Charles R. Mills Kirkpatrick & Lockhart Preston Gates Ellis LLP 1601 K Street, N.W. Washington, DC (202)

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1 Practising Law Institute The ABC s of Broker/Dealer Regulation 2008 May 8, 2008, New York, NY The Customer Relationship: Suitability, Unauthorized Trading, and Churning Charles R. Mills (charles.mills@klgates.com) Kirkpatrick & Lockhart Preston Gates Ellis LLP 1601 K Street, N.W. Washington, DC (202)

2 What is Suitability? A broker-dealer and its registered representatives must have reasonable grounds for believing that a recommended investment is suitable for a customer based on that customer s specific investment needs and circumstances. Legal Bases SEC s Shingle Theory : By hanging out its shingle to do business as a broker-dealer, a firm impliedly represents that it can provide expert investment advice, suitable for its customers. SRO Suitability Rules: FINRA has adopted NASD Conduct Rule 2310 and NYSE Rule 405 2

3 What is Suitability? (Cont d.) NASD Rule Recommendations to Customers (Suitability): (a) In recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs. (b) Prior to the execution of a transaction recommended to a noninstitutional customer, other than transactions with customers where investments are limited to money market mutual funds, a member shall make reasonable efforts to obtain information concerning: (1) the customer's financial status; (2) the customer's tax status; (3) the customer's investment objectives; and (4) such other information used or considered to be reasonable by such member or registered representative in making recommendations to the customer. (c) For purposes of this Rule, the term non-institutional customer shall mean a customer that does not qualify as an institutional account under Rule 3110(c)(4). 3

4 The Elements of Suitability Recommended investments vs. unsolicited orders A transaction is considered to be "recommended" when a brokerdealer brings a specific security to the customer through any means See NASD Notice to Members The customer s investment circumstances: Age Marital status Dependents Employment Net worth /income Tax status Investment experience Investment objectives Risk tolerance Other investments The investment product reasonable-basis suitability Broker-dealers are required to have reasonably investigated recommended securities and have a reasonable basis for all opinions, predictions, and recommendations. 4

5 The Elements of Suitability (Cont d.) Portfolio and margin loan risk factors Suitability is determined in reference to the risks and rewards posed by an investment in relation to the customer s individual circumstances. It is not limited to analyzing a security s risk (volatility) in the abstract. Examples: Over-concentration of assets into one or a few securities, even if they are conservative, blue chip stocks Heavily margining investments when a customer lacks assets to meet margin calls 5

6 Practical Considerations and Distinctions Documenting suitability factors Suitability vs. investment prudence Risk tolerance is determined by the customer s willingness and ability to assume particular levels of risk, not by the risk the broker thinks the customer can afford Risk diversification even a higher risk security might be suitable for a conservative investor when evaluated in the context of a customer s entire portfolio 6

7 Other Factors to Consider Investment Costs Are there less expensive alternatives to achieving the customer s investment objectives? Fee based or wrap accounts Are they suitable for buy-and-hold investors with low turnover? Sales training and compensation policies Improper steering to proprietary, high-cost or high compensation products. E.g., In re Olde Discount Corp., 53 S.E.C. 803 (1998). 7

8 Products with Specialized Suitability Rules Certain types of customers, products and trading are subject to specialized rules: Securities options (CBOE Rule 9.9) Institutional Investors (NASD IM ) Customers who use investment advisers (NASD IM ) Variable annuities (NASD Rule 2821; Regulation No. 60 of NY State Insurance Dept.) Municipal securities (MSRB Rule G-19) Mutual funds (Costs/break points) Variable life insurance (NASD Notice to Members 00-44) Online trading (NASD Notice to Members 01-23) Day trading (NASD Rules 2360 and 2361) Penny stocks (SEC Rule 15g-9) Hedge funds (NASD Notice to Members 03-07) Sales to senior investors (FINRA Notice to Members 07-43) 8

9 Unauthorized Trading General Principle Broker-dealers, based on contract and agency principles, generally are legally bound to follow the instructions of their customers and to act only as authorized. Non-discretionary accounts Duties generally limited to obtaining customer authorization before making trades, diligently executing requested trades and giving honest and complete information when recommending a purchase or sale. De Kwiatkowski v. Bear, Stearns, Inc., 306 F.3d 1293 (2d Cir. 2002). NASD Conduct Rule IM A broker-dealer will be viewed as not dealing fairly with a customer if the broker-dealer or salesperson causes the execution of transactions that are unauthorized by customers or sends confirmations in order to cause customers to accept transactions not actually agreed upon. 9

10 Unauthorized Trading (Cont d.) Discretionary accounts Broker may be considered a fiduciary in the broad sense with affirmative duties to disclose all material facts to the customer, including all material information concerning investment risks, and to manage the account in a manner that directly comports with the customer s needs and objectives. Leib v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 461 F. Supp. 951 (E.D. Mich. 1978). Claims of unauthorized trading can arise when trades are inconsistent with the investment objectives or restrictions of an account. One court has held that, where a registered representative causes an unauthorized trade, he or she is obligated to inform the customer of his or her right to reject the unauthorized trade. Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Cheng, 901 F.2d 1124, 1129 (D.C. Cir. 1990). NASD Conduct Rule 2510 and NYSE Rule 408 generally prohibit transactions in a customer s discretionary account unless there is a written authorization from the customer and the written authorization has been accepted (or approved) by the broker-dealer. 10

11 Unauthorized Trading (Cont d.) SEC Rule 10b-5 Claims Unauthorized trading violates the anti-fraud provisions of SEC Rule 10b-5 when accompanied by an intent to defraud or reckless disregard of the customer s interests. Customer Ratification Courts generally have held that ratification of trades occurs when the evidence establishes that the customer intended to adopt the trade as his or her own. Ratification occurs when the customer, with knowledge of the pertinent facts, manifests an intent to adopt the unauthorized action. Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Cheng, 901 F.2d 1124, 1129 (D.C. Cir. 1990); see also Kurke v. Oscar Gruss and Son, Inc., 454 F.3d 350, 356 (D.C. Cir. 2006). 11

12 Unauthorized Trading (Cont d.) Examples of unauthorized trades: Client did not give prior approval for trade in a nondiscretionary account A trade in a discretionary account was inconsistent with customer s investment objectives and the inconsistency was not disclosed in advance For institutional accounts, a trade was not approved by the customer s officer or employee with authority over the account Trade was not executed in a manner or time period specified by the customer 12

13 Churning Churning is excessive trading in a client s account for the purpose of generating commissions rather than furthering the client s interests Churning requires proof of three elements: 1. the broker exercised control over the account, 2. the transactions in the account were excessive in light of the customer s investment objectives, and 3. the broker acted with the intent to defraud or with willful and reckless disregard of the interest of the client. No bright line turnover rate is determinative, but the SEC has in some cases concluded that a turnover ratio for equities and bonds in excess of 6 can raise an inference of excessive trading. 13

FINRA's Expanded Obligations For Broker-Dealers

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