General Suitability Issues

Stock and Bond Suitability — Investment and Stock Attorney Russell Forkey

One of the main claims made in investor-generated arbitrations is that either some or all of the securities purchased in a customer’s account were unsuitable for the investor or that the investment strategy recommended to the investor was unsuitable.

There are a number of ways to demonstrate whether or not a particular investment or strategy was unsuitable. However, in securities matters, the inquiry always commences with a reference to the relevant rules to which financial professionals are subject.

In this regard, both the Financial Industry Regulatory Authority (FINRA), as well as the New York Stock Exchange, have had suitability rules in place for a number of years. Effective October 7, 2011, revised suitability rules take effect. It is FINRA Rule 2111. This rule provides much more specificity on the issue of suitability than the rule currently in effect.

FINRA Rule 2111(a) provides as follows:

“A member or an associated person must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile. A customer’s investment profile includes, but is not limited to, the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation.”

It is interesting to note that almost all of the required customer information is called for on the new account documents that clients complete at the time that the broker-customer relationship is created. For more information concerning the establishment of an account, please follow the link Opening a Brokerage Account.

Importantly, in the notes to this rule, FINRA has attempted to make sure that the firm and account executive, with which you are dealing, understand that Rule 2111 is comprised of three main obligations. These obligations are (1) reasonable-basis suitability, (2) customer-specific suitability, and (3) quantitative suitability.

The notes to the rule explain each of these concepts:

• Reasonable-basis suitability: The reasonable-basis obligation requires a member or associated person to have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors. In general, what constitutes reasonable diligence will vary depending on, among other things, the complexity of and risks associated with the security or investment strategy and the member’s or associated person’s familiarity with the security or investment strategy. A member’s or associated person’s reasonable diligence must provide the member or associated person with an understanding of the potential risks and rewards associated with the recommended security or strategy. The lack of such an understanding when recommending a security or strategy violates the suitability rule.
• Customer-specific suitability: The customer-specific obligation requires that a member or associated person have a reasonable basis to believe that the recommendation is suitable for a particular customer based on that customer’s investment profile, as delineated in Rule 2111(a).
• Quantitative suitability: Quantitative suitability requires a member or associated person who has actual or de facto control [a high bred account] over a customer account to have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together in light of the customer’s investment profile, as delineated in Rule 2111(a). No single test defines excessive activity, but factors such as the turnover rate, the cost-equity ratio, and the use of in-and-out trading in a customer’s account may provide a basis for a finding that a member or associated person has violated the quantitative suitability obligation.

Finally, the notes to Rule 2111 indicate that the rule prohibits a member or associated person from recommending a transaction or investment strategy involving a security or securities or the continuing purchase of a security or securities or use of an investment strategy involving a security or securities unless the member or associated person has a reasonable basis to believe that the customer has the financial ability to meet such a commitment.

Whether or not this rule has been violated is not something that most investors would know at the time that the transactions, in their account, were taking place. Moreover, the key word in the rule and notes is “reasonable.” This is something that is usually looked at after the fact by an expert witness retained by your attorney, who would then provide expert testimony on the issues of reasonableness and suitability to the arbitration panel if the case were not settled.

Whether the transaction or strategy is reasonable or not requires, in part, comparing your investment objectives to the then characteristics of the investment(s) or strategy at issue. It is the job of the expert to do this. Consequently, not only should you have experienced counsel to represent you but that counsel needs to know what expert would be appropriate for your case.

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