FINRA Lawyer Blog
The Financial Industry Regulatory Authority (FINRA) views its mandate as investor protection and as such, they have given notice that a new suitability rule, Rule 2111, will go into effect on July 9, 2012.
As long as there have been investors and brokers, there have been people who take advantage and people who are taken advantage of. This rule codifies a standard that FINRA thinks is best for the investing public by imposing more stringent regulations on securities that a broker recommends to buy/sell, including those within a client’s existing portfolio. Rule 2111 has significant implications for broker-dealers who maintain retail brokerage accounts. The rule by its own terms, carves out institutional accounts: So if you are a broker-dealer that sells to hedge funds, this is not a game changer. But if you are selling to Main Street as opposed to Wall Street, then this is a very significant rule.
The new rule contains three guiding principles. Each recommendation must have:
- Reasonable-basis suitability (meaning the broker must understand the product).
- Customer-specific suitability (meaning the security or strategy must be in-line with the customer’s risk profile).
- Quantitative suitability (meaning the broker cannot “churn” the account or otherwise charge excessive fees).
The rule imposes new responsibilities upon a broker when recommending an investment to a customer. It used to be that the investment needed to be suitable upon execution – meaning that if you were going to recommend something, at the time of the recommendation you needed to be comfortable that the investment recommendation was suitable. This new suitability rule could now apply to not just a decision to buy or sell a security, but the decision to hold a security within a portfolio, which completely changes the whole dynamic. In fact, the broker’s “hold” recommendation must be suitable even if the securities were purchased at another broker-dealer.
Page two of the notice, which is lengthy and covers a lot, says the new rule imposes broader obligations on firms regarding recommendations of investment strategies. This means the new suitability rule not only applies to an individual recommendation of a security, but to the entire account from a strategy perspective. The notice also states that the term “investment strategy” is interpreted broadly and includes recommendations to hold a security or securities. The way this suitability rule is framed changes the whole landscape. So when you are assessing someone’s portfolio, you better have a good faith basis for saying you want to hold something. Otherwise, the decision, not whether to buy or sell, but merely to hold, can, in light of this new rule, be questioned as being an unsuitable recommendation.
How will regulators be made aware of possible infractions of the Rule? Issues like this often come to light either because a customer files an arbitration or through a written customer complaint to the employer. Once a complaint is filed, the securities administrator is obligated to report the complaint to regulators, who may decide that it is worth looking into.
Another way an issue could be discovered is through a cycle examination of a broker-dealer. The FINRA examiners may want to analyze the investment recommendation or the activity in 50 or 100 randomly selected accounts, whatever the case may be, and through their audit, they may stumble upon what they deem to be a rule violation.
There is a sort of preemptive action that broker/dealers can take. FINRA has published a new form for a new account document. Their position is that broker-dealers need to be making recommendations based on information disclosed on a customer’s account form. To facilitate that, they have provided a new model account form for brokers to look at. Further, FINRA suggested that firms consider revising order tickets to account for hold recommendations.
Firms would be wise to amend their new account forms as they go forward so that it captures the information that FINRA says they need to know. They should also begin training their brokers to capture the appropriate information and take heed of it when recommending a client buy, sell, or hold a particular investment.
Remember, when recommending a client to buy, sell, or hold a particular investment, make sure you have done your homework and that the recommendation is suitable to your client’s circumstances. Moreover, be careful when giving investment advice to non-account holders because FINRA makes clear that the term “customer” may apply to any person with whom you have even an “informal” relationship.
Prior to this rule, did your firm check the suitability of every hold recommendation as well? How will the new FINRA rule affect your internal processes? If you have any questions about the new suitability rule, Rule 2111, please feel free to give me a call at 212-897-5410 or email me at robert@