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SUITABILITY
EXCEPTION REPORTS
SUPERVISION
The Benefits of
Diversification (Charts) Articles
Financial Advisers,
including stockbrokers and financial planners, must abide by the suitability
rules imposed by the National Association of Securities Dealers (NASD) and
the New York Stock Exchange (NYSE). Consider these obligations in the
event that your clients have suffered losses at the hands of a financial
adviser. According to NYSE 405 and NASD Conduct Rule 2310, an
investment recommendation bust be both suitable for a client and have a
reasonable basis.
Although most broker dealer respondents will argue that there is no private
right of action for violation of NASD rules, violations of those rules may
be considered relevant for purposes of Rule 10b-5 unsuitability
claims. GMS Group, LLC v. Benderson, 326 F.3d 75,82 (2nd. Cir.
2003). To establish a claim under Rule 10b-5 for unsuitability, a
claimant must prove (1) the broker recommended (or in the case of a
discretionary account purchased securities which are unsuitable in light of
the investor's objectives; (2) the broker recommended or purchased the
securities with an intent to defraud or with reckless disregard for the
investor's interests; and (3) the broker exercised control over the
investor's account. O' Connor v. R.F.Lafferty & Co., Inc., 965
F.2d 893, 898 (10th Cir.1992). Recklessness is defined as
"conduct that is an extreme departure from the standards of ordinary
care, and which presents a danger of misleading buyers or sellers that is
either known to the defendant or is so obvious that the actor must have been
aware of it."For further support of items 2
& 3, please see Churning Analysis section i.e. scienter and control (see
discussion of de facto control).
The cornerstones of a
more common suitability claim in arbitration, however, are NASD Rule 2310
and NYSE Rule 405. Violations of these industry rules and practices
give rise to a common law claim for negligence; NASD rules evidence the
standard of care a member should achieve. Further, these rules set out
the general standards of industry conduct and are evidence of the code of
procedure by which broker/dealers must abide in dealing with their
customers.
Respondents' "recommendation[s]
must be judged in light of the information available to [them] after
reasonable inquiry as to [Claimants'} situation at the time of the
recommendation[s] and not by reference to subsequent events." Id.
(emphasis added). Section 15(b) (10) Securities Exchange Act of 1934,
Exchange Act Release No. 8135, 1967 SEC Lexis 64 (July 27, 1967).
RULE 2310 PROVIDES IN
RELEVANT PART:
2310. Recommendations
to Customers (Suitability)
(a) In recommending to a
customer the purchase, sale or exchange of any security, a member should
have reasonable grounds for believing that the recommendation is suitable
for such customer upon the facts, if any, disclosed by such customer as to
his other security holdings and as to his financial situation and needs.
(b) Prior to the
execution of a transaction recommended to a non-institutional customer,
other than those with customers where investments are limited to
money-market mutual funds, a member shall make every effort to obtain
information concerning:
i. The customer's financial status;
ii. The customers tax status;
iii. The customer's investment objectives;
iv. Such other information used or considered to be reasonable by such
member or registered representative in making recommendations to the
customer (age and health for example).
The suitability of the
investor must be, by industry rule and written procedure of at least every
major wire house firm, established before the account makes its first
investment.
In 2010, FINRA has
consolidated the rules of the NYSE and NASD into new FINRA Conduct Rules:
Rule 2310 has been replaced with new FINRA Rule 2111 - The new rule adds the
concept of a strategy as opposed to merely making a securities
recommendation. It also breaks down suitability into three main
obligations. Reasonable basis (firms must have a reasonable basis to
believe, based on adequate due diligence, that a recommendation is suitable
at least for some investors), customer specific (firms must have reasonable
grounds to believe a recommendation is suitable for the specific investor
and that a firm refrain for recommending purchases beyond the customer's
capability) and quantitative (firms or associated persons who have actual or
de facto control over a customer account must have a reasonable basis to
believe the number of recommended transactions within a certain period is
not excessive and unsuitable for the customer when taken together, in light
of the customer's profile). Clearly the new suitability rules have
strengthened significance in promoting fair dealing with customers, ethical
sales practices as well as encouraging just and equitable principles of
trade and communications with the public.
Rule 2111 also addresses changes regarding the gathering and use of
information as part of the suitability analysis. For instance, the
information that must be analyzed in determining whether a recommendation is
suitable would include not only information disclosed by the customer in
response to reasonable due diligence in obtaining it, but also information
about the customer that is "known by the member or associated person".
This would include information about the client's age, other investments,
financial situation and needs, tax status, investment objectives, investment
experience, investment time horizon, liquidity needs and risk tolerance, as
well as any other information the member or associated person considers to
be reasonable in making recommendations. Finally, Rule 2111 prohibits
a member or associated person from recommending a transaction or investment
strategy involving a security or securities or the continuing purchase of a
security or securities or use of an investment strategy involving a security
or securities if such recommendation is inconsistent with the reasonable
expectation that the customer has the financial ability to meet such a
commitment.
Rule 405 of the NYSE (the "know your customer rule") has now been replaced
by FINRA Rule 2090, capturing the main ethical standard of the former rule.
Firms would be required to use due diligence, in regard to the opening and
maintenance of every account, to know (and retain) the essential facts concerning every
customer (including the customer's financial profile and investment
objectives or policy), and concerning the authority of each person acting on
behalf of such customer This information may be used to aid the firm in
all aspects of the customer/broker relationship, including, among other
things, determining whether to approve the account, where to assign the
account, whether to extend margin (and the extent thereof) and whether the
customer has the financial ability to pay for transactions. The
obligation arises at the beginning of the customer/broker relationship and
does not depend on whether a recommendation has been made.
FINRA Notices (like #09-25) and other public pronouncements have
stated that a similar know-your-customer obligation is embedded in the
just and equitable principles of NASD Rule 2110 (Now FINRA Rule 2010).
To put this more simply,
after "reasonable basis suitability" had been established, one could compare the suitability obligation of the broker to the customer,
to a 3 legged stool:
1. Background
A. Age, marital status, number of dependents, health, educational experience
B. Professional experience and employment
C. Prior investment experience/trading history, including other
current investments
D. Time Horizon and years to retirement
2. Financial Considerations
A. Net worth (exclusive of home)
B. Liquid net worth (cash and marketable securities)
C. Concentration of a security or industry sector as a percentage of
liquid net worth, average net equity or total assets under
management/control.
D. Income
E. Source, i.e. where the money originally came from and whether it is
replaceable
F. Need for liquidity*
G. History of withdrawals (if any)
H. Tax bracket (present and historical), tax consequences of broker's
trading activity
* Liquidity is the ability to convert an asset into cash immediately, without any
significant loss of principal. Marketability assesses whether there is
a readily available marketplace to buy, sell or exchange an
asset.
3. Risk Tolerance & Risk Capacity
A. Goals and time horizon
B. Investment objectives
C. Communications with broker (written and oral)
D. Mitigation by the customer
Risk tolerance or risk attitude measures the clients abstract ability to
handle risk emotionally. It evaluates the clients willingness to take
on the risk of receiving lower returns in exchange for the possibility of
earning higher ones. This is a risk vs. reward analysis. It is usually
measured in terms of the client being conservative, moderate or
aggressive. It is a good idea to have the client sign a portfolio
policy statement such as declaring for example "the worst decline of my
portfolio from top to bottom is a $150,000 loss on my $1,000,000
portfolio". In any risk profile questionnaire, always use dollars
as opposed to percentages.
Risk Capacity is a measure of a clients ability to sustain risk,
financially. In a practical financial planning context, risk capacity
is measured in terms of a clients asset base, withdrawals, liquidity needs
and time horizon. By getting to know the clients assets, age,
retirement date, withdrawals needed and social security expected or
existing, it is possible to gain a reasonably accurate measure of what a
client will tolerate in terms of risk.
While risk capacity is about the client's financial ability to sustain
underperformance in pursuit of higher returns, risk tolerance measures the
clients willingness to enter into such a trade-off in the first
place.
If a broker makes an
unsuitable recommendation, violating any one of the 3 legs listed above, the
stool falls. Underlying this 3-legged
stool, there are a number of other elements to be aware of.
A broker just refrain from making an unsuitable recommendation even if the
customer expressed an interest in engaging in the inappropriate trade or
asked the broker to make the recommendation. See, e.g.,Dane S.
Faber,Exchange Act Release No. 49216, 2004 SEC LEXIS 277, at *23-24
(Feb. 10, 2004).
4. Additional
Considerations:
A. Was adequate information provided? Did it include full and
fair disclosure of all risks and conflicts of interest along with the
provision of written materials prior to making the investment?
B.
Did the
client have the ability to understand the investment, based on the
investor's background, education and past investment experience? The
fact that a client previously held investments does not make that person a
sophisticated investor. "[Investor] is not a sophisticated
investor. Although she has owned securities for many years, she has
always relied on the investment acumen of her father and other
advisors. She expected [broker] to manage her account and make
investment decisions on her behalf." Thropp v. Bache Halsey
Stuart Shields, Inc., 650 F.2d 817-819 (6th Cir. 1981). What
factors do brokerage firm counsel typically raise as to
sophistication? One typically considers wealth, education,
professional status, investment experience and business background.
However, the NASD has made it clear that wealth is not necessarily an
indicator of sophistication, particularly if the value of the investor's
home constitutes a significant percentage of the customer's net worth.
Likewise, one must consider the scope of sophistication, such that an
investor may be sophisticated in some areas of investing, and
unsophisticated in others. Additionally, advanced education degrees do
not automatically establish that a customer is a sophisticated
investor.
It is helpful to compare the NASD's rule with respect to options
recommendations to the NASD's rule with respect to non-options
transactions. for options recommendations, the NASD requires that the
financial advisor have a reasonable basis for believing, at the time of
making the recommendation, that the customer has such knowledge and
experience in financial matters that he or she may reasonably be expected to
be capable of evaluating the risks of the recommended options
transaction. By comparison, for non-options recommendations no such
knowledge or sophistication requirement exists. Instead, the NASD
requires that the (non-options) recommendation be suitable based upon the
customer's other security holdings as well as his or her financial situation
and needs.
Thus, in the context of a simple negligence action for recommending an
unsuitable investment, the sophistication defense is not legitimate.
Regulatory decisions support this view. For example, in James Chase,
Exchange Act Rel. No. 47476 (Mar. 10, 2003), 79 SEC Docket 2892, 2897, the
SEC concluded that the mere disclosure of risks did not satisfy the
suitability duty. The SEC stated that not only must the customer be
sufficiently sophisticated to fully understand the risks involved with the
investment, the customer also must be able to bear those risks. Of
course, the ability to bear risks, standing alone, does not satisfy the
suitability rule. In Re. Dambro 51 S.E.C. 513, 517 (1993).
Brokerage firm counsel frequently explore investor sophistication in the
context of asserting affirmative defenses. That is because several
courts have held that where a sophisticated investor regularly receives
information concerning the transactions in his or her account and fails
to object within a reasonable time (or the period specified by
contract), one may be barred by the doctrines of waiver, estoppel, laches,
or ratification from asserting a claim e.g., Costello v. Oppenheimer &
Co., Inc. 711 F.2d 1361, 1370 (7th Cir. 1983). However, the threshold
for asserting these defenses is relatively high. For example, to show
that an investor ratified an action, such as to preclude broker liability,
it must be clear from all the circumstances that the customer intended to
adopt the trade as his or her own. Knowledge of the pertinent facts
and the clear intent to approve the unauthorized action are preconditions of
ratification. Van Syckle v. C.L. King & Associates, Inc. 822
F.Supp. 98 104 (N.D.N.Y. 1993). Consequently, the mere receipt of
statements is not dispositive, as the ultimate determination depends also on
the customer's sophistication and the complexity of the transaction at
issue.
Even a seemingly sophisticated investor will not be barred from bringing a
claim if the information he received from his broker was faulty. For
example, a corporate vice-president with a degree in business administration
who opened an options trading account was not barred by waiver, estoppel,
laches or ratification from recovering losses due to the fact that he had
protested several of the transactions, and that the confirmations often were
late or inaccurate. Costello v. Oppenheimer & Co., Inc. 711 F.2d
1361, 1370 7th Cir. 1983. Likewise, "the disparity in
sophistication between the brokerage firm and its customer" is relevant
when considering the application of any written notice requirement.
Modern Settings, Inc. v. Prudential-Bache Securities, Inc., 936 F.2d 640,
645-946 (2d Cir. 1991) (emphasis added).
The NASD cautions that there is no substitute for a suitability analysis,
and "accredited" status under Regulation D of the Securities Act
of 1933 is not necessarily an indicator of sophistication, particularly if
the value of the investor's home constitutes a significant percentage of his
or her net wealth.
C. Did the broker make a reasonable effort to
meet the clients objectives, based on information provided by the
client? For example, a client with Moderate Growth as an
investment objective might be unsuitably implemented if 100% of his
portfolio was placed in equities, with no cushion of cash and fixed income
(bonds) to ease volatility and soften fluctuations. Benjamin Graham in
his book The Intelligent Investor wrote, "An investment operation is
one which upon thorough analysis promises safety of principal and an
adequate return". This illustrates that a 100% stock
portfolio is simply too aggressive for a "moderate growth"
investor. There is far too much risk and volatility to expect any
measure of "safety of principal" in that
scenario. That's what Benjamin Graham meant by an "adequate
return" since fixed income and cash would reduce the yield. in a
more balanced portfolio.
D. Was the purchase over-concentrated related
to the client's portfolio, total net worth, and liquid net worth?
Concentration, the antithesis of the well-diversified portfolio, is central
to any suitability determination. The
SEC and self-regulatory bodies have generally found recommendations to
build a highly concentrated portfolio an unsuitable strategy. See Clintom
H. Holland, Jr. Exchange Act Rel. No. 36621,52 S.E.C. 562, 566 (Dec.
21,1995) (The concentration of high risk and speculative securities [in the
customer's] account...was not suitable."), aff'd 105 F.3d 665 (9th
Cir.1997); Daniel R. Howard, No. C11970032, 2000 NASD Discip. LEXIS
16. at *19 (NASD Nov.16, 2000) ("Howard's recommendations also led to
an undue concentration of these speculative securities [approximately 90
percent of the customer's holdings], making the recommendations particularly
unsuitable."). Also see Stephen Thorlief Rangen, 52 S.E.C.
1304 (1997); Gordon Scott Venters, 51 S.E.C. 292 (1993), James b.
Chase, 79 S.E.C. 2251 (2003) William J. Lucadamo, 1997 WL 1121318
(N.A.S.D.R. 1997; Bruce Martin Miller, 1998 WL 141592 (N.Y.\S.E.
1998) ("The concentration of high risk and speculative securities [in
the customer's] account ... was not suitable."aff'd. 105 F.3d
665 (9th Cir. 1997) (table format).
E.. Was the suitability based solely on the
clients net worth? Remember, a customers specific level of assets does
not, by itself, satisfy a member's obligations under the suitability
rule. See Patrick G. Keel, 51 S.E.C. 282,286 n.14 (1993)
("[E]vidence of wealth, as we have stated previously, is not an
indicator of suitability."); Arthur J. Lewis, 50 S.E.D. 747, 749
(1991) ("The fact that a customer...may be wealthy does not provide a
basis for recommending risky investments"). ("[s]uitability
is determined by the appropriateness of the investment for the investor, not
simply whether the salesman believes that the investor can afford to lose
the money invested.") David Joseph Dambro, 51 S.E.C. 513,517
(1993).
F. Special additional care must be taken when
telemarketing to insure that securities being recommended, are suitable and,
the customer has adequate financial means to invest in these securities, and
to sustain any loss.
G. Similar rules exist in the Rules of the New
York Stock Exchange (the "NYSE") and the American Stock Exchange
(the "AMEX"). However, the NYSE (Rule 405) and the AMEX
(Rule 411) rules extend beyond "recommendations", and apply to all
purchases and sales of securities, not just those recommended, thereby
increasing the registered representative's obligation to know and inquire
into their customer's investment goals, financial objectives, risk tolerance
and past investment history. Even the NASD agreed in Special Notice to
Members 96-32 (May 9, 1996). It stated, "the know your customer
requirement in the Rules of Fair Practice requires a careful review of the
appropriateness of transactions in low-priced, speculative securities, whether
solicited or unsolicited".
H. "Over the years, NYSE Rule 405 the
[Know Your Customer Rule] has evolved to include a suitability
obligation, especially when a broker recommends a security to a
customer". Norman S. Poser - Article - "Civil Liability for
Unsuitable Recommendations" in The Review of Securities &
Commodities Regulation - 1986- vol. 19, p. 67 published by Standard and
Poors. In the Fourth Edition, of his book - Broker-Dealer
Law and Regulation, 2007 at page
19-19, Mr. Poser develops the point even further. He states, "Although
the [NYSE know-your-customer] rule was originally designed to protect stock
exchange members from dishonest or insolvent customers, it is today also
regarded as protecting investors from being induced to purchase securities
whose risks they can ill afford." Norman S. Poser - LLB. Harvard
Law School - Professor of Law - Brooklyn Law School.
5. Recommendations - Suitability is always determined at the time
of the recommendation! NYSE Rule 472, Communications With The
Public, Supplementary Material in the NYSE Manual 472.40 titled Specific
Standards for Communications with the Public, under (1) Recommendations: "A
recommendation must have a basis which can be substantiated as reasonable.
An investor should have access to available data in order to make an
intelligent investment decision. Therefore, information supporting a
recommendation must be provided or offered. For example, disclosures, in a
given context, which satisfies Rule 472.40(2) may not necessarily satisfy
the provision of Rule 472.30(1) where additional facts would be material to
the customer or reader."
Interpretive Memo No. 90-5, issued in August 1990, provides that "for
purposes of these standards, the term 'recommendation' includes any advice,
suggestion or other statement, written or oral, that is intended, or can
reasonably be expected, to influence a customer to purchase, sell or hold
a
security". For a broker to "recommend", then, that a
customer should "stay the course" or "hold" their position
in a declining market, that recommendation must be backed up with all
available reasonable
disclosures. Those disclosures would require him to discuss viable
alternatives with the client, such as protective hedges (puts, stop losses
or custom collars) or taking the money
off the table. To not discuss all viable alternatives with the client
is to omit material information....and in the securities industry, omission
of material facts is fraud. The recommendation, not to
sell, becomes unsuitable when constructive fraud is exhibited by the
broker's not disclosing other alternatives as a reasonable basis for the
recommendation. Further, he breaches his fiduciary duty by making
unsuitable recommendations and not disclosing all material facts to the
client.
If the sale was made in California by a
broker dealer which is not a member of the NYSE (many smaller firms are not), then you can use
Small v. Fritz 30 CAl. 4th 167, 65 p.3d 1255, 132 Cal. REPTR. 2d 490
(2003). The court held that California law allows persons
wrongfully induced to hold stock instead of selling it to pursue a cause of
action for fraud or negligent misrepresentation. The appeals court
said that misrepresentations to forego selling stock is fraud or negligent
misrepresentation if the stockholders can make a bona fide showing of actual
reliance upon the misrepresentation. In finding liability for such
torts, it is not necessary that the perpetrator had face-to-face or personal
communication with the plaintiff. Fraud can be perpetrated by any
means of communication intended to reach and influence the
recipient. Further, the court said that the tort of negligent
misrepresentation does not require scienter or intent to defraud. It
encompasses the assertion, as a fact, or that which is not true, by one who
has no reasonable ground for believing it to be true. Forbearance, the
decision not to exercise a right or power, is sufficient consideration to
support a contract and to overcome the statute of frauds. It is also
sufficient to fulfill the element of reliance necessary to sustain a cause
of action for fraud or negligent misrepresentation. The petition for
review raised only a single issue: "Should the tort of common law
fraud (including negligent misrepresentation) be expanded to permit suits by
those who claim that alleged misstatements by defendants induced them not to
buy or sell securities?" The court concluded that California law
should allow a holder's action for fraud or negligent
misrepresentation since California law has long acknowledged that if the
effect of a misrepresentation is to induce forbearance-to induce persons not
to take action-and those persons are damaged as a result, they have a cause
of action for fraud or misrepresentation. The court was not persuaded
to create an exception to this rule when the forbearance is to refrain
from selling stock. The court said that this conclusion does not expand
the tort of common law fraud, but simply applies long-established legal
principles to the factual setting of misrepresentations that induce
stockholders to hold on to their stock.
In NASD Notice to Members 96-60 (issued to clarify and
supplement "NTM" 96-32) - "However, a broad range of
circumstances may cause a transaction to be considered recommended, and this
determination does not depend on the classification of the transaction by a
particular member as 'solicited' or 'unsolicited'. In particular, a
transaction will be considered to be recommended when the member or its
associated person brings a specific security to the attention of the
customer through any means, (emphasis added) including, but not limited
to, direct telephone communication, the delivery of promotional material
through the mail, or the transmission of electronic messages."
Mis-marking of order tickets constitutes a fraudulent act as well being in
violation of most broker dealers' compliance rules. It is
important to note that it is a violation of Section 204 of the Uniform
Securities Act, NASD Rule 3110, NYSE Rule 440 and SEC Rule 240.17a-3 (6)
(books and records rules) for a registered representative to mark a trade as
"unsolicited" when in fact the transaction was "solicited".
It is well settled in the securities industry that an unsolicited trade is one in which the broker merely acts
as a conduit to complete the transaction brought to him or her by the
client, independently, without input from the broker. Purchases are
considered solicited when the client suggests a security and the broker provides
research reports, upon an initiated or request basis, or provides a supporting favorable
opinion when the client suggests a security for purchase consideration.
In the Merrill Lynch Compliance Outline (August 1997, page 22), it states,
"This is an example of a trade which must be marked solicited.
Client contacts the FC expressing interest in a security not brought
to his or her attention by the FC.
* The FC provides information from
Global Research, discusses the security with the client, and affirmatively
suggests or encourages its purchase."
Further, in the year 2000, Wachovia Securities
stated in its Compliance and Sales Practice Manual (Page
6.8), "The following situations are generally considered to involve
"solicited" transactions:
* A transaction where the client initiates the
inquiry but the Investment Consultant makes a favorable recommendation or gives
a favorable opinion.
* A transaction resulting from research reports or
written information prepared by the ESI Research Department, an Research
Correspondent, or any third party, forwarded by the Investment Consultant to
the client, whether initiated by the Investment Consultant or the
client."
There is support for this from the SEC.
The Commission has not defined what constitutes a recommendation, although
it has stated that a "recommendation may be found to have been implied
even where one has not been made expressly." National Committee
of Discount Brokers, SEC No-Action Letter (May 27, 1980). Purchases
then, by a
client based primarily on the firm's positive research would normally be classified
as solicited when the broker provides the research reports or positive
feedback. It is custom and practice in the securities industry to
classify all subsequent trades in a security the same as the initial purchase,
so long as the follow-up trades are consistent and within a reasonable
period of time. The one exception to this is when the customer closes the
account and transfers (delivers out) the securities to another firm. That is normally
classified as unsolicited, regardless of how the initial purchase is
coded on the confirm. If the confirm is blank and not classified, the
trade is considered solicited. Finally, in the Special NASD
Notice to Members 96-32, it states, "In addition, the
know-your-customer requirement embedded in Article III, Section I of the
Rules of Fair Practice requires a careful review of the appropriateness of
transactions in low-priced, speculative securities, whether solicited of unsolicited."
Clearly the intent of this notice was to charge the broker with a
suitability consideration with respect to aggressive securities,
irrespective of whether the purchase was recommended or not.
California has adopted regulations
which define "unsolicited" orders. (Section 25610, California
Corporations Code # 260.104) The definition applies to
all clients residing in California as of March 31, 1991. The
definition describes those facts which, if present, indicate a solicited
transaction. These definitions must be used when marking order tickets
for California residents.
An order or offer to buy a security is presumed to be
"solicited" if the broker/dealer knows or has reason to know that
the order or offer to buy is in response to one or more of the following
activities in which the selling Account Executive engaged within the last
sixty (60) days.
* publicly quoted a bid or asked price for
the security which identifies the broker/dealer other than on an
inter-dealer quotation system intended for broker/dealer use only;
* made a direct solicitation that clients
purchase the security;
* recommended the purchase of the security
to clients either directly or in a manner which would bring the
recommendation to the attention of clients;
* volunteered information about the issuer
of the security, either to a particular client who then purchased the
security, or to clients generally;
* executed a transaction to purchase or
sell a security pursuant to the AE's discretionary authority for a client in
a discretionary account.
If, in information circulated with respect to a security or an issuer, a
statement is included to the effect that the security is ineligible for
purchase or sale in California, or that an investment in the security is not
recommended for California purchasers, the Account Executive is still
required to mark the order "solicited" (Reference Section 25104,
Corporations Code).
The above rules require a precise written memorialization of any
instruction given or received for the purchase or sale of securities
including but not limited to the terms and conditions of the order and
whether pursuant to discretionary authority. Both the SEC and the NASD have
taken enforcement actions against brokers for mismarking trades as
"unsolicited". see In re Novak 27 S.E.C. Docket 780, Release
No. 34-19660 (1983); In re Fliess, 19 S.E.C. Docket 872, Release No.
34-16642, Mar. 10, 1980; David Stewart, NYSE Exch. Panel Hearing 95-19, 1995
WL, 489458 (1995); Kelly Fradet, NYSE exch. Panel Hearing 89-69, 1989 WL
379930 (1989); Barry Axler, NYSE Exch. Panel Hearing 75-24, 1975 WL 21796
(1975). The SEC has also taken enforcement actions against firms and
managers for failing to ensure, and independently verify, that order tickets
market "unsolicited" were accurate. See In re Dean Witter
Reynolds, Release No. 34-26144 (Apr. 8, 1988); In re Barlage, Release No.
34-25563 (Sept. 30, 1988). State securities regulators have acted to
suspend firms and require that principals requalify after such
violations. see In re George Cole & Co. Inc., Okla. Dept. Sec.,
1982 WL 195089 (Sept. 28, 1982).
6. Concentration - A broker has a fiduciary duty to
diversify his customer's assets and avoid over-concentration in a limited
number of stocks or asset classes (see chart above). In the Matter of Jack H. Stein, before
the National Adjudicatory Council, NASD Regulation, December 2, 2001:
"Stein also concerns over concentration: "the speculative and risky
nature of the stocks that Stein recommended and the high concentration of
those stocks in EA's account made Stein's recommendations unsuitable...Even
assuming, as Stein contends, that EA sought to speculate, Stein concentrated
EA's account too highly in speculative securities" Stein argued
that the customer understood the risks associated with speculative
investments and actively sought to change her investment strategy to one
that involved growth and speculation. The Council stated that even if
the customer understood Stein's recommendations and decided to follow them,
"that (would) not relieve (Stein) of his obligation to make reasonable
recommendations." The Council then cited Clinton Hugh Holland,
Jr. 52 S.E.C. 562 @ 566 (1995 aff'd, 105 F. 3d 665 (9th Cir.
1997). Disciplinary decisions suggest that the burden placed
upon registered representatives to justify a recommended concentration
increases as the type of security becomes more speculative. At least
one decision found a 25% concentration to be "at the high end of the
acceptable range". Note: On the most conservative basis, the maximum concentration in any one asset class or
speculative security should not exceed 15% of an investor's liquid net
worth. It is normal custom and practice in the securities industry for a
branch manager to make a documented call to the client to confirm exceeding this percentage or to require a registered representative to obtain a
written disclaimer
from the client if concentration exceeds this percentage.
7. Past Investment Experience or Sophistication - In the Matter
of Wayne B. Vaughn, before the National Adjudicatory Council, NASD
Regulation, October 22, 1998, "At the NAC Hearing, Vaughan and his
counsel tried to paint VB as a "sophisticated investor" who enjoyed trading
in speculative securities. Vaughn asserted that VB has previously
engaged in a risky trading strategy... in index options and junk bonds.
Vaughan's counsel described VB as someone who had engaged in "sophisticated
trading, enjoyed that, and insisted upon it. "A customer's prior
transactions, however, are not relevant in a suitability determination,
and we do not find that VB's history of risky trading mitigates Vaughn's
conduct. The fact that VB traded junk bonds and index options in the
past does not mean that she understood the risks involved. She could
very well have been following the recommendations of her broker at that
time. (Emphasis added). In re Peter C. Bucchieri, Rel.
No. 34-37218, May 14, 1996: FN9 - The fact that Robert Dibble had
a graduate degree from Harvard, a consideration stressed by Bucchieri does
not establish that he was a sophisticated investor. In re Clinton H.
Holland, Jr. A college economics course and access to information do
not, however, constitute "investment experience" or "sophistication".
In the matter of Douglas Jerome Hellie, NASD
Administrative Proceeding File No. 3-7279, July 23, 1991 (discretionary
account) - "In our view, Trust's prior trades are irrelevant. A
broker must make a customer-specific determination of suitability
and...tailor his recommendations to the customer's financial profile and
investment objectives." "Hellie was given specific
instructions as to the maximum level of risk that purchases for Trust could
entail. He must or should have been aware that a speculative,
low-priced stock such as Interesources, Inc. (Interesources was a
non-exchange, non-NASDAQ stock, listed solely in the "pink sheets"
of the National Quotation Bureau), whose value depended on its being an
acquisition candidate or some other external event, involved a higher risk
than was permissible for the account." "Hellie's arguments
that Voss (CPA and trustee of the trust) did not object to the Interources
trades until three months after the purchases or that Voss would have
characterized the Interesources purchase as "medium risk" are
irrelevant. Interesources was unsuitable for Trust's account
regardless of any improper motivation on Voss's part to characterize it as
such".
8. Fair Dealing - IM-2310-2(a)(1) says. "Implicit in all member and
registered representative relationships with customers and others is the
fundamental responsibility for fair dealing". IM-2310(a)(2) says "that
sales efforts must be judged on the basis of whether they can be reasonably
said to represent fair treatment for the persons to whom the sales efforts
are directed, rather than on the argument that they result in profits to
customers". In re Charles W. Eye, 49 S.E.C. 85, Rel. No.
34-29572, 1991: Her request for a plan to increase income was not
a warrant to escalate risks unduly. If the only approach capable of
producing the desired income involved significant dangers, Eye should have
advised against it. In re Arthur Joseph Lewis, Rel. No. 34-29794,
October 8, 1991: The fact that a customer such as Mrs. McGowan may
be wealthy does not provide a basis for recommending risky investments.
In re Gordon Scott Venters, Rel. No. 34-31833, February 8, 1993:
Whatever interest in speculation Avallone may have had was whetted by
the aggressive and extremely optimistic promotional campaign by Venters and
the firm. At the very least, when Venters learned about his customer's
age and situation, he had a duty to abandon the promotion. Citing
Eugene Erdos, ( the issue is not whether or not the client considers the
transactions in her account suitable, but whether the salesman, when he
undertakes to counsel the client, fulfills the obligation he assumes to make
only such recommendations as would be consistent with the client's financial
situation and needs.).
9. Client Must Understand Risks - In the matter of James B. Chase,
before the National Adjudicatory council, NASD Regulation, August 16, 2001:
Chase's Suitability Obligation. NASD conduct rule 2310, also known as
the "suitability" rule, requires a broker, in recommending a security to a
customer, to have reasonable grounds for believing that the security is an
appropriate investment for that customer, based on the customer's financial
situation and needs. Chase demonstrated a profound lack of
understanding of his customer-specific suitability obligation under Rule
2310. Chase's attorney argued during the proceedings below that
Chase's "primary responsibility [was] to make sure that the customer [was]
fully advised of all the facts and [could] make intelligent decisions."
Again, during the hearing on appeal, Chase's attorney argued that Chase had
fulfilled his suitability obligation by disclosing to YH the risks
associated with following his recommendations to purchase FHC and to open a
margin account. Although it is important for a broker to educate
clients about the risks associated with a particular recommendation, the
suitability rule requires more from a broker than mere risk disclosure.
The broker also has a responsibility to explain forthrightly the
practical impact and potential risks of the broker's course of
dealing. This responsibility requires the broker to ensure the
client's understanding of the risks involved in a recommended
transaction. See Patrick G. Keel, 51 S.E.C. 282,286 (1993) (noting that a broker
must ensure that the customer understands the risks involved in a
recommended securities transaction, in addition to determining that the
recommendation is suitable for the customer). (Emphasis Added)..
Among the broker's fiduciary responsibilities in managing a discretionary
account is the obligation to keep the client informed. that duty
extends to keeping the client advised of market changes affecting the
client's interest and to follow up by acting responsively to protect those
interests. Leib v. Merrill Lynch, Pierce, Fenner & Smith, Inc. 461
F.Supp. 951,953 (D.C.Mich. 1978): In re Rea, 245 B.R. 77,90 (Bkrtcy.N.D.
Tex.2000); Patsos v. First Albany corp., 433 Mass 323,741 N.E.2d 841,
850, n.16 (Mass.2001).
10. Due Diligence Extends Beyond Securities Recommended - NYSE Rule 405, the Know Your
Customer Rule,
requires a broker to "Use due diligence to learn the essential facts
relative to every customer, every order, every cash or margin account
accepted or carried by such organization and every person holding power of
attorney over any account accepted or carried by such organization."
With registered representatives whose firms are members of the the NYSE,
"due diligence" is required on every customer and every trade, not
just those recommended. That obligation extends to on-line and
discount firms that are NYSE members. Rule 405 does not distinguish
between the various types of purchases and sales that customers make.
It simply says you have to "know your customer". The authors of Suitability in Securities Transactions say that the
NYSE staff examiners informally define "essential facts" as "any information
that affects the customer's ability to accept risk" (as reported in The
Business Lawyer, Vol. 54, August 1999, page 1571). Although Rule 405,
unlike NASD Rule 2310, does not enumerate the kinds of information that
"essential" for brokers and brokerage firms to consider, the NYSE did
publish guidance in its 1982 publication entitled "Patterns of Supervision".
In discussing what items should be included in the New Account Form for
customers to complete, the NYSE recommended that brokerage firms/broker's inquire
regarding such facts as: age, occupation, estimated income and net worth,
marital status, number of dependents and investment objective. (See
Legal Duties of Stockbrokers # 7)
11. Recommendations must be related to the Customer's Risk
Tolerance - Clearly, a broker's investment recommendations must be suitable
for the particular customer. A recent arbitration panel awarded
$900,000 to Morgan Stanley Dean Witter customers, finding that MSDW's
speculative investment recommendations did not square with the customers'
investment objectives of income and preservation of capital. Indeed
punitive damages were awarded due to the "egregious trading and
apparent lack of supervision". The broker, therefore, must determine and
honor the investment objective of the customer as well as that customer's
risk tolerance. In doing so, the broker must consider the risk of any
particular investment recommendation or strategy employed. In general,
the basic investment objectives of customers fall into four major
categories:
1. Preservation of Capital (safety,
not willing to lose all or part of the principal invested. The
customer is willing to risk the return on investment but not the
return of investment). Objective is to maintain capital.
Adjusted for inflation, investment returns may be very low or in some years,
negative, in exchange for high liquidity and reduced risk of principal
loss. The historical average annual total return for this allocation
typically ranges from 4% to 6%;
2. Current Income (for retirees and
other fixed income investors through bonds and dividend paying stocks); Objective
is to obtain a continuing income stream from dependable debt and equity
sources. In order to satisfy current yield requirements, an investor
using this model should be willing to absorb some risk of principal
loss. The historical average annual total return for this allocation
typically ranges from 5% to 7%;
3. Income/Growth (current income &
capital appreciation for moderate investors); Objective is to strike a
balance between bonds for current income and stocks for growth.
Despite the relatively balanced nature of the portfolio, an investor using
this model should be willing to assume risk of principal loss. The
historical average annual total return for this allocation typically ranges
from 6% to 8%;
. 3. Capital Growth (increases in value
over time from appreciation in the asset, typically seasoned, quality stock & stock
mutual funds with reinvestment of dividends and capital gains).
Objective is to accumulate wealth, over time, rather than current
income. An investor using this model should be willing to accept the
risk of price volatility in seeking to achieve growth. The historical
average annual total return for this allocation typically ranges from 7% to
9%; and
4. Aggressive Growth/Speculation (high risk,
potentially high return types of investments). Objective is to achieve
above-average growth over time; income is of little, if any,
concern. An investor using this model should be willing to take more
substantial risk in seeking to achieve above-average returns. The
historical average annual total return for this allocation typically ranges
from 9% or greater.
Additionally, investors may have a need for tax-advantaged investments
(such as municipal bonds) or immediate liquidity.
Brokers are instructed as to the relative risk and return of the various
kinds of investments. In Pass Trak (Eighth Edition, Dearborn Financial
Publishing, Inc. 1995), an examination preparation guide for those seeking
to become licensed as (Series 7) brokers, various kinds of investments are
divided into three risk groupings - safety, growth and speculation.
They are :
*Safety: Safe investments (at least
relatively speaking) include cash, money market funds, CD's, U.S. Treasury
securities, bank-grade corporate and municipal bonds, some real estate,
blue-chip stocks, blue-chip stock and bond mutual funds.
*Growth: Growth investments include growth
and some small-capitalization stocks, stock options (covered calls), non-bank
investment-grade bonds, growth stock mutual funds, variable annuities.
Implementation emphasis is normally from the S&P 500 market index..
*Speculation: Speculation includes
speculative stocks and stock options, low-rated debt securities, precious
metals, commodities and futures, speculative limited partnerships,
speculative mutual funds. Implementation emphasis is normally from the NASDAQ
market index.
Pass Trak, at page 351
Salomon Smith Barney, as of the first quarter of
2000, in its Guided Portfolio
Management Program (GPM), provided a framework for its fundamental risk/research rating
system:
Risk Description
Predictability of Earnings/Dividends; Price Volatility
L Low
Risk
High predictability, Low Volatility
M Moderate
Risk
Moderate predictability/Volatility
H High Risk (Aggressive) Low predictability, High Volatility
S Speculative
Risk
Exceptionally Low predictability
Highest Possible Risk
V Venture
Risk
Risk/return consistent with venture;
Only for well diversified portfolios.
Note: The above definitions
differentiate between Aggressive and Speculation!
Some additional definitions are important
to consider:
1. Tax Advantaged Income - The objective
of the tax advantaged income strategy is to produce income from investments
(typically bonds and high-yielding stocks) that provide tax benefits such as
exemption from state taxes.
2. Short Term Trading - The purchase and
sale of a security within a short period of time, often a single trading
session. This is the opposite of buy and hold.
3. Hedge - An investment made in order to
reduce the risk of adverse price movements in a security by taking an
offsetting position in a related security. For example, buying an
option or selling a stock short.
12. Amending the New Account Form and Keeping It Current -
Supplementary Material to NYSE Rule 721.10 enumerates the information
required and, moreover, required the customer's account records contain "[d]ates
of verification of currency of account information". A 1994
pamphlet entitled Understanding Your Role and Responsibilities as a
Registered Representative (sent to all registered reps.) states on page 5,
under Obligations to Your Customers, "The first step in properly serving
your customers is to obtain a clear understanding of each customer's
financial condition. You will obtain some of this information when
opening a new customer's account with your firm. You may also learn other
information through conversations with your customer or checks your firm
makes with credit agencies or other financial institutions. Because a
customer's financial status is constantly changing, account records should
be updated whenever necessary. Just as your customer's financial
position may change, your customer's investment objectives may change.
They should, therefore, be reviewed periodically, and you should make a
written record of any changes as they occur." Custom and
practice in the securities industry is to update the new account form, in
any event, every three years! It should be updated earlier if any
major change in the investor's situation occurs. In section
260.218.5 of the California Corporations rules, it states. (a) Every
broker-dealer shall make and keep current a record for each person who
becomes a customer which record shall state:
(1) The customer's name, date of birth, address, nationality or
citizenship, tax identification or social security number, and the signatures
of the customer, the agent regularly handling the account and a
supervisor designated.
(2) If the broker-dealer, or any of its agents, has made any
recommendation to the customer to purchase, sell or exchange any security,
the record for such customer shall also state the customer's occupation,
marital status, investment objectives, other information concerning the
customer's financial situation and needs which the broker-dealer or the
agent considered in making the recommendation, and the signature of the
broker-dealer or agent who made the recommendation to the customer.
Sections 25218 and 25610, Corporations Code. Reference: Section 25218,
Corporations Code. Amendment filed 11-29-79 as an emergency;
designated effective 1-1-80. Certificate of Compliance included (Register
79, No. 80).
As Morgan Stanley reminds its registered
representatives, suitability is an ongoing process: In order
for the concept of suitability to be meaningful, it should not be static
(limited to the time an account is opened) but should be an ongoing
obligation to review and update suitability determinations. Clients'
investment objectives and finances change with time. Without current
information about a client's financial positions and investment objectives,
a Financial Advisor cannot make well-founded, reasonable decisions
concerning suitability as requires. financial Advisors should be alert
and responsive to changes in their clients' essential information. Any
changes are cause for a Financial Advisor to review a client's suitability
determinations. Furthermore, Financial Advisors are responsible for
updating changes to their clients' essential facts on CPS and may be
required to take further action as indicated.
13. Fiduciary Duty to Customer's Extends "Beyond the Transaction".
Many respondents argue that a broker's duty to the client ceases once the account is set
up and the trades are made. Further, a court case decided 25 years ago
is often cited in arbitration to support this position. In Robinson
v. Merrill Lynch, Pierce, Fenner &Smith, the Court
stated, "A broker's office, without special circumstances not
present here, is simply to buy and sell. The office commences when the
order is placed, and terminated when the transaction was complete. The
risk of the venture is upon the customer who profits if it succeeds and
loses if it fails. When the transaction is closed in accordance with
the understanding of the parties, the broker gets only his commission and
interest upon advances". Respondent's
further argue that the NASD Suitability rules only apply to
"recommendations" made and not beyond the initial
implementation. However, if the firm is a member of the NYSE, Rule 405
requires the broker and the firm to "do due diligence on every trade,
every customer, every cash and margin account", without reference to
the word "recommendation". Finally, the obligation of
Fiduciary Duty is the key to ongoing monitoring! A broker's
Fiduciary Duty never ends. It is the highest duty to the customer and
it continues as long as the account is in the hands of the broker. Every
securities expert will have to admit this under cross
examination. A.G. Edwards writes, "financial consultants
know where to get informed investment recommendations and the latest
financial planning techniques to make sure your plan continues to meet
your needs."
Consider the current custom and practice:
Broker Dealer Law and Regulation (3rd Edition 2002 Supplement) at page
2-155. Standards of conduct relating to risk disclosure and duty to hedge are
contained in the Content Outline for the General Securities Registered
Representative Examination (Test - Series 7). It is available at www.nyse.com/pdfs/series7.pdf.
The Content Outline
authored by
the industry committee of self-regulatory organizations and representatives
from broker/dealers, states on page 3, that the "critical function" of a rep is as follows:
7-0 [The rep] monitors the customer's portfolio and
makes recommendations consistent with changes in economic and financial
conditions as well as the customers needs and objectives.
[The rep]:
7-1 - Routinely
reviews the customer's account to ensure that investments continue to be
suitable.
7-2 - Suggests
to the customer which securities to acquire, liquidate, hold or hedge.
7-3 - Explains
how news about an issuer's financial outlook may affect the performance of
that issuer's securities.
7-4 - Determines which
sources would best answer a customer's questions concerning investments and
uses information from appropriate sources to provide the customer with
relevant information.
7-5 - Keeps the
customer informed about the customer's investments.
The Series 7 examination does establish the
industry standard. The SEC has noted that, "The industry committee
updated the existing statements of the critical functions of registered
representatives to ensure current relevance and appropriateness and drafted
statements of tasks expected to be performed by entry-level registered
representatives and conformed the existing Content Outline to the task
statements'. The Commission also stated that, "[t]he revised examination
tests [and, hence, the Content Outline covers] relevant subject matter
in view of changes in applicable laws, rules, regulations, products, and industry
practices".
This standard of care was articulated in 1995
when the SEC approved rules proposed by the NYSE and the NASD to modify the
qualification examination that financial advisers (registered
representatives) must pass to become licensed to sell securities. In
approving the NYSE's and NASD's proposed rules, the SEC stated that
modifications would "ensure an appropriate level of
expertise". The monitoring responsibility was one of the most
important functions and stated two critical subparts. The
first critical subpart is that a financial adviser "routinely reviews
the customer's account to ensure that the investments continue to be
suitable." This sets forth a duty to monitor, beyond simply
executing the initial purchase of an investment. Although the legal
departments at brokerage firms struggle to define the roles and
responsibilities of their financial advisers as narrowly as possible, this
language reflects an expansive view of the financial adviser's role and
responsibilities. Moreover, this language truly mirrors how brokerage
firms promote their services to the public. For example, consider the
recent advertisements of three firms, Merrill Lynch, Prudential Financial
and A.G. Edwards. In the Wall Street Journal 10-16-01, Merrill Lynch's
full page ad stresses its monitoring responsibility for customers. In the latest "Total Merrill" ad campaign,
under the category "Tracking Progress", the question is asked,
"Does the financial advisor who helps you set definite goals and
provide regular reviews?" Likewise, Prudential boasts to
prospective customers that, through "periodic portfolio reviews"
with its Financial Advisers, there will be "frequent contact" such
that customers "can keep aware of the market and your position,
anticipate when changes are necessary, and make the right adjustments at the
right time".
A.G. Edwards writes that "Its financial
consultants know where to turn to get informed investment recommendations
and the latest financial planning techniques to make sure your plan
continues to meet your needs". Finally, as Morgan Stanley
Dean Witter also reminds its registered representatives, suitability is an on-going
process: "In order for the concept of suitability to be meaningful,
it should not be static (limited to the time an account is opened) but
should be an ongoing obligation to review and update suitability
determinations. Clients' investment objectives and finances change
with time. Without current information about a client's financial
position and investment objectives, a Financial Advisor cannot make
well-founded, reasonable decisions concerning suitability, as
required. Financial Advisors should be alert and responsive to changes
in their clients' essential information. Any changes are cause for a
Financial Advisor to review a client's suitability
determinations".
The second critical subpart provides that the
financial adviser "suggests to the customer which securities to
acquire, liquidate, hold or hedge". This requirement to suggest
hedging (or ways to protect a portfolio against risk of loss, for example
through stop loss orders, collars, pre-paid forward contracts and other
devices) is critically important with concentrated positions in stocks, such
as upon the exercise of employee stock options.
This duty to monitor the clients portfolio after
the initial recommendation (s) must then include the broker's obligation to develop an
exit strategy for the client. This is especially true in a declining
market with the volatility we have observed over the last 3 years. In
2003, an NASD Arbitration Panel (01-02577) awarded two Merrill Lynch
customers $2.1 million for Merrill's failing to implement a stop loss discipline that
the clients wanted when any technology stock dropped below 10-15 per
cent. At that point, the stock should have been sold to avoid a
possibly bigger loss in the future. Further, claimant's argued that
the firm disregarded the client's risk tolerance and failed to supervise the
broker that implemented a concentrated technology portfolio with
"moderate" risk as the written investment objective. The
investor's sued for breach of fiduciary duty, fraud and failure to supervise,
along with the failure to protect the investors with an "exit
strategy".
The duty to monitor the investor's portfolio is
charged to the broker in declining as well as increasing markets.
Methods to be explored with the client like stop losses, protective puts
and custom collars are available through most brokerage
firms. Investment advisers have an ongoing fiduciary duty to protect clients in
falling markets by offering protective strategies to limit losses.
They do not enjoy the luxury of simply arguing "negative market
forces" when dealing with customers' shrunken portfolios. They
must meet their continuing fiduciary obligation to remain proactive in volatile markets by
enumerating viable alternatives and
always letting the customer's know where they stand. A perfect example
of this ongoing duty is the brokerage firm's use of activity letters,
generated by exception reports, which keep the customer continually informed
as to issues such as excessive trading, trading losses and costs which
exceed certain thresholds. Brokers must disclose all material facts
for the duration of the entire account relationship. As the Duffy v.
Cavalier case stated in CA in 1989, "The stockbroker-client
relationship is fiduciary in nature regardless of whether the customer is
sophisticated or not and regardless of whether the broker actually controls
the account. It goes on to state that although a stockbroker may be
obliged merely to carry out his or her customer's stated objectives when the
broker is acting merely as an agent to carry out purchases or sales selected
by the customer, with or without the broker's recommendation, when the
customer invariably follows the broker's recommendations, the broker
controls the account. If based on the customer's actual financial
situation and needs, it would be improper and unsuitable to carry out the
customer's expressed objectives, the broker has the further obligation (1)
to make sure that the customer understands the investment risks in the light
of his or her actual financial situation; (2) to inform the customer that no
speculative investments are suitable if the customer persists in wanting to
engage in speculative transactions without the broker's being persuaded that
the customer is able to bear the financial risks involved; and (3) to
completely refrain from soliciting the customer's purchase of any
speculative securities that the broker considers to be beyond the customer's
risk threshold. Further, the case states that the broker has a
duty to disclose all material facts, irrespective of the sophistication of
the investor". This duty to
provide ongoing monitoring and disclosure translates
into being a gatekeeper as opposed to a cheerleader as markets expand
and contract.
15. Fiduciary duties exist in non-discretionary accounts.
Respondents continue to make the argument that somehow, the broker's
and firm's duties are somehow minimized when the account is
non-discretionary. The obligations of stockbrokers to their
customers for whom they handle non-discretionary accounts were described by
the court in Twomey v. Mitchum, Jones & Templeton, Inc. 262 Cal.
App 2d 690 (1968): "It is contended that the sole obligation of the
broker-dealer is to carry out the stated objectives of the customer.
this may well be true when the broker is acting merely as agent to carry out
purchases or sales selected by the customer, with or without the broker's
recommendation. Here however, there is evidence to sustain the finding
that [the broker's] recommendations, as invariably followed, were for all
practical purposes the controlling factor in the transactions. Under
these circumstances, there should be an obligation to determine the
customer's actual financial situation and needs."
This rule was approved and further explained in Duffy
v. Cavalier, 215 Cal. App. 3d 1517, 1535 (1989)" "the
question is not whether there is a fiduciary duty, which there is in every
broker-customer relationship; rather, it is the scope or extent of the
fiduciary obligation, which depends on the facts of the case "
According to Professor Norman S. Poser in Broker-Dealer
Law and Regulation at 2-49,"...The extent of the broker's duties
depends on the scope of his agency. for example, a broker who does not
make trading decisions or give investment advice, but who simply executes
his customer's orders, is only required to carry out his trading
instructions with loyalty and due care. On the other hand, a broker
who has authority to make and manage investments, or who is deemed to
control his customer's account even though he does not have formal
discretionary authority over the account, owes the customer duties of
faithful service and highest good faith similar to those imposed on the
trustee of a formal trust." (Author cites for fiduciary or
trustee like duties Hudson v. Wilhelm, 651 F.Supp 1062,1066
(D.Colo.1987); Twomey v. Mitchum, Jones & Templeton, Inc., 69
Cal. Rptr. 222, 236 (Cal.App.1968).
16. The Duty of Inquiry by the Customer is Relaxed because of the
Fiduciary Relationship between the Brokerage firm, its Broker and the
Investor. When considering whether
investors reasonably could have discovered the facts giving rise to their
claims, the arbitrators should consider that a fiduciary relationship
creates a climate of trust in which "facts which would ordinarily
require investigation may not excite suspicion, and the same degree of
diligence is not required." Lucas v. Abbott, 198 Colo.
477, 481, 601 P.2d 1376, 1379 (1979). Confidential relationships may
cause a person "to relax the care and vigilance [he or she] would and
should have ordinarily exercised in dealing with a stranger." Ralston
Oil & Gas Co. v. July Corp., 719 P.2d 334, 338 (Colo. App.
1985). Reliance on representations made in the context of the
fiduciary relationship therefore reduces the investor's duty of
inquiry.
17. Brokers breach their Fiduciary Duty when they lull client's
into holding on to their positions i.e. "stay the course" during
volatile markets. The failure to offer clients alternative methods of
protection, when clients become concerned in uncertain markets, and to
disclose the risks of "holding on" in volatile markets is fraud
and violates the broker's fiduciary duty to the client. See,e.g. Small
v. Fritz Companies, 65 P.3d 1255, 173 -178 (Calif. Supreme Court, April
7, 2003) (liability on fraud and negligent misrepresentation claims for
inducing an investor to refrain from selling stock); AUSA Life Ins. Co.
v. Ernst & Young, 206 F.3d 202,220 (2d Cir. 2000) (finding liability
for negligent misrepresentation based on inducing the plaintiff to continue
to hold stock); Vulcinich v. Paine Webber Jackson & Curtis, Inc. 803
F.3d 454,4601 (9th Cir. 1986) (broker violates securities if he fails to
fully disclose al the risks of the investment strategy being pursued on
behalf of the customer); Marbury Management v. Kohn, 629 F.2d
705,709-10 (2d cir. 1980) (broker and firm liable for fraud inducing
non-action. Merrill Lynch, Pierce, Fenner & Smith, Inc. v.
Cheng, 901 F.2d 1124,1129 (D.C. cir. 1990) (damages awarded where broker
failed to advise customer of important information). Further,
NYSE Rule 472.40(1) defines communicating that a customer "stay the
course" or "hold" as a recommendation. NYSE Rule
472.40(1) states, "The term "recommendation" includes any
advice, suggestion or other statement, written or oral, that is intended, or
can reasonably be expected, to influence a customer to purchase, sell or hold
a security"
18. SIX STEPS TO CONFIRM SUITABILITY
Several years ago, speakers at an annual seminar
for the Compliance and Legal Division of the securities Industry Association
(SIA) compiled the "Steps for Confirming Suitability". Since
then, like a good proverb, this material has been passed down. The six
steps have appeared in nearly every such annual seminar since, and even have
appeared (verbatim) in at least one compliance manual at a major wire
house.
So what is this wisdom? the six steps are:
1. Is the account information accurate?
2. What is the nature of the account and
who initiates the transactions?
3. Are the securities being purchased
appropriate in relation to the client?
4. What is the size of the commitment
relative to both the nature of the account and the client's financial
information?
5. How active is the account?
6. Does the activity make sense?
Lets examine the important consideration for each of these steps.
First, the SIA material emphasizes that account
information, such as investment objectives and financial information, must
be accurate and current, noting that certain lifestyle changes (retirement
for example) may create a need to update. Moreover, "true"
investment objectives and financial information must be recorded. That
means that the new account information "should not be updated to
reflect or conform to the account activity unless the information truly
reflects the client's current situation".
The second step is to determine what type of
account exists and who, in reality, is in control of the activity in the
account. Accounts for retired persons, ERISA, widows and trusts are
"generally more conservatively oriented and the presence of speculative
securities, options, short-term trading or concentrated positions should be
cause for reflection." Reps may have clients wishing to invest in
a security or engage in a certain type of activity which may not be suitable
for them. In those circumstances, the SIA material encourages reps to
consult their branch manager, whose duty will be to determine if such
activity is appropriate and what, if any , protective measures should be
taken to ensure that suitability is well documented. Regarding
control, the authors comment that a rep may be deemed to control the
investment decisions in an account whether or not the rep has discretionary
account authority.
Third, reps should satisfy themselves that the
securities purchased are appropriate in relation to the client. The
SIA material suggests that reps consider how the risk ratings of the
security compare to the account information (such as the investment
objectives and risk tolerance) for the client. Additionally, reps
should assess the complexity of the investment and how it compares to the
financial sophistication of the client. Moreover, the SIA material
reminds reps that placing conservative securities on margin increases the
risk due to the leverage involved.
The fourth step involves measuring the size of
the commitment against the client's account equity and portfolio value, as
well as against the client's liquid assets and net worth. The higher
the concentration, the SIA materials observe, the higher the risk.
Reps also need to consider the added expenses (and risk) of a margin
account.
Fifth, how active is the account? Is the
account activity inconsistent with the nature of the account? The SIA
material poses an excellent question to ponder. "Could the
account possibly achieve similar results with less activity or less
risk?" Note that margin related costs must be recouped before the
account even can break even. Additionally, the SIA material advises
reps to ensure that the client understands the risks and costs associated
with an actively traded account (though SEC, NASD and NYSE decisions
establish that this is not a defense to a suitability claim).
Sixth, does the activity make sense? The
SIA material is informative and especially well drafted. It reads
"No matter how well the client may be doing or how aware and agreeable
the client is to the activity and status of the account (including profits
and losses), the RR's actions should be focused upon what is in the best
interests of the client and the protection of the Firm."
Accordingly, reps may want to restrict an account to liquidating orders
only, or refuse to accept an order or limit the size of an order for a
security.
Reps who consider these six steps should be able
to confirm the suitability of the account activity of their clients.
Its worth the
effort.
SUITABLE ALLOCATIONS FOR THE AVERAGE INVESTOR
With minor variations the securities industry agrees that portfolio
diversification should fall within the following parameters for investors
with a moderate risk tolerance:
Years to
% Aggressive/ %Growth/
%
%
%
Retirement
Small-Cap Large-Cap
Intern’l
Bonds Cash
30+
25%
25%
20%
15% 15%
20+
25%
30%
15%
15% 15%
15+
20%
35%
10%
20% 15%
10+
20%
30%
15%
20% 15%
5+
15%
30%
10%
30% 15%
Retired
5%
30%
5%
50% 10%
Source: The Stock
Market Course, George A. Fontanills and Tom Gentile, John Wiley &
Sons, Inc., 2001, at p. 89.
Merrill Lynch, the nations largest brokerage firm publishes these
“allocation” guidelines in a chart labeled “Finding the Right Asset
Allocation” (based on your Investment Objectives):
INVESTOR
RISK
LESS
RISK
MORE RISK
Cap.
Preservation
Income Inc.& Growth
Growth
Agg.Growth
Stocks
15%
30%
45%
60%
75%
Bonds
55%
45%
40%
25%
10%
Cash
30%
25%
15%
15%
15%
INVESTOR
RISK PROFILE
Note: Even
the most aggressive of the above allocations places 10% in bonds and 15% in
cash for diversification. Only
75% is placed in equities.
ASSET ALLOCATION/RISK EXPOSURE
(Average of industry models at 8-10 major brokerage firms)
TOTAL
RISK
RETURN
TOLERANCE
STOCKS
BONDS CASH
RISK RANGE
SAFETY OF PRINC.
21%*
70%
9% -9%
5-7%
(Conserv. Income)
PRES. OF CAPITAL
(Inc. & Cons. Growth) 26%*
68%
6%
-10% 5.5-7.5%
MODERATE
49%**
47%
4%
-14.5% 7-9%
(Growth & Income)
MODERATE/AGG.
67%**
29%
4%
-16.5% 8-10%
(Capital Appreciation)
AGGRESSIVE
84%*** 13%
3%
-20% 10-12% (Capital Appreciation)
SPECULATIVE
95- 100%*** 0
- 5%
0% -28%
12%+
(Capital Appreciation)
__________________________________________________________________
TOTAL RETURN
11%
7%
4%
(Historical)
* Emphasis
on the Dow Jones 65(Blue Chip)/Wilshire 5000 Stock Index..
** Emphasis on the S&P 500
Index (Diversified Large/Mid Cap domestic and international issues).
*** Emphasis on the NASDAQ
Index (Concentrated Large, mid and small cap tech. and telecom issues)
Clearly, the longer you hold stocks, the less risky they are. Research
from Ibbotson Associates looked at every rolling ten-year period from 1926
(there have been 72 so far:1926 - 35; 1927 0 36 and so on) and discovered
only two in which Standard & Poor's 500-stock index posted an average
annual decline. Both were during the Depression. The worst average
annual return was -.089% in the decade ended 1939.
Of
course, no one wants to lose almost 1% a year for a decade. But if you
build your portfolio with different types of assets, some investments will
zig while others zag. Ibbotson examined the same 72 rolling ten-year
periods with a portfolio of 50% stocks and 50% long-term bonds. The
result: not a single losing period. The worst average annual total
return was 1.99%, in the ten years ended 1974, while the best was 16.96% in
the ten years ended 1991.
Similarly, in rolling 13-year time periods over the past 50 years, a mix of
80% stocks and 20% intermediate-term government bonds has produced an
average 10.7% annual return. The worst 13 year period posted a 3.6%
annual return.
INVESTMENT OBJECTIVE
SPECIFICATIONS
Increasing Risk,
Volatility and Return Expectations
1. Income with Capital Pres.
a. Need for current Income
b. Safety of Principal
c. Conservative Focus on Growth i.e. Dow Jones
65/Wilshire 5000 Stocks
emphasis.
d. Low Tolerance for Risk
e. Short term investment time Horizon – (Est.) 1 –
3 years
f. Suggested Asset Allocation: Bonds 70%; Stocks
21%; Cash 9%.
g. Return expectations: 5 – 7%; Risk ratio
-9%
2. Income with Conservative Growth (protection from
inflation)
a. Need for current Income & preservation of
capital
b. Conservative/moderate focus on Growth i.e. Dow
Jones 65/Wilshire 5000
stocks emphasis.
c. Low to medium tolerance for
risk
d. Short to intermediate investment time Horizon –
(Est.) 1– 5 years
e. Suggested Asset Allocation: Bonds 68%; Stocks
26%; Cash 6%
f. Return expectations: 5.5% – 7.5%; Risk ratio
–10%
3. Growth with
Income
a. Equal focus on growth and current
income
b. Moderate Focus on Growth i.e. S&P 500 emphasis
c. Moderate tolerance for risk
d. Intermediate investment time Horizon – (Est.) 5
– 7.5 years
e. Suggested Asset Allocation: Stocks 49%; Bonds
47%; Cash 4%
f. Return expectations: 7 – 9%; Risk ratio
-14.5%
4. Growth/Appreciation
a. Little need for current Income
b. Moderate to Aggressive Focus on Growth i.e. S&P
500/NASDAQ emphasis
c. High tolerance for risk
d. Intermediate to long investment time Horizon –
(Est.) 5 – 10 years
e. Suggested Asset Allocation: Stocks 67%; Bonds
29%; Cash 4%
f. Return expectations: 8 – 10%; Risk ratio
-16.5%
5. Aggressive Growth
a. No need for current Income
b. Aggressive Focus on Growth i.e. NASDAQ emphasis
c. Highest tolerance for risk
d. Long term Investment Time Horizon – (Est.) 10
years +
e. Suggested Asset Allocation: Stocks 84%; Bonds
13%; Cash 3%
f. Return expectations: 10 – 12%; Risk Ratio
-20%
RECOMMENDATIONS SUITABLE FOR CONSERVATIVE INVESTORS
SIFMA, the Securities Industry and Financial Markets
Association, talks about widely accepted understandings in the industry:
conservative investors feel that safeguarding what they have is their top
priority. More formally, this approach is called capital preservation.
These investors want to avoid risk -- particularly the risk of losing any
principal -- even if that means they'll have to settle for very modest
returns.
The SIA, The Securities Industry Association, its
predecessor goes on to state more widely accepted understanding in the
securities industry:
conservative investors allocate most of their portfolio's to bonds and cash
equivalents, such as CD's and money market accounts. They're generally
reluctant to invest in stocks, which may lose value, especially over the
short
term. When conservative investors do venture into stocks, they're
often
inclined to choose blue chip or other larger-cap stocks with well-known
brands because they tend to change value more slowly than other types of
stock and sometimes pay dividend income. Conservative investors
usually
have to settle for modest investment growth, which might make it difficult
to meet long-term goals, such as having enough income during retirement. .
. . . if your retired or expect to retire in the near future, it may
be unwise
to put a lot of your assets at risk in volatile securities, such as stocks,
at
this stage in the game, when your portfolio may not have time to recover
from a market downturn.
19. An investor is not
charged with knowledge of disclosures made
in a prospectus, in the Ninth Circuit.
In securities arbitration, it is often claimed, merely because the claimants
were provided with a prospectus which set forth all relevant and necessary
disclosures, that the claimants are legally charged with knowledge of those
disclosures. While that may be the law in other parts of the country,
it is not the law in the Ninth Circuit.
The basic issue in question is constructive notice and within the Ninth
Circuit it has been held that receipt of a prospectus does not necessarily
place an individual on constructive notice of what is contained within that
prospectus. Even if some cases do intend to hold that mere receipt of
a contradictory prospectus necessarily starts the fraud or misrepresentation
statute of limitations running, the Court does not believe that the Ninth
Circuit would or should adopt such a broad vision of constructive notice.
For example, in Rochelle v. Marine Midland Grace Trust Co. of New York, 535
F. 2d 523, 531-533 (9th Cir. 1976), the Ninth Circuit refused to impute
knowledge of proxy materials filed with the Securities and Exchange
Commission to a company holding debentures, even though it was a
sophisticated investor (emphasis added). In declining to do so,
the Rochelle court explicitly invoked the fundamental policy
considerations underlying the securities laws: We are mindful that the
overriding purpose of Section 10(b) and Rule 10b-5 was to protect the purity
of the securities market and that private claims for relief thereunder are a
means to that end. We would impair the larger purpose if we were to
expand the concept of constructive notice to defeat such claims (emphasis
added). Id. at 522-33.
Luksch v. Latham, 675 F.Supp. 1198, 1201 (N.D. Cal.1987), this
ruling by the Luksch court, in regard to the receipt of a
prospectus, is merely an extension of the general principles of California
and Ninth Circuit law in regard to what constitutes adequate notice to an
individual in regard to a fraud or misrepresentation claim. Following Luksch
the court:
rejected the defendant's attempt to have the court adopt a per se imputation
rule [regarding receipt of the prospectus amounting to knowledge of clear
contradictions between the prospectus and oral representations made to the
investor]. Luksch, 675 F. Supp. at 1201-03. Instead, the
court noted that it must consider various factors before imputing
constructive knowledge, including access to information, knowledge and
business sophistication of the plaintiff, existence of long standing
business relationships and the nature of the plaintiff's allegations. Luksch,
675 Supp. at 1203. The court concluded that constructive knowledge
of information in a prospectus 'should not be legally imputed to investors
except in the unusual case' [emphasis added]. Luksch 675 F.
Supp. at 1199.
Wenzel v. Patrick
Petroleum Co.,
745 F. Supp. 211, 218 (D.Del. 1990).
Johnson v. CIGNA
Corp., 916 P.2d 643, 649 (Colo. App. 1996. The court stated that,
"Defendants respond that the plaintiffs were placed on inquiry notice
of any alleged unsuitability when they were given the PPM's and Subscription
Agreements, which stated that the investments were high risk....... .
This contention assumes, however, that plaintiffs were cognizant, or could
be cognizant, of the application of the term "risky" to
their individual investment situations. To say, as defendants argue,
that a risky investment is one in which the investor could lose all of his
or her money begs the question, since every investment has that possibility.
And, if a fiduciary duty did exist between plaintiffs and defendant's,
plaintiffs' level of inquiry of the significance of the details of their
financial status would be altered.
20.
Sophistication of the investor is an important factor to consider in
determining whether receipt of a prospectus should have given the investor
knowledge of the broker's fraudulent misrepresentations.
See, e.g. Department of Enforcement v. Hornblower & Weeks, 2004
NASD Discip. LEXIS 27 (respondent could not cure defects in disclosure by
providing more detail and further disclosure in the same package or by
answering questions); DOE v. Ryan Mark Reynolds, 2001 NASD Discip.
LEXIS 17 ("The SEC has held that, in the enforcement context, a
registered representative may be found in violation of the NASD's rules and
the federal securities laws for failure to fully disclose risks to customers
even though such risks may have been discussed in a prospectus delivered to
customers"). Department of Enforcement v. Pacific On-Line
Trading & Securities, 2002 NASD Discip. LEXIS 19 (finding that the
subsequent dissemination of disclosure information does not cure earlier
misleading disclosures).
Case law throughout the country holds that the sophistication or experience
of an investor is an important factor to consider in determining if the
investor knew or should have known of a broker's fraudulent
misrepresentation. Harner v. Prudential Securities, Inc., 785
F. Supp. 626, 634 (E.D. Mich. 1992) ("on the issue of whether the
investor exercised due diligence in verifying the existence of a fraud, the experienced
investor and the neophyte are to be judged according to their abilities
and the circumstances of the alleged fraud."); Platsis v. E.F.
Hutton & Co., Inc., 642 F. Supp. 1277, 1283-285 (W.D. Mich. 1986); Rochelle
v. Marine Midland Grace Trust Co. of New York, 535 F. 2nd. 523-33
(9th Cir. 1976) (this court uses the phrase "sophisticated
investor"). Sophistication of the investor was a crucial factor
in Solano v. Delmed, Inc., 759 F. Supp. 847, 853 (D.D.C. 1991).
The Platsis case (W.D. Mich. 1986) provides a particularly clear
picture of the sophisticated investor who should not be allowed to
claim he did not read or understand the prospectus at the time he made his
investment (It should be noted that in Platsis it was
"undisputed that plaintiff received all offering documents prior to
investment." Platsis at 1287.) Mr. Platsis was
a lawyer formerly employed by the FTC and the Michigan Dept. of Attorney
General, Consumer Protection Division, who had taken a course in securities
law at the University of Michigan Law School. Platasis at 1284.
Furthermore, prior to "contacting [E.F.] Hutton, plaintiff, on his own,
had done some oil and gas lease investigation. There was testimony
that plaintiff had investigated at least two oil and gas offerings related
to development wells." Id. at 1285. Clearly, Mr. Platsis
was a sophisticated investor; it is equally clear that many investors are
not.
Harner v. Prudential
Securities, Inc., 785
F. Supp. 626 (E.D. Mich. 1992). Harner supports an important element
of most claimants' cases; namely the idea that in attempting to verify
the existence of fraud, the inexperienced investor is not to be judged by
the same standard as the sophisticated investor. Specifically, Harner
uses a two part test to determine when the investor should be deemed to
have had notice of fraud.
[T}his test employs both objective and subjective components. Whether
the facts were sufficient to raise the possibility of fraud will be
determined by an objective standard. The sophisticated stockbroker and
the uninitiated rube will both be judged by the same standard, i.e., the
"reasonable investor" standard. However, on the issue of
whether the investor exercised due diligence in verifying the existence of a
fraud, the experienced investor and neophyte are to be judged according
to their abilities and circumstances of the alleged fraud. Harner
at 634.
Hirschler v. GMD
Investments,
(CCH) 95,919 (March 28, 1991, E.D. Va. ); 1991 WL 1175773
This case impliedly
supports the proposition that mere receipt of a prospectus may satisfy the
inquiry notice requirement for fraud or misrepresentation only when the
plaintiffs/claimants are sophisticated or experienced investors. That
sophistication of the investors was a much considered factor in this case is
made clear from the emphasis on that factor in the passage cited below.
Plaintiffs are all highly educated, experienced investors. All are
college-educated professionals, and four of the seven undertook at least
some post-graduate study. All plaintiffs had extensive experience
in investment in limited partnerships and/or real estate developments.
For instance, the lead plaintiff David Herschler, who has a D.D.S. from
the Medical College of Virginia, has invested in three other limited
partnerships and maintained four different stock brokerage accounts. ...
Even the investor; with the least limited partnership or real estate
investments, Susan Schaffarzick, owns real estate in California, has
maintained two stock brokerage accounts, and has a master's degree from
Stanford University. Hirschler at WL p.2.
In
the Matter of Michael R. Euripedes: July 28, 1997 (Before the National
Business Conduct Committee, NASD Regulation). Euripedes claims
that he believed that RL had read the Primedex prospectus. This
does not excuse Euripedes' failure to inform RL fully of the investment
risks associated with the Primedex offering. See In re Larry
Ira Klein, Exchange Act Rel. No. 37835 (Oct. 17, 1996); In re Ross Securities,
Inc. 41 S.E.C. 509 (1963) (Emphasis Added).
21. The
recommendation of an outside money manager does not relieve the brokerage
firm of its supervisory responsibilities.
Often respondents will argue that the securities in an outside managed
account are the responsibility of the outside manager and not the
responsibility of the member firm or the financial advisor who recommended
the management company. Many times the broker provides performance
reports on the manager. The fact that a client's funds were entrusted
to a third party does not relieve the firm of its supervisory
obligations. Richard DeCastro, 1998 WL 295513 at #7 (AMEX
1998)(emphasis supplied) "The panel believes that the existence of a
third party power of attorney does not relieve a member organization
or its supervisory personnel of their obligations under the Exchange's rules
to supervise the accounts of their customers." Merrill Lynch
continued to accept and execute the Adviser's orders in these identified
accounts without attempting to ascertain whether the activity reflected by
the monitoring system was consistent with the clients' current financial
situations and investment objectives. In the Matter of Merrill
Lynch, Pierce, Fenner & Smith, Inc., SEC Release No.19070 at
p.2.
EXCEPTION REPORTS
An exception report
provides information designed to assist supervisors, compliance officers,
and securities regulators to discover sales practice problems and violations
such as excessive trading and switching, unauthorized trading, and other
indications of securities fraud. Joint SEC/NASD Report on
Examination Findings Regarding Broker-Dealer Sales of Variable Insurance
Products (June 2004) at p. 10, n6.
Exchange rules require
the diligent supervision of all accounts to ensure, among other things, that
activity in any account is in accord with the client's stated investment
objectives and not excessive in view of the client's financial resources. To satisfy this
requirement, the Branch Manager must perform and document monthly account
reviews. To identify active accounts, a monthly surveillance report is
typically created. The monthly surveillance report is a supervisory
tool designed to identify the most actively traded accounts in the
branch. Generally, review of this report supersedes the Branch
Manager's review of monthly statements. those statements should still
be reviewed as necessary. The report is separated by Investment
Consultant and lists, in descending order of commission to equity, all
accounts that meet the following system-established parameters:
For example:
* a current commission to equity ratio of 5% or more; and/or
* ten or more trades for the month; and/or
* $1,500 or more in commissions for the month.
With respect
to other
traditional brokerage activities, exception reports aid supervisors in
determining high cost to equity in an account (high commissions/fees paid
divided by average account equity), large increases in margin balances or heavy losses in an
account and over-concentration.
Since the technology crash of
March 2000, concentration has been an item both emphasized and tracked in
exception reports. UBS/PaineWebber in an August, 2001 Compliance
Bulletin cited the risk of over-concentration. "A potential risk
to the Financial Advisor's relationship with a client involves
over-concentration. While concentration defies a precise definition,
it may exist in many different scenarios, including where a significant
percentage of client's assets are in a single security, or in a particular
sector or in certain products. Before making a recommendation, the
Financial Advisor should consider all relevant factors such as the client's
net worth, financial needs and objectives, including whether a proposed
investment could present a concentration issue for that
client".
Concentration is a
Suitability Issue
"Concentration is an important aspect of the
suitability determination. Keep in mind that suitable investments can
become unsuitable when they constitute too large a portion of a client's
portfolio. While a client may be suitable to own $10,000 or $25,000
worth of one security, he or she may not be suitable to hold $500,000 or
$5,000,000 worth of the same security. This holds true even for large
cap or blue chip companies since highly negative news could lead to material
declines in any issuer's stock or the particular sector".
"Accordingly, Financial
Advisors are encouraged to review accounts for situations involving
concentrated positions and discuss the risks of such positions with the
client and their Branch Manager. In addition, Financial Advisors
should review objectives with the client to ascertain
whether the client understands and intends to assume the level of risk
associated with the concentrated position. If a client continues to
build a concentration against the Financial Advisor's advice, the Financial
Advisor should speak with the Branch Manager who may wish to consult with
the Legal and Compliance Departments".
Impact of Margin on
Concentrated Positions
"If a client is also trading on margin, it is also
important to consider the risks associated with the use of margin in
determining whether purchasing on margin is suitable for a particular
client. Moreover, it is important that Financial Advisors educate
their clients on the special risks of buying securities on
margin". "The degree of risk may reflect the nature of
the investment itself, (e.g. leverage) and its market, or factors such as
concentrations or margin. Since the analysis must be applied to each
transaction for each client, "wholesale" recommendations are not
appropriate"..
Merrill Lynch was concerned about
suitability with regard to the concentration and the volatility of internet
securities when as early as February 1999 it wrote this inter-office
memorandum. "FC's must be especially mindful of suitability
considerations when recommending internet stocks or placing unsolicited
orders for clients who wish to trade in such securities. FC's should
discuss with clients the risks involved in buying or selling securities
under such volatile market conditions. Client's investment objectives
and risk tolerance levels must be carefully considered to help them
determine what, if any, portion of their portfolios should be invested in
internet stocks".
The Importance of Reviewing Accounts for
Concentration
Merrill Lynch began monitoring
concentration as an exception as of December, 2000 whereby in an
inter-office memorandum, it said, "Managers should carefully review
accounts in which one position or industry sector dominates a clients'
holdings. Concentration of positions in multiple clients accounts has
become an issue with regulators and claimants. For example, recent
regulatory pronouncements and press accounts have confirmed the importance
of making suitable investment recommendations to clients, particularly when
large or concentrated positions are at issue. Of particular concern
are situations involving clients that suffer disproportionate losses in
their accounts as a result of a price decline in a security representing a
substantial portion of their assets. To assist you in identifying
concentrated equity positions in client accounts, the Firm has developed a
web-based Concentration Report".
"The Concentration
Report must be printed, reviewed, and initialed by a qualified
manager. The reports, any notes pertaining to the review, and any
follow up with the FC(s) and/or clients must be retained for 2
years".
Merrill Lynch continued
monitoring concentration as an exception in 2002, where in its Compliance
Manual, Section III, under Recommendations and Dealing with Clients, it
states:
Concentrated Security
Positions
"Care should be taken whenever one position or
industry sector dominates a client's holdings. Depending upon the
industry sector and market conditions, a concentrated security position may
be vulnerable to volatile price movements that may result in substantial
losses and/or margin calls. While there are some investors for whom
this style of investing may be suitable, special care should be taken to
ensure that such clients are fully aware of and able to sustain the risks
inherent in this style of investing".
"If a client wishes to
maintain a large concentration in a particular security, the Firm may
require higher maintenance margin. required approval will depend on
the position size, debit amount, nature of the security and other
factors. A debit of $500,000 or more requires special
approval".
Compliance Notes from
September, 2001 Administrative Manager and Service Manager Conference Call
Concentration:
Risk is intensified when client's have "all their eggs in one
basket." When clients have concentrated security positions, FA's
should:
1. Document discussions with clients regarding diversification.
2. Seek advice from the Executive and Equity Plan Services Department
regarding investment strategies designed to protect concentrated positions
in restricted or controlled securities.
3. Monitor Merrill Lynch research for negative commentary about
specific industry sectors ( e.g. airlines, insurance companies, etc.) and
contact clients whose portfolios are weighted in those industry
sectors.
"You should also use the
monthly concentration report to identify and address accounts that appear to
be over-concentrated in specific securities or industry sectors".
In its Compliance Outline for Private Client Financial Advisors, dated
January 2002, Merrill stated, "Care should be taken whenever one
position or industry sector dominates a client's holdings. Depending
upon the industry sector and market conditions, a concentrated security
position may be vulnerable to volatile price movements that may result in
substantial losses and/or margin calls. While there are some investors
for whom this style of investing may be suitable, special care should be
taken to ensure that such clients are fully aware of and able to sustain the
risks inherent in this style of investing".
Salomon Smith Barney, as early
as March 1999 summarized the branch manager's obligation to consider
concentration in customer accounts as an exception when it stated,
"Prior to contacting the client, the Branch Manager should speak with
the FC and review the activity and positions in the account. the
Branch Manager should be particularly sensitive to:
- The types of securities traded (e.g. low priced stocks, below
investment grade bonds, derivatives, etc.)
- Any large positions (is the FC building a position in many
accounts?)
- Margin balance, volume of trading and holding periods".
Much of the above concerns
regarding concentration could be detected if brokerage firms used
appropriate computer codes in their exception reporting!
With the proper computer
codes, brokerage firms could more properly monitor investor accounts to
prevent sales practice abuses by their registered representatives and better meet their suitability obligations
under NASD rules. Examples of this include:
A. Calculate the ratio
of dollars invested in non-income producing and/or low-ranked securities to
overall account value to determine whether the account holdings reflect the
customer's investment objective.
B. Generate an exception
if estimated income does not comport with an investment objective of income
or income/growth.
C. Generate an exception
when a retiree or person approaching retirement age is overly invested in
growth securities or non-investment grade securities:
D. Generate an exception
when the composition of the account does not comport with the
customer's investment objectives.
E. Generate an exception
when a given security exceeds a specified percentage of account value
and/or liquid net worth; and
F. Generate an exception
when a given industry sector's combined value exceeds a specified percentage of an
account value and/or liquid net worth.
According to SEII (Securities Education Institute,
Inc., a RegED.com company, "In June, 1999, the SEC approved rules for
the NASD and NYSE in connection with the introducing/clearing firm
relationship. Among other things, clearing firms must provide each
introducing firm, both at the inception of the clearing/introducing broker
relationship and annually thereafter, with a list or description of all
exception or other reports, or computer software programs that it offers to
assist the introducing firm in supervising its activities and monitoring its
account. Introducing firms must give to clearing firms written
notification of those specific reports that they need to supervise and
monitor their customer accounts. Thereafter, clearing firms must
maintain, as part of their books and records, all reports requested by the
introducing firm or sufficient data to re-create such reports. By July
31st of each year, clearing firms must notify the chief executive and
compliance officers of their introducing firm clients as to what reports
they offer and what reports their introducing firm clients requested or
received. The rules do not state which firm has the responsibility for
monitoring the reports generated, or whether both firms share the
responsibility to so me degree. Regardless, of which firm generally
has the responsibility for reviewing and acting upon the reports, SRO's will
undoubtedly sanction any firm that ignores a "red flag" that comes
to its attention".
The process of how brokerage
firms interact with the public customer had changed completely in the last
five years. Standard exception reporting, usually presented to
supervisors on a monthly basis, has been completely replaced by automated
compliance and supervision systems. These new systems provide
exception reporting and analysis on a daily basis. The ability of
brokerage firms to track and discover areas of concern and red flags has
become nearly a dynamic part of the day-to-day operations of the
broker-dealer operation. The demands and expectations of
broker-dealers on software systems and providers have changed significantly.
Standard exception reporting and analysis has given way to automated systems
that can red flag exceptions on a daily basis. Branch managers and
supervisory staff are now equipped with the technology and software to
understand and evaluate the quality of practice in every customer account
making older exception reporting systems a "thing" of the past and
antiquated at best. Today's compliance, supervision and surveillance
systems are able to examine for a wide range of brokerage account exceptions
and most of today's systems are suitability based. This is a critical
consideration in securities litigation. Understanding that the
analysis and red flags are sensitive to the finances and investment
experience of each individual client provides a clear advantage to
positioning a case for issues of supervision and failure to supervise.
Branch managers and supervisors now have daily exception reporting and
analysis at their disposal to intervene and provide supervisory authority
and supervision. Systems and software now provide almost immediate
feedback and input as to account activity and the quality of practice.
SUPERVISION
The duty to supervise is a critical component
of federal regulatory compliance. The SEC has held that reasonable
supervision requires 'strict adherence' to internal company procedures,...Edwin
Kantor, 51 S.E.C.440, 446 (May 20, 1993). The Commission has
"made it clear that it is critical for investor protection that a
broker dealer establish and enforce effective procedures to supervise its
employees." Donald T. Sheldon, 52 SEC Docket 3826, 3855
(1992). Establishment of policies and procedures alone is not sufficient
to discharge supervisory responsibilities, however, as on-going monitoring
and review is necessary to ensure that the established procedures which make
up the supervisory program are effective in preventing and detecting
violations.
A widely recognized
standard for measuring a firm's compliance with its supervisory
responsibilities is the following: "Affirmative responsibilities are
placed on those who have a duty to supervise. Supervisors have an
obligation to respond vigorously and with utmost vigilance to indications of
irregularity." Quest Capital Strategies, Inc.
Release No. ID141, 69 SEC 1317 (1999). supra. "A
supervisor cannot ignore or disregard 'red flags' and must 'act decisively
to detect and prevent' improper activity. Indications of wrongdoing
demand inquiry as well as adequate follow-up and review." Section
15(b) of the 1934 Act defines "reasonable supervision" as
"established procedures, and a system for applying such procedures,
which would reasonably be expected to prevent and detect, insofar
as practicable, any violation [of the Act] by [an associated
person]". 15 U.S.C. # 780(b)(4)(E)(i). Broker Dealers have
a fiduciary duty to supervise their brokers.Komanoff v. Mabon, Nugent
& Co. 884 F.Supp. 848,861 (S.D.N.Y.1995) (customer stated a claim
against brokerage firm for breach of fiduciary duty based on a broker's
culpable conduct in adopting trading methods inconsistent with the client's
investment needs and objectives.)
The MSDW Compliance
Manual states, "The Branch Manager must review account information and
discuss it with the Financial Advisor. If Necessary, before approving
a new account, the Manager must contact the client directly if questions of
suitability arise". It goes on to state, "The Branch Manager
will examine the suitability of transactions and/or investment
recommendations based upon the information supplied by the client in the
client profile section of the New Account form. The Branch Manager
should review and compare the client's stated investment objective(s) with
the information that is presented elsewhere on the New Account form and in
any supplementary documentation that may be required (e.g. information on
the New Account form should coincide with information provided on the
client's Option Agreement)".
SSB's Branch Office
Manager's Compliance Manual, revised 3/24/99 states, "The most
comprehensive and proactive response to client account activity and accounts
with material risk exposure is personal client contact by the Branch Manager
which is documented in a letter summarizing the contact. Prior to
contacting the client, the Branch Manager should speak with the FC and
review the activity and positions in the account. The Branch Manager
should be particularly sensitive to:
- The types of
securities traded (e.g. low priced stocks, below investment grade bonds,
derivatives, etc.)
- Any large
positions (is the FC building a position in many accounts?)
- Margin
balance
- Volume of
trading
- Holding
periods
In reviewing the
account, the Branch Manager should:
- Evaluate whether the portfolio and activity is consistent with the
client's investment objectives and risk tolerance
- Evaluate whether the client has sufficient liquid net worth, annual
income, and investment experience necessary and safely assume the risks of
the investments
- Consider the account's cost ratio (commissions and margin interest
divided by equity), turn-over, and credit history
In speaking with the clients, the Branch
manager should:
- Verify the
client's address, occupation, financial objectives, and risk tolerance.
- Determine
whether the client can articulate clearly the investment strategy employed
(is it FC driven?)
- Determine
whether the client understands the status of the account and relative risks.
- Discuss the
portfolio, specific activity, commissions (including loads on mutual funds
and mark-ups on principal transactions), and historical as well as current
profit/loss.
- If there is
a margin debit, discuss the margin interest expense and how it increases the
break-even point (cost ratio) the risks of leverage, and margin calls
- Because
potential "red flags" can be identified with open-ended questions,
inquire about the level of communication with the FC the quality of service,
and any pending or past errors".
The SEC has stated
that "...where the failure of a securities firm and its responsible
personnel to maintain and diligently enforce a proper system of supervision
and internal control results in the perpetration of fraud upon a customer or
in other misconduct in willful violation of the (1933) Act or the (1934)
Act, for purposes of applying the sanctions provided under the securities
laws, such failure constitutes participation in such misconduct and willful
violations are committed not only by the person who performed the misconduct
but also by those who did no properly perform their duty to prevent
it." The responsibility of broker/dealers to supervise their
employees by means of effective, established procedures is in fact a
critical component of the federal investor protection scheme regulating
securities markets. In the matter of Prudential Securities
Incorporated (1993) 1993 Lexis 2866; 51 S.E.C. 726, 738-739.
Supervising "unsolicited" trades
- It is a supervisory and regulatory requirement as well as being an
industry standard of properly mark (designate) an order ticket properly as
"solicited" or "unsolicited". In the securities
industry, there exists a multilevel system that is designed to monitor and
evaluate the trading of brokers in order to determine if there are any
violations of the securities industry - or any red flags that might be
indicative of a violation. It is the industry standard and
understanding that if the trade ticket is not marked "solicited"
or "unsolicited" the trade is considered to be solicited. A
licensed supervisor at the branch level is required to review every trade
made by the securities broker. Additionally, branch offices and the
NASD or NYSE are required to routinely conduct audits of firms practices,
which includes scrutiny of the firm brokers' marking of order tickets.
This is because the marking of tickets either "solicited" or
"unsolicited" can effect the supervision level and attention given
to orders. This is a key issue with respect to non-discretionary
accounts, to determine whether it is the broker or client who in fact,
"controls" the account. When a supervisor or regulator is
reviewing trade tickets to check for issues like unauthorized trading,
suitability or churning, the supervisor will give stronger weight and
concern to solicited trades, than unsolicited trades. It logically
follows that the primary motivation of a broker to mismark an order ticket
is to circumvent proper supervision i.e. to give the impression to his
branch manager that it is, in fact, the client who is directing the
trades. One of the guidelines set forth in most compliance manuals is
for the supervisory manager to "question" the broker and consider
it a "red flag" when a manager notices a large grouping of order
tickets marked "unsolicited" To not review this unusual
occurrence would be a failure to supervise. This is because the false
mismarking of an order ticket can also be considered a fraudulent act.
Not telling a customer a material fact (mismarking the order ticket
inferring to management that it was the customer's idea) is a 10b and 10b-5
violation in that it makes a false statement. Rule 144-130 of the
Arizona Securities Act specifically prohibits "[e]ngaging in a pattern
of marking order tickets as unsolicited when the dealer or salesman directly
or indirectly recommended the transaction or introduced the customer to the
security." In addition, the practice violates SEC Rule 240.17A
(a)(3)(4), NYSE Rule 410 and NASD Books and Records Rules. Finally,
the practice of falsely marking order tickets would also be a violation of
NYSE Rule 401, Good and Ethical Business Practices, NASD Rule 2110,
Standards of Commercial Honor and Principles of Trade, and NASD IM-2310-2,
Fair Dealing with Clients. One major brokerage firm states in a
compliance memo, "A series of orders marked unsolicited will be closely
questioned on the theory that multiple unsolicited orders were, in fact,
solicited." Another major brokerage firm once put it this way in
its Branch Manager's Supervisory Manual, "When reviewing the order
tickets, a Branch Manager must consider the following...A series of orders
market "unsolicited" for the same stock from a client or clients
of the same Financial Consultant. The marking of order tickets as
"unsolicited" will not protect the Branch Manager if the
circumstances are suspicious, in which case the Branch Manager must
determine if the orders are, in fact, solicited..."
NASD Notice to Members 99-45 clearly recites
a firms' supervisory duty. "Written supervisory procedures
document the supervisory system that has been established to ensure that
compliance guidelines are being followed and to prevent and detect
prohibited practices. The written supervisory procedures would
describe the activities the supervisor will conduct, if he or she determines
a transaction is not suitable for a customer. The written procedures
would instruct the supervisor on which reports produced by the surveillance
system the supervisor is to review as part of his or her supervisory
responsibilities, including a description of how often these reports should
be reviewed, the steps to be taken if suspicious activity is discovered, and
how to document the supervisor's oversight activities. These written
procedures should depict clear lines of authority, accountability and
responsibility. In addition, senior management can use the written
procedures to determine whether personnel are complying with the supervisory
system by auditing compliance with the written procedures. These
written supervisory procedures must be updated to properly reflect any
necessary changes to the supervisory system.
Respondent's will invariably argue that there
is no private right of action for violations of the compliance manual
provisions, the Securities Acts or NASD/SEC rules. These violations of rules,
Acts or the
firm's own compliance manual provisions form the basis for common law
negligence, which does provide a private right of action and a basis for
liability. In Dillenbeck v. City of Los Angeles 69 CAl.2d 472,
477-482, 72 Cal. Reptr. 321 (1968) the California Supreme Court held that
the police department's internal safety rules were admissible (a) as
evidence of the standard of due care applicable to the course of conduct of
the officer who was accused of negligence, and (b) to show that the
officer's failure to follow the safety rules constituted evidence of his
negligence. Thus according to the California Supreme Court, evidence
of a rule violation is relevant to the issue of negligence and should be
considered by the trier of fact when determining whether the standard of
care has been met. The Compliance Manual provisions, Acts and
regulatory rules represent evidence of what elements were required to meet
the standard of care and the brokers' or supervisors' failure to follow
those standards is patent evidence of contributory negligence. It
is important to note that a firm's internal rules do not establish legal
duties. Rather the legal duty is established by law and the facts of
the case. Indeed, even a case, very often quoted by respondent's De
Kwiatkowski v. Bear, Stearns & Co. 306 F.3d 1293 (2d Cir. 2002)
states: "No doubt, a duty of reasonable care applies to the broker's
performance of its obligations to customers with non-discretionary
accounts." Id. at 1305. The firm's internal rules
simply provide evidence of what is required to satisfy the duty of due care. Respondent's internal rules do not create an additional duty or
create a cause of action. However, Claimant's have a legal basis to recover
damages for any purported acts inconsistent with the internal manual
guidelines. That legal basis is the duty of due care imposed under the
law of negligence. The evidence of what is required to satisfy that
duty, in part, consists of Respondent's internal guidelines. De
Kwiatkowski is consistent with this position, including Dillenbeck.
De Kwiatkowski stated: "Kwiatkowski...does not argue directly that
non-compliance with internal rules or industry standards is a basis for
liability. Kwiatkowski instead relies on such non-compliance as
evidence of Bear's overall failure to exercise due care, assuming however a
duty as to which due care must be exercised." De Kwiatkowski at
1311.
In Notice to Members 98-96, the NASD noted
that written supervisory procedures that instruct a supervisor to initial
order tickets and blotters or to fill out review logs to document a review
are reasonable, while procedures that merely recite the applicable rules or
fail to describe the steps the firm will take when potential deficiencies
are identiried are not reasonable. Further, a member would not be in
compliance with the Rule if a general securities principal was responsible
for supervising general securities activities, but was not given the
requisite authority to fulfill the supervisory obligations. The rule
requires that each registered person be assigned to at least one
supervisor. This requirement recognizes the obvious fact that a
supervisory system reasonably designed to achieve compliance with the
securities laws does not permit persons to supervise themselves.
Further, a member that receives indications that a supervisor is having
difficulty performing his or her supervisory functions would have an
obligation to investigate to determine whether such person can continue in a
supervisory role.
Rule 3010(a)(8) requires that at least one
principal be designated to review the firm's supervisory system, procedures,
and internal inspections. The purpose of this review is to determine
the effects of changes such as hiring additional registered persons, the
departure of registered persons, commencing a new line of business (e.g.
market making), a change in ownership, or changes in the securities laws, on
the member's existing supervisory systems and procedures. A
supervisory system and/or written procedures that are not current with
regulatory requirements or the structure and business activities of the
member would not be reasonably designed to achieve compliance with the
securities laws. Internal inspections are required under Rule 3010
(c). The mandatory annual review must be reasonably designed to assist
members in detecting and preventing violations of the securities laws.
The 'reasonably" designed standard means, for example, that indications
of problems, or "red flags", must be investigated. When a
member receives an indication of irregularities in a customer's account
(e.g., a compliance program indicates or a supervisor discovers a frequency
of trading in a customer's account that exceeds the customer's normal level
of trading), it must require that the account be examined to determine
whether churning or some other violative conduct has occurred. If it
does not, then that member's examination procedures would not be reasonably
designed to detect or prevent irregularities or abuses"
To effectively defend itself, the Firm must
have adequate procedures of follow-up and review to ensure that the
responsibility delegated to the supervisor is being "diligently exercised."
NY Life Securities, Release No. 34-40459, 68 S.E.C. Docket 103 (Sept.
23, 1998) (The SEC disciplined "NYLIFE Securities...because there was no
system of follow-up and review to determine that the responsibility
delegated to the [supervisor] was being diligently exercised.") The
SEC has disciplined supervisors for their failure to review incoming and
outgoing correspondence. Euro Atlantic Securities, Inc. et all.
Release No. 34-40891, 68 SEC 2612, 1999. Further, the law is
well settled that a Firm is not relieved of its obligations to supervise
when its customer signs a trading authorization for a third party.
Rolf v. Blyth Eastman Dillon, 570 F 2d 38, 45 (2nd Cir. 1978). The
American Stock Exchange has disciplined a Branch Office Manager and the
Firm, when, among other things, the Branch Office Manager "failed to
take meaningful and effective steps to prevent...unsuitable options
transactions from occurring [in an advised account]..." In the
Matter of Richard DeCastro, 1998 WL 295513 (AMEX):
"The Panel
believes that the existence of a third party power of attorney does not
relieve a member organization or its supervisory personnel of their
obligations under the Exchange's rules to supervise the accounts of their
customers." DeCastro, supra. at *7. The Exchange
specifically rejected the Firm's argument that the Branch Office Manager has
no duty to supervise an advised account. Id. See, NYSE
rule 405, Diligence as to Accounts. ("Every member organization is
required...to use due diligence to learn the essential facts relative to ...every
person holding power of attorney over any account accepted or carried by
such organization"). (Emphasis added). NASD and NYSE rules are
the standard by which broker conduct is measured. Mihara v. Dean Witter &
Co., Inc., 619 F.2d 814, 824 (9th Cir. 1980)("Appellants contend that the
admission of testimony regarding the New York Stock Exchange and NASD rules
served to dignify those rules and regulations to some sort of standard.
The admission of testimony relating to those rules was proper precisely
because the rules reflect the standard to which all brokers are held.")
Negligence, or the
failure to act according to a recognized duty of due care, occurs in the
securities context by, among other things: (1) failure to adhere to industry
standards and practices or the firm's own rules and guidelines; (2) failure
to supervise adequately the broker's handing of an account; and (3) making
unfounded representations or omissions that may induce reliance or a false
sense of security. Although deviation from industry custom and
practice does not, in and of itself, provide for a private cause of action,
it has been recognized that the deviation from such industry standard can
form the basis for a a negligence claim. As stated by Professor Poser
in Broker Dealer Law and Regulation (3rd. Edition 2002 Supplement),
at page 2-155,"A court may consider a custom, practice, or usage of the
securities industry, even though it is not formally embodied in an internal
rule of the defendant brokerage firm, in order to determine whether the
conduct of the firm or its employees was reasonable and in accord with
applicable standards of conduct". Professor Poser goes on to
state that, "in negligence and breach of fiduciary duty cases, courts
commonly look to industry custom and practice in order to determine whether
the challenged conduct was reasonable and to determine the appropriate
standard of care." Id. at 2-117 (citing Ehrlich
v. First Natl. Bank of Princeton, 505 A.2d 220, 235
(N.J.Super.1984).
Supervising securities in accounts
transferred in from another brokerage firm - Respondents will invariably
argue that securities it didn't sell are not its responsibility.
Nothing could be further from the truth. This is especially true of
firms that were members of the NYSE. NYSE Rule 405 states that
"Every member organization is required to:
(1) Use due
diligence to learn the essential facts relative to every customer, every
order, every cash or margin account accepted or carried by such
organization and every person holding poser of attorney over any account accepted
or carried by such organization Further, the rule addresses
Supervision of Accounts:
(2) Supervise
diligently all accounts handled by registered representatives of the
organization. The rule also addresses Approval of accounts:
(3)
Specifically approve the opening of an account prior to or promptly
after completion of any transaction for the account or or with a
customer....the....person approving the opening of the the account shall,
prior to giving his approval., be personally informed as to the essential
facts relative to the customer and to the nature of the account.
Moreover, the transferred in securities must
be considered by the broker when making any recommendation to buy or sell in
the new account because NASD Rule 2310 requires him or her to consider the
customer's "other security holdings." If the transferred in
securities are too risky for the customer's investment objectives and risk
tolerance as determined by the new firm, or if they result in the account
being improperly diversified or improperly allocated among asset classes,
then the broker would have a duty to speak to the customer because he or she
could not make the new recommendation without reference to the transferred
in securities. Similarly, the branch office manager or compliance
officer could not approve the new trade (s) without reference to the
securities transferred in.
Further, the
wide ranging applications of the high standard of care in the investment
relationship indicate that the rule must also prohibit a firm from
disclaiming liability for losses on transferred in securities where it has
not disclosed and discussed with the client that it would not rake the
responsibility for securities purchased at another firm. It is simply
not fair and certainly is not honorable, just or equitable for the customer
to be uninformed of any alleged limitation of the firm's liability. At
the very least, the customer agreement should contain a disclaimer in
boldface and capitals, much like the mandated arbitration clause, and the
broker should not contemporaneously in records that he or she informed the
customer of the disclaimer of liability and also discussed the customer's
options respecting the transferred in securities.
The after-the-fact
disclaimer of liability is particularly reprehensible where the transferred
in securities are held in a wrap account or non-managed fee based
account. NYSE Rule 405A requires disclosure of "sufficient
information for the customer to make a reasonably informed determination
whether the [account] is appropriate to suit [his or her] anticipated
needs." Certainly, a customer must be informed of any claim
to limited liability on assets for which he or she will pay an annual fee,
regardless of sales activity. Irrespective of whether the securities
are placed in a non-managed fee based account, the new broker must have
promised some increased level of performance that would, by inference,
include that he or who would make timely recommendations regarding the
transferred in securities. The account did not simply float over to
the new brokerage house on its own. Testimony by the customer may
establish promised by the broker to care for the customer's
securities. Thus, the firm's disclaimer of liability on the
transferred in securities would not only violate NASD Rule 2110 , but it
would also constitute a breach of contract.
Special Supervision
NASD Notice to
Members 97-19 dated April 1997 deals with this issue. It includes a NYSE
memo. "A firm that hires a registered representative with a
recent history of customer complaints, final disciplinary actions involving
sales practice abuse or other customer harm, or adverse arbitration
decisions should determine if it is necessary to develop and implement
special supervisory procedures tailored to the individual
representative. The individual's direct supervisor or other designee
of the firm should consider performing a thorough review of a registered
representative's customer account activity if, subsequent to hiring, the
registered representative becomes subject to customer complaints. Such
a review procedure could be activated, for example, when the registered
representative is named, during a one-year period, in three customer
complaints alleging sales practice abuse".
"A heightened level
of supervision may be appropriate for a registered representative whose CRD
report discloses sales practice problems and not simply isolated instances
of customer complaints, minor disciplinary actions, or arbitrations.
While final disciplinary actions, complaints, or arbitrations resolved in a
manner adverse to the registered representative indicate a disciplinary
problem, multiple pending complaints, disciplinary actions, or arbitrations
may be indicative of a history that should be carefully reviewed. A
firm that employs persons in the following categories and does not have a
standard supervisory policy that addresses such persons should determine
whether existing procedures are adequate to provide reasonable supervision
or whether heightened supervision is warranted:
...registered
representatives with a history of customer complaints, disciplinary actions,
or arbitrations;
...persons hired in
a non-registered capacity who previously were employed as registered
representatives and who have such a
history;
...registered
representatives who develop such a history while associated with the firm;
...registered
representatives terminated from prior employment for what appears to be a
significant sales practice or regulatory violation; or
...registered
representatives who have had a frequent change of employers within the
industry.
Christopher J. Benz, 64 S.E.C. 396
(1997); Douglas Conrad Black, 51 S.E.C. 791, 795 (1993); Houston
A. Goddard, 51 S.E.C. 668, 672
(1993).
"The firm also
should review the registered representative's CRD record and the nature of
the activities in which he or she is, or will be, engaged (considering, for
example, the types of products he or she plans to sell and reviewing the
person's top accounts, including changes or trends in account activity and
commissions earned). The firm should consider meeting with the
registered representative and the person who is or will be his or her
supervisor, during which the supervisor's understanding of the prior conduct
of the registered representative and willingness to accept responsibility
for his or her supervision can be confirmed. The firm could require
the registered representative and his or her direct supervisor to sign an
acknowledgment, indicating their understanding and their agreement to abide
by the terms of the special supervision for the requisite time period.
It also is advisable for the firm to document the termination of a period of
special supervision, including an assessment of whether the objectives of
the supervisory arrangement were met. It is important that firm retain
evidence of special supervision".
"One of the
first things to consider when establishing heightened supervisory procedures
is the nature of the conduct that resulted in the registered
representative's history of customer complaints, disciplinary actions, or
arbitrations, and whether the conduct involved a particular securities
product, customer type, or activity. In any of these instances, the
product, customer, or activity type should be examined to identify the level
and type of risk it presents. the firm should then determine what type
of supervision might best control and limit this type of risk. This
may range from providing the ordinary level of supervision, to restricting a
registered representative's activities for a period of time in a manner that
is based on the firm's assessment of the registered representative's prior
problems, to assigning a mentor or partner in whom the firm has confidence
to work with the registered representative".
"If warranted
after a review of all circumstances, firms should consider whether a
supervisor should exercise closer than normal control over the establishment
of new customer accounts by a registered representative. For example,
if a registered representative has a history of complaints involving initial
transactions in accounts, closer scrutiny of his or her account opening
practices may be warranted. In addition to the normal requirements for
opening a new account set out in NASD Rule 3110 and NYSE Rule 405, the
manager might choose to speak with all or selected new account holders or to
independently verify the customer information on the account form on a
random or consistent basis, depending on the situation. If the firm
deemed it prudent in view of prior activities, it might prohibit any trading
until the account information or the order information could be
independently verified with the customer. Of course, the optional
practice of sending notices to all new customers to verify and ask for
comment on the new account information on file at the firm upon opening of
the account might be sufficient in a specific set of circumstances, as might
a decision to instead monitor subsequent transactions".
"When reviewing
conduct to determine whether heightened supervision is warranted, firms
should focus on whether a specific type of transaction was involved in prior
problems, and should consider prohibiting like transactions, or requiring
supervisory approval of all such transactions in advance of execution, as is
routinely required at many firms in the case of low-priced securities,
options, and discretionary trades. Examples of orders that may pose
potential harm, and as to which many firms may as a matter of practice
already require prior supervisory approval, are: orders in discretionary
accounts; orders in low-priced, speculative securities; orders of an unusual
size or frequency considering the particular account's trading pattern; deep
out-of-the money and uncovered options orders; or mutual fund
switches. Firms also could consider reviewing the registered
representative's customer contacts by, for example, monitoring selected
telephone conversations between the registered representative and both
existing and potential customers or attending meetings between the
representative and his or her clients".
"Enhanced
procedures may be appropriate for registered representatives subject to
special supervision, including, for instance, requiring the approval of all
correspondence prior to use, even when prior approval is not specifically
required by SRO rules. Firms also should take reasonable steps to
prevent such individuals from circumventing approval by, for example, using
the Internet or other electronic media for communications, or restricting
the registered representative's use of certain types of communications,
including the Internet or other electronic media, electronic mail, or mass
mailings, where appropriate". In Notice to members 98-38
(May 1998) It is indicated that unexpected supervisory visits to offices
with personnel who have disciplinary records may be appropriate.
Although FINRA had
proposed a rule to address when a broker should be put on heightened
supervision, at present, the only specific rule is one dealing with
producing managers. For the average broker, there is nothing quite as
clear-cut. FINRA Rule 3010 requires that any supervision plan be
reasonable designed to ensure compliance with applicable securities laws and
regulations and FINRA rules. Consequently, each firm has the
flexibility to tailor a plan to fit its business and to address any concerns
that might be raised by a broker's past or present activities. In
general, FINRA has indicated that heightened supervision should be
considered for brokers whose records reflect disciplinary actions involving
sales practice abuse or a history of customer complaints and/or arbitrations
that were not resolved in their favor. In 2002, for example, Daniel M.
Sibears, senior vice president of FINRA (which was NASD Regulation, Inc. at
the time), spoke before the U.S. House of Representatives. He
said: "Circumstances that may warrant heightened supervisory
controls include registered representatives...who have been the subject of
numerous customer complaints, disciplinary actions or arbitrations;
registered representatives terminated from association with prior firms for
regulatory reasons or concerns; [and] registered representatives who have
frequently changed their employment..."
Red Flags
Another
key issue in supervision is red flags.
Firms cannot meet their supervisory responsibilities with passive or
inactive responses to red flags that indicate improprieties.
Indications of wrong-doing require a vigorous response. See, e.g., William
L. Viera, Exchange Act Rel. No. 26576, 1989 WL 992581 (Feb. 26, 1989); Nicholas
A. Bocella, Exchange Act Rel. No. 26574, 1989 WL 992565 (Feb. 7, 1989); First
Albany Corporation, Exchange Act Rel. 30515, 1992 WL 64040 (Mar. 25,
1992). The SEC
and the courts have provided valuable insight on this subject as follows:
1.
Excerpts from administrative decisions of the SEC, Re: Supervision:
...1987 SEC Lexis 3013 at pages 9-10 (12-15-87), "A branch manager is the
first line of defense when it comes to supervision of registered
representatives and endeavoring to assure their compliance with applicable
laws and regulations". (Administrative Procedure File No. 3-6700).
..."Once the branch manager or compliance officer is on inquiry notice of
any possible improprieties, he or she then has an obligation to make an
independent inquiry of transactions in customer accounts without relying
on the representations of the broker. The branch manager should
contact the client by telephone to verify the representations which the
broker has made to the branch manager regarding a customer's account.
A simple phone call by the branch manager to the customer can also serve to
verify account activity at variance with customer information on the new
account form. Items include the net worth, age, employment, tax
bracket and investment experience representations on the new account form.
Turning a blind eye to questionable account activity can lead to dangerous
consequences for the branch manager, branch offices and the firm".
(Administration Proc.
File No. 3-8969, 1996 SEC Lexis 584 (3-6-96).
..."Activity letters, letters prepared by the branch office seeking a
customer's acknowledgement of excessive trading activity or losses in his or
her account, and the manner in which they are prepared, delivered to the
client and received back by the firm often provide numerous "red flags" to
the branch manager. Once accounts have been singled out for activity
letters, common sense requires that branch managers follow the activity
letter from its preparation through its ultimate receipt from the client in
order to detect any irregularities. Indeed, the mere failure to
receive a return activity letter has been determined to constitute cause
enough for a branch manager to make direct contact with a non-responding
customer".
(Admin. Proc. file No.
3-8209, 1003 SEC Lexis 2866 (10-21-93).
...Lax supervisory practices on the part of Prudential Securities which
dealt with the failure of branch office managers to follow through with
active account reports". "Many customers were not contacted by branch
office managers, even though their accounts repeatedly appeared on active
account reports. In virtually all cases, meaningful contact could
have detected and prevented violations. PSI experienced a serious
breakdown in its active account review procedure (1993 SEC Lexis 2866 at
page 64). The simple expedient of client contact by the branch
manager, it was determined, would have prevented trading improprieties being
engaged in by brokers in branch offices".
The NASD also has notified members that "if 'red flags' or facts that
raise issues about a registered representative's conduct come to the
attention of a firm's supervisors, the firm must conduct a thorough
investigation in order to resolve the concern," Id (citing cases
in which the SEC has imposed liability for supervision failure resulting
from failure to follow up on such red flags). Once a firm has such
knowledge, its duty is to disclose that information. See, e.g.
Glaziers and Glassworker Union Local No. 252 Annuity Fund v. Newbridge
Securities, Inc., 93 F.3d 1171 (3d Cir. 1996) ("Newbridge").
In Newbridge, the employee of a broker-dealer resigned from that firm
to join another firm. The plaintiff's funds followed the employee to
the new broker-dealer. The former broker dealer had strong evidence,
which it forwarded to the NASD, showing that its employee had engaged in
misconduct. However, the firm kept silent. the court wrote that a
fiduciary seeing problems has a duty to inform, and cannot "turn its
'practiced eye' to its self-interest, while turning a blind eye to the
interests of its beneficiary." 93 F.3d at 1182. California
law also requires a fiduciary to disclose to the client all material facts
which might affect their rights or interests. Notice of a sales
violation, therefore, should trigger a direct inquiry into whether the
investor knows what is going on in their account. Pusateri v. E.F.
Hutton, 180 Cal. pp. 3d 247, 255 (1986). In some cases, this duty
also runs to non-customers. Bear Stearns v. Buehler,23 Fed.
Apex. 773 (9thCir. 2001) ("Once aware of troublesome "red
flags", the broker-dealer may have a duty which runs to non-customers
to monitor and investigate any unusual account
activity").
Reasonable supervision "requires strict adherence to internal company
procedures." Dickinson & Co. and John Laurent, Exchange
Act Release No 26338, p. 6 (Oct. 9, 1995) quoting Nicholas A. Roccella, Exchange
Act release No. 26574, 49 SEC 1084, 1086 (1989. Even where
supervisors' knowledge "is limited to red flags or suggestions of
irregularity, [they] cannot discharge their supervisory obligations simply
by relying on the unverified representations of employees, "Id.,quoting
Gutfreund, Strauyss & Meriwether, Exchange Act Release No. 31554,
52 SEC Doc. 4370, 4387 (Dec. 3, 1992). The branch manager "cannot
ignore patterns presented by suspicious events and circumstances but must
devise a response to detect and prevent improper activity." William
L. Viera, Exchange Act Release No. 26576, 49 SEC 1091, 1097
(1989). In addition, a broker'dealer's own in-house guidelines (i.e.,
compliance manuals) help establish the correct standard of cares. Thropp
v. Bache, Halsey, Stuart, Shields, Inc., 650 F.2d 817,820 (6thCir.
1981); Mihara v. Dean Witter & Co., 619 F.2d 814 (9th Cir.1980); Peterzell
v. Dean witter Reynolds, Inc., AAA Case No. 32-136-0416-88-ID (Nov. 9,
1990).
A broker dealer may avoid liability for failure to supervise under the 1934
Act, Section 20(a), only by showing they have acted in good faith by having
maintained and enforced a reasonable and proper system of supervision
and internal control so as to prevent violations of the Exchange
Act. However, in supervising its employees, a firm may not simply
rely on the supposed integrity of the broker. Rhumbline Advisors, 68
S.E.C. 276 (1998); First Capital Strategists, Advisers Act Rel. No.
1648 (Aug. 13, 1997). As recently articulated in George M. Lintz, 74
S.E.C. 849 92001: The "supervisory obligations imposed by the
federal securities laws require a vigorous response even to indications of
wrongdoing. Thus, supervisors must respond not only when they are
"explicitly informed of an illegal act, "but also when they are
"aware only of 'red flags' or 'suggestions' of irregularity." See
id. at *34-35. "Red flags and suggestions of irregularities
demand inquiry as well as adequate follow-up and review." In
re Edwin Kantor, Exchange Act Release No. 32341, 1993 SEC LEXIS 1240, at
*16 (May 20, 1993). 2001 WL 121982 at *3 (emphasis supplied).
Supervisory red flags require action: a supervisor who reviews the sales of
registered representatives and is confronted with red flags fails reasonable
to supervise when he or she does not take corrective action in
response. In re W.J. Nolan & Co., Exchange Act Release No.
34-44833 (Sept. 24, 2001); Donna M. Morehead, 77 S.E.C. 1935, 2002 WL
1371019 at *4 (2002).
2. Off-site
representatives require special supervision.
A significant number of NASD members employ registered persons who engage in
securities-related activities, on a full or part time basis, at locations
away from the offices of the member. These off-site representatives,
often classified for compensation purposes as independent contractors, may
also be involved in other business enterprises such as insurance, real
estate sales, accounting, estate or tax planning. They may also
operate as separate business entities under names other than those of the
members. Irrespective of an individual's location or compensation
arrangements, all associated persons are considered to be employees of the
firm with which they are registered for purposes of compliance with NASD
rules governing the conduct of registered persons and the supervisory
responsibilities of the member (Notice to Members 86-65 - Compliance with
the NASD rules of Fair Practice).
The fact that an associated person conducts business at a separate location
or is compensated as an independent contractor does not alter the
obligations of the individual and the firm to comply fully with all
applicable regulatory requirements. Thus, firms employing off-site
representatives are responsible for establishing and carrying out procedures
that will subject these individuals to effective supervision designed to
monitor their securities-related activities and to detect and prevent
regulatory and compliance problems. This can include:
1. Educating off-site personnel regarding their obligations as
registered persons to the firm and to the public, including prohibited sales
practices.
2. Maintaining regular and frequent contact with such individuals.
3. Implementing appropriate supervisory practices, such as records
inspections and compliance audits at the representatives' places of
employment, to ensure that their methods of business and day-to-day
operations comply with applicable rules and requirements.
For greatest effectiveness in preventing and detecting violations, visits
should be unannounced and include, for example, a review of on-site customer
account documentation and other books and records, meetings with individual
representatives to discuss the products they are selling and their sales
methods, and an examination of correspondence and sales literature. To
fulfill these obligations, a firm should consider whether the number and
location of its registered principals provides the capability to supervise
its off-site representatives effectively.
NASD Notice to Members 99-45 clarifies this even further.
"Unannounced visits may be appropriate, particularly where there are
indications of misconduct or potential misconduct, such as the receipt of a
significant number of customer complaints, personnel with disciplinary
records, or excessive trade corrections, extensions, liquidations, or
variable contract replacements. Each firm should determine the types
of "red flags" that would trigger an unannounced inspection.
The frequency and scope of inspections should be determined based on factors
such as the nature and volume of business conducted at the office and the
nature and extent of contact with customers".
Also see, e.g. SEC
Legal Bulletin No. 17:Remote Office Supervision (March 19, 2004) at
1. See SEC Bulletin at 3; NASD Notice to Members 98-38, NASD Reminds
Members of Supervisory and Inspection Obligations (May 1998).
3. The
broker-dealer is liable for the stockbroker's wrongdoing. The law
makes employers liable for the harm caused by their employees acting in the
course and scope of their employment. Thus, if a stockbroker's
misconduct causes harm in an account, the employing brokerage firm is liable
side-by-side with the stockbroker. The legal principle that imposes
liability on employers for losses caused by their employees is ancient
enough to be known primarily by a Latin name: "respondeat
superior." The principle makes sense for two reasons.
First, it recognized the reality that the employee, who controls the purse
strings and otherwise has the ability to exercise control over the
employee's conduct, is in the best position to prevent the employee from
causing harm. The employer clearly is in a better position to prevent
harm than is the customer or an uninvolved third party, for example.
Second, respondeat superior is consistent with the ancient and
widespread legal principle that, as section 3521 of the California Civil
Code puts it, he who takes the benefit must bear the
burden."
4. Transaction
confirmations and other account statement do not put the
claimant on notice of unauthorized trading or churning in the account.
99 Civ. 9795 (LAK) United States District Court for the Southern District of
New York, 2000 U.S. Dist. LEXIS 3635 February 14, 2000 Filed and
Decided. An order to vacate an arbitration award was filed by
respondent Merit Capital Associates, Inc. and heard by Lewis A. Kaplan,
District Judge, following an award by an NASD arbitration panel in the
amount of $314,199.80 plus interest in favor of petitioner Mohammad Al-Azhari
and jointly and severally against respondent Merit Capital. The New
York Supreme Court confirmed the NASD arbitration award, stating,
"First, respondents have not shown that the notice defense upon which
they rely constitutes a "clearly governing legal principle".
"They rely on a line of cases holding that, in securities fraud
claims, transaction confirmations or other account statements put the
claimant on notice of the transactions enumerated therein and start the
statute of limitations on actions based on those transactions.
Although respondents seek to extrapolate from this principle that such
notice constitutes a defense to allegations of unauthorized trading or
churning, their effort is unavailing. Their cases recognize a notice
defense only where respondent has moved to dismiss the complaint as time
barred, which is not the case here, as petitioner's notice of claim
indisputably was filed before the limitations period expired.
Accordingly, respondents have not shown that the notice defense is clearly
recognized law and should have barred petitioner's claims in this
case". Further, an investors silence upon receiving account statements,
without complaint, does not constitute ratification. See Kravitz v.
Pressman, Frohlich & Frost, Inc.447 F.Supp.203, 211 (D.C.Mass.
1978).
In Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Cheng, 901 F.2d
1124 (Ct. App. D.C. 1990), the Court of Appeals for the District of Columbia
Circuit concluded that a broker's duty to a customer - under the basic
principles of agency law, as recognized by the District of Columbia -
encompasses the duty to inform the customer of the right to reject
unauthorized trades, and that the failure to do so, as a matter of law,
constitutes a breach of that duty. Since the customers in this case
were not informed of their right to disavow the unauthorized trades, said
the Court of Appeals, "there could not have been "ratification"
of such trades. "Ratification occurs only," said the
court, "when the customer, with full knowledge of the facts, manifests
his intention to adopt the unauthorized transaction."
5. Simply
disclosing the risks of a recommendation does not satisfy the fiduciary
responsibility of suitability. What are a rep's suitability
obligation. The SEC's recent decision, In the Matter of the
Application of James B. Chase (SEC Release 34-47476), outlines a rep's
suitability obligations and addresses several defenses that the rep had
raised to justify his investment recommendation. The SEC's decision
was the third of three involving stockbroker Chase. After an NASD
hearing panel found that Chase had violated securities rules, he appealed to
the NASD's National Adjudicatory Council, which not only affirmed the
findings but also imposed more severe sanctions. Chase then appealed
to the SEC.
At issue was whether it was appropriate for a financial advisor to recommend
the purchase of a concentrated position of a speculative stock partially on
margin to an investor of limited financial resources. Two NASD rules
came into play. The first was Conduct Rule 2110, which requires one to
"observe high standards of commercial honor and just and equitable
principles of trade". The second, Conduct Rule 2310, requires one
to have reasonable grounds for believing that a recommendation is suitable,
given such factors as the customer's financial status, tax status and investment objectives. Before the SEC, Chase argued six
points to support his position that the investment recommendation was
suitable. He argued that the customer was young and had a lifetime of
earning potential; that she wanted to buy the stock; that he [Chase] fully
informed the customer of all the risks associated with investing in
the stock; that the customer otherwise was knowledgeable, because she
was studying economics in college and, by using the Internet could evaluate
suitability herself; that the customer's mother, accountant and attorney all
received duplicate confirmations of the trades, and, finally, that the
customer changed her investment objectives from income and low risk to
growth and speculation.
The SEC was not persuaded by Chase's defenses. It concluded that the
customer's limited financial means "demanded an investment strategy
that limited risk." The SEC faulted Chase for failing to
recommend such a strategy, instead recommending the purchase of a
concentrated position in a speculative stock on margin. As to Chase's
defenses, the SEC concluded that it was "non-determinative" that
the customer was young and had a lifetime of earning potential, because at
the time she had no income and no prospects of any anticipated income.
Chase was obligated to consider the customer's actual financial profile and
needs at the time of the recommendation. Second, even if the
customer wanted to buy the stock, that fact did not alter Chase's duty to
recommend only suitable investments. Third, mere risk disclosure is
not sufficient to satisfy the suitability requirement. A financial
advisor must not only ensure that a customer understands the risks, but also
that the customer can bear those risks.
Fourth, in line with past precedents, the SEC believes that a college
education does not establish that a customer is a "sophisticated
investor." Likewise, it rejected Chase's fifth defense, finding
irrelevant the fact that he had informed the customer's mother, accountant
and attorney of his stock purchases - the duty was to the customer.
Finally, even if the customer had changed her objectives from income and low
risk to growth and speculation, the SEC observed that investment objectives
constitute only one factor in determining suitability. Rep's should
understand and abide by all of the lessons of the Chase decision. It
bears repeating that the SEC considers it to be a "profound
misunderstanding" for a rep to believe that his or her suitability
obligations can be satisfied simply by disclosing the risks of
recommendations. As Chase discusses, much more is
required.
6. Broker Dealer
enforcement of policies and procedures. It is custom and practice in
the securities industry for firms to establish internal guidelines for
sanctions against personnel (both registered representatives and
supervisors) who may be in violation of regulatory requirements and/or firm
policies or procedures. These sanctions are normally designed to
assist the firm in maintaining a high standard of commercial honor and to
serve as a deterrent to future violations. Sanctions imposed by
broker-dealers may include one or more of the following:
* Letter of Caution;
* Censure, Fine, or Suspension;
* Rescission of Trade(s) with RR bearing cost of market exposure and
other related costs;
* Forfeiture of Commissions;
* Suspension of Branch hiring/recruiting privileges;
* Heightened Supervision;
* "No More Business" in all or certain accounts;
* Prohibition against advertising;
* Retraction of supervisory privileges and/or authority;
* Remedial education or training at the RR expense;
* Internal or independent special examination or review at RR expense;
* Termination ("Discharge") from firm.
Securities Industry Group Outlines Best Practices For Supervisors and
Compliance Professionals To Protect Investors
 he Securities Industry and Financial
Markets Association (SIFMA) - formerly the Securities Industry Association,
a trade group for 650 financial services firms in the U.S. and throughout
the world -- has published "Best Practices" for its member firms.
Although "aspirational in nature", SIFMA states that its members
have an obligation to "abide by the highest professional
standards" because "anything less would be inconsistent with the
trust our clients have placed in us."
The Best Practices cover several areas - from firm management to
relationships with regulators - but the two most interesting relate to the
Best Practices for sales supervisors and for compliance professionals. SIFMA
does cover the area of "investor rights", but its treatment is
generic -- the right to "quality service", "full, clear
reporting", and "prompt, fair resolution of problems" - with
two exceptions. The first is that "significant conflicts of
interest" must be disclosed. The second is that, in presenting
investment recommendations, the firm "will present you [the investor]
with reasonable investment alternatives" and "disclose the
comparative risks, benefits and costs." Typically, firms often fail to follow these two Best Practices.
Clearly, the two most substantive Best Practices relate to sales
supervision and the role of the compliance professional. Let's examine four
excellent recommendations for sales supervision. First, SIFMA expects firms
to have "stringent" hiring procedures for financial advisers.
Firms need to review their practices to ensure that they capably can screen
candidates and whether additional protections are necessary.
Second, firms should use "special supervision" for financial
advisers who have a disciplinary history of customer sales abuse or other
customer harm. In the author's experience, this kind of heightened
supervision frequently can detect, if not prevent, significant customer harm
that may escape standard supervision processes.
Third, firms should understand that effective supervision and sound
written supervisory procedures are the "first line of defense in
guarding against sales practice abuses." Securities regulators have
delivered this message for many years. When firms detect problems, they must
take corrective action.
Finally, the Best Practices call for firms to "consider tying a
component of the branch manager's compensation to his/her effective
supervision" of financial advisers. That should get the point across!
SIFMA's Best Practices have a similar theme with respect to the role of
the compliance professional. There are five excellent recommendations.
First, firms must insist on "compliance and high ethical
standards" throughout the firm, and senior management must lead by
example. Securities regulators recently have emphasized that this
"culture of compliance" is necessary to comply with securities
rules and regulations.
Second, personal performance evaluations should have a component for the
compliance record of the individual as well as for the branch office. This
is similar to the sales supervision Best Practice noted above for branch
manager compensation, and it makes sense.
Third, firms should ensure that they provide an effective means of
communicating compliance, regulatory or ethical concerns to compliance
professionals and senior management. The Best Practice envisions firms
including confidential and anonymous communications so that there is no fear
of retaliation against those who may be viewed as
"whistleblowers".
Fourth, firms must support and provide adequate resources to compliance
professionals. That includes having programs for skill development as well
as "compensation, benefits and recognition in keeping with their
contributions." That also includes ensuring that compliance
professionals have sufficient access to information at the firm to discharge
their duties.
Finally, SIFMA recommends that firms involve compliance professionals in,
and recognize their input "as an integral component" of, hiring
and firing decisions. Likewise, firms should "actively involve"
compliance professionals in internal disciplinary processes to make certain
that action taken is "fair, consistent and appropriate."
In conclusion, SIFMA's Best Practices should be followed, as securities
regulators already require, or soon may require, these "best
practices" to be minimal standards of conduct.
FEND
- Securities Expert Witness
Telephone:
(310)641-0377
FAX: (310)649-3663
Email: fendmase@ca.rr.com
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