Although suitability is a well-established principle within the securities industry, broker-dealers and their registered representatives sometimes forget that FINRA Rule 2111 (Suitability) has three separate and distinct suitability obligations. We will begin with an overview of all three main suitability obligations. Then, we will be going in-depth on these areas across three different blogs; this particular blog will focus in on Reasonable-Basis Suitability.
Suitability Obligations Overview
FINRA Rule 2111 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 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)
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. The reasonable‐basis obligation reflects the principle that there must be an investment theme or rationale for each product, and that the product is not “designed to fail.”
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, even if the security or investment strategy is suitable for at least some investors. Representatives cannot fulfill their suitability responsibilities to their customers when they fail to understand the securities and investment strategies they recommend.
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 and has completed any required training regarding the product or strategy.
In its efforts to meet its reasonable-basis suitability obligation, a firm should consider several factors, including 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.
The reasonable-basis suitability obligation is critically important, especially in light of the fact that, in recent years, securities products and investment strategies that representatives recommend have become increasingly complex.
For more on the three main suitability obligations FINRA Rule 2111 imposes on broker-dealers and their associated persons, please see the next blogs in this series, “FINRA Rule 2111: Customer-Specific Suitability” and “FINRA Rule 2111: Quantitative Suitability”.
Furthermore, please consult our other posts on FINRA Rule 2111 for additional information on the topic.