Welcome to the third and final part in our series on the three main suitability obligations outlined in FINRA Rule 2111 (Suitability). As with our earlier posts, “FINRA Rule 2111: Reasonable-Basis Suitability” and “FINRA Rule 2111: Customer-Specific Suitability”, we will begin with a brief overview of the three main suitability obligations imposed on broker-dealers and their associated persons; then, this particular blog will focus in on Quantitative Suitability.
Suitability Obligations Overview
FINRA Rule 2111 imposes three main, distinct suitability obligations on broker-dealers and their registered representatives:
- Reasonable-Basis Suitability (a reasonable basis to believe, based on reasonable due diligence, that a recommendation is suitable for at least 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 when taken together in light of the customer’s investment profile)
Quantitative suitability requires a registered representative who has actual or de facto control over a customer account to have a reasonable basis for believing that, in light of the customer’s investment profile as delineated in Rule 2111(a), a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together.
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 such 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. No single test defines excessive activity, but factors that may form a basis for a finding of excessive trading or “churning” 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 part 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.
For more on the three main suitability obligations FINRA Rule 2111 imposes on broker-dealers and their associated persons, please see the other blogs in this series, “FINRA Rule 2111: Reasonable-Basis Suitability” and “FINRA Rule 2111: Customer-Specific Suitability”. To prevent unsuitable recommendations, a broker-dealer should regularly train its registered representatives to comply with these suitability obligations.
Furthermore, please consult our other posts on FINRA Rule 2111 for additional information on the topic.