Mixing Brokerage Sales and Lending

One of the more interesting recent cases is that of Scott v. Dime Savings Bank of New York, 1995 U.S. Dist. LEXIS 4009 (March 31, 1995, amended May 15, 1995). The case began in 1987 when Leon Scott went to a branch of Dime seeking a $5,000 loan for he and his mother. The loan was to be secured by the house owned by his mother. Scott claimed that the loan officer told him that she was pretty sure he could get the loan and that he could probably get a larger one if he wished. Subsequently he and his mother borrowed $100,000 from Dime. Prior to taking out the loan Scott received a letter on Dime stationary signed by a Dime employee who called himself a "Financial Services Consultant" discusing several investment opportunities. He also had a conversation with Sebastian Bulfamente, a dual employee of Dime and a company called Invest. Invest was a firm which contracted with Dime to provide brokerage services. Bulfamente had a desk inside the branch. Scott also had a conversation with George Harrienger, an Invest Manager, who Scott claimed told him that he could obtain investment returns of 20-25% by investing the proceeds of the loan.

Borrower Uses Loan Proceeds to Open Investment Account

Two weeks after closing on the loan Scott opened a trading account with Invest. It was originally opened as a cash account but later changed to a margin account. In a margin account, an investor can leverage his or her available cash by borrowing funds from the broker to purchase securities. The margin account carries with it a substantially higher risk of loss due to the fact that price declines in the purchased securities will result in "margin calls" where the investor must put up additional cash to cover the price decline. If the investor does not have the cash then the securities are liquidated and the proceeds and the investor's cash are applied to cover the amounts stil owing the broker. Scott invested approximately $52,000 of the loan proceeds in the account. Unfortunately, the entire account was wiped out in the stock market crash of October, 1987. In 1988 Scott brought a pro se action against Invest and Dime on behalf of himself and his 97 year old mother.

The Lender Liability Claims

The Scott's claims essentially fell into three traditional lender liability areas: fraud, breach of fiduciary duty and negligence. After trial, the jury returned a verdict in favor of the Scotts on the breach of fiduciary duty and negligence claims but not on the fraud claims.

Breach of Fiduciary Duty

Dime filed a motion to set aside the jury verdict. The court analyzed the motion by first examining the evidence supporting the claim of breach of fiduciary duty and found that there was ample evidence to support the verdict. The traditional lender-borrower relationship is not a fiduciary one. The court said that the jury could have found sufficient evidence that the relationship betweeen Dime and the Scotts went way beyond the typical lender-borrower relationship. This was shown by the way the bank lent the Scotts more money than they were originally seeking and then used promotional materials to convince Scott to invest the loan proceeds. The court also noted that securities brokers owe a fiduciary duty to their customers and that the duty which Invest had to the Scotts could be imputed to Dime on the basis of the dual employee status that the brokers had.


The court then went on to examine the claim of negligence. The court noted that the Invest broker primarily responsible for the account testified that Invest had made no investigation into the suitability of a margin account for Scott. Such an investigation was necessary to determine if Scott had the requisite financial sophistication to understand the risk which is inherent to a margin account. The court found that this in and of itself was sufficient evidence for the jury to have reached the conclusion that Dime, acting through its agent Invest, had acted negligently.

Court Holding

The end result of the court's analysis was that both jury findings were upheld. Fortunately for Dime, the jury also determined that the Scotts shared a portion of the responsibility for what ultimately occurred. For that reason the Scotts ended up with only a setoff of $36,000 against the entire claim of Dime arising under the loan. Dime did, however, agree that it would grant Mrs. Scott a life tenancy in the house and would not seek to exercise its foreclosure rights until she died.

Lesson for Lenders

This case highlights what can become a major problem area for lenders as they move into non-traditional financial services businesses. The financial rewards for doing so may be greater than simply making a loan but the legal risks involved are greater as well. Lenders must act proactively to insure that these legal risks are minimized if they are to reap the potential benefits.

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Copyright (C) 1995, Gerald Blanchard
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