ARE YOU A SOPHISTICATED INVESTOR?

INCONSISTENT STANDARDS FOR MEASURING SOPHISTICATION OF INVESTORS

by Lawrence C. Melton, Esq., lmelton@dhayeslaw.com

THE HAYES LAW FIRM, www.dhayeslaw.com, 1-866-332-3567(toll free)

In the previous three blogs, I argued that sophistication is not a defense to specific causes of action, such as securities fraud, unsuitable recommendations and broker negligence.  Now I want to discuss the criterion for designating an investor as "sophisticated." 

Who is sophisticated?  Who is not sophisticated?  And Why? 

The standards by which sophistication is measured are anything but uniform.  The truth is nobody knows at what point an unsophisticated investor becomes sophisticated.  There are no common indices by which sophistication is identified.  Presumably, investor sophistication, if it is to be considered by an arbitration panel at all, should at a minimum require a factual evaluation of the client's level of understanding with respect to risk.

Erratic and unpredictable, the case law provides little guidance.  Sometimes the cases will include consideration of several factors when assessing sophistication, such as wealth, age, education, professional status, investment experience, and business background.  Banca Cremi, S.A. v. Alex Brown & Sons, Inc., 132 F.3d 1017, 1029 (4th Cir. 1997).  Nonetheless, inconsistencies plague the entire system, and the sophisticated-investor doctrine is frequently misapplied.

Obviously it is injudicious to equate sophistication with income or net worth.  Ambitious individuals often achieve high levels of wealth with little or no understanding of the the stock market.

Can one equate business experience with sophistication?  This is doubtful, judging from prior decisions.  The SEC once found an investor unsophisticated, even though he owned his own roofing company, had a degree in business administration and maintained a $3 million brokerage account.  Dale E. Frey, Release No. 221, 79 S.E.C. Docket 1727, 2003 WL 245560 (Feb. 5, 2003)http://www.sec.gov/litigation/aljdec/id221lam.htm. 

In a different case, the SEC determined that a city finance manager was not sophisticated because of his inability to understand inverse floaters.  Kenneth R. Ward, Release No. 8210, Release No. 47535, 79 S.E.C. Docket 2363, 2003 WL 1447865 (March 19, 2003).

What about education?  Is there a precise level of education that establishes sophistication?  Apparently not, says the S.E.C., which once held that an investor who was studying economics in college and was able to download information regarding the investment from the Internet did not have sophistication.  James Chase, Exchange Act. Rel. No. 47476, 79 SEC Docket 2892, 2897 (Mar. 10, 2003)http://www.sec.gov./litigation/opinions/34-47476.htm.

Going even further, the SEC once held that a graduate business degree from Harvard does not establish that a customer is a sophisticated investor.  Bucchieri, 52 S.E.C. 800, 804 (1996).   From these examples, all one can conclude is that an investor may be sophisticated in some areas, and unsophisticated in others.

There is, however, a codified definition of "accredited investor" in Section 2(15) of the Securities Act of 1933, which assumes risk tolerance for the accredited investor.  15 U.S.C. Section 77(b)(15) (1982).  An accredited investor, it should be noted, is never exempted from the application of the anti-fraud provisions of any state or federal securities act.  Even an accredited investor can be taken advantage of by failures to disclose facts necessary to make an informed decisions about an investment.  The NASD has cautioned that accredited status "is not necessarily an indicator of sophistication, particularly, if the value of the investor's home constitutes a significant percentage" of the customer's net worth.  NASD NTM 05-26.

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Comments

[Long time investor]

This is right on. When I retired, I had only had a 401K and they said I have 20 years of investment experience even though I don't know the difference between a stock and an equity.

Now I know where I can get help.

Really helpful blog.