When a customer opens an account at a broker-dealer or investment advisory firm, the customer’s registered representative or stockbroker has a duty to recommend investments, securities, and investment strategies that are consistent and suitable in light of the customer’s investment profile. Upon opening an account at a broker-dealer or investment advisory firm, the customer will usually complete, or sign a completed, account opening form stating important information about the customer including, but not limited to, their investment objectives, time horizon, financial profile, risk tolerance, age, net worth, income and occupation. This provides information to the broker-dealer’s registered representatives or investment advisors regarding the investor’s risk tolerance, investment timeline, financial profile and other investment goals. A registered representative or stockbroker has a duty to recommend investments, securities and investment objectives that are consistent and suitable in light of the customer’s stated investment objectives. In fact, the Financial Industry Regulatory Authority, Inc. (“FINRA”) has established rules that require that all investment recommendations are suitable for customers. Specifically, FINRA Rule 2111 states that:
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.
To ensure that a broker is recommending suitable investments, the broker should also comply with FINRA Rule 2090, the Know Your Customer Rule, which states, “Every member shall use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer and concerning the authority of each person acting on behalf of such customer.” FINRA Rule 2090 requires brokers to use reasonable diligence in the maintenance of every account. This means that there may be circumstances when a broker is required to adjust a customer’s risk profile due to changes in the customer’s personal life such as retirement. An investment could be unsuitable because the customer does not have the financial ability to incur the risk associated with a particular investment or product, the investment or strategy is not in line with the investor’s financial needs, or the customer did not understand the risk associated with a particular investment. If a broker breaches these duties when recommending a security or investment strategy to a customer, the broker could be held liable for losses from damages incurred by the customer.
Suitability is broken down into three categories: reasonable basis suitability; customer specific suitability; and quantitative suitability.Reasonable Basis Suitability
Before recommending an investment strategy, security, stock, structured product, or other financial instrument, a stock broker must have a reasonable basis as to why that particular recommendation is suitable in general. This requires the registered representative to conduct due diligence to determine whether the investment is suitable for at least some investors. Making a recommendation without performing any due diligence on a particular investment or unreasonably relying on the investment promoter’s own due diligence report is a common circumstance where the registered representative could potentially have failed to satisfy their reasonable basis suitability requirements.Customer Specific Suitability
After determining that the investment is at least suitable for some hypothetical investors, the stockbroker must then determine whether the investment is suitable to the particular investor to whom they are making the recommendation. FINRA has provided brokers and firms with interpretive materials explaining the suitability requirements imposed upon them. One such interpretive material is FINRA Notice to Members (“NTM”) 04-30, which states that registered representatives consider their customer’s financial status, tax status, and investment objectives when making a recommendation. Additionally, FINRA NTM 04-30 requires that registered representatives fully disclose the risks, costs and rewards of each product in a fair and balanced manner. The customer specific suitability rules and interpretive materials also covers a broker or advisor’s suitability obligations when recommending an investment strategy to a customer.Quantitative Suitability
Quantitative suitability applies to firms where their registered representatives have actual or de-facto control over their customer’s account. This additional suitability requirement looks beyond how individual trades conform to the customer’s investment goals and risk tolerance in a vacuum, and instead looks at the entire trading strategy. In this respect, quantitative suitability claims are often similar to churning claims because they often correspond with alleged excessive trading activity. However, quantitative suitability claims differ from churning because with a churning claim, the stockbroker has traded for the purpose of generating commissions, while a quantitative suitability claim alleges that pattern trading strategies employed by the broker was not suitable for that particular investor.
Contact Lax & Neville LLP with your questions about suitability. Our attorneys have the experience needed to analyze your portfolio activity and formulate a strategy to potentially recover your losses and/or damages.