On July 9, 2012, two new FINRA rules are supposed to take effect: Rule 2090 (“know-your customer”) and Rule 2111 (“suitability rule”). The know-your-customer and suitability rules are probably the second and third most important self-regulatory rules governing the conduct of stockbrokers. (The MOST important rule is the unwritten “prime directive” – keep selling, boys and girls, until they catch us.) Though the rules don’t take effect for a while, this is probably a good time to tell you about them since most of what they contain already applies to your present and past relationships with financial advisors. The principal aspects of these rules have existed in one form or another for years in the brokerage industry, and the new rules contain most of the same features found in previous NASD and NYSE rules covering the same subject matter. Nevertheless, these new versions will create some new or clarified obligations.
The know-your-customer and suitability rules are supposed to protect investors and ensure fair dealing with customers. They form the core of industry-recognized duties and obligations owed to investors. And like many duties and obligations, they often are ignored when they interfere with making a sale. (See “Prime Directive” above.)
The Know-Your-Customer Rule (FINRA Rule 2090)
The “know-your-customer” rule requires a brokerage firm and its brokers to determine through “reasonable due diligence” all “essential facts” concerning every customer of the brokerage firm. The essential facts are those required to effectively service a customer’s account; act in accordance with special instructions from the customer; know the authority of any individual acting on behalf of the customer; and comply with securities laws, rules, and regulations. Only by first complying with the know-your-customer rule can a brokerage firm and broker hope to comply with…
The Suitability Rule (FINRA 2111)
The “suitability” rule requires that a brokerage firm and its brokers “have a reasonable basis to believe that a recommended transaction or investment strategy… is suitable for the customer, based on the information obtained through the reasonable diligence of the [firm or broker] to ascertain the customer’s investment profile.” That investment profile includes such listed criteria as 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.
Rule 2111 is intended to codify three main suitability obligations:
- Reasonable basis suitability, meaning that the recommendation must be suitable for at least some investors. For instance, an investment product so defectively designed that it’s almost guaranteed to result in loss presumably would fail this test. (If you think there couldn’t possibly be any such products, think again.)
- Customer specific suitability, meaning the recommendation must be suitable for the particular customer to whom it is made, based on that customer’s unique investment profile (as described in the know-your-customer rule.)
- Quantitative suitability, meaning that a series of recommended transactions must not be so excessive in number or cost that they are unsuitable when looked at as a group. Churning is a type of quantitative unsuitability involving a fraudulent intent by the broker, but excessive purchases and sales need not be fraudulent to be quantitatively unsuitable.
Each of these three suitability obligations requires the broker to exercise “reasonable diligence” in deciding whether to make the recommendation.
Unlike the earlier version of the suitability rule, which was limited to recommendations for the purchase, sale or exchange of any security, Rule 2111 will explicitly expand the suitability obligation to cover both investment transactions and “investment strategies.” Brokerage firms have argued for years that their suitability obligations only applied to individual transactions. We, on the other hand, have always argued that suitability concerns didn’t begin and end with a specific order. The new rule confirms that we were correct. Brokers will no longer be able to deny that they are required to ensure that the overall strategies they recommend are suitable.
Supplementary Material to the rule indicates that FINRA applies a broad interpretation to the term “strategy.” Significantly, FINRA now explicitly states that a recommendation to “hold” a security is a strategy and must be suitable. This resolves an old argument between brokerage firms and investors’ lawyers. Henceforth, brokers will have to understand that their advice to “stay the course” will be evaluated for suitability, and that an unsuitable recommendation to hold in the face of market declines will be actionable.
While there are many types of business conduct and sales violations for which brokerage firms and financial advisors can be sued, unsuitable investment advice has always been the most common cause of investment-related disputes. If you’ve suffered surprising losses or losses greater than you thought could occur, your broker’s recommendations may well have been unsuitable. How can you know for sure? Ask us. We’ll review your account without cost or obligation and tell you whether we can help you recover all or some of your money.
Hugh Berkson is a Securities Attorney with McCarthy, Lebit, Crystal & Liffman, Co. LPA. Hugh is rated AV® Preeminent™ by Martindale-Hubbell®.
He obtained a business degree in Finance from the University of Texas at Austin in 1989, and is a 1994 graduate of Case Western Reserve University School of Law, where he was a member of the Order of the Barristers and received both the American Jurisprudence Award, (National Mock Trial) in 1993 and the Jonathan M. Ault Mock Trial Prize for 1993-1994.