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Unsuitable Investment Claims 101
Published: October 7, 2009
Author: Jason J. Knutson and Claudia N. Lombardo
Claims against stockbrokers and other financial advisors are on the rise. The Financial Industry Regulatory Authority (FINRA), which oversees nearly 4,800 brokerage firms, 172,000 branch offices and approximately 646,000 registered securities representatives, reports that 2009 experienced a 65 percent increase in the number of cases filed as compared to 2008. The increase in the number of cases filed does not mean that claimants are winning more often, however.
In 2009, only 45 percent of cases resulted in an award of damages to the investor. [1] And, on average, investors who win get back less than half of their claimed loss, according to a study by Attorney Dan Solin and the Securities Litigation & Consulting Group. This statistic reveals that achieving a good result on securities cases is no easy charge. Moreover, it is almost impossible to put a securities claim in front of a sympathetic jury. Almost all new account agreements contain a binding arbitration clause, and those clauses are strictly enforced. [2]
Securities cases are almost always arbitrated by the FINRA, or a similar entity. Generally, the cases are heard by a panel of three arbitrators. One of the arbitrators will have worked in the securities industry and another will almost always be a securities lawyer. [3] "It's like having a doctor on a jury in a medical malpractice suit," says Brian Smiley of the Public Investors Arbitration Bar Association.
Worse yet, some of the traditional benefits of arbitration are not present in the securities arena. For instance, the time between filing for arbitration and receiving a decision from the panel is almost 18 months, and the trend for case turnaround shows increasing delay. Additionally, the plaintiff's lawyer's discovery tools are markedly reduced in securities litigation. Depositions are allowed only in very limited circumstances and requests to admit and interrogatories are forbidden altogether.
For all these reasons, it is important to analyze every potential securities claim with intense scrutiny. The first step is to consider whether you have a claim. Most investment-related problems do not rise to the level of an arbitration claim. For example, investing in trendy markets that do not live up to their reputation likely does not amount to stockbroker malpractice. Likewise, a broker who chooses investments from lists of firms that pay the brokerage extra is not necessarily committing malpractice as long as the investments are suitable to the individual investor. [4]
Cases involving allegations that the defendant purchased unsuitable securities for the claimant are one of the most common causes of action in securities claims. In addition to the difficulties described above, suitability cases offer special challenges of their own.
Suitability cases can most easily be described as events when an investor's funds are placed in investments that are unreasonable based on the particular circumstances of that particular investor. In other words, while high-risk stocks might be acceptable for one investor, they will not be for another. When a broker buys securities for a customer that fall outside the bounds of reasonableness in light of the customer's overall financial position, the investment may be unsuitable.
The Rules Governing Unsuitable Investments
Under FINRA Rule 2730(19) on Suitability,
(A) No member or person associated with a member shall recommend to any customer any transaction or trading strategy for the purchase or sale of a security future unless such member or person associated with the member has reasonable grounds to believe upon the basis of information furnished by the customer after reasonable inquiry by the member or person associated with the member concerning the customer's investment objectives, financial situation and needs, and any other information known by the member or associated person, that the recommended transaction or trading strategy is not unsuitable for the customer.
(B) No member or person associated with a member shall recommend to a customer a transaction in any security future unless the person making the recommendation has a reasonable basis for believing, at the time of making the recommendation, that the customer has such knowledge and experience in financial matters that the customer may reasonably be expected to be capable of evaluating the risks of the recommended transaction, and is financially able to bear the risks of the recommended position in the security future.
The closest thing to a suitability rule in Wisconsin can be found in the Wisconsin Uniform Securities Law, Wis. Stat. § 551.501.
551.501 General fraud. It is unlawful for a person, in connection with the offer, sale, or purchase of a security, directly or indirectly, to do any of the following:
(1) To employ a device, scheme, or artifice to defraud.
(2) To make an untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading.
(3) To engage in an act, practice, or course of business that operates or would operate as a fraud or deceit upon another person.
Federal case law instructs that in order to prove unsuitability the claimant must show that:
(1) The securities were unsuited to the buyer's needs;
(2) The defendant knew or reasonably believed the securities were unsuited to the buyer's needs;
(3) The defendant recommended or purchased the unsuitable securities for the buyer anyway;
(4) That with scienter, the defendant made material misrepresentations or failed to disclose materials facts relating to the suitability of the securities; and
(5) The buyer justifiably relied to his detriment on the defendant's fraudulent conduct. [5]
The common thread running between the unsuitability rules is that a broker's recommendations must be appropriate based on the particular investment needs of each individual investor.
Applying The Rules To Case Facts
The next step in analyzing a suitability claim is to find evidence that the broker violated the applicable rules. One useful piece of data in proving a suitability case is evidence that the broker used very similar investment strategies for a varied group of investors with different goals. For example, a high-risk bond position may be appropriate for a 25 year old computer programmer who asked for aggressive growth from his investments, but the same high-risk bonds would likely be unsuitable for a 75 year old widow who depends on the income from her investments for living expenses.
Another example of conduct that contrasts suitability includes a broker putting a large percentage of the client's portfolio in one stock or industry. Likewise, evidence that the broker failed to explain the risk of loss involved in a particular investment with the customer will bolster a suitability claim.
The broker has a duty to know the customer. As a result, the broker should ask the new customer questions about the customer's assets, liabilities, other securities and other accounts. A good broker will ask for and receive an income statement, information on home ownership and other real estate owned. Likewise, the broker should have inquired as to marital status, employment and educational background.
When a customer opens a new account with a broker, he or she is asked to complete a new client agreement. Invariably, somewhere on the form, the customer is asked to check a box describing his investment goals or risk tolerance. The categories are sometimes labeled 'aggressive growth,' 'mixed,' and 'conservative.' A broker should define those terms for the investor and give examples of aggressive investments and conservative investments. Similarly, the broker should explain applicable terms to the customer (e.g. preservation of capital, income, capital growth, tax advantages, diversification, and speculation). If the customer does not remember filling out a new account form, it may be because the broker filled it out for him or her and then simply asked for a signature.
The potential failings of the broker described above are meaningless unless an underlying unsuitable securities transaction took place as well. Some of the most common examples of unsuitable investments made by brokers are:
- Recommending below investment grade or unrated bonds to a customer with low risk investment objectives
- Recommending tax advantaged investments for individuals who do not receive the benefit.
- Recommending 'pink sheet stocks'
- Selling stock options when the customer does not have ample assets to cover a margin call on the option contracts
- Recommending a client use home equity to invest in securities when the client does not have other adequate assets to afford the mortgage if the securities fail
Obviously this is not an exhaustive list of the kinds of unsuitable investments a broker may recommend. What is common to almost all suitability claims is either a failure by the broker to fully understand the client's financial position or, in more egregious cases, the broker's disregard of the client's financial position altogether. What is clear about these claims is that they are inherently driven by the individual circumstances of the claimants.
Building The File
Because suitability cases are fact driven, recreating the investor's circumstances at the time the questionable investments were made is the key. What did the claimant tell the broker about his investment objectives, goals and risk tolerance? It is important to take the time to try and recreate as many conversations that the broker and investor had as possible.
A good first step in building the case file is to ask the client for a written narration of the claim. This summary should include the client's investment history from as far back as possible. Ask the client to try and contextualize the conversations with the broker and to reproduce any calendars or phone logs that show attempts at contact with the broker. During this process the client may remember details that have been forgotten, or uncover correspondence or transaction slips that were misplaced. The client summary will also prove to be a handy tool when designing an outline of the case to be reviewed by potential expert witnesses.
At a minimum, the securities lawyer should try to gather the following information from a potential claimant:
- Age
- Amounts invested in which securities
- Branch location
- Brokerage name
- Brokers' names
- Correspondence to and from the brokerage
- Customer agreement
- Date the unsuitable investments were discovered
- Documents relied on by the customer to make purchases
- Education history
- Employment history
- Future income that was disclosed to the broker
- Income
- Information about where the money is now
- Investment goals
- Liquidity needs
- Margin calls
- Martial status then and now
- Monthly statements in chronological order
- Net out of pocket loss
- Net worth
- Net worth of residence
- New account documents
- Pre-nup or post-nup
- Prior brokerage experience
- Prior investment experience
- Risk tolerance
- Spouse's assets
- Statements from other brokerages with accounts
- Tax bracket
- Total invested
- Type of products
- Types of activity years to retirement
Because the credibility of the claimant is essential to a claim of unsuitability, it may be worth independently confirming some of the claimant's information through tax returns, real estate assessor's records, and criminal court records.
Frequently clients have friends or family who invest with the same broker. These people are essentially witnesses to the client's claim. Other investors that the same broker placed in the same securities without regard to individual circumstances can bolster a suitability claim.
Finally, research the securities. The investments held by the client prior to the unsuitable transactions may prove just as important as the securities at the center of the claim. If the client was invested in various individual stocks, the history and analyst forecast for those stocks becomes valuable data. The investor section of most company web pages contains press release and historical financial information. Likewise, the countless securities publications in print and on the Internet represent a vast archive of information that will show not only what kind of securities are at issue, but what information was available to the broker for review, and when that information was released.
How the individual securities performed will also be driven in part by the market performance overall. Historical market data is also readily available and will demonstrate how far outside the bounds of normalcy the unsuitable investments were. Market performance generally will also become a key issue at the point that damages are calculated.
The Common Defenses
As with any plaintiff's claim, the usual defenses exist in securities cases. Suitability claims feature some defenses that are less frequently encountered in the typical plaintiff's case, however. Most claimants in securities cases trust their advisors explicitly. As a result, when something goes wrong, investors are often slow to complain.
Sometimes investors simply do not understand that they have lost money. If they do recognize a loss, investors often blame it on the market, rather than investigating what happened. Brokerage defendants are able to frame customer inaction as a 'waiver' of a potential claim by the customer. Unlike some other kinds of plaintiff's cases, in the securities realm, a client has to seasonably object when the broker acts unacceptably. [6] For instance, if a client continues to accept buy confirmations on accounts, he or she may be found to have waived a potential claim.
Likewise, a claimant's failure to complain immediately upon discovering a violation may be deemed estoppel or ratification of the unsuitable investment. [7] That is to say, when a customer does not take advantage of an opportunity to object about the way his account is being managed, the mismanagement may be ratified. The doctrine of laches, or in pari delicto may also apply where a claimant is found to be equally culpable for the wrongdoing on an account.
The aggressive, sophisticated customer presents special challenges in suitability cases. Here, the defense will likely claim that the investments were the client's idea and the broker, despite giving the client repeated warnings, grudgingly followed the client's instructions to make a potentially poor investment. Arguably, the current trend is to hold brokers responsible when they let costumers commit this kind of 'financial suicide.' Recently, a broker was sanctioned for failing to correct a client's erroneous belief about the safety of commodities trading and for failing to stop the client from continued trading once the broker was aware of the erroneous beliefs. [8] Inevitably these conflicts result in argumentum ad hominem attacks that highlight the importance of a believable claimant.
Just because a customer was engaged in aggressive trading with a previous broker, does not free the subsequent broker from following the rules of suitability. For instance, In the Matter of Wayne B. Vaughan, NAC Hearing October 22, 1998, the defense argued that the claimant was a sophisticated investor who had engaged in speculative trading with previous brokers. The panel ruled that "A customer's prior transactions, however, are not relevant in a suitability determination, and we do not find that VB's history of risky trading mitigates Vaughan's conduct."
Some cases will provide facts helpful to buttress a claim that the broker stood idly by as the customer walked down a path to financial ruin. The amount of broker control over the account, the presence of options trading, the presence of an ongoing relationship with the customer, and failing to provide disclosures are all examples of factors that may spare a suitability claim for a client who asked to risk his accounts.
Moreover, just because a broker explains that an investment carries risk does not absolve him from purchasing unsuitable investments for the claimant. On the contrary, when a broker takes particular care to document that the risks of an investment were discussed with the client, he has also documented the awareness of the risk of what he was recommending unsuitably. A broker should certainly consider a client's investment objective, even when that objective is fast growth, which is inherently risky. That consideration should not trump the customer's financial situation generally. The broker must still recommend investments that are appropriate given the customer's particular financial situation.
If in the end, if a client insists on a disastrous course of investing, the broker always has the final option of refusing to comply. To do otherwise indicates that the broker did not have the best interests of the customer at heart, and was instead willing to earn a commission at the customer's expense.
Complicating matters, there is ample case law vindicating brokers whose customers insisted on unsuitable high risk investments. The Ninth Circuit has held that a broker does not have a duty to stop a client from engaging in unsuitable commodities transactions. [9] Likewise, the Seventh Circuit has held that customer-directed transactions fall outside the suitability requirements. [10] As a result, cases involving clients who insist on risk may often prove untenable as different jurisdictions struggle to define broker's duties to customers in these situations.
Conclusion
The securities arbitration system is punishing on plaintiffs. Not only does the system deprive claimants of a jury, but it puts the claim before industry members whose sense of outrage has almost always been dulled by the deluge of securities improprieties of recent years.
The deficiencies of the system are amplified in suitability cases. It is more difficult for securities professionals on arbitration panels to distance themselves from their in-depth knowledge of the market. As a result, they struggle to believe that a claimant really may not have known how a variable annuity worked, or that it really is not unreasonable when a claimant does not call his broker immediately upon noticing a loss on his or her account.
Likewise, market data, like most any data, can be manipulated. The somewhat amorphous concept of risk, which is the crux of suitability cases, can be lost in stacks of market research and numbers, and the fact that a customer was never informed about dangers is tossed about in a sea of charts and formulas.
In an effort to cut through the complexities of these cases, perhaps the most important question to ask when assessing a potential claim is 'did the customer act reasonably'? That one question not only addresses how and why the investments were made, but will also anticipate the common defenses in suitability claims.
[1] See the FINRA website at http://www.finra.org/ArbitrationMediation/AboutFINRADR/Statistics/.
[2] Shearson/American Express, Inc. v. McMahon, 482 U.S. 220 (1987).
[3] FINRA Code of Arbitration Procedure for Customer Disputes, Rule 12402.
[4] Donna Rosato, When Your Broker Goes Bad, Money, Sept. 2009, at 105.
[5] Brown v. E.F. Hutton Group, Inc., 991 F.2d 1020, 1031 (2d Cir. 1993).
[6] Costello v. Oppenheimer & Co., 711 F.2d 1361 (7th Cir. 1983).
[7] Altschul v. Paine, Webber, Jackson & Curtis, Inc., 518 F. Supp. 591, 592 (S.D.N.Y. 1981).
[8] Nobrega v. Futures Trading Group, Inc., [1999] Sec. L. Rep. (BNA) Vol. 31, No. 28, p. 950 (CFTC 1999).
[9] Wasnick v. Refco, Inc., 911 F.2d 345, 349 (9th Cir. 1990).
[10] Associated Randall Bank v. Griffin, Kubik, Stephens & Thompson, Inc., 3 F.3d 208, 212 (7th Cir. 1993).
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