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Advisor Beware

Registered reps always have an obligation to do what is in the best interests of their customers, which includes making recommendations that are suitable for their investment objectives and risk tolerance.

A well-to-do and loyal customer called to announce she had made a substantial investment in a hedge fund limited partnership — outside of my firm. I was stunned. I thought the vast majority of her assets were invested with me or in real estate. When I asked about the specifics of the investment, she wasn't sure about the details, but said she was going to “make a lot of money” and would send me the hedge fund's investment package.

After reviewing the documentation, I'm deeply troubled, particularly given what she's told me about her investment objectives and assets, and what I know about her portfolio. Do I have any liability or duty to talk to her about this investment?

As you know, registered reps always have an obligation to do what is in the best interests of their customers, which includes making recommendations that are suitable for their investment objectives and risk tolerance. The term “recommendation” covers not only a direct solicitation to purchase a security, but also the common situation where, say, a client calls to ask what you think of an investment he has heard about and you give a positive report that leads to a purchase. In many jurisdictions, advising a client to continue to hold a security is also considered a recommendation, irrespective of whether the original purchase was made through you. However, if you tell a client that a security is not something you believe is suitable and he makes the purchase anyway, it is doubtful that any arbitration panel would hold you responsible for any losses.

Hedge funds are “lightly” regulated private investments originally designed for sophisticated wealthy investors. In recent years, the industry has exploded — there are over 8,000 hedge funds managing more than $1 trillion in assets. This unprecedented growth has caused concerns among regulators, who fear the “retail-ization” of hedge funds — selling hedge funds to retail investors through broker/dealers — may create widespread sales practice problems.

After reviewing the hedge documents, you apparently concluded this product was not suitable for your client. The good news is that the ethical obligations associated with expressing your opinion should not come into conflict with your concerns over the potential liability for doing so. Sharing that you are “deeply troubled” about the purchase is the right thing to do. Since you aren't recommending a purchase, nor reacting positively to an idea the customer brought to you, your opinion isn't actionable.

Confirming your conversation by letter or email with your client is prudent. You might also take the opportunity to explain that any investment sold with promises that she will “make a lot of money” carries with it the potential for significant loss.
Philip M. Aidikoff
Aidikoff Uhl & Bakhtiari
Beverly Hills, Calif.

[email protected]

This situation confirms something that I've seen time and again — registered reps are usually in the dark about a wealthy client's total portfolio. Clients seem to only want to tell their reps enough information to stop them from calling with investment ideas.

Unfortunately, this conflicts with the well-known securities industry rule: Know your customers. There is no way a rep will ever know exactly if a customer has been honest with him. As a result, many advisors suffer the consequences that you now face. The fact is that high-net-worth clients are in nearly every FAs' crosshairs, and rivals are frequently approaching your clients with specific investment ideas and chipping away at the amount of business they do with any one rep.

This may not be the worst thing that could happen, but you also may be in a position where this investment will come back to haunt the client. When clients lose money, they tend to blur the lines as to who recommended, sold or advised them to retain an investment. You may get the blame if it goes bad — even if you had nothing to do with the recommendation.

Attack this problem in two ways. First, you should understand the investment the client has found for himself. Once understood, the goal is to protect the client and the firm, while not offending the client. You accomplish this goal by telling the client that, given your knowledge of his portfolio, you wouldn't have made such a recommendation. You should also make clear — as politely but directly as possible — that the investment is not appropriate.

You need to ensure that all of your conversations with the client are recorded in writing, preferably in a letter to the client, and involve your compliance department and manager from the inception to the resolution of the problem.

In addition, you should redouble communications with all of your clients to ensure you have up-to-date, accurate information. Don't think the SEC's “Broker-Dealer Books and Record Rules” (under the Securities Exchange Act of 1934), which requires firms to update customer records every three years, is enough back-up. It's only a minimum. Check (and double check) customer information more frequently. By following this advice, you will have an additional layer of protection if a complaint arises.

Remember: Protect yourself. If this investment fails, the customer may decide to go ahead with an arbitration claim. Documenting and communicating your position, while ensuring that your customer records are current, may protect you and your firm from any liability in an arbitration claim.
Ernest E. Badway
Saiber Schlesinger Satz & Goldstein
Newark, N.J.

[email protected]

Not sure whether you have to pay back a forgivable loan? Seen a work colleague do something that makes you squeamish?

Don't fret. Send your questions to Registered Rep. Contributing Editor Ann Therese Palmer at [email protected]. Then, look for an answer in a future Ethical Rep column. Anonymity guaranteed.

The Ethical Rep.
Registered Rep.
249 West 17th Street, Third Floor
New York, N.Y. 10011-5300
[email protected]
Fax: 913-514-3890.

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