- First Circuit Affirms Customer Suitability Obligations Under FINRA Rules
- September 26, 2012 | Authors: Matthew C. Applebaum; David C. Boch; W. Hardy Callcott; Paul M. Tyrrell
- Law Firms: Bingham McCutchen LLP - Boston Office ; Bingham McCutchen LLP - San Francisco Office ; Bingham McCutchen LLP - Boston Office
In Cody v. SEC,1 the First Circuit upheld the decision of the SEC affirming the finding that a registered representative violated the FINRA suitability rule when he knowingly recommended a product he did not fully understand. The decision in Cody underscores a representative’s individual duty to investigate and understand the securities he or she recommends and highlights the more in-depth review that is required before recommending complex securities such as collateralized mortgage obligations (“CMOs”).
Summary of Procedural History and Key Facts
According to the decision, in February 2003, Cody made recommendations to two sets of customers who were “near or in retirement, were not skilled investors, and expressed no interest in acquiring speculative investments for the accounts at issue.” Cody recommended that both sets of customers purchase units of Credit Suisse First Boston Mortgage Securities Corp. IndyMac Manufactured Housing Passthru (the “Credit Suisse Security”), a fixed-income security collateralized by installment sales contracts and installment loans for mobile homes.2 Although he discussed the Credit Suisse Security with the customers beforehand, Cody admitted that he had not “really understood” the security when he recommended it and did not know or explain information concerning the tranche he was recommending, the kind of assets collateralizing the securities or other relevant factors such as liquidity. Moreover, Cody knew that the security had an “A” rating, but did not know that it had been downgraded from “AA” by Fitch four months earlier. According to the decision, the securities were sold in 2004 at losses between 55 percent and 66 percent of the customers’ initial investments.
FINRA filed a disciplinary complaint against Cody in January 2008.3 Other conduct at issue included a late Form U4 filing; Cody’s excessive in-and-out trading of customer accounts; and his use of monthly reports that misleadingly listed bonds at par values, rather than their substantially lower market values, without explaining the distinction to the customers. Furthermore, Cody recommended three allegedly unsuitable non-investment-grade corporate bonds to one customer. A FINRA Hearing Panel found that Cody had violated NASD Rules 2310 and 2110 by, among other things, making unsuitable recommendations, churning their accounts, using misleading monthly reports and delaying his report of the settlement. The panel imposed a $27,500 fine and three-month suspension. Both sides appealed, and the Appeals Panel substantially upheld the decision while increasing the suspension to one year. Cody petitioned the SEC to overturn the findings and penalties, save for the ruling about the monthly statements, and delayed reporting of the settlements. The SEC affirmed FINRA’s decision based on an independent review of the record. Cody then appealed the SEC decision to the First Circuit.
The Court’s Analysis of Suitability Obligations
Although the conduct at issue in Cody was governed by the prior suitability rule, NASD Rule 2310, the Court’s discussion is equally relevant to the current rule, FINRA Rule 2111. FINRA Rule 2111 codifies the three main suitability obligations: reasonable-basis suitability, customer-specific suitability and quantitative suitability. Cody involved each of these components, but particularly reasonable-basis suitability, which requires the member and associated person to conduct “reasonable diligence” on the security such that they have “an understanding of the potential risks and rewards associated with the recommended security or strategy.” FINRA Rule 2111.05.
On appeal, Cody argued that he sufficiently understood the Credit Suisse Security before recommending it, based primarily on his discussion with a colleague (a principal at the firm where Cody was licensed) who specialized in fixed-income securities. Cody’s colleague provided information such as “the issuer, the coupon percentage, the date of maturity, the nature of the collateral and the chance for prepayment,” as well as a printout from Bloomberg. Cody also knew that the security had an “A” credit rating. The Court observed that notwithstanding this “basic information,” Cody “did not know that the security’s credit rating had been recently downgraded [from “AA”], he did not know that the security was one of the riskiest tranches of securities collateralized by the same pool of assets, and, by his own admission, he did not understand that securities collateralized by housing assets have fundamentally different risks than traditional bonds that are backed by the credit of a government or a corporation.” Most important, the Court held that Cody’s colleague’s recommendation did not “immunize” Cody; the “responsibility to investigate belonged to Cody” as the one making the recommendations to the customers.
The Court’s decision emphasizes a representative’s independent obligation to educate him or herself on the significant characteristics of the security he or she intends to recommend to customers.4 The decision illustrates the in-depth investigation that a representative must make in order to understand the risks of relatively complex securities such as CMOs.5 The import of the Court’s decision is that before recommending the CMO, Cody should have investigated the ratings history (i.e., the recent downgrade), the risks of the tranche he recommended (in this case, one of the riskier tranches), and the specific risks of the underlying collateral, not merely the general nature of the collateral.
Cody also appealed the SEC’s determination that three non-investment grade corporate bonds — which the customer sold at a profit — were unsuitable. Cody claimed that he purchased these higher-yielding and riskier investments because the customer had increased his monthly withdrawals from $2,000 to $2,500, indicating a need for higher yield investments. The SEC held, and the First Circuit agreed, that this increase in withdrawals did not by itself signal a change in the customer’s investment objectives that would justify a move to riskier investments.
Finally, Cody challenged several aspects of the SEC’s finding that Cody had engaged in excessive trading through a pattern of in-and-out trading over which he exercised de facto control. In one account, which had an average market value of less than $425,000, Cody executed 140 trades over a year period, resulting in a turnover ratio of 3.4 and a commission to equity ratio of 8.7 percent. Trading in another account was of a similar frequency and magnitude. The Court rejected Cody’s arguments that the excessiveness of the trading should be measured against the entire life of the account, not just one year, and that all of the DeSimone’s accounts should have been considered in the calculations, not just the IRA account. On the latter point, the Court noted that the customer’s accounts had different objectives, and therefore it was appropriate to focus only on the IRA account.
The First Circuit decision makes clear that representatives have an independent duty to educate themselves as to the specific characteristics of the securities they recommend, including their risk profile, and that they must make a knowing assessment of the security before making recommendations to customers. Any lack of understanding as to a security’s features on the part of a representative recommending the security to his or her customers will expose the representative to a possible suitability claim. Therefore, firms would do well to educate their representatives on the products they recommend before allowing them to recommend those products. For the more complex securities being offered today, this may require specific training of representatives before they are authorized to recommend such securities. For other securities, it may mean providing representatives with access to sufficient information about the security for them to make an informed decision as to whether or not it is suitable for a customer based on the customer’s suitability profile6 before making a recommendation.
1 Cody v. Securities and Exchange Commission, &under;&under;&under; F.3d &under;&under;&under;, No. 11-2247, 2012 WL 3871561 (1st Cir. Sept. 07, 2012). The facts are stated in more detail in the SEC’s decision, Release No. 64565 (May 27, 2011), 2011 WL 2098202.
2 He invested $86,500 from James Bates’ IRA (23% of the total account) and $31,725 from the DeSimones’ joint account (13% of the total account).
3 In 2005, shortly after moving to another firm, Cody entered into settlements with the four customers, compensating them for their losses on the Credit Suisse Security, but he did not amend his Form U-4 until September 2007.
4 Recent FINRA guidance similarly states that “even if a firm’s product committee has approved a product for sale, an individual broker’s lack of understanding of a recommended product or strategy could violate the [reasonable-basis suitability] obligation, notwithstanding that the recommendation is suitable for some investors.” Regulatory Notice 11-25 (May 2011), at page 8.
5 The heightened suitability concerns presented by complex securities such as asset-backed securities have been a consistent focus of FINRA, as discussed most recently in FINRA’s Regulatory Notice 12-03 (Jan. 2012).
6 The suitability rule lists the information that presumptively should be requested for an investor’s customer profile, and requires members or associated persons to use “reasonable diligence” to seek that information. FINRA Rule 2111(a) and 2111.04.