Understanding the Basic Suitability Rules
That Financial Advisers Must Honor

inancial advisers, including stockbrokers and financial planners, must abide by the suitability rules imposed by the National Association of Securities Dealers (NASD) and the New York Stock Exchange (NYSE). Consider these obligations in the event that your clients have suffered losses at the hands of a financial adviser.

The cornerstones of the suitability claim in arbitration are NASD Rule 2310 and NYSE Rule 405.

Rule 2310 Provides in Relevant Part:

2310. Recommendations to Customers (Suitability)

(a) In recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.

(b) Prior to the execution of a transaction recommended to a non-institutional customer, other than transactions with customers where investments are limited to money market mutual funds, a member shall make reasonable efforts to obtain information concerning:

i. The customer's financial status;

ii. The customer's tax status;

iii. The customer's investment objectives; and

iv. Such other information used or considered to be reasonable by such member or registered representative in making recommendations to the customer.

The meaning of the term "recommendation" is subject to some debate. However, the NASD in Notice to Members ("NTM") 96-60 (issued to clarify and supplement NTM 96-32), defined the term as follows:

A broad range of circumstances may cause a transaction to be considered recommended, and this determination does not depend on the classification of the transaction by a particular member as solicited [recommended] or unsolicited [not recommended]. In particular, a transaction will be considered to be recommended when the member or its associated person brings a specific security to the attention of the customer through any means, including but not limited to, direct telephone communication, the delivery of promotional material through mail, or the transmission of electronic messages.

NYSE Interpretive Memo No. 90-5 (August, 1990) provides that the term "recommendation", used in NYSE Rule 472 ("Communications with the Public"), "includes any advice, suggestion, or other statement, written or oral, that is intended, or can reasonably be expected, to influence a customer to purchase, sell or hold a security". Although the NYSE does not have a suitability rule per se, its Rule 405 is a close (but not identical) proxy. Its "Know Your Customer" rule provides:

Diligence as to Accounts

Rule 405.

Every member organization is required through a general partner, a principal executive officer or a person or persons designated under the provisions of Rule 342(b)(1) to:

(1) Use due diligence to learn the essential facts relative to every customer, every order, every cash or margin account accepted or carried by such organization and every person holding power of attorney over any account accepted or carried by such organization

Although Rule 405, unlike NASD Rule 2310, does not enumerate the kinds of information that is "essential" for brokers and brokerage firms to consider, the NYSE did publish guidance in its 1982 publication entitled, "Patterns of Supervision". In discussing what items should be included in the New Account Form for customers to complete, the NYSE recommended that brokerage firms inquire regarding such facts as: age, occupation, estimated income and net worth, marital status, number of dependents and investment objective. Likewise, Supplementary Material to NYSE Rule 721.10 enumerates the information required and, moreover, requires that the customer's account records contain "[d]ates of verification of currency of account information".

Clearly, a broker's investment recommendations must be suitable for the particular customer. The broker thus must determine honor the investment objective of the customer as well as that customer's risk tolerance. In doing so, the broker must consider the risk of any particular investment recommendation or strategy employed.

In general, the basic investment objectives of customers fall into four major categories:

1. Preservation of Capital (safety, not willing to lose all or part of the principal invested);
2. Current Income (for retirees and other fixed income investors through bonds and dividend paying stocks, for example);
3. Capital Growth (increases in value over time from appreciation in the asset, typically stocks and stock mutual funds, and reinvestment of dividends and income); and
4. Speculation (high risk, potentially high return types of investments).

Additionally, investors may have a need for tax - advantaged investments (such as municipal bonds) or immediate liquidity.

Brokers are instructed as to the relative risk and return of the various kinds of investments. In Pass Trak (Eighth Edition, Dearborn Financial Publishing, Inc. 1995), an examination preparation guide for those seeking to become licensed as (Series 7) brokers, various kinds of investments are divided into three risk groupings - safety, growth and speculation. They are:

Safety: Safe investments (at least relatively speaking) include cash, money market funds, CDs, U.S. Treasury securities, bank-grade corporate and municipal bonds, some real estate, blue-chip stocks, blue-chip stock and bond mutual funds.

Growth: Growth investments include growth and small-capitalization stocks, stock options, non-bank grade bonds, growth oriented limited partnerships, growth stock mutual funds, commodities funds, variable annuities.

Speculation: Speculation includes speculative stocks and stock options, low-rated debt securities, precious metals, commodities and futures, speculative limited partnerships, speculative mutual funds.
Pass Trak, at page 351

Based upon the above principles, one can see that financial advisers have significant and extensive obligations to make only "suitable" recommendations. That's something you may wish to share with your clients.

______________________________________________________________________
James J. Eccleston is a securities attorney, representing investors as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He is a past co-chair of the Chicago Bar Association's Securities Law Committee, a past chair of its Financial and Investment Services Committee, a registered investment advisor and a licensed securities principal of the National Association of Securities Dealers (NASD). He maintains an informative website at www.FinancialCounsel.com. He is an equity partner with Shaheen, Novoselsky, Staat & Filipowski and can be reached at 312-621-4400.