FINRA Rule 2111 requires financial professionals to follow suitability guidelines when recommending securities to customers.
Representatives must follow this three-step process to make sure their recommendations are appropriate:
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 Rule 2111. In plain English, this step requires two things.
First, the representative must understand the recommended security or strategy well enough to explain its potential benefits and risks. If a product is too complex to understand, the representative shouldn’t recommend it.
Second, the representative must be able to explain why the product could be suitable for at least some investors. If a product is so risky or inappropriate that it wouldn’t fit any investor, it shouldn’t be recommended to anyone. If it could fit 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 considered suitable for at least some investors, the representative must decide whether it’s suitable for the specific customer receiving the recommendation.
This decision is based on the customer’s investment profile, typically gathered on the account form. This information includes:
Suitability is rarely a simple checklist. Some general principles often apply - for example, an elderly investor living on a small fixed income will usually have limited ability to take market risk. But the full picture matters. An elderly customer with substantial wealth and a portion of assets set aside for higher-risk investing may be able to take on more risk than someone with the same age but limited resources.
One important part of this step is watching for red flags - details that don’t fit together. For example, a customer might state a speculative (very risky) objective while also having limited assets and significant monthly liabilities. In that situation, it’s essential for the representative to act in a fiduciary capacity and avoid exposing the customer to high levels of risk, even if that means earning less in commissions*.
*Speculative strategies can be complex and involve high commission costs for the investor, leading to more pay for the representative.
If the representative determines the security is unsuitable 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 or strategy is suitable, it still can’t be recommended in excessive amounts. For example, a covered call might be suitable for an investor, but concentrating all of the investor’s capital in a single strategy is generally not reasonable. The representative must consider 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) will 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 customer’s overall investment objective, representatives may face penalties and fines. Firms may also be held liable if a supervision failure enabled the representative’s conduct.
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