In July 2012, the new FINRA Suitability Rule 2111 became the standard for all broker-dealers to adhere to. Suitability is a large component of the Series 7 Examination and may also be covered on the Series 6, 10, 24, and 26 Examinations. With this in mind, let’s review FINRA Rule 2111. The rule is divided into parts A (retail investors) and B (institutional investors). We will discuss Part A only as it relates to your regulatory examination.
The rule states: “A member or an associated person must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile. A customer’s investment profile includes, but is not limited to,
- The customer’s age
- Other investments
- Financial situation and needs
- Tax status
- Investment objectives
- Investment experience
- Investment time horizon
- Liquidity needs
- Risk tolerance
- Any other information the customer may disclose to the member or associated person in connection with such recommendation”
Clearly, the Rule 2111 list is long and specific. However, since FINRA acknowledges that some firms currently ask customers for this information without using these specific terms, the rule does not dictate the use of specific terminology or a method for obtaining this information.
If a firm decides to exclude any of these factors as irrelevant, it needs to explain in writing why it is not requesting the information. (Age, for example, would not be relevant for clients that are entities.)
FINRA confirms that nothing in the rule changes the long-standing practice that suitability becomes an issue as soon as the firm or one of its associated personnel makes a recommendation.
FINRA spells out several guiding principles for determining whether a communication is a recommendation.
- Content, context, and presentation are important—e.g., would it be reasonably viewed as a suggestion to take or not take action?
- The more individually tailored a communication is, the more likely it will be classified as a recommendation.
- Although a series of actions that, considered individually, may not be considered a recommendation, may collectively be viewed as one.
- A recommendation does not need to come from a live person—it may be computer-generated.
FINRA also notes that a recommendation is not suitable just because the client agreed to act upon it, and that a firm (and its personnel) may not avoid liability for unsuitable investments by using disclaimers.
Rule 2011 identifies three main suitability obligations: reasonable-basis, customer-specific, and quantitative suitability. Each one must be addressed with regard to recommendations to clients.
Reasonable-Basis Suitability: Is it appropriate for anyone? According to FINRA, “Reasonable-basis suitability requires a broker to have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors.”
In general, the amount of diligence that a firm or its associated personnel is required to undertake will vary depending on the complexity and potential risks of the investment product or strategy, and how familiar the firm or its personnel are with the product or strategy. The firm and its personnel must understand the potential risks and rewards associated with recommendations made to clients.
Customer-Specific Suitability: Is it appropriate for that client? FINRA states “Customer-specific suitability requires that a broker have a reasonable basis to believe that the recommendation is suitable for a particular customer based on that customer’s investment profile. …. The new rule requires a broker to attempt to obtain and analyze a broad array of customer-specific factors.”
Quantitative Suitability: Are you trading too much? The third and final obligation under the new suitability rules addresses discretion. It is called quantitative suitability and requires a registered representative “who has actual or de facto control over a customer account to have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together in light of the customer’s investment profile.”
While FINRA does not state how many questions may appear on a given topic, we believe that you should be prepared to answer a number of questions covering the various aspects of suitability.
Thanks for spending time with us. We hope you found it worthwhile.
—Securities Training Corporation