POINTING FINGERS

by Hartley Bernstein Hartley Bernstein

Think back to early 2000. Smiling investors were grateful to prescient brokers who had been steering them towards the new wave of technology stocks. Portfolios – and lifestyles – were growing. What a difference a year makes. Many of those investors have been wiped out. Others are now licking their wounds, counting their losses and wondering what happened. Was it inevitable, or should they have received better guidance from those brokers who seemed so wise one long year ago? And can those brokers be held liable regarding investments they recommended to their clients?

It comes down to a question of suitability. Brokers must have a reasonable basis for believing that the investments they recommend are appropriate in view of a client’s objectives, investment experience, risk tolerance and financial situation. When brokers fail to adequately consider these factors, and instead recommend “unsuitable” investments, they can be held responsible for subsequent losses. As we have seen recently, online brokers are not insulated from such liability. The NASD has made it clear that suitability rules apply to online brokers who recommend investments as well as to their traditional offline counterparts (See Playing By The Rules, Part II – Suitability Rules).

The recent carnage in the financial markets has prompted more and more investors to complain about brokerage sales practices. Brokers should not be surprised. In a bull market, with virtually every stock soaring, almost any recommendation shines. A bear market, on the other hand, exposes each recommendation to far greater scrutiny. Complaints against brokers increased dramatically after the October 1987 stock market crash. The same pattern may be surfacing again. The NASD says arbitration complaints are up 15% for the first quarter of 2001.

According to the Securities and Exchange Commission, suitability complaints have increased at the greatest pace, with customers charging that their brokers pushed them into inappropriate stocks and other unwise investments. In fact, unsuitable recommendations are now the fifth most common complaint by investors. In the first three months of 2001, 141 investors cited such problems in complaints to the SEC, a 58% increase from the same period last year. But suitability claims still trail behind charges of misrepresentation, which top the list of investor grievances.

Many of the suitability complaints have been filed by retired investors who say they wanted conservative investments but were steered instead to risky technology stocks. SEC Acting Chairperson Laura Unger places some of the blame on a “certain amount of euphoria that everyone was feeling.” She has indicated that the SEC may take “more significant” action if the trend of unsuitability complaint continues. In that case the SEC may decide to examine brokerage firm records to determine if there has been a pattern of unsuitable recommendations. If there is, enforcement actions may follow.

What is considered unsuitable? That depends upon the particular customer’s “profile.” One complaint was filed by a customer who opened a brokerage account to manage $500,000 for her 80 year old mother who was suffering from Alzheimer’s disease. The customer now charges that the broker, who promised to pursue conservative investments, made more than 300 trades, buying mostly technology stocks. When those stocks began to fall, the broker began to borrow against the value of the account in order to buy more technology stocks on margin. Margin permits a customer to buy more securities by borrowing against their own holdings – but losses can be precipitous if the stock prices fall. By late February 2001, the customer says the value of the account had been reduced to $15,000 – and she had paid an estimated $94,000 in brokerage fees.

While suitability must be judged on a case-by-case basis, there are some signs that should not be overlooked. Here are a few:

1. Lack of diversification.

Are you seeking conservative, low-risk investments? A concentrated portfolio may benefit from sudden rises in a single sector (like technology) but by the same token it is subject to more dramatic losses when there is a downturn.

2. Margin trading

Margin accounts are inherently more risky than cash accounts. Although they permit an investor to buy more stock by borrowing against the value of his or her holdings, they can suffer more dramatic and rapid losses in a down market. Conservative investors would be well warned to avoid margin accounts.

3. Speculative transactions

Again, if an investor has conservative goals, speculative investments should be avoided. Investors should be concerned if their broker recommends little-known stocks, those that are not traded on national markets, or highly volatile securities.

4. Untimely Investments

A broker should consider the investor’s age as well as their investment objectives. For example, it may be appropriate for a younger customer to buy an investment instrument that matures in 10 or 15 years , even if there is a penalty for early liquidation. However, that same investment would not be appropriate for a senior citizen on a fixed income who will undoubtedly be forced to liquidate early and incur a penalty.

In the end, the facts will dictate whether a broker’s recommendations have been unsuitable. But investors can protect themselves at the outset and avoid unpleasant problems down the road. Make certain that your broker knows your objectives, experience and financial condition. Don’t be vague about your goals or shy about revealing your age, background and income. Remember, the portfolio you save may be your own.

About Hartley Bernstein: Hartley Bernstein is a corporate and securities attorney and civil litigator with a specialty in business transactions and civil litigation.