Liability of Broker-Dealers for Unsuitable Recommendations of Institutional Investors

Article excerpt

I. INTRODUCTION

The suitability doctrine prohibits a securities broker-dealer from recommending a security to a customer unless she has a reasonable belief that the security is suitable for that customer.1 It imposes a IMAGE FORMULA10

duty on the broker-dealer to take the financial situation, risk threshold, investment sophistication, investment objectives, and other securities holdings of her customers into account when she recommends a security to them.2 The suitability doctrine was originally formulated more than sixty years ago as an ethical standard by the National Association of Securities Dealers ("NASD"), a self-- regulatory organization ("SRO") of the securities industry to which almost all brokers and dealers are required to belong.3 A brokerdealer who recommended an unsuitable security could be disciplined by the NASD,4 but she would not be subject to legal sanctions.5

Over the years, however, the suitability doctrine has undergone "a subtle shift from ethics to law."6 As long ago as 1978, the Second Circuit held in Clark v. John Lamina Investors, Inc.,7 that a broker's unsuitable recommendation to a customer violated Rule 10b-5, the SEC's general and most important antifraud rule.8 Furthermore, a IMAGE FORMULA12

broker's unsuitable recommendation may be actionable under state law.9 Although the law differs from state to state in how it characterizes the relationship between a broker and a customer, the prevailing view is that where the customer places her trust and confidence in the broker, the broker owes the customer a fiduciary duty and that an unsuitable recommendation may be a breach of this duty.10

Until the 1980s, the suitability doctrine was applied almost exclusively to recommendations made to individual investors. Perhaps the clearest example of a suitability violation occurs where a broker recommends speculative securities to a customer whose financial situation clearly calls for conservative investments. For example, an elderly widow or retired person who needs the income from her investments for her living expenses and who has no reasonable expectation of being able to replace any substantial trading losses might also be unaware of the risks of the recommended investment because she lacks the background or education to understand investments or the securities markets. The investment might also be inconsistent with her investment objective. For example, the widow or retiree might want conservative investments, in order to preserve her principal and receive an assured income, rather than speculation or short-term trading.12 Thus, the recommendation of speculative securities might be unsuitable for the investor if she is unable to bear the risks of the investment, if she is unable to understand these risks, or if the investment is inconsistent with her investment objectives.12 IMAGE FORMULA14

investment is inconsistent with her investment objectives.12

In recent years, however, a number of lawsuits and arbitrations have been brought to recover losses suffered not by individual investors but by institutions, including states and municipalities, publicly and privately owned companies, and educational and religious organizations. In several well-publicized cases, large government entities, including Orange County, California,13 and the State of West Virginia,14 and large publicly owned corporations, such as Procter & Gambler15 and Gibson Greeting Cards,16 have attempted to recover substantial losses incurred as a result of making risky investments. Losses have also been incurred by many smaller institutions, including churches, credit unions, colleges, and school districts. In some of these cases, the institution has claimed that the investments recommended to it by a broker-dealer were unsuitable for the institution in light of its investment objectives as reflected in the governing law, its charter, or its written investment policy. …