Assigning investment responsibility
In the aftermath of dramatic losses by investors in bond markets last year, securities professionals and their customers who invest for city, state and other municipal pension funds are trying to settle on the ground rules for allocating responsibility.
Dealer responsibilities have recently been clarified as a result of a new suitability interpretation promulgated by the National Association of Securities Dealers (NASD) in Washington. These new guidelines state explicitly that under normal circumstances, there is an arm’s-length relationship between dealer and institutional customer. As a counterparty to transactions with their customers, dealers do not have any fiduciary obligations nor do they perform the function of investment advisor.
Still, substantial legal and ethical standards apply to dealers when they sell securities to any customer. These include provision of a clear and complete description of the securities being sold, the price of the instrument expressed in a market-transparent format, disclosure of any material nonprice considerations and efforts to assure investor understanding of the instrument.
But while securities professionals are scrutinizing their suitability obligations, relatively little has been written about the flip side of suitability — that is, the responsibilities of institutional investors as they enter into securities transactions.
Efforts to shift investment losses to dealers who have met their responsibilities carry ominous implications for the industry and markets. A dealer must know with certainty that, if he or she behaves in a lawful and ethical manner, there is a binding transaction. It is for this reason that the dealer’s duties in selling securities must be clearly articulated.
In order for markets to operate at all, there has to be a certain time in every transaction when the economic risk of a security transfers from seller to buyer. Considerations of equity should line up hard against any investor who reaps the benefits from an aggressive investment program in rising markets and afterwards, in declines, looks to duck losses by asserting the investments were unsuitable.
Institutional investors must own up to the fact that the financial markets of today are risky and volatile and that there is no appropriate means of dealing with this except to trust investment decisions to competent professionals who, in turn, provide responsible reporting and informed oversight. Innovation in financial markets has come a long way toward developing instruments that permit investors to manage risk in these volatile markets.
NASD’s suitability rule does not guarantee that an investment is, in fact, a wise choice or even an appropriate one for an investor — though this is certainly the rule’s objective. The thrust of the rule is that a dealer’s recommendation should be suitable, based on information disclosed by the investor.
Seldom will a dealer have all the necessary information to be assured that securities will precisely fit an investor’s investment strategy, unless the dealer is acting as an investment advisor. This would require not only complete and unfettered access to information fully describing all the financial assets of the customer, but a complete picture of current and expected cash flows as well.
Sometimes, dealers are prepared to act as investment advisors and even as asset managers for their customers — a different arrangement from the normally arm’s-length relationship between dealers and investors. But, it is imperative for all investors to realize that, in the end, it is their responsibility to decide what to choose from the menu of suggestions presented by a dealer.