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SEC Law page has an article called "Brokers Have to be Their Own Judge" wherein it discusses the issue of "Did a broker have a reasonable basis for believing that the recommendation was suitable?" The author states "it requires brokers to make a determination of the essential facts relating to his customers, their financial situations and goals, and their investment experience. The doctrine also requires the broker to learn all essential facts regarding the particular investment being recommended and to have a reasonable basis for recommending that investment to that particular customer." Nice rule. Unfortunately, it has little relationship to reality. What good does it do to supposedly learn all the facts about an issue if you have little idea of what anyone is talking about in the first place and effectively no background to put it to proper use. Suggesting that a janitor in a hospital learn all the facts about a patient for brain surgery in no way implies competency in developing a plan for care. Brokers are NOT taught alpha, beta, diversification, asset allocation, standard deviation, correlation, Bill Sharpe or many of the other basics needed to comprehend risk and reward. And if you do not know those, there is no way you can determine suitability. How do I know what has been taught????- I taught many of the licenses for years. The above info is NOT tested on the exam- therefore not required in the licensing instruction. And the securities firms wouldn't let me teach it anyway since it would reduce sales.
The statements go on--"The National Association of Securities Dealers' (NASD) Rule 2310 (formerly Article III, section 2 of the Rules of Fair Practice) provides, "[i]n recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs." While the rule defines suitability by using the term "suitable" (thereby rendering the rule virtually useless for determining what is suitable), it does make clear that the only requirement is "reasonable grounds" for making the recommendation."
O.K., here again how can one determine "reasonable grounds?" If you are suggesting that a prudent man's determination of suitability/reasonableness is simply passing an exam on which the basics of risk and reward are ineffectively addressed, if at all, and you find that element sufficient, then go ahead, call up a broker. It is my opinion that one does NOT possess the basics for a suitability application unless they have been properly trained in alpha, beta, correlation, diversification, etc.
And further, "Over the years, the NASD has attempted to provide guidance to the industry...." A falsification. I have tried repeated times to get the SEC and NASD to recognize their responsibility to include basic risk reward criteria for brokers and arbitrators -only to be rebuffed at every turn (see letters on file herein).
He does state however that , "even in-house compliance manuals do not provide sufficient guidance. Some firms attempt to address the issue by limiting recommendations of broker to "pre-approved" securities, or to securities trading on national exchanges. But like any general rule, such policies are often too inclusive and run the risk of being blindly applied." My comment- in house compliance manuals are designed and written by attorneys and other back office reps who have apparently never taken a true course in the application of securities. I have read many. Pitiful.
The article suggests that a broker "Understand the investment or strategy, the essential facts relating to the security and the reason it is being recommended to any customer. Once you have identified an investment that you believe is worthwhile, make sure that you have adequate and timely information regarding your customer. As discussed in earlier columns, simply obtaining information on a new account form when an account is opened may not be sufficient. That information should be reviewed and updated periodically, and should be reviewed at least once a year, perhaps during an annual review of the account with the customer
Make sure your customer has all of the necessary information regarding a particular security, issuer or investment strategy. While an obligation to provide information regarding widely known securities may be less than for more obscure securities, it is important that the customer have all of the relevant information at hand regarding any investment. Even the most sophisticated and wealthy customer can be unsuitable for a sophisticated options trading strategy that he cannot understand.
Be sure that you have determined the percentage of a client's liquid net worth being put into a particular investment or investment strategy that involves any significant degree of risk. While not stated in any rule, a particular investment may be suitable when using 10 percent of a customer's net worth, but it may be entirely unsuitable when it uses 90 percent of his net worth. Make sure that your customer understands why the investment is being made, and that you answer any questions he or she has regarding the investment or strategy."
Well, it all sounds very nice. But to suggest that your broker, planner, insurance agent (remember, an agent can sell indexed annuities without a securities license) who has almost nil background in risk and reward is going to ascertain whether or not a standard client understands the nuances, complexities and economic scenarios of an emerging mutual fund - almost all funds for that matter- with 50 securities and a 12b-1 fee has a screw loose.
Costs: (Financial Advisors Legal Association) The average cost professionals pay to defend themselves against litigation could rise to $30,000 in 2002. Big NASD problem areas: supervision, review of transactions and correspondence, outside business activities, private securities transactions and suitability.
Suitability Claims for Unrecommended Securities Purchases: A Theory of Broker-Dealer Liability, FREDERICK MARK GEDICKS, Brigham Young University - J. Reuben Clark Law School (2006)
Although the online revolution has indeed afforded individual investors control of their investment portfolios and direct access to market information and services, profits have proven more elusive. Assembling drastically under-diversified portfolios, trading on impulse and rumor, and blithely leveraging their holdings with margin loans, many of these self-directed investors incurred substantial losses in self-managed accounts despite the relentless appreciation of equities during the 1990s. Others were misled by the initial appreciation of their holdings, misunderstanding this as confirmation that their risky strategies were sound, when in fact they were not. After the market turned in early 2001, it became clear that many self-directed investors lacked basic knowledge about securities markets and investing generally, and as a result incurred substantial losses when their under-diversified, speculative, and over-leveraged portfolios evaporated in the bursting of the technology bubble and the general market decline.
It is well-established that full-service broker-dealers have an affirmative fiduciary obligation to inform themselves of each customer's investment objectives and general financial situation, so as to ensure that each security they recommend is "suitable" to the customer's investment objectives and financial situation.