Unsuitable recommendation

A product can be perfectly legal, correctly priced and honestly described, and still be the wrong thing for the person buying it.

That is an unsuitable recommendation. The fault is not in the product. It is in the match between the product and the investor.

Chapter 10 lists it as one of the things an investor has to watch for. Some intermediaries, it says, may try to sell products that do not meet the investment objectives and risk profile of that particular investor.

The workbook gives one example, and it is worth memorising. A stock broker advises a senior citizen with low risk tolerance to deal in futures, options or penny stocks.

Nothing in that is illegal. Futures and options are regulated products on a regulated exchange. They are simply not for her.

The advice the chapter gives investors is blunt. Review the risk attached to every recommendation you are handed.

The definition (Chapter 10, opening section). An investor should be careful about the suitability of the investment products being suggested or sold to him against his specific investment objectives. Some unscrupulous intermediaries may try to sell products that do not meet the investment objectives and risk profile of that particular investor. The remedy the workbook puts on the investor is to review the associated risk of each investment recommendation.

What a suitable recommendation looks like in this paper. Section 10.2 states the derivatives desk's side of the same duty:

• brokers and dealers are expected to know their clients and to exercise care to ensure the derivative product being sold is suitable to his understanding and financial capabilities;
• they should avoid recommending futures and options to a client unless they have a reasonable basis for believing that the customer has such knowledge and financial experience that he or she is capable of evaluating, and financially able to bear, the risks of the transaction;
• they must seek to obtain and verify specific categories of information about the client, including, but not limited to, net worth, annual income, and investment experience and knowledge;
• they must give the client a detailed explanation of the special characteristics and risks of trading derivative products, and issue and obtain a signed Risk Disclosure Document at account opening.

Why derivatives sharpen the problem. Section 10.2 says the potential risk of trading with derivatives, as opposed to hedging, is not widely understood, and that in pricing complex contracts there is a real danger of unethical sales practices — clients "may be fleeced or induced to buy unsuitable derivative contracts at unfair prices and without properly understanding the risks involved". Options are named as a more complex product than futures, because judging whether the premium is fair is difficult. The leveraged nature of derivatives then magnifies everything: a small initial outlay can encourage a client to build positions beyond his risk tolerance, and the option seller's risk is unlimited and can run to many times the premium collected.

The risk profile a recommendation has to fit. Section 10.1 names the parameters on which risk tolerance can depend: age, personal income, combined family income, number of dependents, occupation, marital status, education, existing liabilities and access to other inherited sources of wealth. The same section warns that an investor's objectives are often poorly developed and unrealistic, that people find it difficult to describe their attitude to risk in their own words, that new investors may not understand the concepts an adviser puts to them, and that a single investment model will not fit all.

Where the pitch happens. The chapter names investor seminars as a place where advisers may pitch unsuitable products, and tells investors to avoid rushed decisions there and to seek objective third-party advice before committing funds. The contact rules in the same section bar sales agents from exploiting a person's inexperience, vulnerability, credulity or loyalties, from high pressure or luring tactics, and from calling outside 9 am to 8 pm unless the customer asks.

The figures SEBI now forces onto the screen. Following a SEBI study published in January 2023 on individual traders' F&O results in FY 2021-22, brokers must display Risk Disclosure facts as a pop-up at every login, which the client must acknowledge before proceeding: 9 out of 10 individual F&O traders incurred net losses; loss makers registered net trading losses close to Rs 50,000 on average; loss makers spent a further 28% of those net trading losses on transaction costs; those making net trading profits spent 15% to 50% of the profits on transaction costs. Brokers must keep individual clients' profit and loss data for at least five years.

Illustrative client. The percentages and the Rs 50,000 are the workbook's own study figures.

Mrs Saroja Iyengar, 68, a retired schoolteacher in Mysuru, brings Rs 6,00,000 of retirement money to a broking branch. She says she wants safety and a little income. On the Chapter 10 parameters her profile reads: age 68, no salary income, one dependent, no inherited wealth, low risk tolerance.

The dealer recommends writing index call options for the premium income, plus two penny stocks "for the upside".

Why this is the workbook's own example of unsuitability

What the study figures do to her corpus. Treat her as a typical individual F&O loss maker:

Average net trading loss of loss makers  = Rs 50,000
Extra transaction costs, 28% of the loss = 0.28 x 50,000 = Rs 14,000
Total damage                             = Rs 64,000
As a share of Rs 6,00,000                = 10.7%

Rs 64,000 is not a catastrophe on its own. The point is the base rate: 9 out of 10 individual traders in this segment incurred net losses, in an account that was never built to carry the risk. And writing options exposes her to a loss with no stated ceiling at all, which is a different order of problem from Rs 64,000.

What the branch should have done. Seek and verify her net worth, annual income, and investment experience and knowledge. Find no reasonable basis for believing she can evaluate or bear F&O risk. Recommend nothing in that segment. Issue and obtain a signed Risk Disclosure Document if she trades at all, show her the four login facts, and retain her profit and loss data for at least five years.

Two names for two different failures. Suppose the dealer had instead put her into products that did suit her, but traded them 40 times a month to earn brokerage. That is churning, not an unsuitable recommendation. The wrong product is unsuitability; excessive trading for commission is churning. Both can sit in the same account at once.

Chapter 10 (Sales Practices and Investor Protection Measures) names Unsuitable Investment Recommendations in its opening list of investor cautions, between "High Return" or "Risk-Free" investments and churning. Section 10.1 supplies the risk-profile parameters, and section 10.2 supplies the derivatives broker's suitability duty and the Risk Disclosure Document.

Expect three shapes of question. A definition question, with churning as the distractor — the two are defined in consecutive paragraphs. A scenario question that gives a client's age, income and stated objective and asks whether a named product is suitable; the senior-citizen-and-futures pattern is the workbook's own illustration. And a duty question: what a derivatives broker must seek to obtain and verify before recommending F&O (net worth, annual income, investment experience and knowledge), and on what footing it may recommend at all (a reasonable basis for believing the client can evaluate and financially bear the risks).

• Unsuitability is about the product-to-investor match; churning is about trading frequency for commission. The workbook defines them one after the other and the paper uses each as the other's distractor.
• Nothing has to be illegal or dishonest. An unsuitable recommendation can be made in good faith about a well-run product on a recognised exchange. That is what separates it from fraud.
• Disclosure does not cure it. A signed Risk Disclosure Document tells the client what the risks are. It does not make an unsuitable product suitable for that client.
• "Avoid recommending" is the workbook's wording for futures and options where there is no reasonable basis for believing the client can evaluate and bear the risk. It is not an absolute prohibition on selling derivatives to retail clients.
• The information list is open. The broker-dealer must seek and verify specific categories of information including, but not limited to net worth, annual income, and investment experience and knowledge. Candidates drop "knowledge", and some treat the list as exhaustive.
• Section 10.1 names nine risk-tolerance parameters — age, personal income, combined family income, number of dependents, occupation, marital status, education, existing liabilities, access to other inherited sources of wealth — but introduces them as some of the key parameters. The list illustrates; it does not close.
• Investor seminars are a named item in the chapter, not an aside. So are the contact rules, including the 9 am to 8 pm calling window.
• Series VIII teaches unsuitability as an investor caution and a sales-desk duty, not as a numbered regulation. The adviser's Regulation 17 obligation is suitability and the stock broker's code-of-conduct duty is the suitability rule; both belong to other papers. This paper cites no regulation number for either, so do not attach one in an answer.
• It is also not mis-selling as that term is defined elsewhere. Mis-selling is a defined unfair trade practice under the PFUTP Regulations in another paper. Chapter 10 here describes the conduct and the duty without invoking that definition.