One of the most common forms of misconduct by a broker is making unsuitable investment recommendations to clients. Suitability of an investment is a two-part analysis. FINRA Rule 2111 requires that the brokerage firm first perform due diligence into an investment before recommending it to any client. This is referred to as a “reasonable basis suitability” analysis. According to FINRA Rule 2111.05, “The reasonable-basis obligation requires a member or associated person to have a reasonable basis to believe, based on reasonable due diligence, that the recommendation is suitable for at least some investors.” FINRA Regulatory Notice 10-22 further explains the reasonable basis due diligence obligations of firms. Specifically:
The Securities and Exchange Commission and federal courts have long held that a BD that recommends a security is under a duty to conduct a reasonable investigation concerning that security and the issuer’s representations about it. (See Hanly v. SEC, 415 F.2d 589, 595-96 (2d. Cir. 1969); SEC v. Great Lake Equities Co., 1990 U.S. Dist. LEXIS 19819 at *16-17 (E.D. Mich. 1990); SEC v. North American Research and Development Corp., 424 F.2d 63, 84 (2d Cir. 1970). See also SEC v. Current Financial Services, Inc., 100 F. Supp. 2d 1, 14-15 (D.D.C. 2000); District Business Conduct Committee for District No. 4 v. Everest Securities, Inc., 1994 NASD Discip. Lexis 188 (Sept. 2, 1994), aff’d, 52 S.E.C. 958, 962-63 (Aug. 26, 1996), aff’d, 116 F. 3d 1235 (8th Cir. 1997); Securities Act Release No. 4445, 27 Fed. Reg. 1415 (Feb. 2, 1962).
RN 10-22 at 3
The due diligence process may vary depending on the type, complexity, and risk of a security, but FINRA Rule 2111.05 generally requires that the process “provide the member or associated person with an understanding of the potential risks and rewards associated with the recommended security or strategy. The lack of such an understanding when recommending a security or strategy violates the suitability rule.” Proper understanding of an investment by the broker is important for several reasons. First, if there are “red flags” (i.e. risks) disclosed about the investment, then it may be unsuitable for the firm to approve and recommend the investment to anyone. Further, assuming that the firm approves the investment for sale, in order for a broker to recommend a security, they must truthfully disclose all material facts and risks about the security to their client. Otherwise, they can be liable for making misrepresentations or omitting material information. Thus, without performing substantial due diligence into an investment, it is impossible for an advisor to accurately represent the investment to client.
If an investment passes the reasonable basis suitability process, the second step is for the advisor to perform a client-specific suitability analysis. Specifically, according to FINRA Rule 2111(a):
A member or an associated person must have a reasonable basis to believe that a recommended transaction 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.” An investment that is suitable for one client may not be suitable for another. For example, generally, high-risk or illiquid investments are not suitable for elderly or retired investors because they do not have the time horizon to make-up for losses, or may need access to their money if they no longer have income from their employment. Analyzing the client asset and investment portfolio is also important because a recommendation may be unsuitable if it will result in a client being over-concentrated in a security, asset, class, or industry. A client can also be over-concentrated by investing too much money in illiquid investments.
We would be happy to review your accounts if you think your advisor recommended unsuitable investments to you. We work on a contingency fee basis so we don’t get paid until you do. Contact Stoltmann Law Offices today for a free evaluation