Many investor arbitration cases involve claims that an investment recommendation was unsuitable. Suitability is an important concept because it often forms the basis for whether a broker met his or her duties to their client. FINRA now has new proposed rules governing suitability. While the proposed change improves upon the existing rule, it does not do enough to protect investors and halt the need for investors to file unsuitability claims - claims that arise from a broker's violation of the "know your client" rule.
FINRA (Financial Industry Regulatory Authority) is the self-regulatory organization (SRO) that emerged after the New York Stock Exchange merged with the NASD (National Association of Securities Dealers). Because the two SROs had their own regulations, some related and some redundant, FINRA is attempting to reconcile the two sets of regulations into a single set of coherent guidelines for the securities industry.
Know Your Customer
The proposed rule would require broker-dealers to use "due diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer and concerning the authority of each person acting on behalf of such customer." This is derived from the current NYSE Rule 405(1).
The obligation would arise at the beginning of the customer/broker relationship, independent of whether the broker has made a recommendation. The proposed supplementary material would define "essential facts" as those "required to (a) effectively service the customer's account, (b) act in accordance with any special handling instructions for the account, (c) understand the authority of each person acting on behalf of the customer, and (d) comply with applicable laws, regulations, and rules."
The proposed new suitability rule, FINRA Rule 2111, would require a broker-dealer or associated person (broker) to have "a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer...."
This assessment must be "based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer's investment profile." This profile is based on a non-exhaustive laundry list of items, including,
- Customer's Age
- Other Investments
- Financial Situation and Needs
- Tax Status
- Investment Objectives
- Investment Experience
- Investment Time Horizon
- Liquidity Needs
- Risk Tolerance
The last item is the all-purpose "any other information the customer may disclose to the member or associated person in connection with such recommendation."
Codifies Existing Obligations
FINRA notes the proposal would codify interpretations of the three main suitability obligations, listed below:
Reasonable basis (members must have a reasonable basis to believe, based on adequate due diligence, that a recommendation is suitable for at least some investors);
Customer-specific (members must have reasonable grounds to believe a recommendation is suitable for the particular investor at issue); and
Quantitative (members must have a reasonable basis to believe the number of recommended transactions within a certain period is not excessive).
What It Does Not Do
Some believe that the new rule should also encompass and define a fiduciary obligation on the part of the broker and brokerage firm in favor of the customer. FINRA omitted this obligation from the proposed rule perhaps because of the 1,000 comments (many from securities firms) opposing the potential obligation.
FINRA left the door open to imposing this obligation in the future: "The suitability obligations set forth in proposed Rule 2111 would not be inconsistent with the addition of a fiduciary duty at some future date."