Remember Your Suitability Obligations

onsider the following scenario. A rep recommends that a customer purchase a stock, in fact a large quantity of the stock, believing that the price of the stock will rise. Does the rep have a regulatory problem? Not necessarily.

Now add these three facts to our scenario. The first fact is that the stock recommended is issued by a development stage company with no revenues. The second fact is that the large quantity of the stock recommended comprises a "concentrated" position in the customer's account. The third fact is that, upon review, the rep has no basis to predict that the price of the stock will rise. Now, knowing those additional facts, does the rep in that scenario have a problem? You bet. Indeed, that scenario resulted in the NASDR's suspending the rep for one year, fining the rep and ordering the rep to pay restitution to the customer.

The scenario highlights three important requirements of the suitability rule. These are that a rep: 1) should analyze a company before recommending it, sharing both positive and negative information that he or she uncovers; 2) should not predict the price of the stock unless he or she has an adequate basis to do so; and 3) should recommend a purchase amount that is not excessive, in view of the concrete information that he or she has regarding the financial capability and the investment objectives of the customer. Let's explore these three requirements in greater detail.

Analysis

As a rep, you know that you need to have an adequate basis for your recommendations to purchase securities, and that those recommendations should be based upon a reasonable investigation. What is reasonable, of course, varies with the circumstances. At a minimum, know that you must analyze sales literature. You also must review public filings of the company that you are considering recommending. Your investigation must be even more thorough with smaller companies of recent origin. And you cannot simply rely upon the issuer or your employer brokerage firm. Hence, reps should not rely upon their firm's research reports exclusively.

What your analysis uncovers you must disclose, if the information is "material". Materiality has been defined as what a reasonable investor would consider important in making his or her investment decision, or whether disclosure of such information would significantly alter the total mix of information made available. And if a rep's investigation is incomplete, such that he or she lacks essential information about the company, that too must be disclosed to the customer.

Price Predictions

Reps should understand that predicting price often is found to be unjustifiable and fraudulent. This is true even if a rep casts his prediction merely as an opinion or as a possibility rather than as a guarantee.

Further, reps never should make predictions of specific and substantial price increases for speculative securities of unseasoned companies. The same is true with respect to companies that have suffered losses or operated at small profits

Finally, regulations require that reps have a reasonable basis for any price prediction. Reps can rely upon their brokerage firm's research reports as some support for their price predictions.

Concentration

Whether a concentration in a particular security is unsuitable varies from case to case. For example, many disciplinary decisions fault reps for concentrating accounts into one or two securities, but at least one decision found a 25% concentration to be "at the high end of the acceptable range." Clearly, the disciplinary decisions suggest that the burden placed upon reps to justify a recommended concentration increases as the type of security becomes more speculative.

One factor for reps to consider is whether the customer has the financial capability to bear the risk of a particular securities recommendation (concentrated or not). How certain does a rep need to know his customer's financial situation? In one disciplinary decision, the customer told the rep that she would inherit money from her mother. The rep claimed as a defense that this information from his customer allowed him to conclude that she had the financial wherewithal for his recommendation. However, the defense was rejected. The decision held that all recommendations must be based upon concrete information, not merely the possibility, that there will be adequate finances.

Finally, the suitability rule requires more than just risk disclosure. Thus, even if a customer wants to engage in highly speculative or otherwise aggressive trading, for instance through concentration in a particular security, a broker must refrain from making recommendations for which the customer is not financially capable.

Reps would be well advised to remember these three requirements of the suitability rule.