Failure to Diversify

One of the most effective ways to manage risk in an investment strategy is by diversifying a portfolio. As the old saying goes, “don’t put all your eggs in one basket.” While this is perhaps one of the most fundamental rules of investing, it is also one that is often ignored. Stock brokers and financial advisors have a fundamental obligation to diversity their customer’s holdings across different sectors and asset classes. The failure to diversify can often lead to significant losses.

The Fifth Circuit Court of Appeals, in Metzler v. Graham, explained that it is difficult to establish a fixed percentage in evaluating failure to diversify cases, explaining, “[t]he degree of investment concentration that would violate this requirement to diversify cannot be stated as a fixed percentage, because a fiduciary must consider the facts and circumstances of each case.” Metzler v. Graham, 112 F.3d 207 (5th Cir. 1997). The Financial Industry Regulatory Authority, or FINRA, offers a similar note of warning, “[t]here is no simple or single answer that is right for everyone. Whether your stock portfolio includes six securities, 20 securities or more is a decision you have to make in consultation with your investment professional or based on your own research and judgment.”

While it is correct that courts and arbitration panels evaluate failure to diversify cases on a case-by-case basis, there are a number of court cases that provide examples of impermissible conduct. We have summarized cases from several jurisdictions below.

GIW Industries, Inc. v. Trevor, Stewart, Burton & Jacobsen, Inc., was an Eleventh Circuit Court of Appeals decision concerning the failure to diversify a bond portfolio. The case originated from a district court decision in Georgia. The Court found that a concentration of 70% in government bonds with a single maturity date created an unreasonable risk. see GIW Industries, Inc. v. Trevor, Stewart, Burton & Jacobsen, Inc., 895 F.2d 729 (11th Cir. 1990).

In Culbertson v. J.J.B Hillard and W.L. Lyons, a FINRA arbitration panel in Ohio awarded $129,000 in compensatory damages as well as $45,150 in attorneys’ fees. FINRA Case 11-03226. The case concerned the brokers, failure to diversify a client’s account. According to the FINRA award, the Claimant alleged that her assets were over-concentrated almost exclusively in low-growth cash and fixed income investments.

In re Estate of Janes, was a 1997 cases decided by the New York State Court of Appeals, which, despite the misnomer, is the highest court in New York State. In that case, the Court found that there was sufficient evidence at trial to find that an investment portfolio, which included a 71% concentration in Kodak stock constituted a failure to diversify. See In re Estate of Janes, 90 N.Y.2d 41 (N.Y. 1997). The trial court in arriving at this conclusion that the investment allocation was not diversified also considered the age and lifestyle of the investor, who was a 72 year old widow.

In a Securities and Exchange Commission administrative proceeding, Paine Webber, Inc. was ordered to, among other things, pay an administrative fine of $5 million for failing to diversify client assets. This case is significant because it involved illiquid private placements rather than traditional equities like stocks or mutual funds.

In Plasterers’ Local Union v. Pepper, was a Fourth Circuit Court of Appeals case concerning the failure to diversify certificate of deposits. The case concerned an appeal of a Maryland district court holding. The appeals court found that the Maryland district court appropriately found that a concentration in conservative investments of CDs of less than $100,000 and treasury bills was unreasonable. However, the case was ultimately remanded back to the district court to calculate what damages, if any, should be awarded. Plasterers’ Local Union v. Pepper, 663 F.3d 210 (4th Cir. 2011)

In Van Billiard v. Farrell Distrib. Corp., a federal district court in Vermont held that a plaintiff demonstrated a prima facie case, defeating a motion to dismiss, by alleging that the defendant invested over 90% of their assets in equities and only 10% in fixed income. Van Billiard v. Farrell Distrib. Corp., 2009 U.S. Dist. LEXIS 112381, 2009 WL 4729965 (D. Vt. Dec. 3, 2009).

If you or someone you know suffered investment losses due to a non-diversified portfolio, you may be able to recover your losses. Contact the law firm of Fitapelli Kurta today for a free and confidential consultations.