We have updated this post! We are leaving this post up as to not disturb any saved links; however, please visit our more recent post, FINRA Rule 2111: Reasonable-Basis Suitability, for current information on the topic.
FINRA Rule 2111 (Suitability) imposes three main suitability obligations on broker-dealers and their associated persons:
- Reasonable-Basis Suitability (a reasonable basis to believe, based on reasonable due diligence, that a recommendation is suitable at least for some investors)
- Customer-Specific Suitability (a reasonable basis to believe that a recommendation is suitable for the specific customer based on the customer’s investment profile
- Quantitative Suitability (a reasonable basis to believe, when possessing actual or de facto control over a customer account, that a series of recommended transactions are not excessive or unsuitable for the customer in the customer’s investment profile)
We discuss each of these suitability obligations in greater detail below.
Reasonable-Basis Suitability
The reasonable-basis suitability obligation requires a broker-dealer or associated person to have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors. In general, what constitutes reasonable diligence will vary depending on, among other things, the complexity of and risks associated with the security or investment strategy and the broker-dealer’s or associated person’s familiarity with the security or investment strategy. A broker-dealer’s or associated person’s reasonable diligence must provide the broker-dealer or associated person with an understanding of the potential risks and rewards associated with the recommended security or strategy. The lack of such an understanding when recommending a security or strategy violates the suitability rule.
With this in mind, a firm’s policies and procedures should prohibit registered representatives from offering any type of security that has not been vetted and formally approved by the firm. Since the reasonable-basis suitability obligation applies not only to the broker-dealer but also to associated persons, the policies and procedures should further prohibit a registered representative from offering certain securities until the registered representative has a complete understanding of the potential risks and rewards associated with the security.
In its efforts to meet its reasonable-basis suitability obligation, a firm should consider the following:
- Expected Performance. A firm should consider how the security would perform in a wide range of normal and, more importantly, extreme market actions.
- Investor Suitability. A firm should consider for whom the security is intended.
- Improvement to the Firm’s Current Offerings. It may be a good practice to refrain from approving a security that does not materially add to or improve the firm’s current offerings.
- Compensation. A firm should examine how it and its registered representatives will be compensated. If a conflict is present, the firm should identify how it will manage it.
- Liquidity. A firm should carefully consider the liquidity risk of each security (or type of security) offered by the firm.
- Risks. A broker-dealer should gain an understanding of all risks associated with a particular security.
- Training Needs. A firm should not approve a particular security unless it has the internal resources to train registered representatives or is able to have a third party educate registered representatives on the product.
Customer-Specific Suitability
The customer-specific suitability obligation requires that a broker-dealer or associated person to have a reasonable basis to believe that the recommendation is suitable for a particular customer based on that customer’s investment profile. FINRA Rule 2111 requires a broker-dealer or associated persons to attempt to obtain and analyze a broad array of customer-specific factors. 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 broker-dealer or associated person in connection with such recommendation.
This suitability determination should precede any recommendation of the security to a customer. To achieve compliance with the customer-specific suitability requirement, a firm’s policies and procedures should require the registered representative to verify that each recommended security is suitable for the specific customer to whom it is recommended. The registered representative should make a reasonable effort to determine, among other things, the following:
- Whether the customer has a net worth, including liquid net worth, sufficient to sustain the risks, including loss of investment;
- Whether the customer is in a financial position appropriate to enable him to realize, to a significant extent, the benefits described in the prospectus, memorandum, term sheets, and/or offering documents;
- Whether the customer meets any suitability requirements, such as those found in the firm’s procedures or transaction guidelines;
- Whether the customer has sufficient investment knowledge and sophistication to properly understand the features, terms, conditions, risks, and potential rewards of the recommended security.
Quantitative Suitability
Quantitative suitability requires a broker 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.
Certain securities are designed for short term holding periods or are commonly used in short-term trading strategies. Therefore, a broker-dealer may not find it terribly unusual to see frequent trading involving these securities within a customer’s account, especially if the customer is an institutional customer. However, to effectively supervise transactions with short term holding periods, a broker-dealer and its supervisors must be able to distinguish between legitimate trading strategies involving these securities and excessive trading that violates that quantitative-suitability standard. Factors that may form a basis for a finding of excessive trading include turnover rate, cost-to-equity ratio, and the use of in-and-out trading.
In contrast to securities with short term holding periods, securities with long term holding periods are generally illiquid and may even be subject to mandatory holding periods. Because these products are illiquid, it is unlikely that they could be excessively traded in violation of the quantitative suitability standard. Nonetheless, a firm should be watchful of registered representatives who recommend that their clients invest a significant portion of their assets in illiquid securities. Although an investment in one of these products may seem suitable in isolation, a client’s cumulative investments in illiquid products could subject him or her to excessive liquidity risk.
Concluding Thoughts
Although suitability is a well-established principle within the securities industry, broker-dealers and their registered representatives sometimes forget that FINRA Rule 2111 contains three distinct suitability obligations. To prevent unsuitable recommendations, a broker-dealer should regularly train its registered representatives to comply with these suitability obligations.