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Suitability

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:
  1. The customer's financial status;
  2. The customer's tax status;
  3. The customer's investment objectives; and
  4. 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 investment portfolio.

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 omission.

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 risk."

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 variable annuities.

Asset Allocation

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 tolerate risk.

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.

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