Investor and dealer responsibilities in securities transactions: when is redress for loss warranted?

• Author: McNair, Mark

When engaging in securities transactions, broker/dealers' obligation to recommend suitable transactions is matched by the public investor's responsibility for establishing clear investment policies, effective internal control and monitoring of investments, and adequate disclosure of investment performance.

Brokers and dealers have an obligation to recommend transactions that are suitable for their customers. This obligation is not a guarantee against loss, nor does it preclude investors from engaging in speculative transactions in hopes of obtaining higher yields; rather, it imposes a minimal burden on trained professionals who make affirmative recommendations. This longstanding dealer obligation, however, has been instrumental in the integrity of the United States financial market because many investors - including local governments, which are increasingly important market participants - believe that recommendations they receive will be in accord with their investment objectives and their tolerance for risk.

Because of this suitability standard, local government officials expect that their broker or dealer will make the most advantageous yet appropriate investments for their jurisdiction. As a result, most public investors, relying on recommendations of their brokers, have invested with confidence and success. Like other customers, some local governments have suffered losses, sometimes as a result of unsuitable investments - whether in derivatives or more traditional financial instruments.

This article focuses on three major issues. The first is the importance of local governments assuming greater responsibility when undertaking securities transactions. Just as local governments have responsibilities as issuers when they raise funds, so too local governments when they act as investors must ensure that funds entrusted to them are wisely invested and managed. The second issue addresses measures that local governments should take if they suffer losses in securities transactions - including disclosure, remedial action, and possibly seeking redress if the losses are the result of unsuitable recommendations or other inappropriate dealer activity. Third, the article highlights the importance of the dealer's responsibility to recommend suitable transactions. Dealers owe certain basic responsibilities to all of their customers, and there are strong public policy reasons not to diminish such responsibilities when making recommendations to public officials. Rare speculative behavior by local officials raises other policy issues but should not be a reason to abolish a dealer's suitability determination on which thousands of local governmental entities rely.

Roles of Investors and Dealers

Securities transactions place responsibilities both on the dealer making the recommendation and on the local governmental entity that is considering it. For their part, dealers must comply with rules of fair practice and ethical standards as well as state and federal securities laws. Specifically, suitability rules have been established by the National Association of Securities Dealers (NASD) and other self-regulatory organizations (SROs). In general, dealers must recommend transactions to customers which are suitable based on information regarding the security and the customer. This longstanding requirement forms the basis of the relationship between dealers and their customers and has been important in maintaining the integrity of the U.S. market. The scope of this requirement, however, can be overstated by some investors: this obligation is not a guarantee against loss; it applies only to recommendations; and it does not preclude dealers recommending transactions with risks, provided such risks are disclosed and in accord with a customer's investment objectives.

Public-sector investors, likewise, must recognize and take appropriate responsibility when undertaking securities transactions. Because of their responsibility for the public trust, state and local government officials' primary objective is to seek investments that provide safety of principal, the required liquidity, and the commensurate yield. In seeking these investments, public investors place orders and/or receive advice, both solicited and unsolicited, on their investments from dealers. Although information provided by dealers on pricing, structure, and risk factors of an instrument may be otherwise unavailable, this does not relieve the local government of its responsibility for ensuring that the investment is prudent, safe, liquid, and consistent with its investment policies and objectives. In this regard, governmental investors should be aware of reasonably foreseeable risks of market price loss, illiquidity, nonmarketability, or default because dealers are not insurers against losses that may result from market fluctuation or poor choices in the instruments purchased. Therefore, governmental investors are cautioned to understand thoroughly the instruments in which they choose to invest and to ensure that the prices offered are reasonable.

Many losses suffered by local governments, but not all, could have been avoided if the local governments had taken greater responsibility when considering securities transactions. Ideally there should be "shared" responsibility for securities transactions; however, the importance of local governmental entities taking appropriate responsibility for investments does not in any way obviate the longstanding regulatory requirement that dealers make suitable recommendations.

Losses in Securities Transactions

Many investors have used complicated securities products advantageously, and securities products can be expected to become increasingly complex to meet the special portfolio objectives of some sophisticated investors. There have been, however, several incidents in which purveyors of derivatives, as well as investors in both the public and private sector, have experienced severe consequences as a result of their participation in this area of the market. Bankers Trust, a major developer of these instruments, came under extreme pressure as a result of its questionable sales practices involving derivatives, evidenced most notably by tapes of trading desk conversations, which led to a consent order. Two of its customers, Gibson Greeting Cards and Proctor & Gamble, both alleged fraudulent misrepresentation regarding interest rate swap transactions with Bankers Trust. Gibson alleged 1) that the transactions contained substantial and material risks that were not determinable by Gibson upon a reasonable review, 2) that Bankers Trust as designer of these products knew the risks and had a legal duty to disclose them, and 3) that Bankers Trust misrepresented the value of Gibson's derivative securities to Gibson's detriment.

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