Some investors prefer to leave investment decisions to a broker or investment adviser. Others like to be apprised of the day-to-day status of their portfolio, performing independent research before every transaction. Financial professionals must be aware of their clients’ wishes and comply with them. If a broker or investment adviser executes a transaction without the permission of his or her client, the broker has violated industry rules and possibly also federal laws that prohibit unauthorized trading.
When Brokers Can Trade on Behalf of Clients
Whether a broker has permission to execute trades on behalf of a client without express permission for each transaction depends on the agreement between the broker or investment adviser and the client. Clients with discretionary accounts have given their brokers a limited power of attorney that permits such activity. Nondiscretionary accounts usually require consent from the client before each transaction.
Brokers and clients are free to negotiate any arrangement. For instance, an investor may give a broker permission to make discretionary trades up to a certain monetary limit. Absent any sort of agreement, the broker does not have discretionary authority.
Deeming an account discretionary does not give the professional total control over the account. Brokers or investment advisers with discretionary authority must execute trades in accordance with a client’s goals. Failure to do so may still violate unauthorized trading rules.
Laws and Rules that Prohibit Unauthorized Trading
The Financial Industry Regulatory Authority (FINRA) is the self-regulating body that promulgates and adopts rules its members must follow. NASD Rule 2510, which is incorporated into the FINRA Manual, specifically prohibits brokers or investment advisers from executing discretionary trades unless the client has given express, written permission to the professional. Furthermore, FINRA Rule 4512 imposes on brokers several record-keeping requirements, one of which is to keep a list of people who have authority to make discretionary trades for the account.
Unauthorized trading has also been interpreted to violate FINRA Rule 2020, which prohibits the use of manipulative, fraudulent, or deceptive practices, and Rule 2010, which requires its member to observe “high standards of commercial honor” and fair trade principles.
Unauthorized trading may be considered securities fraud under federal law. SEC Rule 10b-5, codified at 17 C.F.R. § 240.10b-5, prohibits engaging in fraudulent schemes, misrepresentations or omissions, and deceitful practices in connection with the sale or purchase of a security. Some courts have held that there must be an accompanying misrepresentation or omission along with the unauthorized trading to satisfy the requirements of a 10b-5 claim, however. Private actions brought pursuant to Rule 10b-5 also require proof of investor reliance, which may be difficult to prove in cases of unauthorized trading.
Unauthorized trading may create liability under several other causes of action. Investors may have claims for malpractice or negligence. Investment advisers may be liable for a breach of fiduciary duty, and brokers who engage in unauthorized trading may have breached their duty of suitability. Unauthorized trading may also constitute a breach of contract. Finally, many state laws also prohibit unauthorized trading.
Remedies Available to Investors
Depending on the circumstances of the case, investors whose brokers or advisers have engaged in unauthorized trading can pursue an arbitration claim or a lawsuit filed in court. In either case, the investors could seek actual damages. These include, at a minimum, out-of-pocket losses caused by the broker’s prohibited trading. If the transactions resulted in losses during an upward-trending market, the investor may also seek market gains he or she would have otherwise experienced.