Allegations of unauthorized trading claims present significant risks for investment brokers and brokerage firms. In addition to investor arbitration with the Financial Industry Regulatory Authority (FINRA), brokers and brokerage firms can also face U.S. Securities and Exchange Commission (SEC) investigations and enforcement actions. While these enforcement actions carry the potential for administrative and civil penalties in most cases, the SEC also refers brokers and brokerage firms to the U.S. Department of Justice (DOJ) for criminal prosecution when warranted.

As a result, brokers and brokerage firms must have an accurate understanding of what constitutes an unauthorized trade. It is also critical that brokerage firms adopt—and that brokers follow—internal policies and procedures designed to prevent unauthorized transactions or trading. While unauthorized trading can be dangerous, it can also be avoided. Additionally, with documented policies and procedures in place, brokers and brokerage firms will be able to successfully defend against misguided allegations of unauthorized transactions or trading in many cases.

“Brokers and brokerage firms need to be very careful to comply with the SEC’s and FINRA’s rules regarding trading authorization. Executing unauthorized trades is considered investor fraud regardless of the outcome, as investors are entitled to make informed decisions about their investment strategies. When unauthorized trades lead to investor losses, brokers and brokerage firms can face liability in FINRA arbitration, cease-and-desist orders from the SEC, suspension or debarment, and other penalties.” – Dr. Nick Oberheiden, Founding Attorney of Oberheiden P.C.

Understanding when a trade is considered “unauthorized” is crucial for both maintaining compliance and defending against investment fraud allegations. While brokers and brokerage firms can secure customer authorization in multiple ways, there are also various circumstances in which executing trades can exceed brokers’ authority. So, when is a trade considered “unauthorized”?

3 Sources of Authority Governing Trade Authorization

There are three primary sources of authority that govern trading authorization. Brokers and brokerage firms must address all three sources, as they each approach the requirement to obtain a customer authorization in different ways.

1. SEC Rule 10b-5

The first source of authority governing trade authorization is SEC Rule 10b-5. Most brokers and brokerage firms will be familiar with SEC Rule 10b-5, as it establishes the general obligation for participants in the securities industry to avoid defrauding and deceiving investors. This obligation extends to prohibiting an unauthorized trading claim, as failing to obtain authorization amounts to an omission of material fact in relation to the purchase or sale of a security. SEC 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 . . . [t]o make any untrue statement of a material fact or to omit to state a material fact . . . [or] 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.”

Broadly, customers are entitled to the confidential or sensitive information they need to make informed investment decisions. Trading without a customer’s authorization necessarily involves a lack of material information. When facing allegations of unauthorized trading under SEC Rule 10b-5, asserting a successful defense generally involves demonstrating that the customer’s understanding is misguided and that the customer in fact provided authorization, even if unknowingly, after gaining access to the necessary material information.

2. SEC Regulation Best Interest (Reg BI)

Adopted in 2019, the SEC’s Regulation Best Interest (Reg BI) further enhanced the protections afforded to investors in the broker-customer relationship. As the SEC explains, it adopted REG BI as part of “a package of rulemakings and interpretations designed to enhance the quality and transparency of retail investors’ relationships with investment advisers and broker-dealers, bringing the legal requirements and mandated disclosures in line with reasonable investor expectations, while preserving access (in terms of choice and cost) to a variety of investment services and products.”

Reg BI has four “component obligations,” all of which touch on the topic of trading authorization in some way. These are Disclosure, Care, Conflict of Interest, and Compliance.

Disclosure

Under Reg BI’s Disclosure Obligation, brokers and brokerage firms must provide investors “in writing, full and fair disclosure of all material facts relating to the scope and terms of the relationship with the retail customer and all material facts relating to conflicts of interest that are associated with the recommendation.” Whether due to a conflict of interest or otherwise, making a trade without a customer’s authorization will involve some form of disclosure violation in most, if not virtually all, cases.

Care

The Care Obligation under Reg BI requires that brokers and brokerage firms “have a reasonable basis to believe that each recommendation or series of recommendations made is in the best interest of the particular retail customer and does not place their financial or other interests ahead of the interest of the retail customer.” It also requires brokers and brokerage firms to exercise the care required to maintain compliance with Reg BI’s other requirements. In the unauthorized trading context, the Care Obligation often, though not exclusively, comes into play when brokers execute a series of transactions. Customers will frequently assert that they did not provide authorization for the full series (particularly when the series leads to investment losses), and they will allege that executing the series of transactions violated their broker’s or brokerage firm’s duty of care.

Conflict of Interest

Conflict-of-interest allegations are also common in unauthorized trading cases. In FINRA arbitration, for example, investors’ lawyers will often allege that brokers executed trades without their customers’ authorization to generate additional fees or commissions. Such a conflict of interest may violate not only Reg BI but SEC Rule 10b-5 and various other securities laws and regulations as well.

Compliance

Under Reg BI’s Compliance Obligation, “a broker-dealer must establish, maintain and enforce written policies and procedures reasonably designed to achieve compliance with Reg BI, including the Conflict of Interest Obligation.” Failure to adopt, implement, and enforce an effective compliance program can lead to unauthorized trading (among other violations). It can also lead to inadequate documentation of customer authorization, which can potentially have the same legal implications as failing to secure authorization. FINRA Rules require a brokerage firm to adopt comprehensive compliance policies and procedures as well; and, under FINRA Rule 3120, a brokerage firm must adopt a documented supervisory control system that is designed to prevent unauthorized trading (among other violations).

3. FINRA Rule 3260

FINRA Rule 3260 addresses unauthorized trading from two perspectives: (i) it prohibits brokers and brokerage firms from engaging in “excessive” transactions; and, (ii) it requires adequate controls regarding trading in customers’ discretionary accounts.

Critically, FINRA Rule 3260 also acknowledges the “price and time” exception to the customer authorization requirement. Under this exception, brokers and brokerage firms have “discretion as to the price at which or the time when an order . . . shall be executed . . . until the end of the business day on which the customer granted such discretion, absent a specific, written contrary indication signed and dated by the customer.” This exception protects brokers and brokerage firms from facing liability when they are unable to execute ordered trades immediately and can serve as a strong defense against relevant allegations of unauthorized trading.

In addition, FINRA’s Regulatory Notice 08-18 provides recommendations regarding “Sound Practices” for preventing unauthorized trading of proprietary securities products. These “Sound Practices” range from implementing mandatory vacation policies to conducting heightened scrutiny of red flags such as unusual patterns of cancellations or corrections. While adhering to the recommendations in Regulatory Notice 08-18 won’t necessarily protect a brokerage firm from liability (FINRA states that the Notice “is not an exhaustive list, and is not intended to create a safe harbor”), compliance can mitigate a firm's risk—and it will provide support for the firm’s defense strategies in many cases.

When Isn’t a Trade Considered “Unauthorized”?

Now that we’ve covered the rules governing trading authorization, when isn’t a trade considered “unauthorized”? Even in the absence of express written authorization for a specific trade, adequate authorization can still exist due to various circumstances. With this in mind, some examples of potential defenses to unauthorized trading allegations include:

• Investor Authorization – When an investor provides express authorization after receiving due disclosure of all material information (including any conflicts of interest), the investor’s authorization stands unless and until revoked.
• Discretionary Account Trading – Once an investor opens a discretionary account (subject to compliance with all relevant disclosure obligations), trades executed in line with the firm’s discretionary authority will be deemed authorized.
• Margin Account Trading – With due disclosure, brokers and brokerage firms will also have the authorization to conduct discretionary trades in a customer’s margin account.
• Adequate Compliance Policies and Procedures – Brokerage firms can often defend against unauthorized trading allegations by demonstrating that rogue brokers have engaged in misconduct beyond the firm’s oversight and despite the firm’s adoption of adequate compliance policies and procedures.
• Adequate Supervisory Controls – When it comes to preventing unauthorized trades, compliance and supervisory controls go hand-in-hand. Demonstrating that a firm has adequate supervisory controls can assist with defending against unauthorized trading allegations as well.