In 2005, there were more than 5,100 broker / dealers registered with FINRA. By the end of 2010, there were less than 4,700 broker / dealers registered with FINRA. Since 2010, that number has declined even more with some well-known broker / dealers either having their licenses suspended, losing their licenses outright, or voluntarily withdrawing as members of FINRA. Many of these broker / dealers are no longer registered with FINRA due to their participation in the sale of millions of dollars in alternative investments such as Provident Royalties and Medical Capital. Given the recent state of real estate across the country and the growing number of arbitration claims and lawsuits involving investments in Real Estate Investment Trusts (“REITs”), it is likely that the number of broker / dealers registered with FINRA will continue to decline. As a result, attorneys’ representing investors in claims against broker / dealers on the verge of losing or withdrawing their FINRA registration are taking on the tactic of naming individuals in FINRA arbitrations under the theory of liability as “control persons.”
The law pertaining to “control person” liability varies significantly depending on the jurisdiction in which a case is venued. Generally, “control person” liability arises from the Securities Exchange Act of 1934, which provides that anyone who controls another liable under the Act shall be jointly and severally liable to the same extent of the controlled person unless the controlling person acts in good faith and did not directly or indirectly induce the unlawful activity. The definition of who is a “control person” is what varies among the jurisdictions although most courts have adopted either the “culpable participation” or “potential control” theories of control person liability.
Under the “culpable participation” theory of control-person liability, there must be a violation of the Securities Exchange Act by a controlled person and the controlling person must have exercised control over the controlled person and likewise participated in the unlawful activity. Under the “potential control” theory, the investor must prove not only a violation of the law, but likewise that the control person participated in the operation of the firm or the supervision of the controlled person and possessed the potential control over the specific transaction upon which the unlawful activity is predicated. The focus under this theory is on the alleged control person’s ability to control the alleged wrongdoing and liability is not simply imposed because the alleged control person holds a position of power within the broker / dealer firm. The potential control theory is the more common approach taken by the courts throughout the country, although the culpable participation theory of liability still prevails in the Second, Third and Fourth Circuits of the United States appellate courts.
Although lawyers representing investors are naming alleged control persons more often in FINRA arbitration claims, not all control person claims are successful before arbitration panels. In the past 12 months, the media has reported on several arbitrations in which the panels not only dismissed claims made by investors against alleged control persons, but awarded attorneys’ fees and costs to the alleged control persons for having to defend against such frivolous claims. Therefore, individuals who had nothing to do with an alleged unlawful transaction and likewise had no ability to control the others involved in the unlawful activity, have hope of successfully defending themselves against claims of control person liability by investors desperate to treat their financial advisors, broker / dealers and others as insurance policies for their unfortunate, yet fully-informed investment decisions.