Business Memo: Defending Against Allegations of Unsuitability — Part II: The Period of Limitations

The most frequent allegation brought against broker-dealers and RRs is that of “unsuitability” of recommendations. We discussed avoiding unsuitable recommendations in our July 2003, February 2004 and September 2004 issues. We discussed in our last issue, July 2007, the defenses of ratification, waiver, estoppel and laches. In this issue we will discuss the statute of limitations, or more precisely, the period of limitations.

As now implemented, the cause of action for “unsuitability” in arbitration has become a sort of “malpractice” action against broker-dealers and registered representatives, similar to negligence and recklessness malpractice actions against lawyers and doctors. That development arose out of the recent movement of disputes out of courts and into arbitration over the past, say, thirty years. The roots of the unsuitability” action, even when resolved in arbitration, are actually in the court action of securities fraud. The action was created in state and federal statutes and rules (e.g., Rule 10b-5) and cases beginning early in the last century. And the roots of its period of limitations, not surprisingly, are in that same action of securities fraud.

Those roots are twisted indeed, with complications that only lawyers care about. But we need not analyze the complications. Suffice it to say that it is not possible to predict reliably how a panel will rule on a period of limitations argument.

Arbitrators deciding period of limitations questions must answer two primary sub-questions: (1) how long is it? and (2) when does it start?

How long is it? In practice, arbitrators appear to disagree, but it is pretty clear that it is either two or six years. A long line of federal and state statutes and cases culminated in the Sarbanes-Oxley Act in 2002, which states that, at least in court, an “action (for) . . . a claim of fraud, deceit, manipulation, or contrivance in contravention of . . . the securities laws . . . may be brought not later than the earlier of (1) 2 years after the discovery of the facts constituting the violation [the period of limitation], or (2) 5 years after such violation [the period of ‘repose’].” (Because the discovery of the facts could occur a long time after the violation, the period of “repose” is intended to set an “outer limit”, as it were, to assure the matter is finally closed at some reasonable time.)

Rule 12206(a) of the National Association of Securities (NASD, now the Financial Regulatory Authority, FINRA) rules concerning arbitration of disputes between customers and broker-dealers states that “no claim shall be eligible for submission to arbitration . . . where six years have elapsed from the occurrence or event giving rise to the claim.” However, under the heading “Effect of Rule on Time Limits for Filing Claim in Court”, Rule 12206(d) states that “the rule does not extend applicable statutes of limitations.”

At first blush, it may appear that paragraph (d) in effect adopts the much shorter court litigation period of limitation of (usually) two years. And this is frequently argued by broker-dealers in arbitrations. But in fact, the more frequently accepted argument is that, although technically the six-year “eligibility” period is not a period of “limitation”, it in fact acts as one, and prevails over the two-year litigation period. Most courts hold that the six-year period mentioned in paragraph (a) limits the time within which an arbitration may be started, and paragraph (d) only says that state and federal periods limiting when a contractual arbitration clause may be enforced will not be extended. They hold paragraph (d) does not apply litigation securities law fraud limitation periods to “securities fraud” claims (i.e., unsuitability, churning, unauthorized transactions, etc.) in FINRA arbitrations. And it appears most arbitration panels deciding limitation questions agree. They do not generally give opinions explaining their decisions, but there appear to be few arbitrations dismissed on grounds of the period of limitations.

When does the period begin to run? FINRA Rule 12206(d) states that the “eligibility” period in FINRA arbitrations runs “from the occurrence or event giving rise to the claim”. That means, for “unsuitability” claims, the arbitration period of “eligibility” begins to run on the date of the purchase(s) claimed to be unsuitable (assuming the recommendation(s) and the purchase(s) were essentially simultaneous.) (Notice: it begins to run, and it expires, regardless of when or if the customer “realizes” that a recommendation was unsuitable.)

When the court litigation period of limitation begins is more complicated. The Sarbanes Oxley provision states that it begins “after discovery of the facts constituting the violation…”

This language would seem to indicate that the claimant has to actually discover the unsuitability for the period to begin running. But the courts have not been so kind to claimants. Rather, they hold that the period begins running at the earlier of when the claimant discovered, or, in the exercise of due diligence, should have discovered, the unsuitability (or other type of “fraud”, e.g., churning). This latter concept is sometimes called “constructive notice” and refers to the moment when, if the claimant had been sufficiently diligent, he or she would have noticed or should have suspected a recommendation was unsuitable. This concept is most often applied by the courts harshly against claimants, often starting the period of limitations when the claimant received a monthly or other statement from the broker indicating that the recommended security had dropped in value.

Small (and large) broker-dealers should take steps to take advantage of whichever period of limitations is applied by the arbitrators or a court. This should be done by assuring that evidence in writing exists of events which will cause the period to begin running. Of course, industry rules require records be kept of the date of purchase. If, however, the broker makes a recommendation well before a purchase is made, it is best to document the date of the recommendation so that if a claim is later made, the broker can claim and prove the earlier start date. And for purposes of later facing a claim, brokers should inform customers of negative news (not just positive news) about past investments made, and record the fact of giving the information, in order to be able to claim and prove that the customer had evidence of a recommendation’s negative aspects, and thus its “unsuitability”, if the arbitrators believe it was unsuitable.

Reprinted from The St. Louis Broker-Dealer newsletter, July 2008.

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