The law imposes a duty upon securities brokers only to recommend securities that the broker reasonably believes are suitable for the customer. The broker’s belief must be based upon a reasonable inquiry concerning the customer’s investment objectives, risk tolerance, financial situation and needs, tax status, other security holdings, and any other relevant information known by the broker. This suitability duty is based on a “homely truth about investing — that investment decisions can be made only in light of the goals and needs of the person for whom they are made.” 1
Despite this, unsuitable recommendations of securities are among the most common violations in the brokerage industry. “Perhaps the clearest example of a suitability violation occurs where a broker recommends speculative securities to a customer whose financial situation and risk tolerance clearly calls for conservative investments (for example, a retired person who needs the income from his investments for his living expenses and who has no reasonable expectation of being able to replace any substantial trading losses).”2
An unsuitable recommendation of securities constitutes a dishonest, unethical and fraudulent business practice. If such a recommendation results in financial loss, the customer has a right to recover that loss from the individual broker and his or her brokerage firm.
Broadly speaking, there are three benchmarks for determining whether an investment or investment portfolio is suitable: (1) investment objective(s), (2) time horizon, and (3) risk tolerance. Brokerage firms’ account opening forms typically display investment objective(s) information in a “check the box” format. These forms are usually completed by the broker, purportedly based on information from the customer. Typical choices include “asset preservation” or “income,” “growth,” and (sometimes) “speculation.”
Most experts agree that the overall portfolio of an investor with an objective of asset preservation and/or income should contain a substantial allocation to money market, and/or investment-grade short-term fixed income investments. If that investor has a longer time horizon and requires some growth in order not to outlive his or her assets, a substantial allocation to dividend-paying stocks may be appropriate as well. A portfolio comprised substantially of non-dividend-paying growth stocks might be suitable for a younger investor saving for retirement, but not for someone in need of income from investments. A longer time horizon militates in favor of a greater allocation to stocks, and vice versa.
A designation of “speculation” as an investment objective or a level of risk tolerance should be regarded with extreme suspicion. Based on our experience, it is an indicator that the broker intends to use your account solely as a vehicle to generate excessive commissions. An investor should communicate the investor’s true investment objectives and risk tolerance in writing to the brokerage firm.
A broker cannot have a reasonable basis for recommending an investment or investment strategy without knowing the risk of the particular investment or investment strategy being recommended, and explaining that risk to the customer. A broker cannot know the risk of a particular investment or investment strategy, and properly explain it to the customer, without measuring the risk.
1 NORMAN POSER, BROKER DEALER REGULATION ss 3.03 (3d ed. 2005) (quoting Robert Mundheim, Professional Responsibilities of Broker-Dealers: The Suitability Doctrine. 1965 Duke L.J. 445, 448).
2 NORMAN POSER, BROKER DEALER REGULATION ss 3.03 (3d ed. 2005).