Unsuitability is a common customer complaint. In these situations, the customer alleges that the broker recommended investments that were not appropriate for his investment goals, or even his age and investment objectives. Financial professionals have a duty to take steps that ensure that an investment is suitable for a client. Unsuitability is another problem in securities arbitrations, since the claim is typically made after the entire account loses money, rather than at the close of a truly unsuitable investment. Arbitrators often struggle with unsuitability claims, as the inquiry requires a determination, often without expert witnesses, of just what is suitable for the customer.
An example of unsuitability might involve a 95-year-old widow living on fixed income and having a broker recommend speculative investments such as options and futures, penny stocks, etc that are extremely unsuitable because the widow has a low risk tolerance. On the other hand, an executive with significant net worth and investing experience might be comfortable taking on those speculative investments as part of his or her portfolio. A broker making speculative recommendations to the executive is less likely to run into unsuitability issues.
These claims have potential for disaster for the broker, since a customer who was perfectly well informed of the risks, and willing to take same, may later claim unsuitability. If the investment was not within reasonable guidelines for the customer, the broker may have been found to have made an unsuitable recommendation, even years after the fact, and despite similar profitable investments in the same account.
Brokers need to make sure that they understand the risks of the various products they recommend, and that the customers understand those same risks. As discussed below, account documentation can be critical in arbitrating these types of claims.
As in the case of Unauthorized Trading, SRO rules come into play in suitability claims, and can lead to enforcement proceedings. NYSE Rule 405 requires that a firm use due diligence to learn the essential facts relative to every customer and every order. Article III, Section 2 NASD Rules of Fair Practice requires a member to have reasonable grounds for believing that a recommendation is suitable for the customer based on other securities holdings, the customer’s financial situation and his investment needs.