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An Important Reminder About Concentration Limits: How Much is Too Much?

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Financial Services E-Blast
February 7, 2018

If you work with clients in the State of Ohio, it is important to be mindful of concentration limits placed on the recommendations of direct placement programs (DPPs), such as non-traded real estate investment trusts (“REITs”). Under the Ohio Administrative Code, an advisor cannot recommend DPPs that make up more than 10% of a client’s liquid net worth.

On this topic, the Ohio Division of Securities recently issued Order No. 17-018 providing notice of intent to suspend or revoke an individual’s Ohio Investment Adviser Representative and Ohio Securities Salesperson licensure for exceeding these concentration limits. The advisor at issue in the Order sold securities in excess of the 10% concentration limit despite order tickets and alternative investment account forms identifying client net worth and despite product prospectuses prohibiting the sale of a particular security in excess of 10% of a client’s liquid net worth.

The Division of Securities’ enforcement of concentration limits arises from the nature of direct placement programs—these investments tend to have higher risks to investors—and the “know your customer” requirement. In this regard, an investment professional may only recommend a security that is suitable for his or her client based on that individual’s investor profile. Specifically, OAC 1801:6-3-19(A)(5) states that no dealer or salesperson shall:

Sell, purchase, or recommend the sale or purchase of any security without reasonable grounds to believe that the transaction or recommendation is suitable for the customer, based upon reasonable inquiry concerning the customer’s investment objectives, financial situation and needs, and any other relevant information known to dealer or salesperson.

See also FINRA Rule 2111.

Brokerage firms also have a corresponding supervisory duty to monitor customer accounts and identify instances where customers are invested in excess of the designated concentration limit. OAC 1301:6-3-19(B) states that no dealer shall:

(1) Fail to institute reasonable procedures and to adopt reasonable precautions designed to avoid the sale or other disposition of any security by a salesperson employed by the dealer upon representations contrary to the statements contained in the registration by description or application for registration by qualification or in a manner contrary to the terms of any order of the division relating to the securities;

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(9) Fail to reasonably supervise a salesperson or other persons associated with the dealer or to establish reasonable procedures designed to avoid violations of Chapter 1707, of the Revised Code or of Chapter 1301:6-3 of the Administrative Code by salesperson or other persons associated with the dealer;

See also FINRA Rule 3110. For example, the Ohio Division of Securities issued a Cease and Desist Order against a well-known Broker-Dealer for approving the recommendation of DPPs in excess of the 10% concentration limit and for approving recommendations when there was conflicting information about a client’s liquid net worth. As a result, the Division took the position that the recommendations were unsuitable, violated Ohio’s concentration limits, and violated the prospectus’ concentration limits. The Division also alleged that the Broker-Dealer failed to supervise its salespersons by approving at least eight recommendations that violated these rules. See Order No. 16-008 (March 14, 2016); Order No. 16-016, (June 1, 2016).

To ensure compliance with Ohio’s concentration limits, advisors and firms doing business in the State of Ohio should:

  1. Review their training and education programs. Advisors and firms must understand Ohio’s concentration limits and how to properly calculate a client’s liquid net worth.
  2. Understand their documentation. Before making or approving an investment recommendation, advisors and firms must understand all documents on file for a client. If there are forms showing different information about a client’s liquid net worth—for example, a new account form completed years prior—advisors and firms must understand why the information is different. It is imperative that the point of sale documentation for the DPP is accurate and does not inflate a client’s liquid net worth to bring the sale within the 10% concentration limit.
  3. Review their supervisory procedures. Firms must understand who is licensed to sell securities in the State of Ohio and be mindful of any recommendations into DPPS to ensure recommendations comply within the 10% threshold.

If you have any question Ohio’s concentration limits, or any issues impacting the financial services industry, please contract a member of our Securities Litigation Practice Group.