Suitability

The adviser’s fiduciary duties

The Investment Advisers Act of 1940 codifies the fiduciary duty of investment advisers to act for the benefit of their clients. The SEC has made it clear that an investment adviser must make a reasonable determination that the investment advice provided is suitable for a client based on the client’s financial situation and investment objectives. Advisers who have failed in their fiduciary duty to make only suitable investments for their clients have been sanctioned by the SEC. Accord-ingly, it is imperative that advisers fully understand the suitability requirement and how to assess and document suitability in their practices.

Suitability analysis

A suitability analysis requires all of the investment adviser’s skills. The adviser must first establish an effective line of communication with the client and gather information. Next, he must step into the shoes of the client (in essence “be the client”) in an effort to glean his or her investment objectives, risk tolerance and risk capacity (see August 1999 “Software Solutions”), financial needs, and long-term plans. The adviser must then assimilate the acquired information in order to design (e.g., develop an asset allocation plan and select securities) and maintain a portfolio that is suitable for the client. Finally, the adviser must monitor and annually update the information to ensure continued suitability. While this may seem a daunting task, a little planning, taking the guidelines and examples in the appendix to this article into consideration, will make the process almost effortless.

What you should avoid

What follows are a few important “Dont's” to keep in mind:

• Do not rely on memory alone.
  When the conduct of an investment adviser is questioned, the focus is not necessarily on performance (although this may well be what triggered the question), but rather on the adviser’s plans and procedures. Plans and procedures do not exist in the mind; they must be documented. The best defense to suitability scrutiny is documentation of a plan that addresses diversification, control and disclosure of risk, and an investment policy, among other things.

• Do not use general or vague investment objectives.
  Spend the time to develop objectives that are suitable for the client. Simply stating the obvious (e.g., “I want to make money”) is not an appropriate approach and can be a problem if suitability is ever questioned. Many people have no concept that the more money you stand to make, the more risk you must be willing to take. Explore and probe the client’s risk tolerance to determine just how much money the client really wants to make.



• Do not speak to a client about risk in general terms when the investment poses specific, known risks.
  Providing a client with written risk disclosures does not necessarily fulfill an adviser’s obligation of risk disclosure; many clients will choose to rely solely on the adviser’s spoken word. In the Prudential Securities limited partnership litigation, brokerage firms attempted to defend their sale of the high risk investments to clients by arguing that the prospec-tuses disclosed all of the specific risks of the investments. The New York court shot down that defense, stating that it “provides no protection to someone who warns his hiking companion to walk slowly because there might be a ditch ahead when he knows with near certainty that the Grand Canyon lies one foot away.”



• Do not assume a client understands.
  Even the powerful and sophisticated can claim that an adviser failed to disclose a material fact to them. As one judge opined when speaking about the Securities Exchange Act: “The [Exchange Act] does not speak in terms of ‘sophisticated’ as opposed to ‘unsophisticated’ people dealing in securities. The rules when the giants play are the same as when the pygmies enter the market.” Scherk v. Alberto - Culver Co., 417 U.S. 506, 526 (1974).

AIMR standards

The Association for Investment Management and Research (AIMR) has an excellent set of standards governing portfolio investment recommendations and actions [see Standard IV(B.2)]. Information on AIMR standards can be obtained at www.aimr.org. All AIMR members, CFA charterholders, and candidates enrolled in the CFA Program are bound by AIMR’s Code of Ethics and Standards of Profes-sional Conduct. These standards can also serve as valuable guidelines for finan-cial advisers not bound by AIMR’s code.

Checklist

Click here for the Invest Suitability Checklist and use it as a suitability guide before making investment recommendations to clients.

Tracy Pride Stoneman, JD, represents investors, stockbrokers, and financial professionals in investment related disputes. Ms. Stoneman’s experience includes time as a municipal judge and as a partner and trial lawyer in a large Dallas, Texas, law firm. She has published numerous articles in the securities field and is a frequent lecturer on securities fraud, arbitration, and investment disputes. She is active in the national organization of attorneys who represent investors in securities cases—the Public Investors Arbitration Bar Association (PIABA). She has her own firm in Colorado Springs and Westcliffe, Colorado. Feel free to email her at Tracy@InvestorFraud.com.

Click here for the Investment Suitability Checklist