by Lawrence C. Melton, Esq. lmelton@dhayeslaw.com
THE HAYES LAW FIRM, www.dhayeslaw.com, 1-866-332-3567 (toll free)
Unsuitable Recommendations and Sophisticated Investors
The suitability doctrine requires that a broker-dealer who makes recommendations to a customer recommend only those securities that he reasonably believes suitable for the customer. NASD Conduct Rule 2310. The SEC has held that a customer's sophistication does not allow a financial adviser to disregard the customer's investment objectives in recommending investments. 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.
Even the most sophisticated investor deserves proper recommendations. "The fact that a customer ... may be wealthy does not provide a basis for recommending risky investments." Arthur Joseph Lewis, 50 S.E.C. 747, 749 (1991). "Suitability is determined by the appropriateness of the investment for the investor, not simply by whether the salesman believes that the investor can afford to lose the money." David Joseph Dambro, 51 S.E.C. 513, 517 (1993). See also Krull v. SEC, 248 F.3d 907 (9th Cir. 2001) (giving deference to the SEC's interpretation of "unsuitability" under the NASD's Rules of Fair Practice). http://www.ca9.uscourts.gov/ca9/newopinions.nsf/24A7001BA9783BE088256A3A005B2561/$file/9970290.pdf?openelement
On December 11, 2006, The Honorable Roger T. Benitez of the Southern District of California stated the following:
"It is well-established that wealth of the customer (however accumulated) and sophistication are not bases for recommending risky investments, nor are they defenses to claims of unsuitability. Had the arbitrators accepted these defenses in response to the claim of unsuitability, they would have been in manifest disregard of the law."
Strobel v. Morgan Stanley Dean Witter, No. 04cv1069-BEN (BLM), 2006 WL 3735739 (S.D. Cal. order filed Dec. 12, 2006) (Amended Order Denying Petition to Vacate Arbitration Award; Denying Cross Petition to Confirm Arbitration Award and Remanding with Instructions). http://www.reinsurancefocus.com/uploads/StrobelOrder.pdf
According to the S.E.C., proper analysis requires a two-tiered approach: (1) the customer must be able to understand the risk and (2) the customer must be able to bear the risk. James Chase, Exchange Act. Rel. No. 47476, 79 SEC Docket 2251, 2003 WL 917974 at *4-5 (Mar. 10, 2003).
http://www.sec.gov./litigation/opinions/34-47476.htm.
The sophisticated investor defense falls short because it only goes to the first tier. The second tier, pertaining to the ability to bear risk, is wholly unrelated to sophistication. The savviest investor in the world may not be able to bear a high risk investment due to his current financial situation. Irrespective of sophistication level, the broker must ensure that the investor can financially sustain the risk prior to recommending the investment.
The specific language of the governing rule is relevant. NASD Conduct Rule 2310, which requires recommendations to be suitable, has no sophistication element. Juxtapose this with NASD Conduct Rule 2860(b)(19), the rule governing the recommendation of options, which arguably does have a sophistication element. NASD Conduct Rule 2860(b)(19), requires the financial adviser to have a "reasonable basis for believing, at the time of making the recommendation, that the customer has such knowledge and experience in financial matters that he may reasonably be expected to be capable of evaluating the risks of the recommended transaction..." Importantly, such language is missing from Rule 2310. If Rule 2310 was meant to have a sophistication element, it would have included the same or similar language as Rule 2860(b)(19). The conspicuous absence of such language from Rule 2310 is telling. Needless to say, if sophistication is not an element of Rule 2310, it is likewise not a defense.
http://finra.complinet.com/finra/display/display.html?rbid=1189&element_id=1159000424
Sophistication is NOT a Defense to Negligence
The sophistication defense is also not legitimate in the context of a simple negligence action. It is noteworthy that the elements of a negligence claim are different from the elements of a claim under Section 10(b) and Rule 10b-5. Brokerage houses sometimes try to rationalize using sophistication as a defense on the basis of the justifiable reliance element in Section 10(b) and Rule 10b-5 claims. They argue that the investor must prove "justifiable reliance," which allegedly requires an inquiry into investor sophistication. This rationale, of course, is not applicable to a common law negligence claim, because justifiable reliance is not an element of negligence.
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