Business Memo: Defending Against Allegations of Unsuitability – Part I

Joseph R. Soraghan

By Joseph R. Soraghan

As pointed out in our July, 2003 issue, far and away the most frequent allegation brought against broker-dealers and RRs is alleged “unsuitability” of recommendations by RRs. As also pointed out in that issue, a claimant alleging unsuitability must show that the securities or investment program recommended were (1) unsuitable to the investor’s circumstances; and (2) that the broker-dealer and RR held sufficient “control” over the investor.

In that issue, we discussed what aspects of the RR’s recommendations could be unsuitable. In the next two issues, i.e., February, 2004 and September, 2004, we discussed what constituted “control” and what constituted a “recommendation.” In this issue we will discuss briefly the defenses available to a broker-dealer to a claim of unsuitability.

The most obvious and best defense, of course, is “suitability,” i.e., a showing by the broker-dealer that the offense alleged simply did not happen, and that all aspects of the RR’s recommendations were suitable. Other defenses which the broker should consider are lack of control, the statute of limitations (i.e., that the claimant’s eligibility to file a claim has expired), ratification, estoppel, waiver, and laches.

Ratification, Waiver, Estoppel and Laches

In this issue, we will discuss the defenses of ratification, estoppel, waiver and laches. The small broker-dealer should be aware of these defenses and should prepare its compliance systems to make such defenses in future claims.

Ratification

The theory of ratification is that the claimant-customer has ratified the actions of the broker-dealer and the RR, and thus is bound to accept them. In order to make this defense the broker-dealer must show (1) that the claimant knew all the material facts concerning the existence of his claim (i.e., knew that he had a valid claim); (2) that he had the intent to approve the actions of the broker-dealer now alleged to be unsuitable; and (3) that the customer has accepted the benefits of the broker-dealer’s actions.

Waiver

The theory of the defense of waiver is that the customer has waived the unsuitability of the broker-dealer’s conduct, or has waived his right or claim. In order to make this defense, the broker-dealer must produce evidence to show that (1) the claimant had actual or constructive knowledge that he had a valid claim; and (2) that the customer had an intention to waive his right or claim.

As can be seen, this claim is virtually identical to that of ratification.

Estoppel

The defenses of ratification and waiver essentially are based on a theory that the claimant has made a choice, and having done so must live by it. The defenses of estoppel and laches are based more on the theory that the claimant by his conduct has lured the broker-dealer into taking action which would be unfair and to the detriment of the broker-dealer if the claim was granted.

To make the defense of estoppel, the broker-dealer must show that (1) the claimant knew all the material facts giving rise to his claim; (2) that the claimant intended, or took actions leading the broker-dealer to believe he intended, that the broker-dealer act to his detriment based upon the customer’s inaction; (3) that the broker-dealer in fact did act to his detriment; (4) in reliance on claimants’ action or inaction.

Laches

The theory of the defense of laches is that the claimant has unreasonably delayed in asserting in his claim, to the prejudice of  he broker-dealer. Making the defense of laches requires that the broker-dealer show (1) knowledge by the claimant-customer that he has a claim against the broker-dealer; (2) unreasonable delay by the claimant in bringing his claim; and (3) prejudice or injury to the broker-dealer caused by such delay.

Analysis
The claims of ratification and waiver are virtually identical to one another, and the defenses of estoppel and laches are very similar to one another. All four of these defenses require a difficult showing that the claimant knew, or should have known, that he had a claim. Because it is virtually impossible to show actual knowledge, the hotly contested issue on which the parties produce evidence, and which the arbitrators must decide, is whether the claimant had sufficient information, and sufficient sophistication, to know that the actions of the broker-dealer or his RR were so unsuitable as to give the claimant a right to recover.

Some courts and arbitrators have ruled that once the customer has received account statements and confirmations, etc., even though he does not understand from them the unsuitability of the RR’s recommendations, the customer has a duty to be sufficiently suspicious to either know, or seek expert assistance about, whether the broker-dealer’s and RR’s actions were improper. Other courts and arbitration panels have ruled that account statements and confirmations, although they inform the customer that transactions have taken place, do not inform the customer that such recommendations and transactions were unsuitable, and therefore the customer does not have sufficient knowledge of his claim to have ratified or waived or for estoppel or laches to apply, simply because he received account documents.

Last, three of these defenses require a showing of intent on the part of the claimant. That is, for ratification or waiver, an intent to waive the unsuitability of the broker-dealers’ actions, and in estoppel, an intent to lure the broker into taking some action to the broker’s injury. Obviously, proving such an intent would be very difficult for the broker. And, to make a defense of estoppel and laches, the broker-dealer must show that he has been lured into prejudicial action or inaction by the claimants’ action or inaction. This is also a very difficult showing for a broker to make.

Also, these are “affirmative” defenses. That is, the burden  of proof of showing that the defense exists is on the broker and the RR. Theoretically at least, the burden is not placed upon the claimant of showing that these defenses do not exist.

These Defenses are Rarely Successful in Themselves
Courts, and probably arbitration panels, are generally reluctant to apply these defenses, particularly when the claimant is an unsophisticated investor. This is perhaps not surprising when it is remembered that in order for these defenses to even come into the play, the arbitrators must have decided that the actions of the broker and his RR were unsuitable.

Therefore, in establishing its supervisory and record keeping systems, the broker-dealer should realize that the actual best “defense”, in the event of a claim being made for unsuitability, is to be able to defeat the claimants’ allegations of unsuitability and lack of supervision in the first place. This will be discussed in a later issue of The St. Louis Broker-Dealer.

Reprinted from The St. Louis Broker-Dealer newsletter, July 2007.

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