or on the pink sheets. One must be very wary of some OTC stocks; OTCBB stocks either are penny stocks or are offered by companies with bad credit records. Instruments such as bonds do not trade on a formal exchange and therefore also are considered OTC securities. This market is crucial due to the unavailability of this market in Saudi Arabia as it will be discussed later, and the regulator has mentioned speculative stocks which are another synonym to penny stocks in it is regulation.
- Who are the Saudi Regulators:
1. The Council of Ministries, Shura (Consultative ) Council
Any national legislation comes from two authorities, which are Saudi Council of Ministers and Shura Council. These regulators have similar authority like the congress in the United States. In addition, any law must be ratified by royal decree from the King and is found to be fully compatible with the kingdom"s conservative interpretations of Shari"a (Islamic Law) as pointed out in Saudi constitution (The Basic Law of Governance). According to article 20 in Council of Ministries Statute, it states “Taking into consideration the stipulations of the statute of the Consultative council, statutes, international treaties, and agreements and franchises will be issued and amended in accordance with Royal Decrees after having been studied by the Council of Ministers of Ministers.” From this article, it can be seen that there is another authority which is the Shura Council that must review any legislation and then it transfers the legislation to the council of ministers. According to Shura Council Law, it states in its article 18 the following “Laws, international treaties and agreements, and concessions shall be issued and amended by royal decrees after being reviewed by the Shura Council.” These two authorities have the right to suggest, discuss, and vote on all legislations and then give it to the Saudi King. Then, the King has to sign any law to become effective. Hence, the king has issued the Capital Market law in 2004 to be the main regulater in securities field.
2. CMA (Capital Market Authority)
Capital Market Authority has equal tasks, objectives, and goals as organize securities market in Saudi as it is given by congress to the Securities Exchange Commission in the United States. Capital Market Law, which was issued in 2004, has provided the power to CMA in its article five as follow “a. The Authority shall be the agency responsible for issuing regulations, rules and instructions, and for applying the provisions of this Law”. To achieve these objectives, the Authority shall:
Regulate and develop the Exchange, seek to develop and improve methods of systems and entities trading in Securities, and develop the procedures that would reduce the risks related to Securities transactions…4. Protect citizens and investors in Securities from unfair and unsound practices or practices involving fraud, deceit, cheating or manipulation. 5. Seek to achieve fairness, efficiency and transparency in Securities transactions…” Furthermore, article six gives the power to CMA to issue and amend the implementing regulations when it says “a. The Authority shall have the power to carry out its functions under this Law as well as the regulations, rules and instructions issued pursuant thereto including, but not limited the power to, Set forth policies and plans, conduct studies and issue necessary rules to achieve the Authority’s objectives. Also to Issue and amend the Implementing Regulations as may be necessary to enforce the provisions of this Law.” This article is important to the analysis of this paper due to the availability of rules that talk about suitability concept in particular in its authorized person implementing regulation. On the other hand, there is nothing mentioned explicitly about suitability in SEC rules, and always refer to Self Regulatory Organization rules regarding this concept except few rules talk about penny stocks. Therefore, the comparison would be either between statutes from both side, or implementing regulation and SRO rules in the other side, or implementing regulations in both countries.
3. SRO (Saudi Stock Exchange)
Saudi Capital Market law indicates in its law that there is only one self regulatory organization unlike the US. Article twenty states “a. A market shall be established in the Kingdom for the trading in Securities which shall be known as the “Saudi Stock Exchange”, and will have the legal status of a joint stock company in accordance with the provisions of this Law. This Exchange shall be the sole entity authorized to carry out trading in Securities in the Kingdom…c. The objectives of the Exchange include the following: …3. Establishing and enforcing professional standards for brokers and their agents…” Until now, no standards have been created by Saudi exchange yet, and they apply fundamental rules in CMA implementing regulations.
1.3 Who is a broker, dealer, investment advisor or an authorized person?
A. The definition of broker in US.
There are a variety of different names to describe brokers such as “stockbroker," "account executive “and” financial consultant." Usually, the regulatory authorities refer to the name of "registered representatives," to reflect that they must be licensed before doing any business with clients or with authorities themselves. This requirement is the same in both laws. This requirement is the same in both laws. The securities act of 1933 defines clearly the broker and dealer. Section 3(a) (4) (A) of the Act generally states a broker as “any person engaged in the business of effecting transactions in securities for the account of others.” Therefore, the broker works mainly as an agent.
B. The definition of dealer in US.
Alternatively, the dealer acts as a principal as it mentioned in section 3(a) (5) (A) of the Act “any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise”.
C. The definition of investment advisor in the United States:
It has to be distinguished between the broker and investment advisor, so we know each ones business as it has been discussed in early sections about a broker, especially when there is an advice to a client in securities business. Likewise, Section 202 (a) (11) defines investment advisor as “any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities; but does not include…. (C) any broker or dealer whose performance of such services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefore…” Furthermore, it is obvious that an investment advisor gets commission or special compensation when he/she advices a customer, unlike the broker gets nothing because this is not his main business and incidental. Because of the two different roles between an investment advisor and a broker, the broker dealer is exempted from the definition of investment advisor.
On the other hand, in some cases a broker or a dealer must register as an investment advisor and the act of 1940 would be applicable. A recent proposed rule states three things such that broker must deal with them as an advisory account:
(1) Each account which exercises investment authority, unless the investment discretion is granted by a customer on a temporary or limited basis.
(2) If the broker-dealer charges a separate fee for, or separate contracts to provide, advisory services.
(3) A broker-dealer that is registered under the Exchange Act and also registered within Investment Advisers Act would be an investment adviser only regarding to those accounts for which it provides services that makes the broker-dealer apply the Investment Advisers Act.
D. The definition of broker in Saudi.
Saudi Capital Market Law has broadened the definition of the broker in securities field comparing to the definition stated in the securities act of 1933. In article thirty two of CML, it points out the following “a. Broker means a joint stock company that carries on brokerage activities and the broker agent who is working at the brokerage company and carries out all or part the following activities:
1. acts in a commercial capacity as an intermediary in the trading of Securities, other than persons working on the basis of a contractual arrangement as defined in paragraph (b) of this Article, including any person who commercially acts as a custodian for Securities;
2. Presents in a commercial capacity an offer to others for obtaining financial assets in the form of Securities by opening an account through which transactions in Securities may be effected;
3. Effects in a commercial capacity Securities transactions for its own account other than by way of issuing Securities, in order to create a market in Securities and make a profit out of the difference between offer prices for Securities and demand;
4. Acquires or places Securities in a commercial capacity for an issuer or a person who controls an issuer;
5. Acts as an intermediary in a commercial capacity - other than persons who act on the basis of a contractual arrangement as defined in paragraph (b) of this Article - including in arranging currency or Securities swaps…”
E. The definition of investment advisor in Saudi.
In comparison, Saudi Capital Market Law of 2004 has pointed out who is an investment advisor in article one as “Unless the context otherwise indicates, the following words and phrases, wherever they appear in this Law, shall have the meaning herein specified… Investment Adviser: An adviser, who provides, offers or agrees to provide, advice to others in their capacity as investors or potential investors, in relation to purchasing, selling, subscribing or underwriting a security, or exercising any right conferred by a security to acquire, dispose of, underwrite or convert a security.” In addition, one of the implementing regulations has defined investment advisor and the meaning of advising. According to this regulation, the investment advisor is as “an employee of an authorized person who performs the activity of advising on behalf of an authorized person with or for a client”. Moreover, the law explains the meaning of advising as “advising a person on the merits of dealing in a security or exercising any right to deal conferred by a security”.
F. The definition of authorized person in Saudi.
The implementing regulation of Saudi capital market law cites another name called authorized person, which means a person who is authorized to carry on securities business by the Authority (CMA). It broadly includes all securities business to be held through this person. It means that this person can act as broker or dealer or investment advisor or both as long as he/she is registered with the Saudi capital market authority. The importance of this name in this paper is that the Capital Market Authority issued the authorized person to implement regulations, which contains the fiduciary duty, and the suitability concepts under this regulation.
G. The differences between United States and Saudi.
In the US, Brokers, and dealers have been regulated under the securities act of 1933, while the investment advisors must apply different acts called apply investment advisor act of 1940 and investment companies act of 1940. Therefore, the situation is stricter in the US and makes some conflict when someone delivers a recommendations to their customers. If this person is a broker, he/she has to deliver a recommendation that is solely to a specific transaction because his/her main business in this case is executing transaction and giving advice. Alternatively, if this person is an investment advisor, he/she can give advice to all transactions due to this being his/her main job. Another point is good to be mentioned is that even though associated persons do not have to register separately with the SEC, they must be supervised by a registered broker-dealer.
They might also have to register with the self-regulatory organizations of which their employer is a member as stated in early section. For example, the Financial Industry Regulatory Authority, Inc. ("FINRA") the National Association of Securities Dealers, Inc. ("NASD")) or a specific national securities exchanges have a mandatory rules that a broker has to register with them before dealing in securities which are listed in their exchange. Some of them are not joined FINRA; so they have their rules of registration as well.
On the contrary, Saudi has only one regulation as stated above about the authorized person firm, so we have one authority for both authorized person and their core workers which is much clearer than the American system. From these rules stated above regarding Saudi CML and its implementing of regulation, it is explicit that Saudi law distinguishes between a broker ,a dealer ,or an investment advisor and all of them have to register as an authorized person and then can choose either to work in all or one of them as they provide enough qualification in their registration statement with the Capital Market Authority. Therefore, there is only one implementing regulation that is applied, unlike the US system which has the securities act of 1933 to register as a broker dealer and the investment advisor act of 1940 to register as an IA.
As it can be seen clearly, there is lighter regulation regarding authorized person that covers all types of businesses providers in Saudi ,unlike the US system where a broker has to be under securities act of 1933 and if he/she is an investment advisor, he/she has to comply with investment advisors act of 1940 or both regulations if he/she wants to work in both. Thus, any broker should be aware and careful to accept or not accept to be under heavy regulations when he/she gives any advice as it is stated above. Moreover, the practicality is unifying regulations instead of having separate regulations so that investors or professionals have the familiarity and simplicity to understand these regulations. Lastly, under both law, a broker can be an investment advisor if they are registered to give advice as their main business.
Section 2: Fiduciary duty of a broker dealer in US and in Saudi.
2.1: Fiduciary Duty in general:
There are several definitions regarding fiduciary duty in general. It is considered as the highest standard of care at either equity or law. A fiduciary (abbreviation fid) is expected to be extremely loyal to the person to whom he/she owes the duty (the "principal"): he/she must not put his personal interests before the duty. Furthermore, he/she must not profit from his position as a fiduciary, unless the principal consents. The word itself comes originally from the Latin fides, meaning faith, and fiducia, trust. To clarify more, a fiduciary obligation exists whenever the relationship with the client involves a special trust, confidence, and reliance on the fiduciary to exercise his discretion or expertise in acting for the client. The fiduciary must knowingly accept that trust and confidence to exercise his expertise and discretion to act on the client"s behalf. For example, when one person does agree to act for another in a fiduciary relationship, the law prohibits the fiduciary from acting in any manner adverse or contrary to the interests of the client, or from acting for his own benefit in relation to the subject matter. The client has a right to get the best efforts of the fiduciary on his/her behalf and the fiduciary must exercise all of the skill, care and diligence for his/her actions when acting on behalf of the client. A person acting in a fiduciary capacity is held to a high standard of honesty and full disclosure in regard to the client and must not obtain a personal benefit at the expense of the client. In Bristol and West Building Society v Mothew case regarding the characteristics of fiduciary duty, the court says “The distinguishing obligation of a fiduciary is the obligation of loyalty. The principal is entitled to the single-minded loyalty of his fiduciary. This core liability has several facets. A fiduciary must act in good faith; he must not make a profit out of his trust; he must not place himself in a position where his duty and his interest may conflict; he may not act for his own benefit or the benefit of a third person without the informed consent of his principal. This is not intended to be an exhaustive list, but it is sufficient to indicate the nature of fiduciary obligations. They are the defining characteristics of the fiduciary…” Form this case, it shows clearly how a principal has several fiduciary obligations toward his/her clients.
To conclude, a fiduciary duty is a legal or ethical relationship between parties. One party has to do his/her best as a professional toward his/her client in order to achieve the best advantage to him/her with providing the full disclosure even though if there is a conflict of interest.
2.2: Fiduciary Duty for Brokers in United States:
As mentioned above regarding the fiduciary duty obligation in general, the same concepts are applied for a broker as it is seen in suitability rules and court precedents. A broker has a duty to act with the highest standard of good faith and loyalty, in the interest of his or her principal, in all transactions concerning or affecting the subject matter of his or her agency. When a person agrees to act as a broker, he or she generally is acting as a fiduciary, in a position of great trust and confidence. Consequently, the broker must act with the utmost good faith and loyalty in the interest of his or her principal in all dealings affecting the subject matter of his or her agency, or be liable to the principal for loss or damage resulting from a failure to do so.
Analyzing what has been discussed, it is obvious to point out that a broker dealer has a fiduciary duty toward his client. The 11th Circuit Court of Appeals states that “the law is clear that a broker owes a fiduciary duty of care and loyalty to a securities investor.” Then there is a need to know how the court determines what the fiduciary responsibilities of a broker to his customer. This case mentions special circumstances that clarify what a broker dealer has to do in order not to breach his/her fiduciary duty obligation. “These obligations are : (1) the duty to recommend a stock only after studying it sufficiently to become informed as to its nature, price, and financial prognosis; (2) the duty to carry out the customer’s orders promptly in a manner best suited to serve the customer’s interests; (3) the duty to inform the customer of the risks involved in purchasing or selling a particular security; (4) the duty to refrain from self-dealing or refusing to disclose any personal interest the broker may have in a particular recommended security; (5) the duty not to misrepresent any material fact to the transaction; and (6) the duty to transact business only after receiving prior authorization from the customer.” As a result, the court has applied the NASD rule 2310 in different words with the same concepts in addition to 10b-5 provision which are discussed later in this paper.
From the case discussed above, it is helpful to know how courts explain the fiduciary duty concept on specific breaches of fiduciary duty performed by brokers. First, a broker owes a special duty of fair dealing where he or she is acting for an inexperienced client. In Prall v. Gooden, the court says “It also must be kept in mind that a real estate broker stands in a fiduciary relationship with his customer or client and is thus bound to protect his clients" interests. He must, therefore, make a full, fair and understandable explanation to the client before having him sign any contracts, particularly when those contracts are with the broker himself.” Second, a broker must consider the age of his/her client before giving a recommendation. In Howard v. Hester, the court explains implicitly how a broker has to fulfill the fiduciary duty toward this category when it says “ real estate men stand in a confidential relation to their clients and principals, and extreme care must be exercised by them to see that their transactions bear the searching light of fair and aboveboard dealing; this is especially true when dealing with aged persons.” Third, fiduciary duty owed by a broker to a customer includes at least an obligation to manage the customer"s account as expressed by the customer"s needs and objectives, to inform the customer of risks in particular investments, to refrain from self-dealing, to follow the customer"s order instructions, to disclose any self-interest, to stay abreast of market changes, and to explain changes; however, the only fiduciary duty owed to investors by a discount broker is the duty not to misrepresent any fact material to any transactions between the parties. Fourth, selling securities to customer asks for securities not subject to fluctuation and providing a higher return than the present portfolio of the customer. Here, the situation is about not taking consideration of the customer’s wishes. Thus, the broker has to update customer’s information yearly as or when the customer asks for that. Fifth, another precedent talks about unfitness of investment due to the focus on speculative stock from established start-up company with no earning or dividend history, which supports the claim of unsuitability. Sixth, a fiduciary duty exists if there is a dual position to act as a broker and an investment advisor. The convenient investigation is not whether customer thought these trades were appropriate investments, but whether, in fact, they were suitable for his account as it mentioned in the decision. Finally, a case pointed out that regardless of customer"s desire to purchase growth stocks, broker had a duty to advice against such investment since he knew it was inadequate with customer"s stated needs. As a result, broker dealer’s advice is very important and he/she then is no liable of breaching fiduciary duty as long as he/she spends enough time with the customer to talk about all risks involved and consented by customer.
A broker also has to recommend suitable transaction even if it contradicts with customer’s wishes. For instance, suppose a customer suggested to trade aggressive and speculative securities, a broker dealer is obliged to advice him/her about the unfitness of these securities according to his/her financial situation. In a case, a broker who made investment recommendations that contradicted with church building fund"s conservative objectives breached NASD suitability rules. Although each trade was approved by volunteer church committee members, the SEC concluded these members were too financially inexperienced and unsophisticated to understand what broker dealer advised them when it says “ The Commission determined that even if the customer had authorized aggressive trading, the broker was not entitled to ignore the financial situation and character of the account. Further, the Commission stated that whether the customer considers the broker’s transactions appropriate is not the test for determining the propriety of his conduct.” This decision can be applied broadly due to having many governmental or private charity services, who invest in securities in order to increase their profit to help its beneficiaries. Thus, a broker has to recommend only convenient securities and financial instrument which fits his/her clients. Bear in mind, many of them cannot be considered as professional institutional investors who do not need recommendation until they meet specific conditions stated above.
On the other hand, the simple existence of a broker-customer or investment advisor-customer relationship may not be proof of the fiduciary character of the relationship. Moreover, there are some cases that fiduciary relationship may not exist between a broker and a customer. For example:
a. The customer of a securities broker alleges only that a special agreement created by a margin agreement, but does not allege that the agreement had language indicating the existence of a special relationship or that it was anything other than a standard broker agreement.
b. The stockbroker and customer do not know each other before the opening of the brokerage account and the customer constantly questions and challenges the stockbroker"s investment decisions.
c. An individual alleges his or her minimal knowledge of investments and his or her reliance on the account executive as a long-standing personal friend to guide him or her in business matters.
d. The investor is an experienced business person who uses his or her own judgment with respect to investments and all relevant information is either given to the investor or is available to him or her in printed reports or brochures.
2.3: Fiduciary Duty for Brokers in Saudi:
Saudi law has similar concepts about fiduciary duty. As it can be seen that enormous number of precedents in the United States jurisdiction mentioned clearly the fiduciary duty of a broker toward his client; however, there is no explicit statutory or regulation stating this concept. Saudi authorized person implementing regulation explains what the main conditions of the fiduciary duty are. It is a good step for brokers and customers to understand this concept, especially that the Saudi law is still new, and that no precedents in this area have been published. Thus, the importance of the US precedents can be very helpful to broaden the application of this concept. Anyway, authorized person states in its article 40 the following “An authorized person owes the statutory fiduciary duties set out in Annex 5.4 to its customers.” Going forward to annex 5.4, which article 40 refers to finding four obligations that a broker or authorized person must do when dealing with his/her clients. These obligations are “
1. Loyalty
An authorized person must act in all cases in good faith and in the interests of the customer.
2. Conflict of interest
An authorized person must comply with principle 10 provided for at paragraph (b) of Article 5 and with the provisions of Article 41 of these Regulations.
3. No secret profits
An authorized person must not use the customer’s property, information or opportunities for its own or anyone else’s benefit unless the authorized person makes full disclosure of such usage to the customer and obtains his consent.
4. Care, skill and diligence
An authorized person owes the customer a duty to exercise the care, skill and diligence which would be exercised in the same circumstance by a person having both:
o The knowledge and experience that may reasonably be expected of a person in the same position as the authorized person; and
o The knowledge and experience which the authorized person has”
From the article stated above, it can be noticed clearly that Saudi regulator (CMA) has adopted similar concepts from the United States, especially precedents that clarify the fiduciary duty of a broker. Another thing is the same tasks of execution broker in both laws, which explains that the broker has no obligation toward his/her client except not to misrepresenting information. The Saudi regulator has defined the execution-only customer as “a customer for whom the authorized person only deals as agent in accordance with instructions provided by the customer and whom an authorized person does not advise.” From the definition, it seems to be that there is no fiduciary duty as a broker to deal with this kind of customer because there is no advice that has to be given by the broker and also the customer himself/herself makes transactions which the broker executes only.
Section 3: Securities exchange act of 1934 regarding Securities Fraud and Unsuitable Recommendations, theories of liability, and precedents and the similar concepts in Saudi Capital Market Law.
A. US Securities Exchange Act of 1934
3.1: Section 10-b about anti fraud provision in securities exchange act of 1934.
The main anti fraud provision in the securities exchange act is section 10(b). This section has many applications that regulator like securities exchange commission rely on to claim in most market abuse by participants either by their members or ordinary investors who violates securities laws. This section makes it unlawful for any person, directly or indirectly, to "use or employ, in connection with the purchase or sale of any security … any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors."
3.2: Misrepresentation theory and the components of establishing unsuitability Claim (Rule 10b-5):
Later, the SEC has issued specific rule with respect to its authority one of the most important rules, which is rule 10b-5. It is promulgated pursuant to the authority of § 10(b) of the Securities Exchange Act of 1934. SEC Rule 10b-5 provides, in pertinent part, that “it shall be unlawful for any person, directly or indirectly, to: (a) employ any device, scheme, or artifice to defraud; (b) make any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, or (c) engage in any act, practice, or course of business that operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of a security.” According to this long established rule, it became as a flag arises whenever there is a fraud case. Therefore, precedents have been mentioned various theories about liability of unsuitable recommendation provided by a broker to his/her client and other violations like market manipulation, insider trading and so on. What this paper focus on is about the violation of a broker toward his/her customer and the same rule applies in this type of fraud.
3.3: Theories of liability for unsuitable recommendation.
As long as this paper is focused on unsuitable recommendation by a broker, a cause of action for any unsuitable trading claim requires a threshold finding that the broker"s recommendation was unsuitable for the particular customer, given that customer"s knowledge, financial situation, needs, and investment experience and objectives. However, unsuitable trading is not by itself a violation of the federal securities laws. The case should be build with additional evidence of wrongdoing on the part of the broker must be presented to bring these claims within the purview of the Securities Exchange Act of 1934 § 10(b) and SEC Rule 10b-5. In this regard, an unsuitable trading case is really nothing more than a specialized form of a traditional SEC Rule 10b-5 claim. In recognition of this, two theories of liability for a broker"s recommendation of unsuitable transactions have developed, both within the established framework of SEC Rule 10b-5 actions.
A. Material misstatement/ Omission theory
The first theory of liability, sometimes referred to as the "omission theory," or the "material misstatement/omission theory," explains the broker"s failure to disclose the unsuitability of a recommended transaction as a material omission, or, conversely, the broker"s assertion that his recommendation is consistent with the customer"s needs and objectives as a material misstatement, within the meaning of SEC Rule 10b-5.
B. Fraud by conduct
The second theory of liability, known as the "fraud by conduct" theory, or the "fraudulent practice theory," permits liability for unsuitable recommendations even in the absence of material misrepresentations or omissions on the part of the broker. Under this theory, the unsuitable recommendation itself constitutes a fraudulent or deceptive practice proscribed by SEC Rule 10b-5(a) and (c).
3.4: Precedents regarding unsuitable recommendation under rule 10b-5.
An unsuitable trading claim under the material misstatement/omission theory, which is considered a violation of SEC Rule 10b-5(b).This rule states in part that: "it shall be unlawful for any person, directly or indirectly, to: … (b) Make any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading." This is the main anti provision in the exchange acts of 1934, which can be imposed to any securities fraud. The suitability rule of NASD always comes beside this rule whenever there is material misstatement/ omission theory. This rule has a scienter element which is required to prove the unsuitability of recommendation with the assistance of NASD suitability rule that SEC has to approve first. Any client of a broker dealer who has damaged under this theory has to prove some elements to apply this rule.
The fourth circuit has held in a famous case that a brokerage firm was not responsible regarding unsuitability approach. Alex Brown & Sons did not fraudulently sell unsuitable investments when it sold collateralized mortgage obligations (CMOs) to Banca Cremi because the bank was a sophisticated investor with knowledge of the risks. Banca Cremi had lost millions of dollars on six Collateralized Mortgage Obligations sold to it by Alex Brown after the market in CMOs collapsed in 1994. The court found that the bank itself had chosen its investment strategy by balancing CMO risks and benefits against its goals. Then, the court held that “a 10b-5 unsuitability claim against a brokerage firm must have five elements:
1) That the securities purchased were unsuited to the buyer"s needs;
2) That the defendant knew or reasonably believed the securities were unsuited to the buyer"s needs;
3) That the defendant recommended or purchased the unsuitable securities for the buyer anyway;
4) That, with scienter, the defendant made material misrepresentations (or, owing a duty to the buyer, failed to disclose material information) relating to the suitability of the securities; and
5) That the buyer justifiably relied to its detriment on the defendant"s fraudulent conduct.”
After knowing the basic elements of establishing a suitability claim, it is convenient to discuss other precedents to broaden the concept of suitability by providing precedents that breaches the concept. There are many precedents regarding unsuitable recommendation made by the broker, which breaches rule 10b-5.
First, it is convenient to focus on speculative stocks that might not be suitable for all clients as it mentioned above and later section when talking about the NASD rules and some rules in securities exchange act of 1934 about certain conditions of the customers that must have in order to deal in these types of securities. Although a customer has investment objectives such as speculation or growth, the broker has the obligation to tell the customer that some transaction might not fit his/her needs according to the information he/she already provided to the broker dealer. In Saudi law, the broker has to explain to the customer all risks involved in the transaction and has to sign consent that the customer approved this transaction without any responsibilities from the broker especially if he/she discussed the unsuitability of the transaction with the client.
These examples would reflect the unsuitability of recommendation approach and clarify how courts interpreted. One case is about an unemployed widow, who invested on the market to seek income. Also, another elderly woman stated in the registration that she wants capital gain and dividends. Her broker recommends selling stocks that do not pay any dividend. It is very obvious that these stocks did not match their goals. Therefore, the broker has breached rule 10b-5. Another case about speculative securities of a brokerage house sold to a seventy-nine year old retired man who was living alone. We look here to the age of the client, marital status, and the job status. This man had no job and his income is limited. That is why this person is looking for fixed income from dividends and is supposed to be invested in blue ship companies or very safe instruments. Another example is the sale of a highly speculative security by misrepresentations and omissions which has been discussed about the elements to establish the case to customers who had indicated need for non speculative securities producing a reasonable income. Not only that but also sale of speculative securities in a boiler room. These types of securities are volatile and might face many rumors from speculators. That means it is not suitable for many categories of investors.
B. Saudi Capital Market Law of 2004 and its Implementing Regulations:
As it has been mentioned above regarding section 10-b in the securities exchange act of 1934 and SEC rule 10-b5 regarding the anti fraud provision, the Saudi Capital Market Law of 2004 has a similar concept about fraud. However, Saudi law has divided financial fraud in to two major frauds. One is market manipulation and the other is about insider trading all in separate articles. Thus, the US regulator has to refer to the main general section and rules in its claims, which differs in Saudi. Article 49 in CML states “a. Any person shall be considered in violation of this Law if he intentionally does any act or engages in any action which creates a false or misleading impression as to the market, the prices or the value of any Security for the purpose of creating that impression or thereby inducing third parties to buy, sell or subscribe for such Security or to refrain from doing so or to induce them to exercise, or refrain from exercising, any rights conferred by such Security. b. The Authority shall set out rules determining the acts and practices which shall constitute violations of paragraph (a) of this Article. These rules shall specify the acts and practices excluded from the application of the provisions of paragraph (a) of this Article. The powers of the Authority provided for in this paragraph shall include the power to set forth the rules, define the circumstances and procedures aiming at stabilizing the prices of Securities offered to the public, and the manner in which and the period during which these actions must be taken. c. The following acts and practices shall be among those which shall be considered types of manipulation that are prohibited by paragraph (a) of this Article: 1. To perform any act or practice aiming at creating a false or misleading impression of an existing active trading in a Security as may be contrary to the reality. These acts and practices shall include, but not be limited to the following…”
As it can be seen, it mentions the fraud of Market manipulation in general and with some violations that breaches the law but without any limitation for these types of frauds. It is a flexible way to add new violations because it changes every time. The law has given the Capital Market Authority to issue new rules whenever it is needed. From this analysis, this article can be the main anti fraud provision in securities fraud, and the Saudi regulator (CMA) can establish the claim of unsuitable recommendation claim that is given by a broker to a customer.
Moreover, the CMA has issued another implementing regulation called Market Conduct Regulation. This law has a special part about authorized person conduct. It contains some rules regarding churning and prohibition of dealing contrary to a recommendation. These two articles are related to the suitability concept, and a broker violates the regulation if he/she does that. Article sixteen says “An authorized person must not advise or solicit a client to deal or deal or arrange a deal in the course of managing for a client if the dealing would reasonably be regarded as contrary to the interest of the client, having regard to the number and frequency of trades relative to the client"s investment objectives, financial situation and the size and character of his account.” This article talks about churning, which is called unauthorized trading. It always comes beside unsuitable recommendation as a main violations made by a broker. Moreover, the article mentioned a clear picture about unsuitability of recommendation as it will be mentioned later about suitability concept. The other article is article nineteen, which is in the same regulation which points out the following “Where an authorized person or any of its affiliates issues an investment recommendation, research, study or analysis relating to a security it is prohibited from:
1) providing advice to a client or making a trade for a client that is contrary to the recommendation unless the authorized person, prior to providing the advice or making the trade, discloses to the client the recommendation and the potential conflict of interest between the authorized person and the client; or
2) Making a trade for its own account in the security that is contrary to the recommendation unless reasonable grounds exist to make the trade.” This rule prohibits the broker to execute transaction to his/her against his/her recommendations, or studies unless provide full disclosure to the customer. To clarify, this violation is considered as an unsuitable recommendation to the client because there is obvious client’s misrepresentation. Moving to another regulation, the professionals can rely on authorized person implementing regulation which talks about suitability concept to strength the claim. This rule will be discussed later in this paper.
In conclusion, the CML has not mentioned the unsuitability of recommendations in the statue itself; however, the Capital Market Authority’s implementing regulations are much clearer than SEC rules regarding suitability, due to all concepts are stated in these regulations. On the other hand, the US law refers to the securities exchange act of 1934 there is a suit in front of federal courts for violating rule 10b-5 while referring only to NASD 2310 rule regarding suitability to establish cases on arbitration. Finally, the same theories of liability that many precedents mention when analyzing unsuitable recommendation violation under rule 10-b5 seem to be applicable in Saudi law so that it can be beneficial to be stated in this type of fraud.
Section 4: Self Regulatory Organizations, and Authorized Person’s Rules about Suitability
4.1 What a broker needs to know regarding opening a client account?
A. Know your customer rules in Self regulatory organization in US:
There are many rules that have the same concept of knowing your customer. The NYSE rule 405 is the most famous rule in this area. It points out that “Every member organization is required …. to… use due diligence to learn the essential facts relative to every customer, every order, every cash or margin account accepted or carried by such organization and every person holding power of attorney over any account accepted or carried by such organization, and every person holding power of attorney over any account accepted or carried by such organization." It is not clear by itself which information should be enough to know about a customer; however, it would be clear when you use it beside the suitability rule. Another rule is the Duty to Know and Approve Customers. This rule is based on The American Exchange (AMEX), when it mentioned “pursuant to Rule 411, members and member organizations are required in connection with recommending transactions in the Shares to have a reasonable basis to believe that a customer is suitable for the particular investment given reasonable inquiry concerning the customer’s investment objectives, financial situation, needs, and any other information known by such member.” From these two rules, it is clear that any broker must have some information about his/her customer before opening any account. This is how a broker should have reasonable belief and basic ground to execute each transaction to his/her customer separately according to these information.
B. Know your customer rule in Saudi law:
It is really crucial for any broker or an authorized person to know some information before he/she accepts any customer in order to open an account. Thus, a broker might rely on obtained information to give the appropriate advice to a client as long as it contains current general information about a customer. This rule or article is called know your customer. In article 39 of authorized person in Saudi, it states that “
1) Before an authorized person deals, advises, or manages for a customer, it must obtain information from the customer concerning the customer’s financial situation, investment experience and investment objectives relevant to the services to be provided. Such information must be obtained as a precondition to providing such services.
2) The information required under paragraph (a) of this Article must at a minimum include the information required by Annex 5.3.
3) The authorized person must request an update of such information from each customer at least annually.
4) If the customer refuses to provide the information required under this Article, the authorized person may not deal, advice or manage for him.
5) An authorized person must retain a record of all information obtained from the customer pursuant to this Article.”
This rule focuses on the current information which should be updated in yearly basis, so the broker is fully informed about his/her client’s financial situation, investment objectives and experience. It also refers to a guide that provides basic elements about any client. For instance, Annex 5.3 asks about approximate annual income, approximate net worth (excluding residence), if the customer has any current investment portfolio and how he/she diversified his/her portfolio, whether the investment knowledge and experience are limited or good or extensive, and if the customer is an individual how he/she thinks the ideal portfolio could be. Unfortunately, the Saudi law does not mention any information about institutional investors/customers, so we could rely on the guidelines which are offered by the US regulations or rules to provide a broad picture of changing the Saudi law to follow the US standards or with more improved legal structure with matching the best practices globally.
4.2 Suitability concept for an individual client and an institutional client:
A. Broker dealer suitability obligation regarding to an individual client:
1. The United States rules about individual clients:
Every self regulatory organization has a suitability rule; however, the most favorite rules for practitioners are those of the NASD and New York Stock Exchange (“NYSE” or “Exchange”) due to the clarity, generality and most of brokers are registered in NASD. The NASD"s suitability rule, Conduct Rule 2310 always mentioned in court cases or decisions by the SEC and other regulators in the United States. This rule states “
(a) In recommending to a customer the purchase, sale or exchange of any security, a member should have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by the customer as to his security holdings and as to his financial situation and needs.
(b) Prior to the execution of a transaction recommended to a non-institutional customer, other than transactions with customers where investments are limited to money market mutual funds, a member shall make reasonable efforts to obtain information concerning:
(1) The customer"s financial status;
(2) The customer"s tax status;
(3) The customer"s investment objectives; and
(4) Such other information used or considered to be reasonable by such member or registered representative in making recommendations to the customer.
(c) For purposes of this Rule, the term “non-institutional customer” shall mean a customer that does not qualify as an “institutional account” under Rule 3110(c)(4).”
The other famous rule of NYSE 405 is less specific, providing that every member organization of the Exchange is required to “Use due diligence to learn the essential facts relative to every customer, every order, every cash or margin account accepted or carried by such organization and every person holding power of attorney over any account accepted or carried by such organization.”
A broker-dealer usually has an obligation to recommend only specific investments of securities or overall investment strategies that are suitable for their customers. The concept of suitability appears in specific SRO rules such as NASD Rule 2310 and has been interpreted as an obligation under the antifraud provisions of the federal securities laws. Under suitability requirements, a broker-dealer must have an "adequate and reasonable basis" for any recommendation that he/she makes. Here, only securities and options of these securities apply suitability rules; however, it is not mentioned in the commodities exchange act even though another provision applies. It is worth to point out that there is no comparable suitability rule in the Commodity Exchange Act of 1936, which governs future trading according to two famous precedents. One case states “noting that nothing in legislative history of Act supports recovery under suitability theory.” The other case also affirmed that no suitability concept in commodities when it said “commodities broker has no duty to determine a client"s suitability.” On the other hand, there is such conduct may violate § 4b of the commodities exchange act, which makes it unlawful to "cheat or defraud" or willfully deceive any person with respect to any commodity contract. Thus, the courts have affirmed that no suitability suits can be arise under commodities exchange act.
From analyzing what has been discussed, it is obvious to point out that a broker dealer has a fiduciary duty toward his client. The 11th Circuit Court of Appeals states that “the law is clear that a broker owes a fiduciary duty of care and loyalty to a securities investor.” Then there is a need to know how the court determines what the fiduciary responsibilities of a broker to his customer. This case mentions special circumstances that clarify what a broker dealer has to do in order not to breach his/her fiduciary duty obligation. “These obligations are : (1) the duty to recommend a stock only after studying it sufficiently to become informed as to its nature, price, and financial prognosis; (2) the duty to carry out the customer’s orders promptly in a manner best suited to serve the customer’s interests; (3) the duty to inform the customer of the risks involved in purchasing or selling a particular security; (4) the duty to refrain from self-dealing or refusing to disclose any personal interest the broker may have in a particular recommended security; (5) the duty not to misrepresent any material fact to the transaction; and (6) the duty to transact business only after receiving prior authorization from the customer.” As a result, the court has applied the NASD rule 2310 in different words with the same concepts in addition to 10b-5 provision which will be discussed later in this paper.
2. The Saudi rules about individual clients:
Saudi Authorized Person Implementing Regulation pointed out the concept of suitability concept clearly, which is similar to 2310 NASD rule in different language with the same concept; however, this rule can be applied for both individual and institutional investors. Unfortunately, it is not interpreted to broaden the concept for institutional investors, and provide very basic information for this important category. Anyway, article 43 states:
“(a.) An authorized person must not deal, advise or manage for a customer or take collateral for its own account from a customer, unless the advice or transaction is suitable for that customer having regard to the facts disclosed by that customer and other relevant facts about that customer of which the authorized person is, or reasonably should be, aware.
(b.) In reviewing the suitability of advice or a transaction for a customer, an authorized person must have regard to:
1) The customer’s knowledge and understanding of the relevant securities and markets, and of the risks involved;
2) The customer’s financial standing, including an assessment of his net worth or of the value of his portfolio based on the information disclosed by that customers;
3) The length of time the customer has been active in the relevant markets, the frequency of business and the extent to which he relies on the advice of the authorized person;
4) The size and nature of transactions that have been undertaken for the customer in the relevant markets; and
5) The customer’s investment objectives.
(c.) Notwithstanding paragraph (a) of this Article, if an authorized person has advised a customer that a transaction is not suitable for him and the customer decides to proceed with the transaction, an authorized person may accept an order to buy or sell the security from the customer, provided that a record of the advice provided to the customer is retained.
(d.) This Article does not apply to dealing for an execution-only customer.”
B. Broker dealer suitability obligation regarding to an institutional client:
There is a rule regarding suitable recommendation to non natural investors, whom are defined in the rule as an institutional investor. Those categories have special circumstances in complying with suitability rule of NASD 2310. Thus, the regulator has issued interpretation IM-2310-3 which gives enough details how to furnish suitable recommendation to each client. A broker dealer has to be careful to evaluate investment risk and the ability of the customer to make an independent judgment of their broker. An institutional investor can be any entity other than natural person, and has in its account more than ten million under their management or in their securities portfolio. As it is mentioned above, the ability of knowing that a customer can make an independent evaluation of the investment risk and judgment of investments are crucial elements to rely on the fulfillment of the suitability rule. For more clarification, the evaluation of investment risk should include:
• The institution"s use of one or more consultants, investment advisers or bank trust departments;
• The general level of experience of the institutional customer in financial markets;
• The institution"s ability to understand the economic features of the security involved and to independently evaluate how market developments would affect the security; and
• The complexity of the security or securities involved.
In addition to these factors, The determination of the institutional client capability could be affected by whether there are any written or oral understandings between the broker and the client regarding the services to be given by the broker dealer, the presence or absence of a pattern of acceptance of the broker-dealer recommendations, and the use of ideas, suggestions, market views and information obtained by customers from other brokers or market professionals.
These current interpretation beside the current interpretation would be an added value to the suitability article in Saudi law, it is worth to mention that Saudi law only asks regular questions regarding institutional customer such as name, address, date of registration, number of employees, capital, annual total business, bank information, and other financial information that customers might disclose. Thus, there is a gap that needs to be filled by the authority (CMA) in order to provide enough obligations whether an institutional customer needs a recommendation or not from their broker. For instance, the level of experience in securities market, the use of investment advisor in taking investment decisions, and so on which are in the US regulations about institutional investors.
4.3 Special Attention regarding Low-priced securities; start-up companies; low-rated bonds according to NASD rules and SEC rules and similar articles in the Saudi authorized person regulations:
One of the most important issues in broker dealing business is recommending low priced securities to customers. These securities have enhanced suitability rules and special disclosure documents that have to be applied by a broker because a client who invests in these types of securities might lose a substantial amount of money or all or more if he/she deals in margin and vice versa. Otherwise, a broker would breach his fiduciary duty toward his/her client. It has a similar meaning to what professionals or regulators call penny stock. There are many rules governing this special type of securities, which are rules 15g-2 through 15g-9, and Schedule 15G. The SEC has defined penny stock as “any equity security other than a security that: (a) is an NMS stock listed on a "grandfathered" national securities exchange, (b) is an NMS stock listed on a national securities exchange or an automated quotation system sponsored by a registered national securities association (including Nasdaq) that satisfies certain minimum quantitative listing standards, (c) has a transaction price of five dollars or more, (d) is issued by a registered investment company or by the Options Clearing Corporation, (e) is a listed security futures product, or (f) is a security whose issuer has met certain net tangible assets or average revenues.” In addition, penny stocks include the equity securities of private companies with no active trading market if they do not qualify for one of the exclusions from the definition of penny stock.” It can be seen that a penny stock can be traded in the regular market or over the counter (OTC). Moreover, its price has to be lower than five dollars even though each transaction by a customer has to be greater than five dollars. In contrast, these circumstances and the definition are neither available in Saudi Capital market law of 2004 nor it is implemented. In addition, Saudi did not establish primary markets for startup companies or companies who lost more than half of their capital yet. In addition, there is no over the counter securities in Saudi. Capital Market Law in its article twenty stated “a. A market shall be established in the Kingdom for the trading in Securities which shall be known as the “Saudi Stock Exchange”, and will have the legal status of a joint stock company in accordance with the provisions of this law. This Exchange shall be the sole entity authorized to carry out trading in Securities in the Kingdom…” As it is obvious, there is only one exchange in Saudi to carry out trading in securities, and it is also implied that off-exchange trading is prohibited according to the law. Thus, it is not easy to define the speculative securities. Saudi law has to issue new rules regarding penny stocks. It would be a good idea to establish primary market beside the secondary market and both of them are under the Saudi stock exchange so that the exchange would have two markets instead of one that contain all securities. The separation would enhance the quality of trading by individual and institutional investors, the decrease of highly speculation by speculators on trading index that crashed the Saudi market in 2006. If this idea is in place, it is recommended to put startup companies for three years, and these companies have to make profit for three years as a main condition to transfer to the secondary market. Furthermore, the CMA must put some rules about the limitation of fluctuation of these securities in market and not reach certain amount of money in this period as stated above. These clear conditions or improved rules would be helpful guidelines to an authorized person in recommending speculative securities in addition to the available guidelines about penny stocks in the US regulations so that a customer knows the potential risk of investing before making any decision.
There are some documents a customer must receive by the broker if the transaction involved penny stocks. The broker dealer has to deliver risk disclosure document, as set forth in schedule 15G, and receive a signed and dated acknowledgement of receipt of that document from the customer according to rule 15g-2. Moreover, a broker has to investigate to see if the customer is able to deal in penny stocks and deliver a suitability statement so the broker wait to get signed and dated copy of them as required in rule 15g-9. Furthermore, the broker must wait at least two business days after sending to the customer the risk disclosure document and the suitability statement before effecting the transaction. In addition, Exchange Act Rules 15g-3 through 15g-6 generally order a broker to provide for each penny stock customer many things. For instance, information on market quotations and, where appropriate, offer and bid prices; the total amount of any compensation received by the broker-dealer in connection with such transaction; the aggregate amount of cash indemnification that any associated person of the broker-dealer, who is a natural person and who has communicated with the customer concerning the transaction at or prior to the customer’s transaction order; and monthly account statements indicating the market value of each penny stock held in the customer’s account.
Shifting to NASD rules will provide some information regarding suitability on penny stocks. It obliges the broker to put in consideration the ability of a customer to carry the risk of dealing in this type of securities when it states "recommending speculative low-priced securities to customers without knowledge of or attempt to obtain information concerning the customers" other holdings, their financial situation and other necessary data is prohibited. The principle here is that this practice … involves a high probability that the recommendation will not be suitable for at least some of the persons solicited."
Correspondingly, the Saudi law has taken similar approach when it assures that a customer understands the risk of the transaction in these special categories. The authorized person regulation in its article 42 says “….
a. An authorized person must not deal, advise or manage for a customer, or take collateral for its own account from a customer, unless it has taken reasonable steps to enable the customer to understand the nature of the risks involved in the type of transaction in which the customer would be engaging.
b. An authorized person must not deal, advise, or manage for a customer:
- In derivatives securities, contingent liability securities or non-retail investment funds, unless it has informed the customer of the nature and extent of the risks involved in such securities; or
· In illiquid or speculative securities, unless it has informed the customer of the nature and extent of the risks involved in such securities, including any difficulties in determining their value.”
The authorized person regulation furnished conditions that a firm has to satisfy prior dealing of its client account. He is obliged to tell the customer all the risks involved in these transactions, and how a broker could determine with the use of financial instruments and judging the real value. Moreover, it is implied that this rule can be used beside Suitability article in case of imposing sanction if there is a breach of fiduciary duty from a broker dealer. This rule should be used beside the suitability rule in authorized person regulation to complete the picture; however, the lack of additional rules and schedules would make it unclear how to apply these rules. Therefore, it is suggested that Saudi law adds some provisions or schedules regarding this area. Moreover, the risk disclosure statement which is in schedule 15g raises a question in SEC care to provide not misleading information to all customers and has the least required standards of information from broker dealer to any client. There is good case that facilitates the understanding of the risk rule in Saudi. This case imposes the fiduciary duty concept to teach some basic techniques regarding dealing with securities. It states “where customer from her broker decision as to which stocks should be sold short and when, and customer, not having education or experience to decide these matters for herself, relied on broker"s advice in this regard, broker was fiduciary and had duty to advise her of risks of her investments. The "law does not impose liability for fraud simply because a person is led to make investments that may have turned out to be unwise or unprofitable, but here, the broker had a duty to explain short selling in a way the customer could understand” Therefore, the lack of experience in the securities field especially when a customer deals with risky transactions which obliges the broker to teach customers till they understand the transaction to fulfill their duties.
4.4 The use of investment advisor when a client seeks an advice under both regulations:
The situation is totally differs when any client uses an investment advisor regularly to help in dealing with securities. As noticed above, a financial advisor has a fiduciary duty to his/her clients to provide many things such as advice. If the broker knows that, he/she might not be responsible for breaching of suitability rules. However, the broker should be aware that an investment advisor is capable of knowing investment risks of the security/securities and taking independent judgment. Then, it would be the investment advisor’s responsibility. As a result, either a natural or an institutional investor can rely on the NASD 2310 and its interpretation IM 2310-3, and a broker is not responsible to give an advice as long as he/she only executes transactions.
In contrast, the Saudi law has an authorized person, who can work as investment advisor as well as a broker or even both together, so if they are the same authorized persons, they are responsible, and if they are different, then, the courts have to look for the type of broker’s clients and weather a customer uses financial consultant or not.
To support this view, there are some cases when a broker does not have an obligation to inform a customer of the unsuitability of a proposed investment. Mainly, among these situations is when the broker acts as order-taker only, executing transactions selected by the customer or the customer"s agent, such as an independent investment advisor, without providing any contribution as to what investments should appropriately be made. In these circumstances, the broker has no duty to discuss the suitability of the customer-designated transactions and cannot be held liable for silence. In one precedent, the court states that a broker has “no duty to monitor independent investment decisions of clients, especially in case of discount brokerage that does not provide advice, in return for lower trading fees…The court also found that even if the broker and bank were considered fiduciaries, they were exempt from liability under DOL regulations protecting brokerage firms that merely execute trades and do not give investment advice for a fee” It means that a customer has appointed an investment advisor or he/she wanted to execute orders for lower fees. The same concept is in Saudi law. Another case mentions that the client’s prior plan to apply specific strategies provided by investment advisor or not results to no liability on the broker. This precedent says “customer"s prior intent to engage in particular investment strategy precludes broker liability for executing trades in furtherance of that strategy.” Thus, the broker duty is very little fiduciary duty towards his/her client. The court highlights this point of view when it says “where there is no solicitation or recommendation from broker, he has minimal duty, if any, to investigate trade ordered by customer and disclose material facts relating to that trade.” Therefore, when a brokerage firm acts solely in a clearing capacity will bear no responsibility for the suitability of securities transactions. Nevertheless, a brokerage firm should be aware that precedent exists holding a duty to disclose the unsuitability of an investment may arise in situations where a broker has actual knowledge of the inappropriateness of the customer"s requested trade, regardless of who recommended the inappropriate investment. Here, the concept might be changed due to the knowledge of a broker of unsuitability recommendation from investment advisor. The court mentioned that a broker dealer is liable if he aided or abetted the investment advisor suggestion even if the transaction is not suitable. The court says “while there can be no liability on part of broker/dealer who merely executes orders for unsuitable securities recommended to customer by independent investment advisor with sole discretionary authority to control account, where such broker aided and abetted investment advisor"s unsuitable trading by expressing confidence in his suggestions to customer, knowing such recommendations were inappropriate, liability could exist.” This clear precedent gives more attention to the concept of aiding and abetting when there is a claim under 10b-5 rule. In conclusion, it can be seen that there are similar concepts in both laws about the using of investment advisor on regular business besides the broker who execute transaction only. Also, the situation would change if they were the same. So, each case should provide specific information, which leads to shifting the liability to one of them or to both of them.
Section 5: Final comparison, evaluation, and recommendations
5.1: Final Comparison and evaluation between United States and Saudi Arabia Laws:
Overall, this paper has a complicated comparison between two laws, which differ in various infrastructure of the body of law; however, there is similar concepts regarding the main topic about suitability doctrine despite the dissimilarity of the legal language.
In their body of law, both countries have different sources. The US law is considered as a common law; while Saudi is considered as an Islamic Law. Both of them do not rely completely on securities in their origin because they apply statues and precedents in any upcoming cases with few exceptions. To elucidate, if there is no statute in place, US courts rely on common law, which means the judge makes law. On the contrary, Saudi rely on Islamic Principles, which means that courts go to the main sources of Islam such as Profit Mohamed Peace Be Upon Him Says, and Muslim’s religious scholars to extract principles that could be applied on the case. This paper has concluded in the early section that none of these laws rely on their origin usually, and they apply a combination between civil law and common law.
Both of these laws have partially matching structures of authorities in place. On the other hand, there are various self regulatory organizations in the US, while Saudi has only one official SRO, which is the Saudi Stock Market.
In addition, fiduciary duty in both laws has similar concepts. The US system rely on precedents that mentioned the fiduciary duty of broker in depth, unlike Saudi, it has stated this concept in clear rule in one of its implementing regulations, which might make it easier for investors and brokers to understand the concept.
Suitability concept in both laws has been mentioned in different places with different applications. In the US, the Securities Exchange Act of 1934 has a main anti provision, which covers all types of securities fraud. Also, there is a SEC rule that has interpreted this section. Therefore, it covers the suit of unsuitable recommendation claims made by brokers event though there is no clear rule regarding this type and need to from the plaintiff to prove that there is misrepresentation, which means that the broker has scienter to mislead his/her client. Moreover, self regulatory organizations have their own rules of suitability that can be used by its own in any arbitration decision without the need of proving the scienter element.
Alternatively, Saudi Capital Market Law of 2004 also does not have a section regarding suitability; however, there is an article about securities fraud that gives the CMA opportunity to add new violations in implementing regulations. These regulations have mentioned the suitability concept in different rules with some cases that are considered breaching of unsuitable recommendations. These rules except the rule in the CML do not mention that scienter element either are necessary to succeed in any claims or not, which provides a dark area for professionals. In addition, Saudi Exchange does not issue any standards or rules, which means that there is no comparable concept in Saudi SRO. Therefore, there is a difficulty to solving cases through arbitration and if there is a need or not for scienter element comparing to US self regulatory organizations.
Lastly, there are disadvantages and advantages in both regulations. In US, the main disadvantage is the enormous number of rules about suitability, especially in self regulatory organizations, which might lead to difficult and costly litigations although it might be another argument about the flexibility of each organization to rely on its own rules. On the contrary, there are very strong interpretation about different types of investors, especially rules about penny stocks and institutional investors regarding suitability concept that a broker must apply when dealing with his/her clients. In Saudi, even though there are simple regulations about suitability, there are inefficient and lack of rules about penny stock and institutional investors. It is too difficult to apply the same rules that apply to individual investors. Therefore, there should be new rules that organize these areas; especially that these types are mentioned in Saudi law.
5.2: Recommendations:
This paper has recommendation for both countries as the following:
A. USA
1. Securities and Exchange Commission should make a clear rule about unsuitable recommendation made by the broker, which would be added to rule 10b-5,as it has rules about insider trading for example
2. Self Regulatory Organizations have to improve their suitability doctrine, especially about new financial instruments, and derivatives when broker invest clients money in any type of funds.
3. Simplifying the process and rules of suitability. i.e. reform the rules and eliminate the interpretation and put unified rules in all SRO.
4. Eliminating or unifying the claim of suitability in court or in arbitration.
B. Saudi
1. Taking some of the rules regarding suitability from US, and changing it according to the new situation of securities world beside the best suitability rules all over the world to have very solid rules about suitability.
2. Saudi Stock Exchange must have its own rules and standards of evaluating suitable recommendation as it is considered as the only self regulatory organization.
3. Accepting arbitration in securities field as an alternative dispute resolution.
4. Announcing judicial precedents in public to improve the legal field in Saudi.
5. Rushing into eliminating the Committee for Resolution of Securities Disputes that is under Capital Market Authority, and transferring it to the regular court system, because there is an obvious conflict of interests.
6. Studying the rich US precedents and applying them to Saudi regulations if they are suitable.
Bibliography:
1. SEC guide to broker dealer registration, division of trading and markets, April 2008. See http://www.sec.gov/divisions/marketreg/bdguide.htm.
2. Reich. Nancy E, Proof of Unsuitable and Unauthorized Trading By Securities Brokers, 1994, Database updated August 2009.
3. Mills, Charles R. and K&L Gates, THE CUSTOMER RELATIONSHIP: SUITABILITY, UNAUTHORIZED TRADING, AND CHURNING. The ABCs of Broker-Dealer Regulation 2007
5. 5D Disclosure & Remedies Under the Sec. Laws § 18:12
6. Jacobs, Arnold S. Disclosure and Remedies Under the Securities Laws Chapter 18. Brokers and Other Fiduciaries, Database updated November 2009
7. Bromberg, Alan R and Lowenfels ,Lewis D. Part 2. Rule 10b-5 in Operation
Chapter 13. Direct-Personal Dealing (Securities Broker-Dealers) XII. Broker-Dealer Suitability E. Private Damage Actions and the Suitability Doctrine, Database updated November 2009
Capital Market Law issued by Royal Decree No. M/30 dated 2/6/1424H (2004)
Authorized Person Regulations issued by the board of the Capital Market Authority pursuant to its resolution number 1-83-2005 dated 21/05/1426H corresponding to 28/06/2005G
See Colonial Realty Corp. v Bache & Co. (1966, CA2 NY) 358 F2d 178, cert den 385 US 817, 17 L Ed 2d 56, 87 S Ct 40.
According to FINRA website, Registered Representative - Persons associated with a member, including assistant officers other than principals, who are engaged in the investment banking or securities business for the member including the functions of supervision, solicitation, or conduct of business in securities or who are engaged in the training of persons associated with a member for any of these functions, are designated as representatives. Also, it defines the Associated Person as any person engaged in the investment banking or securities business who is directly or indirectly controlled by a FINRA member, whether or not they are registered or exempt from registration with FINRA. An associated person includes, but is not limited to, every sole proprietor, partner, officer, director, or branch manager of any FINRA member.
See The Basic Law of Governance, issued by Royal Decree No. A/90, 01/03/1992. Article 70 of this law states “International treaties, agreements, regulations and concessions are approved and amended by Royal decree”.
Capital Market Law, issued by Royal Decree No. M/30 dated 2/6/1424H (2004)
See 17 CFR Part 275 [Release No. IA-2652; File No. S7-22-07] RIN 3235-AJ97
See Glossary of Defined Terms Used in the Regulations and Rules of the Capital Market Authority, Amended by Resolution of the Board of the Capital Market Authority Number 1-28-2008 and Dated 17/8/1429H Corresponding to 18/8/2008G
Id GLOSSARY OF DEFINED TERMS USED IN THE REGULATIONS AND RULES OF THE CAPITAL MARKET AUTHORITY, 2008.
See Lieb v. Merrill Lynch, Pierce, Fenner and Smith, 461 F.Supp. 951, 953 (E.D.Mich. 1978).
See Or.—Prall v. Gooden, 226 Or. 554, 360 P.2d 759 (1961).
SeePaul F. Wickswat, Exchange Act Rel. No. 29907, 50 SEC Docket 165 (Nov. 6, 1991)
In this release, the opinion of the commission was “Regardless of Taylor"s acquiescence in the options transactions in her account, Wickswat, having undertaken to act as her investment counselor, was charged with making only such recommendations as were consistent with her financial situation and needs. The proper inquiry is not whether Taylor viewed Wickswat"s recommendations as suitable, but whether Wickswat fulfilled his obligations to his client. There is no indication in the record that Dr. Taylor"s oral consent to Wickswat"s options strategies or her acquiescence in his trading was intended to change her investment objectives. Inaction by Dr. Taylor under these circumstances did not constitute authorization for Wickswat to employ strategies at odds with her investment goals. If Wickswat believed options trading was in Dr. Taylor"s interest, he was obliged to disclose fully the risks involved and obtain either a meaningful consent to the adoption of new investment objectives or an assent to a limited departure from her general objectives in order to employ such a risky trading strategy.
We agree with the NASD that Wickswat"s strategy was highly unsuitable for Dr. Taylor"s account, an account that was meant to serve as a source of retirement income. Wickswat cavalierly disregarded his customer"s investment objectives and exposed her account to undue risk. We accordingly affirm the NASD"s finding of violation.”
See Charles W. Eye, [1991 Transfer Binder] Fed Sec L Rep (CCH) ¶84,840, 1991 SEC LEXIS 1601 (Aug. 15, 1991)
In John M. Reynolds, S.E.C. Exchange Act Release No. 34-30036, 50 S.E.C. 805, 1991 WL 288500
See Caraluzzi v. Prudential Securities, Inc., 824 F. Supp. 1206 (N.D. Ill. 1993).
A Chapter 7 debtor, as a registered securities broker, did not stand in a “fiduciary capacity” to a 67-year-old woman with a high school education to whom he sold securities, such that any fraud by the debtor in connection with the sale would not provide a basis to except the resulting debt from discharge, given the lack of evidence of any intention between the parties to create any ascertainable res that the debtor would administer for the woman"s benefit. In re Verrone, 277 B.R. 66 (Bankr. W.D. Pa. 2002).
The mere existence of a broker-client relationship, without more, does not imply a confidential relationship. DeSciose v. Chiles, Heider & Co., Inc., 239 Neb. 195, 476 N.W.2d 200 (1991).
Evidence that a customer has placed his or her trust and confidence in a broker, with the broker"s knowledge, to manage the customer"s account for the customer"s benefit will be indicative of the existence of a fiduciary relationship but will not, by itself, establish that relationship. Paine, Webber, Jackson & Curtis, Inc. v. Adams, 718 P.2d 508 (Colo. 1986).
See Corbey v. Grace, 605 F. Supp. 247 (D. Minn. 1985). The court held “Under the reasoning of Rude, Corbey has failed to specify the content of any special agreement or relationship and thus, does not state a claim for breach of fiduciary duty in count four.”
In this case, plaintiff was an able, experienced businessman, who used his own independent judgment with respect to his investments. He established a Cessna distributorship in Omaha in 1955. He opened a different private aircraft distributorship in Long Beach, California, in 1969. In 1975, he sold the Cessna distributorship back to Cessna and opened a different distributorship. At the time of trial, he operated businesses selling aviation parts (including engines) in Omaha, Long Beach, and Oklahoma City, Oklahoma. Plaintiff did a great deal of business with defendant, but did substantial business with other securities firms. Plaintiff sold 52,200 shares of Cessna stock through other brokers. During one period of time while defendant"s agent was offering investments to plaintiff, plaintiff was selling corporate airplanes to defendant. Plaintiff testified that during the time from 1972 to 1982, when defendant"s agent called him, plaintiff asked questions about the S.I.D. as to which sales were proposed. Plaintiff testified that he “asked the most intelligent questions I could think of at the time.” Plaintiff did complain that he received “incorrect answers,” but defendant"s testimony showed that all pertinent information either was given to plaintiff or was available to him in printed reports or brochures. A typical report set out the location of the S.I.D., its purpose, and the relationship of defendant to the S.I.D. as fiscal agent. Plaintiff testified as to a lack of knowledge in all these areas. The jury apparently believed defendant"s evidence in this regard. The trial court did not err in refusing plaintiff"s tendered instructions and in refusing to instruct the jury on plaintiff"s theory of a fiduciary relationship with defendant.
See City of San Jose v Paine, Webber, Jackson & Curtis, Inc. (1991, ND Cal) 1991 US Dist LEXIS 8318. See in particular :Issue # 2: If the City asserts an “omission” theory, what is the basis for the dealer defendants" duty to disclose?
Under this theory, it would appear that a suitability claim is merely a specialized form of an ordinary omission claim. A general omission claim exist & when a defendant omit[s] to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.” 17 C.F.R. § 240.10b-5. An unsuitability claim, then, would arise where a defendant, knowing of plaintiff"s investment objectives, recommends a course of trading that is at odds with those objectives. In such a case, the defendant has omitted the fact that the recommendation is unsuitable.
The court mentioned the following “In order to establish unsuitable investments by broker, based on fraud by conduct, investor must prove broker recommended (or in case of discretionary account purchased) securities unsuitable in light of investor"s objectives, broker recommended or purchased securities with intent to defraud or with reckless disregard for investor"s interest, and broker exercised control over investor"s account. Securities Exchange Act of 1934, § 10(b), 15 U.S.C.A. § 78j(b). Fraud by conduct is a violation of Rule 10b-5(a) and (c) and is analogous to a churning claim. Trujillo, at *61; Woodruff v. Merrill Lynch, Pierce, Fenner, & Smith, Inc., Fed.Sec.L.Rep. (CCH) ¶ 95,386, 1989 WL 224581 at *3 1989 U.S.Dist.Lexis 17196 at *9 (D.Neb. July 14, 1989). Churning is excessive trading on an account by a broker in light of the investor"s objectives. Hotmar v. Lowell H. Listrom & Co.,808 F.2d 1384, 1385-86 (10th Cir.1987). This circuit has also recognized a violation of the NYSE Know Your Customer rule and the NASD Suitability Rule can be used to determine whether an account had been churned. Id. at 1386-87. See also Miley v. Oppenheimer & Co., Inc., 637 F.2d 318, 333 (5th Cir.1981). The Miley court acknowledged these rules are excellent tools to assess the “ reasonableness or excessiveness of a broker"s handling of an investor"s account.” 637 F.2d at 333. Thus, the rules are used to assess the quantity and quality of the broker"s trading activity.
For Rule 10(b)(5) purposes, scienter includes recklessness.” See Breard v. Sachnoff & Weaver, Ltd., 941 F.2d 142, 144 (2nd Cir. 1991). The court says: (failure to disclose prior fraud conviction in offering memorandum "could be considered reckless as a matter of law" in private action under § 10(b) of Securities Exchange Act of 1934).
Powell & Mc Gowan, Inc., 41 S.E.C. 933, 934–35 (1964).
In this case, the court held the following “ Where registered broker-dealer violated anti-fraud provisions of securities acts by recommending to aged and infirm customer that he supply capital to registrant which was in precarious financial condition and by effecting securities transactions at prices not reasonably related to prevailing market prices, failed to comply with net capital and record-keeping requirements, and failed to amend registration application to correct information with respect to stock ownership, held, in the public interest to revoke broker-dealer registration.”
The Commission in its release cited a broker-dealer’s sale of securities to customers whose confidence its principal had gained, at prices far in excess of market prices and the firm’s own cost, as grounds for revoking the registration of the one broker-dealer and denying the application for registration of another broker-dealer organized by same principal.
Barnett & Co., 40 S.E.C. 1, 4 n.7 (1960); Best Sec., Inc., 39 S.E.C. 931, 933 (1960).
The commission in its release mentioned the following “In proceeding to determine whether broker-dealer"s registration should be suspended pending final determination of issue of revocation, where broker-dealer within period of several months sold large number of shares of one issuer to public investors throughout the country by means of long distance telephone calls and there is evidence that broker-dealer"s salesmen made false and misleading statements in connection with such sales regarding, among other things, increase in market price, listing on national securities exchanges and issuer"s contracts for pay TV antennas, held, sufficient showing made to require suspension of registration in public interest and for protection of investors.” In another part, the commission states that Barnett and Co had violated section 10b-5 in Securities Exchange Act.
See MARKET CONDUCT REGULATIONS, Dated 20/8/1425H Corresponding to 4/10/2004G
See Authorized Person Implementing regulation, Article 39, issued by the Board of the Capital Market Authority pursuant to its resolution number 1-83-2005
A “recommendation” has been further defined by the NASD in NASD Notice to Members 96-60 as follows: “… a broad range of circumstances may cause a transaction to be considered recommended, and this determination does not depend on the classification of the transaction by a particular member as “solicited” or “unsolicited.” In particular a transaction will be considered to be recommended when the member or its associated person brings a specific security to the attention of the customer through any means, including, but not limited to, direct telephone communication, the delivery of promotional material through the mail, or the transmission of electronic messages.”
Similarly, with regard to options transactions, the NASD Board of Governors" Interpretation of Appendix E § 16, requires brokers to obtain the following information prior to recommending options transactions: the customer"s investment objectives; employment status; estimated annual income from all sources; estimated net worth, exclusive of family residence; estimated liquid net worth; marital status and number of dependents; age; and investment experience and knowledge.
The District Court, Aspen, J., held that: “(1) some general fraud allegations were pleaded with sufficient specificity; (2) allegations of churning were sufficient to survive motion to dismiss; (3) CEA did not provide cause of action based on theory of “unsuitability”; (4) defendants were not entitled to summary judgment on conversion claim; and (5) parent company could not be held accountable for actions of subsidiary or its employee.”
Ultimately, however, the CFTC decided not to adopt the proposed rule. It also declined to adopt a proposed rule regarding churning. It gave brief reasons:
(1) those provisions would merely have codified principles that are implicit in the anti-fraud provisions of the Act and the CFTC"s rules and (2) the benefits to be gained from codification are outweighed by the risk of unintentionally narrowing the scope of these provisions.
Lacking any guidance from Congress, and clear signals from the administrative agency with expertise in the area, we decline to be the first court to hold that the CEA implicitly imposes a suitability rule on brokers. Accordingly, we grant defendants" motion to dismiss Count II.
See Section 4b of the Commodity Exchange Act (7 U.S.C. § 6b) provides in pertinent part: "It shall be unlawful (1) for any member of a contract market, or for any correspondent, agent, or employee of any member, in or in connection with any order to make, or the making of, any contract of sale of any commodity in interstate commerce, made, or to be made for or on behalf of any other person, or (2) for any person, in or in connection with any order to make, or the making of, any contract of sale of any commodity for future delivery, made, or to be made for or on behalf of any other person
(A) to cheat or defraud or attempt to cheat or defraud such other person;
(B) willfully to make or cause to be made to such other person any false report or statement thereof, or willfully to enter or cause to be entered for such person any false record thereof;
(C) willfully to deceive or attempt to deceive such other person by any means whatsoever in regard to any such order or contract or the disposition or execution of any such order or contract, or in regard to any act of agency performed with respect to such order or contract for such person. "
See Lieb v. Merrill Lynch, Pierce, Fenner and Smith, 461 F.Supp. 951, 953 (E.D.Mich. 1978).
See the Financial Industry Regulatory Authority (FINRA)Notice 09-25.
See the NASD"s Policy Statement to Art III § 2 of its Rules of Fair Practice
In this case, the court states the fact and then provide clear requirement on how a broker should explain how the nature of short selling as the following “In the circumstances of this case Moore had a duty to explain the nature of short selling to Vucinich in a way that she could understand what she was getting into. Failure to perform that duty would amount to reckless violation of Section 10(b) of the Securities Exchange Act. Kehr v. Smith Barney, Harris, Upham and Co., Inc., 736 F.2d 1283, 1286 (9th Cir.1984). Such failure would also create liability for constructive fraud under California law. Cal.Civ.Code Sec. 1575(1) (West 1982): Twomey, 262 Cal.App.2d at 720, 69 Cal.Rptr. 222.
In an explanation of the nature of short selling, the following information would have been relevant to Vucinich: that a short sale involved her borrowing stock that Paine, Webber had on hand; that maintenance of a short sale position required being able to meet margin calls; that her collateral would be drawn on by Paine, Webber and used up until it fell to the 50 percent margin requirement; that she would have to pay dividends if the borrowed stock paid dividends; that she would have to pay interest regularly as a debtor for the stocks borrowed; that the certain payment of interest and the probable payment of dividends would deplete her collateral and increase her vulnerability to a margin call; that short sales carry risks substantially different from ownership of common stocks; and that short selling is not normally what is meant by the phrase "capital gains objective."
Glossary for defined terms in Saudi securities law implementing regulation has defined the execution only customer as “a customer for whom the authorised person only deals as agent in accordance with instructions provided by the customer and whom an authorised person does not advise.”
Chee v Marine Midland Bank N.A. (1991,ED NY) CCH Fed Secur L Rep ¶95806
The court says in its holding the following “Investor who purchased 18,000 shares of common stock through broker at $7 per share and who sold stock at nine cents a share after the market disappeared brought action against broker to recover damages for violations of Securities Act of 1933 and rule promulgated pursuant to Securities Exchange Act of 1934. The District Court, Heebe, Chief Judge, held that broker which did no more than act solely as investor"s agent in executing a purchase order and which neither solicited the order nor recommended the stock could not be deemed to be an offeror or a seller, and even if broker did offer or sell the stock to investor, broker did not violate any duty in failing to make a more thorough investigation as to the bid and asked price or in failing to disclose that seller"s broker had ceased dealing with the public.”