A suitability claim is one of the most common
customer claims made to a panel of securities arbitrators.
In order to meet their duty to recommend suitable
investments a brokerage firm must "Know Their Customer." New York Stock
Exchange Rule 405 requires a firm to perform due diligence to learn the
essential facts and background of the customer. The suitability rule is
codified in NASD Rule 2310 which states:
- (a) In recommending to a customer the purchase,
sale or exchange of any security, a member shall 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.
- (b) Prior to the execution of a transaction
recommended to a non-institutional customer, other than transactions with
customers where investments are limited to money market mutual funds, a member
shall make reasonable efforts to obtain information concerning:
- The customer's financial status;
- The customer's tax status;
- The customer's investment objectives; and
- Such other information used or considered to be
reasonable by such member or registered representative in making
recommendations to the customer.
Brokerage firms record suitability information on
new account forms and customer questionnaires and periodically update the
information as a customer may experience changes in their risk profile during
their lifetime. This information is usually entered into the firm's computer
and maintained in a manner that permits supervisors to ensure that brokers at
the firm comply with the suitability rules. Each and every investment must be
suitable in its own right and also as measured in the context of the overall
The suitability of the overall mix of investments in
a portfolio is determined by asset allocation. Asset allocation is the split of
investment products between cash, fixed income, equities or other
non-traditional asset classes.
Failure to Supervise
A brokerage firm has a duty to supervise a broker to
assure the client's investment objectives and risk tolerance is being followed.
Proper safeguards would identify trading problems and minimize losses.
Misrepresentation and Fraud
A brokerage firm is a fiduciary of the customer. The
firm's requires the disclosure to the customer of all material facts. False
representations of a material fact give rise to a claim for misrepresentations.
Similarly, the firm has a duty to inform a customer of all facts that may be
important to the customer in the purchase, sale or decision to hold a security,
The failure to provide all material information to the customer constitutes an
Material facts may include those that have a bearing
on the quality of the investment, risk factors involved in the investment,
background of the company or executives or company financials.
A brokerage firm may be held liable if the firm
misrepresents or omits material facts and the client loses money.
Overconcentration and Lack of Diversification
Brokers have a duty to recommend a diversified
portfolio. Diversification manages and limits investment risk. Investing a
disproportionately large portion of a client's portfolio in a single market
sector (i.e. all technology or telecommunication stocks), a single investment
vehicle (i.e. all stocks or annuities and no bonds or fixed income securities),
or a single asset class (i.e. all funds invested in growth equity mutual funds
and little or none in fixed income funds), creates unacceptable "concentration
Churning of an Account
Churning is excessive trading or turnover of an
account in order to generate broker commissions. This may also include
unjustified mutual fund switching or so-called IRC Section 1035 switching of
Asset allocation involves dividing an investment
portfolio among different asset categories, such as stocks, bonds, and cash.
The process of determining which mix of assets to hold in your portfolio is a
very personal one. The asset allocation that works best for you at any given
point in your life will depend largely on your time horizon and your ability to
Time horizon is the expected number of months,
years, or decades you will be investing to achieve a particular financial goal.
An investor with a longer time horizon may feel more comfortable taking on a
riskier, or more volatile, investment because he or she can wait out slow
economic cycles and the inevitable ups and downs of our markets. By contrast,
an investor saving up for a teenager's college education would likely take on
less risk because he or she has a shorter time horizon.
Risk tolerance is the investor's ability and
willingness to lose some or all of your original investment in exchange for
greater potential returns. An aggressive investor, or one with a high-risk
tolerance, is more likely to risk losing money in order to get better results.
A conservative investor, or one with a low-risk tolerance, tends to favor
investments that will preserve his or her original investment.
Many investors use asset allocation as a way to
diversify their investments among asset categories. By including asset
categories with investment returns that move up and down under different market
conditions within a portfolio, an investor can protect against significant
losses. Historically, the returns of the three major asset categories have not
moved up and down at the same time. Market conditions that cause one asset
category to do well often cause another asset category to have average or poor
returns. By investing in more than one asset category, you'll reduce the risk
that you'll lose money and your portfolio's overall investment returns will
have a smoother ride. If one asset category's investment return falls, you'll
be in a position to counteract your losses in that asset category with better
investment returns in another asset category.