Due Diligence

Suitability? How Sophisticated Are Your Clients, Really?

Are your clients sophisticated enough to understand structured products? Are you?

Whether a complex financial product was appropriate for the investor who bought it often hinges on whether that investor was “sophisticated,” says a story in the Wall Street Journal today about retail investors who are filing arbitration claims against Merrill Lynch over CDOs that went bust.

The investors say the CDOs should never have been sold to people who didn’t know enough about markets to understand such products. But banks usually counter-claim that they only sell such high-risk products to investors who are sophisticated enough to understand the risks. Merrill sold the instruments to investors with $5 million or more in net worth, which means they fall well within a category of investors deemed “accredited”--or sophisticated--by the SEC. That term applies to anyone with a net worth of $1 million or more, an annual income of $200,000 or control of a trust with $5 million or more.

Those who bought the CDOs also signed disclosures that say they involve considerable risk and that “some or all of the investment may be lost.” And yet, despite these disclosures, financial advisors allegedly told clients that the investments had little or no risk. That sounds like a mixed message to me.

What do you think? Should someone with $1 million in net worth have a responsibility to understand complex investment products? Or should it be up to their financial advisors to make sure they understand how those products work?

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