Hot Tips Turned Flops: Liability for Unsuitable Investment Advice - An Integrated Approach

This paper develops a new analytical framework for assessing losses from unsuitable investment advice, integrating both legal and economic aspects. First, a core of legal concepts for assessing losses is identified that is common to most jurisdictions. These include negligence in advice, causation as examined by the but-for-test, and the loss caused by the unsuitable advice. Building upon these legal concepts, five economic tests are developed for analyzing the causal chain from improper advice to financial loss. If the tests show that the advice was unsuitable, the investor did not know about it, the investment violated his risk patterns, and the assets most likely chosen with suitable advice would have performed better, an economic proof for establishing liability is provided, thus supporting legal assessments of losses. Several new analytical tools are suggested to substantiate the analysis. As a major conclusion, it is shown that proving liability for unsuitable investment advice gets more difficult, the more financially sophisticated an investor is.