Update, Reaction, and Analysis Regarding Suitability and SB 978

N. Mitchell Feinstein, Esq.By N. Mitchell Feinstein, Esq.

In a previous post, I had discussed the probable passage of legislation in California to require real estate brokers to determine that trust deed investments offered to the public were appropriate for an investor.  The bill, SB 978, is still wending its way through the labyrinth known as the legislative process.

The reaction from members of  the industry with whom I have discussed the prospect of obtaining and reviewing prospective investor information has ranged from unabashed pleasure (“I have been doing this for years, and getting this information has saved me in expensive litigation several times!”) to concern that there is no bright line test and therefore the broker will have to bear unbearable risk (“How can I know if the investment is suitable?”)

Undoubtedly, the source of this proposed legislation is the decades-old “Know Your Customer” rule which has been the standard in the securities industry.  In researching this issue I came upon a well written article by Mark J. Astarita, Esq. which seeks to answer the question raised by all brokers: How do I know when I have complied with the rule?

Below, with his permission, is a copy of his article.  As can be seen, compliance is obtained by demonstrating that the broker used reasonable efforts to obtain the information and had an orderly process for doing so.  The burden can be met without great expense and the benefits provided to the broker, i.e. protection from litigation by an investor, outweigh this cost.

Please read and make your own decisions. Comments welcome.


N. Mitchell Feinstein, Esq.


Brokers Have to Be Their Own Judge

Suitability is an often mentioned, but seldom understood concept

By Mark J. Astarita, Esq.

Suitability is an often misunderstood concept in the law. To most, it means that that brokers are required to ensure that their customers invest only in securities that are “suitable” for them. This oversimplification worries many brokers who, armed with this definition, often lament that they cannot possibly know what a particular arbitrator or regulator will deem suitable after the fact. It is no wonder, then, that brokers often ask how they are to protect themselves against such claims.

In reality, the suitability doctrine does not involve an after-the-fact determination; it merely requires that a broker have a reasonable basis for recommending a security or investment strategy. There is no formula or litmus test that can be applied to a particular scenario. No such test is needed because the doctrine only requires brokers to conduct themselves in a fair and equitable manner with their customers, to have a reasonable basis for recommending a particular security or strategy to a particular customer, and to have reasonable grounds for believing that the customer understands the investment or strategy, and the risks involved in the investment.

Even with that clarification, the doctrine is often troublesome when reviewing accounts. Since it is not a black-and-white issue, the application of the rule must be done carefully, keeping in mind that the question is, “Did the broker have a reasonable basis for believing that the recommendation was suitable?”

In reviewing cases for suitability, arbitrators, regulators and compliance officers must remember that the application of the doctrine does not involve the substitution of their view of suitability for those of the broker. The doctrine requires that the examiner review the broker’s conduct and determine if the broker had a reasonable basis for believing that the recommendation was suitable for the customer (in light of the customer’s financial condition), and whether he had a reasonable basis for believing that the customer understood the investment and its risks.

For a better understanding of the doctrine, and the broker’s obligations under it, it is important to keep in mind that the current rules are part of the anti-fraud provisions of the various securities acts. They arose out of the Securities and Exchange Commission’s (SEC) attempts to control high-pressure sales tactics engaged in by boiler rooms in the 1960s, when brokers were accused of recommending the same security to every person they could speak to.

Whether the rule is called a suitability rule or the “know-your-customer rule,” its original intent was to stop brokers from soliciting transactions from every potential customer he could locate. As the rule has evolved, its purpose is still to stop fraud, but now it requires brokers to make a determination of the essential facts relating to his customers, their financial situations and goals, and their investment experience. The doctrine also requires the broker to learn all essential facts regarding the particular investment being recommended and to have a reasonable basis for recommending that investment to that particular customer.

The various self-regulatory agencies have attempted to create rules to clarify the doctrine. The National Association of Securities Dealers’ (NASD) Rule 2310 (formerly Article III, section 2 of the Rules of Fair Practice) provides, “[i]n 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 facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.” While the rule defines suitability by using the term “suitable” (thereby rendering the rule virtually useless for determining what is suitable), it does make clear that the only requirement is “reasonable grounds” for making the recommendation.

Today, while a broker is required to learn the essential facts regarding every customer and investment, the broker must have a reasonable basis for believing that the investment meets the customer’s needs and goals, and that the customer has the ability to bear the risk of loss of the investment and understands.

At the extremes, application becomes a relatively easy exercise. Recommending options to a 95-year-old widow who has never invested in her life is clearly not a suitable recommendation. However, most cases do not come with such fine lines. Take the situation of recommending to a 60-year-old man that he invest $20,000 in a start-up company. Is such a recommendation suitable for that investor? The answer depends on who that investor is. If the customer has a $20 million portfolio and has years of experience in investing in speculative investments, a broker, armed with those facts, is probably making a suitable recommendation, assuming the underlying investment is sound. On the other hand, if the $20,000 constitutes a significant portion of the customer’s net worth, then the recommendation is not suitable.

One can quickly see that suitability is not easy to apply in close circumstances. Over the years, the NASD has attempted to provide guidance to the industry, but its releases also relate to the extreme cases. One example is recommending a speculative, low-priced security to a customer without any attempt to obtain information regarding the customer’s other securities holdings, his or her financial background and situation, and similar information. Another example is recommending purchases, or continuing purchases, that are inconsistent with a reasonable expectation that the customer has the financial ability to meet such a commitment. Clearly, these situations demonstrate a violation of the doctrine but do not help a broker understand the doctrine.

Even in-house compliance manuals do not provide sufficient guidance. Some firms attempt to address the issue by limiting recommendations of broker to “pre-approved” securities, or to securities trading on national exchanges. But like any general rule, such policies are often too inclusive and run the risk of being blindly applied.

Again, the broker is still left to divine the middle ground. While the NASD has also adopted different rules with respect to penny stocks that make the suitability issue clearer regarding those securities, there are a host of other situations. There are some general guidelines, though, and while they don’t guarantee a recommendation is suitable, they may provide sufficient justification to support a recommendation and may aid in the examination of a customer’s investments before a problem arises in an account. Of course, no one can guarantee that a regulator or arbitration panel will not find a particular recommendation unsuitable, but a hindsight review of a particular investment or strategy is not as important as an examination of the question — did the broker have a reasonable basis for making this recommendation?

  1. Understand the investment or strategy, the essential facts relating to the security and the reason it is being recommended to any customer. Once you have identified an investment that you believe is worthwhile, make sure that you have adequate and timely information regarding your customer. As discussed in earlier columns, simply obtaining information on a new account form when an account is opened may not be sufficient. That information should be reviewed and updated periodically, and should be reviewed at least once a year, perhaps during an annual review of the account with the customer.
  2. Make sure your customer has all of the necessary information regarding a particular security, issuer or investment strategy. While an obligation to provide information regarding widely known securities may be less than for more obscure securities, it is important that the customer have all of the relevant information at hand regarding any investment. Even the most sophisticated and wealthy customer can be unsuitable for a sophisticated options trading strategy that he cannot understand.
  3. Be sure that you have determined the percentage of a client’s liquid net worth being put into a particular investment or investment strategy that involves any significant degree of risk. While not stated in any rule, a particular investment may be suitable when using 10 percent of a customer’s net worth, but it may be entirely unsuitable when it uses 90 percent of his net worth.
  4. Make sure that your customer understands why the investment is being made, and that you answer any questions he or she has regarding the investment or strategy.

There will never be a perfect solution to the problem of determining suitability after the fact, but if brokers know the rules, and what is expected of them, the concept is not something to be feared.

Mark J. Astarita, Esq. is a partner in the law firm of Beam & Astarita, LLC in New York City who represents brokers and brokerage firms in a wide variety of matters. He can be reached at (212) 509-6544 or by e-mail at astarita@seclaw.com. This article originally appeared in the March, 1997 issue of Research Magazine.

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