FINRA’s suitability rule governs the interactions between customers and their licensed registered representatives. The rule requires that a financial advisor must have a reasonable basis to recommend the purchase or sale of a particular security, and that the recommendation must be based on the customer’s investment objectives, tolerance for risk and other financial considerations.
In other words, a broker can’t recommend a transaction that would be inconstant with your investment objectives.
To borrow a phrase, suitability is the rule that launched a hundred thousand customer claims. Little did the securities industry regulators realize when they drafted that investor friendly rule that it would come to dominate the (then) tiny dispute resolution forum at the former National Association of Securities Dealers (now FINRA). Securities attorneys usually “check for suitability” as part of their initial analysis into the claim.
There is no more common claim in the forum than the suitability claim, nor is there a rule that has generated so much controversy. The case of the poor, sweet, trusting widow having her portfolio churned or concentrated in penny stocks is the standard by which the suitability rule is frequently measured. In reality, finding a suitability violation is usually much more complicated.
One of the things a brokerage firm must always do at the inception of the relationship is attempt to determine a customer’s investment objectives and risk tolerances. This to make sure that all of the recommendations made to the customer are suitable. This is usually done via a standard opening account document, which asks the customer to select one (or more) risk preferences such as “conservative” “aggressive” or “speculation”. There is usually also a question asking for investment objectives, such as “income” “income and growth” “growth” or “trading”. Some firms ask detailed questions on risk and investment objectives, with the client expected to hand write the answers to the questions, and initial the responses. Other times, the financial advisor will present a blank form to the client, asking only for a signature, with the intent to fill in the suitability information at a later date. Securities attorneys have an uphill battle correcting this omission when there is a dispute, so it is always best to check the boxes personally before signing any opening account document.
FINRA also requires brokerage firms to periodically update the clients’ risk tolerance and investment objectives whenever a major life event occurs in the customer’s life such as death of a spouse, retirement or loss of a job. This is to ensure that recommendations made by the firm remain suitable, and consistent with the changed circumstances in the customer’s life.
What complicates determining when a suitability violation has occurred is when a risk averse client has a small position in a speculative stock in an account that is marked as “conservative.” If it is a small amount, such as 5-10% of the otherwise conservative portfolio, an argument can be made that the risky positon was part of an otherwise conservative portfolio, and made only to give the client some upside potential. Many firms require customers to sign off on the transaction if it is inconsistent with their stated objectives. Prior to email this was impractical, as a letter had to be sent, signed, then returned. Now, with emails and texting available, obtaining authorization has been simplified.
Another tool at the brokerage firm’s disposal is the negative consent letter also known as a “happy letter.” Branch managers are obligated to review their registered representatives' transactions on a daily and monthly basis. Sometimes time gets away from them, and only a monthly review is performed. If the manager spots transactions that are unsuitable, or inconsistent with the customer’s objective, he is obligated to question the representative, and, if appropriate, contact the client. This contact can be by way of a phone call, or by way of a letter informing the client that the transactions in the account were either high risk, concentrated in a particular security or sector, or otherwise inconsistent with the client’s stated objectives. The client is then asked to either contact the firm if the trades were inconsistent with his or her objectives (unsuitable), or to sign and return the letter indicating that the client understands the risks and affirms the transactions.
The regulator FINRA also sends auditors to the branches to conduct periodic inspections. There are usably several customer files that are picked at random (out of thousands) for review. These audits sometimes result in a letter of warning to the branch office to take corrective action. Sometimes a particular rep is found to have engaged in a pattern of violations. In that case the rep is placed on heightened supervision, and the branch manager is ordered to review his transactions even more closely.
The best way for a client to protect his hard earned money is to review each trade confirmation sent on the account, and to periodically check the holdings in the account to make sure they are suitable. The better brokerage firms will have the client come in for periodic reviews, but the reality is that the modern day financial planner is expected to be an asset gatherer, not a stock picker. This means that the only way to truly make certain that the transactions in your account are suitable is to check them yourself.
The Law Office of David Liebrader practices exclusively in the field of investment loss recovery. For the past 23 years, our securities attorneys have dedicated our law practice to assisting investors who have been victims of investment fraud via fraudulent and unsuitable investment transactions. During that time we have recovered money for over one thousand individuals, pension plans, trusts and companies. The recoveries we have obtained via judgments, awards and settlements on behalf of our clients exceed $40,000,000.
If you suspect that you have been the victim of investment fraud, or had a financial advisor recommend unsuitable investments to you, call us today for a free, confidential consultation at 702-380-3131.