This blog post is part of a series addressing FINRA Suitability Rule 2111. Our suitability experts will examine the genealogy of the rule and how it has evolved over the years through Notices to Members, Regulatory Notices, and changes to the rule itself. In particular, customer-specific and reasonable-basis suitability will be examined.
In this post we examine the three components of suitability obligations due under FINRA Rule 2111.
Components of Suitability Obligations
Under FINRA Suitability Rule 2111, there are three components to the suitability obligation: reasonable-basis suitability; customer-specific suitability; and quantitative suitability. Each will be discussed in turn.
As discussed in previous blog posts, the concept of suitability can be succinctly stated as appropriately matching investments to the investor. With Rule 2111, FINRA has now made both ends of this task explicit.
FINRA Rule 2310 clearly dealt with the customer and required that for each recommendation to a customer, “a member have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.”
The “basis of the facts, if any” language was essentially voided for retail clients under NTM 90-52, which imposed an affirmative duty upon the broker to profile the client. This modification was addressed originally in Article III, Sections 2 and 21 (c) of the Rules of Fair Practice, and later in Rule 2310(b), which added the explicit requirements for the broker to gather basic information about non-institutional clients.
FINRA Rule 2111 continues the client profiling requirement (and incorporates the phrase “customer’s investment profile”) of Rule 2310(b) and adds more specific areas of inquiry. Most important among the new profiling questions are: the customer’s needs; the customer’s investment time horizon; the customer’s liquidity needs; and the customer’s risk tolerance.
While explicitly listing the new profiling questions in the Rule is helpful, they have been part of industry profiling practices for decades, if not longer. Indeed, most member firm New Account Forms have required the broker to inquire about the customer’s time horizon and risk tolerance as well as other aspects of their financial life.
Lastly, it is worth noting that FINRA has also incorporated the New York Stock Exchange (“NYSE”) Rule 405 into FINRA Rule 2090 (Know Your Customer). As with NYSE Rule 405, FINRA Rule 2090 is a due diligence based rule. Rule 2090 states:
Every member shall use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer and concerning the authority of each person acting on behalf of such customer.
Instead of approaching suitability by focusing on what is required for broker recommendations (as does Rule 2111), Rule 2090 approaches suitability by concentrating on the due diligence required for every customer relationship. Under Rule 2090, suitability is ensured by knowing and understanding the customer prior to account opening, and maintaining the account in accord with what is known.
Importantly, the “maintenance” language in Rule 2090 creates an ongoing requirement to know the customer. That is to say, the broker must continue to conduct her due diligence on the customer’s particular facts and circumstances during the lifetime of the relationship.
This is an important element of profiling as a customer’s life situation can change and thus require changes in her investments or strategies. As with the new profiling questions of Rule 2111, these have been an industry practice for decades, if not longer.
The reasonable-basis suitability component addresses how broker-dealers and their associated persons must perform due diligence on investments before they recommend them. The first level of due diligence is performed at the firm level and requires the member firm to first determine that the investment is at least suitable for some of its investors.
Methods employed by firms to determine this first level of suitability will “vary depending on, among other things, the complexity of and risks associated with the security or investment strategy and the member's or associated person's familiarity with the security or investment strategy.”
The second reasonable basis suitability determination is carried out by the broker when she educates herself about the investment. This is how the broker comes to “know the investment”.
One of the primary goals of the reasonable basis suitability obligation is that:
A member's or associated person's reasonable diligence must provide the member or associated person with an understanding of the potential risks and rewards associated with the recommended security or strategy.
As mentioned above, a failure to “know the investment” makes the recommendation unsuitable. FINRA clearly states this in the Supplementary Material to Rule 2111:
The lack of such an understanding (about the potential risks and rewards of the recommending security or strategy) when recommending a security or strategy violates the suitability rule.
The explicit quantitative suitability component highlights the potential for abuse in instances where accounts are “churned” by frequent purchases and sales of securities in order to generate excess commissions. As mentioned above, there can be instances where one trade, viewed in isolation could be suitable, but if made repeatedly, would change all the trades to unsuitable transactions. FINRA Rule 2111 addresses this potential head on, stating:
Quantitative suitability requires a member or associated person who has actual or de facto control over a customer account to have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together in light of the customer's investment profile, as delineated in Rule 2111(a).  (Emphasis added)
The Rule also addresses common metrics used to evaluate churning:
No single test defines excessive activity, but factors such as the turnover rate, the cost-equity ratio, and the use of in-and-out trading in a customer's account may provide a basis for a finding that a member or associated person has violated the quantitative suitability obligation.
The Accelerant Securities Practice Group has many experts on FINRA Suitability Rule 2111, including: Gerry Guild, John Duval, Sr., Tom Brakke, and Jack Duval.
Portions of this blog originally appeared in the Accelerant white paper Leveraged and Inverse ETFs: Trojan Horses for Long-Term Investors, by Jack Duval.
 See supra Note 33.
 FINRA NTM 90-52; available at http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=1514&element_id=1273&highlight=90-52#r1514; accessed July 31, 2013.
 The Rules of Fair Practice was what the original NASD Manual was called. The numbering system was changed in May 1996.
 See supra Note 34 and accompanying text.
 FINRA Rule 2090 (Know Your Customer); available at http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=13389&element_id=9858&highlight=2090#r13389; accessed August 1, 2013.
 See supra Note 34. FINRA Rule 2111 Supplementary Material .05 Components of Suitability Obligations.
 Id. See also FINRA NTM 05-26 for suggested best practices for vetting new products.