Let me enlighten you. One of the classic rants that an industry lawyer like myself hears from brokers goes more or less like this:
“Bill, what the hell is this suitability crap? The customers said that they were unhappy with their current broker. Complained to me about the lousy returns. I told them that to make more, they would need to take on more risk. ‘You want safety, put your money in the bank.’ Those were my words. Now those bastards are suing me because they lost money? What else was I supposed to do? I warned them!”
Something like this may have run through the mind of Janet Gurley Katz during recent regulatory proceedings. In a Feb. 2010 opinion, the Securities and Exchange Commission (SEC) sustained the censure and permanent bar of Katz by the New York Stock Exchange for a number of sales practice violations. (For a detailed analysis, please visit “An All Too Human Appeal,” at BrokeAndBroker.com.)
Among the issues that the SEC reviewed, was the finding that Katz had engaged in unsuitable trading, which the regulator explained as follows: A registered representative is obligated to make “a customer-specific determination of suitability and to tailor his recommendations to the customer's financial profile and investment objectives.”
In the Katz case, some of the broker's customers are described as “not savvy market people,” living on modest retirement incomes, and whose brokerage accounts represented a significant portion of their net worth. Despite those factors, Katz recommended investments in below-investment-grade individual securities. Moreover, these customers generated the highest transaction costs of any of the accounts at issue, and these extra expenses increased the amount by which their investments had to appreciate before they would realize a net gain.
The NYSE and SEC believed that the clients should have been placed in more conservative, diversified investments, for example, high-yield or high-income mutual funds. When dealing with even modest investments that represent all or substantially all of a customer's net worth, the SEC affords little margin for error or loss. Moreover, if a safe, non-speculative strategy is commanded by the investor's financial needs, recommending a portfolio of specific securities rather than seeking more diversification will likely be frowned upon by regulators. You may find such regulatory second-guessing unfair, but your opinion is meaningless because these Monday-morning quarterbacks draft the charges, hold the hearings, and impose the sanctions.
Among other things, Katz argued that the subject clients clearly demonstrated a willingness to assume risk. The SEC would have none of it: A client's awareness of, or even desire for, risk does not relieve a registered representative of the obligation to tailor recommendations to each customer's financial profile. Katz did not meet this obligation. She instead admitted that she essentially followed the same investment strategy for all of her clients, testifying that “if you are looking for safety of principal, you go to the bank, put your money in the bank, you should not be talking to me.”
To better fireproof your business against suitability allegations, consider these scenarios:
A relatively unsophisticated customer wants to realize “income” but also tells you that he's heard about this “margin thing” and likes the idea of getting a bigger bang for his bucks. He cuts you short when you warn him about buying on margin and says that he understands that margin is risky but wants to give it a shot anyway.
An unsophisticated kid fresh out of college has set aside some “play money” and tells you to load him up with stocks, to trade as often as you can, and to look for penny stocks that can make him millions. He tells you that he wants to take on the highest risk he can. Keep your wits about you.
If a customer tells you that he want-to double his money, that's not a green light to pile on the risk. If you recommend investments inconsistent with the financial situation and background of either of the above types, expect a knock on your door from a plaintiff's lawyer or a regulator — and expect an earful about suitability.