70 U. Cin. L. Rev. 527

 

Copyright (c) 2002 University of Cincinnati Law Review

University of Cincinnati

 

Winter, 2002

 

70 U. Cin. L. Rev. 527

 

 

ARTICLE: THE PROFESSIONAL OBLIGATIONS OF SECURITIES BROKERS UNDER FEDERAL LAW: AN ANTIDOTE FOR BUBBLES?

 

 

Steven A. Ramirez *

 

* Professor of Law, Washburn University School of Law. Professor William Rich caused me to write this Article by arranging a Faculty Scholarship Forum at Washburn University in the Spring of 2001 and asking me to participate. He has been a constant positive influence in my efforts to improve as a scholar. My excellent former secretary Mary Beth Bero has also been a consistently positive factor in helping me be a productive scholar. The background of the President's [initiative] is

 

 

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I. Introduction

 

In the wake of the stock market crash of 1929 and the ensuing Great Depression, President Franklin D. Roosevelt proposed legislation specifically designed to extend greater protection to the investing public and to elevate business practices within the securities brokerage industry. n1 This legislative initiative ultimately gave birth to the Securities Exchange Act of 1934 (the '34 Act). n2 The '34 Act represented the first large scale regulation of the nation's public securities markets. n3 Up until that time, the securities brokerage industry n4 had been left to regulate itself (through various private stock exchanges). This system of  [*528]  self-regulation had the benefit of being expertly promulgated, administered, and enforced, but it lacked government sanctioning power. In addition, because the professional standards were set by the profession itself, the regulations were susceptible to dilution. n5 Because the industry's unassisted efforts at self-regulation had failed so spectacularly, n6 the '34 Act was aimed at preserving self-regulation within a legal framework that assured the enforcement of higher industry standards. n7 The '34 Act, therefore, empowers self- regulatory organizations (SROs) to wield initial regulatory authority, subject to the federal oversight of the Securities and Exchange Commission (SEC). n8 The '34 Act thus effec-tively preserved self-regulation while at the same time mandating "just and equitable principles of trade" in the securities brokerage industry with the specific intent of raising industry standards for the protection of investors. n9 This was a key element of the New Deal effort to reconstruct investor confidence and restore macroeconomic stability and growth. n10

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Since 1934, however, the courts have largely ignored the logical implications of this New Deal initiative to elevate standards of conduct within the securities industry and insure investor protection when assessing the duties of broker-dealers to customers. Instead, the courts essentially allow federal law to define federal securities fraud claims and look exclusively to state law for non-fraud claims. This result is in large part the responsibility of counsel who have represented investors against securities professionals. For the most part, the theories advanced to invoke federal protections have been stilted and have allowed courts to fail to fully appreciate the policy foundations of the '34 Act and the nature of the professional obligations imposed under the Act, particularly as amended in 1938, 1964, and 1975. Rather, courts have blithely assumed, on a vast majority of occasions, that except in cases of fraud, state law principles of fiduciary duties are the exclusive source of broker-dealer obligations in a private suit to recover monetary damages. Moreover, academic commentators have failed to devote much thought to how the federal oversight of self-regulation fits with remedies for broker-dealer misconduct. n11 Fundamentally, the '34 Act embodied a legislative compromise whereby federal law would elevate industry standards while preserving self-regulation so long as that compromise would secure the transcendent goal of investor protection. n12 This Article consequently posits that the '34 Act (particularly as amended in sub- sequent years) effectively mandates minimum standards of professional conduct (giving rise to state law remedies) without interfering with state fiduciary duty law and without creating an entire new class of federal  [*530]  remedies, claims, and law. In essence, federal law supports state law claims for broker malpractice or professional liability. n13

 

In the decades following the '34 Act, the fact that the courts failed to fully appreciate the significance of the Act mattered little; state law fiduciary principles generally supported broker liability on a basis similar to the industry standards required under the '34 Act. In addition, Rule 10b-5 n14 was broadly interpreted to extend remedies to investors harmed by misconduct. However, a growing body of state-based case law has narrowed broker-dealer fiduciary obligations. Thus, in the wake of the fading memory of the Great Depression, state law has developed unevenly, with a number of courts wandering into a decisively caveat emptor mode, as if the Great Depression and the '34 Act had never occurred. n15 Meanwhile, in the federal courts, the New Deal remedies  [*531]  in favor of investors have generally been reversed so that federal law now provides remedies that are more restrictive than those available under state law. n16 For the first few decades after the New Deal, then, it mattered little whether the professional liability of brokers was given effect, as other equally generous means of recovery were available. n17 Today, however, fiduciary concepts and private securities litigation have contracted to such a point that broker liability is now best based upon federally mandated industry standards and traditional state claims of professional liability, such as malpractice. Most important, there are compelling policy reasons for courts to give effect to these standards: the economic imperatives of stemming speculative bubbles and an erosion in professional conduct. Recognition of professional standards can thereby avoid another meltdown in investor confidence like that which occurred in 1929 and which seems to be recurring in 2002 in the wake of relaxed standards of conduct for securities brokers.

 

This Article does not posit that the '34 Act provided for federal fiduciary standards preemptive of state fiduciary duties, or even for federal private rights of action against broker-dealers for violation of industry standards. n18 Rather, the Act preserved industry self-regulation  [*532]  while mandating high industry standards of professional conduct with powerful enforcement mechanisms. Congress and President Roosevelt specifically intended these mandated self-regulatory standards to operate to protect investors, but to do so outside of an express federal remedial scheme. The most logical result is the imposition of federally mandated industry standards that operate to give investors contract and professional negligence remedies in accordance with state law.

 

This Article shows that under the '34 Act, federal law imposes minimum professional obligations upon securities broker-dealers that should operate to benefit and protect investors by, among other things, providing monetary damages to investors harmed by professional misconduct. Part II of the Article reviews in detail the content, scope, and source of these federally mandated standards of professional conduct. Integral to this review is an analysis of the history of the federal regulatory regime of the securities brokerage industry. Part III of this Article attempts to account for more than sixty-five years of common law development of the professional obligations of securities professionals. For the most part, these common law obligations have diverged from the federally imposed regime, especially as the lessons of the Great Depression have faded. Part IV assesses the risks of allowing professional standards to meander lower, as has been the trend in the courts. The Article concludes that the recent dilution of investor remedies originally contemplated by the drafters of the '34 Act risks excessive speculation, reduced investor confidence, and the continued erosion of the market niche of professional broker-dealers. In the end, this Article seeks to demonstrate that high standards of professional conduct, enforceable by aggrieved investors, will stabilize financial markets as well as the business of providing professional broker-dealer services.

 

II. Federal Professional Obligations for Securities Professionals

 

A paramount goal of the Securities Exchange Act of 1934, as embodied in the legislation's conference committee report, was to "prevent inequitable and unfair practices" on securities exchanges. n19 This Part will show that this fundamental goal has given rise to a persistent effort to professionalize the securities brokerage industry. This effort has led to standards of conduct that should operate to benefit  [*533]  and protect investors harmed by brokers' misconduct, including supporting state law claims for traditional professional negligence. n20

 

A. The Legislative and Political History of the '34 Act

 

The ultimate political source of the New Deal regulatory initiatives- including the regulation of securities-was President Franklin D. Roosevelt. n21 President Roosevelt was quite clear about the purposes of the Securities Act of 1933 n22 and the Securities Exchange Act of 1934. n23 He viewed these legislative initiatives as a seamless effort n24 to raise the standards of conduct across the entire securities business and to replace  [*534]  the principle of caveat emptor n25 with a "clearer understanding of the ancient truth" that those managing "other people's money" should be subject to trustee duties. n26 Focusing specifically upon the regulation of the securities broker-dealer profession, Roosevelt stated that his legislative proposal was animated by a "broad purpose of protecting investors" and to provide for "better supervision" of securities exchanges. n27 The goal of the Act was therefore to establish "a minimum standard of fair dealing" on securities exchanges. n28 The '34 Act was essentially an attempt to make capitalism more durable by making "intelligent adjustments," rather than an attempt to "destroy" the market mechanism for allocation of capital. n29 Thus, for example, the '34 Act focuses upon disclosure obligations rather than having the government approve securities for sale to the public. n30

 

The legislative history of the securities acts evinces an intent that is entirely consistent with President Roosevelt's goal of elevating standards within the securities profession. n31 The House Report accompanying the  [*535]  '34 Act plainly states that "constant extension of the legal conception of a fiduciary relationship-a guarantee of 'straight shooting'" is required to "support[ ] the constant extension of . . . confidence which is the foundation of a maturing and complicated economic system." n32 The '34 Act therefore "proceeds on the theory that the exchanges are public institutions" and "not private clubs to be conducted only in accordance with the interests of their members." n33 Consequently, the Securities and Exchange Commission was "empowered" to impose appropriate rules for "the protection of investors" and "to insure fair dealing." n34 Still, Congress hoped that the bill would give exchanges the power to reform themselves and that Commission action would not be needed. n35 These precepts form the foundation upon which the modern mandatory self-regulatory regime is built.

 

This self-regulatory regime came about because the securities industry was able to launch a substantial attack upon any effort to displace industry self-regulation with a federalized, transcendent fiduciary principle or an effort for detailed statutory standards of conduct. n36 The "central compromise" of the '34 Act was to implement a scheme of "cooperative regulation" instead of fully federalized regulation. n37 This  [*536]  compromise had a sound basis in policy. First, the compromise gave recognition to the fact that the brokerage industry is complex and often in need of flexible and swift regulatory action. n38 Second, the exchanges had a history of some level of self-regulation. n39 Third, the use of self-regulation lowers the expenses of regulation and dispenses with the need for vast bureaucracies. n40 Finally, self-regulation can impose ethical standards beyond minimum legal requirements. n41 The mandatory self-regulation compromise thus reflected the hope that "well-managed exchanges" would have the power under the '34 Act to raise industry standards. n42

 

In 1938, Congress took another step in professionalizing the securities brokerage industry when it passed the Maloney Act, n43 which expanded the SEC's authority into the over-the-counter securities market by expanding the concept of self-regulation beyond just broker-dealers that were exchange members. Congress intended the Maloney Act to stem unethical conduct (and insist upon "professional conduct") that, "while technically outside of the area of definite illegality," would nevertheless prove harmful to "customer and to decent competitor" alike. n44 This  [*537]  theme of protecting "decent competitor[s]" was not just hollow rhetoric, as securities brokerage industry trade groups sponsored and supported the Maloney Act. n45 Ultimately, the Maloney Act gave rise to the National Association of Securities Dealers, Inc. (the NASD), the only "Securities Association" ever registered pursuant to section 15A of the '34 Act. n46 As the NASD puts it, it "is not an organization that was imposed upon the investment banking and securities business by Congress . . . . The privilege of self-regulation was actively sought by the securities business . . . ." n47 Virtually every registered broker-dealer is now required to be a member of the NASD. n48 The effect of the NASD is to nationalize the standards of professional conduct applicable to broker-dealers. n49

 

In 1964, Congress acted again to further professionalize the securities brokerage industry and raise business standards. n50 The premise of the Securities Acts Amendments of 1964 (the '64 Amendments) n51 was to give specificity to the '34 Act's "general objective" of protecting "investors against malpractices in the securities and financial markets." n52 In fact, Congress determined that further action was required because of "the reliance which the investing public necessarily places upon the competence and character of professionals" in the securities markets. n53 Congress found that "inexperienced or unqualified persons" subjected the "investing public to undue hazards." n54 To remedy perceived shortcomings in the then existing statutory scheme, Congress drafted section 15(b)(7), n55 which required the NASD to promulgate rules mandating that any person associated with a member broker- dealer meet standards of "training, experience, . . . and such other qualifications"  [*538]  as the NASD may prescribe. n56 This legislation was enacted in response to an SEC Special Study of the Securities Markets completed in 1963. n57 A consistent theme of the Special Study underlying the promulgation of the '64 Amendments was the SEC's stated need to upgrade industry standards n58 and to further professionalize the brokerage industry. n59 In line with this theme, the Commission recommended competency standards and character and fitness standards as in "the legal profession." n60 Ultimately, the industry, through the NASD, adopted rigorous standards of character and fitness requiring that members and associated persons be "capable of complying with" all laws and regulations and of "observing high standards of commercial honor and just and equitable principles of trade." n61 It is notable that the securities industry itself was virtually unanimous in its support of this regulatory initiative to strengthen the hand of the SEC in imposing higher industry standards. n62 After the '64 Amendments, standards of professional competence and integrity were imposed upon all broker- dealers as recommended by the Special Study. n63

 

In 1975, Congress again acted to give more power to the SEC to enforce industry standards. First, the SEC was given power to directly enforce SRO rules and regulations. n64 Second, the Commission was given enhanced authority to disapprove changes in an exchange's rules  [*539]  and to review disciplinary actions taken by an exchange so as to provide for more uniform sanctions and standards. n65 As part of this effort, Congress in 1975 reviewed the history of mandatory self-regulation and made many statements that bore directly upon the issue of the intent of the '34 Act. The 94th Congress stated that the 73d Congress opted to allow self-regulation to continue to "govern the conduct and professional standards of professional participants in the securities markets." n66 The 94th Congress also recognized that "the SEC is charged with supervising the exercise of this regulatory power in order to assure that it is used . . . to protect investors and assure fair dealing in securities." n67

 

Finally, in 1995, Congress overhauled private litigation under the federal securities laws. The Private Securities Litigation Reform Act of 1995 (PSLRA) n68 stemmed from an attitude in the courts as well as in Congress (eager to respond to industry clamor) that private securities litigation is often "vexatious." n69 While the PSLRA raised the bar dramatically on plaintiff claims, Congress did not change the ability of the SEC to mandate industry standards in the securities industry, did not alter the method or procedure by which customer broker disputes were arbitrated, and evinced no intent to allow enforcement means other than private statutory claims to be diluted. The PSLRA demonstrates that both the industry and Congress remain as committed as ever to the SEC's ongoing role of imposing professional standards in lieu of caveat emptor in the securities industry.

 

Viewing the legislative history of the '34 Act, as well as the legislative history of the major amendments promulgated by Congress subsequent to 1934, certain elements of consistent legislative and political intent  [*540]  emerge. For example, one consistent theme is that Congress valued certain elements of self-regulation and did not want to regulate the brokerage on a wide scale. n70 Nor did Congress ever undertake to displace state law claims generally or state fiduciary duty claims in particular. n71 Nevertheless, Congress did intend to impose "professional standards" and "ethical standards" for "professional participants" in the securities brokerage industry. n72 In this initiative, Congress (and President Roosevelt) certainly wanted to enhance investor remedies, impose more demanding professional obligations, and thereby increase investor confidence. n73

 

B. The Text of the '34 Act

 

The text of the '34 Act (as amended) embodies this intent of the political branches. The foundation of federally mandated self-regulation consists of 15 U.S.C. § §  5, n74 6, n75 15A n76 and 15(a)(8). n77 Section 5 requires the registration of all securities exchanges. n78 Section 15(a)(8) requires that all broker-dealers be members of either an exchange or a registered securities association. n79 Sections 6 and 15A specify the requirements of registration for national securities exchanges and registered securities associations, respectively. n80 The only "securities association" registered with the SEC is the NASD. n81 Both the NASD and the various stock exchanges registered with the SEC (such as the NYSE) are defined in the '34 Act as "self-regulatory organization[s]." n82 All of this means that every broker- dealer is a member of some self-regulatory organization.

 

The registration requirements mandate that SRO rules "are designed to prevent fraudulent and manipulative acts and practices" and "promote just and equitable principles of trade." n83 These mandates are  [*541]  specific requirements of a transcendent goal to "protect investors and the public interest." n84 The registration requirements for SROs further mandate disciplinary procedures for violations of the '34 Act and SRO rules and mandate sanctions for such violations including censures, fines, suspensions, and expulsions. n85 Moreover, an SRO may "summarily" suspend anyone who has been expelled, barred, or suspended by any other SRO. n86 In other words, SROs have the power to impose the professional death penalty upon the career of any securities professional. Thus, each stock exchange and the NASD must require members to treat customers not in accordance with the concept of caveat emptor but rather in accordance with concepts of professionalism, and they must enforce such standards of conduct. Certainly, the statutory language requiring rules that "promote just and equitable principles of trade" is consistent with professionalism and inconsistent with caveat emptor. n87

 

The '34 Act's reach extends beyond the broker-dealer itself to any "person associated with a broker-dealer." n88 Under the Act, these individuals must take and pass entry examinations. n89 In addition, such persons may not enter or remain in the securities industry unless they satisfy certain standards of character and fitness. n90 Moreover, any person who violates any SRO rule is also subject to an SEC enforcement action or administrative proceeding which may result in a bar from the industry, fines, injunctive relief, or ancillary equitable relief including disgorgement of any ill-gotten gains. n91 The '34 Act also provides criminal sanctions against any person who willfully violates the Act, any person who knowingly makes a false statement on any form or application filed pursuant to the Act, or any person who knowingly files a false application with an SRO. n92 Thus, each person who has any  [*542]  degree of responsibility in the securities brokerage industry is subject to detailed regulatory strictures and powerful civil and even criminal sanctions.

 

Consistent with the '34 Act's theme of supervised self-regulation, however, the SEC has power to supervise the SROs in virtually all regulatory aspects. n93 If an SRO fails in its enforcement duties, the SEC may directly impose sanctions for violations of SRO rules. n94 If an SRO enacts a rule or regulation that the SEC deems inappropriate, the SEC may "abrogate, add to, and delete from" the rule as it sees fit. n95

 

C. SRO Rules of Professional Conduct

 

Because SRO rules are fundamentally focused upon customer protection and investor rights, even the charters, constitutions, and bylaws of such organizations recognize that they exist in part to assure the protection of investors. The National Association of Securities Dealers, Inc., Certificate of Incorporation states that the NASD was formed to "adopt, administer, and enforce rules of fair practice and rules to prevent fraudulent and manipulative acts," "to promote . . . high standards of commercial honor," and "to promote just and equitable principles of trade for the protection of investors." n96 The NYSE constitution contains similar language articulating essentially the same goals. n97

 

The NASD, the NYSE, and all other SROs are governed by their members. These members are broker-dealers, meaning that the brokerage industry itself is responsible for imposing and enforcing SRO standards. n98 Still, the SEC has broad oversight power over the SROs,  [*543]  and federal law operates as the ultimate enforcement mechanism. n99 The SEC has plenary power over SRO rules. n100 The SROs similarly are the primary enforcers of their rules; still, the SEC has de novo appellate review over all such sanctions. n101 Federal law also provides that discipline by one SRO is grounds for discipline by another SRO, such that if a member is expelled by one SRO they are essentially barred from participating as a member of any other SRO, and hence the entire securities industry. n102

 

The role of federal law and the SEC has not been prominent in the promulgation of industry standards and SRO regulations. Rather, the SEC and the prospect of further federal legislation have combined to enforce a kind of self-discipline whereby the industry-dominated SROs are able to successfully impose high standards of conduct upon an industry wary of further government regulatory action. n103 This is another purpose for the existence of SROs: "To promote self-discipline among members . . . ." n104 This combination of primary industry self-regulation with close government supervision and government-backed enforcement has proven to be a powerful recipe for high standards of professional conduct.

 

The Commission in particular interpreted the scheme of self-regulation imposed by the '34 Act as sufficient to support broad professional duties for registered broker-dealers under what has become known as the "shingle-theory." n105 In the seminal case of In re Duker &  [*544]  Duker, n106 the Commission stated: "Inherent in the relationship between a dealer and customer is the vital representation that the customer will be dealt with fairly and in accordance with the standards of the profession." n107 By 1943, the SEC's "shingle theory" had the benefit of court imprimatur, evidencing a broad consensus among authorities that the '34 Act had imposed inherent professional obligations upon broker-dealers, indeed even upon dealers acting in a principal capacity. n108

 

The SRO rules governing broker-dealer conduct attest to the success of this regime in giving rise to a scheme of self-regulation that imposes a code of conduct that both protects customers and allows the industry to impose efficient business practices. These standards of professional conduct generally fall into four categories of professional duties in favor ofcustomers of registered broker-dealers: first, brokers must only make recommendations of securities to customers that are suitable in light of the customer's investment objectives and capabilities; second, broker-dealers may not engage in "churning," the exercise of control over an account to generate excessive transactions (and commissions) in light of a customer's investment objectives; third, the SRO rules impose broad supervisory duties upon broker-dealers; and fourth, a broker must observe general "high standards of commercial honor" and "just and equitable principles of trade."

 

1. Suitability

 

The suitability requirement means that a broker has an affirmative duty to take "reasonable efforts" to assure that a recommendation is in accordance with a customer's objectives and financial status. n109 The NYSE has its own version of the suitability requirement, and in some respects the NYSE has interpreted its rule in a more demanding manner  [*545]  than the NASD obligation. n110 Additionally, industry-sponsored arbitra- tion fora have spawned numerous cases where brokers have been held liable under the suitability doctrine for allowing customers to undertake excessively risky trading. n111 Ultimately, these industry authorities insist that suitability requirements demand an "ongoing supervision" of a customer's trading to avoid allowing the securities markets to devolve into casinos. n112

 

2. Churning

 

The prohibition against "churning" precludes a broker from using control over a customer's account to generate excessive trading activity, in view of the customer's financial resources, objectives, and needs, in order to maximize commissions. n113 The NASD has prohibited such excessive trading through interpretive memoranda. n114 In determining whether activity is excessive, the SEC has used its administrative powers  [*546]  to define and prohibit "churning." n115 The courts have also played a significant role in defining when a broker controls an account as well as when trading is "excessive." n116 In fact, the SEC long ago recognized that a broker may inappropriately control an account even in the absence of a formal grant of discretionary trading authority. n117 Together, the suitability requirement and the churning prohibition mean that brokers may not put their interests before the customer, and they must exercise care in recommending transactions.

 

3. Supervisory Duties

 

An additional source of mandated industry standards arises from the SRO requirement that all firms maintain compliance manuals designed to assure that firms and their agents comply with the securities laws and SRO rules and regulations. n118 Every broker-dealer also may use compliance manuals as a means oftransmitting its own higher standards of professional conduct to its agents. Courts typically hold firms to their own articulated standards of professionalism. n119 Examples of firms imposing higher standards include such undertakings as terminating accounts to protect customers from their own excessively risky trading when circumstances so demand. n120

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4. High Standards of Conduct

 

General requirements of "high standards of commercial honor" and "just and equitable principles of trade" have given rise to numerous other interesting applications. n121 For example, a broker acting in a principal capacity (selling securities out of the broker's inventory) may not charge a customer an "excessive" markup in price. n122 Similarly, a broker may not use knowledge of a customer's order to generate personal profits by "interpositioning" a trade of a broker or by "front-running" ahead of the order. n123 This transcendent obligation of fairness has been extended to require brokers to obtain the best transaction executions available for customers, n124 to refrain from taking improper steps to evade liability, n125 and to assure that the public has a bona fide opportunity to participate in initial public offerings of securities that become "hot issues." n126 In sum, this industry standard imposes broad obligations of fairness and disclosure. n127

 

In general, and with certain important exceptions, these industry standards correlate to fiduciary duties of care, loyalty, and disclosure. The obligations imposed under these industry standards, however, are particularized to the broker- dealer context and do not have the same kind of general breadth associated with broad fiduciary duties. Moreover, nowhere in the statutory scheme is the term "fiduciary" used in connection with the mandatory general industry standards imposed under the '34 Act. The legislative history of the Act does include one reference to the term "fiduciary." However, the great weight of the legislative history and the language used by President Roosevelt in support of the '34 Act evinces an intent to avoid invoking the term. Thus, interpreting the plain meaning of the statute and its legislative history leads to a clear conclusion: the '34 Act did not intend to impose a federal fiduciary obligation upon broker-dealers, provide any federal fiduciary duty remedies, or in any way disturb or interfere with the  [*548]  development of fiduciary principles under state law. The next Part of this Article addresses the intent of the drafters of the federal securities laws with respect to the effect of SRO rules upon the civil liability of brokers to customers.

 

III. SRO Rules and Professional Liability

 

The conclusion that Congress did not intend to impose federal fiduciary principles is central to the broker-dealer regulation provisions of the '34 Act. The Act reflects a determination to raise industry standards within the context of the traditional self-regulation of the securities brokerage industry. Self-regulation, in its most modern form, has three primary advantages: first, "industry participants bring to bear expertise and intimate knowledge of the securities industry and thereby should be able to respond quickly to regulatory problems;" second, "self-regulation supplements the resources of the government and reduces the need for large government bureaucracies;" and third, SROs can adopt and enforce compliance with "ethical standards beyond those required by law." n128 Imposing broad fiduciary obligations or detailed statutory mandates would frustrate the foundations of self- regulation. This Article posits that Congress rejected traditional notions of caveat emptor as well as any broad federal fiduciary obligation and instead chose a third means of raising industry norms: professionalization and accompanying liability for malpractice under state law. n129

 

A. SRO Rules and Implied Private Actions

 

Noticeably absent from the entire scheme of mandatory self-regulation is any authorization of a private right of action for a violation of an SRO rule or regulation. Instead, in terms of broker misconduct short of fraud, Congress seems to have intended state law claims to play the dominant role. n130

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Shortly after the promulgation of the '34 Act, both the courts as well as the SEC broadly interpreted the Act's provisions to support private rights of action. n131 More recently, however, federal courts have restricted private rights of action. n132 Under the more modern approach to implying private rights of action under a federal statute, courts presume a lack of congressional intent to authorize such suits in the absence of some statutory provision supporting such a private right of action. n133 Courts have thus ruled that violations of SRO rules do not support implied rights of action. n134 In the case of professional obligations in the securities industry, it is therefore difficult to show that Congress intended to provide investors with federal private rights of action.

 

On the other hand, the breach of an SRO rule may play a role in private actions under Rule 10b-5. Here, courts use SRO rules as evidence of fraud or standards by which to judge whether conduct is consistent with scienter. n135 Scienter requires at least a showing of recklessness, and SRO rules have been used to support a finding that a broker recklessly omitted to disclose a material fact. n136 This approach seems consistent with Congressional intent, as breach of industry standards is not tantamount to showing an intent to defraud, but such a breach does reveal much about a securities professional's state of mind, especially since a professional can be presumed to know industry standards. n137

 

Aside from the lack of congressional intent, implied rights of action from breach of SRO rules suffer from other infirmities. They would, for example, involve the federal judiciary in a meddlesome and activist role in the securities brokerage industry that runs contrary to the premise of  [*550]  self-regulation. n138 Additionally, transforming industry standards into "legal" claims necessarily substitutes judges for industry experts in the process of applying the standards. n139 Thus, the securities industry seems particularly ill-suited for recognition of private claims against violators of SRO rules.

 

B. Fiduciary Obligations of Securities Brokers Under State Law

 

Whether described as "considerable confusion" or as "judicial smoke," it is clear that courts have not always consistently articulated the fiduciary obligations of broker-dealers under state law. n140 Even a cursory review of authorities shows deep division within the courts regarding the fiduciary duties of broker-dealers. n141 Some courts seem to follow the traditional rule that a broker always owes a customer a fiduciary duty. n142 Other courts seem to impose fiduciary duties only upon a showing that a customer has authorized a broker to trade on the customer's behalf in a discretionary account. n143 Sometimes, courts within the same jurisdiction seem to take drastically different approaches to the issue of fiduciary duties owed by a stockbroker. n144 But by any  [*551]  measure, it is clear that courts are approaching the issue of fiduciary duties in a more restrictive fashion than in the past. n145

 

In 1934, Congress assumed that an ordinary stockbroker owed fiduciary duties to clients with respect to the giving of investment advice. n146 This concept of fiduciary duty was general and wide-ranging. n147 The courts in pre-1934 days applied the fiduciary concept to brokers in a variety of circumstances, but with a less professionalized industry in mind. n148 Thus, there was no corollary to the churning prohibition or the suitability doctrine. n149 A dealer on the other hand, called a "jobber" in many sources, was held to deal with customers on a principal-to-principal basis rather than as agent-to-principal. n150 The logical upshot of this distinction is that dealers generally did not owe fiduciary duties. n151 The '34 Act gives short shrift to this distinction, and  [*552]  the SEC has in many ways obliterated it in its "shingle theory" cases. n152 Thus, in terms of both fiduciary duties n153 and minimum professional standards of conduct, n154 modern law makes no distinction between the obligations that brokers and dealers have to their customers. n155

 

Congress nowhere contemplated the concept of limited fiduciary duty that has recently emerged in the securities brokerage industry. n156 Some courts have sharply circumscribed the limits of a general fiduciary duty in a typical broker-client relationship. n157 Under this approach, a broker may dispense with most traditional fiduciary obligations simply by refraining from exercising discretion n158 over an account. n159 In these circumstances, a broker's fiduciary duty is limited to proper execution of trades-which is roughly akin to requiring a car salesman to discharge a fiduciary obligation through proper execution of a bill of sale. n160 Indeed, after twenty-five years, this narrow conception of fiduciary duty has never given rise to liability for improper execution of trades in a reported decision. n161

 

Although Congress may not have predicted that over time states would greatly relax the fiduciary obligation of securities brokers, the result is fully consonant with the intent of the '34 Act. n162 Section 28 has always operated to leave state claims to state law, and state courts have  [*553]  consequently been the final arbitrators of the fiduciary obligations owed by securities brokers. n163 Implicit in this regime is the fact that state regulation (through claims of breach of fiduciary duty) may be an inadequate means of imposing high standards of commercial conduct in the securities industry. n164

 

In the final analysis, concepts of fiduciary duty fall short of the goal of conservative investor protection in the securities brokerage industry. Fiduciary duty may serve well as a state-by-state ceiling upon broker obligations, where states may need to balance investor protection against the possibility of raising business costs to prohibitive levels. However, a federal minimum standard of professional conduct, embodied in SRO rules, has the immeasurable benefit of being promulgated and supported by industry expertise and experience. n165 A judge sitting in equity jurisdiction, or a jury sitting to determine damages, is a poor substitute for industry leaders and experts in determining appropriate conduct. n166 Thus, fiduciary duty has operated, and probably should continue to operate, restrictively as a basis for imposing nationalized standards of professional conduct in the securities industry. n167

  [*554]  

C. SRO Rules and State Law Professional Liability Claims

 

The language and legislative history of the '34 Act certainly addressed broker duties even if they failed to impose either a broad new federal fiduciary duty or private rights of action against errant brokers. n168 Additionally, the specific intent of the '34 Act was to elevate commercial standards of conduct within the brokerage industry to higher and more uniform standards and to create a durable scheme of regulation to protect investors and restore investor confidence. n169 The '34 Act uses terminology consistent with fiduciary obligations, but in the end it opts for terms more akin to professional obligations and high commercial standards rather than broad fiduciary obligations. n170 This, in turn, is fully consistent with the Act's aim to preserve industry self- regulation while placing such regulation on a firmer foundation. n171 Because the similarity between the concepts underlying fiduciary principles and the mandatory federal standards is so apparent (and at least at one point in the legislative record downright invisible), n172 and because in the context of the securities field they bear similar functions, it is somewhat understandable that the legal analysis of brokers' professional obligations has essentially been subsumed into the analysis of fiduciary duties. n173 Nevertheless, in the final analysis, the mandatory federal standards are best viewed as professional standards. n174 The remainder of this Article will therefore use this terminology when referring to the structure of industry standards built upon the foundation of the '34 Act.

  [*555]  

Congress intended to elevate industry standards and to enhance enforcement mechanisms, all in the name of investor protection. n175 In light of this, it would be anomalous to conclude that Congress intended to leave standards of conduct unchanged or to leave investors with no remedies at all for the newly mandated industry standards. n176 This is especially so given the "broad remedial purposes" of the federal securities laws. n177 Accordingly, there must be a strong presumption that Congress intended to enhance the hand of investors against broker-dealers who violated Congress's new uniform standards of professional conduct. n178 The strong sanction provisions of the '34 Act further suggest that Congress did not wish to skimp upon enforcement methods for industry standards. n179 Private enforcement has always been deemed integral to the overall regulatory scheme of the federal securities laws. n180 Government agencies do not enjoy sufficient funding stability to shoulder the sole burden of enforcement. n181 Prominent government regulators themselves have emphasized the importance of private enforcement to the efficacy of the securities laws. n182

  [*556]  

Under legal principles extant in 1934, this congressional imposition of a mandatory self-regulatory regime that articulated high standards of professional conduct had great significance. n183 Then, as now, professionals owed duties of due care to observe professional standards of conduct. n184 Holding securities professionals to these uniform, expertly promulgated standards is fully in accordance n185 with the intent of the '34 Act and each significant Congressional effort to amend the Act with respect to broker-dealer regulation since 1934. n186

 

Setting industry standards had enormous legal implications under state law principles in 1934, and it has enormous implications under state law principles today. n187 Courts have imposed higher standards  [*557]  upon professionals specifically "because the higher standards of care imposed on them by their profession and by . . . licensing requirements engenders trust in them by clients that is not the norm of the marketplace." n188 The law usually imposes a duty of care upon persons holding themselves out to the public as having specialized skill. Under the Restatement (Second) of Torts, n189 professionals (or those engaged in a skilled trade) are duty-bound to exercise a professional standard of care-meaning they must observe industry standards. n190 This professional obligation inheres in the professional relationship and may be enforced either in an action sounding in tort or contract. n191 In other words, professionals implicitly warrant that they will exercise the degree of skill and judgment that can reasonably be expected from similarly situated professionals. n192 Generally, breach of professional standards gives rise to favorable construction of statutes of limitations, n193 restricted defenses such as comparative negligence, n194 and freedom from the restrictions of the "economic loss doctrine," which is recognized in  [*558]  various jurisdictions. n195 While expert testimony is generally required to establish the violation of industry standards, n196 the establishment of such a violation is evidence that may support a jury finding of professional negligence. n197 Indeed, in the specific context of SRO rules, violations have been found in the absence of a finding of scienter. n198

 

Predictably, some jurisdictions are more restrictive than others in imposing the obligation of professional care. n199 Even in such jurisdictions, liability may well obtain under the industry standards imposed by the SROs and the SEC. n200 The Restatement applies an identical standard to skilled trades. n201 Professional malpractice claims have both a contractual and tort basis. n202 In the context of securities brokerage accounts, every account has a customer account agreement, and this agreement, being drafted by the broker, is to be strictly construed against the broker. n203 Moreover, every broker has an agreement with an SRO. n204 These agreements necessarily are intended to benefit and protect investors by imposing standards of high business ethics. n205 All of these agreements are drafted by brokers and the brokerage industry and ought to be construed strictly in favor of investors. n206 Under these principles, a breach of industry standards would be an actionable breach  [*559]  of contract under either professional malpractice standards n207 or a third- party-beneficiary contract analysis. n208

 

The reluctance of Congress to federalize industry regulation and create broad federal remedies should not act to blur what Congress did achieve: n209 it mandated elevated standards of industry conduct and professionalism that would have profound effect under existing state law principles of negligence, professional liability, and contract, both in 1934 as well as under present state law. Thus far, only a few courts have utilized the industry standards arising from mandatory self- regulation in precisely this manner. n210 The next Part of this Article will show that this approach to broker liability rests upon a sound policy basis: the need to prevent economic disruptions associated with speculative bubbles.

 

IV. The Economic Risks of Caveat Emptor in the Securities Profession

 

It is no accident that the '34 Act was promulgated in the aftermath of the greatest economic catastrophe in U.S. history. n211 The law and  [*560]  macroeconomics of the Act was patent: Roosevelt sought to place the American capitalistic system upon a firmer legal and regulatory foundation. n212 Most urgently, Roosevelt sought to take positive action to restore investor confidence and spur more investment transactions leading to greater economic growth. n213 Since the Great Depression, the legal foundation laid under the financial system has not cracked in any significant way; instead, our nation has had more than sixty-five years of largely uninterrupted economic growth. In light of this record of success (and perhaps, more importantly, lack of failure), high standards of professionalism in the securities brokerage industry must be considered fundamental to efficient capital markets. Recognition of professional liability for violation of these high standards of conduct would serve to strengthen financial markets.

 

In addition to facilitating investment transactions, the '34 Act also served to address the risks implicit in speculative bubbles. n214 The central lesson of the Great Depression was that a precipitous decline in stock prices can have significant macroeconomic consequences, and that excessive speculation can lead directly to severe economic disruptions. n215  [*561]  Even today, prominent economists recognize that speculative bubbles n216 can have severe adverse impacts upon macroeconomic performance, without fully understanding the relationship between fiscal policy, monetary policy, and the negative effects of a burst asset bubble like stock price swoons. n217 While the link between a professionalized securities industry and containment of speculative pressure seems sound and has been assumed to be significant by both contemporary observers and Congress in 1934, it is by no means definitively proven. n218 Nevertheless, it does seem to benefit from both a powerful logical argument and the track record of American securities markets since 1934. n219 Current conditions in the U.S. equity markets seem to illustrate the point further. First, recently the United States saw a dramatic expansion in the degree of participation in the stock market generally. n220  [*562]  Second, stock prices ran up to historic highs in defiance of nearly all professional assessments. n221 Third, stock prices suffered a dramatic depreciation after the bubble burst. n222 Fourth, macroeconomic policy makers seem to be quite challenged in assessing the degree of damage done generally to the economy from the speculative excesses. n223 A fundamental erosion in the degree to which investment decisions were professionally guided seems central to any explanation of how the bubble developed.

 

John Maynard Keynes recognized, after the Great Depression, that a gradual increase in the frequency of equity ownership is generally accompanied by an increase in investors that have "no special knowledge . . . in the valuation of investments." n224 This, in turn, can be expected to increase price volatility as the "mass psychology of a large number of ignorant individuals" begins to dominate the market. n225 Eventually, even professional investors begin to chase the market rather than exert a rational influence on market prices. n226 Keynes thus showed how market professionals succumb to mass psychology, a phenomenon that seems to have repeated itself more recently in the American stock market. n227 However, the proposal for a more professionalized securities brokerage industry would serve to stem "mass psychology" at the  [*563]  source; professional brokers would be widely available to investors who have "no special knowledge" and "mass psychology" would be more informed. n228

 

Nevertheless, many neoclassical economic theorists assume that parties should enjoy freedom of contract to negotiate any fiduciary duties as a matter of efficiency. n229 Commentators have generally responded to this by pointing out that fiduciary duty is a concept premised upon extra-contractual operation and the vindication of non-contractual values. n230 This Article seeks to demonstrate that mandatory professional duties are more efficient than contract-based duties, in that a lack of investor confidence in the fairness of the securities brokerage industry leads to fewer investment transactions, not more. n231 Congress was faced with this scenario when it enacted the '34 Act. n232 At that time, greater freedom of contract had led directly to the near extinction of the securities industry. n233 The empirical evidence therefore strongly suggests that more wealth maximizing transactions will occur under a mandatory professional standards regime.

 

Of course, in a context where a rule of law gives rise to more economic growth in a relatively clear and ascertainable manner, any neoclassical justification is beside the point. n234 This is because neoclassical economic analysis assumes too much and posits benefits that are too  [*564]  theoretical-namely, mere efficiency. n235 In essence, neoclassical economic modeling requires profligate assumptions such as perfect information, perfect mobility of resources, and zero transaction costs. n236 Under these assumptions, human beings, as rational maximizers, will transact until resources are allocated to their most valuable use. n237 Consequently, either wealth or utility will be theoretically maximized. n238 But that is it. Under those unrealistic assumptions, wealth or utility will be maximized but not growth, jobs, or productivity. n239 Neoclassical theory has never posited that efficiency leads to more output or more jobs or more of any other macroeconomic aggregate. n240

 

There are other non-economic reasons for imposing professional standards upon the brokerage industry. Just as the social context of 1934 demanded political action to repair our economic system, the social context of the twenty-first century presents a context that is at  [*565]  least as compelling. n241 First, the breadth of securities ownership now is greater than ever. n242 Broadening securities ownership is certain to result in a higher percentage of inexperienced, unsophisticated, and less educated securities owners than if ownership were largely limited to a small class of society. n243 Second, an age crisis is looming in America and abroad. Right now, more Americans than ever are depending upon the securities markets to deliver returns sufficient to provide for retirement. n244 Experience has proven that unleashing a securities industry dominated by a caveat emptor mentality upon less sophisticated investors, who will be dependent upon securities markets for retirement, will result in countless personal tragedies. n245 Examples of securities professionals fleecing small investors abound. n246

  [*566]  

The securities brokerage industry has also evolved in a manner that supports industry standards of professional conduct. The reality facing the industry today is that technology has progressed to a point where the market price for a broker acting as mere order taker can achieve revenue of about ten dollars per trade. n247 The industry survives by its ability to sell a bundle of services that at bottom consists of professional services and professional advice; the technological reality of the year 2002 is that an investor can buy securities through a machine without seeing or talking to a real person. Under these circumstances, the securities industry can hardly tolerate a public profile akin to used car salespersons. Indeed, the ability of any broker-dealer to sell its professional services is compromised every time an investor is victimized by a competitor that fails to adhere to professional standards. n248 Under these circumstances, strictly enforcing industry norms of professionalism is fundamental to commercial survival. n249

 

Securities markets should not be operated as if they are casinos. That market is well occupied, and regulated broker-dealers are not well-suited to hawking securities as games of chance. Similarly, banks, investment companies, and insurance companies each sell investment products and investment management services that compete with broker-dealers. But brokers have the ability to offer a myriad of investment products in a single account that is individually tailored and managed with professional advice and guidance. This is the market niche that allows broker- dealers to thrive in a market with revenues in excess of those available to a mere order taker. It is particularly appropriate to impose professional standards upon market participants who hold themselves out to the public, either through advertising or service pricing, as "full-service" securities professionals. n250 Put simply, this market niche must be defended by limiting entry to true professionals.

 

The abolition of caveat emptor in the securities brokerage industry in 1934 was the appropriate response to the Great Depression. From virtually any analysis, further erosion of the abolition of caveat emptor is not appropriate. The securities brokerage industry is central to investor perspectives on securities markets. The efficiency of these markets,  [*567]  central to our economic system, is at stake if industry standards erode. Caveat emptor is not a sustainable standard of business in the securities brokerage industry in a modern capitalist system. n251

 

V. Conclusion

 

For reasons that are not clear, there are few reported decisions holding a securities broker to the standard of care to which virtually every other trade or profession is held. From real estate brokers to beauty shop owners and from landscaping companies to lawyers, courts have insisted that professionals adhere to the standards of the industry and exercise professional care. This standard of care is evidenced by codes of conduct or codes of ethics, usually promulgated by the relevant profession itself. In the securities industry, SROs like the NYSE and the NASD have promulgated detailed codes of conduct specifically designed by the industry to inculcate standards of "high honor" or "just and equitable principles of trade" throughout the securities brokerage industry. There is no good reason for courts to decline to hold the industry to its own professional standards and thereby frustrate the fundamental purpose of self-regulation-investor protection. The text and legislative history of the '34 Act, on the other hand, furnish a sound basis upon which a law of broker malpractice ought to be built. Indeed, insulating the industry from such liability is ultimately destructive of the very professional standards that the industry thrives upon.

 

Separate and apart from the question of why courts have largely insulated brokers from legal principles that apply to virtually every other skilled trade or profession is the question of the economic risks that such legal machinations pose. Holding that the imposition of professional duties only raises transaction costs misses several compelling economic points. Speculative bubbles and unfair securities markets marked by principles of caveat emptor instead of professionalism will devastate investor confidence, as it has so dramatically in the past, and greatly diminish transactions in securities regardless of costs. We as a society already have "been there and done that" when it comes to caveat emptor in the securities markets and have found that-regardless of any efficiency justification-it is prone toward economic catastrophe. In 1933, just before the enactment of the federal securities laws, efficiency offered little comfort to Wall Street in the midst of an eighty-three percent decline in share prices. In the final analysis, the economic foundations of raising industry conduct to instill investor confidence was  [*568]  sound policy in 1934 and it is sound policy today. Courts should recognize professional liability in the securities brokerage industry as a means of reversing recent judicial hesitancy to hold brokers to the standards of professionalism that those brokers hold out to the public.

 

 

 

FOOTNOTES:

n1 only too familiar to everyone. During the post-war decade some 50 billions of new securities were floated in the United States. Fully half or $ 25,000,000,000 worth of securities floated during this period have been proved to be worthless. These cold figures spell tragedy in the lives of thousands of individuals who invested their life savings, accumulated after years of effort, in these worthless securities. The flotation of such a mass of essentially fraudulent securities was made possible because of the complete abandonment by many underwriters and dealers in securities of those standards of fair, honest, and prudent dealing that should be basic to the encouragement of investment in any enterprise. Alluring promises of easy wealth were freely made with little or no attempt to bring to the investor's attention those facts essential to estimating the worth of any security. High-pressure salesmanship rather than careful counsel was the rule in this most dangerous of enterprises.H.R. Rep. No. 73-85, at 2 (1933).

n2 Securities Exchange Act of 1934, ch. 404, 48 Stat. 881 (codified as amended at 15 U.S.C. § §  78a-78mm (2000)).

n3 Howell E. Jackson & Edward L. Symons, Jr., Regulation of Financial Institutions 653 (1999). Some state regulation of the securities markets and the securities brokerage industry was in place in 1934, but for a variety of reasons it was of limited effectiveness. Id. at 656. For example, states had inadequate resources for expert regulatory staff, and a lack of uniformity created opportunities for regulatory competition and avoidance whereby business could gravitate towards lax jurisdictions. Id.

n4 The '34 Act regulates both "brokers" and "dealers." A broker is defined as "any person engaged in the business of effecting transactions in securities for the account of others." 15 U.S.C. §  78c(a)(4) (2000). A dealer is defined as "any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise." 15 U.S.C. §  78c(a)(5) (2000). This paper refers to both of these types of entities under the terms "broker-dealer" or "securities brokerage industry."

n5 See Jackson & Symons, supra note 3, at 659 (discussing how the New Deal transformed private regulation to "quasi-public" self-regulation). See also U.S. Securities and Exchange Commission, Report Pursuant to Section 21(a) of the Securities exchange Act of 1934 Regarding the NASD and the NASDAQ Market 7 (1996) (discussing the benefits of self-regulation and the risk that self-regulation may favor industry interests over those of investors) [hereinafter SEC Report].

n6 "One would have to turn the pages of history back to the days of the South Sea bubble to find an equivalent fantasy of security selling." H.R. Rep. No. 73-85, at 3.

n7 See SEC v. Zandford, 122 S. Ct. 1899, 1903 (2002) ("Among Congress' objectives in passing the Act was 'to insure honest securities markets and thereby promote investor confidence' after the market crash of 1929."); Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 315 (1985) (stating that the "primary objective of the federal securities laws" is investor protection through promotion of a "high standard of business ethics" in "every facet of the securities industry") (quoting SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 186-87 (1963)); Affiliated Ute Citizens v. Unites States, 406 U.S. 128, 151 (1972) (noting that the intent of the '34 Act was to "'achieve a high standard of business ethics in the securities industry"' and that the Act must consequently "be construed . . . flexibly to effectuate its remedial purposes") (quoting SEC v. Capital Gains Research Bureau, 375 U.S. 180, 186, 195 (1963)); Silver v. N.Y. Stock Exch., 373 U.S. 341, 366 (1963) ("It requires but little appreciation of . . . what happened in . . . the 1920's and 1930's to realize how essential it is that the highest ethical standards prevail as to every aspect of the [securities business].").

n8 Compare 15 U.S.C. §  78f (2000) (delineating powers of exchanges) and 15 U.S.C. §  78o-3 (2000) (delineating powers of National Association of Securities Dealers, the only registered securities association), with 15 U.S.C. §  78s (2000) (specifying oversight powers of the SEC). See also William O. Douglas, Democracy and Finance 64-65, 82 (1940) (stating that stock exchanges are the "scales upon which that great national resource, invested capital, is weighed"; therefore, they may not be allowed to be run as "private club[s]" and instead government must exercise a "residual role" and "keep the shotgun, so to speak, behind the door, loaded, well-oiled, cleaned and ready for use"). Justice Douglas served as Chairman of the SEC during the 1930s. Id. at viii.

n9 See 15 U.S.C. §  78f(b)(5) (2000) (requiring rules of SROs to "protect investors and the public interest").

n10 "This proposal . . . puts the burden of telling the whole truth on the seller. It should give impetus to honest dealing in securities and thereby bring back public confidence." H.R. Rep. No. 73-85, at 2 (quoting letter from President Franklin D. Roosevelt). The Great Depression demolished investor confidence so thoroughly that investors had "grown timid to the point of hoarding" cash. This breakdown in free, unregulated securities markets posed a historic threat to "honest enterprise" and capitalism generally. S. Rep. 73-47, at 1 (1933).

n11 See Cheryl Goss Weiss, A Review of the Historic Foundations of Broker-Dealer Liability for Breach of Fiduciary Duty, 23 J. Corp. L. 65, 119 (1997) (stating that "key issue" to fiduciary obligation is "control"); Roberta S. Karmel, Is the Shingle Theory Dead?, 52 Wash. & Lee L. Rev. 1271, 1272-73 (1995) (contending that the shingle theory, discussed infra note 105, is no longer a sound basis for civil liability under the antifraud provisions of the federal securities laws); Gregory A. Hicks, Defining the Scope of Broker and Dealer Duties-Some Problems in Adjudicating the Responsibilities of Securities and Commodities Professionals, 39 DePaul L. Rev. 709, 713 (1990) (arguing that fiduciary duty concepts may saddle market professionals with "extravagant" duties that have "unpersuasive" foundations that are untethered to industry understandings and practices); Carol R. Goforth, Stockbrokers' Duties to their Customers, 33 St. Louis U. L.J. 407 (1989) (reviewing common law of broker liability with little analysis of role of SRO rules in supporting professional liability); Robert H. Mundheim, Professional Responsibilities of Broker-Dealers: The Suitability Doctrine, 1965 Duke L.J. 445 (1965) (discussing industry professional obligations but failing to assess the extent to which such standards support professional liability).

n12 "The bill proceeds on the theory that the exchanges are public institutions . . . and are not private clubs to be conducted only in accordance with the interests of their members." H.R. Rep. No. 73-1383, at 15 (1934).

n13 Of the scores of reported broker liability cases, few even discuss broker liability in terms of malpractice or professional liability. See Ferritto v. Olde & Co., 577 N.E.2d 101, 104 (Ohio App. 1989) (affirming jury verdict for broker's negligent violation of the New York Stock Exchange's (NYSE) Business Conduct Rule 405, which requires brokers to "learn the essential facts relative to every customer" and "every order"); Twomey v. Mitchum Jones & Templeton, 69 Cal. Rptr. 222, 244 (1968) (stating that "ethical standards" can form the basis for civil liability for negligence even if such violations are unsupported by an express or implied right of action under federal law); McCollum v. Billings, 279 N.Y.S.2d 609, 616-617 (1967) (finding the claim that the broker "failed to exercise their special skill and competence" invoked jurisdiction of state court for redress under state law). The Twomey court did not address explicitly whether its substantive basis for liability rested upon fiduciary duty concepts or professional malpractice. See id. at 227- 28. The opinion is premised on the term "misfeasance," which is consistent with professional malpractice as well as breach of fiduciary duty. See id. at 227. Similarly, the Ferritto court applied concepts of professional negligence in the context of a claim for breach of fiduciary duty. 577 N.E.2d at 585.

n14 Rule 10b-5 provides: It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to 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) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.17 C.F.R. 240.10b-5 (2001). As such, Rule 10b-5 is the general anti-fraud provision of the federal securities laws.

n15 Ferdinand Pecora served for seventeen months, from January 1933 to July 1934, as counsel to the Senate Committee on Banking and Currency during the time of hearings on the Securities Act and the Exchange Act. See Ferdinand Pecora, Wall Street under Oath: the Story of Our Modern Money Changers 3 (Augustus M. Kelley ed., 1973) (1939). Pecora published a summary of those congressional hearings because "[a]fter five short years, we may now need to be reminded what Wall Street was like before Uncle Sam stationed a policeman at its corner." Id. at xi. Pecora was prescient in predicting a failure of public memory: Under the surface of the governmental regulation of the securities market, the same forces that produced the riotous speculative excesses of the "wild bull market" of 1929 still give evidences of their existence and influence. Though repressed for the present, it cannot be doubted that, given a suitable opportunity, they would spring back into pernicious activity. Frequently we are told that this regulation has been throttling the country's prosperity. Bitterly hostile was Wall Street to the enactment of the regulatory legislation. It now looks forward to the day when it shall, as it hopes, reassume the reins of its former power. . . . The public, however, is sometimes forgetful. As its memory of the unhappy market collapse of 1929 becomes blurred, it may lend at least one ear to the persuasive voices of The Street subtly pleading for a return to the "good old times." Forgotten, perhaps, by some are the shattering revelations of the Senate Committee's investigation . . . .Id. at ix-x.

n16 See, e.g., Steven A. Ramirez, Arbitration and Reform in Private Securities Litigation: Dealing with the Meritorious as well as the Frivolous, 40 Wm. & Mary L. Rev. 1055, 1059 (1999) (noting that Congressional "reforms" in private securities litigation during the 1990s had the perverse effect of using federal law to narrow investor rights).

n17 The '34 Act regulates both broker-dealers as well as individuals working for broker-dealers, under the term "person[s] associated with a broker or dealer." The term "person associated with a broker or dealer" or "associated person of a broker or dealer" means any partner, officer, director, or branch manager of such broker or dealer (or any person occupying a similar status or performing similar functions), any person directly or indirectly controlling, controlled by, or under common control with such broker or dealer, or any employee of such broker or dealer, except that any person associated with a broker or dealer whose functions are solely clerical or ministerial shall not be included in the meaning of such term . . . .15 U.S.C. §  78c(a)(18) (2000). Thus, for purposes of this article the term "brokers" or "broker- dealers" refers to individuals as well as firms.

n18 Given the breadth of the '34 Act, which regulates everything from insider trading to public company disclosure obligations, and the reach of the New Deal generally, which regulates everything from deposit insurance to monetary policy, such far-reaching and intrusive regulation would have been politically problematic.

n19 E.g., S. Rep. No. 73-185, at 1 (1934) (conference report on final bill). Neither by the Securities Act of 1933 nor by the

n20 Securities Exchange Act of 1934 does the Federal Government undertake to approve or guarantee the present soundness or the future value of any security. The investor must still, in the final analysis, select the security which he deems appropriate for investment. The purposes of the Securities Act of 1933 are to make available to him complete and truthful information from which he may intelligently appraise the value of a security, and to safeguard against the negligent and fraudulent practices perpetrated upon him in the past by incompetent and unscrupulous bankers, underwriters, dealers and issuers.S. Rep. No. 73-1455, at 153 (1934).

n21 For example, in addition to the usual legislative process, President Roosevelt directed the Secretary of Commerce to form a committee to study the problems inherent in federal regulation of the securities markets. The result of this study was transmitted by the President to Congress and became the basis of the '34 Act. See Report to the Sec'y of Commerce by the Comm. on Stock Exch. Regulation, reprinted in Senate Comm. on Banking and Currency, 73d Cong., 2d Sess., Letter from the President of the United States to the Chairman of the Comm. on Banking and Currency with an Accompanying Report Relative to Stock Exch. Regulation, reprinted in 5 Legislative History of the Securities Act of 1933 and Securities Exchange Act of 1934, Item 16, at III (Comm. Print 1934) (J.S. Ellenberger & Ellen P. Mahar eds., 1973) [hereinafter Stock Exchange Regulation Study].

n22 Securities Act of 1933, ch. 38, 48 Stat. 74 (codified as amended at 15 U.S.C. § §  77a-77aa (2000)).

n23 Supra note 2.

n24 S. Rep. No. 73-792, at 1 (1934) (stating that the '33 Act was "one step" in our "broad purpose of protecting investors") (quoting letter from President Franklin D. Roosevelt). Congress also viewed the various New Deal initiatives aimed at restructuring our system of financial regulation as an integrated effort to address the same complex of problems: In the course of the investigation thus far conducted by the subcommittee a record of more than 12,000 printed pages has been compiled and more than 1,000 exhibits received in evidence. The subcommittee has endeavored to investigate thoroughly and impartially some of the complex and manifold ramifications of the business of issuing, offering, and selling securities and the business of banking and extending credit. It has endeavored to expose banking operations and practices deemed detrimental to the public welfare; to reveal unsavory and unethical methods employed in the flotation and sale of securities; and to disclose devices whereby income-tax liability is avoided or evaded. Its purpose throughout has been to lay the foundation for remedial legislation in the fields explored and in some measure that purpose has already been achieved. During the progress of this investigation, Congress enacted the Banking Act of 1933, the Securities Act of 1933, the Securities Exchange Act of 1934, and several amendments to the revenue act calculated to eliminate methods of tax avoidance described before the subcommittee.S. Rep. No. 73-1455, at 3-4 (1934).

n25 "This proposal adds to the ancient rule caveat emptor, the further doctrine 'let the seller also beware.' It puts the burden of telling the whole truth on the seller." H.R. Rep. No. 73-85, at 2 (quoting letter from President Franklin D. Roosevelt).

n26 H.R. Rep. No. 73-85, at 1-2 (1933). See also Jackson & Symons, supra note 3, at 659 ("While it had a profound effect on capital formation, the 1933 Act was recognized from the start as simply the first phase of federal regulation over the securities industry.").

n27 H.R. Rep. No. 73-1383, at 1 (1934) (quoting letter from President Franklin D. Roosevelt).

n28 Stock Exchange Regulation Study, supra note 21, at v. Roosevelt was modeling his securities initiatives on Louis Brandeis's landmark work, Other People's Money, which posited that investment professionals should be subject to duties akin to a "trustee." See Louis D. Brandeis, Other People's Money and How the Bankers Use It 199-200 (1911). See also generally Sheldon M. Jaffe, Broker-Dealers and Securities Markets §  1.03 (1977). The bill is conceived in a spirit of the truest

n29 conservatism. It attempts to change the practices of exchanges and the relationships between listed corporations and the investing public to fit modern conditions, for the very purpose that they may endure as essential elements of our economic system. The lesson of 1921-29 is that without changes they cannot endure. The bill is not a moral pose or a vengeful striking back at brokers for the losses which nearly the entire Nation has suffered in the last 5 years. Nor is its purpose or effect to regiment business in any way. It is simply an earnest attempt to make belated intelligent adjustments, long required by changing conditions, in a faulty system . . . which from the coldly objective viewpoint of the welfare of a conservative public simply has not worked.H.R. Rep. No. 73-1383, at 3.

n30 See S. Rep. No. 73-792, at 13 (1934).

n31 Indeed, section 2 of the '34 Act articulates many broad and important policy reasons for regulation, all of which militate for the abolition of caveat emptor and the creation of "fair and honest" markets: For the reasons hereinafter enumerated, transactions in securities as commonly conducted upon securities exchanges and over-the-counter markets are affected with a national public interest which makes it necessary to provide for regulation and control of such transactions and of practices and matters related thereto, including transactions by officers, directors, and principal security holders, to require appropriate reports to remove impediments to and perfect the mechanisms of a national market system for securities and a national system for the clearance and settlement of securities transactions and the safeguarding of securities and funds related thereto, and to impose requirements necessary to make such regulation and control reasonably complete and effective, in order to protect interstate commerce, the national credit, the Federal taxing power, to protect and make more effective the national banking system and Federal Reserve System, and to insure the maintenance of fair and honest markets in such transactions.15 U.S.C. §  78b (2000).

n32 H.R. Rep. No. 73-1383, at 5. Unless constant extension of the legal conception of a fiduciary relationship-a guarantee of "straight shooting"-supports the constant extension of mutual confidence which is the foundation of a maturing and complicated economic system, easy liquidity of the resources in which wealth is invested is a danger rather than a prop to the stability of that system. When everything everyone owns can be sold at once, there must be confidence not to sell. Just in proportion as it becomes more liquid and complicated, an economic system must become more moderate, more honest, and more justifiably self-trusting.Id.

n33 Id. at 15.

n34 Id.

n35 See id. The original bill submitted to the Committee

n36 dealt very specifically and definitely with a number of admitted abuses. In many cases, however, the argument was made that while the solutions offered might be correct, their effects were so far-reaching as to make it inadvisable to put these solutions in the form of statutory enactments that could not be changed in case of need without Congressional action. Representatives of the stock exchanges constantly urged a greater degree of flexibility in the statute and insisted that the complicated nature of the problems justified leaving much greater latitude of discretion with the administrative agencies than would otherwise be the case.Id. at 6.

n37 Jackson & Symons, supra note 3, at 659-62; Jaffe, supra note 28, §  1.04. Stock exchanges raise essentially new problems in

n38 Federal regulation. They do not present a static situation susceptible to fixed standards. On the contrary, it is a highly dynamic, ever-changing picture, subject to untold and unknown possibilities and combinations that are today unpredictable. The thing to be avoided is the placing of this complex and important mechanism in a strait jacket. Your committee has considered as an alternative suggestion that the proposed enactment cover in its detailed provisions all known unfair, inequitable, and unsocial practices by express provisions with a minimum discretionary power of regulation by the governmental body responsible for enforcement. While it is possible to fix by law certain basic standards as a guide to conduct in the matter of regulation of exchanges, these must be limited to minimum requirements. The point specifically is that while certain provisions might be included in any regulations, such provisions should not be the only power of correction left open to an administrative agency, but it should have broad discretion to operate directly on various abuses as the future may prove them to exist. It is not proposed that the Government so dominate exchanges as to deprive these organizations of initiative and responsibility, but it is proposed to provide authority to move quickly and to the point when the necessity arises.Stock Exchange Regulation Study, supra note 21, at 6.

n39 Jaffe, supra note 28, §  1.04.

n40 SEC Report, supra note 5, at 7.

n41 Id. See also S. Rep. No. 88-379, at 42 (1963) (stating that self-regulation allows regulation of "un-ethical as distinct from illegal conduct").

n42 H.R. Rep. No. 73-1383, at 15.

n43 Maloney Act, Pub. L. No. 719, ch. 677, 52 Stat. 1070 (1938).

n44 S. Rep. No. 75-1455, at 3 (1938); H.R. Rep. No. 75-2307, at 4 (1938). The 75th Congress articulated the problem with direct government regulation of industry norms when it compared the Maloney Act with a "second" option of "cooperative regulation": The first would involve a pronounced expansion . . . of the [SEC]; the multiplication of branch offices; a large increase in the expenditure of public funds; an increase of the problem of avoiding the evils of bureaucracy; and a minute, detailed, and rigid regulation of business conduct by law. It might very well mean expanding the present process of registration . . . to include the proscription not only of the dishonest, but also of those unwilling or unable to conform to rigid standards of . . . professional conduct . . . .S. Rep. No. 75-1455, at 3-4; H.R. Rep. No. 75-2307, at 4-5.

n45 VI Louis Loss & Joel Seligman, Securities Regulation 2789-90 (1990).

n46 Jackson & Symons, supra note 3, at 662.

n47 National Association of Securities Dealers, Inc., Manual 160 (2000) [hereinafter NASD Manual]. According to the NASD, "[w]ithout legislative authority, . . . the problem of effectively promoting self-regulation was a difficult one." Id. at 159.

n48 See 15 U.S.C. §  78o(b)(8) & (9) (2000).

n49 See S. Rep. No. 88-379, at 42 (1963) ("In the light of . . . the desirability of uniform application of standards," it would be "anomalous" to allow membership in SROs to be optional).

n50 See Securities Acts Amendments of 1964, Pub. L. No. 88-467, 78 Stat. 565.

n51 Id.

n52 H.R. Rep. No. 88-1418, at 4 (1964).

n53 S. Rep. No. 88-379, at 43.

n54 Id.

n55 15 U.S.C. §  78o(b)(7) (2000).

n56 Id.

n57 See Report of Special Study of Securities Markets, H.R. Doc. No. 88-95, pt. 1, at 151 (1st Sess. 1963) [hereinafter Special Study]. The Special Study was authorized by Congress in order to assess any inadequacies in the regulation of the securities brokerage industry. Id. at 1. Congress was concerned that speculative excesses had once again permeated the nation's securities exchanges and wanted to assure the maintenance of investor confidence. Id. at 1-2.

n58 As the SEC stated: "The functions of this report and of any changes proposed are to strengthen the mechanisms facilitating the free flow of capital into the markets and to raise standards of investor protection, thus preserving and enhancing the level of investor confidence." Id. at v (letter of transmittal dated Aug. 8, 1963).

n59 Graham L. Sterling, Jr., National Association of Securities Dealers and the Securities Acts Amendments of 1964, 20 Bus. Law. 313 (1965) ("A consistent theme of the Special Study is the professionalization or upgrading of the industry."). Congress stated that one of the "major subjects" of the '64 Amendments was to "strengthen qualification standards and disciplinary controls" over securities industry personnel. H.R. Rep. No. 88-1418, at 2 (1964). Congress specifically intended the '64 Amendments to impose standards of "training, experience and competence" for securities industry personnel. Id.

n60 Special Study, supra note 57, at 161.

n61 NASD Manual, supra note 47, Rule 1014(a)(3), at 3120.

n62 See H.R. Rep. No. 88-1418, at 3 (1964).

n63 Special Study, supra note 57, at 159-61. It is significant that Congress in 1964 recognized the intent to protect investors from "malpractices" in the securities markets. Supra note 50. Malpractice is a term that has long been associated with professional liability for negligence. Black's Law Dictionary 971 (7th ed. 1999) (defining malpractice to mean "[a]n instance of negligence or incompetence on the part of a professional"); see also Black's Law Dictionary 1111 (4th rev. ed. 1968) (citing Gregory v. McGinnis, 134 S.E. 527, 529 (S.C. 1926)).

n64 See 15 U.S.C. §  78u(a)(1) (2000).

n65 See 15 U.S.C. §  78s(b) & (c) (2000). In fashioning the Securities Exchange Act of

n66 1934, Congress considered the question whether to continue in effect the system of regulation by which the industry voluntarily undertook to govern the conduct and professional standards of professional participants in the securities markets or to rely instead on direct regulation by governmental authority. Convinced that an attempt to regulate the industry directly through government on a wide scale would be "ineffective," the Congress chose to develop a unique pattern of regulation combining both industry and government responsibility. This pattern, which has remained substantially unchanged for 40 years, calls upon industry organizations-the exchanges and the NASD-to exercise delegated governmental power in order to enforce at their own initiative compliance by members of the industry with both the legal requirements laid down in the Securities Exchange Act and ethical standards which go beyond those requirements.H.R. Rep. No. 94-123, at 6 (1975). See also S. Rep. No. 94-75, at 22 (1975) (same).

n67 Id.

n68 Pub. L. No. 104-67, 109 Stat. 737 (1995) (codified in scattered sections of 15 U.S.C.).

n69 See Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 739 (1975) ("[L]itigation under Rule 10b-5 presents a danger of vexatiousness different in degree and in kind from that which accompanies litigation in general."). One particularly graphic critic of securities lawyers was former Senator Alfonse D'Amato of New York, who stated that plaintiffs' securities lawyers were "sharks, sharks for hire" and "bandits." 141 Cong. Rec. S17,935- 36 (daily ed. Dec. 5, 1995) (statement of Sen. D'Amato).

n70 Supra note 37.

n71 See 15 U.S.C. §  78bb (2000).

n72 Supra notes 8, 9, 19, 27, 32, 33, 44, 52, 53, 60, 63 and 66.

n73 Supra notes 9, 29, 52, 58 and 59.

n74 15 U.S.C. §  78e (2000) (prohibiting securities transactions except on registered exchanges).

n75 15 U.S.C. §  78f (2000).

n76 15 U.S.C. §  78o-3 (2000).

n77 15 U.S.C. §  78o (2000).

n78 Supra note 74.

n79 Supra note 77.

n80 Supra notes 75 and 76.

n81 Supra note 46 & accompanying text.

n82 15 U.S.C. §  78c(26) (2000).

n83 15 U.S.C. §  78f(b)(5) (2000). More specifically, the SEC must deny registration to an exchange unless its rules: are designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation and coordination with persons engaged in regulating, clearing, settling, processing information with respect to, and facilitating transactions in securities, to remove impediments to and perfect the mechanism of a free and open market and a national market system, and, in general, to protect investors and the public interest.Id. See also 15 U.S.C. §  78o(b)(6) (2000) (stating identical requirements for registration of national securities association).

n84 15 U.S.C. §  78f(b)(5) (2000); 15 U.S.C. §  78o-3(b)(6) (2000); 15 U.S.C. §  78b (2000) (stating that one purpose of the '34 Act is to insure "fair and honest markets" for securities transactions).

n85 15 U.S.C. §  78f(b)(6) (2000); 15 U.S.C. §  78o-3(b)(7) (2000).

n86 15 U.S.C. §  78f(d)(3) (2000); 15 U.S.C. §  78o-3(h)(3) (2000).

n87 15 U.S.C. §  78f(b)(5) (2000).

n88 Supra note 17.

n89 15 U.S.C. §  78o(b)(7) (2000).

n90 E.g., 15 U.S.C. §  78o(b)(4) (2000).

n91 E.g., 15 U.S.C. §  78u(d)(1) (2000) (authorizing SEC to bring action "to enjoin" violation of securities laws or SRO rules). Among the most significant provisions of the securities laws are the broad antifraud provisions specifically applicable to broker-dealers. 15 U.S.C. §  78o(c) (2000).

n92 15 U.S.C. §  78ff (2000). The Commission, by rule, may abrogate, add to,

n93 and delete from (hereinafter in this subsection collectively referred to as "amend") the rules of a self-regulatory organization (other than a registered clearing agency) as the Commission deems necessary or appropriate to insure the fair administration of the self-regulatory organization, to conform its rules to requirements of this [Act] and the rules and regulations thereunder applicable to such organization, or otherwise in furtherance of the purposes of this [Act] . . . .15 U.S.C. §  78s(c) (2000).

n94 E.g., 15 U.S.C. §  78u (2000).

n95 15 U.S.C. §  78s(c) (2000).

n96 NASD Manual, supra note 47, at 1011 (Paragraphs (1), (3) and (4)). The NASD is required by law to impose rules designed to "promote just and equitable principles of trade," but appears to have gone a step further in requiring "high standards of commercial honor." See 15 U.S.C. §  78o-3 (2000). See also NASD Manual, supra note 47, Rule 2110, at 4111.