The Benefits of Diversification (Charts) Articles

 Financial Advisers, including stockbrokers and financial planners, must abide by the suitability rules imposed by FINRA (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 FINRA and NASD Conduct Rule 2310, an investment recommendation must be both suitable for a client and have a reasonable basis.

 While Suitability must be reasonable, it only applies to “customers”.  FINRA’s definition of a customer in FINRA Rule 0160 merely excludes a “broker or dealer”.  However, FINRA does a better job in defining a customer in FINRA Conduct Rule 2111 (Frequently Asked Questions on Suitability) page 2 of 27, “In general, for purposes of the suitability rule, the term customer includes a person who is not a broker or dealer, who opens a brokerage account at a broker-dealer or purchases a security for which the broker-dealer receives or will receive, directly or indirectly compensation even though the security is held at an issuer, the issuer’s affiliate or custodial agent (e.f. “direct application” business, “investment program” securities, or private placements), or using another similar arrangement.”. 

 Although most broker dealer Respondents will argue that there is no private right of action for violation of NASD rules, violations of those rules may be  considered relevant for purposes of Rule 10b-5 unsuitability claims.  GMS Group, LLC v. Benderson, 326 F.3d 75,82 (2nd. Cir. 2003).  To establish a claim under Rule 10b-5 for unsuitability, a claimant must prove (1) the broker recommended (or in the case of a discretionary account purchased securities which are unsuitable in light of the investor’s objectives; (2) the broker recommended or purchased the securities with an intent to defraud or with reckless disregard for the investor’s interests; and (3) the broker exercised control over the investor’s account.  O’ Connor v. R.F.Lafferty & Co., Inc., 965 F.2d 893, 898 (10th Cir.1992).  Recklessness is defined as “conduct that is an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it.”For further support of items 2 & 3, please see Churning Analysis section i.e. scienter and control (see discussion of de facto control).

 The cornerstones of a more common suitability claim in arbitration, however, are NASD Rule 2310 and NYSE Rule 405. Violations of these industry rules and practices give rise to a common law claim for negligence; NASD rules evidence the standard of care a member should achieve.  Further, these rules set out the general standards of industry conduct and are evidence of the code of procedure by which broker/dealers must abide in dealing with their customers.

 Respondents’ “recommendation[s]” must be judged in light of the information available to [them] after reasonable inquiry as to [Claimants’} situation at the time of the recommendation[s] and not by reference to subsequent events.” Id. (emphasis added).  Section 15(b) (10) Securities Exchange Act of 1934, Exchange Act Release No. 8135, 1967 SEC Lexis 64 (July 27, 1967).

 In July of 2012, the Financial Industry Regulatory Authority (“FINRA”)  put into effect new rules of conduct that narrow the gap between brokers’ duties and investors’ expectations of their brokers’ responsibility.

Many Respondent’s in arbitration try to convince arbitration panels that licensed brokers generally do not owe a duty to act in the best interests of their customers. Instead, they argue that the duty of a broker to a customer with a non-discretionary account has been much more limited: only to recommend investments that are suitable in light of their client’s objectives, financial needs and circumstances. This, they contend, is true even where customers place exclusive reliance on their brokers and always follow their recommendations.  Finally there is regulatory clarification.

 The Securities and Exchange Commission approved new FINRA Rule 2111, an updated version of the old NASD Rule 2310 (Suitability) requires brokers and their firms to “have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile.”

 FINRA’s new Rule 2111 expands a broker’s responsibility toward the customer. While not reaching the level of requiring brokers to act in their customers’ best interests, the new standard is an improvement in the protection of investors because it will explicitly cover situations that industry members have historically opposed. Specifically, the new suitability standard will no longer apply only to recommendations concerning the purchase or sale of a security. Rather, it now applies also to the recommendation of investment strategies. Additionally, the new rule directly applies the suitability standard to a broker’s recommendation to hold a security, rather than just to purchase or sell a security. This expansion nullifies years of denials by brokers and their firms that a recommendation to “hold” a security constitutes actionable behavior. It recognizes the reality that investors sometimes refrain from executing a transaction on the advice and recommendation of their adviser.

 The rule further explains the three primary suitability obligations of a broker. First, a broker must make a reasonable-basis suitability determination, based on reasonable diligence, that the recommendation is suitable for at least some investors. What constitutes “reasonable diligence,” however, is undefined, and depends on a variety of factors such as the complexity, the risks and the rewards associated with the security or the investment strategy. Second, assuming the recommendation is suitable for at least some investors, a broker must then make a customer-specific suitability determination to ensure that the recommendation is suitable for a particular customer based on his or her investment profile. Finally, where brokers exercise actual or de factor control over a customer’s account, they must have a reasonable basis for believing that a series of recommended transactions, even if individually suitable, are not collectively unsuitable for the customer. Factors relevant to this determination are turnover ratio, cost-equity ratio and the existence of short-term trading.

 The new rule is undoubtedly an improvement over the former suitability rule, and will benefit investors in their interactions with their brokers, and in customer arbitration claims where their brokers have violated the rules. The benefits of the revisions, however, are mitigated by the new rule’s limitations. For example, the rule leaves much ambiguity regarding the precise contours of a broker’s obligations. Additionally, the duty is only triggered by a “recommendation” of the broker, as opposed to an adviser acting under a fiduciary duty, who in required in all respects to provide guidance in the client’s best interests. While the regulatory trends appear to favor protecting investors, much work still needs to be done, and investors must remain vigilant to ensure their advisers are recommending securities and investment strategies that are appropriate for their purposes.



 2310. Recommendations to Customers (Suitability)

 (a) In recommending to a customer the purchase, sale or exchange of any security, a member should have reasonable grounds for believing that the recommendation is suitable for such customer upon the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.

 (b) Prior to the execution of a transaction recommended to a non-institutional customer, other than those with customers where investments are limited to money-market mutual funds, a member shall make every effort to obtain information concerning:

      i.  The customer’s financial status;

      ii.  The customers tax status;

      iii.  The customer’s investment objectives;

      iv.  Such other information used or considered to be reasonable by such member or registered representative in making recommendations to the customer (age and health for example).

 The suitability of the investor must be, by industry rule and written procedure of at least every major wire house firm, established before the account makes its first investment.

In 2010, FINRA has consolidated the rules of the NYSE and NASD into new FINRA Conduct Rules:

      Rule 2310 will be replaced with new FINRA Rule 2111 – The new rule adds the concept of a strategy as opposed to merely making a securities recommendation.  It also breaks down suitability into three main obligations.  Reasonable basis (firms must have a reasonable basis to believe, based on adequate due diligence, that a recommendation is suitable at least for some investors), customer specific (firms must have reasonable grounds to believe a recommendation is suitable for the specific investor and that a firm refrain for recommending purchases beyond the customer’s capability) and quantitative (firms or associated persons who have actual or de facto control over a customer account must have a reasonable basis to believe the number of recommended transactions within a certain period is not excessive and unsuitable for the customer when taken together, in light of the customer’s profile).  Clearly the new suitability rules have strengthened significance in promoting fair dealing with customers, ethical sales practices as well as encouraging just and equitable principles of trade and communications with the public.

      Rule 2111 also addresses changes regarding the gathering and use of information as part of the suitability analysis.  For instance, the information that must be analyzed in determining whether a recommendation is suitable would include not only information disclosed by the customer in response to reasonable due diligence in obtaining it, but also information about the customer that is “known by the member or associated person”.  This would include information about the client’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs and risk tolerance, as well as any other information the member or associated person considers to be reasonable in making recommendations.  Finally, Rule 2111 prohibits a member or associated person from recommending a transaction or investment strategy involving a security or securities or the continuing purchase of a security or securities or use of an investment strategy involving a security or securities if such recommendation is inconsistent with the reasonable expectation that the customer has the financial ability to meet such a commitment.

      Rule 405 of the NYSE (the “know your customer rule”) has now been replaced by FINRA Rule 2090, capturing the main ethical standard of the former rule.  Firms would be required to use due diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer (including the customer’s financial profile and investment objectives or policy), and concerning the authority of each person acting on behalf of such customer This information may be used to aid the firm in all aspects of the customer/broker relationship, including, among other things, determining whether to approve the account, where to assign the account, whether to extend margin (and the extent thereof) and whether the customer has the financial ability to pay for transactions.  The obligation arises at the beginning of the customer/broker relationship and does not depend on whether a recommendation has been made.  FINRA Notices (like #09-25) and other public pronouncements have stated that a similar know-your-customer obligation is embedded in the  just and equitable principles of NASD Rule 2110 (Now FINRA Rule 2010).

 To put this more simply, after “reasonable basis suitability” had been established, one could compare the suitability obligation of the broker to the customer, to a 3 legged stool:


     1.  Background

           A.  Age, marital status, number of dependents, health, educational experience

           B.  Professional experience and employment

           C.  Prior investment experience/trading history, including other current investments

           D.  Time Horizon and years to retirement


     2.  Financial Considerations

           A.  Net worth (exclusive of home)

           B.  Liquid net worth (cash and marketable securities)

           C.  Concentration of a security or industry sector as a percentage of liquid net worth, average net equity or total assets under management/control.

           D.  Income

           E.  Source, i.e. where the money originally came from and whether it is replaceable

           F.  Need for liquidity*

           G.  History of withdrawals (if any)

           H.  Tax bracket (present and historical), tax consequences of broker’s trading activity


                *  Liquidity is the ability to convert an asset into cash immediately, without any significant loss of principal.  Marketability assesses whether there is a readily available marketplace to buy, sell or exchange an asset.


     3.  Risk Tolerance & Risk Capacity


          A.  Goals and time horizon

          B.  Investment objectives

          C.  Communications with broker (written and oral)

          D.  Mitigation by the customer


                  A very useful way to analyze suitability is to use the “TREAT” method:


                         T – Time Horizon

                         R – Risk Tolerance

                         E – Expected Return

                         A – Asset Class Preference

                         T – Tax Status


                   Risk tolerance or risk attitude measures the clients abstract ability to handle risk emotionally.  It evaluates the clients willingness to take on the risk of receiving lower returns in exchange for the possibility of earning higher ones.  This is a risk vs. reward analysis. It is usually measured in terms of the client being conservative, moderate or aggressive.  It is a good idea to have the client sign a portfolio policy statement such as declaring for example “the worst decline of my portfolio from top to bottom is a $150,000 loss on my $1,000,000 portfolio”.  In any risk profile questionnaire, always use dollars as opposed to percentages.

                    Risk Capacity is a measure of a clients ability to sustain risk, financially.  In a practical financial planning context, risk capacity is measured in terms of a clients asset base, withdrawals, liquidity needs and time horizon.  By getting to know the clients assets, age, retirement date, withdrawals needed and social security expected or existing, it is possible to gain a reasonably accurate measure of what a client will tolerate in terms of risk.

                    While risk capacity is about the client’s financial ability to sustain underperformance in pursuit of higher returns, risk tolerance measures the clients willingness to enter into such a trade-off in the first place.

                     If a broker makes an unsuitable recommendation, violating any one of the 3 legs listed above, the stool falls.  Underlying this 3-legged stool, there are a number of other elements to be aware of.

                    A broker just refrain from making an unsuitable recommendation even if the customer expressed an interest in engaging in the inappropriate trade or asked the broker to make the recommendation.  See, e.g.,Dane S. Faber,Exchange Act Release No. 49216, 2004 SEC LEXIS 277, at *23-24 (Feb. 10, 2004).


4.  Additional Considerations:


    A.  Was adequate information provided?  Did it include full and fair disclosure of all risks and conflicts of interest along with the provision of written materials prior to making the investment?

     B.  Did the client have the ability to understand the investment, based on the investor’s background, education and past investment experience?  The fact that a client previously held investments does not make that person a sophisticated investor.  “[Investor] is not a sophisticated investor.  Although she has owned securities for many years, she has always relied on the investment acumen of her father and other advisors.  She expected [broker] to manage her account and make investment decisions on her behalf.”  Thropp v. Bache Halsey Stuart Shields, Inc., 650 F.2d 817-819 (6th Cir. 1981).  What factors do brokerage firm counsel typically raise as to sophistication?  One typically considers wealth, education, professional status, investment experience and business background.  However, the NASD has made it clear that wealth is not necessarily an indicator of sophistication, particularly if the value of the investor’s home constitutes a significant percentage of the customer’s net worth.  Likewise, one must consider the scope of sophistication, such that an investor may be sophisticated in some areas of investing, and unsophisticated in others.  Additionally, advanced education degrees do not automatically establish that a customer is a sophisticated investor.

      It is helpful to compare the NASD’s rule with respect to options recommendations to the NASD’s rule with respect to non-options transactions.  for options recommendations, the NASD requires that the financial advisor have a reasonable basis for believing, at the time of making the recommendation, that the customer has such knowledge and experience in financial matters that he or she may reasonably be expected to be capable of evaluating the risks of the recommended options transaction.  By comparison, for non-options recommendations no such knowledge or sophistication requirement exists.  Instead, the NASD requires that the (non-options) recommendation be suitable based upon the customer’s other security holdings as well as his or her financial situation and needs.

     Thus, in the context of a simple negligence action for recommending an unsuitable investment, the sophistication defense is not legitimate.  Regulatory decisions support this view.  For example, in James Chase, Exchange Act Rel. No. 47476 (Mar. 10, 2003), 79 SEC Docket 2892, 2897, the SEC concluded that the mere disclosure of risks did not satisfy the suitability duty.  The SEC stated that not only must the customer be sufficiently sophisticated to fully understand the risks involved with the investment, the customer also must be able to bear those risks.  Of course, the ability to bear risks, standing alone, does not satisfy the suitability rule.  In Re. Dambro 51 S.E.C. 513, 517 (1993).

      Brokerage firm counsel frequently explore investor sophistication in the context of asserting affirmative defenses.  That is because several courts have held that where a sophisticated investor regularly receives information concerning the transactions in his or her account and fails to  object within a reasonable time (or the period specified by contract), one may be barred by the doctrines of waiver, estoppel, laches, or ratification from asserting a claim e.g., Costello v. Oppenheimer & Co., Inc. 711 F.2d 1361, 1370 (7th Cir. 1983).  However, the threshold for asserting these defenses is relatively high.  For example, to show that an investor ratified an action, such as to preclude broker liability, it must be clear from all the circumstances that the customer intended to adopt the trade as his or her own.  Knowledge of the pertinent facts and the clear intent to approve the unauthorized action are preconditions of ratification.  Van Syckle v. C.L. King & Associates, Inc. 822 F.Supp. 98 104 (N.D.N.Y. 1993).  Consequently, the mere receipt of statements is not dispositive, as the ultimate determination depends also on the customer’s sophistication and the complexity of the transaction at issue.

     Even a seemingly sophisticated investor will not be barred from bringing a claim if the information he received from his broker was faulty.  For example, a corporate vice-president with a degree in business administration who opened an options trading account was not barred by waiver, estoppel, laches or ratification from recovering losses due to the fact that he had protested several of the transactions, and that the confirmations often were late or inaccurate.  Costello v. Oppenheimer & Co., Inc. 711 F.2d 1361, 1370 7th Cir. 1983.  Likewise, “the disparity in sophistication between the brokerage firm and its customer” is relevant when considering the application of any written notice requirement.  Modern Settings, Inc. v. Prudential-Bache Securities, Inc., 936 F.2d 640, 645-946 (2d Cir. 1991) (emphasis added).

      The NASD cautions that there is no substitute for a suitability analysis, and “accredited” status under Regulation D of the Securities Act of 1933 is not necessarily an indicator of sophistication, particularly if the value of the investor’s home constitutes a significant percentage of his or her net wealth.

     C.  Did the broker make a reasonable effort to meet the clients objectives, based on information provided by the client?  For example, a client with Moderate Growth as an investment objective might be unsuitably implemented if 100% of his portfolio was placed in equities, with no cushion of cash and fixed income (bonds) to ease volatility and soften fluctuations.  Benjamin Graham in his book The Intelligent Investor wrote, “An investment operation is one which upon thorough analysis promises safety of principal and an adequate return”.   This illustrates that a 100% stock portfolio is simply too aggressive for a “moderate growth” investor.  There is far too much risk and volatility to expect any measure of  “safety of principal”  in that scenario.  That’s what Benjamin Graham meant by an “adequate return”  since fixed income and cash would reduce the yield. in a more balanced portfolio.

     D.  Was the purchase over-concentrated related to the client’s portfolio, total net worth, and liquid net worth?  Concentration, the antithesis of the well-diversified portfolio, is central to any suitability determination.  The SEC  and self-regulatory bodies have generally found recommendations to build a highly concentrated portfolio an unsuitable strategy.  See Clintom H. Holland, Jr. Exchange Act Rel. No. 36621,52 S.E.C. 562, 566 (Dec. 21,1995) (The concentration of high risk and speculative securities [in the customer’s] account…was not suitable.”), aff’d 105 F.3d 665 (9th Cir.1997); Daniel R. Howard, No. C11970032, 2000 NASD Discip. LEXIS 16. at *19 (NASD Nov.16, 2000) (“Howard’s recommendations also led to an undue concentration of these speculative securities [approximately 90 percent of the customer’s holdings], making the recommendations particularly unsuitable.”). Also see Stephen Thorlief Rangen, 52 S.E.C. 1304 (1997); Gordon Scott Venters, 51 S.E.C. 292 (1993), James b. Chase, 79 S.E.C. 2251 (2003) William J. Lucadamo, 1997 WL 1121318 (N.A.S.D.R. 1997; Bruce Martin Miller, 1998 WL 141592 (N.Y.\S.E. 1998) (“The concentration of high risk and speculative securities [in the customer’s] account … was not suitable.”aff’d. 105 F.3d 665 (9th Cir. 1997)  (table format).

     E..  Was the suitability based solely on the clients net worth?  Remember, a customers specific level of assets does not, by itself, satisfy a member’s obligations under the suitability rule.  See Patrick G. Keel, 51 S.E.C. 282,286 n.14 (1993) (“[E]vidence of wealth, as we have stated previously, is not an indicator of suitability.”); Arthur J. Lewis, 50 S.E.D. 747, 749 (1991) (“The fact that a customer…may be wealthy does not provide a basis for recommending risky investments”).  (“[s]uitability is determined by the appropriateness of the investment for the investor, not simply whether the salesman believes that the investor can afford to lose the money invested.”) David Joseph Dambro, 51 S.E.C. 513,517 (1993).

     F.  Special additional care must be taken when telemarketing to insure that securities being recommended, are suitable and, the customer has adequate financial means to invest in these securities, and to sustain any loss.

     G.  Similar rules exist in the Rules of the New York Stock Exchange (the “NYSE”) and the American Stock Exchange (the “AMEX”).  However, the NYSE (Rule 405) and the AMEX (Rule 411) rules extend beyond “recommendations”, and apply to all purchases and sales of securities, not just those recommended, thereby increasing the registered representative’s obligation to know and inquire into their customer’s investment goals, financial objectives, risk tolerance and past investment history.  Even the NASD agreed in Special Notice to Members 96-32 (May 9, 1996).  It stated, “the know your customer requirement in the Rules of Fair Practice requires a careful review of the appropriateness of transactions in low-priced, speculative securities, whether solicited or unsolicited”.

      H.  “Over the years, NYSE Rule 405 the [Know Your Customer Rule] has evolved to include a suitability obligation, especially when a broker recommends a security to a customer”.  Norman S. Poser – Article – “Civil Liability for Unsuitable Recommendations” in The Review of Securities & Commodities Regulation – 1986- vol. 19, p. 67 published by Standard and Poors.  In the Fourth Edition, of his book – Broker-Dealer Law and Regulation, 2007 at page 19-19, Mr. Poser develops the point even further.  He states, “Although the [NYSE know-your-customer] rule was originally designed to protect stock exchange members from dishonest or insolvent customers, it is today also regarded as protecting investors from being induced to purchase securities whose risks they can ill afford.”  Norman S. Poser – LLB. Harvard Law School – Professor of Law –  Brooklyn Law School.

 5.  Recommendations – Suitability is always determined at the time of the recommendation!   NYSE Rule 472, Communications With The Public, Supplementary Material in the NYSE Manual 472.40 titled Specific Standards for Communications with the Public, under (1) Recommendations:  “A recommendation must have a basis which can be substantiated as reasonable.  An investor should have access to available data in order to make an intelligent investment decision.  Therefore, information supporting a recommendation must be provided or offered. For example, disclosures, in a given context, which satisfies Rule 472.40(2) may not necessarily satisfy the provision of Rule 472.30(1) where additional facts would be material to the customer or reader.”  Interpretive Memo No. 90-5, issued in August 1990, provides that “for purposes of these standards, the term ‘recommendation’ includes any advice, suggestion or other statement, written or oral, that is intended, or can reasonably be expected, to influence a customer to purchase, sell or hold a security”.  For a broker to “recommend”, then, that a customer should “stay the course” or “hold” their position in a declining market, that recommendation must be backed up with all available reasonable disclosures.  Those disclosures would require him to discuss viable alternatives with the client, such as protective hedges (puts, stop losses or custom collars) or taking the money off the table.  To not discuss all viable alternatives with the client is to omit material information….and in the securities industry, omission of material facts is fraud.   The recommendation, not to sell, becomes unsuitable when constructive fraud is exhibited by the broker’s not disclosing other alternatives as a reasonable basis for the recommendation.  Further, he breaches his fiduciary duty by making unsuitable recommendations and not disclosing all material facts to the client.

       If the sale was made in California by a broker dealer which is not a member of the NYSE (many smaller firms are not), then you can use Small v. Fritz 30 CAl. 4th 167, 65 p.3d 1255, 132 Cal. REPTR. 2d 490 (2003).  The court held that California law allows persons wrongfully induced to hold stock instead of selling it to pursue a cause of action for fraud or negligent misrepresentation.  The appeals court said that misrepresentations to forego selling stock is fraud or negligent misrepresentation if the stockholders can make a bona fide showing of actual reliance upon the misrepresentation.  In finding liability for such torts, it is not necessary that the perpetrator had face-to-face or personal communication with the plaintiff.  Fraud can be perpetrated by any means of communication intended to reach and influence the recipient.   Further, the court said that the tort of negligent misrepresentation does not require scienter or intent to defraud.  It encompasses the assertion, as a fact, or that which is not true, by one who has no reasonable ground for believing it to be true.  Forbearance, the decision not to exercise a right or power, is sufficient consideration to support a contract and to overcome the statute of frauds.  It is also sufficient to fulfill the element of reliance necessary to sustain a cause of action for fraud or negligent misrepresentation.  The petition for review raised only a single issue:  “Should the tort of common law fraud (including negligent misrepresentation) be expanded to permit suits by those who claim that alleged misstatements by defendants induced them not to buy or sell  securities?” The court concluded that California law should allow a holder’s action for fraud or negligent misrepresentation since California law has long acknowledged that if the effect of a misrepresentation is to induce forbearance-to induce persons not to take action-and those persons are damaged as a result, they have a cause of action for fraud or misrepresentation.  The court was not persuaded to create an exception to this rule when the forbearance is to refrain from selling stock. The court said that this conclusion does not expand the tort of common law fraud, but simply applies long-established legal principles to the factual setting of misrepresentations that induce stockholders to hold on to their stock.

       In NASD Notice to Members 96-60 (issued to clarify and supplement “NTM” 96-32)  – “However, a broad range of circumstances may cause a transaction to be considered recommended, and this determination does not depend on the classification of the transaction by a particular member as ‘solicited’ or ‘unsolicited’.  In particular, a transaction will be considered to be recommended when the member or its associated person brings a specific security to the attention of the customer through any means, (emphasis added) including, but not limited to, direct telephone communication, the delivery of promotional material through the mail, or the transmission of electronic messages.”  Mis-marking of order tickets constitutes a fraudulent act as well being in violation of most broker dealers’ compliance rules.  It is important to note that it is a violation of Section 204 of the Uniform Securities Act, NASD Rule 3110, NYSE Rule 440 and SEC Rule 240.17a-3 (6) (books and records rules) for a registered representative to mark a trade as “unsolicited” when in fact the transaction was “solicited”.

      It is well settled in the securities industry that an unsolicited trade is one in which the broker merely acts as a conduit to complete the transaction brought to him or her by the client, independently, without input from the broker.  Purchases are considered solicited when the client suggests a security and the broker provides research reports, upon an initiated or request basis, or provides a supporting favorable opinion when the client suggests a security for purchase consideration.  In the Merrill Lynch Compliance Outline (August 1997, page 22), it states, “This is an example of a trade which must be marked solicited.  Client contacts the FC expressing interest in a security not brought to his or her attention by the FC.

           *  The FC provides information from Global Research, discusses the security with the client, and affirmatively suggests or encourages its purchase.”

      Further, in the year 2000, Wachovia Securities stated in its Compliance and Sales Practice Manual (Page 6.8), “The following situations are generally considered to involve “solicited” transactions:

           *     A transaction where the client initiates the inquiry but the Investment Consultant makes a favorable recommendation or gives a favorable opinion.

           *     A transaction resulting from research reports or written information prepared by the ESI Research Department, an Research Correspondent, or any third party, forwarded by the Investment Consultant to the client, whether initiated by the Investment Consultant or the client.”

      There is support for this from the SEC.  The Commission has not defined what constitutes a recommendation, although it has stated that a “recommendation may be found to have been implied even where one has not been made expressly.”  National Committee of Discount Brokers, SEC No-Action Letter (May 27, 1980).  Purchases then, by a client based primarily on the firm’s positive research would normally be classified as solicited when the broker provides the research reports or positive feedback.  It is custom and practice in the securities industry to classify all subsequent trades in a security the same as the initial purchase, so long as the follow-up trades are consistent and within a reasonable period of time.  The one exception to this is when the customer closes the account and transfers (delivers out) the securities to another firm.  That is normally classified as unsolicited, regardless of how the initial purchase is coded on the confirm.  If the confirm is blank and not classified, the trade is considered solicited.  Finally, in the Special NASD Notice to Members 96-32, it states, “In addition, the know-your-customer requirement embedded in Article III, Section I of the Rules of Fair Practice requires a careful review of the appropriateness of transactions in low-priced, speculative securities, whether solicited of unsolicited.”  Clearly the intent of this notice was to charge the broker with a suitability consideration with respect to aggressive securities, irrespective of whether the purchase was recommended or not.

      California has adopted regulations which define “unsolicited” orders. (Section 25610, California Corporations Code # 260.104)  The definition applies to all clients residing in California as of March 31, 1991.  The definition describes those facts which, if present, indicate a solicited transaction.  These definitions must be used when marking order tickets for California residents.

 An order or offer to buy a security is presumed to be “solicited” if the broker/dealer knows or has reason to know that the order or offer to buy is in response to one or more of the following activities in which the selling Account Executive engaged within the last sixty (60) days.

      *  publicly quoted a bid or asked price for the security which identifies the broker/dealer other than on an inter-dealer quotation system intended for broker/dealer use only;

      *  made a direct solicitation that clients purchase the security;

      *  recommended the purchase of the security to clients either directly or in a manner which would bring the recommendation to the attention of clients;

      *  volunteered information about the issuer of the security, either to a particular client who then purchased the security, or to clients generally;

      *  executed a transaction to purchase or sell a security pursuant to the AE’s discretionary authority for a client in a discretionary account.

 If, in information circulated with respect to a security or an issuer, a statement is included to the effect that the security  is ineligible for purchase or sale in California, or that an investment in the security is not recommended for California purchasers, the Account Executive is still required to mark the order “solicited” (Reference Section 25104, Corporations Code).

 The above rules require a precise written memorialization of any instruction given or received for the purchase or sale of securities including but not limited to the terms and conditions of the order and whether pursuant to discretionary authority. Both the SEC and the NASD have taken enforcement actions against brokers for mismarking trades as “unsolicited”.  see In re Novak 27 S.E.C. Docket 780, Release No. 34-19660 (1983); In re Fliess, 19 S.E.C. Docket 872, Release No. 34-16642, Mar. 10, 1980; David Stewart, NYSE Exch. Panel Hearing 95-19, 1995 WL, 489458 (1995); Kelly Fradet, NYSE exch. Panel Hearing 89-69, 1989 WL 379930 (1989); Barry Axler, NYSE Exch. Panel Hearing 75-24, 1975 WL 21796 (1975).  The SEC has also taken enforcement actions against firms and managers for failing to ensure, and independently verify, that order tickets market “unsolicited” were accurate.  See In re Dean Witter Reynolds, Release No. 34-26144 (Apr. 8, 1988); In re Barlage, Release No. 34-25563 (Sept. 30, 1988).  State securities regulators have acted to suspend firms and require that principals requalify after such violations.  see In re George Cole & Co. Inc., Okla. Dept. Sec., 1982 WL 195089 (Sept. 28, 1982).

 6.  Concentration – A broker has a fiduciary duty to diversify his customer’s assets and avoid over-concentration in a limited number of stocks or asset classes (see chart above).  In the Matter of Jack H. Stein, before the National Adjudicatory Council, NASD Regulation, December 2, 2001:  “Stein also concerns over concentration:  “the speculative and risky nature of the stocks that Stein recommended and the high concentration of those stocks in EA’s account made Stein’s recommendations unsuitable…Even assuming, as Stein contends, that EA sought to speculate, Stein concentrated EA’s account too highly in speculative securities”  Stein argued that the customer understood the risks associated with speculative investments and actively sought to change her investment strategy to one that involved growth and speculation.  The Council stated that even if the customer understood Stein’s recommendations and decided to follow them, “that (would) not relieve (Stein) of his obligation to make reasonable recommendations.”  The Council then cited Clinton Hugh Holland, Jr. 52 S.E.C. 562 @ 566 (1995 aff’d, 105 F. 3d 665 (9th Cir. 1997).  Disciplinary decisions suggest that the burden placed upon registered representatives to justify a recommended concentration increases as the type of security becomes more speculative.  At least one decision found a 25% concentration to be “at the high end of the acceptable range”.  Note:  On the most conservative basis, the maximum concentration in any one asset class or speculative security should not exceed 15% of an investor’s liquid net worth. It is normal custom and practice in the securities industry for a branch manager to make a documented call to the client to confirm exceeding this percentage or to require a registered representative to obtain a written disclaimer from the client if concentration exceeds this percentage.

 7.  Past Investment Experience or Sophistication – In the Matter of Wayne B. Vaughn, before the National Adjudicatory Council, NASD Regulation, October 22, 1998, “At the NAC Hearing, Vaughan and his counsel tried to paint VB as a “sophisticated investor” who enjoyed trading in speculative securities.  Vaughn asserted that VB has previously engaged in a risky trading strategy… in index options and junk bonds.  Vaughan’s counsel described VB as someone who had engaged in “sophisticated trading, enjoyed that, and insisted upon it.  “A customer’s prior transactions, however, are not relevant in a suitability determination, and we do not find that VB’s history of risky trading mitigates Vaughn’s conduct. The fact that VB traded junk bonds and index options in the past does not mean that she understood the risks involved.  She could very well have been following the recommendations of her broker at that time.  (Emphasis added).  In re Peter C. Bucchieri, Rel. No. 34-37218, May 14, 1996:  FN9 – The fact that Robert Dibble had a graduate degree from Harvard, a consideration stressed by Bucchieri does not establish that he was a sophisticated investor. In re Clinton H. Holland, Jr. A college economics course and access to information do not, however, constitute “investment experience” or “sophistication”.

      In the matter of Douglas Jerome Hellie, NASD Administrative Proceeding File No. 3-7279, July 23, 1991 (discretionary account) – “In our view, Trust’s prior trades are irrelevant.  A broker must make a customer-specific determination of suitability and…tailor his recommendations to the customer’s financial profile and investment objectives.”  “Hellie was given specific instructions as to the maximum level of risk that purchases for Trust could entail.  He must or should have been aware that a speculative, low-priced stock such as Interesources, Inc. (Interesources was a non-exchange, non-NASDAQ stock, listed solely in the “pink sheets” of the National Quotation Bureau), whose value depended on its being an acquisition candidate or some other external event, involved a higher risk than was permissible for the account.”  “Hellie’s arguments that Voss (CPA and trustee of the trust) did not object to the Interources trades until three months after the purchases or that Voss would have characterized the Interesources purchase as “medium risk” are irrelevant.  Interesources was unsuitable for Trust’s account regardless of any improper motivation on Voss’s part to characterize it as such”.

 8.  Fair Dealing – IM-2310-2(a)(1) says. “Implicit in all member and registered representative relationships with customers and others is the fundamental responsibility for fair dealing”.  IM-2310(a)(2) says “that sales efforts must be judged on the basis of whether they can be reasonably said to represent fair treatment for the persons to whom the sales efforts are directed, rather than on the argument that they result in profits to customers”. In re Charles W. Eye, 49 S.E.C. 85, Rel. No. 34-29572, 1991:  Her request for a plan to increase income was not a warrant to escalate risks unduly.  If the only approach capable of producing the desired income involved significant dangers, Eye should have advised against it.  In re Arthur Joseph Lewis, Rel. No. 34-29794, October 8, 1991:  The fact that a customer such as Mrs. McGowan may be wealthy does not provide a basis for recommending risky investments.  In re Gordon Scott Venters, Rel. No. 34-31833, February 8, 1993:  Whatever interest in speculation Avallone may have had was whetted by the aggressive and extremely optimistic promotional campaign by Venters and the firm.  At the very least, when Venters learned about his customer’s age and situation, he had a duty to abandon the promotion.  Citing Eugene Erdos, ( the issue is not whether or not the client considers the transactions in her account suitable, but whether the salesman, when he undertakes to counsel the client, fulfills the obligation he assumes to make only such recommendations as would be consistent with the client’s financial situation and needs.).

 9.  Client Must Understand Risks – In the matter of James B. Chase, before the National Adjudicatory council, NASD Regulation, August 16, 2001:  Chase’s Suitability Obligation.  NASD conduct rule 2310, also known as the “suitability” rule, requires a broker, in recommending a security to a customer, to have reasonable grounds for believing that the security is an appropriate investment for that customer, based on the customer’s financial situation and needs.  Chase demonstrated a profound lack of understanding of his customer-specific suitability obligation under Rule 2310.  Chase’s attorney argued during the proceedings below that Chase’s “primary responsibility [was] to make sure that the customer [was] fully advised of all the facts and [could] make intelligent decisions.”  Again, during the hearing on appeal, Chase’s attorney argued that Chase had fulfilled his suitability obligation by disclosing to YH the risks associated with following his recommendations to purchase FHC and to open a margin account.  Although it is important for a broker to educate clients about the risks associated with a particular recommendation, the suitability rule requires more from a broker than mere risk disclosure.  The broker also has a responsibility to explain forthrightly the practical impact and potential risks of the broker’s course of dealing.  This responsibility requires the broker to ensure the client’s understanding of the risks involved in a recommended transaction.  See Patrick G. Keel, 51 S.E.C. 282,286 (1993) (noting that a broker must ensure that the customer understands the risks involved in a recommended securities transaction, in addition to determining that the recommendation is suitable for the customer). (Emphasis Added)..  Among the broker’s fiduciary responsibilities in managing a discretionary account is the obligation to keep the client informed.  that duty extends to keeping the client advised of market changes affecting the client’s interest and to follow up by acting responsively to protect those interests.  Leib v. Merrill Lynch, Pierce, Fenner & Smith, Inc. 461 F.Supp. 951,953 (D.C.Mich. 1978): In re Rea, 245 B.R. 77,90 (Bkrtcy.N.D. Tex.2000); Patsos v. First Albany corp., 433 Mass 323,741 N.E.2d 841, 850, n.16 (Mass.2001).

 10.  Due Diligence Extends Beyond Securities Recommended – NYSE Rule 405, the Know Your Customer Rule, requires a broker to “Use due diligence to learn the essential facts relative to every customer, every order, every cash or margin account accepted or carried by such organization and every person holding power of attorney over any account accepted or carried by such organization.”  With registered representatives whose firms are members of the the NYSE, “due diligence” is required on every customer and every trade, not just those recommended.  That obligation extends to on-line and discount firms that are NYSE members.  Rule 405 does not distinguish between the various types of purchases and sales that customers make.  It simply says you have to “know your customer”.  The authors of Suitability in Securities Transactions say that the NYSE staff examiners informally define “essential facts” as “any information that affects the customer’s ability to accept risk” (as reported in The Business Lawyer, Vol. 54, August 1999, page 1571).  Although Rule 405, unlike NASD Rule 2310, does not enumerate the kinds of information that “essential” for brokers and brokerage firms to consider, the NYSE did publish guidance in its 1982 publication entitled “Patterns of Supervision”.  In discussing what items should be included in the New Account Form for customers to complete, the NYSE recommended that brokerage firms/broker’s inquire regarding such facts as: age, occupation, estimated income and net worth, marital status, number of dependents and investment objective. (See Legal Duties of Stockbrokers # 7)


11.  Recommendations must be related to the Customer’s Risk Tolerance – Clearly, a broker’s investment recommendations must be suitable for the particular customer.  A recent arbitration panel awarded $900,000 to Morgan Stanley Dean Witter customers, finding that MSDW’s speculative investment recommendations did not square with the customers’ investment objectives of income and preservation of capital.  Indeed punitive damages were awarded due to the “egregious trading and apparent lack of supervision”.  The broker, therefore, must determine and honor the investment objective of the customer as well as that customer’s risk tolerance.  In doing so, the broker must consider the risk of any particular investment recommendation or strategy employed.  In general, the basic investment objectives of customers fall into four major categories:

       1.  Preservation of Capital (safety, not willing to lose all or part of the principal invested.  The customer is willing to risk the return on investment but not the return of investment).  Objective is to maintain capital.  Adjusted for inflation, investment returns may be very low or in some years, negative, in exchange for high liquidity and reduced risk of principal loss.  The historical average annual total return for this allocation typically ranges from 4% to 6%;

       2.  Current Income (for retirees and other fixed income investors through bonds and dividend paying stocks); Objective is to obtain a continuing income stream from dependable debt and equity sources.  In order to satisfy current yield requirements, an investor using this model should be willing to absorb some risk of principal loss.  The historical average annual total return for this allocation typically ranges from 5% to 7%;

      3.  Income/Growth (current income & capital appreciation for moderate investors); Objective is to strike a balance between bonds for current income and stocks for growth.  Despite the relatively balanced nature of the portfolio, an investor using this model should be willing to assume risk of principal loss.  The historical average annual total return for this allocation typically ranges from 6% to 8%;

 .     3.  Capital Growth (increases in value over time from appreciation in the asset, typically seasoned, quality stock & stock mutual funds with reinvestment of dividends and capital gains).  Objective is to accumulate wealth, over time, rather than current income.  An investor using this model should be willing to accept the risk of price volatility in seeking to achieve growth.  The historical average annual total return for this allocation typically ranges from 7% to 9%; and

       4.  Aggressive Growth/Speculation (high risk, potentially high return types of investments).  Objective is to achieve above-average growth over time;  income is of little, if any, concern.  An investor using this model should be willing to take more substantial risk in seeking to achieve above-average returns.  The historical average annual total return for this allocation typically ranges from 9% or greater.

 Additionally, investors may have a need for tax-advantaged investments (such as municipal bonds) or immediate liquidity.

 Brokers are instructed as to the relative risk and return of the various kinds of investments.  In Pass Trak (Eighth Edition, Dearborn Financial Publishing, Inc. 1995), an examination preparation guide for those seeking to become licensed as (Series 7) brokers, various kinds of investments are divided into three risk groupings – safety, growth and speculation.  They are :

      *Safety:  Safe investments (at least relatively speaking) include cash, money market funds, CD’s, U.S. Treasury securities, bank-grade corporate and municipal bonds, some real estate, blue-chip stocks, blue-chip stock and bond mutual funds.

     *Growth:  Growth investments include growth and some small-capitalization stocks, stock options (covered calls), non-bank investment-grade bonds, growth stock mutual funds, variable annuities.  Implementation emphasis is normally from the S&P 500 market index..

      *Speculation:  Speculation includes speculative stocks and stock options, low-rated debt securities, precious metals, commodities and futures, speculative limited partnerships, speculative mutual funds.  Implementation emphasis is normally from the NASDAQ market index.


Pass Trak, at page 351


     Salomon Smith Barney, as of the first quarter of 2000, in its Guided Portfolio Management Program (GPM), provided a framework for its fundamental risk/research rating system:


     Risk Description                 Predictability of Earnings/Dividends; Price Volatility


L      Low Risk                        High predictability, Low Volatility


M    Moderate Risk                 Moderate predictability/Volatility


H    High Risk (Aggressive)    Low predictability, High Volatility


S    Speculative Risk               Exceptionally Low predictability


                                                 Highest Possible Risk


V    Venture Risk                     Risk/return consistent with venture;


                                                 Only for well diversified portfolios.


    Note:  The above definitions differentiate between Aggressive and Speculation!


     Some additional definitions are important to consider:

      1.  Tax Advantaged Income – The objective of the tax advantaged income strategy is to produce income from investments (typically bonds and high-yielding stocks) that provide tax benefits such as exemption from state taxes.

      2.  Short Term Trading – The purchase and sale of a security within a short period of time, often a single trading session.  This is the opposite of buy and hold.

      3.  Hedge – An investment made in order to reduce the risk of adverse price movements in a security by taking an offsetting position in a related security.  For example, buying an option or selling a stock short.

 12.  Amending the New Account Form and Keeping It Current – Supplementary Material to NYSE Rule 721.10 enumerates the information required and, moreover, required the customer’s account records contain “[d]ates of verification of currency of account information”.  A 1994 pamphlet entitled Understanding Your Role and Responsibilities as a Registered Representative (sent to all registered reps.) states on page 5, under Obligations to Your Customers, “The first step in properly serving your customers is to obtain a clear understanding of each customer’s financial condition.  You will obtain some of this information when opening a new customer’s account with your firm. You may also learn other information through conversations with your customer or checks your firm makes with credit agencies or other financial institutions. Because a customer’s financial status is constantly changing, account records should be updated whenever necessary.  Just as your customer’s financial position may change, your customer’s investment objectives may change.  They should, therefore, be reviewed periodically, and you should make a written record of any changes as they occur.”  Custom and practice in the securities industry is to update the new account form, in any event, every three years!  It should be updated earlier if any major change in the investor’s situation occurs.  In section 260.218.5 of the California Corporations rules, it states. (a) Every broker-dealer shall make and keep current a record for each person who becomes a customer which record shall state:

 (1) The customer’s name, date of birth, address, nationality or citizenship, tax identification or social security number, and the signatures of the customer, the agent regularly handling the account and a supervisor designated.

 (2) If the broker-dealer, or any of its agents, has made any recommendation to the customer to purchase, sell or exchange any security, the record for such customer shall also state the customer’s occupation, marital status, investment objectives, other information concerning the customer’s financial situation and needs which the broker-dealer or the agent considered in making the recommendation, and the signature of the broker-dealer or agent who made the recommendation to the customer.  Sections 25218 and 25610, Corporations Code. Reference: Section 25218, Corporations Code.  Amendment filed 11-29-79 as an emergency; designated effective 1-1-80. Certificate of Compliance included (Register 79, No. 80).

      As Morgan Stanley reminds its registered representatives, suitability is an ongoing process:  In order for the concept of suitability to be meaningful, it should not be static (limited to the time an account is opened) but should be an ongoing obligation to review and update suitability determinations.  Clients’ investment objectives and finances change with time.  Without current information about a client’s financial positions and investment objectives, a Financial Advisor cannot make well-founded, reasonable decisions  concerning suitability as requires.  financial Advisors should be alert and responsive to changes in their clients’ essential information.  Any changes are cause for a Financial Advisor to review a client’s suitability determinations.  Furthermore, Financial Advisors are responsible for updating changes to their clients’ essential facts on CPS and may be required to take further action as indicated.

 13.  Fiduciary Duty to Customer’s Extends “Beyond the Transaction”.  Many respondents argue that a broker’s duty to the client ceases once the account is set up and the trades are made. Further, a court case decided 25 years ago is often cited in arbitration to support this position.  In Robinson v. Merrill Lynch, Pierce, Fenner &Smith, the Court stated, “A  broker’s office, without special circumstances not present here, is simply to buy and sell.  The office commences when the order is placed, and terminated when the transaction was complete.  The risk of the venture is upon the customer who profits if it succeeds and loses if it fails.  When the transaction is closed in accordance with the understanding of the parties, the broker gets only his commission and interest upon advances”.  Respondent’s further argue that the NASD Suitability rules only apply to “recommendations” made and not beyond the initial implementation.  However, if the firm is a member of the NYSE, Rule 405 requires the broker and the firm to “do due diligence on every trade, every customer, every cash and margin account”, without reference to the word “recommendation”.  Finally, the obligation of Fiduciary Duty is the key to ongoing monitoring!  A broker’s Fiduciary Duty never ends.  It is the highest duty to the customer and it continues as long as the account is in the hands of the broker. Every securities expert will have to admit this under cross examination.  A.G. Edwards writes, “financial consultants know where to get informed investment recommendations and the latest financial planning techniques to make sure your plan continues to meet your needs.”


Consider the current custom and practice:  Broker Dealer Law and Regulation (3rd Edition 2002 Supplement) at page 2-155.  Standards of conduct relating to risk disclosure and duty to hedge are contained in the Content Outline for the General Securities Registered Representative Examination (Test – Series 7).  It is available at 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”


      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.




     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)



       RISK                                                                                                    RETURN

  TOLERANCE           STOCKS         BONDS         CASH          RISK       RANGE


SAFETY OF PRINC.      21%*              70%                9%              -9%        5.5-7%

(Conserv. Income)



(Mod./Cons. Tot. Ret.)    26%*              68%                6%             -10%    6.0 -7.5%


MODERATE                   49%**             47%                4%             -14.5%     7-9%

(Growth & Income)


MODERATE/AGG.        67%**             29%                4%             -16.5%    8-10%

(Capital Appreciation)


AGGRESSIVE                84%***           13%                3%              -20%    10-12%  (Capital Appreciation)


SPECULATIVE           95- 100%***    0 – 5%               0%             -28%       12%+

(Capital Appreciation)



TOTAL RETURN           11%                  7%                 4%



* Emphasis on the Dow Jones 65(Blue Chip)/Wilshire 5000 Stock Index..

** Emphasis on the S&P 500 Index (Diversified Large/Mid Cap domestic and international issues).

*** Emphasis on the NASDAQ Index (Concentrated Large, mid and small cap tech. and telecom issues)

     Clearly, the longer you hold stocks, the less risky they are.  Research from Ibbotson Associates looked at every rolling ten-year period from 1926 (there have been 72 so far:1926 – 35; 1927 0 36 and so on) and discovered only two in which Standard & Poor’s 500-stock index posted an average annual decline.  Both were during the Depression. The worst average annual return was -.089% in the decade ended 1939.

     Of course, no one wants to lose almost 1% a year for a decade.  But if you build your portfolio with different types of assets, some investments will zig while others zag.  Ibbotson examined the same 72 rolling ten-year periods with a portfolio of 50% stocks and 50% long-term bonds.  The result: not a single losing period.  The worst average annual total return was 1.99%, in the ten years ended 1974, while the best was 16.96% in the ten years ended 1991.

     Similarly, in rolling 13-year time periods over the past 50 years, a mix of 80% stocks and 20% intermediate-term government bonds has produced an average 10.7% annual return.  The worst 13 year period posted a 3.6% annual return.


                                              INVESTMENT OBJECTIVE



                          Increasing Risk, Volatility and Return Expectations


1.  Income with Capital Pres.

     a. Need for current Income

     b. Safety of Principal

     c. Conservative Focus on Growth i.e. Dow Jones 65/Wilshire 5000 Stocks


     d. Low Tolerance for Risk

     e. Short term investment time Horizon – (Est.) 1 – 3 years

     f.  Suggested Asset Allocation:  Bonds 70%; Stocks 21%; Cash 9%.

     g. Return expectations: 5 – 7%; Risk ratio -9%


2.  Moderately Conserv. Total Return, Balanced with Capital Preservation

     a. Need for current Income & preservation of capital

     b. Conservative/moderate focus on Growth i.e. Dow Jones 65/Wilshire 5000

         stocks emphasis.

     c. Low to medium tolerance for risk

     d. Short to intermediate investment time Horizon – (Est.) 1– 5 years

     e. Suggested Asset Allocation:  Bonds 68%; Stocks 26%; Cash 6%

      f. Return expectations:  5.5% – 7.5%; Risk ratio  –10%


3.  Growth with Income

     a. Equal focus on growth and current income

     b. Moderate Focus on Growth i.e. S&P 500 emphasis

     c. Moderate tolerance for risk

     d. Intermediate investment time Horizon – (Est.) 5 – 7.5 years

     e. Suggested Asset Allocation:  Stocks 49%; Bonds 47%; Cash 4%

      f. Return expectations:  7 – 9%; Risk ratio -14.5%


4.  Growth/Appreciation

     a. Little need for current Income

     b. Moderate to Aggressive Focus on Growth i.e. S&P 500/NASDAQ emphasis

     c. High tolerance for risk

     d. Intermediate to long investment time Horizon – (Est.) 5 – 10 years

     e. Suggested Asset Allocation:  Stocks 67%; Bonds 29%; Cash 4%

      f. Return expectations:  8 – 10%; Risk ratio -16.5%


5.  Aggressive Growth

     a. No need for current Income

     b. Aggressive Focus on Growth i.e. NASDAQ emphasis

     c. Highest tolerance for risk

     d. Long term Investment Time Horizon – (Est.) 10 years +

     e. Suggested Asset Allocation:  Stocks 84%; Bonds 13%; Cash 3%

      f. Return expectations:  10 – 12%; Risk Ratio -20%





SIFMA, the Securities Industry and Financial Markets Association, talks about widely accepted understandings in the industry:

              conservative investors feel that safeguarding what they have is their top

              priority.  More formally, this approach is called capital preservation.

             These investors want to avoid risk — particularly the risk of losing any

             principal — even if that means they’ll have to settle for very modest returns.


The SIA, The Securities Industry Association, its predecessor goes on to state more widely accepted understanding in the securities industry:

              conservative investors allocate most of their portfolio’s to bonds and cash

              equivalents, such as CD’s and money market accounts.  They’re generally

              reluctant to invest in stocks, which may lose value, especially over the short

              term.  When conservative investors do venture into stocks, they’re often

              inclined to choose blue chip or other larger-cap stocks with well-known

              brands because they tend to change value more slowly than other types of

              stock and sometimes pay dividend income.  Conservative investors usually

              have to settle for modest investment growth, which might make it difficult

              to meet long-term goals, such as having enough income during retirement. .

              . . .  if your retired or expect to retire in the near future, it may be unwise

              to put a lot of your assets at risk in volatile securities, such as stocks, at

              this stage in the game, when your portfolio may not have time to recover

              from a market downturn.




19.  An investor is not charged with knowledge of disclosures made in a prospectus.


    The SEC – in its commitment to protecting investors – has long held that information in prospectuses “furnishes the background against which the salesman’s representations may be tested, “and that “those who sell securities by means of representations inconsistent with it do so at their peril”  See Dept. of Enforcement v. Reynolds 2001 NASD Discip. LEXIS17, at #35 (J7n. 25, 2001); see also In re Klein, 52 S.E.C. 1030, 1036 (1996) (holding that broker’s delivery of a prospectus to an investor did not excuse broker’s failure to inform the investor fully of the risks of the investment package the broker proposed); In re Foster, 51 S.E.C. 1211, 1213 n.2 (1999) (“Notwithstanding [broker] Foster’s distribution of the prospectuses, he is liable for making untrue statements of material facts and omitting to state material facts.”). As early as 1963, in a case in which a registered broker-dealer made false and misleading statements in the offer and sale of securities, the SEC stated:


     “At the expense of restating the obvious, we emphasize that compliance with these requirements for delivery of a prospectus or offering circular does not, however license broker-dealers or their salesmen to indulge in false or fanciful oral representations to their customers.  The anti-fraud provisions of the Securities Act and the Securities Exchange Act apply to all representations whether made orally or in writing, during or after the distribution.  We have repeatedly held that the making of representations in the sale of securities unsupported by a reasonable basis is contrary to the obligation of fair dealing imposed on broker-dealers and their salesmen by the securities laws.  This obligation is not diminished because a prospectus or offering circular containing information specified by the Act and our rules has been or is to be delivered.  Such information furnishes the background against which the salesman’s representations may be tested.  Those who sell securities by means of representations inconsistent with it do so at their peril”. In Re Ross Secs., Inc 41 S.E.C., at 510.


     Ninth circuit federal courts have also held that written risk disclosures in a prospectus do not bar investors’ claims for damages based on contrary oral representation as a matter of law.  In Casella v. Webb 883 F2nd 805 (9th Cir. 1989) the 9th circuit held that constructive knowledge of the contents of written risk disclosures cannot bar a purchaser’s recovery under Section 12(a) (2).  In Casella the investors did not read the offering memorandum which described the underlying investment as risky, and instead, relied on their broker’s contrary oral representations.


    In securities arbitration, it is often claimed, merely because the claimants were provided with a prospectus which set forth all relevant and necessary disclosures, that the claimants are legally charged with knowledge of those disclosures.  While that may be the law in other parts of the country, it is not the law in the Ninth Circuit.

     The basic issue in question is constructive notice and within the Ninth Circuit it has been held that receipt of a prospectus does not necessarily place an individual on constructive notice of what is contained within that prospectus.  Even if some cases do intend to hold that mere receipt of a contradictory prospectus necessarily starts the fraud or misrepresentation statute of limitations running, the Court does not believe that the Ninth Circuit would or should adopt such a broad vision of constructive notice.  For example, in Rochelle v. Marine Midland Grace Trust Co. of New York, 535 F. 2d 523, 531-533 (9th Cir. 1976), the Ninth Circuit refused to impute knowledge of proxy materials filed with the Securities and Exchange Commission to a company holding debentures, even though it was a sophisticated investor (emphasis added).  In declining to do so, the Rochelle court explicitly invoked the fundamental policy considerations underlying the securities laws:  We are mindful that the overriding purpose of Section 10(b) and Rule 10b-5 was to protect the purity of the securities market and that private claims for relief thereunder are a means to that end.  We would impair the larger purpose if we were to expand the concept of constructive notice to defeat such claims (emphasis added). Id. at 522-33.

      Luksch v. Latham, 675 F.Supp. 1198, 1201 (N.D. Cal.1987),  this ruling by the Luksch  court, in regard to the receipt of a prospectus, is merely an extension of the general principles of California and Ninth Circuit law in regard to what constitutes adequate notice to an individual in regard to a fraud or misrepresentation claim.  Following Luksch the court:

      rejected the defendant’s attempt to have the court adopt a per se imputation rule [regarding receipt of the prospectus amounting to knowledge of clear contradictions between the prospectus and oral representations made to the investor].  Luksch, 675 F. Supp. at 1201-03.  Instead, the court noted that it must consider various factors before imputing constructive knowledge, including access to information, knowledge and business sophistication of the plaintiff, existence of long standing business relationships and the nature of the plaintiff’s allegations.  Luksch, 675 Supp. at 1203.  The court concluded that constructive knowledge of information in a prospectus ‘should not be legally imputed to investors except in the unusual case’ [emphasis added].  Luksch 675 F. Supp. at 1199.


Wenzel v. Patrick Petroleum Co., 745 F. Supp. 211, 218 (D.Del. 1990).

 Johnson v. CIGNA Corp., 916 P.2d 643, 649 (Colo. App. 1996.  The court stated that, “Defendants respond that the plaintiffs were placed on inquiry notice of any alleged unsuitability when they were given the PPM’s and Subscription Agreements, which stated that the investments were high risk……. .  This contention assumes, however, that plaintiffs were cognizant, or could be cognizant, of the application of the term “risky” to  their individual investment situations.  To say, as defendants argue, that a risky investment is one in which the investor could lose all of his or her money begs the question, since every investment has that possibility.  And, if a fiduciary duty did exist between plaintiffs and defendant’s, plaintiffs’ level of inquiry of the significance of the details of their financial status would be altered.

 20.  Sophistication of the investor is an important factor to consider in determining whether receipt of a prospectus should have given the investor knowledge of the broker’s fraudulent misrepresentations.

      See, e.g. Department of Enforcement v. Hornblower & Weeks, 2004 NASD Discip. LEXIS 27 (respondent could not cure defects in disclosure by providing more detail and further disclosure in the same package or by answering questions); DOE v. Ryan Mark Reynolds, 2001 NASD Discip. LEXIS 17 (“The SEC has held that, in the enforcement context, a registered representative may be found in violation of the NASD’s rules and the federal securities laws for failure to fully disclose risks to customers even though such risks may have been discussed in a prospectus delivered to customers”).  Department of Enforcement v. Pacific On-Line Trading & Securities, 2002 NASD Discip. LEXIS 19 (finding that the subsequent dissemination of disclosure information does not cure earlier misleading disclosures).

      Case law throughout the country holds that the sophistication or experience of an investor is an important factor to consider in determining if the investor knew or should have known of a broker’s fraudulent misrepresentation.  Harner v. Prudential Securities, Inc., 785 F. Supp. 626, 634 (E.D. Mich. 1992) (“on the issue of whether the investor exercised due diligence in verifying the existence of a fraud, the experienced investor and the neophyte are to be judged according to their abilities and the circumstances of the alleged fraud.”); Platsis v. E.F. Hutton & Co., Inc., 642 F. Supp. 1277, 1283-285 (W.D. Mich. 1986); Rochelle v. Marine Midland Grace Trust Co. of New York,  535 F. 2nd. 523-33  (9th Cir. 1976) (this court uses the phrase “sophisticated investor”).  Sophistication of the investor was a crucial factor in Solano v. Delmed, Inc.,  759 F. Supp. 847, 853 (D.D.C. 1991).


The Platsis case (W.D. Mich. 1986) provides a particularly clear picture of the sophisticated investor who should not be allowed to claim he did not read or understand the prospectus at the time he made his investment (It should be noted that in Platsis it was “undisputed that plaintiff received all offering documents prior to investment.”  Platsis  at 1287.)  Mr. Platsis was a lawyer formerly employed by the FTC and the Michigan Dept. of Attorney General, Consumer Protection Division, who had taken a course in securities law at the University of Michigan Law School.  Platasis at 1284.  Furthermore, prior to “contacting [E.F.] Hutton, plaintiff, on his own, had done some oil and gas lease investigation.  There was testimony that plaintiff had investigated at least two oil and gas offerings related to development wells.” Id. at 1285.  Clearly, Mr. Platsis was a sophisticated investor; it is equally clear that many investors are not.

 Harner v. Prudential Securities, Inc., 785 F. Supp. 626 (E.D. Mich. 1992).  Harner supports an important element of most claimants’ cases;  namely the idea that in attempting to verify the existence of fraud, the inexperienced investor is not to be judged by the same standard as the sophisticated investor.  Specifically, Harner uses a two part test to determine when the investor should be deemed to have had notice of fraud.

      [T}his test employs both objective and subjective components.  Whether the facts were sufficient to raise the possibility of fraud will be determined by an objective standard.  The sophisticated stockbroker and the uninitiated rube will both be judged by the same standard, i.e., the “reasonable investor” standard.  However, on the issue of whether the investor exercised due diligence in verifying the existence of a fraud, the experienced investor and neophyte are to be judged according to their abilities and circumstances of the alleged fraud. Harner at 634.

 Hirschler v. GMD Investments,  (CCH) 95,919 (March 28, 1991, E.D. Va. ); 1991 WL 1175773

 This case impliedly supports the proposition that mere receipt of a prospectus may satisfy the inquiry notice requirement for fraud or misrepresentation only when the plaintiffs/claimants are sophisticated or experienced investors.  That sophistication of the investors was a much considered factor in this case is made clear from the emphasis on that factor in the passage cited below.

      Plaintiffs are all highly educated, experienced investors.  All are college-educated professionals, and four of the seven undertook at least some post-graduate study.  All plaintiffs had extensive experience in investment in limited partnerships and/or real estate developments For instance, the lead plaintiff David Herschler, who has a D.D.S. from the Medical College of Virginia, has invested in three other limited partnerships and maintained four different stock brokerage accounts. … Even the investor; with the least limited partnership or real estate investments, Susan Schaffarzick, owns real estate in California, has maintained two stock brokerage accounts, and has a master’s degree from Stanford University.  Hirschler at WL p.2.

    In the Matter of Michael R. Euripedes:  July 28, 1997 (Before the National Business Conduct Committee, NASD Regulation).  Euripedes claims that he believed that RL had read the Primedex prospectus.  This does not excuse Euripedes’ failure to inform RL fully of the investment risks associated with the Primedex offering.  See In re Larry Ira Klein, Exchange Act Rel. No. 37835 (Oct. 17, 1996); In re Ross Securities, Inc. 41 S.E.C. 509 (1963) (Emphasis Added).


21.  The recommendation of an outside money manager does not relieve the brokerage firm of its supervisory responsibilities.


     Often respondents will argue that the securities in an outside managed account are the responsibility of the outside manager and not the responsibility of the member firm or the financial advisor who recommended the management company.  Many times the broker provides performance reports on the manager.  The fact that a client’s funds were entrusted to a third party does not relieve the firm of its supervisory obligations.  Richard DeCastro, 1998 WL 295513 at #7 (AMEX 1998)(emphasis supplied) “The panel believes that the existence of a third party power of attorney does not relieve a member organization or its supervisory personnel of their obligations under the Exchange’s rules to supervise the accounts of their customers.”  Merrill Lynch continued to accept and execute the Adviser’s orders in these identified accounts without attempting to ascertain whether the activity reflected by the monitoring system was consistent with the clients’ current financial situations and investment objectives.  In the Matter of Merrill Lynch, Pierce, Fenner & Smith, Inc., SEC Release No.19070 at p.2.



      An exception report provides information designed to assist supervisors, compliance officers, and securities regulators to discover sales practice problems and violations such as excessive trading and switching, unauthorized trading, and other indications of securities fraud.  Joint SEC/NASD Report on Examination Findings Regarding Broker-Dealer Sales of Variable Insurance Products (June 2004) at p. 10, n6.

      Exchange rules require the diligent supervision of all accounts to ensure, among other things, that activity in any account is in accord with the client’s stated investment objectives and not excessive in view of the client’s financial resources.  To satisfy this requirement, the Branch Manager must perform and document monthly account reviews.  To identify active accounts, a monthly surveillance report is typically created.  The monthly surveillance report is a supervisory tool designed to identify the most actively traded accounts in the branch.  Generally, review of this report supersedes the Branch Manager’s review of monthly statements.  those statements should still be reviewed as necessary.  The report is separated by Investment Consultant and lists, in descending order of commission to equity, all accounts that meet the following system-established parameters:

      For example:

          *  a current commission to equity ratio of 5% or more; and/or

          *  ten or more trades for the month; and/or

          *  $1,500 or more in commissions for the month.

       With respect to other traditional brokerage activities, exception reports aid supervisors in determining high cost to equity in an account (high commissions/fees paid divided by average account equity), large increases in margin balances or heavy losses in an account and over-concentration.

     Since the technology crash of March 2000, concentration has been an item both emphasized and tracked in exception reports.  UBS/PaineWebber in an August, 2001 Compliance Bulletin cited the risk of over-concentration.  “A potential risk to the Financial Advisor’s relationship with a client involves over-concentration.  While concentration defies a precise definition, it may exist in many different scenarios, including where a significant percentage of client’s assets are in a single security, or in a particular sector or in certain products.  Before making a recommendation, the Financial Advisor should consider all relevant factors such as the client’s net worth, financial needs and objectives, including whether a proposed investment could present a concentration issue for that client”.

     Concentration is a Suitability Issue


“Concentration is an important aspect of the suitability determination.  Keep in mind that suitable investments can become unsuitable when they constitute too large a portion of a client’s portfolio.  While a client may be suitable to own $10,000 or $25,000 worth of one security, he or she may not be suitable to hold $500,000 or $5,000,000 worth of the same security.  This holds true even for large cap or blue chip companies since highly negative news could lead to material declines in any issuer’s stock or the particular sector”.

     “Accordingly, Financial Advisors are encouraged to review accounts for situations involving concentrated positions and discuss the risks of such positions with the client and their Branch Manager.  In addition, Financial Advisors should review objectives with the client  to ascertain whether the client understands and intends to assume the level of risk associated with the concentrated position.  If a client continues to build a concentration against the Financial Advisor’s advice, the Financial Advisor should speak with the Branch Manager who may wish to consult with the Legal and Compliance Departments”.

     Impact of Margin on Concentrated Positions

 “If a client is also trading on margin, it is also important to consider the risks associated with the use of margin in determining whether purchasing on margin is suitable for a particular client.  Moreover, it is important that Financial Advisors educate their clients on the special risks of buying securities on margin”.  “The degree of risk may reflect the nature of the investment itself, (e.g. leverage) and its market, or factors such as concentrations or margin.  Since the analysis must be applied to each transaction for each client, “wholesale” recommendations are not appropriate”..

      Merrill Lynch was concerned about suitability with regard to the concentration and the volatility of internet securities when as early as February 1999 it wrote this inter-office memorandum.  “FC’s must be especially mindful of suitability considerations when recommending internet stocks or placing unsolicited orders for clients who wish to trade in such securities.  FC’s should discuss with clients the risks involved in buying or selling securities under such volatile market conditions.  Client’s investment objectives and risk tolerance levels must be carefully considered to help them determine what, if any, portion of their portfolios should be invested in internet stocks”.


The Importance of Reviewing Accounts for Concentration

      Merrill Lynch began monitoring concentration as an exception as of December, 2000 whereby in an inter-office memorandum, it said, “Managers should carefully review accounts in which one position or industry sector dominates a clients’ holdings.  Concentration of positions in multiple clients accounts has become an issue with regulators and claimants.  For example, recent regulatory pronouncements and press accounts have confirmed the importance of making suitable investment recommendations to clients, particularly when large or concentrated positions are at issue.  Of particular concern are situations involving clients that suffer disproportionate losses in their accounts as a result of a price decline in a security representing a substantial portion of their assets.  To assist you in identifying concentrated equity positions in client accounts, the Firm has developed a web-based Concentration Report”.

      “The Concentration Report must be printed, reviewed, and initialed by a qualified manager.  The reports, any notes pertaining to the review, and any follow up with the FC(s) and/or clients must be retained for 2 years”.

      Merrill Lynch continued monitoring concentration as an exception in 2002, where in its Compliance Manual, Section III, under Recommendations and Dealing with Clients, it states:

      Concentrated Security Positions

 “Care should be taken whenever one position or industry sector dominates a client’s holdings.  Depending upon the industry sector and market conditions, a concentrated security position may be vulnerable to volatile price movements that may result in substantial losses and/or margin calls.  While there are some investors for whom this style of investing may be suitable, special care should be taken to ensure that such clients are fully aware of and able to sustain the risks inherent in this style of investing”.

      “If a client wishes to maintain a large concentration in a particular security, the Firm may require higher maintenance margin.  required approval will depend on the position size, debit amount, nature of the security and other factors.  A debit of $500,000 or more requires special approval”.

 Compliance Notes from September, 2001 Administrative Manager and Service Manager Conference Call


Concentration: Risk is intensified when client’s have “all their eggs in one basket.”  When clients have concentrated security positions, FA’s should:

           1.  Document discussions with clients regarding diversification.

           2.  Seek advice from the Executive and Equity Plan Services Department regarding investment strategies designed to protect concentrated positions in restricted or controlled securities.

           3.  Monitor Merrill Lynch research for negative commentary about specific industry sectors ( e.g. airlines, insurance companies, etc.) and contact clients whose portfolios are weighted in those industry sectors.

      “You should also use the monthly concentration report to identify and address accounts that appear to be over-concentrated in specific securities or industry sectors”.  In its Compliance  Outline for Private Client Financial Advisors, dated January 2002, Merrill stated, “Care should be taken whenever one position or industry sector dominates a client’s holdings.  Depending upon the industry sector and market conditions, a concentrated security position may be vulnerable to volatile price movements that may result in substantial losses and/or margin calls.  While there are some investors for whom this style of investing may be suitable, special care should be taken to ensure that such clients are fully aware of and able to sustain the risks inherent in this style of investing”.

      Salomon Smith Barney, as early as March 1999 summarized the branch manager’s obligation to consider concentration in customer accounts as an exception when it stated, “Prior to contacting the client, the Branch Manager should speak with the FC and review the activity and positions in the account.  the Branch Manager should be particularly sensitive to:

          –  The types of securities traded (e.g. low priced stocks, below investment grade bonds, derivatives, etc.)

           –  Any large positions (is the FC building a position in many accounts?)

           –  Margin balance, volume of trading and holding periods”.

      Much of the above concerns regarding concentration could be detected if brokerage firms used appropriate computer codes in their exception reporting!

      With the proper computer codes, brokerage firms could more properly monitor investor accounts to prevent sales practice abuses by their registered representatives and better meet their suitability obligations under NASD rules.  Examples of this include:

      A.  Calculate the ratio of dollars invested in non-income producing and/or low-ranked securities to overall account value to determine whether the account holdings reflect the customer’s investment objective.

      B.  Generate an exception if estimated income does not comport with an investment objective of income or income/growth.

      C.  Generate an exception when a retiree or person approaching retirement age is overly invested in growth securities or non-investment grade securities:

      D.  Generate an exception when the composition of the account does not comport with the customer’s investment objectives.

      E.  Generate an exception when a given security exceeds a specified percentage of account value and/or liquid net worth; and

      F.  Generate an exception when a given industry sector’s combined value exceeds a specified percentage of an account value and/or liquid net worth.

 According to SEII (Securities Education Institute, Inc., a company, “In June, 1999, the SEC approved rules for the NASD and NYSE in connection with the introducing/clearing firm relationship.  Among other things, clearing firms must provide each introducing firm, both at the inception of the clearing/introducing broker relationship and annually thereafter, with a list or description of all exception or other reports, or computer software programs that it offers to assist the introducing firm in supervising its activities and monitoring its account.  Introducing firms must give to clearing firms written notification of those specific reports that they need to supervise and monitor their customer accounts.  Thereafter, clearing firms must maintain, as part of their books and records, all reports requested by the introducing firm or sufficient data to re-create such reports.  By July 31st of each year, clearing firms must notify the chief executive and compliance officers of their introducing firm clients as to what reports they offer and what reports their introducing firm clients requested or received.  The rules do not state which firm has the responsibility for monitoring the reports generated, or whether both firms share the responsibility to so me degree.  Regardless, of which firm generally has the responsibility for reviewing and acting upon the reports, SRO’s will undoubtedly sanction any firm that ignores a “red flag” that comes to its attention”.

      The process of how brokerage firms interact with the public customer had changed completely in the last five years.  Standard exception reporting, usually presented to supervisors on a monthly basis, has been completely replaced by automated compliance and supervision systems.  These new systems provide exception reporting and analysis on a daily basis.  The ability of brokerage firms to track and discover areas of concern and red flags has become nearly a dynamic part of the day-to-day operations of the broker-dealer operation.  The demands and expectations of broker-dealers on software systems and providers have changed significantly.  Standard exception reporting and analysis has given way to automated systems that can red flag exceptions on a daily basis.  Branch managers and supervisory staff are now equipped with the technology and software to understand and evaluate the quality of practice in every customer account making older exception reporting systems a “thing” of the past and antiquated at best.  Today’s compliance, supervision and surveillance systems are able to examine for a wide range of brokerage account exceptions and most of today’s systems are suitability based.  This is a critical consideration in securities litigation.  Understanding that the analysis and red flags are sensitive to the finances and investment experience of each individual client provides a clear advantage to positioning a case for issues of supervision and failure to supervise.  Branch managers and supervisors now have daily exception reporting and analysis at their disposal to intervene and provide supervisory authority and supervision.  Systems and software now provide almost immediate feedback and input as to account activity and the quality of practice.




 The duty to supervise is a critical component of federal regulatory compliance.  The SEC has held that reasonable supervision requires ‘strict adherence’ to internal company procedures,… Edwin Kantor, 51 S.E.C.440, 446 (May 20, 1993).  The Commission has “made it clear that it is critical for investor protection that a broker dealer establish and enforce effective procedures to supervise its employees.”  Donald T. Sheldon, 52 SEC Docket 3826, 3855 (1992). Establishment of policies and procedures alone is not sufficient to discharge supervisory responsibilities, however, as on-going monitoring and review is necessary to ensure that the established procedures which make up the supervisory program are effective in preventing and detecting violations.

 A widely recognized standard for measuring a firm’s compliance with its supervisory responsibilities is the following: “Affirmative responsibilities are placed on those who have a duty to supervise.  Supervisors have an obligation to respond vigorously and with utmost vigilance to indications of irregularity.”  Quest Capital Strategies, Inc.   Release No. ID141, 69 SEC 1317 (1999). supra.A supervisor cannot ignore or disregard ‘red flags’ and must ‘act decisively to detect and prevent’ improper activity.  Indications of wrongdoing demand inquiry as well as adequate follow-up and review.”  Section 15(b) of the 1934 Act defines “reasonable supervision” as “established procedures, and a system for applying such procedures, which would reasonably be expected to prevent and detect, insofar as practicable, any violation [of the Act] by [an associated person]”.  15 U.S.C. # 780(b)(4)(E)(i).  Broker Dealers have a fiduciary duty to supervise their brokers.Komanoff v. Mabon, Nugent & Co. 884 F.Supp. 848,861 (S.D.N.Y.1995) (customer stated a claim against brokerage firm for breach of fiduciary duty based on a broker’s culpable conduct in adopting trading methods inconsistent with the client’s investment needs and objectives.)

      One continuing question in investment brokerage, is when should the supervisor call the client?  The governing principle here should be to look for and react to red flags.  One way regulators expect supervisors to conduct follow-up is by having regular client contact.  Although this expectation is not articulated in any specific regulatory rule, it is based upon numerous SEC, NASD and FINRA pronouncements and litigated case law, and is standard industry practice.  The advantages are:

      – It insures full disclosure is provided

      – It helps identify issues at an early stage

      – it protects client interests as well as the firm interests.

      The MSDW Compliance Manual states, “The Branch Manager must review account information and discuss it with the Financial Advisor.  If Necessary, before approving a new account, the Manager must contact the client directly if questions of suitability arise”.  It goes on to state, “The Branch Manager will examine the suitability of transactions and/or investment recommendations based upon the information supplied by the client in the client profile section of the New Account form.  The Branch Manager should review and compare the client’s stated investment objective(s) with the information that is presented elsewhere on the New Account form and in any supplementary documentation that may be required (e.g. information on the New Account form should coincide with information provided on the client’s Option Agreement)”.

      SSB’s Branch Office Manager’s Compliance Manual, revised 3/24/99 states, “The most comprehensive and proactive response to client account activity and accounts with material risk exposure is personal client contact by the Branch Manager which is documented in a letter summarizing the contact.  Prior to contacting the client, the Branch Manager should speak with the FC and review the activity and positions in the account.  The Branch Manager should be particularly sensitive to:

      – The types of securities traded (e.g. low priced stocks, below investment grade bonds, derivatives, etc.)

      –  Any large positions (is the FC building a position in many accounts?)

     –  Margin balance

     – Volume of trading

      – Holding periods

      In reviewing the account, the Branch Manager should:

           –  Evaluate whether the portfolio and activity is consistent with the client’s investment objectives and risk tolerance

           –  Evaluate whether the client has sufficient liquid net worth, annual income, and investment experience necessary and safely assume the risks of the investments

           –  Consider the account’s cost ratio (commissions and margin interest divided by equity), turn-over, and credit history


In speaking with the clients, the Branch manager should:

      –  Verify the client’s address, occupation, financial objectives, and risk tolerance.

      –  Determine whether the client can articulate clearly the investment strategy employed (is it FC driven?)

      –  Determine whether the client understands the status of the account and relative risks.

      –  Discuss the portfolio, specific activity, commissions (including loads on mutual funds and mark-ups on principal transactions), and historical as well as current profit/loss.

     –  If there is a margin debit, discuss the margin interest expense and how it increases the break-even point (cost ratio) the risks of leverage, and margin calls

      –  Because potential “red flags” can be identified with open-ended questions, inquire about the level of communication with the FC the quality of service, and any pending or past errors”.

      The SEC has stated that “…where the failure of a securities firm and its responsible personnel to maintain and diligently enforce a proper system of supervision and internal control results in the perpetration of fraud upon a customer or in other misconduct in willful violation of the (1933) Act or the (1934) Act, for purposes of applying the sanctions provided under the securities laws, such failure constitutes participation in such misconduct and willful violations are committed not only by the person who performed the misconduct but also by those who did no properly perform their duty to prevent it.”  The responsibility of broker/dealers to supervise their employees by means of effective, established procedures is in fact a critical component of the federal investor protection scheme regulating securities markets.  In the matter of Prudential Securities Incorporated (1993) 1993 Lexis 2866; 51 S.E.C. 726, 738-739.

 Supervising “unsolicited” trades It is a supervisory and regulatory requirement as well as being an industry standard of properly mark (designate) an order ticket properly as “solicited” or “unsolicited”. In the securities industry, there exists a multilevel system that is designed to monitor and evaluate the trading of brokers in order to determine if there are any violations of the securities industry – or any red flags that might be indicative of a violation.  It is the industry standard and understanding that if the trade ticket is not marked “solicited” or “unsolicited” the trade is considered to be solicited.  A licensed supervisor at the branch level is required to review every trade made by the securities broker.  Additionally, branch offices and the NASD or NYSE are required to routinely conduct audits of firms practices, which includes scrutiny of the firm brokers’ marking of order tickets.  This is because the marking of tickets either “solicited” or “unsolicited” can effect the supervision level and attention given to orders.  This is a key issue with respect to non-discretionary accounts, to determine whether it is the broker or client who in fact, “controls” the account. When a supervisor or regulator is reviewing trade tickets to check for issues like unauthorized trading, suitability or churning, the supervisor will give stronger weight and concern to solicited trades, than unsolicited trades.  It logically follows that the primary motivation of a broker to mismark an order ticket is to circumvent proper supervision i.e. to give the impression to his branch manager that it is, in fact, the client who is directing the trades.  One of the guidelines set forth in most compliance manuals is for the supervisory manager to “question” the broker and consider it a “red flag” when a manager notices a large grouping of order tickets marked “unsolicited”  To not review this unusual occurrence would be a failure to supervise.  This is because the false mismarking of an order ticket can also be considered a fraudulent act.  Not telling a customer a material fact (mismarking the order ticket inferring to management that it was the customer’s idea) is a 10b and 10b-5 violation in that it makes a false statement.  Rule 144-130 of the Arizona Securities Act specifically prohibits “[e]ngaging in a pattern of marking order tickets as unsolicited when the dealer or salesman directly or indirectly recommended the transaction or introduced the customer to the security.”  In addition, the practice violates SEC Rule 240.17A (a)(3)(4), NYSE Rule 410 and NASD Books and Records Rules.  Finally, the practice of falsely marking order tickets would also be a violation of NYSE Rule 401, Good and Ethical Business Practices, NASD Rule 2110, Standards of Commercial Honor and Principles of Trade, and NASD IM-2310-2, Fair Dealing with Clients.  One major brokerage firm states in a compliance memo, “A series of orders marked unsolicited will be closely questioned on the theory that multiple unsolicited orders were, in fact, solicited.”  Another major brokerage firm once put it this way in its Branch Manager’s Supervisory Manual, “When reviewing the order tickets, a Branch Manager must consider the following…A series of orders market “unsolicited” for the same stock from a client or clients of the same Financial Consultant.  The marking of order tickets as “unsolicited” will not protect the Branch Manager if the circumstances are suspicious, in which case the Branch Manager must determine if the orders are, in fact, solicited…”

 NASD Notice to Members 99-45 clearly recites a firms’ supervisory duty.  “Written supervisory procedures document the supervisory system that has been established to ensure that compliance guidelines are being followed and to prevent and detect prohibited practices.  The written supervisory procedures would describe the activities the supervisor will conduct, if he or she determines a transaction is not suitable for a customer.  The written procedures would instruct the supervisor on which reports produced by the surveillance system the supervisor is to review as part of his or her supervisory responsibilities, including a description of how often these reports should be reviewed, the steps to be taken if suspicious activity is discovered, and how to document the supervisor’s oversight activities.  These written procedures should depict clear lines of authority, accountability and responsibility. In addition, senior management can use the written procedures to determine whether personnel are complying with the supervisory system by auditing compliance with the written procedures.  These written supervisory procedures must be updated to properly reflect any necessary changes to the supervisory system.

 Respondent’s will invariably argue that there is no private right of action for violations of the compliance manual provisions, the Securities Acts or NASD/SEC rules.  These violations of rules, Acts or the firm’s own compliance manual provisions form the basis for common law negligence, which does provide a private right of action and a basis for liability.  In Dillenbeck v. City of Los Angeles 69 CAl.2d 472, 477-482, 72 Cal. Reptr. 321 (1968) the California Supreme Court held that the police department’s internal safety rules were admissible (a) as evidence of the standard of due care applicable to the course of conduct of the officer who was accused of negligence, and (b) to show that the officer’s failure to follow the safety rules constituted evidence of his negligence.  Thus according to the California Supreme Court, evidence of a rule violation is relevant to the issue of negligence and should be considered by the trier of fact when determining whether the standard of care has been met.  The Compliance Manual provisions, Acts and regulatory rules represent evidence of what elements were required to meet the standard of care and the brokers’ or supervisors’ failure to follow those standards is patent evidence of contributory negligence.  It is important to note that a firm’s internal rules do not establish legal duties.  Rather the legal duty is established by law and the facts of the case.  Indeed, even a case, very often quoted by respondent’s De Kwiatkowski v. Bear, Stearns & Co. 306 F.3d 1293 (2d Cir. 2002) states: “No doubt, a duty of reasonable care applies to the broker’s performance of its obligations to customers with non-discretionary accounts.”  Id. at 1305.  The firm’s internal rules simply provide evidence of what is required to satisfy the duty of due care.  Respondent’s internal rules do not create an additional duty or create a cause of action. However, Claimant’s have a legal basis to recover damages for any purported acts inconsistent with the internal manual guidelines.  That legal basis is the duty of due care imposed under the law of negligence.  The evidence of what is required to satisfy that duty, in part, consists of Respondent’s internal guidelines.  De Kwiatkowski is consistent with this position, including Dillenbeck.  De Kwiatkowski stated:  “Kwiatkowski…does not argue directly that non-compliance with internal rules or industry standards is a basis for liability.  Kwiatkowski instead relies on such non-compliance as evidence of Bear’s overall failure to exercise due care, assuming however a duty as to which due care must be exercised.”  De Kwiatkowski at 1311.

In Notice to Members 98-96, the NASD noted that written supervisory procedures that instruct a supervisor to initial order tickets and blotters or to fill out review logs to document a review are reasonable, while procedures that merely recite the applicable rules or fail to describe the steps the firm will take when potential deficiencies are identiried are not reasonable.  Further, a member would not be in compliance with the Rule if a general securities principal was responsible for supervising general securities activities, but was not given the requisite authority to fulfill the supervisory obligations.  The rule requires that each registered person be assigned to at least one supervisor.  This requirement recognizes the obvious fact that a supervisory system reasonably designed to achieve compliance with the securities laws does not permit persons to supervise themselves.  Further, a member that receives indications that a supervisor is having difficulty performing his or her supervisory functions would have an obligation to investigate to determine whether such person can continue in a supervisory role.

 Rule 3010(a)(8) requires that at least one principal be designated to review the firm’s supervisory system, procedures, and internal inspections.  The purpose of this review is to determine the effects of changes such as hiring additional registered persons, the departure of registered persons, commencing a new line of business (e.g. market making), a change in ownership, or changes in the securities laws, on the member’s existing supervisory systems and procedures.  A supervisory system and/or written procedures that are not current with regulatory requirements or the structure and business activities of the member would not be reasonably designed to achieve compliance with the securities laws.  Internal inspections are required under Rule 3010 (c).  The mandatory annual review must be reasonably designed to assist members in detecting and preventing violations of the securities laws.  The ‘reasonably” designed standard means, for example, that indications of problems, or “red flags”, must be investigated.  When a member receives an indication of irregularities in a customer’s account (e.g., a compliance program indicates or a supervisor discovers a frequency of trading in a customer’s account that exceeds the customer’s normal level of trading), it must require that the account be examined to determine whether churning or some other violative conduct has occurred.  If it does not, then that member’s examination procedures would not be reasonably designed to detect or prevent irregularities or abuses”

 To effectively defend itself, the Firm must have adequate procedures of follow-up and review to ensure that the responsibility delegated to the supervisor is being “diligently exercised.”  NY Life Securities, Release No. 34-40459, 68 S.E.C. Docket 103 (Sept. 23, 1998) (The SEC disciplined “NYLIFE Securities…because there was no system of follow-up and review to determine that the responsibility delegated to the [supervisor] was being diligently exercised.”)  The SEC has disciplined supervisors for their failure to review incoming and outgoing correspondence.  Euro Atlantic Securities, Inc. et all. Release No. 34-40891, 68 SEC 2612, 1999.  Further, the law is well settled that a Firm is not relieved of its obligations to supervise when its customer signs a trading authorization for a third party.  Rolf v. Blyth Eastman Dillon, 570 F 2d 38, 45 (2nd Cir. 1978).  The American Stock Exchange has disciplined a Branch Office Manager and the Firm, when, among other things, the Branch Office Manager “failed to take meaningful and effective steps to prevent…unsuitable options transactions from occurring [in an advised account]…”  In the Matter of Richard DeCastro, 1998 WL 295513 (AMEX):

      “The Panel believes that the existence of a third party power of attorney does not relieve a member organization or its supervisory personnel of their obligations under the Exchange’s rules to supervise the accounts of their customers.” DeCastro, supra. at *7. The Exchange specifically rejected the Firm’s argument that the Branch Office Manager has no duty to supervise an advised account.  Id. See, NYSE rule 405, Diligence as to Accounts.  (“Every member organization is required…to use due diligence to learn the essential facts relative to every person holding power of attorney over any account accepted or carried by such organization”).  (Emphasis added).  NASD and NYSE rules are the standard by which broker conduct is measured. Mihara v. Dean Witter & Co., Inc., 619 F.2d 814, 824 (9th Cir. 1980)(“Appellants contend that the admission of testimony regarding the New York Stock Exchange and NASD rules served to dignify those rules and regulations to some sort of standard.  The admission of testimony relating to those rules was proper precisely because the rules reflect the standard to which all brokers are held.”)

      Negligence, or the failure to act according to a recognized duty of due care, occurs in the securities context by, among other things: (1) failure to adhere to industry standards and practices or the firm’s own rules and guidelines; (2) failure to supervise adequately the broker’s handing of an account; and (3) making unfounded representations or omissions that may induce reliance or a false sense of security.  Although deviation from industry custom and practice does not, in and of itself, provide for a private cause of action, it has been recognized that the deviation from such industry standard can form the basis for a a negligence claim.  As stated by Professor Poser in Broker Dealer Law and Regulation (3rd. Edition 2002 Supplement), at page 2-155,”A court may consider a custom, practice, or usage of the securities industry, even though it is not formally embodied in an internal rule of the defendant brokerage firm, in order to determine whether the conduct of the firm or its employees was reasonable and in accord with applicable standards of conduct”.  Professor Poser goes on to state that, “in negligence and breach of fiduciary duty cases, courts commonly look to industry custom and practice in order to determine whether the challenged conduct was reasonable and to determine the appropriate standard of care.”  Id. at 2-117 (citing Ehrlich v. First Natl. Bank of Princeton, 505 A.2d 220, 235 (N.J.Super.1984).

 Supervising securities in accounts transferred in from another brokerage firm – Respondents will invariably argue that securities it didn’t sell are not its responsibility.  Nothing could be further from the truth.  This is especially true of firms that were members of the NYSE.  NYSE Rule 405 states that “Every member organization is required to:

      (1)  Use due diligence to learn the essential facts relative to every customer, every order, every cash or margin account accepted or carried by such organization and every person holding poser of attorney over any account accepted or carried by such organization  Further, the rule addresses Supervision of Accounts:

      (2)  Supervise diligently all accounts handled by registered representatives of the organization.  The rule also addresses Approval of accounts:

      (3)  Specifically approve the opening of an account prior to or promptly after completion of any transaction for the account or or with a customer….the….person approving the opening of the the account shall, prior to giving his approval., be personally informed as to the essential facts relative to the customer and to the nature of the account.

 Moreover, the transferred in securities must be considered by the broker when making any recommendation to buy or sell in the new account because NASD Rule 2310 requires him or her to consider the customer’s “other security holdings.”  If the transferred in securities are too risky for the customer’s investment objectives and risk tolerance as determined by the new firm, or if they result in the account being improperly diversified or improperly allocated among asset classes, then the broker would have a duty to speak to the customer because he or she could not make the new recommendation without reference to the transferred in securities.  Similarly, the branch office manager or compliance officer could not approve the new trade (s) without reference to the securities transferred in.

      Further, the  wide ranging applications of the high standard of care in the investment relationship indicate that the rule must also prohibit a firm from disclaiming liability for losses on transferred in securities where it has not disclosed and discussed with the client that it would not rake the responsibility for securities purchased at another firm.  It is simply not fair and certainly is not honorable, just or equitable for the customer to be uninformed of any alleged limitation of the firm’s liability.  At the very least, the customer agreement should contain a disclaimer in boldface and capitals, much like the mandated arbitration clause, and the broker should not contemporaneously in records that he or she informed the customer of the disclaimer of liability and also discussed the customer’s options respecting the transferred in securities.


     The after-the-fact disclaimer of liability is particularly reprehensible where the transferred in securities are held in a wrap account or non-managed fee based account.  NYSE Rule 405A requires disclosure of “sufficient information for the customer to make a reasonably informed determination whether the [account] is appropriate to suit [his or her] anticipated needs.”   Certainly, a customer must be informed of any claim to limited liability on assets for which he or she will pay an annual fee, regardless of sales activity.  Irrespective of whether the securities are placed in a non-managed fee based account, the new broker must have promised some increased level of performance that would, by inference, include that he or who would make timely recommendations regarding the transferred in securities.  The account did not simply float over to the new brokerage house on its own.  Testimony by the customer may establish promised by the broker to care for the customer’s securities.  Thus, the firm’s disclaimer of liability on the transferred in securities would not only violate NASD Rule 2110 , but it would also constitute a breach of contract.


Special Supervision


     NASD Notice to Members 97-19 dated April 1997 deals with this issue. It includes a NYSE memo.  “A firm that hires a registered representative with a recent history of customer complaints, final disciplinary actions involving sales practice abuse or other customer harm, or adverse arbitration decisions should determine if it is necessary to develop and implement special supervisory procedures tailored to the individual representative.  The individual’s direct supervisor or other designee of the firm should consider performing a thorough review of a registered representative’s customer account activity if, subsequent to hiring, the registered representative becomes subject to customer complaints.  Such a review procedure could be activated, for example, when the registered representative is named, during a one-year period, in three customer complaints alleging sales practice abuse”.

      “A heightened level of supervision may be appropriate for a registered representative whose CRD report discloses sales practice problems and not simply isolated instances of customer complaints, minor disciplinary actions, or arbitrations.  While final disciplinary actions, complaints, or arbitrations resolved in a manner adverse to the registered representative indicate a disciplinary problem, multiple pending complaints, disciplinary actions, or arbitrations may be indicative of a history that should be carefully reviewed.  A firm that employs persons in the following categories and does not have a standard supervisory policy that addresses such persons should determine whether existing procedures are adequate to provide reasonable supervision or whether heightened supervision is warranted:

      …registered representatives with a history of customer complaints, disciplinary actions, or arbitrations;

      …persons hired in a non-registered capacity who previously were employed as registered representatives and who have such a history;

     …registered representatives who develop such a history while associated with the firm;

      …registered representatives terminated from prior employment for what appears to be a significant sales practice or regulatory violation; or

      …registered representatives who have had a frequent change of employers within the industry.

 Christopher J. Benz, 64 S.E.C. 396 (1997); Douglas Conrad Black, 51 S.E.C. 791, 795 (1993); Houston A. Goddard, 51 S.E.C. 668, 672 (1993).

      “The firm also should review the registered representative’s CRD record and the nature of the activities in which he or she is, or will be, engaged (considering, for example, the types of products he or she plans to sell and reviewing the person’s top accounts, including changes or trends in account activity and commissions earned).  The firm should consider meeting with the registered representative and the person who is or will be his or her supervisor, during which the supervisor’s understanding of the prior conduct of the registered representative and willingness to accept responsibility for his or her supervision can be confirmed.  The firm could require the registered representative and his or her direct supervisor to sign an acknowledgment, indicating their understanding and their agreement to abide by the terms of the special supervision for the requisite time period.  It also is advisable for the firm to document the termination of a period of special supervision, including an assessment of whether the objectives of the supervisory arrangement were met.  It is important that firm retain evidence of special supervision”.

      “One of the first things to consider when establishing heightened supervisory procedures is the nature of the conduct that resulted in the registered representative’s history of customer complaints, disciplinary actions, or arbitrations, and whether the conduct involved a particular securities product, customer type, or activity.  In any of these instances, the product, customer, or activity type should be examined to identify the level and type of risk it presents.  the firm should then determine what type of supervision might best control and limit this type of risk.  This may range from providing the ordinary level of supervision, to restricting a registered representative’s activities for a period of time in a manner that is based on the firm’s assessment of the registered representative’s prior problems, to assigning a mentor or partner in whom the firm has confidence to work with the registered representative”.

      “If warranted after a review of all circumstances, firms should consider whether a supervisor should exercise closer than normal control over the establishment of new customer accounts by a registered representative.  For example, if a registered representative has a history of complaints involving initial transactions in accounts, closer scrutiny of his or her account opening practices may be warranted.  In addition to the normal requirements for opening a new account set out in NASD Rule 3110 and NYSE Rule 405, the manager might choose to speak with all or selected new account holders or to independently verify the customer information on the account form on a random or consistent basis, depending on the situation.  If the firm deemed it prudent in view of prior activities, it might prohibit any trading until the account information or the order information could be independently verified with the customer.  Of course, the optional practice of sending notices to all new customers to verify and ask for comment on the new account information on file at the firm upon opening of the account might be sufficient in a specific set of circumstances, as might a decision to instead monitor subsequent transactions”.

      “When reviewing conduct to determine whether heightened supervision is warranted, firms should focus on whether a specific type of transaction was involved in prior problems, and should consider prohibiting like transactions, or requiring supervisory approval of all such transactions in advance of execution, as is routinely required at many firms in the case of low-priced securities, options, and discretionary trades.  Examples of orders that may pose potential harm, and as to which many firms may as a matter of practice already require prior supervisory approval, are: orders in discretionary accounts; orders in low-priced, speculative securities; orders of an unusual size or frequency considering the particular account’s trading pattern; deep out-of-the money and uncovered options orders; or mutual fund switches.  Firms also could consider reviewing the registered representative’s customer contacts by, for example, monitoring selected telephone conversations between the registered representative and both existing and potential customers or attending meetings between the representative and his or her clients”.

      “Enhanced procedures may be appropriate for registered representatives subject to special supervision, including, for instance, requiring the approval of all correspondence prior to use, even when prior approval is not specifically required by SRO rules.  Firms also should take reasonable steps to prevent such individuals from circumventing approval by, for example, using the Internet or other electronic media for communications, or restricting the registered representative’s use of certain types of communications, including the Internet or other electronic media, electronic mail, or mass mailings, where appropriate”.  In Notice to members 98-38 (May 1998) It is indicated that unexpected supervisory visits to offices with personnel who have disciplinary records may be appropriate.

      Although FINRA had proposed a rule to address when a broker should be put on heightened supervision, at present, the only specific rule is one dealing with producing managers.  For the average broker, there is nothing quite as clear-cut.  FINRA Rule 3010 requires that any supervision plan be reasonable designed to ensure compliance with applicable securities laws and regulations and FINRA rules.  Consequently, each firm has the flexibility to tailor a plan to fit its business and to address any concerns that might be raised by a broker’s past or present activities.  In general, FINRA has indicated that heightened supervision should be considered for brokers whose records reflect disciplinary actions involving sales practice abuse or a history of customer complaints and/or arbitrations that were not resolved in their favor.  In 2002, for example, Daniel M. Sibears, senior vice president of FINRA (which was NASD Regulation, Inc. at the time), spoke before the U.S. House of Representatives.  He said:  “Circumstances that may warrant heightened supervisory controls include registered representatives…who have been the subject of numerous customer complaints, disciplinary actions or arbitrations; registered representatives terminated from association with prior firms for regulatory reasons or concerns; [and] registered representatives who have frequently changed their employment…”


Red Flags


       Another key issue in supervision is red flags.  Firms cannot meet their supervisory responsibilities with passive or inactive responses to red flags that indicate improprieties.  Indications of wrong-doing require a vigorous response.  See, e.g., William L. Viera, Exchange Act Rel. No. 26576, 1989 WL 992581 (Feb. 26, 1989); Nicholas A. Bocella, Exchange Act Rel. No. 26574, 1989 WL 992565 (Feb. 7, 1989); First Albany Corporation,Exchange Act Rel. 30515, 1992 WL 64040 (Mar. 25, 1992).   The SEC and the courts have provided valuable insight on this subject as follows:

     1.  Excerpts from administrative decisions of the SEC, Re: Supervision:

               …1987 SEC Lexis 3013 at pages 9-10 (12-15-87), “A branch manager is the first line of defense when it comes to supervision of registered representatives and endeavoring to assure their compliance with applicable laws and regulations”.  (Administrative Procedure File No. 3-6700).

               …”Once the branch manager or compliance officer is on inquiry notice of any possible improprieties, he or she then has an obligation to make an independent inquiry of transactions in customer accounts without relying on the representations of the broker.  The branch manager should contact the client by telephone to verify the representations which the broker has made to the branch manager regarding a customer’s account.  A simple phone call by the branch manager to the customer can also serve to verify account activity at variance with customer information on the new account form.  Items include the net worth, age, employment, tax bracket and investment experience representations on the new account form.  Turning a blind eye to questionable account activity can lead to dangerous consequences for the branch manager, branch offices and the firm”.

 (Administration Proc. File No. 3-8969, 1996 SEC Lexis 584 (3-6-96).

                …”Activity letters, letters prepared by the branch office seeking a customer’s acknowledgement of excessive trading activity or losses in his or her account, and the manner in which they are prepared, delivered to the client and received back by the firm often provide numerous “red flags” to the branch manager.  Once accounts have been singled out for activity letters, common sense requires that branch managers follow the activity letter from its preparation through its ultimate receipt from the client in order to detect any irregularities.  Indeed, the mere failure to receive a return activity letter has been determined to constitute cause enough for a branch manager to make direct contact with a non-responding customer”.

 (Admin. Proc. file No. 3-8209, 1003 SEC Lexis 2866 (10-21-93).

                …Lax supervisory practices on the part of Prudential Securities which dealt with the failure of branch office managers to follow through with active account reports”.  “Many customers were not contacted by branch office managers, even though their accounts repeatedly appeared on active account reports.  In virtually all cases, meaningful contact could have detected and prevented violations.  PSI experienced a serious breakdown in its active account review procedure (1993 SEC Lexis 2866 at page 64).  The simple expedient of client contact by the branch manager, it was determined, would have prevented trading improprieties being engaged in by brokers in branch offices”.

      The NASD also has notified members that “if ‘red flags’ or facts that raise issues about a registered representative’s conduct come to the attention of a firm’s supervisors, the firm must conduct a thorough investigation in order to resolve the concern,” Id (citing cases in which the SEC has imposed liability for supervision failure resulting from failure to follow up on such red flags).  Once a firm has such knowledge, its duty is to disclose that information.  See, e.g. Glaziers and Glassworker Union Local No. 252 Annuity Fund v. Newbridge Securities, Inc., 93 F.3d 1171 (3d Cir. 1996) (“Newbridge”).  In Newbridge, the employee of a broker-dealer resigned from that firm to join another firm.  The plaintiff’s funds followed the employee to the new broker-dealer.  The former broker dealer had strong evidence, which it forwarded to the NASD, showing that its employee had engaged in misconduct.  However, the firm kept silent. the court wrote that a fiduciary seeing problems has a duty to inform, and cannot “turn its ‘practiced eye’ to its self-interest, while turning a blind eye to the interests of its beneficiary.”  93 F.3d at 1182.  California law also requires a fiduciary to disclose to the client all material facts which might affect their rights or interests.  Notice of a sales violation, therefore, should trigger a direct inquiry into whether the investor knows what is going on in their account.  Pusateri v. E.F. Hutton, 180 Cal. pp. 3d 247, 255 (1986).  In some cases, this duty also runs to non-customers.  Bear Stearns v. Buehler,23 Fed. Apex. 773 (9thCir. 2001) (“Once aware of troublesome “red flags”, the broker-dealer may have a duty which runs to non-customers to monitor and investigate any unusual account activity”).

      Reasonable supervision “requires strict adherence to internal company procedures.”  Dickinson & Co. and John Laurent, Exchange Act Release No 26338, p. 6 (Oct. 9, 1995) quoting Nicholas A. Roccella, Exchange Act release No. 26574, 49 SEC 1084, 1086 (1989.  Even where supervisors’ knowledge “is limited to red flags or suggestions of irregularity, [they] cannot discharge their supervisory obligations simply by relying on the unverified representations of employees, ” Id.,quoting Gutfreund, Strauyss & Meriwether, Exchange Act Release No. 31554, 52 SEC Doc. 4370, 4387 (Dec. 3, 1992).  The branch manager “cannot ignore patterns presented by suspicious events and circumstances but must devise a response to detect and prevent improper activity.”  William L. Viera, Exchange Act Release No. 26576, 49 SEC 1091, 1097 (1989).  In addition, a broker’dealer’s own in-house guidelines (i.e., compliance manuals) help establish the correct standard of cares.  Thropp v. Bache, Halsey, Stuart, Shields, Inc., 650 F.2d 817,820 (6thCir. 1981); Mihara v. Dean Witter & Co., 619 F.2d 814 (9th Cir.1980); Peterzell v. Dean witter Reynolds, Inc., AAA Case No. 32-136-0416-88-ID (Nov. 9, 1990).

      A broker dealer may avoid liability for failure to supervise under the 1934 Act, Section 20(a), only by showing they have acted in good faith by having maintained and enforced a reasonable and proper system of supervision and internal control so as to prevent violations of the Exchange Act.  However, in supervising its employees, a firm may not simply rely on the supposed integrity of the broker.  Rhumbline Advisors, 68 S.E.C. 276 (1998); First Capital Strategists, Advisers Act Rel. No. 1648 (Aug. 13, 1997).  As recently articulated in George M. Lintz, 74 S.E.C. 849 92001:  The “supervisory obligations imposed by the federal securities laws require a vigorous response even to indications of wrongdoing.  Thus, supervisors must respond not only when they are “explicitly informed of an illegal act, “but also when they are “aware only of ‘red flags’ or ‘suggestions’ of irregularity.” See id. at *34-35.  “Red flags and suggestions of irregularities demand inquiry as well as adequate follow-up and review.” In re Edwin Kantor, Exchange Act Release No. 32341, 1993 SEC LEXIS 1240, at *16 (May 20, 1993).  2001 WL 121982 at *3 (emphasis supplied). Supervisory red flags require action: a supervisor who reviews the sales of registered representatives and is confronted with red flags fails reasonable to supervise when he or she does not take corrective action in response.  In re W.J. Nolan & Co., Exchange Act Release No. 34-44833 (Sept. 24, 2001); Donna M. Morehead, 77 S.E.C. 1935, 2002 WL 1371019 at *4 (2002).

 2.  Off-site representatives require special supervision.

      A significant number of NASD members employ registered persons who engage in securities-related activities, on a full or part time basis, at locations away from the offices of the member.  These off-site representatives, often classified for compensation purposes as independent contractors, may also be involved in other business enterprises such as insurance, real estate sales, accounting, estate or tax planning.  They may also operate as separate business entities under names other than those of the members.  Irrespective of an individual’s location or compensation arrangements, all associated persons are considered to be employees of the firm with which they are registered for purposes of compliance with NASD rules governing the conduct of registered persons and the supervisory responsibilities of the member (Notice to Members 86-65 – Compliance with the NASD rules of Fair Practice).

      The fact that an associated person conducts business at a separate location or is compensated as an independent contractor does not alter the obligations of the individual and the firm to comply fully with all applicable regulatory requirements.  Thus, firms employing off-site representatives are responsible for establishing and carrying out procedures that will subject these individuals to effective supervision designed to monitor their securities-related activities and to detect and prevent regulatory and compliance problems. This can include:

           1.  Educating off-site personnel regarding their obligations as registered persons to the firm and to the public, including prohibited sales practices.

           2.  Maintaining regular and frequent contact with such individuals.

           3.  Implementing appropriate supervisory practices, such as records inspections and compliance audits at the representatives’ places of employment, to ensure that their methods of business and day-to-day operations comply with applicable rules and requirements.

      For greatest effectiveness in preventing and detecting violations, visits should be unannounced and include, for example, a review of on-site customer account documentation and other books and records, meetings with individual representatives to discuss the products they are selling and their sales methods, and an examination of correspondence and sales literature.  To fulfill these obligations, a firm should consider whether the number and location of its registered principals provides the capability to supervise its off-site representatives effectively.


     NASD Notice to Members 99-45 clarifies this even further.  “Unannounced visits may be appropriate, particularly where there are indications of misconduct or potential misconduct, such as the receipt of a significant number of customer complaints, personnel with disciplinary records, or excessive trade corrections, extensions, liquidations, or variable contract replacements.  Each firm should determine the types of “red flags” that would trigger an unannounced inspection.  The frequency and scope of inspections should be determined based on factors such as the nature and volume of business conducted at the office and the nature and extent of contact with customers”.

 Also see, e.g. SEC Legal Bulletin No. 17:Remote Office Supervision (March 19, 2004) at 1.  See SEC Bulletin at 3; NASD Notice to Members 98-38, NASD Reminds Members of Supervisory and Inspection Obligations (May 1998).

 3.  The broker-dealer is liable for the stockbroker’s wrongdoing.  The law makes employers liable for the harm caused by their employees acting in the course and scope of their employment.  Thus, if a stockbroker’s misconduct causes harm in an account, the employing brokerage firm is liable side-by-side with the stockbroker.  The legal principle that imposes liability on employers for losses caused by their employees is ancient enough to be known primarily by a Latin name:  “respondeat superior.”  The principle makes sense for two reasons.  First, it recognized the reality that the employee, who controls the purse strings and otherwise has the ability to exercise control over the employee’s conduct, is in the best position to prevent the employee from causing harm.  The employer clearly is in a better position to prevent harm than is the customer or an uninvolved third party, for example.  Second, respondeat superior is consistent with the ancient and widespread legal principle that, as section 3521 of the California Civil Code puts it, he who takes the benefit must bear the burden.”


4.  Transaction confirmations and other account statement do not put the claimant on notice of unauthorized trading or churning in the account.  99 Civ. 9795 (LAK) United States District Court for the Southern District of New York, 2000 U.S. Dist. LEXIS 3635 February 14, 2000 Filed and Decided.  An order to vacate an arbitration award was filed by respondent Merit Capital Associates, Inc. and heard by Lewis A. Kaplan, District Judge, following an award by an NASD arbitration panel in the amount of $314,199.80 plus interest in favor of petitioner Mohammad Al-Azhari and jointly and severally against respondent Merit Capital.  The New York Supreme Court confirmed the NASD arbitration award, stating, “First, respondents have not shown that the notice defense upon which they rely constitutes a “clearly governing legal principle”.  “They rely on a line of cases holding that, in securities fraud claims, transaction confirmations or other account statements put the claimant on notice of the transactions enumerated therein and start the statute of limitations on actions based on those transactions.  Although respondents seek to extrapolate from this principle that such notice constitutes a defense to allegations of unauthorized trading or churning, their effort is unavailing.  Their cases recognize a notice defense only where respondent has moved to dismiss the complaint as time barred, which is not the case here, as petitioner’s notice of claim indisputably was filed before the limitations period expired.  Accordingly, respondents have not shown that the notice defense is clearly recognized law and should have barred petitioner’s claims in this case”. Further, an investors silence upon receiving account statements, without complaint, does not constitute ratification.  See Kravitz v. Pressman, Frohlich & Frost, Inc.447 F.Supp.203, 211 (D.C.Mass. 1978).

      In Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Cheng, 901 F.2d 1124 (Ct. App. D.C. 1990), the Court of Appeals for the District of Columbia Circuit concluded that a broker’s duty to a customer – under the basic principles of agency law, as recognized by the District of Columbia – encompasses the duty to inform the customer of the right to reject unauthorized trades, and that the failure to do so, as a matter of law, constitutes a breach of that duty.  Since the customers in this case were not informed of their right to disavow the unauthorized trades, said the Court of Appeals, “there could not have been “ratification” of such trades.  “Ratification occurs only,” said the court, “when the customer, with full knowledge of the facts, manifests his intention to adopt the unauthorized transaction.”

 5.  Simply disclosing the risks of a recommendation does not satisfy the fiduciary responsibility of suitability.  What are a rep’s suitability obligation.  The SEC’s recent decision, In the Matter of the Application of James B. Chase (SEC Release 34-47476), outlines a rep’s suitability obligations and addresses several defenses that the rep had raised to justify his investment recommendation.  The SEC’s decision was the third of three involving stockbroker Chase.  After an NASD hearing panel found that Chase had violated securities rules, he appealed to the NASD’s National Adjudicatory Council, which not only affirmed the findings but also imposed more severe sanctions.  Chase then appealed to the SEC.

      At issue was whether it was appropriate for a financial advisor to recommend the purchase of a concentrated position of a speculative stock partially on margin to an investor of limited financial resources.  Two NASD rules came into play.  The first was Conduct Rule 2110, which requires one to “observe high standards of commercial honor and just and equitable principles of trade”.  The second, Conduct Rule 2310, requires one to have reasonable grounds for believing that a recommendation is suitable, given such factors as the customer’s financial status, tax status and investment objectives.  Before the SEC, Chase argued six points to support his position that the investment recommendation was suitable.  He argued that the customer was young and had a lifetime of earning potential; that she wanted to buy the stock; that he [Chase] fully informed the customer of all the risks associated with investing in the stock; that the customer otherwise was knowledgeable, because she was studying economics in college and, by using the Internet could evaluate suitability herself; that the customer’s mother, accountant and attorney all received duplicate confirmations of the trades, and, finally, that the customer changed her investment objectives from income and low risk to growth and speculation.

      The SEC was not persuaded by Chase’s defenses.  It concluded that the customer’s limited financial means “demanded an investment strategy that limited risk.”  The SEC faulted Chase for failing to recommend such a strategy, instead recommending the purchase of a concentrated position in a speculative stock on margin.  As to Chase’s defenses, the SEC concluded that it was “non-determinative” that the customer was young and had a lifetime of earning potential, because at the time she had no income and no prospects of any anticipated income.  Chase was obligated to consider the customer’s actual financial profile and needs at the time of the recommendation.  Second, even if the customer wanted to buy the stock, that fact did not alter Chase’s duty to recommend only suitable investments.  Third, mere risk disclosure is not sufficient to satisfy the suitability requirement.  A financial advisor must not only ensure that a customer understands the risks, but also that the customer can bear those risks.

      Fourth, in  line with past precedents, the SEC believes that a college education does not establish that a customer is a “sophisticated investor.”  Likewise, it rejected Chase’s fifth defense, finding irrelevant the fact that he had informed the customer’s mother, accountant and attorney of his stock purchases – the duty was to the customer.

       Finally, even if the customer had changed her objectives from income and low risk to growth and speculation, the SEC observed that investment objectives constitute only one factor in determining suitability.  Rep’s should understand and abide by all of the lessons of the Chase decision.  It bears repeating that the SEC considers it to be a “profound misunderstanding” for a rep to believe that his or her suitability obligations can be satisfied simply by disclosing the risks of recommendations.  As Chase discusses, much more is required.

 6.  Broker Dealer enforcement of policies and procedures.  It is custom and practice in the securities industry for firms to establish internal guidelines for sanctions against personnel (both registered representatives and supervisors) who may be in violation of regulatory requirements and/or firm policies or procedures.  These sanctions are normally designed to assist the firm in maintaining a high standard of commercial honor and to serve as a deterrent to future violations.  Sanctions imposed by broker-dealers may include one or more of the following:

      *  Letter of Caution;

      *  Censure, Fine, or Suspension;

      *  Rescission of Trade(s) with RR bearing cost of market exposure and other related costs;

      *  Forfeiture of Commissions;

      *  Suspension of Branch hiring/recruiting privileges;

      *  Heightened Supervision;

      *  “No More Business” in all or certain accounts;

      *  Prohibition against advertising;

      *  Retraction of supervisory privileges and/or authority;

      *  Remedial education or training at the RR expense;

      *  Internal or independent special examination or review at RR expense;

      *  Termination (“Discharge”) from firm.


 Securities Industry Group Outlines Best Practices For Supervisors and Compliance Professionals To Protect Investors

 The Securities Industry and Financial Markets Association (SIFMA) – formerly the Securities Industry Association, a trade group for 650 financial services firms in the U.S. and throughout the world — has published “Best Practices” for its member firms. Although “aspirational in nature”, SIFMA states that its members have an obligation to “abide by the highest professional standards” because “anything less would be inconsistent with the trust our clients have placed in us.”

 The Best Practices cover several areas – from firm management to relationships with regulators – but the two most interesting relate to the Best Practices for sales supervisors and for compliance professionals. SIFMA does cover the area of “investor rights”, but its treatment is generic — the right to “quality service”, “full, clear reporting”, and “prompt, fair resolution of problems” – with two exceptions. The first is that “significant conflicts of interest” must be disclosed. The second is that, in presenting investment recommendations, the firm “will present you [the investor] with reasonable investment alternatives” and “disclose the comparative risks, benefits and costs.”  Typically, firms often fail to follow these two Best Practices.

 Clearly, the two most substantive Best Practices relate to sales supervision and the role of the compliance professional. Let’s examine four excellent recommendations for sales supervision. First, SIFMA expects firms to have “stringent” hiring procedures for financial advisers. Firms need to review their practices to ensure that they capably can screen candidates and whether additional protections are necessary.

 Second, firms should use “special supervision” for financial advisers who have a disciplinary history of customer sales abuse or other customer harm. In the author’s experience, this kind of heightened supervision frequently can detect, if not prevent, significant customer harm that may escape standard supervision processes.

 Third, firms should understand that effective supervision and sound written supervisory procedures are the “first line of defense in guarding against sales practice abuses.” Securities regulators have delivered this message for many years. When firms detect problems, they must take corrective action.

Finally, the Best Practices call for firms to “consider tying a component of the branch manager’s compensation to his/her effective supervision” of financial advisers. That should get the point across!

 SIFMA’s Best Practices have a similar theme with respect to the role of the compliance professional. There are five excellent recommendations. First, firms must insist on “compliance and high ethical standards” throughout the firm, and senior management must lead by example. Securities regulators recently have emphasized that this “culture of compliance” is necessary to comply with securities rules and regulations.

 Second, personal performance evaluations should have a component for the compliance record of the individual as well as for the branch office. This is similar to the sales supervision Best Practice noted above for branch manager compensation, and it makes sense.

 Third, firms should ensure that they provide an effective means of communicating compliance, regulatory or ethical concerns to compliance professionals and senior management. The Best Practice envisions firms including confidential and anonymous communications so that there is no fear of retaliation against those who may be viewed as “whistleblowers”.

 Fourth, firms must support and provide adequate resources to compliance professionals. That includes having programs for skill development as well as “compensation, benefits and recognition in keeping with their contributions.” That also includes ensuring that compliance professionals have sufficient access to information at the firm to discharge their duties.

 Finally, SIFMA recommends that firms involve compliance professionals in, and recognize their input “as an integral component” of, hiring and firing decisions. Likewise, firms should “actively involve” compliance professionals in internal disciplinary processes to make certain that action taken is “fair, consistent and appropriate.”

 In conclusion, SIFMA’s Best Practices should be followed, as securities regulators already require, or soon may require, these “best practices” to be minimal standards of conduct.