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Commission Affirms Finra Sanctions For Unsuitable Recommendations

Richard G. Cody, Exchange Act Rel. 64565, May 27, 2011

Finra suspended Cody for one year and levied fines and costs totaling $34,000. It found he made unsuitable recommendations to retail customers, churned customer accounts, sent misleading information to customers, and failed to update his U4 to disclose settlements. The Commission upheld the sanctions on appeal.

The customers involved were largely unsophisticated in investment matters, had modest means, and were retired or nearing retirement. They were seeking low risk income producing investments.

Cody recommended Credit Suisse bonds collateralized by manufactured housing installment purchase contracts to two customers. The tranche recommended by Cody was eighth out of eleven tranches in priority. He described them to one customer as "asset backed securities supported by mortgages on homes." Cody did no independent investigation of the bonds and recommended them to customers after a brief conversation about them with another member of his firm.

He recommended highly speculative junk rated bonds to another customer. Those bonds yielded a gain of $2,000 on a $108,000 investment over a six month period when sold.

Cody also sent a customers spread sheets he prepared analyzing her account that used par value rather than market value for bonds, understating actual market value by 9% to 36%.

Cody settled complaints with two of his customers paying a total of $76,000. He did not amend his U4 disclosure form for two years to reflect these payments.

This case offers a good summary of the due diligence responsibilities of a sales agent who recommends a security to a customer. Agents must have "reasonable grounds for believing the recommendation is suitable upon the basis of the facts . . . disclosed by such customer as to his other security holdings and as to his financial situation and needs."

Recommendations violate this rule if:

  • the agent's understanding of the investment is insufficient to establish a reasonable basis for making a recommendation;
  • the agent inadequately assesses whether the recommendation is suitable for the specific investor; or
  • the level of trading is excessive in light of the customer's investment needs and objectives.
The Commission noted that Cody's recommendation of the Credit Suisse bonds was unreasonable as he made no investigation to determine their specific characteristics. He failed to learn what tranche they represented and how this would affect their risks and liquidity. It was imperative that he understand the "essential features" of those bonds including their credit rating history.

The test requires actual objective investigation and knowledge, rather than the rep's personal subjective belief in the suitability of the investment. See, F.J. Kaufman & Co. of Va., 50 SEC 164, (1989) ("a broker-dealer in his dealings with customers impliedly represents that his opinions and predictions respecting a [security] which he has undertaken to recommend are responsibly made on the basis of actual knowledge and careful consideration. . . . [I]t is not a sufficient excuse that a dealer personally believes the representation for which he has no adequate basis."); Distribution by Broker-Dealers of Unregistered Securities, Exchange Act Rel. 6721 (February 2, 1962) ("[T]he making of recommendations for the purchase of a security implies that the dealer has a reasonable basis for such recommendations which, in turn, requires that, as a prerequisite, he shall have made a reasonable investigation.").

Cody claimed that because the Credit Suisse customers had previous experience in buying asset backed securities his recommendations were reasonable. The Commission dismissed this argument noting that the customers' experience was irrelevant to the suitability of these particular bonds. See, Larry Ira Klein, 52 SEC 1030, 1037, n. 28 (1996); Hanley v. SEC, 415 F.2d, 589, 596 (2d Cir. 1969)("The fact that [the broker's] customers may be sophisticated and knowledgeable does not warrant a less stringent [investigation] standard.").

Cody also claimed that because his firm approved the transactions he has no liability. It noted that regardless of whether a firm monitors or approves transactions agents "are responsible for the suitability of the recommendations they make to their customers."

As to the non-investment grade bonds Cody recommendation the Commission noted they were per se unsuitable for the customer who was retired, had modest means, and wanted low-risk investments that preserved his principle. It noted that suitability is determined at the time a recommendation is made and therefore it is irrelevant whether or not the investment makes a profit.

Further, the Commission found that Cody engaged in excessive trading in a customer's account. Commissions during a sixteen month period were $41,000 while the account earned $32,000. The account would have needed to earn almost 9% just to pay the commissions.