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New Suitability Rule Seen Complicating Arbitrations

6/22/2012

Dow Jones Compliance Watch

New rules on what makes a suitable recommendation for clients may also make it tougher for brokers who find themselves in arbitration over a client complaint.

Brokers will have to take into account more details about each investor’s circumstances when making a recommendation, and that could give investors more legal ammunition–and arbitrators more issues to consider.

The Financial Industry Regulatory Authority’s beefed-up suitability rule, which takes effect July 9, obligates brokers to ensure the securities and investment strategies they recommend are suitable for clients over the long-term, not just at the time of the sale. It also expands the list of customer information that brokers generally must try to collect before making a recommendation; added are a client’s age, investment experience, time horizon, liquidity needs and risk tolerance.

Faun M. Phillipson, a New York-based securities attorney who represents brokers and firms, expects no sudden or dramatic change on July 9. Many brokers likely have already been taking the “supposedly new factors” into account, she believes.

“I don’t think it changes the world as far as investor protection,” she says. “But it is a game-changer when it comes to customer arbitrations.”

When investors feel burned by an adviser’s recommendation, they’ll have new arguments to take to arbitration such as, “You left out my liquidity needs,” says Ms. Phillipson, a partner at Phillipson and Uretsky LLP. Moreover, “it gives arbitrators more reason to potentially grant awards,” she says.

According to Finra’s dispute resolution system, the mandatory forum where customers must air grievances with their brokers and firms, unsuitability is already a common claim brought to arbitration. Of the 1,997 cases filed this year through May, 569 have involved an unsuitability claim, Finra data shows, although each case can contain multiple allegations.

While attorneys don’t expect an overnight spike in arbitrations, there will be a bigger burden on brokers and firms when defending themselves. For example, the rule now holds them liable for a “hold” recommendation–that is, when they explicitly advise a client to stick with an existing investment, as opposed to moving money into something else.

Finra says that firms may use a risk-based approach to documenting compliance with the rule, meaning brokers aren’t required to document each and every recommendation and the basis for it. Although this is intended to give firms flexibility, attorneys counter that documentation is key to defending against an investor claim.

Paul A. Merolla, a partner at Murphy & McGonigle in New York, says the less documentation, the more risk for the broker-dealer.

“If a firm doesn’t document a particular item, it doesn’t mean that they will be unsuccessful in proving it, but it will likely be subject to witness testimony and the credibility of the witnesses,” he says.

Ms. Phillipson says brokers need to be consistent in their documentation, no matter whether a recommendation is a buy, sell or hold.

If a broker were to document one out of five recommendations, an arbitrator is likely to question why the other four weren’t written down, she says. “Consistency is going to be the key.”

But attorneys who represent investors don’t exactly view the new suitability rule as a windfall.

“It’s an improvement, but I don’t see it as this moment where everything changes for investors or their lawyers,” says Ryan K. Bakhtiari, of Aidikoff, Uhl & Bakhtiari in Beverly Hills, Calif.

He notes that in states such as California, which already has a strong broad fiduciary duty law, investment advisers and brokers are held to the same standard of care as dictated by the new rule.

“But in states where the fiduciary duty isn’t so broad or strong, investors will see some improvement in their ability to recover damages,” says Mr. Bakhtiari, who also serves as the president of the Public Investors Arbitration Bar Association.

While the suitability rule requires brokers’ recommendations to be consistent with the customers’ best interests, Mr. Bakhtiari says investors would be best served by the Securities and Exchange Commission adopting a universal fiduciary standard.

In addition to acting in a client’s best interest, the fiduciary standard would require disclosure of conflicts of interest and “would be the best possible outcome for investors,” he says.


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