In 2011, the SEC approved two new modifications to existing rules on client suitability for investment. The new rules were proposed by FINRA who’s stated purpose is to dedicate itself to “investor protection and market integrity”. FINRA was and is concerned about sales practice abuses and yield chasing behavior that could significantly impact investors during a market correction.
The new regulations came into effect in July 2012 and though they were aimed at brokers, even RIAs (Registered Investment Advisors) with a fiduciary responsibility took note. Having studied the regulation I found many of the key points were buried in long legal notices that were challenging to follow. Below I’ve summarized the key points surrounding FINRA Rule 211 on Suitability.
FINRA’s regulation states that firms and their associated persons “must have a reasonable basis to believe” that a transaction or investment strategy involving securities that they recommend is suitable for the customer. A reasonable basis to believe must be based on a proper due diligence process to ascertain a customer’s investment profile. FINRA then goes on to state which information about a customer is required.
- Other investments
- Financial situation and needs – which likely includes questions about income and net worth
- Tax status
- Investment objectives – e.g. retirement plans
- Investment experience
- Investment time horizon
- Liquidity needs
- Risk tolerance
Firms are expected and obligated to learn as much about a customer as reasonably possible before recommending a course of action. However, if a client refuses to give certain information or if it is not available, a firm may still give a recommendation provided they believe they have enough information to give suitable advice.
Herein lies one of the challenges with the new regulation. On one hand FINRA is saying certain information is needed to give a recommendation but on the other it is saying firms can move ahead without the points above if they judge it to be suitable after completing “reasonable diligence”. Firms are thus encouraged to use their own judgment. At least until a client complains and a judge decides what is “reasonable basis to believe” in the suitability of a transaction.
2. What Is A Recommendation?
Understandably not all interactions with a client or prospective client can be considered a recommendation. If firms had to collect all the information required to meet the regulation just to speak to a prospect then their business would suffer heavily. As outlined in this extensive FAQ, FINRA does not define the word “recommendation”. What they do say however is that the normal distribution of marketing materials does not constitute a recommendation. They then encourage firms to read past notices so as to understand the word “recommendation”.
Certain communications would be considered a recommendation. For example an outbound-targeted communication encouraging the purchase of a security or an online portfolio analysis tool where clients input information and then receive buy and sell options.
However, generic electronic libraries of research reports on a website with buy and sell orders would not be considered a recommendation. The key differentiation appears to be targeting. If you are speaking to a specific customer or a group of customers who share a particular characteristic then it’s likely you are recommending a course of action and would need to follow the FINRA 2111 guidelines above.
3. What Is “Reasonable Diligence”?
As noted above firms are expected to complete “reasonable diligence” in understanding a client’s specific information. Reasonable diligence simply means asking the client for the information. FINRA doesn’t explicitly say how, though it’s likely to be via questionnaire. A broker can take a client’s answers at face value so long as the questions asked are not confusing or misleading. Additionally if the client exhibits signs of diminished capacity or other “red flags” then the broker can have reasonable course to believe their information is inaccurate and should be cautious about recommending a transaction.
A lot more than can be said about FINRA 2111 and I encourage you to read the extensive FAQ, which digs into the nuances of the regulation. Thanks to this shift in policy it appears brokers are moving closer and closer to fiduciaries, which will have a significant impact on the industry.
Let’s continue the conversation in the comments section below.