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Undue Concentration In Brokerage Portfolio Fails Suitability Test
Written: December 6, 2012

Scales of Justice

In a Financial Industry Regulatory Authority (“FINRA”) Arbitration Statement of Claim filed in August 2011, Claimant Culbertson asserted breach of fiduciary duty; negligence; suitability; failure to supervise; breach of contract; respondeat superior; and violations of FINRA and NYSE Rules. By the date of the hearing, Claimant sought $172,000 compensatory damages; $92,000 attorneys’ fees; $10,545 costs. In the Matter of the FINRA Arbitration Between Phyllis E. Culbertson, Claimant, vs. J J.B. Hilliard, W.L. Lyons, LLC, Respondent (FINRA Arbitration 11-03226, November 29, 2012).

Respondent generally denied the allegations, asserted various affirmative defenses, and requested expungement for an unnamed party.

Undue Concentration

Claimant alleged that the assets in her account were not in keeping with her investment objective and over-concentrated — characterizing her portfolio as almost exclusively in low-growth cash and fixed-income investments, and complaining that during the time she was Respondent’s client, that the equity allocation of her portfolio never exceeded 10 percent of her total investments.

Decision

The FINRA Arbitration Panel found Respondent J.J.B. Hilliard, W.L. Lyons, LLC liable and ordered it to pay to Claimant Culbertson: $129,000 compensatory damages; $10,545 costs; $300 reimbursed filing fee; $45,150 attorney’s fees.

Bill Singer‘s Comment

I wish that this FINRA Arbitration Panel offered a tad more in the way of rationale for its finding of liability.  Claimant set forth a case that seemed to argue that there was a lack of “suitability” in the Respondent’s recommendations, ultimately manifesting itself in the form of an “undue concentration;” however, I can’t really say that the Panel concurred or disagreed. The arbitrators may have found a lack of suitability or undue concentration but it’s not spelled out. About all that I can say is that the Panel largely awarded the damages sought without explaining why.

Whether a stockbroker or a brokerage firm is recommending “suitable” investments, and whether such recommendations ultimately result in a portfolio that is deemed overly concentrated is the legend of lawsuits. One merely needs to review a typical year’s litigation/arbitration docket for suitability cases to see the names of Merrill Lynch,Bank of AmericaWells FargoUBS, Morgan Stanley, JP Morgan, and virtually every other industry player.  Given the litigious nature of this area, it behooves both industry participants and public customers to familiarize themselves with FINRA’s Suitability rule, presented in full-text below (I have highlighted in red some key concepts):

FINRA Rule 2111: Suitability

(a) A member or an associated person must have areasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtainedthrough the reasonable diligence of the member or associated person to ascertain the customer’s investment profile. A customer’s investment profile includes, but is not limited to, the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation.

(b) A member or associated person fulfills the customer-specific suitability obligation for an institutional account, as defined in Rule 4512(c), if (1) the member or associated person has a reasonable basis to believe that the institutional customer is capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies involving a security or securities and (2) theinstitutional customer affirmatively indicates that it is exercising independent judgment in evaluating the member’s or associated person’s recommendations. Where an institutional customer has delegated decisionmaking authority to an agent, such as an investment adviser or a bank trust department, these factors shall be applied to the agent.

Supplementary Material

.01 General Principles. Implicit in all member and associated person relationships with customers and others is the fundamental responsibility for fair dealing. Sales efforts must therefore be undertaken only on a basis that can be judged as being within the ethical standards of FINRA’s rules, with particular emphasis on the requirement to deal fairly with the public. The suitability rule is fundamental to fair dealing and is intended to promote ethical sales practices and high standards of professional conduct.

.02 Disclaimers. A member or associated person cannot disclaim any responsibilities under the suitability rule.

.03 Recommended Strategies. The phrase “investment strategy involving a security or securities” used in this Rule is to be interpreted broadly and would include, among other things, an explicit recommendation to hold a security or securities. However, the following communications are excluded from the coverage of Rule 2111 as long as they do not include (standing alone or in combination with other communications) a recommendation of a particular security or securities:

(a) General financial and investment information, including (i) basic investment concepts, such as risk and return, diversification, dollar cost averaging, compounded return, and tax deferred investment, (ii) historic differences in the return of asset classes (e.g., equities, bonds, or cash) based on standard market indices, (iii) effects of inflation, (iv) estimates of future retirement income needs, and (v) assessment of a customer’s investment profile;

(b) Descriptive information about an employer-sponsored retirement or benefit plan, participation in the plan, the benefits of plan participation, and the investment options available under the plan;

(c) Asset allocation models that are (i) based on generally accepted investment theory, (ii) accompanied by disclosures of all material facts and assumptions that may affect a reasonable investor’s assessment of the asset allocation model or any report generated by such model, and (iii) in compliance with NASD IM-2210-6 (Requirements for the Use of Investment Analysis Tools) if the asset allocation model is an “investment analysis tool” covered by NASD IM-2210-6; and

(d) Interactive investment materials that incorporate the above.

.04 Customer’s Investment Profile. A member or associated person shall make a recommendation covered by this Rule only if, among other things, the member or associated person has sufficient information about the customer to have a reasonable basis to believe that the recommendation is suitable for that customer. The factors delineated in Rule 2111(a) regarding a customer’s investment profile generally are relevant to a determination regarding whether a recommendation is suitable for a particular customer, although the level of importance of each factor may vary depending on the facts and circumstances of the particular case. A member or associated person shall use reasonable diligence to obtain and analyze all of the factors delineated in Rule 2111(a) unless the member or associated person has a reasonable basis to believe, documented with specificity, that one or more of the factors are not relevant components of a customer’s investment profile in light of the facts and circumstances of the particular case.

.05 Components of Suitability Obligations. Rule 2111 is composed of three main obligations: reasonable-basis suitability, customer-specific suitability, and quantitative suitability.

(a) The reasonable-basis obligation requires a member or associated person to have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors. In general, what constitutes reasonable diligence will vary depending on, among other things, the complexity of and risks associated with the security or investment strategy and the member’s or associated person’s familiarity with the security or investment strategy. A member’s or associated person’s reasonable diligence must provide the member or associated person with an understanding of the potential risks and rewards associated with the recommended security or strategy. The lack of such an understanding when recommending a security or strategy violates the suitability rule.

(b) The customer-specific obligation requires that a member or associated person have a reasonable basis to believe that the recommendation is suitable for a particular customer based on that customer’s investment profile, as delineated in Rule 2111(a).

(c) Quantitative suitability requires a member or associated person who has actual or de facto control over a customer account to have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together in light of the customer’s investment profile, as delineated in Rule 2111(a). No single test defines excessive activity, but factors such as the turnover rate, the cost-equity ratio, and the use of in-and-out trading in a customer’s account may provide a basis for a finding that a member or associated person has violated the quantitative suitability obligation.

.06 Customer’s Financial Ability. Rule 2111 prohibits a member or associated person from recommending a transaction or investment strategy involving a security or securities or the continuing purchase of a security or securities or use of an investment strategy involving a security or securities unless the member or associated person has a reasonable basis to believe that the customer has the financial ability to meet such a commitment.

.07 Institutional Investor Exemption. Rule 2111(b) provides an exemption to customer-specific suitability regarding institutional investors if the conditions delineated in that paragraph are satisfied. With respect to having to indicate affirmatively that it is exercising independent judgment in evaluating the member’s or associated person’s recommendations, an institutional customer may indicate that it is exercising independent judgment on a trade-by-trade basis, on an asset-class-by-asset-class basis, or in terms of all potential transactions for its account.


 
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