Selling Away: When a Broker Sells Investments the Firm Did Not Approve

What selling away is

A registered representative of a brokerage firm is supposed to sell only what the firm has reviewed and put on its platform. When the broker instead sells customers an outside investment, a friend's start-up, a real estate note, a private fund, a promissory note program, often for a finder's fee or a piece of the deal, and does not run it through the firm, the industry calls it selling away. The investments are frequently the ones that fail, because no compliance department ever looked at them. The dispute that follows is usually with the firm, because the broker and the issuer have no money left.

The rules the broker broke

FINRA Rule 3280, private securities transactions of an associated person, is the center. Before participating in any private securities transaction, meaning any securities transaction outside the regular course or scope of his employment with the firm, including a new offering not registered with the SEC, the broker must give the firm written notice describing the transaction in detail, his proposed role and whether he has received or may receive selling compensation. If compensation is involved, the firm must approve or disapprove in writing. If the firm approves, it must record the transaction on its books and records and supervise the broker's participation as if the transaction were executed on behalf of the firm. If it disapproves, the broker may not participate in any manner. Selling compensation is defined broadly: commissions, finder's fees, securities or rights to acquire them, a share of profits, even expense reimbursements.

FINRA Rule 3270, outside business activities, requires prior written notice to the firm before a registered person works for or is compensated by any outside business. Its supplementary material requires the firm, on receiving notice, to consider whether customers would view the activity as part of the firm's business and whether it is really a private securities transaction under Rule 3280. A broker who disclosed an "outside consulting business" that was in fact a sales channel for private notes put the firm on notice.

FINRA Rule 3110, supervision, requires the firm to maintain a supervisory system and written procedures reasonably designed to achieve compliance with the securities laws and FINRA rules, including review of correspondence and transactions and designated supervisors for every representative. A firm that never asked about outside activities, never reviewed the broker's emails and ignored customer checks written to an unfamiliar entity has a supervision problem whether or not it knew about the particular deal.

Why the firm can be liable for a deal it never saw

The Texas control-person theory is the investor's strongest, because the statute reverses the burden: once control is shown, the firm must prove it had no reason to know. A brokerage firm controls its registered representatives by definition; the fight is over what it reasonably could have known. The guide on control persons and aiders under the Texas Securities Act explains the statute, and the federal version is covered in the Rule 10b-5 guide.

The red flags that decide the case

Selling-away cases are won on what the firm should have seen. The usual evidence:

• Customer checks or wires payable to an outside entity, processed through the firm's office or discussed on firm email.
• Large or unexplained withdrawals from customers' brokerage accounts shortly before the outside investment, visible on the firm's own exception reports.
• The broker's disclosed outside business activity, especially one involving real estate, lending or "consulting."
• Marketing for the outside deal on firm letterhead, from a firm email address, in the firm's office or at a firm-sponsored event.
• Prior customer complaints or regulatory history for the broker that called for heightened supervision.
• The broker's lifestyle or compensation that did not match his production at the firm.
• Annual compliance questionnaires on which the broker denied outside activities, and what the firm did to test the answers.

The firm's defense is the mirror image: the customer dealt with the broker outside the office, wrote checks to a third party, signed subscription documents stating the firm was not involved, and received statements that never showed the investment. Those facts weaken apparent authority but do not answer the supervision and control-person theories, which turn on what the firm knew or should have known regardless of what the customer understood.

Example

Suppose a Southlake retiree has a brokerage account with a national firm. Her broker tells her about a "private income fund" run by a company he describes as a client, and she wires $200,000 from her brokerage account to the fund after signing documents in his branch office. The fund is a Ponzi scheme run by the broker's brother-in-law, and the broker received 8 percent of every dollar raised. The firm's exception report flagged the wire as a large outbound transfer; a supervisor called the customer, who said the broker had recommended it, and the supervisor closed the alert. The broker's compliance questionnaire listed an outside business as "marketing consultant." The broker is liable for fraud and under the Texas Securities Act. The firm is liable for failure to supervise, and as the broker's control person under section 4008.055 it must prove it could not have known, which the closed alert makes difficult. The investor's claims go to FINRA arbitration against both.

Where the claim goes and what it recovers

Because the broker is an associated person of a FINRA member and the dispute arises in connection with the firm's business activities, the investor can demand FINRA arbitration against the firm and the broker. The firm will argue the deal was not its business; panels routinely reject that argument where the broker used his position to make the sale. The guide on FINRA arbitration versus court explains the forum. Claims against the issuer and its principals, who are not FINRA members, go to court, often in parallel.

Recovery is the amount invested less any returns, with interest; rescission under the Texas Securities Act when a misstatement or registration violation is shown; and attorney's fees where the statute or the panel allows. If the outside investment was a Ponzi scheme, a receiver may also be collecting and distributing assets, and a payment from the receiver reduces, but does not replace, the claim against the firm. The guide on Ponzi scheme recovery explains the interaction.

For firms: the exposure and the response

A firm learning that a representative sold away faces the customers' claims, a FINRA inquiry and possibly state regulators. The response that limits damage is the same as the response that was owed in the first place: identify every affected customer from the firm's own records, preserve the broker's communications and files, review the supervision record honestly, and decide early whether to resolve customer claims before an arbitration panel assesses the supervision evidence. Terminating the broker ends the conduct; it does not end the firm's responsibility for what happened under its supervision.

When to involve a litigator

As soon as you learn that an investment your broker sold you does not appear on any firm statement. The six-year FINRA eligibility clock and the Texas deadlines run from the sale, the broker's records and the firm's exception reports are purged on schedules, and the issuer's assets move. A litigator can obtain the firm's supervision file in arbitration discovery and tell you whether the case is against the broker alone or the firm. Tina Wysk represents investors and firms in securities and investment disputes in FINRA arbitration and in Dallas state and federal courts.