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Suitability: An Intro to FINRA Rule 2111

In recent years, the securities industry has received more extensive regulation. Regulations seek to increase investor protections and hold brokers and firms accountable to the public. FINRA, the Financial Industry Regulatory Authority, has played a primary role in creating rules to regulate the securities industry. It also enforces violations of these rules.

One of FINRA's goals is investor protection. It protects investors from risky or abusive behavior by broker-dealers. To further this goal, FINRA created a customer-specific suitability rule. 

Investment objectives must consider the customer's investment objectives. This rule requires brokers to have a reasonable basis to believe that a specific investment strategy is suitable for a particular customer account. 

Read on to learn more about suitability and FINRA Rule 2111.

What Is FINRA?

FINRA, the Financial Industry Regulatory Authority, oversees all brokerage firms and financial advisors. FINRA is the successor to the National Association of Securities Dealers (NASD). The U.S. Securities and Exchange Commission (SEC) oversees FINRA, a not-for-profit, self-regulating organization (SRO) authorized by Congress.

The Securities Exchange Act of 1934 (Exchange Act) created SROs to enforce industry standards and requirements for securities trading and brokerage. FINRA creates and enforces rules governing the broker-dealer industry. Several FINRA rules ban unauthorized trading. FINRA also sets up procedures to handle disputes between brokers and customers, including arbitration procedures.

Members of FINRA include all securities firms doing business with the public. FINRA also provides oversight and enforcement to the following:

  • New York Stock Exchange
  • NASDAQ
  • MSRB
  • The American Stock Exchange
  • The International Securities Exchange

FINRA can discipline members who fail to comply with federal securities laws and FINRA's regulations.

Suitability and FINRA Rule 2111

FINRA has numerous rules governing brokers and firms. FINRA's suitability rule, Rule 2111, discusses reasonable-basis suitability. It requires broker-dealers to ensure a recommended transaction or investment strategy is suitable for the customer. Brokers must base recommendations on facts obtained through reasonable diligence. This rule addresses past abuses and yield-chasing behavior in brokers at a client's expense. 

Rule 2111 places three main suitability obligations on brokers and other registered representatives:

  • Reasonable basis obligation
  • Customer-specific obligations, including an expanded list of factors to consider
  • Quantitative suitability obligation

Rule 2111, the suitability rule, only applies to recommended securities and investment strategies involving securities.

Reasonable Basis Obligation

Under FINRA Rule 2111, a broker must have a reasonable basis for believing a recommendation is suitable for a particular customer. A broker can satisfy this obligation through sales practices, due diligence, and understanding how such recommendations are fit for the general public.

What constitutes a reasonable basis will vary depending on the circumstances. In recent years, securities and investment strategies have become more complex. It's essential that brokers fully understand any recommended strategy, or they risk running afoul of FINRA's suitability requirement.

Customer-Specific Factors

FINRA Rule 2111 must adhere to the "know your customer" requirement. The new rule requires the broker to know as much as possible about a customer before recommending any investment strategy.

Rule 2111 expanded the list of customer-specific factors that a broker must analyze. These customer-specific factors include the following:

  • The customer's age
  • Other investments
  • Net worth
  • Tax status
  • Investment experience, objectives, and investment time horizon
  • Liquidity needs
  • Risk tolerance
  • Financial situation
  • Any other information the customer provides

Brokers must use reasonable diligence to gather as much information about a customer's investment profile before making any recommendations. The onus is on the broker to ask relevant questions rather than on the client to volunteer information.

Quantitative Suitability

The requirement for quantitative suitability included in FINRA Rule 2111 addresses illegal churning. The rule codifies rulings from excessive trading cases.

Brokers often receive fees for transactions they make on their client's behalf. The broker may be tempted to make unnecessary transactions. Excessive trading by a broker to boost their commission at a client's expense is unethical. It's a conflict of interest.

Rule 2111 requires brokers to have a reasonable belief that a series of transactions is suitable. The transactions may be suitable when viewed in isolation. However, the transactions must also be suitable when taken together.

Regulation Best Interest

FINRA adopted the SEC's Regulation Best Interest standard of conduct to address conduct concerning retail customers. Regulation Best Interest (Reg BI) employs the best interest rather than a suitability standard.

Regulation Best Interest established a new, enhanced standard of conduct under the Exchange Act for broker-dealers and associated persons that are natural persons (financial professionals) of a broker-dealer.

The BI standard applies when making recommendations of securities transactions or investment strategies involving securities (including account recommendations) to retail customers. A broker-dealer must comply with Regulation Best Interest and Rule 2111 regarding recommendations to retail investors. Compliance with Reg BI results in Rule 2111 compliance. Among other obligations, Reg BI requires broker-dealers to do the following:

  • Act in the best interest of their retail customers at the time of the recommendation
  • Not place the financial or other interest of the broker-dealer ahead of the retail customer's interests and asset allocation
  • Address conflicts of interest by providing adequate disclosures

A broker-dealer meeting the best interest standard would meet the suitability standard. BI goes beyond suitability obligations with increased investor protections.

Get Legal Help With FINRA Rules

Understanding FINRA's rules about suitability is critical for making informed decisions and fully protecting yourself and your investments. If you have had a brokerage firm that caused you severe loss from unsuitable investment advice, get help. 

If you have questions about FINRA rules or broker conduct, consider getting legal assistance from an experienced securities lawyer. They can explain your legal options, including filing claims in FINRA arbitration against the brokerage firm supervising your financial advisor. Don't let an investment adviser or an investment company act against your best interests.

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