Know That Your Duties to Customers Extend "Beyond the Transaction"

n attorney recently told me that a rep's duties to his or her customers (in a non-discretionary account) terminate upon the consummation of the transaction. No wonder, that attorney cited a court opinion from 25 years ago. That court opinion is prehistoric in terms of how the securities industry and the roles of registered representatives ("financial advisors" and "financial consultants") have evolved.

Consider the rep who does not explain the risks of a particular investment or investment strategy which are unsuitable in light of the customer's financial capability or investment objectives. Likewise, consider the rep who fails to recommend a hedging strategy (such as a collar) for a customer who is unwilling or unable to sell his or her position. What are the duties of reps in those scenarios? In modern times, Professor Norman Poser states the guiding legal principle in his treatise Broker Dealer Law and Regulation (3rd Edition 2002 Supplement), at page 2-50:

Since the fiduciary duties of a broker [or financial advisor] include the duty to use the skill and diligence necessary to protect his customer's interests, negligent conduct may be a breach of fiduciary duty. In this regard, it is normally not sufficient for a broker to exercise ordinary care and judgment in discharging his duties; he must employ such care, skill, prudence, diligence, and judgment as might reasonably be expected of persons skilled in his calling. If his customer's money is lost because the broker undertakes his duties without possessing the requisite skills, or because of his negligence, the broker is liable for the loss.

Possessing the requisite skills makes good business sense. But reps should know that possessing the requisite skills is required to avoid liability to customers who suffer losses. Remember that reps, especially at the large wirehouses, have a wealth of resources to consult. Although reps in smaller firms may not have the in-house resources, they nonetheless should develop a network of competent professionals outside of the brokerage firms to answer those questions.

What are the standards used to judge liability? As stated by Professor Poser:

A court may consider a custom, practice, or usage of the securities industry, even though it is not formally embodied in an internal rule of the defendant brokerage firm, in order to determine whether the conduct of the firm or its employees was reasonable and in accord with applicable standards of conduct.

Broker Dealer Law and Regulation (3rd Edition 2002 Supplement), at page 2-155.

Standards of conduct relating to risk disclosure and duty to hedge are contained in the Content Outline for the General Securities Registered Representative Examination (Test Series 7). The Content Outline, authored by an industry committee of self-regulatory organizations and representatives from broker/dealers, states that a "critical function" of a rep is as follows:

[The rep] monitors the customer's portfolio and makes recommendations consistent with change in economic and financial conditions as well as the customers needs and objectives.

[The rep]:
Routinely reviews the customer's account to ensure that investments continue to be suitable.
Suggests to the customer which securities to acquire, liquidate, hold or hedge.
Explains how news about an issuer's financial outlook may affect the performance of that issuer's securities.
Determines which sources would best answer a customer's questions concerning investments and uses information from appropriate sources to provide the customer with relevant information.
Keeps the customer informed about the customer's investments.

The Securities Exchange Commission has noted that, "the industry committee updated the existing statements of the critical functions of registered representatives to ensure current relevance and appropriateness and drafted statements of tasks expected to be performed by entry-level registered representatives and conformed the existing Content Outline to the task statements". The Commission also stated that, "[t]he revised examination tests [and, hence, the Content Outline covers] relevant subject matter in view of changes in applicable laws, rules, regulations, products, and industry practices".

Accordingly, and in view of what are "industry practices", reps need to understand that their obligations go beyond merely executing transactions for their customers. Reps need to consult your firm's resources and/or your network of professionals who can assist you service your clients as you monitor customers' accounts. Reps need to speak up with risk disclosures and recommendations to hedge. In short, reps need to be a 21st Century Rep, not a dinosaur.