The Securities Litigation Expert Blog

Lost Gains Cases: The Broker Appropriation Fact Pattern

Posted by Jack Duval

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.


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Topics: Investment Suitability, Lost Gains Cases

Lost Gains Securities Arbitration Cases

Posted by Jack Duval

Feb 26, 2020 9:15:30 AM

This post begins a series exploring Lost Gains securities arbitration cases.

A record eleven-year (and nearly uninterrupted) bull market has caused a decline in the number of FINRA securities arbitration claims.  In short, very few investors have lost money during this period.  Indeed, on a calendar year-end basis, the worst annual decline in the S&P 500 price index has been 6.25 percent, in 2018, and this would be even less if dividends were included.

Chart 1:  S&P 500 v. FINRA Annual Arbitration Claims[1]

jack duval accelerant finra suitability fiduciary expert - S&P 500 v. Arbitration Claims chart

In Chart 1, above, it can be seen that since the end of 2008, the S&P 500 price index (green line) has increased by 258 percent and the number of FINRA arbitration claims (red line) has decreased by 47 percent.  These trends are certainly well known to securities litigators.

After this record-setting bull market, one would suspect there would be some FINRA arbitration cases arising from customer accounts that did not appreciate, i.e. that the client lost out on the gains that were to be had.  However, these claims have not been prevalent.[2]

In this post, I will explore some reasons why Lost Gains cases are not more common, as well as the common types of Lost Gains cases that I have seen brought.

First, I need to make a distinction, most claimant’s attorneys make lost gains claims, but tend not to bring lost gains cases.

Lost Gains Claims

In a typical FINRA customer arbitration, the brokerage client has lost money in her account.  The claimant will usually plead damages from the principal (out-of-pocket) loss and what the account would have made if it had been invested suitably, this is known as the market-adjusted damage (“M-AD”).

The M-AD damage is a lost gain claim.  In essence, the claimant is saying, but for the unsuitable recommendations of the broker, her principal would, first, not have declined, and second, it would have appreciated.

Lost Gains Cases

Lost gains cases are different from lost gains claims because, in them, the claimant did not lose money on her investmentd.  That is, the account was profitable (or flat) over the period at issue.

Thus when a lost gains case if brought, it only contains the lost gain damage claim, there is no out-of-pocket loss claim.

Reticence to Bring Lost Gains Cases

I believe attorneys are reluctant to bring Lost Gains cases for a number of reasons, including the following:

First, the claimants are perceived to be unsympathetic.  They either didn't lose money or actually made money, just not as much as they could have but for the allegedly unsuitable investment recommendations or other violative behavior by the broker.

Second, because there are no out-of-pocket losses, the damage claim rests entirely upon the market-adjusted damages theory.  While panels frequently award market-adjusted damages, they are less common than awards of out-of-pocket losses.

Third, since Lost Gains cases are perceived to have the headwinds described above, they are typically only brought for large clients who can make seven- or eight-digit damage claims.  Since fewer investors have accounts large enough to support such claims (likely $10 million or more), this necessarily reduces the number of potential claims.

Despite these issues, lost gains cases are brought, and can be won.

Two Common Fact Patterns in Lost Gains Cases

Although there are many fact patterns that could give rise to a Lost Gains case, I want to discuss two types that I have had experience with.  Importantly, they both involve abusive behavior and are not of the sour grapes variety, i.e. where the market was up 20 percent and the client was only up 17.

Those types are:

  • Where the broker appropriates the investment gains for herself through abusive commissions and/or fee structures, (“broker appropriation”), and;
  • The failure of the broker to follow client instructions (“failure to follow”).

In my next post, I will explore these fact patterns in more detail.



[1]      Data obtained from Bloomberg and FINRA.

[2]      This is anecdotal as FINRA arbitration statistics do not track Lost Gains claims.  To get a sense of these case filings, I have surveyed a number of securities litigators across the country.


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


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Topics: Investment Suitability, Lost Gains Cases

SEC Regulation Best Interest - Lost Gains Cases

Posted by Jack Duval

Oct 4, 2018 9:12:46 AM

Accelerant SEC Regulation Best Interest - Logo 

This blog post continues my series on SEC Regulation Best Interest ("RBI") and the DOL Rule.

A "lost gains" case is one in which the claimant is asking for gains they believe they should have earned but did not.  These cases are different from the traditional securities litigation, where the claimant is asking for actual losses that have been incurred. 

Because the damage theory involves foregone gains instead of out-of-pocket losses, lost gains cases are generally considered to have a higher degree of difficulty.

On the face of it, this is common sense.  If an investor puts $10 million into an account and it declines to $5 million.  Most arbitrators can understand how the client has been damaged.  However, if the same investor puts $10 million into an account and six years later it's still worth $10 million, this is likely to generate less sympathy.

However, in my experience, lost gains cases can represent some of the most abusive fact patterns.

In the lost gains cases I have been involved with, the client’s accounts were essentially treated as an ATM for the Registered Representative.  These fact patterns involved extremely high fees charged for products that were churned into and out of the accounts at issue (as well as account-level fees).  The results were that the Registered Representative appropriated the growth of the accounts.

What growth wasn't appropriated was lost to the short-term holding of the investments.  That is, the investments were never invested as intended and allowed the time needed to generate returns.

In these cases, the clients were invested during strong bull markets but did not participate because of the abusive nature of the trading in their accounts.  

Six years later, they had experienced no growth while their Registered Representatives had made millions (literally).  In a bear market, such a pattern would exacerbate the decline in the accounts due to market forces and be discovered much sooner.  Bull markets hide these kinds of abuses, and the current historic bull market will surely be no exception.

However, what is different this time is the SEC’s pending Regulation Best Interest (“RBI”), which could be made law before the market declines.

Lost Gains Cases Under Regulation Best Interest

Under SEC Regulation Best Interest, lost gains cases should be easy.

This is because the burden of proof will be on the respondents to show their strategy was in the client's best interest and, as I've discussed in my RBI blog post series, they will need to produce contemporaneous evidence of their analyses showing how they came to that conclusion.[1]

In the fact pattern discussed above, this will be impossible.  Furthermore, a key defense will be removed.

Long-Term Time Horizons and the Risks of “Time Diversification”

In many securities litigations, a client's long-term time horizon is used as a defense to justify aggressive investments.  The logic is that the longer an investment is held, the less likely it is to generate a loss.  This is known as “time diversification”.  The problem with time diversification is that it is, at best, only partially correct, at worst it is a setup for disastrous portfolio decisions.[2]

The paradox of time diversification is that in order to benefit from higher returns (in equities usually) the client must increase their risk of interim declines in order to reduce their risk of a terminal loss.[3]

If RBI becomes law, the long-term time horizon will take on a different implication. 

Time Horizon, Fees, and Taxes under Regulation Best Interest

It has always been true that the longer a client's time horizon, the more important minimizing fees and avoiding taxes become.  This is not a matter of debate.  This is not something that reasonable minds can differ upon.  This is a 100 percent mathematical certainty.

Under RBI, this will become a key focal point.

If a client with a long-term time horizon is put into high fee products, charged high account-level fees, and/or churned into and out of commission product on a short-term basis, there is no way to argue it is in their best interest.

For instance, if fees can be reduced by one full percentage point per year, in 30 years time, the difference in terminal values will be about 30 percent.[4] 

For taxable accounts, the difference can be even more stark.  Annual after-tax returns of mutual funds often fall between one and two full percentage points compared to their pre-tax returns (the ones that are advertised).[5]

When combined, high expenses and tax-inefficient investing destroy investor returns.  In such a scenario, the broker, investment manager, and government all get paid before the investor, who is taking all the risk.[6]

Furthermore, the deleterious effects of high fees and taxes are completely return agnostic.  The return-destroying math holds true through all markets, good, bad, or sideways and compounds over time, to the investors disadvantage.

Costs Under Regulation Best Interest

As I have written about here, the SEC has recognized the importance of costs under RBI.[7]

While cost is not the only factor when evaluating an investment or investment strategy, it is one of the most important, if not the most important.  The customers tax status is also critical, which is why it is part of the profiling required under FINRA Rule 2111 and under RBI.[8]

RBI requires the Registered Representative undertake a fact specific analysis before the recommendation is made.  As mentioned above, this analysis will need to show why the recommended investment or strategy is in the best interest of the client compared to other investments offered by the firm.[9]

Any firm that can effectuate stock transactions for a client can purchase index ETFs for the same client (and most will have selling agreements with index mutual fund providers).  Thus, virtually every Broker-Dealer will be required to show why their investment or strategy  recommendation is better over the long-term than an index ETF or mutual fund on a net after-fee, after-tax basis (for their long-term investors).

This will present a significant hurdle for BDs because almost all equity investors are categorized as long-term investors, which is as it should be.[10]

Thus, all client accounts with a long-term time horizon will require an analysis that justifies the fees charged and taxes generated compared to low-fee, low-tax alternatives such as index ETFs and mutual funds.  In my opinion, this analysis will have to be rigorous, mathematical in nature, and be based on conservative assumptions.

Supervision to Avoid Lost Gains Cases

Supervisors will need to insure their Registered Representatives have undertaken a fact specific analysis for all their clients.  For those clients with a long-term time horizon, supervisors will need to insure the analyses comport to industry standards, reflect the client’s best interest given their particular facts and circumstances, and that the findings are reflected in the client’s portfolio.



[1]      Regulation Best Interest; Jack Duval; Available at:; Accessed October 4, 2018.

[2]      “The Myth of Time Diversification: Analysis, Application, and Incorrect New Account Forms”; Jack Duval; PIABA Bar Journal; Spring 2006; Available at:; Accessed October 4, 2018.

[3]       Statistically, the risk of interim declines is known as “first passage time probability”.

[4]       Reducing Attorney Fees (Investment Fees, that is); Jack Duval; Available at:; Accessed October 4, 2018.

[5]       Taxes – Another Killer of Attorney Returns; Jack Duval; Available at:; Accessed October 4, 2018.

[6]        Wealth Confiscation by Your Three Investment “Partners”; Jack Duval; Available at:; Accessed October 4, 2018.

[7]         SEC Regulation Best Interest – Reasonable Care; Jack Duval; Available at:; Accessed October 4, 2018.

[8]         Under RBI, the Retail Customer Investment Profile includes “tax status”; SEC Regulation Best Interest; Release No. 34-83062; File No. S7-07-18; 406.  Available at:; Accessed October 4, 2018.

[9]          A separate issue is investments not offered by the firm.  This will likely come up for advisors who only sell one type of product such as insurance.  This is a key difference between RBI and the fiduciary duty imposed upon Registered Investment Advisors.  An Investment Advisor's duties are not limited to the products their firm sells.  This is a non-trivial difference and a significant shortfall in RBI.

[10]        Short-term investors should not be invested in equities.  The received view is that only funds which can be held for five years or more should be invested in equities, although some authors suggest avoiding equities unless having a 12-year time horizon.


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


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Topics: supervision, FINRA Rule 2111 (Suitability), Investment Suitability, Suitability Expert, Securities Exchange Commission, Regulation Best Interest, Fact Specific Analysis, Lost Gains Cases

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