CONCENTRATION
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A. SEC ADMINISTRATIVE ACTIONS:
1. In re Dean Witter Reynolds, Inc., n/k/a Morgan Stanley Dean Witter, Inc., Mark Rodgers, and Paul Grande, Securities Exchange Act Release No. 46578 (October 1, 2002).
i) Dean Witter monitors security positions firm-wide in an effort to detect and prevent excessive concentration levels in any security held by the firm or individual branch offices. In that regard, Dean Witter requires its compliance department to prepare concentration reports on a monthly basis in order to inform management of concentrated security positions maintained by the firm or individual branch offices. If a security reaches specified concentration levels, Dean Witter imposes certain restrictions on the trading of those issues to limit further accumulation.
ii) Rodgers continued purchasing e-Net stock for his customers, on margin, and without any restrictions from Dean Witter. Dean Witter management was never aware of this procedural breach because Dean Witter did not prepare the concentration report during this critical time period due to a shortage of available personnel. Had Dean Witter generated the concentration reports for the months of April, May and June 1998, the size of the e-Net position would have been flagged, and most likely restricted to purchases requiring prior compliance department approval.
2. In re Paine Webber, Securities Exchange Act Release No. 36724 (January 17, 1996).
i) First, the heavy concentrations of Geodyne in numerous customer accounts, and the customers' conservative investment objectives, were apparent from the RR's customer records, which, under PaineWebber procedures, the BOM was required to review quarterly. Moreover, the RR received numerous awards and was publicized in PaineWebber literature as a leading seller of Geodyne. Notwithstanding signs of excessive concentration of Geodyne, the BOM failed to conduct a reasonable inquiry into sales of Geodyne. Such an inquiry was particularly appropriate because, by 1990, the BOM was informed of at least three customer complaints against the RR relating to Geodyne. Had the BOM contacted the RR's customers and discussed the suitability of their investments in Geodyne in light of their conservative investment objectives, he could have learned that the RR was inaccurately representing Geodyne to his customers.
ii) The resident manager in place in and after March 1990 failed reasonably to supervise the RR referred to above by (1) failing to do any independent checks on the suitability of direct investments for the various customers; (2) failing to monitor the outgoing mail to prevent the RR from sending out false valuations; (3) signing and approving the mailing of one false account valuation without verifying its contents; and (4) failing to conduct adequate quarterly portfolio reviews of the RR's customers, which would have alerted him to the extensive overconcentration and unsuitability of the direct investments in many of these accounts.
3. In re F. Otto Busot, Securities Exchange Act Release No. 37660 (September 9, 1996).
i) Hampton sold direct investments to customers for whom the investments were not suitable in light of their age, financial condition and conservative investment objectives. Many of Hampton's customers were retired or close to retirement and expressly informed him that they desired liquid, income-producing, low-risk investments. In several instances, Hampton concentrated all or most of these customers� investments in direct investments, which were not liquid and not suitable for investors with conservative investment objectives.
ii) Notwithstanding signs of excessive concentration of direct investments, Busot failed to conduct a reasonable inquiry into Hampton's sales of direct investments. Such an inquiry was particularly appropriate because, by the time of the violations described above, Busot had been informed of several customer complaints against Hampton relating to direct investments. Had Busot contacted Hampton's customers and discussed the suitability of direct investments in light of their conservative investment objectives, Busot could have learned that Hampton was misrepresenting the nature of direct investments to his customers.
B. NASD REGULATORY MATERIAL:
4. BEFORE THE NATIONAL ADJUDICATORY COUNCIL NASD REGULATION, INC., NASD Dep�t of Enforcement v. Daniel Richard, Complaint No. C11970032 (November 16, 2000).
The suitability rule can be violated in a number of ways. Most often, the rule is violated based on the quality of the recommended transactions when compared to the customer's financial situation and needs. See In re Rafael Pinchas, Exchange Act Rel. No. 41816, at 10-12 (Sept. 1, 1999). The rule also can be violated if a representative's recommendations are quantitatively unsuitable.
Even where a customer affirmatively seeks to engage in highly speculative or otherwise aggressive trading, a representative is under a duty to refrain from making recommendations that are incompatible with the customer's financial profile. See In re John M. Reynolds, 50 S.E.C. 805, 808-09 (1992) (regardless of whether the customers wanted to engage in aggressive and speculative trading, the representative was obligated to abstain from making recommendations that were inconsistent with their financial situation); In re Gordon Scott Venters, 51 S.E.C. 292, 294-95 (1993) (same).
5. BEFORE THE NATIONAL ADJUDICATORY COUNCIL NASD REGULATION, INC., NASD Dep�t of Enforcement v. James B. Chase, Complaint No. C8A990081 (August 15, 2001).
A customer's investment objectives, however, are but one factor to consider in determining whether the broker's recommendations were suitable for the customer. Furthermore, a broker cannot rely upon a customer's investment objectives to justify a series of unsuitable recommendations that may comport with the customer's stated investment objectives but are nonetheless not suitable for the customer, given the customer's financial profile. Again, during the hearing on appeal, Chase's attorney argued that Chase had fulfilled his suitability obligation by disclosing to YH the risks associated with following his recommendations to purchase FHC and to open a margin account. Although it is important for a broker to educate clients about the risks associated with a particular recommendation, the suitability rule requires more from a broker than mere risk disclosure. See Patrick G. Keel, 51 S.E.C. 282, 286 (1993) (noting that a broker must ensure that the customer understands the risks involved in a recommended securities transaction, in addition to determining that the recommendation is suitable for the customer).
("The proper inquiry is not whether [the customer] viewed [the broker's] recommendations as suitable, but whether [the broker] fulfilled his obligation to his client.").
Chase argued that because YH was studying economics in college and was able to download information about FHC off of the Internet, she had sufficient knowledge to evaluate the suitability of the investment for herself. A college economics course and access to information do not, however, constitute "investment experience" or "sophistication." Cf., Peter C. Bucchieri, 52 S.E.C. 800, 805 n.9 (1996) (noting that customer's graduate degree from Harvard did not make him a sophisticated investor).
Nor do we find that Chase should be absolved of responsibility for his recommendations because YH's mother, accountant, and attorney were all allegedly involved in YH's financial planning and received duplicate confirmation forms. There is no evidence that these three people had any investment knowledge or experience, nor do we know the extent to which they participated in the management of her affairs. Even if they did, Chase would in no way be relieved of his suitability obligation. As a licensed securities professional, Chase had a duty to recommend only suitable investments to YH. The fact that YH's mother, attorney and accountant, who were neither Chase's clients nor licensed securities professionals, may have received information about the purchases that Chase made for YH's account does not reduce, alter, or relieve Chase from his suitability obligation.
We find that the Hearing Panel's fine and requirement to requalify are appropriately remedial and consistent with the Guideline, but we believe that the egregious conduct at issue here warrants an increase in the suspension from six months to one year.14 We are troubled that Chase demonstrated a complete lack of understanding of his suitability obligation. Rather than recommending the investment of some of YH's assets in a growth stock to generate a greater return in light of her monthly withdrawals, Chase recommended that she purchase FHC, a risky stock issued by a company with no operating history or profits, until it comprised 100 percent of her portfolio. Chase also recommended the use of a margin account to purchase still more FHC stock, until she held more in FHC shares than her entire liquid net worth. Chase testified that he believed his only responsibility to his clients was risk disclosure. This belief was erroneous. As explained above, regardless of the course the customer wants to take, a registered representative has a duty to refrain from making recommendations that are unsuitable for a customer, based on that customer's financial situation and needs.
6. NASD District Business Conduct Committee For District No. 3 v. Kevin D. Kunz, & Kunz and Cline Inc. Management, Inc., Complaint No. C3A960029(July 7, 1999).
Conduct Rule 2310 provides that a representative may make only such recommendations as would be consistent with the customer's financial situation and needs. See In re Larry Ira Klein, Exchange Act Rel. No. 37835, at 10 (Oct. 17, 1996). Even where a customer affirmatively seeks to engage in highly speculative or otherwise aggressive trading, a representative is under a duty to refrain from making recommendations that are incompatible with the customer's financial profile. See In re Gordon Scott Venters, 51 S.E.C. 292, 294-95 (1993); In re John M. Reynolds, 50 S.E.C. 805, 809 (1992). This is especially true where a broker/dealer's recommendation leads to a high concentration in the customer's account of a particular security or group of securities that are speculative. See, e.g., In re Clinton Hugh Holland, Exchange Act Rel. No. 37991, at 8 (Dec. 21,
1995), aff'd, 105 F.3d 665 (9th Cir. 1997) (table format).
7. NASD Dep�t of Enforcement v. Jack H. Stein, before the National Adjudicatory Council, NASD Regulation, Complaint No. C07000003 (December 2, 2001).
Stein's recommendations led EA to place significant portions of her asset value in speculative oil, gas, and mining securities, which were inconsistent with the relatively safe investments that she had held in the account prior to transferring her account to Josephthal. Even assuming, as Stein contends, that EA sought to speculate, Stein concentrated EA's account too highly in speculative securities.
C. FINANCIAL EDUCATION NETWORK DEVELOPMENT:
8. Mason A. Dinehart - Financial Education Network Development � See http://www.fend.com/ca.html October 4, 1997, updated 1-20-03. (Caution: The following was pulled from Mason A. Dinehart�s web site. All text below that is not in quotations must be paraphrased or attributed to Mason A. Dinehart.)
DUTY TO DIVERSIFY - The Prudent Investor Principle - Diversification is essential to prudent investing. One of the time honored investment maxims is that risk can be reduced by diversification. The Nobel Prize in Economics was awarded to Harry Markowitz in 1990 for a rigorous explanation of this principle. There is general agreement that a portfolio of investments is truly diversified only when it is made up of distinctly separate & broadly different asset classes (see Diversification Chart - Suitability Defined & Explained) It takes at least 50 stocks, spread among 5, usually 6 non-correlated asset classes to achieve adequate diversification and thereby reduce non-systemic risk. This is firm-specific risk - the risk of one company causing a significant move, either up or down, in a portfolio (Modern Portfolio Theory - Edward Elton & Martin Gruber - 1987). Even index funds alone do not assure that the diversification requirement is met. In recent years a handful of stocks have moved the S&P 500, and, even more, the NASDAQ Composite Index. In 1998 the top five stocks contributed 25% of the S&P 500 performance and 70% of the NASDAQ; the top ten stocks contributed 41% and 82% respectively! These are not broad cross-sections of American industry, as was the case as recently as 1995, when the top ten in the S&P 500 only contributed 13% of the performance. For real diversification today, international assets along with the Russell 2000 should be considered as well. For diversification internationally, one need not look to foreign stocks alone. American companies, as of year-end 2000, with their percentages of foreign earnings include; AIG (53%), Coca-Cola (82%), Gillette (63%), Intel (58%), Microsoft (37%) and Pfizer (49%). William Sharpe, another Nobel Prize winner from Stanford University and creator of the Sharpe Ratio wrote in 1978," Diversification does reduce risk, and the reduction can be greater, the wider the range of possible investments". The duties increase for the broker as fiduciary! A fiduciary may invest in many things but he should not gamble. Gambling may be defined as buying an asset without an inherent, ascertainable underlying buildup of value through earnings or interest. It is clear that a fiduciary must diversify unless it is clearly "prudent" not to! In the absence of specific authorization to do otherwise, a conscious concentration and lack of diversification would constitute a serious breach of fiduciary obligation. Further, breach of the duty to diversify constitutes an independent basis of liability, separate from a breach of the general duty of prudence (Liss v Smith, 991, F. Supp. 278,301 (SDNY, 1998)). Diversification is uniformly acknowledged to be a pre-requisite of a well managed account. Anything that deviates from that expected treatment of a customer must be justified by the broker. The decision to concentrate a portfolio in only one asset class, and not diversify, must be fully grounded in the broker's research, into (a) the portfolio design and (b) the specific securities selected. It is not sufficient simply to have a reasonable basis for recommending a concentration of securities in only one asset class, rather the broker/fiduciary must also have reasonable grounds for deviating from the norm of prudent investing! If a broker/fiduciary chooses to sell securities where there is a conflict with his own firm i.e. proprietary products, the required justification is even greater. The broker must make a reasonable determination that because of "special circumstances" it is more prudent not to diversify. Note that the test is prudence, not whether the broker thinks he can make more profits by not diversifying, but whether it is more prudent to forego the protection and risk diminution afforded by diversification. Note also, that the language "reasonable determination" implies an objective standard, not just the subjective opinion of the broker. For a fiduciary then, the threshold is even higher. A fiduciary must have a compelling reason not to diversify i.e. it must be "clearly prudent not to do so". Furthermore, prudent management is evaluated on an ongoing basis. Even if the broker may have had reasonable grounds at the outset, retaining the investments & increasing the concentration may become imprudent later. True diversification does not promise that the portfolio will outperform the market, only that it will be intelligently designed for the investor�s financial circumstances.
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