When recommending the purchase of a security, NASD Rule 2310 requires that a broker dealer (and its representative) must have reasonable grounds for believing that the recommendation is suitable for the customer on the basis of that investor’s financial situation and needs. Understanding the scope of this duty is critical in considering whether an investor may have a valid claim against a broker dealer based on an unsuitable investment recommendation.
Traditionally, the duty to make suitable recommendations has been thought of as requiring that the investment be a good fit for the investor based on the specific profile. However, a number of FINRA Notices to Members and recent FINRA enforcement actions have made clear that this traditional conception of suitability analysis in fact is only the second step in the two-step process to determine if an investment is suitable.
The first step in determining whether a particular investment is suitable for investors is to determine whether the investment is suitable for any investor. FINRA explained this in Notice to Members 03-71 in 2003 (relating to, among other investments, non-traded Real Estate Investment Trusts).
A reasonable-basis suitability determination is necessary to ensure that an investment is suitable for some investors (as opposed to a customer-specific suitability determination, discussed below, which is undertaken on a customer-by-customer basis). Thus, the reasonable-basis suitability analysis can only be undertaken when a member understands the investment products it sells. Accordingly, a member must perform appropriate due diligence to ensure that it understands the nature of the product, as well as the potential risks and rewards associated with the product. Moreover, the fact that a member intends to offer a [non-conventional investment] only to institutional investors does not relieve the member of its responsibility to conduct due diligence and a reasonable-basis suitability analysis.
While a firm may rely in good faith upon materials such as the prospectus or an offering memorandum, that analysis is not sufficient where the information contained therein is not sufficient to fully understand the risk of the product, or does not provide enough information to allow a broker dealer to train its representatives on selling the product.
So how might this work in practice? This is best evidenced by the complaint filed by FINRA on May 31, 2011, against David Lerner & Associates (“DLA”) relating to their sale of the Apple Ten REIT. FINRA argued that there were several red flags indicating that Apple Ten was not a suitable investment including the fact that previous Apple REITs had failed to adjust the valuation of their shares despite significant declines in actual performance. Another red flag was the fact that dividends were being paid out that significantly exceed Funds from Operations, meaning that Apple REITs were paying dividends from new investors’ monies or by taking on additional debt. Failing to detect these red flags, or to offer to sell shares of Apple Ten despite these red flags, was a violation of NASD Rule 2310, requiring that an investment be suitable for any investor while also requiring that adequate due diligence be conducted before recommending an investment. What that means is this—when an investment goes wrong, especially one that is non-traditional like a non-traded REIT or a private placement, a broker dealer may be liable if there were earlier signs of this trouble that were not detected.
Once a broker dealer has determined that an investment is suitable for any investor, the second step is to determine whether the investment is suitable for the specific customer. This involves a number of considerations such as the investor’s age, investment needs (such as retirement income), the investor’s time frame, tax bracket, risk tolerance, liquidity needs, and net worth. The due diligence conducted at step one is intended to discern not only whether the investment is suitable for the public at large, but also what type of investor may be a good fit for the particular investment.
Thus a second type of breach may occur where the broker dealer, or its representative, makes investments that should not have been recommended given the particular investor’s situation. For example, this might mean that a conservative investor with little tolerance for risk was put in a volatile investment. It may mean that the investor who needed the money to be liquid was put into an illiquid investment with a long holding period. Or it could simply mean that an investor who was retired or soon to be retired, and who was relying on the investment for retirement income, was put in an aggressive or speculative investment.
The bottom line is this. An investment may be unsuitable for two reasons. First, it may be that the investment itself was never suitable, and should not have been sold to any investors. Or, the investment may not have been suitable for the particular investment. A valid claim based on a breach of the duty to make suitable recommendations requires that only one of these violations occurred.