Far too many reps are learning the hard way how little responsibility clients shoulder when it comes to assessing the suitability of their investments.
When confronted with a suitability complaint, reps typically react with bluster: “These charges are baseless — I've got documentation proving that I'm not at fault!”
The sad truth is that almost all the responsibility for ensuring a customer's investments are suitable lies with the rep, and the only reliable way to fight a suitability complaint is to avoid getting one in the first place.
The OK Corral
Perhaps the most dangerous myth on Wall Street is the one that says that there's no suitability problem as long as the customer agreed to the trade.
Unfortunately, a recommendation is not suitable merely because the customer approves it. In order to be suitable, a recommendation must be compatible with the customer's financial situation and needs — independent of the customer's opinions on the matter.
Crazy as it sounds, the rep is required to dictate to the customer what is best for him, financially speaking.
In the classic suitability case, a client with limited means is placed in a speculative stock. The rep claims the customer said to “go ahead” even after being warned against buying the stock. The customer pooh-poohs the rep's warnings and threatens to execute the trade elsewhere if the rep declines to process it.
The rep might well have proof of this exchange — a letter or emails detailing the client's bullheadedness. But guess what? An arbitrator hearing the case is still likely to rule that the client could not afford the loss of the invested assets and that the advisor should have recommended a lower-risk strategy or a lesser number of shares.
The Book on Suitability
NASD Conduct Rule 2310: Recommendations to Customers (Suitability) states that when a rep recommends that a customer purchase, sell or exchange any security, the rep must have “reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.
This means that prior to the execution of a recommended transaction, the rep must make reasonable efforts to determine the customer's financial status, tax status, investment objectives as well as any other information used or considered to be reasonable in making the underlying recommendation.
NASD Interpretive Material 2310-2: Fair Dealing with Customers cites some potentially troublesome situations for reps. For example, reps should avoid predicting either substantial or specific increases in a speculative stock, because both are practices the SEC views as inherently fraudulent. When facing complaints about such transactions, some respondents resort to what they think is a clever maneuver — I never “guaranteed” the increase; I merely “thought” it could happen. But this dodge will not work: The SEC gives reps no credit for framing the proposition as an opinion or possibility.
For reps engaging in unsuitable recommendations, the penalties can be stiff. In addition to getting charged under NASD Rule 2310, the rep will get cited for a violation of NASD Conduct Rule 2110, which requires that registered representatives “observe high standards of commercial honor and just and equitable principles of trade.” Completing the painful trifecta, there's also a reasonable expectation of a customer-initiated arbitration case.
So how can such problems be avoided? For starters, an advisor needs to look at client holding pages from the perspective of a regulator; look for accounts invested in one or a few suspicious stocks; and look for accounts carrying positions out of whack with their income/net worth.
Then, a rep should give timely updates about customers' changed financials on their account forms and have the client so acknowledge.
Finally, for reps who have recommended something that's obviously unsuitable, reject the order when it comes in. Sure, that's a tough pill for a commissioned salesperson to swallow, but, if the trade ain't suitable, it ain't suitable.
In these days of hyperactive regulatory activity, the money a rep gains on such transactions might simply get transferred to the pockets of the lawyer representing him before an arbitration panel.
Bill Singer is a partner with the law firm of Gusrae, Kaplan & Bruno. rrbdlaw.com