Failure to Diversify / Overconcentration

Overconcentration is often the result of a stockbroker making unsuitable investment recommendations to an investor. A stockbroker’s failure to diversify an investment portfolio increases the risk that the investor will suffer losses in their account. The goal of diversification is straight-forward: spreading out investment risk to minimize the risk of loss.

When assessing whether the account concentration is consistent with an investor’s profile and is therefore appropriate for an investor, a stockbroker must consider the investor’s:

• Age,
• Financial condition,
• Risk tolerance,
• Investment objectives, and
• Sophistication.

Stockbrokers must also abide by the standards set out in Regulation Best Interest, which requires them to place their customers’ best interest ahead of their own when making investment recommendations.

To manage risk, broker-dealers and brokers are expected to avoid overconcentration of investor portfolios in a single security (i.e., investing only in Apple stock), a single group of securities (i.e., investing only in tech stocks), or a single asset class (i.e., investing only in stocks “aka” equities, fixed income such as bonds and funds, or real estate). Investing in different asset classes reduces the risk of loss for the investor. Diversification represents a prudent investment strategy that seeks a balance between returns, credit risks, liquidity risks, interest risks, market volatility, and other economic events.

A FINRA arbitration claim to recover damages suffered due to of a broker’s overconcentration of a customer’s account or failure to diversify is at least partly based on whether the broker managed these risks.

A failure to diversify claim may also raise other issues such as whether the firm properly supervised the broker and the recommendations given to the investor, whether the firm established, maintained, and enforced a supervisory system and procedures reasonably designed to supervise the suitability of representatives’ recommendations, or whether the firm reasonably investigated internal red flags and any suitability concerns that may have been raised by the investor.

Until recently, under FINRA rules, broker-dealers were held to a suitability standard, and brokers had to recommend investments that were suitable for customers based on their investment profile. The recommendations did not necessarily have to be in the client’s best interest.

Through Regulation Best Interest (Reg BI), the Securities and Exchange Commission set out to enhance the relationship between broker-dealers and investors. Under Reg BI, broker-dealers are required to act in their customers’ best interest and not place the interest of the financial professional or financial institution ahead of the customers’ interests.

Fiduciary standards differ based on whether the investor is dealing with a registered representative at a securities broker-dealer or an SEC-registered investment adviser. Broker-dealers are not required to adhere to the same fiduciary standard as registered investment advisers. Federal law imposes a fundamental duty on registered investment advisers to act in their client’s best interests. The standard comprises a duty of care and a duty of loyalty.

Accordingly, a registered investment adviser who fails to diversify a customer’s portfolio or fails to act as a prudent investment manager is in breach of their fiduciary duty to the customer. Whereas a stockbroker’s recommendations to concentrate a customer’s account into the same security or type of security, may be a violation of Reg BI, but not be a breach of fiduciary duty.

Although securities laws establish a higher fiduciary standard for registered investment advisers, a fiduciary relationship may be formed between an investor and a broker-dealer if the stockbroker offers personalized investment advice to their retail customers, beyond advice that is incidental to the brokerage relationship. It may also be formed based on the scope of the relationship if a customer relies on a stockbroker’s representations about their financial expertise to solicit the client’s business, if the stockbroker has a high degree of control over accounts of elderly customers with little investment experience, or if the stockbroker assumes control over an investor’s account. Thus, a fiduciary relationship can be formed regardless of whether the investor has a non-discretionary brokerage account or a fee-based investment advisory account. Breach of fiduciary responsibilities may also be established by common law.

Investors should ask their broker questions to ensure that their investment account is adequately diversified across asset classes and sectors. Avoiding concentration risk is important for investors seeking to reduce their risk of investment losses. Investors should not put all their investment eggs in one basket and avoid investing in complex investments that they do not understand.

The Iorio Altamirano LLP legal team has represented investors in cases alleging failure to diversify and overconcentration and has experience litigating securities fraud cases before FINRA and JAMS. If you believe that your broker improperly overconcentrated your investment account, contact our stockbroker fraud attorneys toll-free at (855) 430-4010 for a confidential and free consultation today.