Why FINRA’s New Rules on “Suitability” Are Important for Investors

FINRA, the regulatory organization that governs broker-dealers, has now implemented a major overhaul of its suitability rules that could have a big impact on investors who feel that they were misled by their stock broker. The new rules went into effect on July 9th and require brokers to (1) perform reasonable due diligence on investment products they recommend, (2) understand those investments, and (3) have a reasonable basis to believe that a security or investment strategy is “suitable” or appropriate for the given investor.  Suitability evaluations must be undertaken with respect to every investor and his or her particular situation. Among other things, a broker must look at an investor’s age, investment experience, time horizon, liquidity needs and risk tolerance when making an investment recommendation.  In short, every investors situation is unique and investment recommendations must take that into account.

The Securities and Exchange Commission (SEC) initially approved FINRA’s new suitability rule (Rule 2111) way back in November of 2010, but it delayed implementation until this month. FINRA has now issued two Regulatory Notices which provide specific guidance as to what this new rule means; Regulatory Notice 11-02, and Regulatory Notice 11-25.

The new rule requires a broker to “have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the [firm] or associated person to ascertain the customer’s investment profile.”

This is nothing new, really.  What is new is that the new rules impose suitability obligations on overall investment strategies, not just specific investment. In its rule filing, FINRA said the term “investment strategy” would be interpreted broadly and cover a recommendation to hold an investment as well as a “buy” or “sell” recommendation. FINRA has also stated that  the new suitability rule would apply to “potential” customers and to “investment-related” products that are not securities, such as mortgages and insurance.

Another significant aspect of this new rule is the implementation of what FINRA calls a “best interest” standard, which sounds a lot like a fiduciary duty to me.  According to some commentators, this is essentially an end-run around the ongoing contentious debate about whether to impose fiduciary standards on brokers and brokerage firms.  According to FINRA’s new guidance the “best interest” standard is really just a formalization of the standard that has always been in place, and they cite to numerous cases explicitly state that “a broker’s recommendations must be consistent with his customers’ best interests.”

Regardless of whether this standard is new or old, the “best interest” standard will likely to be a big topic in FINRA arbitrations for years to come.  FINRA also left the door open to explicitly imposing fiduciary obligations on brokers in the future, stating that “the suitability obligations set forth in proposed Rule 2111 would not be inconsistent with the addition of a fiduciary duty at some future date.”

One thought on “Why FINRA’s New Rules on “Suitability” Are Important for Investors

  1. This reminds me of ERISA rules and regs and issues raised in the 90s and early 2000. It is welcomed, but it also requires a solid disclosure agreement written in plain english and lots of pre-planning (brokers will be Covering Their A**) and not selling, which may impact their revenue. Ironically, crowdfunding is part of the JOBS Act … let’s see what the portals will need to do!

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