1.888.397.9867 •
Securities, Options and Futures Consultants

STOCK ISSUES

Securities and Investment Suitability ...

In recent years and particularly since the 2000 and 2008 market slides, the issue of investment suitability has become a central factor in a majority of investor claims of stock broker misconduct. Establishing and proving such claims requires of the attorney and his expert witness both an understanding of the rules and guidelines for broker actions and the insight and experience needed to identify and, if found, to measure and prove the unsuitability of a specific course of broker conduct in guiding the customer’s account.

Brokerage Accounts

Multiple layers of legal standards and industry rules have evolved in an effort to provide ample protection of investor interests in brokerage account situations.

At the federal level, the U.S. Securities and Exchange Commission holds that “When your broker recommends that you buy or sell a particular security, your broker must have a reasonable basis for believing that the recommendation is suitable for you.” The basis for this belief requires consideration of the client’s overall financial situation, investment objectives and tolerance for risk.

Over the years the New York Stock Exchange (NYSE), FINRA (Financial Industry Regulatory Authority), and other industry self-regulatory organizations have in times past adopted investment suitability rules to be observed by member firms and brokers. Again, a balance of objectives, needs and risk tolerance is stipulated.

At the level of individual brokerage firms, extensive and detailed Compliance Manuals provide guidance for brokers to keep within reasonable standards for suitable conduct. Individual states also have regulations governing acceptable broker procedures.

Such rules notwithstanding, the question of investment suitability, while often the basis of a claim, can be difficult to identify and quantify without a knowledge of industry practices and a factual understanding of the quality and performance of stocks and various industry products including derivatives. Experience in discovery and documentation of patterns of misconduct is also important. See Securities Rules & Regulations.

Types of Unsuitability

While the possibilities of stock broker misconduct might seem open-ended, experience has shown that the following situations can make strong cases for successful arbitration or litigation involving investment suitability:

Lack of Customer Knowledge – Has the broker sought adequate information about the investor’s fiscal means, financial goals and life circumstances? Do records exist to show that this knowledge was sought and documented?

Change of Customer Risk Profile – Was or should the broker have been aware of material changes in the investor profile including employment, age, health or lifestyle issues affecting risk tolerance and the needs for investment income or appreciation?

Lack of Diversity / Over-concentration – Were the investor’s funds placed in an appropriate mix of investments compatible with his or her preferences, needs and risk profile, not only as to individual companies purchased but also among diverse industrial sectors? A common situation during the 2000 market slide was an over-concentration in the technology sector, which suffered significant losses while other sectors such as financial and healthcare services actually fared quite well. The market as a whole, as measured by the S&P 500 with technology and telecommunications stocks removed, actually made money over 2000 to 2002. Similarly, was there an over-concentration in mortgage-backed securities or other collateralized obligations as the 2008 crisis came on?

Excessive Use of Margin – Were asset purchases made with margin and was the investor fully aware of the risks, costs (margin interest) and rules relating to such purchases? It is not uncommon that the basic costs of margin activity effectively preclude the possibility of reasonable investment return.

In analysing an individual brokerage account for suitability, it is often useful to evaluate the quality of a stock portfolio into which a customer has been invested. This can be done by assessing the overall ranking of the stocks into which the investor has been placed. Such tools as the S&P Earnings and Dividend Rankings, or other well-known stock quality ratings, can be employed for assessing the overall quality of the portfolio to assess if it is of average quality or better. Obviously, a portfolio with many below average quality stocks, or stocks which are not even ranked or rated, is likely to be persuasive with a trier-of-fact that little attention was paid to placing an unsophisticated investor into suitable investments, as is a sector analysis showing that most investments were placed into one or a small number of market sectors.

Investment Adviser Accounts

Just as unsuitable conduct can occur in recommendations in individual brokerage accounts, so too can it occur in recommendations by investment advisers. Here, two types of suitability can be identified: customer-specific suitability, which relates to whether the funds or investment products selected are suitable for the individual investor based on the suitability criteria above (the client's overall financial situation, investment objectives and tolerance for risk); and, reasonable basis suitability, which relates to whether the product is appropriate for any investor. An adviser is responsible for both types of suitability and must perform appropriate due diligence before offering the product to any customers through a recommended product list (reasonable basis suitability) or to any particular client (customer-specific suitability). This dual nature to suitability for the sale of investment products often confounds investment advisers who accept as true the claims of product sponsors, and then recommend the investment to most or all would-be clients without really determining if the product is suitable to either any investor or the particular client.

FINRA has promulgated a number of Notices to Members relating to these issues over the years, including when known as NASD. We recite some of the original notices here and suggest that the interested reader digest these and other notices in their current form.

• Notice 03-07 (NASD Reminds Members of Obligations When Selling Hedge Funds)
• Notice 03-71 (Non-Conventional Investments)
• Notice 05-26 (New Products)

These and other notices up through the current date are an excellent source of materials on what conduct is suitable and what is not.