New FINRA Suitability Rule in a Nutshell

FINRA Rule 2111, the new suitability rule enacted by the Financial Industry Regulatory Authority (“FINRA”), takes effect on July 9, 2012. Rule 2111 states in pertinent part:

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, and any other information the customer may disclose to the member or associated person in connection with such recommendation.

In its recent Regulatory Notice 12-25, FINRA provided guidance on the obligations of firms and brokers under the new rule.

The previous suitability rule, NASD Rule 2310, was largely interpreted through case law. The new rule codifies several of those interpretations and imposes some new or modified obligations on the securities industry.

Also, the new rule adds some additional categories to what comprises a customer’s “investment profile.” Firms and brokers are obligated to obtain and analyze a customer’s investment profile prior to making any recommendations to that customer.

The new rule identifies the three prongs of a suitability determination as: 1) reasonable-basis suitability; 2) customer-specific suitability; and 3) quantitative suitability.

Reasonable-basis suitability: prior to making a recommendation, the broker is required to use reasonable diligence to understand the nature of a security or investment strategy involving a security, and its potential risks and rewards, and determine whether the recommendation is suitable for at least some investors.

Customer-specific suitability: prior to making a recommendation of a particular security or investment strategy involving a security to a particular customer, the broker is required to have a reasonable basis to believe that the recommendation is suitable for that customer based on that customer’s investment profile.

Quantitative suitability: before a broker with control over a customer’s account, may execute a series of recommended transactions in that account, the broker is required to have a reasonable basis to believe that the series of transactions are not excessive.

The prior rule, NASD 2310, required that firms obtain and analyze a customer’s other securities holdings, financial situation and needs, financial status, investment objectives, and tax status prior to making any investment recommendations. The new rule, however, explicitly adds a customer’s age, investment experience, time horizon, risk tolerance and liquidity needs to this list. All of these factors together comprise the customer’s investment profile.

The prior suitability rule was limited to recommendations to a customer to sell, buy or exchange a security. The new rule, adds recommendations of investment strategies involving a security, including explicit recommendations to hold a security.

In its Regulatory Notice 11-02 announcing the Securities and Exchange Commission’s (“SEC”) approval of the new rule, FINRA cited numerous cases that have held that a broker’s recommendations must be consistent with their customer’s best interests. Examples of some situations where brokers have been found to have violated the suitability rule by placing their own interests ahead of the customer’s interest:

• Recommending one investment over another solely to receive a larger commission;
• Recommending that a customer trade on margin so the customer could purchase a larger number of securities resulting in a larger commission to the broker;
• Recommending new issues by the broker’s firm so that the broker could keep his job; and
• Recommending speculative securities solely because they paid high commissions.

FINRA notes that the obligation to act in a customer’s best interest does not mean the broker has to recommend the least expensive product. A broker is only obligated to make a recommendation that is suitable and the broker is not placing the broker’s own interests before the interests of the customer. In addition to cost, brokers must analyze a product’s stated objectives, characteristics, liquidity, potential benefits compared to its risks, volatility and likely performance in a variety of economic and market conditions.

The new suitability rule does not create totally new obligations for firms and brokers. While it does create some new duties, Rule 2111 mostly clarifies and codifies case law interpretations and existing FINRA and SEC guidance, regarding the suitability obligations of firms and brokers.

The Florida securities lawyers at Rabin Kammerer Johnson represent investors nationwide in FINRA arbitration matters. Investors nationwide who have incurred recoverable investment losses due to specific failures by stockbrokers and brokerage firms, and who may have a FINRA arbitration claim, may contact the Florida securities lawyers at Rabin Kammerer Johnson for a free and confidential consultation by calling toll free at 877.915.4040.