FINRA Rule 2111 explains how FINRA expects broker-dealers and registered representatives to approach suitability. Before making a recommendation, a representative follows a three-step process designed to prevent inappropriate investment decisions. Here’s what each step means.
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 how it works, they shouldn’t recommend it.
Second, the representative must be able to support the idea that the recommendation could be suitable for at least some investors. If a product is so risky or inappropriate that it wouldn’t be suitable for any customer, the representative should not recommend it to anyone.
If the recommendation can be suitable for at least some investors, 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 deemed suitable for at least some investors, the representative must decide whether it’s suitable for the specific investor they’re advising. This is done by analyzing 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 fairly consistent; 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 look at the full picture and decide whether the recommendation fits the customer’s overall profile.
One important exception is the need to watch for red flags (information that doesn’t seem to fit together). For example, a customer might list a speculation (very risky) investment objective, but also have very limited assets and large monthly liabilities. In that situation, the representative should act in a fiduciary capacity and avoid exposing the customer to high levels of risk - even if that means giving up potential commissions (speculative strategies can be complex and may involve high commission costs for the investor).
If the representative determines the security is not suitable for the customer, 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, it still can’t be recommended in excessive amounts. For example, a Treasury bond may be suitable for an investor, but investing all of the investor’s capital in a single security is generally not a sound recommendation. The representative must consider not only whether the security is suitable, but also how much exposure is reasonable.
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. If trades are frequent and don’t appear connected to the investor’s overall objective, representatives may face penalties and fines. Firms may also be held liable if inadequate supervision enabled the activity.
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