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FINRA Rule 2111
“Suitability” is the requirement that licensed financial professionals make investments consistent with a client’s investment objectives. No other rule has generated so much controversy or litigation. Love or hate the suitability rule, it forms the backbone of investor protection in the United States.
The suitability rule can be found in the Financial Industry Regulatory Authority’s Rules at Rule 2111. It requires that a licensed broker dealer, acting through one of its registered representatives have a reasonable basis to believe that the investment or investment strategy being recommended is suitable for the client based upon a reasonable investigation into the client’s investment objectives.
There are a number of ways in which a broker dealer or registered representative can satisfy the investigation requirement into a client’s investment needs and objectives. First and foremost is by preparing an opening account questionnaire that asks important questions of the client. Questions seeking information on net worth, risk tolerance, liquidity needs, investment time horizon, investment experience, specific investment objectives such as speculation, aggressive, income or conservative are among the choices most commonly found on opening account documentation. Some firms ask more detailed questions in order to assign a ranking, which is then used to determine a detailed asset mix. Other less reputable firms have clients sign the form in blank (or worse, using DocuSign), then select the riskiest investment choice in order to sell the client risky and high commission investments.
Using the new account form as a roadmap, the broker dealer and registered representative are supposed to make recommendations that fit squarely within the stated risk tolerance and investment objectives. The suitability rule also requires firms to periodically update suitability preferences when they have a basis to believe that the client’s investment objective has changed. Life events such as the death of a spouse, retirement, unemployment, an inheritance or a major injury justify revisiting a client’s investment objectives, and documenting the changes in order to make sure that future investment recommendations are consistent with the client’s investment objectives, and in compliance with the suitability rule.
Broker dealers are also tasked with supervising the way in which the registered representative manages the account in order to achieve compliance with the suitability rule. Over concentration, unauthorized trading, excessive trading (known as churning) should generate red flags at the broker-dealer’s compliance level. Sophisticated computer programs are now available to assist brokerage firms in detecting abuse. Once violations are detected it is incumbent on the broker dealer to vigorously investigate the wrongdoing, and understanding the client’s investment objectives- and which investments are suitable for him or her- is key to determining the correct response.
FINRA has made it very clear that failure to document suitability is, in and of itself, a violation of its rules. Periodic audits and branch inspections by both the firm and FINRA personnel are all designed to achieve compliance with the suitability rule.
In addition to customer specific suitability, broker dealers are also required to adhere to what is commonly referred to as “reasonable basis suitability.” This can be thought of as the macro view of suitability. Whereas “micro” suitability pertains to specific recommendations to individual customers, “reasonable basis” suitability is concerned with making sure the investment offered has sufficient positive attributes to recommend it at all. This is particularly applicable when brokerage firms are approached with private placement offerings by sponsors who are looking to enlist the brokerage firm’s sales force in selling the investment to the firm’s customers. In order to make sure the investment isn’t a “defective product” FINRA requires the broker-dealer to perform an independent analysis to make sure the “deal points” are sound, and as represented. Brokerage firms are expected to review (and test) the financials, the fees being charged, risk factors and conflicts of interest, the history of the sponsor, as well as issues pertaining to permitting and licensing. All this is to make sure that the investment is suitable for at least some customers, not necessarily every customer.
Lastly, the concept of quantitative suitability requires that when a financial advisor is acting with discretion making investments for a client, the investments recommended are not over concentrated in a particular field. In other words, to ensure the account remains balanced, and not concentrated in a particular asset class or type of investment (such as a group of illiquid investments).
The suitability rule is one of the great innovations in investor protection. That FINRA chose to codify it and enforce it has resulted in a better informed and better protected class of retail investors. While it is costly from a compliance perspective, the broker dealers have been able to pass these costs along to customers, who have benefited greatly from heightened disclosures and supervision, which provide a measure of security lacking in unregulated markets.
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