What The Hell Is A Preferred Alternative Allocation?

January 20, 2015

Where's the popular Employment Tuesday at BrokeAndBroker.com? Great question. Seems the folks at Simply Hired, who supply the feed for our Job Board ,are having online issues today. Simply stated, Simply Hired is down this morning and the BrokeAndBroker.com Employment Page has gone dark along with whatever glitch is running amok.

You ever read something that, at first blush, you thought you understood but when you try to explain it to someone else, you realize that you must have missed something because it's not making any sense? At that point, you go back and re-read . . . and then re-read again, and perhaps again. Then it hits you. You didn't miss anything. The writer either assumed too much or failed to provide you with sufficient content and context. Consider a recent public customer's arbitration against three industry respondents.  It's a clear-cut victory for the respondents . . . except, well, it's impossible to figure out why. Which doesn't mean that the industry folks were wrong or should not have won. It just means that we don't quite understand the underlying facts  or the Decision.

Case In Point

In a Financial Industry Regulatory Authority ("FINRA") Arbitration Statement of Claim filed in November 2013, public customer Claimant Saunders alleged breach of fiduciary duty, actual and constructive fraud, and gross negligence in connection with investments in various stocks.  Claimant sought $485,000 in compensatory damages plus punitive damages, attorneys' fees, and costs. In the Matter of the FINRA Arbitration Between Lucille R. Saunders, Claimant, vs. Sterne, Agee & Leach, Inc.; Anderson & Strudwick, Incorporated; and Jenry G. Alley, Respondents (FINRA Arbitration 13-03335, January 7, 2015).

Blood From A Rock?

In May 2014, Respondent Anderson & Strudwick, Incorporated filed for Chapter 7 bankruptcy, which prompted a Stay in the arbitration against that firm. In response to Claimant Saunder's motion, on August 2014, the United States Bankruptcy Court for the Eastern District of Virginia lifted the Stay.

Two Down And One To Go

In November 2014, Claimant dismissed with prejudice Respondent Sterne, Agee & Leach, Inc. and Respondent Alley.

The arbitration proceeded solely against Respondent Anderson & Strudwick.


The sole FINRA Arbitrator decided that:

1. Claimant's claims are denied in their entirety. The Arbitrator finds that Claimant's preferred alternative allocation would have incurred losses which far exceed Claimant's actual out-of-pocket losses. Accordingly, these preferred alternative allocation losses cannot be used as a credible basis for calculating Claimant's compensable losses. . .

Bill Singer's Comment


According to online FINRA BrokerCheck records as of January 19, 2015, Respondent Anderson & Strudwick inc. / Sterne, Agee & Leach, Inc. reported that Claimant Saunders' allegations in this case consisted of:


Respondent Alley (who would be dismissed from the arbitration) stated in response:


I'm not exactly what happened with the suitability allegation between the customer's initial complaint and the arbitration Decision.  Given the terse nature of the Decision,  we're pretty much left to fend for ourselves when it comes to understanding both the underlying facts and the rationale for the dismissal of the customer's claims.  Maybe it was part of the arbitration, maybe not -- maybe the FINRA Arbitrator deliberated on that allegation, maybe not.  

Six-Year Eligibility

Given that the arbitration was first filed in November 2013, it seems likely that FINRA's six-year eligibility timeframe would have precluded most of the Claimant's pre-2007 claims, whatever those may have been.

SIDE BARFINRA Arbitration Rule 12206. Time Limits
(a) Time Limitation on Submission of Claims
No claim shall be eligible for submission to arbitration under the Code where six years have elapsed from the occurrence or event giving rise to the claim. The panel will resolve any questions regarding the eligibility of a claim under this rule. . . .

Again, maybe the arbitrator considered the eligibility issue. Maybe not. Maybe it was argued. Maybe not. Hey . . . ya gotta love all these guessing games. Maybe not?

Preferred Alternative Allocation

All of which leaves us with whatever claims likely remained from 2007 through 2012 and what the Arbitrator intriguingly called "Claimant's preferred alternative allocation." If a case is going to hinge on a preferred alternative allocation strategy, it would have been nice for the Decision to explain just what was the initial allocation strategy. 

Unfortunately, we seem left to deal with what the Decision offers us in the form of a question: If Claimant had pursued her own investment strategy, would she have sustained losses in excess of what she ascribed to the Respondents' efforts? Yeah, I know, that's a mouthful -- but, go ahead, knock yourself and try to wrap your head around the issue.  The Arbitrator apparently concluded that if public customer Saunders had pursued her strategy, she would have been worse off than by what she opted to do in following the Respondents' suggestion. All of which boils down to a contest between whether a customer's or a stockbroker's recommendations would lose more money. Let's think that through. 

Suitability Rule

The Suitability Rule (as fully set out below) requires that the stockbroker have a reasonable basis for believing that a recommended strategy is suitable for the customer based upon considerations including the customer's background and risk tolerance. There's noting in the Suitability Rule that suggests that making more money or losing less is a exception to the concept of a stockbroker's reasonable belief

Imagine a customer who came up with a horrific investment strategy. She listens to her stockbroker, who tells her that her investing approach sucks, and the broker recommends another strategy. At the end of a period of time, if the customer had, in fact, pursued her strategy, let's say she would have lost $20,000; however, by following her stockbroker's recommendations she lost $10,000 (or maybe even made $10,000). Following that proposed analysis, the Suitability Rule seems to be viewed by the Arbitrator as a policy in which the ends justify the means. The thrust of the Suitability Rule, howeveris to place the onus of reasonableness on the stockbroker making a recommendation.

To be clear - to be very clear - the FINRA Arbitrator did NOT find that Respondents had recommended an unsuitable investment strategy. What the Arbitrator did find (or at least it's my flawed understanding) is that you cannot calculate compensable losses sustained by a public customer, if the yardstick offered by that customer is a losing investment strategy that he or she was prepared to pursue.  That's quite a premise. It may have been convincing with more of an explanation by the Arbitrator but, as it is, it's simply provocative -- and a bit dubious. 

In the end, what's unfortunate about this arbitration is that we're left with a public customer who apparently lost her case for reasons that don't quite seem to make sense; and, similarly, we have industry respondents who prevailed but that victory has a somewhat hollow ring to it.  It's an odd Decision that's a disservice to all parties but this may have managed to fall within that category.

FINRA Rule 2111. Suitability

(a) A member or an associated person must 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. 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) the institutional 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 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 Rule 2214 (Requirements for the Use of Investment Analysis Tools) if the asset allocation model is an "investment analysis tool" covered by Rule 2214; 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.