Unsuitability Leading to Investment Loss
Simply put, a recommendation is unsuitable if it is inappropriate for an investor. In an over-simplistic example, recommending a penny stock to an elderly retired widow would be deemed unsuitable. However, unsuitability determinations are always more nuanced and apply to all ages, risk tolerances, financial abilities, and experiences. Unsuitability can also apply to the wealthy. In a recent matter involving a wealthy physician, the broker utilized margin to purchase securities, which increases risk, and also recommended leveraged mutual funds that were aggressive in nature. The portfolio was simply not sustainable. It would have been unsuitable for anyone. As was to be expected, a minor downturn in the market caused the entire portfolio to implode.
Unsuitability can be about a specific transaction, but generally, the concept is applied to a portfolio's composition and/or strategy. Unsuitability can also be applied to a product. Examples involve concentration, margin/credit line usage, and excessive transactions and/or mark-ups. In one particular instance, a broker recommended a portfolio that consisted of close to 50% exposure to financial stocks. Such a recommendation was extremely unsuitable regardless of risk tolerances and financial wherewithal of the client. When financial stocks plummeted, the portfolio was decimated. In another situation, a financial advisor failed to perform proper due diligence on a mutual fund and recommended the fund based on his beliefs about the fund's safety and lack of fluctuation. By neglecting due diligence efforts, the advisor misrepresented the product which equated to an unsuitable recommendation. Suitability is the cornerstone of most, if not all, investor claims. However, it does not exist in a vacuum. Almost all FINRA claims, fraud-based, negligence, or otherwise, are multi-faceted. Omissions, churning, and breaches of contract/fiduciary duties are all examples of unsuitability. Suitability is a construct of FINRA Rule 2111. It essentially says that a stockbroker/financial advisor must have reasonable grounds for recommending a security, strategy or particular portfolio construction. Recommendations on the construction of a portfolio include, but are not limited to, concepts of concentration, margin usage, and options strategies. Recommendations, thus suitability, applies to purchases, sales and any proactive statement from a stockbroker/advisor that a client holds a position or maintain a strategy.
If financial advisors or brokers make an unsuitable recommendation they have also, concurrently, violated Federal and state securities laws. Furthermore, the have potentially breached codified and/or common law fraud statutes. If not fraudulent, unsuitable recommendations are always, at the very least, negligent. Common law negligence is a viable cause of action in FINRA matters. Lastly, unsuitable recommendations breach various duties, including those of a fiduciary nature, and also breach contracts. These contracts may be direct or as a third party beneficiary.
The concept of suitability applies to institutional accounts also, although there are some nuances recognized by FINRA. However, the financial advisor and financial firm still must have a reasonable basis to believe that the institutional client is able to evaluate the concepts and strategies that are being recommended. The reason being is that an institution is not simply an entity. An institution, such as a Bank/Credit Union, Corporate entity or even a municipality are all manned by human beings. Each person has their own background, experience, and sophistication. A financial advisor and his supervisor cannot assume that because it is an institutional account, their duties are non-existent. The firm and its registered representative have to ensure the corporate or municipal agents understand the risks on their own accord. This determination would include the agent's general knowledge. It would also include the agent's specific knowledge in regard to the investment strategies and various independent transactions involving the recommended security or securities. In short, as far as FINRA is concerned, the only way a financial advisor and brokerage firm can escape their duties, on the subject of suitability, is when the institutional customer states affirmatively that it is acting on its own accord. In essence, when it is clear that the financial institution is just an order taker. This is rare, as the whole point of hiring a financial services firm, and pay large fees, is to get solid, sound and suitable recommendations.