Sunday, January 22, 2012

WSJ on the 'sophisticated investor' defense

By Tim Husson, PhD

The Wall Street Journal's Financial Advisor blog has a new article on the 'sophisticated investor' defense in securities litigation. This defense is typically used by defendants (usually banks or investment houses) in response to claims against them related to suitability of complex investment products. It boils down to the assertion that because a claimant has a high net worth, he or she is capable of understanding and willing to assume the risks of even extraordinarily complex strategies. From the article:

Regulators require that an investor have a certain amount of wealth–$1 million, for example–to be able to purchase certain complicated securities. But “money and sophistication are not synonymous,” says John Lovi, a securities litigator and founding partner of Steptoe & Johnson’s New York office.

He uses reality television star Kim Kardashian as an example: She may have more than enough money to be considered an accredited investor by the Securities and Exchange Commission, but that doesn’t mean she is sophisticated about investing, he notes.
The basis for this defense comes from the SEC's definition of accredited investors, which defines to whom investment houses can sell certain types of risky investments. These investments typically qualify for what is known as a Regulation D exemption, meaning they do not have to submit detailed financial information to the SEC in the interests of disclosure. This of course means that often very little is known about these investments, analyst coverage is poor or non-existent, and that the products would not likely be successful in a transparent marketplace with full disclosure.

At SLCG we encounter suitability issues in a wide variety of securities litigation cases, including cases where the claimant was wealthy but not financially sophisticated. We think it's encouraging that FINRA arbiters often make this distinction, even if their regulatory framework does not, but in the long term the best solution is probably to revise the regulations themselves to correct this simple logical error.

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