The law imposes a duty upon securities brokers only to recommend securities or investment strategies (including an explicit recommendation to hold an investment) that the broker reasonably believes are suitable for the customer. The broker’s belief must be based upon a reasonable inquiry concerning the customer’s investment profile. This suitability duty is based on a “homely truth about investing — that investment decisions can be made only in light of the goals and needs of the person for whom they are made.”
Despite this, unsuitable recommendations of securities or strategies are among the most common violations in the brokerage industry. “Perhaps the clearest example of a suitability violation occurs where a broker recommends speculative securities to a customer whose financial situation and risk tolerance clearly calls for conservative investments (for example, a retired person who needs the income from his investments for his living expenses and who has no reasonable expectation of being able to replace any substantial trading losses).”
An unsuitable recommendation of securities constitutes a dishonest, unethical and fraudulent business practice. If such a recommendation results in financial loss, the customer has a right to recover that loss from the individual broker and his or her brokerage firm.
Broadly speaking, a brokerage firm’s suitability obligation is three-fold. First, a broker must determine whether there exists “a reasonable basis to believe, based upon reasonable diligence, that the recommendation is suitable for at least some investors.” In so doing, the broker must gain “an understanding of the potential risks and rewards associated with the recommended security or strategy.”
Second, a broker must have a reasonable basis to believe that the recommended security or strategy is suitable for the specific customer to whom it is made.
Third, a broker who had actual or de facto control over a customer’s account must have a reasonable basis to believe that a series of recommended transactions is not excessive and unsuitable based on the customer’s investment profile.
In undertaking a customer-specific suitability analysis, firms must use reasonable diligence to ascertain and analyze the customer’s investment profile, which includes, but is not limited to, the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose. Firms must know the essential facts concerning every customer and concerning the authority each person acting in behalf of a customer, including any limitations on that authority. Furthermore, “a broker’s recommendation must be consistent with his customer’s best interests” and a broker is prohibited from placing his or her interests ahead of the customer’s interests.
Most experts agree that the overall portfolio of an investor with an objective of asset preservation and/or income should contain a substantial allocation to money market, and/or investment-grade short-term fixed income investments. If that investor has a longer time horizon and requires some growth in order not to outlive his or her assets, a substantial allocation to dividend-paying stocks may be appropriate as well. A portfolio comprised substantially of non-dividend-paying growth stocks might be suitable for a younger investor saving for retirement, but not for someone in need of income from investments. A longer time horizon militates in favor of a greater allocation to stocks, and vice versa.
A designation of “speculation” as an investment objective or a level of risk tolerance should be regarded with extreme suspicion. Based on our experience, it is an indicator that the broker intends to use your account solely as a vehicle to generate excessive commissions. An investor should communicate the investor’s true investment objectives and risk tolerance in writing to the brokerage firm.
A broker cannot have a reasonable basis for recommending an investment or investment strategy without knowing the risk of the particular investment or investment strategy being recommended, and explaining that risk to the customer. A broker cannot know the risk of a particular investment or investment strategy, and properly explain it to the customer, without measuring the risk.
1 NORMAN POSER, BROKER DEALER REGULATION ss 3.03 (3d ed. 2005) (quoting Robert Mundheim, Professional Responsibilities of Broker-Dealers: The Suitability Doctrine. 1965 Duke L.J. 445, 448). 2 NORMAN POSER, BROKER DEALER REGULATION ss 3.03 (3d ed. 2005).
If you have investment losses or problems involving unsuitable advice, call the lawyers at Page Perry for experienced representation at (770) 673-0047 or (877) 673-0047 (toll free).