What Types of Investment Losses are Recoverable

Recoverable investment losses generally fall under one of three categories. They are excessive trading also known as churning, misrepresentations or omissions, and unsuitable investments.

Excessive trading, sometimes known as churning occurs when a broker, exercising control over the account engages in transactions which are excessive in size and scope to the needs and objectives of the client for the purpose of generating commissions. Churning generally occurs in accounts where the broker has discretionary authority, or authorization to make transactions without first consulting with the client. Excessive trading also occurs in accounts where a client does not follow the trading closely. This gives unethical brokers opportunity to make unnecessary and inappropriate transactions. You can prevent excessive trading by always opening your mail from the broker and closely reviewing the monthly statements for signs of trades you did not approve.

A rule of thumb to measure churning is the generally accepted "Six Times Turnover" Rule. If an account’s equity has been turned over six times in the course of a year, with the broker making all or most of the transactions, there is a presumption the account has been churned.

Unauthorized trading also falls under the classification of misrepresentations and omissions. Unless power of attorney has been given to the broker, all trades must be approved prior to their execution. If you spot unauthorized trades in your account, make sure to ask for an adjustment immediately. Put your request in writing. Make sure you contact the branch manager and demand the transaction be rescinded or you risk ratifying the transaction.

A close relative of unauthorized trading is the "failure to execute." Often an investor will instruct a broker to sell an investment when it is up (to take profits) or when it is down (to cut losses.) A broker may be reluctant to do this when he is holding a large position in the stock for fear it will depress the price. Or, he may simply disregard the client’s instructions. Again, timely complaints in writing to the branch manger are essential to prove this claim.

Another form of misrepresentation is any guarantee against loss either verbally or in writing. There are no guarantees in the stock market. Don’t be lead to believe there are guaranteed investments unless your broker is talking about an FDIC insured c.d. Also, be mindful of a broker downplaying or glossing over the risks of an investment. For every overnight success there are at least ten overnight failures. Make sure you quantify the risks before you commit to the purchase. The only way to do this is by asking the risk be spelled out, preferably in writing before making an investment.

The third area of concern is unsuitable investments. The NASD and NYSE require that investment professionals make recommendations and investments that are consistent with their clients’ investments needs and objectives. This is also mandated under many states' laws, which states that brokers are fiduciaries. An example of an unsuitable investment is where the bulk an elderly, income dependent client’s irreplaceable assets are sold, and the proceeds used to purchase high-risk investments. A close relative of unsuitability is over-concentration. When a broker concentrates your account in shares of a single stock, or puts a large percentage of the account into high-risk stocks or options, the account could be considered to be over-concentrated. To prevail on a case for over-concentration you must establish that the concentration was inconsistent with your investment objectives.

Some of the more common types of losses occur in the scenarios below:

Ponzi Schemes: A Ponzi scheme is an investment that depends on the fund raising prowess of the promoter rather than on the success of the underlying investment program. In a Ponzi scheme an investor is typically promised large returns which are paid from money raised from new investors. Eventually the promoter runs out of new investors and the Ponzi scheme collapses.

Limited Partnerships: Although a legitimate form of operating entity, these programs have been used by many unscrupulous operators to siphon fees and large commissions from investors. "LP"s offer some of the highest commission payouts to brokers. Unfortunately, these investments are usually long term and illiquid. This means investors are stuck with this investment for long periods of time. Typical LP investments include oil and gas programs and real estate investments.

Promissory Notes: Many start-up and small companies issue promissory notes or "investment notes" as a means of raising capital. These small offerings have long been the means of support for brokers who cant qualify for, or who have lost other securities licenses. These Notes typically promise high rates of return to compensate for the high (and often undisclosed) risks of investing. Sadly, most investors in these start-ups are forced to accept worthless stock or warrants in the company once the company defaults on its interest payments. Caveat Emptor.

Selling Away: "Selling Away" describes when a stockbroker with a brokerage firm sells an investment to a client that is not made through the firm. In a typical situation a broker will tell his client of a great opportunity he should get in on. The client will then write the broker a check and the broker will invest the money directly in a program. Selling Away is a violation of NASD and NYSE rules.

Margin Abuse: When a client opens a "margin" account he is allowed to borrow money from the brokerage firm to buy stocks. Federal regulations limit how much an investor can borrow, and require a client to maintain a certain percentage of the borrowed money in the account as collateral. The risk of margin is that if a stock purchased with borrowed money declines in value, an investor may be required to deposit additional funds in the account to "cover" a margin "call." Margin allows the broker to maximize commissions by providing additional capital for purchases. Highly volatile stocks should be purchased on margin only for the most risk tolerant investor.