Can you relate to the following scenario: You had or currently maintain an investment account at a brokerage firm or with a registered investment advisor. You have lost a significant amount of money and do not know whether to just chalk it up to bad luck or timing, or if you have been the victim of securities fraud. For our purposes we will define securities fraud as negligence or a misrepresentation or omission in connection with the purchase or sale of a security by an investment professional.
A common misconception among the general public and members of the investment community alike is that good brokers/ advisors are those who make money for their clients and bad brokers/ advisors are those whose recommendations are not profitable. Whereas everyone invests with the goal to increase worth, a losing investment does not necessarily equate to a cause of action against the broker/advisor for securities fraud, nor do gains on investments necessarily equate to the lack of a cause of action against the broker/advisor. A good broker/advisor, one who does not run afoul of the rules and regulations, is one who makes suitable recommendations, based upon your needs, objectives and risk tolerance, not on the broker/advisor's desire to be a hero. The greater the potential returns, the greater the risks, and unless you have stated a need, tolerance, understanding and acceptance of those risks, the broker would be well advised to eschew the temptation of being a hero by "hitting a home run" in favor of investments that are compatible with your profile.
The securities industry is a highly regulated industry. Brokers and Financial Advisers are required to abide by the rules and regulations promulgated by the governmental and self-regulatory organizations ("SROs") that regulate and safeguard the securities industry, such as the Securities and Exchange Commission ("SEC") and the Financial Industry Regulatory Authority ("FINRA"). Additionally, federal and state governments have enacted statutes, such as the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Advisors Act of 1940 and various state securities acts to protect you and provide for full and fair disclosure.
Among the numerous rules and regulations, two stand out as guiding principals by which all business is to be conducted. One is to "deal fairly", and the second is to, "know your customer". The former is somewhat amorphous, a general precept that governs all actions; the latter is designed specifically to crystallize the proper relationship between the broker and you. It has come to mean, through years of testing and refinement, that the broker has a duty and obligation to make recommendations that are "suitable" for you based upon your specific investment objectives, investment experience, risk tolerance and any other factors pertinent in determining a suitable recommendation.
The most common way brokers and financial advisers incur liability is by failing to make recommendations for you that are "suitable" for you specifically. A broker and a brokerage firm have a duty to recommend only suitable investments to you. A suitable recommendation is one that takes into consideration your individual situation, including, but not limited to, your financial needs and tolerance for risk. By contrast, a recommendation that is unsuitable is one that fails to be appropriate for you given their specific situation and tolerance for risk.
One particular area where I see a breakdown with regard to suitability is with retirees who need monthly income from their investments. The typical scenario is that the customer retires after many years with the same company. He has little to no prior investment experience, and now has a large, lump sum from which he needs to replace his prior wages. For example, he may walk in with $500,000.00 and ask if he can have $3,500.00/ month. Many well meaning, but uninformed or under-informed advisors will tell him that the stock market has historically returned 10% to 12% a year on average, and since his income needs are below that level he should be able to take those monthly withdrawals and still have the corpus continue to grow. In essence they are recommending substituting capital appreciation for dividends and interest in order to meet the client's objective. This strategy is wholly unsuitable for reasons too numerous to mention in this article, not the least of which it is predicated on the market appreciating in a straight line. The problem is magnified when the client is locked into his withdrawals, as is the case with 72(t) plans.
In future posts I will discuss what else to look for to help you determine if you are the victim of securities fraud.
