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