Focus On Securities

By Michael A. Collora
Send Email to: mcollora@dwyercollora.com 
 
This article first appeared in the May 7, 2001 issue of Lawyers Weekly entitled,
" Case Provides Road Map to Thorny Issue of Stockbroker/Fiduciary Role".

It was also published in David E. Robbins book, Securities Arbitration, "How Do I Do It? How Do I Do It Better?" by the Practising Law Institute, 2001.
 
  Introduction

The recent decision by Massachusetts Justice Marshall, speaking for a unanimous court in Patsos v. First Albany Corp., 433 Mass. 323 (2001), that under certain circumstances a stockbroker may be a fiduciary for his customer, while evolutionary rather than revolutionary, should provide additional legal support for those alleging fraud by their stockbrokers and financial advisers. In effect, the Patsos Court has given a road map to the customer to allege and prove that even absent a written power of attorney or discretionary agreement, if the broker controlled the account and the customer trusted and relied upon the broker, the broker was a fiduciary. Such an allegation may not only permit the customer to circumvent the ordinary statutes of limitation for tort or contract, but impose duties on any broker acting other than as an order taker. Its reasoning could be applied to cases beyond the state's borders.

Facts

The plaintiff Patsos had a simple complaint: his money was stolen by his stockbroker, an employee of First Albany in 1988 and 1989. However, despite receiving monthly statements showing withdrawals, he claimed he was unaware that his money was illegally removed until early 1995, well past the six-year statute of limitations for breach of contract or four-year statute for M.G.L. c. 93A. Thus, his only viable solution to overcome this deadline was to claim that, due to fraudulent concealment by the broker, a violation of M.G.L. c. 260, § 112, the time period did not begin to run until he "discovered" the wrongdoing.

 
The Court's Reasoning

The Patsos Court noted that, to claim fraudulent concealment in these circumstances, the broker must have breached some duty of disclosure that could only be found if the broker was a fiduciary. There was no written power of attorney or discretionary agreement justifying such a claim. However, Patsos argued that in his circumstances a fiduciary relationship existed because he was inexperienced, relied completely on the broker, invariably followed his advice, trusted him and did not understand the entries on the brokerage statement. He also argued that a simple check entry was ambiguous and did not put him on notice as to the fraud. The Court found these factors sufficient to overturn a summary judgment in favor of First Albany and affirmed the Appellate Court's decision to remand the case for trial.

Addressing issues raised by the appeal, Justice Marshall pointed out that in the past the Supreme Judicial Court had found a fiduciary relationship where the customer and broker had developed a "full relation of principal and broker" even in the absence of a written agreement, citing Berenson v. Nirenstein, 326 Mass. 285, 289 (1950) (conduct of the parties may create a confidential and fiduciary relationship). Once a person becomes a fiduciary, that person has an obligation to disclose all of the facts giving rise to knowledge of a cause of action, or the statute of limitations does not run. See Demoulas v. Demoulas Super Mkts., Inc., 424 Mass. 501, 519 (1997).

Simple Broker-Customer Relationships

Not all relationships between stockbroker and customer will rise to a fiduciary nature, of course. In the stockbroker context, Patsos does not change earlier court rulings to the effect that no fiduciary relationship exists where only a simple broker-customer relationship is shown. Thus, an administratrix's general allegations that the deceased relied on the broker, combined with her assertion that the deceased desired only good and safe securities, would not survive a motion to dismiss. See Vogelaar v. H. L. Robbins & Co., Inc., 348 Mass. 787 (1965) (rescript).
Similarly, a so-called long-term friendship with the broker by an inexperienced investor was insufficient to create a fiduciary relationship in Lefkowitz v. Smith Barney, Harris Upham & Co., Inc., 804 F.2d 154, 155 (1st Cir. 1986).

Even in a situation similar to the facts in Patsos, the court concluded that a brokerage house which had kept dividends due an estate for over forty years could successfully withstand any breach of contract claim beyond the six-year statute of limitations, since there was only a simple stockbroker-customer relationship and no trust relationship had been in existence for many years. See Brine v. Paine Webber, Jackson & Curtis, Inc., 745 F.2d 100 (1st Cir. 1984).

Distinguishing Factors

Yet, as Justice Marshall noted, Berenson and other Massachusetts cases such as Birch v. Arnold & Sears, Inc., 288 Mass. 125 (1934), have recognized that a characterization of the relationship between customer and broker will depend upon how "full" that relationship has become. In Patsos, the court did not enlarge the broker's liability to that of an insurer for the account, but pointed out the factors which may differentiate a mere order taker, with only an obligation to execute an order, from a more complicated relationship of trust and reliance on the broker.

These factors include the experience and acumen of the customer, the claimed expertise by the broker, the degree of discretion given to the broker by the customer (that is, acting without consulting the customer), and the degree of personal trust given to the broker by the customer. Patsos at 334-35. Federal courts have also relied in such factors. See Lehman Brothers Commercial Corp. v. Minmetals International Nonferrous Metals Trading Co., ___ F.Supp. ___, 2000 U.S.Dist. LEXIS 16445 at *31 (S.D.N.Y. 2000).

Effect On Statutes Of Limitation
If a fiduciary relationship can be found, the statute of limitations may be tolled for certain common law claims, although not for federal claims such as those brought under Section 10(b)(5). See Lampf, Pleva, Lipkind Prupis & Petigrow v. Gilbertson, 501 U.S. 350, 363 (1991). But see Pincay v. Andrews, ___ F.3d ___, 2001 U.S. App. LEXIS 1553 (9th Cir. 2001) (holding that, while allegations under RICO are subject to the "injury discovery" statute of limitations, even an allegation of a fiduciary relationship will not forestall the statute's running if plaintiff had constructive notice of the fraud).

Additionally, the broker might be found to owe other duties to the customer, such as managing the account in accordance with the customer's needs and objectives, keeping the customer advised of the status of the account, and explaining any risks in his handling of the account to that customer.

Those duties may arise from failure to adhere to industry standards, violating internal procedures, lack of supervision, failure to carry out a customer's instructions, misleading the customer, or lacking skill for the task involved. See deKwiatkowski v. Bear Stearns & Co, ___ F.Supp. ___, 2000 U.S. Dist. LEXIS 18752 (S.D.N.Y. 2000). The deKwiatkowski court stated that a customer is not only entitled to probity but also to competence. In such fiduciary situations, the purchase of speculative securities, frequent trades, and high commissions will become suspect. See Leib v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 461 F.Supp. 951, 954 (E.D. Mich. 1978), aff'd, 647 F.2d 165 (6th Cir. 1981) (cited favorably by Patsos at 334).

Typical Duties Owed By A Broker
Of course, even in a non-discretionary situation, the ordinary broker still owes duties to his customer, including having a reasoned basis for stock recommendations, refraining from misrepresentation of material facts, receiving authorization for the trade, executing the trade properly, and refraining from self-dealing. See Patsos at 333 (citing Leib v. Merrill Lynch, Pierce, Fenner, & Smith, Inc. at 952).

The SEC has always argued for a special duty of fair dealing between broker and customer, and the courts have upheld these duties, particularly where the broker makes a stock recommendation. See Hanly v. Securities and Exch. Comm'n, 415 F.2d 589, 597 (2nd Cir. 1969) ("[b]y his recommendation [a registered representative] implies that a reasonable investigation has been made"). In fact, even individual brokers can be held personally liable for their employers' recommendations if they fail to investigate the stock, particularly in recommending new issues. See Securities and Exch. Comm'n v. Hasho, 784 F.Supp. 1059, 1107-08 (S.D.N.Y. 1992).

The SROs' Eligibility Rule

The Patsos ruling may not help all of those claiming fraudulent concealment. If the alleged claims are more than six years old, the existence of an arbitration agreement will complicate matters. The NASD, for example, will not accept a matter for arbitration if it is more than six years old. See NASD Code of Arbitration § 10304 (former Rule 15).
As a consequence, brokerage houses have claimed that a matter that is not arbitrable is not triable in court. Supporting that contention, certain federal courts have ruled that if arbitration cannot proceed (which in the First Circuit, is an issue for the arbitrators to decide, see Paine Webber, Inc. v. Elahi, 87 F.3d 589 (1st Cir. 1996)), the case is over and the investor is out of luck; see, also Ohio Co. v. Nemecek, 98 F.3d 234 (6th Cir. 1996) (time limitation rules in arbitration function as statutes of repose, and equitable tolling does not apply); Edward D. Jones & Co. v. Sorrells, 957 F.2d 509 (7th Cir. 1992; First of Michigan Corp. v. Trudeau, 237 Mich. App. 445 (1999). Thus, if the Massachusetts state or First Circuit federal courts followed these precedents, claims subject to arbitration may not benefit by the expanded time limits in Patsos.

However, in such a situation, the investor could sue the brokerage house and broker in state court, and argue that he or she should stay in court and be forced to go to arbitration only if the court directs the case to the NASD or a similar self-regulatory organization and it, in turn, accepts the claim. The NASD rules seemingly permits this procedure, stating that "this Rule [of repose] shall [not] apply to any case which is directed to arbitration by a court of competent jurisdiction." NASD Code of Arbitration § 10304.

Receipt of Monthly Statements

The Patsos case will also help customers where the broker has been stealing for many years through false entries and the like, although brokerage firms will try to use the fine print on the back (similar to that on bank statements) to argue that the customer has ratified the accuracy of the monthly activity unless prompt objection was made. In Pastos, First Albany had argued that the client's monthly statement entries were "conclusive after a review of ten days" and were sufficient notice to and binding upon a customer even as to a defalcation.

On this point, the Patsos court held that a simple entry of a check amount and date would not suffice to put someone on notice as to a fraud, thus avoiding addressing the "adhesion of contract" defense advanced by Patsos. Patsos at 337-38.

Nonetheless, one must expect that in the future brokerage firms will argue that customers have ratified entries on their statements if they do not object within a short time after receipt, referring by analogy to the Uniform Commercial Code's short statute of limitation on forged checks, enacted in Massachusetts law as M.G.L. c. 106-406.

That argument has not always been successful. See, e.g., Lichtenstein v. Kidder Peabody & Co., 777 F. Supp. 423 (W.D. PA. 1991) (denying ratification defense where fraud by broker is alleged). Given the ruling in Patsos, brokerage firms in the Bay State are unlikely to be successful on that point. Finally, where churning of accounts and unsuitability of purchases are alleged, these ratification defenses should not act as valid defenses, as no one entry is likely to put the recipient on notice as to the fraud.

Conclusion

While Patsos is not remarkable in its holding, it will be helpful to a customer whose broker has in effect taken over, and dominated the account, to the detriment of that customer. Nonetheless, brokerage firms will continue to defend these cases on grounds of ratification and claim that the broker was not a fiduciary; they now have less legal support for those assertions.