FINRA Rule 2111 explains how FINRA expects broker-dealers and their representatives to approach suitability. Before making a recommendation, a representative follows a three-step process designed to reduce the chance of inappropriate investment decisions. Here’s how each step works.
Reasonable-basis suitability requires a broker to have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors. Reasonable diligence must provide the firm or associated person with an understanding of the potential risks and rewards of the recommended security or strategy.
The quoted language above is directly from FINRA. In plain English, this step requires two things:
First, the representative must understand the security or strategy well enough to explain its potential risks and rewards. If a product is so complex that the representative can’t reasonably understand it, they shouldn’t recommend it to clients.
Second, the representative must be able to support the idea that the product is suitable for at least some investors. If a product is so risky or inappropriate that it wouldn’t be suitable for any client, it shouldn’t be recommended at all. If it could be suitable for some clients, the representative moves to the next step.
Customer-specific suitability requires that a broker, based on a particular customer’s investment profile, has a reasonable basis to believe that the recommendation is suitable for that customer. The broker must attempt to obtain and analyze a broad array of customer-specific factors to support this determination.
Once a security is considered suitable for at least some investors, the representative must decide whether it’s suitable for the specific investor who would receive the recommendation. This decision is based on the information provided by the investor on their account form. This information includes:
Determining suitability is partly objective and partly judgment-based. Some guidelines are broadly applicable - for example, an elderly investor living on a small fixed income generally shouldn’t be exposed to high stock market risk. But the details matter. An elderly investor who is also a millionaire may have a portion of assets they can afford to risk. The representative’s job is to evaluate the full picture and make a suitability decision based on the customer’s overall profile.
One important exception is the need to watch for red flags - details that don’t seem to fit together. For example, an investor might state a speculative (very risky) investment objective but have very limited assets and large monthly liabilities. In that situation, the representative should act in a fiduciary capacity and avoid exposing the client to high levels of risk, even if that means giving up commissions (speculative strategies can be complex and may involve higher commission costs for the investor, which can increase compensation for the representative).
If the representative determines the security is not suitable for the client, they should not recommend it and should look for a better fit. If it is suitable, they move on to the final step.
Quantitative suitability requires a broker with actual or de facto control over a customer’s account to have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, is not excessive and unsuitable for the customer when taken together in light of the customer’s investment profile.
Even when a security is suitable for a client, it may not be suitable in excessive amounts. For example, a Treasury bond might be appropriate for an investor, but investing all of the investor’s capital in a single security usually creates unnecessary concentration risk. The representative’s responsibility is to determine both:
This rule also helps prevent recommendations that are made primarily to generate commissions. When a representative trades excessively in a customer’s account to benefit themselves, they engage in the prohibited practice of churning.
If a representative is accused of churning, the broker-dealer (and possibly FINRA) may investigate. For example, FINRA investigated a California broker who engaged in excessive trading, generating $2.2 million in commissions while causing $2.2 million in losses for his clients. This led to a $50,000 fine, a restitution payment of $115,000, and an 18-month suspension. When trades are frequent and don’t appear connected to the investor’s overall objectives, representatives may face penalties and fines. Firms may also be held liable if inadequate supervision enabled the activity.
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