Investor's Watchdog.com: Stock, finance and investment protection for investors

Unauthorized trading is rampant.  If a broker gets caught doing it, even once, he’ll likely be fired and maybe barred from the securities industry.  So, why do they get away with it?  Two reasons.

First, the odds are that at least half of all unauthorized trades will prove to be profitable.  Stocks move up and stocks move down.  If a broker buys a stock without permission, he is buying a stock that he expects to rise in price.  If he guesses correctly, and the stock goes up, when you call him to ask about the unauthorized trade, he will explain that reversing the trade will mean giving up the profit.  If, though, you “ratify” the trade (approving it after-the-fact), he will sell the stock and you get to keep the profit.  Keep the profit or give up the profit.  Which would you choose?  And so we see why at least half of all unauthorized trading goes unreported.

Brokers get away with the remainder of the universe of unauthorized trades by hoodwinking their customers in a variety of ways.  Oftentimes the broker convinces the customer after-the-fact that the trade was wise and asks the customer to take a “wait-and-see approach.”  If the stock goes up, everyone is happy.  If not, the customer, by ratifying the trade, has given the broker an alibi.  If the customer complains later that the trade was unauthorized, the broker will deny it, and any subsequent arbitration action will be nothing more than a swearing contest.  FINRA (the broker’s trade organization) provides the arbitration forum.  The odds are therefore stacked against the customer.   

Other times, the broker will simply draw on his personal relationship (if he has one) with the customer, asking the customer not to report the unauthorized trade because it will cost the broker his job.  Oftentimes, the broker will agree to pay personally whatever loss the customer sustains because of the unauthorized trade.  If the customer agrees, the broker has ensured deniability.  If he reneges on the promise to make good the customer’s losses, the broker will simply deny the unauthorized trade and the promise to make up the losses.  The arbitration panel (on which one of the three arbitrators will be currently employed in the securities industry) will have a simple swearing contest.  Not surprisingly, brokers usually win swearing contests.

In our next post on this topic, we will cover the best way for a customer to respond to an unauthorized trade.