I continue to wade my way through a few months’ worth of cases, press releases, etc., looking for things that manage to catch my attention. I found this SEC settlement from the end of July involving Integral Financial, a BD out of California, and its founder, majority owner, President, and Chairman of the Board of Directors, Weiming “Frank” Ho. In and of itself, the case isn’t exactly ground-breaking. It involved four RRs who spent two years making unsuitable recommendations to ten customers, and their supervisor, Mr. Ho, who failed to monitor the reps’ trading and their compliance with the firm’s WSPs. What makes it interesting is not the trading itself; rather, it was the failed defensive strategy that Mr. Ho employed, which I will get to momentarily.
First, some background, starting with the product at issue: variable interest rate structured products (“VRSPs”). According to the SEC, VSRPs are “complex, illiquid, structured securities” with long maturity dates. Traditional bonds provide periodic fixed-interest payments and are directly linked to a bond issuer’s ability to make those payments and repay principal at maturity. By comparison, the VRSPs at issue only paid fixed amounts for an introductory or “teaser” period of one to five years. After that, the interest payments are not guaranteed, nor are they solely linked to the issuer’s ability to meet its payment obligations. In fact, investors in VRSPs can lose some or all of their invested principal at maturity if the products’ derivative components fail to perform within certain pre-determined ranges. Given that, the SEC concluded that “the VRSPs present higher risks than traditional municipal or corporate bonds.”
Next, let’s look at the ten investors. According to the SEC, they “had reached or were approaching retirement age and relied on their investments for income; had conservative or moderate risk tolerances; investment objectives such as capital preservation, growth and/or income; limited investment experience; investment time horizons of less than fifteen years; higher liquidity needs; in most cases, a net worth of less than $500,000; and were unwilling to risk losing their invested principal.”
Putting the product and the investors together: the SEC concluded that the recommendations by the reps to purchase the VRSPs were not suitable for the customers. This was only exacerbated by the fact that the reps sold too much of that product, managing to exceed the firm’s internal concentration limit on structured products. Perhaps not surprisingly, none of the reps in question had reviewed the firm’s WSPs in the last five years, and one had never reviewed them.
But, on to Mr. Ho, the supervisor. He, of course, was supposed to review the trades, to ensure that they were, in fact, appropriate for the customers based on their respective investment objective, risk tolerance, financial wherewithal, etc. Unfortunately, he didn’t exactly do that. Instead, he “directed the Integral RRs to have the Customers sign the firm’s standard risk disclosure form to confirm that a trade was suitable.” And this is the point of today’s post, as I hear this all the time from reps involved in an arbitration or a regulatory inquiry revolving around suitability: the customer wanted the product. The problem is: this is not, as Mr. Ho learned, a defense (at least not a valid defense) to a suitability case. As the SEC put it in the Integral settlement, “[o]btaining a customer’s written consent for a trade does not relieve a broker-dealer or its registered representative from the obligation to conduct a proper suitability determination based on all of the relevant circumstances relating to the customer.”
I know that this may seem like Suitability 101, but given how frequently I find myself instructing my clients on this issue, it seems that a reminder is appropriate. The simple fact is, the duty to make a suitable recommendation exists, period. It does not matter what a customer wants. It does not matter whether a customer personally deems the product to be suitable, and is willing to sign an attestation or certification or whatever to that effect. The duty is the BD’s. As FINRA put it succinctly in item .02 in the Supplementary Material to Rule 2111, “[a] member or associated person cannot disclaim any responsibilities under the suitability rule.” In other words, you can’t slough that responsibility off on to the customer.
Not to get too legal on you, but there is more than ample case law supporting this straightforward proposition. For instance, recommendations are “not suitable merely because the customer acquiesces in [them].” Dane S. Faber, Securities Exchange Act Release No. 49216, 2004 SEC LEXIS 277, at *23–24 (February 10, 2004). Or, “a broker’s recommendations must serve his client’s best interests and the test for whether a broker’s recommendations are suitable is not whether the client acquiesced in them, but whether the broker’s recommendations were consistent with the client’s financial situation and needs.” Dep’t of Enforcement v. Bendetsen, No. C01020025, 2004 NASD Discip. LEXIS 13, at *12 (NAC August 9, 2004). I could go on, but you get the point. As I put this a few years ago in a post with a similar subject matter, “[a] customer cannot conclusively agree that a recommendation was suitable, as that is not something a customer is deemed capable of knowing.”
So, given this, what’s the purpose in getting a customer to sign a piece of paper that not only provides no legal defense, but could actually get you in hot water with FINRA (or, as was the case with Mr. Ho, the SEC)? The answer, of course, is that there is no point in doing this. If you are looking for a document that will actually help you defend a suitability case, it is, simply enough, an accurate and up-to-date new account form, one that captures a client’s true investment objective, etc. Armed with THAT, there’s a LOT that I can do to defend a suitability claim. Armed with that, it is relatively easy to defend the invariable insistence by the complaining customer that he/she was a conservative investor, someone unwilling to expose themselves to the slightest degree of risk of loss of principal. While a good NAF is hardly a silver bullet – given customers’ predictable willingness to swear that it was signed in blank, or that the signature was forged, or that the NAF was altered after it was signed, etc., etc. – it is as good and effective a piece of documentary evidence that you will encounter.
The lesson, then? Don’t waste your time getting your customers to confirm that they view your recommendations to be suitable. Spend your time, instead, insuring that you can prove, if need be, at some possibly distant point in the future, that at the moment you made a recommendation, you were working with solid information about your customer. And the best way to accomplish that is a good new account form.