Suitability Claims and Purchases of Unrecommended Securities: a Theory of Broker-Dealer Liability
54 Pages Posted: 21 Oct 2004 Last revised: 9 Jun 2015
It is well-established that full-service broker-dealers have an obligation to recommend to their customers only the purchase of securities that are "suitable" to the customer's investment objectives and financial situation. There seems to be widespread agreement, however, that a broker-dealer cannot incur liability on suitability grounds unless it first recommends a securities purchase to a customer.
Accordingly, discount broker-dealers argue they are necessarily immune from liability on suitability claims because they act as "order clerks" who merely execute unsolicited customer orders; online discounters have adopted the same position. Full-service broker-dealers similarly argue that although they owe a suitability obligation for recommended purchases, they cannot be liable for a customer's purchase of an unsuitable security when the broker-dealer merely executed the customer's purchase order without having recommended or otherwise encouraged the order.
This Article argues that it was judicial application of the suitability obligation largely in the context of customer disputes with full-service broker-dealers that led to establishment of the recommendation as a condition precedent to suitability liability. The shift to arbitration in the late 1980s, which undermined judicially developed legal limitations on suitability liability, combined with the further shift to unbundled online order-execution in the early 1990s, which significantly reduced the incidence of customer interaction with account executives, eliminated factors which undergirded the recommendation as a condition precedent to suitability liability, and opened the door to liability on suitability grounds for unrecommended customer purchases.
This Article develops a theory of broker-dealer liability for suitability claims on unrecommended purchases by inexperienced and unsophisticated customers. Since the market turn early 2001, it has become clear that many individual investors lack basic knowledge about investing, and regularly incur substantial losses due to lack of diversification, speculation, and over-leveraging. This Article argues that the common law duty of an agent to provide information to his or her principal justifies imposition on brokers-dealers of a "duty to warn" inexperienced and unsophisticated customers when their trades are inconsistent with their investment objectives or other aspects of their personal financial situation of which their broker-dealer is aware. The Article also suggests that the agent's duty to give information might support imposition on broker-dealers of a "duty to rescue" in certain limited circumstances when such customers persist in financially destructive or otherwise irrational trading that entails no reasonable prospect of investment profits and has already resulted in large losses. Unlike common law agents, broker-dealers should not be permitted to contract out of this duty, because of the general statutory policy of the securities laws against waiver of rights under such laws, and because of specific policies promoting investor protection and market efficiency that would be undermined by waiver. The Article concludes with the suggestion that in light of the looming social security funding crisis that will require greater reliance on private savings to fund retirement, a general broker-dealer duty to warn inexperienced and unsophisticated investors of the unsuitability of unrecommended purchases is sound policy.
Keywords: Suitability, Agency, Fiduciary Duty, Broker/Dealer, Discount, Online, Unrecommended Purchases
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