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Lost Gains Cases: The Broker Appropriation Fact Pattern

Posted by Jack Duval

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Mar 6, 2020 6:59:31 AM

This post is the second in a series exploring Lost Gains securities arbitration cases.

In my previous post, I defined “Lost Gains” cases as those where the claimant has no investment loss and possibly even a small gain, but has not participated in the upside that was available in the market.

I identified two common fact patterns in those cases:[1]

  • Broker appropriation of investment gains, and;
  • Failure to follow instructions.

Here I will examine the broker appropriation fact pattern.

Broker Appropriation of Investment Gains

Broker appropriation of investment gains is the most common type of Lost Gains case, and I have been involved in a number of these.

In my experience, broker appropriation cases have a typical fact pattern involving a client who has, or should have, a long-term buy-and-hold approach to investing.  This is the vast majority of clients, since most clients don’t have the time or inclination to follow the markets closely, and (as will be discussed below) want to avoid short-term capital gains and the accompanying taxes.

The second part of the typical broker appropriation fact pattern is the purchase of high commission investment products such as: new issue closed-end funds, preferred stocks, UIT's, and other products with high up-front commissions, and their subsequent sale after a short period.  This purchase-and-sale pattern is repeated with the client’s cash (from securities sales) serving as an evergreen source of funds.

This behavior is a form of churning, but is not as obvious as the rapid fire buying and selling of stocks to generate commissions.

The difference is that the commissions are hidden inside the purchase price of the newly issued securities, so the client does not see them.  In theory, the client could discover these hidden commissions if she read the prospectus for each product that was sold to her.  In my experience, almost no client reads prospectuses, or if they do, they give up after reading one and never venture back, especially when they receive multiple prospectuses every month.

I’ve written about this as it relates to Complexity Risk, and how clients are highly unlikely to understand the language in a prospectus, even if they do read it.  Indeed, often the brokers selling complex investments don’t understand them.

Importantly, FINRA has been crystal clear that delivery of a prospectus does not cure an otherwise unsuitable recommendation and that there can be no disclaiming of any responsibilities under the suitability rule (by prospectus delivery or any other method).[2]

Multiple Fee Layers

In broker appropriation cases it is also not uncommon to see multiple fee layers.  That is, there will often be three discrete charges assessed against the client, including:

  • Commissions charged on the investment product(s) upon sale to the client (1 to 7 percent);
  • Annual internal management fees inside the product(s) sold (1 to 3 percent), and;
  • Annual account asset-based fees on the same assets (1 to 2 percent).

This “triple dipping” is especially pernicious.  Furthermore, it is, in my experience, never explicitly disclosed to the client.

In aggregate, these commissions, internal fees, and account asset-based fees can easily add up to three to seven percent (or more) of an account’s assets each year.

When this is the case, the abusive nature of the investment strategy becomes clear.[3]

Dividing (Potential) Gains

An example is instructive.  Assume a long-term oriented client has a 60/30/10 (stocks/bonds/cash) asset allocation and the expected returns are 10 percent for the stocks, three percent for the bonds, and one percent for the cash.  The blended expected return for the portfolio is thus seven percent.

If the aggregate annual commissions and fees are even three percent, they will consume 43 percent of the expected return, over time.

One way to think about this is that the client takes 100 percent of the risk, but will only get 57 percent of the return.  Of course, no one would knowingly accept such a strategy, and it cannot be said to be suitable.


Another issue in broker appropriation cases is the tax implications of short investment holding periods.  Short-term capital gains are taxed at the investor’s ordinary income rate.  For most investors, this rate is at or close to 40 percent (combining federal, state, and local taxes).[4]

Thus, the various government entities take 40 percent of these gains, despite (like the broker) taking none of the risk.  In the business, this is known as a bad trade.  While there can be instances where taking a short-term gain is the appropriate action, it should not be the norm for a long-term investor.

Going back to our seven percent blended return example, if the broker is taking three percent off the top through fees and commissions, and short-term capital gains taxes are consuming 40 percent of the remaining four percent gain, that leaves only 2.4 percent for the investor on a net, after-tax basis.

This 2.4 percent net, after-tax, return is roughly 34 percent of the original seven percent gross return.  A long-term investment strategy which can be reasonably expected to leave only 34 percent of potential returns for the client is abusive and cannot be said to be suitable.

In my next post, I will examine the failure to follow instructions fact pattern in Lost Gains cases.



[1]      Lost Gains Securities Arbitration Cases; Jack Duval; February 26, 2020.  Available at:; Accessed March 4, 2020.

[2]      See “Understanding FINRA Suitability Rule 2111 – Prospectus Delivery and Suitability”; Jack Duval; December 19, 2013.  Available at:;  Accessed February 18, 2020.

[3]      It is important to remember that under FINRA Rule 2111, an investment strategy recommended to a client must be suitable.  If the costs of a strategy will consume the lion’s share of the expected returns, then that strategy cannot be said to be suitable.

[4]      For instance, the 2020 federal short-term capital gains tax rate is 37 percent for a married couple, filing jointly, with over $622,051 in income.  Of course, state and local taxes would be added to this.  See “Capital Gains Tax Brackets 2019 and 2020:  What They are and Rates; Robert Farrington; The College Investor; March 1, 2020.  Available at:; Accessed March 4, 2020.

To learn more about suitability and fiduciary expert Jack Duval, click here.


Topics: Investment Suitability, Lost Gains Cases


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