In 2012, the suitability rules the Financial Industry Regulatory Authority (FINRA) uses changed. Rule 2111 clarified and codified many precedents that were previously upheld and interpreted through case law. Rule 2111 replaces NASD Rule 2310 and offers clear standards that apply to securities brokerages and professionals.
The Stipulations of the Rule
Advisement professionals must adhere to rules not only surrounding security purchases, sales, and exchanges but also during recommended transaction and investment strategy-related activities. FINRA regulated members and associated professionals must demonstrate reasonable-basis suitability, customer-specific suitability, and quantitative suitability.
Under the reasonable-basis obligation, a professional must reasonably believe a given recommendation makes sense for investors based on due diligence. Someone may prove reasonability based on the strategy complexity and the professional’s experience handling the type of strategy.
The customer-specific suitability obligation asks that professionals use the information available within an investment profile to make a reasonable recommendation for the specific individual. In other words, a recommendation must make sense for a client’s age, current investment profile, risk tolerance, investment experience, tax circumstances, and other available information.
The quantitative suitability obligation directs professionals to only engage in a series of transactions that will not lead to excessive and unsuitable risks. When viewed as a portfolio or investment profile, each action must appear reasonable based on the customer’s profile. A high turnover rate, the cost-equity ratio, and other signs may indicate a violation of quantitative suitability. In addition to these suitability requirements, the rule also stipulates professionals only recommend transactions and strategies a client can financially afford.
Under the current rule, a “customer” may include someone with an existing account as well as potential investors who later open an account with the FINRA regulated firm. If a firm or advisor receives any form of compensation for the recommendation, he or she must adhere to the suitability rule.
Professionals Who Must Adhere to the Rule
All organizations, professionals, and associated persons who sell securities in the general marketplace must maintain licensing and registration through FINRA. Associated persons may include employees, contractors, and registered representatives. The SEC gives this non-government organization the power to hold noncomplying representatives and firms accountable. The organization examines, audits, and oversees over 3,900 securities firms, 160,000 branches, and almost 635,000 representatives.
Suitability Rule Exemptions
In some cases, a professional does not need to meet the suitability rule. For those working with high net worth individuals and financial institutions, the professional must only reasonably believe the client can make independent decisions regarding investment risks and strategy creation. In addition to this reasonable basis, the client must acknowledge an ability to exercise investment independence. In accepting the risk independently, liability transfers from the advising professional to the high net worth individual or organization.
The Role of Documentation in Suitability Assessments
FINRA does not require member firms and related professionals to document suitability for individual clients. However, documenting the logic and evidence behind each suitability obligation can help an advisor protect the client and maintain FINRA compliance. Simple and ongoing record keeping practices may protect advisors from any suitability challenges that may arise.
What Clients Should Know About Suitability
All FINRA regulated firms and professionals undergo training and certification to maintain compliance. Clients, on the other hand, do not always recognize their rights within a financial advisory arrangement. If an investment adviser or other financial advisor recommends or manages any securities-related financial investment activity, he or she must meet the suitability rule under FINRA. Failure to do so constitutes a regulatory violation and may reveal instances of professional misconduct or fraud.
If you trust your investment portfolio to a FINRA regulated advisory firm and lose significant assets, you may want to discuss your legal rights with an attorney. Financial professionals must use reasonable care when advising clients about securities.