Brokerage firms like Merrill Lynch and LPL Financial owe a duty to reasonably supervise the conduct of their financial advisors and the accounts they manage for clients. This is a direct liability claim, as opposed to causes of action based on the misconduct of the advisor which then relies on the agency relationship between the advisor and the firm to impose liability on the firm. Irrespective of agency issues, like whether the misconduct engaged in by the financial advisor was outside the scope of the employment relationship with the firm, brokerage firms can be held directly liable for negligent supervision so long as the elements are met.
Negligent supervision claims are very important in the context of fraud and Ponzi scheme-type cases. These cases, frequently referred to as “Selling away”, come in many forms but usually boil down to the following. A financial advisor solicits a client to invest in something – a company, a promissory note, a partnership – that is not “formally” offered by the brokerage firm. This is the most common fact pattern in Ponzi scheme cases. Even if the investor is justified in believing the investment was offered through the firm, the negligent supervision claim can be a winner regardless because of its nature as a direct liability claim. You can win your case against the brokerage firm for the Ponzi scheme orchestrated by the firm’s broker if you can develop and win the negligent supervision case.
The duty element of a negligent supervision claim against a brokerage firm is rooted in FINRA Rule 3110 which requires to “establish and maintain a system to supervise the activities of each associated person (broker/advisor) that is reasonably designed to achieve compliance with applicable securities laws and regulations, and with applicable FINRA rules.” This rule requires brokerage firms to have written procedures, perform internal inspections, review transactions, and investigate applicants for registration. The rule and its supplemental materials are quite lengthy and attorneys who practice in this area know it well. Another source for the duty element for negligent supervision claims is the supervision and compliance manuals which courts have held are admissible as evidence of duty. Thropp v. Bache Halsey Stuart Shields, Inc., 650 F.2d 817, 820 (6th Cir. 1981) and Mihara v. Dean Witter & Co., 619 F.2d 814 (9th Cir. 1980). Likewise, courts have held that FINRA Rules can form the basis for a negligence claim. Ginzkey, et al., v. National Securities Corp.,C18-1773RSM, 2021 U.S. Dist. LEXIS 80699 *2 (W.D. Wash., April 27, 2021).
Once sufficient evidence is presented to establish the duty element of the negligent supervision claim, like any claim based on negligence, the investor-claimant must prove that the brokerage firm breached this duty to supervise. Likely, the brokerage firm will argue that it has written supervisory materials, has processes and procedures in place, and executed those processes and procedures “reasonably” so no duty was breached. To overcome this, expert testimony will likely be needed so that testimony about those procedures and how they were executed in a particular case fell below the standard of care. The existence of “red flags” of misconduct and the firm’s failure to alert or address those red flags, will be critical.
Finally, the investor must prove any damages sustained by the investor was the result of the firm’s negligent supervision. This causation element is satisfied where evidence establishes that “but for” the firm’s negligent supervision, the financial advisor would not have committed the misconduct at issue and the investor would not have been damaged from it. Attorneys who are experienced in representing investors and proving negligent supervision claims understand how to obtain the evidence necessary to win these cases through the discovery process and understand how to present the evidence to give investors the best chance at victory.