|
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). 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 (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.
To put this more simply,
one could compare the suitability obligation of the broker to the customer
as a 3 legged stool:
1. Background
A. Age, marital status, number of dependents, health, educational experience
B. Professional experience
C. Prior investment experience/trading history
D. 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 activities
* 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? .
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
CAP PRESERV.
21%*
70%
9% - 9%
5-8%
(Income)
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 Index (Blue Chip).
** 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.
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 |