Because many complex financial products have the potential for sudden and/or severe losses of principal, it is imperative that firms recommending these products document a thorough “reasonable basis” suitability analysis.
Given the current difficult and unpredictable conditions in U.S. and global financial markets, securities broker-dealers and their registered representatives often turn to complex financial products in an attempt to meet their clients' investment objectives. Regardless of a client's investment goals, a broker must understand the products they sell and analyze whether they are suitable for its clients. Indeed, the Financial Industry Regulatory Authority (“Finra”) clearly mandates that broker-dealers and their representatives have significant suitability and due diligence obligations before recommending them to investor clients. It is critical, therefore, that firms and their brokers understand these suitability obligations to minimize future liability.
Finra Rule 2111 became effective in July 2012 and generally requires that a firm or associated person “have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer's investment profile.” The new rule expands the composition of the customer investment profile by adding five new factors to be considered in the suitability analysis: age, investment experience, time horizon, liquidity needs and risk tolerance.
“Reasonable-Basis” Suitability
Because many complex financial products have the potential for sudden and/or severe losses of principal, it is imperative that firms recommending these products document a thorough “reasonable basis” suitability analysis. To meet this requirement, a firm and its representatives must have a reasonable basis to believe, based on “reasonable diligence,” that a recommendation is suitable for at least some investors. The reasonable diligence performed must provide the firm with an understanding of the possible risks and rewards of the recommended security or investment strategy. Thus, it is important that a firm be prepared to demonstrate the “reasonable diligence” that it exercised in conducting this analysis by maintaining a robust “due diligence” file. Put simply, if a firm cannot demonstrate to regulators or claimants in arbitration that it conducted reasonable due diligence that resulted in an understanding of the material features and risks of the product, it may never have a chance to demonstrate how or why it determined that the product was suitable for a particular client.
A recent Finra Dispute Resolution arbitration case involving a very sophisticated and experienced claimant is illustrative. In April 2012, a Finra Dispute Resolution arbitration panel found that the respondent firm failed to perform an adequate “reasonable basis” suitability determination before it sold collateralized bond obligations to James Zeigon, the former chief executive of Global Institutional Services for Deutsche Bank. It is hard to imagine a more sophisticated and less sympathetic claimant than a very senior executive with one of the world's largest financial services firms. Yet, the arbitration panel in Zeigon apparently based its decision, at least in part, on its finding that the subject investment was too complex for anybody. Indeed, if a former bank president, arguably someone on the outer fringes of sophistication, is not a suitable customer for collateralized bond obligations, is anyone? The product was not a Ponzi scheme or an otherwise unapproved sale. It may have been unsuitable for the majority of customers, but Zeigon was highly sophisticated. This has troubling implications for the ability to evaluate potential exposure for respondents in litigation against sophisticated claimants.
“Customer-Specific” Suitability
After the “Reasonable Basis” suitability determination is made, the broker must perform a “customer-specific” suitability analysis. This requires that a firm and its brokers have a reasonable basis to believe that the recommendation is suitable for a particular customer, based on the customer's investment profile. Logic (and Finra) advise that the customer-specific suitability analysis should not turn on any one factor, but, instead, consider the customer's investment profile as a whole, especially as it relates to a specific product. Indeed, the suitability analysis for a traditional value-oriented mutual fund may be less involved than the analysis for a product that contains, for example, an embedded derivative component. Thus, it is critical that the broker's analysis that a particular product is suitable for a particular client be well-documented showing consideration for the customer's investment profile.
“Quantitative” Suitability
If a product has met the “reasonable basis” and “customer specific” suitability tests, a firm should also consider quantitative suitability. This analysis is focused on whether a product recommendation or transaction that may be suitable in isolation may become unsuitable in the broader context of the client's accounts as a whole. Quantitative suitability requires a broker who has control over a customer's account to have a reasonable basis to believe that a recommended series of transactions, when considered together, are not excessive or unsuitable in light of the customer's investment profile -- even if each individual transaction was deemed suitable on its own. In other words, it may be possible to have too much of a good thing, and the quantitative suitability aspect of new Finra Rule 2111 seeks to address that concern.
Practical Tips
Suitability determinations, especially for complex products, are still more of an art than a science. Despite the limited guidance provided by Finra, and its concerns relating to transaction in complex products, potential liability can be mitigated. First, the firm must conduct a well-documented “reasonable basis” suitability analysis, demonstrating a sound understanding of the investment, and a “reasonable basis” supporting the suitability of a particular complex product for any investor. Second, a firm must ensure that its representatives are adequately trained in, and can articulate, the features, risks, costs and other material characteristics of the investment prior to making a recommendation. This effort can include in-house training provided by the firm's alternate products and/or compliance staff, as well as the focused training provided by certain sponsors of alternative products or relevant professional associations. Third, brokers should document their “customer-specific” suitability and maintain notes of meetings or conversations with clients regarding the basis for the recommendation of an alternative product. Additionally, firms may consider using investor qualification agreements that contain specific customer attestations as their understanding of, and suitability for, a particular investment. Notably, when dealing with complex financial products, Finra encourages firms to adopt the approach mandated for options trading accounts under Rule 2360 which requires “a reasonable basis for believing…that the customer has such knowledge and experience in financial matters that he may reasonably be expected to be capable of evaluating the risks of the recommended transaction, and is financially able to bear the risks of the recommended position.”
Perhaps Zeigon signifies hostility toward complex products being recommended to retail investors. That hostility could be a reaction to the number and nature of complex products that have underperformed and, in some cases, have turned out to be downright fraudulent. Regardless of the cause, given the scrutiny and regulation of broker-dealers dealing in complex alternative investments, there are no “silver bullets” to fully protect against a customer dispute or regulatory inquiry arising from the sale of these products. However, a solid understanding of the requirements of the new Finra suitability rule, and adherence to sound business practices should assist in reducing the potential for customer or regulatory claims and in defending such claims if they do arise.
Todd D. Kremin, attorney at Kaufman Dolowich Voluck & Gonzo LLP, concentrates his practice in the areas of insurance coverage and litigation. He represents insurance and reinsurance carriers in the areas of directors-and-officers liability, professional liability (errors and omissions) and fiduciary liability. Robert Usinger is a graduate of Brooklyn Law School and a Director at Everest National Insurance Company, where he manages securities and financial institutions claims.
The views expressed in this article are those of the authors only and do not reflect the views of Kaufman Dolowich Voluck & Gonzo and Everest National Insurance Company.
