[author: Jennifer Krein, Esq.]
The Financial Industry Regulation Authority (“FINRA”) updated the suitability requirements for brokers in July 2012. FINRA’s goal was to codify principles found in case law and expand language to account for a wide range of potential situations in FINRA Rule 2111. Since then, with the Rule’s broadened language and more detailed focus on recommendations, suitability cases and issues have grown. A broker must understand the Rule’s language modifications and the obligations it requires: to provide reasonably-based, customer specific, and quantitatively suitable recommendations with supporting documentation proportional to the risk of the product or strategy suggested.
FINRA’s use of the term “investment strategy” in Rule 2111 is a significant change. Previously, suitability concerned “the purchase, sale or exchange of any security.” Now, suitability applies broadly to any “recommended transaction or investment strategy involving a security.” FINRA’s change to any “recommended transaction” opens the gates to invoke a wider range of suitability claims by current clients. The change also opens claims to potential customers who follow broker recommendations and later become clients.
The expansion from a security into an “investment strategy” is interpreted broadly and raises suitability in cases where a non-security is used in a strategy with securities. For illustration, imagine a broker recommends that a client sell property in order to invest the profits in a retirement account. In this scenario, the entire recommendation, even though it includes non-security property, is considered part of the overall strategy when looking at a potential suitability problem. Another effect of expanding the language to an “investment strategy” is that a broker is responsible for explicit hold recommendations, even if that broker did not recommend the purchase originally.
In addition to adhering to the expanded language, a broker must meet the reasonable basis obligation for recommendations, which is a two pronged analysis. First, through reasonable diligence, a broker must have a reasonable basis at the time of the investment recommendation that the security or investment strategy is suitable for at least some investors. For instance, the FINRA Department of Enforcement filed a complaint against some brokers for reasonable basis unsuitability under Rule 2111 for recommending illiquid, self-offerings, which by their nature would be unsuitable for any investor.
Second, a broker must understand the securities and strategies in the recommendation as well as the associated risks and rewards. The two pronged requirement is increasingly more important as investment strategies and products have become more complex over the past few years. So, even if a product is suitable for some investors or even a particular client, if a broker does not understand the investment recommended, then it is a violation.
Once a broker meets the reasonable basis obligation, the recommendation must be tailored specifically to an individual client according to their investment profile. The number of factors used to create a client’s investment profile has expanded to include age, other investments, financial situation, needs, tax status, investment objectives, investment time horizon, liquidity needs, investment experience and risk tolerance. The investment profile should be taken very seriously since the FINRA Department of Enforcement filed a complaint against a few brokers for investor profile unsuitability under Rule 2111 for recommending high-risk, illiquid, alternative investments.
A broker is required to use reasonable diligence to gather this information, which is typically satisfied by simply asking the client, unless red flags exist. Examples of red flags include misleading or confusing questions, the client exhibits a diminished capacity, or signs that the information the client has provided is not accurate. In some circumstances, clients do not want to disclose all of their information. In those situations, a broker has two options. The first is to narrow the range of recommendations to fit the information that is provided. The second is to make the recommendation so long as enough information exists to satisfy a reasonable basis for suitability.
Beyond making reasonable recommendations according to a client’s specific investment profile, a broker must also practice quantitative suitability. A broker who is in control of client accounts must have a reasonable basis when recommending a series of transactions. This requirement protects clients from excessive trading. Some factors used to identify a possible quantitative issue include in-and-out trading, turnover rates, and cost-to-equity ratios.
As part of satisfying the three obligations of reasonable basis, client specific recommendations and quantitative suitability, a broker must act “in the best interest” of a client. This standard does not create an affirmative obligation to recommend the least expensive product or strategy, but it does require a suitable recommendation in which the client’s interest is first. Currently, the most common examples of the “best interest of the client” violations occur when brokers make recommendations or excessively trade to boost commissions, as well as when brokers act through firm driven agendas to recommend products or strategies designed to benefit the company. FINRA encourages firms to evaluate their compensation structures and make adjustments if there are incentives to trade excessively or provide unsuitable recommendations in order to lower the risk of this type of violation.
When a broker deals with institutional or financially sophisticated clients, an exemption to the Rule’s suitability requirement may apply. To fall within the exemption, sophisticated clients must have assets of at least $50 million. This carve-out applies to individuals as well as banks or other financial institutions. Once the monetary threshold is met, a broker must first have a reasonable basis to believe that a sophisticated client is capable of independently evaluating investment risks and strategies. Second, a broker must obtain an affirmative indication that the sophisticated client is exercising independent judgment. In addition to the sophisticated investor, a suitability exemption for broker communications exists when the communications are “educational in nature,” so long as they do not include a recommendation for particular securities or strategies.
Once a suitable investment strategy is executed, a broker should record the process. There is no affirmative duty to document why a product or strategy was recommended, unless a broker determines that one of the client specific factors for the investment profile is not relevant. In that scenario, a broker must disclose the reason with specificity. However, while no such duty exists generally, FINRA highly encourages providing proportional documentation based on the level of risk and complexity in the recommendation. For instance, less documentation on the investment decision may be needed in cases where a broker recommends a large capital, stable security. However, if a broker recommends a highly complex product or strategy, then a much more detailed explanation for the recommendation is warranted.
Even though not required, a broker should cover their bases by keeping basic records to reflect that the broker understood the product or strategy and used the client’s investment profile to create the suitable recommendation. A broker should also document any exceptions or extenuating circumstances and have compliance and supervisory personnel review the records regularly as a precaution to a suitability challenge.
When to Seek Legal Advice
To account for the new parameters, a broker should examine recommendations more closely and keep solid records supporting recommendations. Many brokers have sterling records, but it takes only one client’s complaint to tarnish years of sound investment practices. If a broker faces a suitability challenge, then it is important that they seek the advice of a knowledgeable attorney. The outcome could affect not only the broker-client relationship, but could also result in employment and career consequences.
FINRA Rule 2111 (a)
FINRA Regulatory Notice 12-55 FAQ 6(b)
FINRA Regulatory Notice 12-55 FAQ(10(a))
FINRA Regulatory Notice 11-25 FAQ (7)
FINRA Rule 2111.05 (a), FINRA Regulatory Notice 12-25 FAQ (22)
Department of Enforcement v. John Carris Investments, LLc, George Carris, Andrey Tkatchenko, Jason Barter Disciplinary Proceeding No. 2011028647101.
FINRA Rule 2111.05(b)
FINRA Rule 2111(a)
Department of Enforcement v. Wall Street Strategies, Inc., Garry Savage, Sr., Louis Karl Kittlaus, Disciplinary Proceeding No. 2012033508702.
FINRA Regulatory Notice 12-25 FAQ(16)
FINRA Rule 2111.05(c)
FINRA Regulatory Notice 11-02, FINRA Regulatory Notice 12-25 (FAQ 1)
FINRA Rule 2111(b), FINRA Regulatory Notice 12-25
FINRA Regulatory Notice 12-25, FINRA Rule 4512 (c)(3)
FINRA Rule 2111 (b), FINRA Rule 2111.07
Rule 2111.03, FINRA Regulatory Notice 12-25 FAQ(8)
FINRA RULE 2111.04
FINRA Regulatory Notice 11-25