All advisers and brokerage firms have a fundamental responsibility to deal fairly with investors and to make “suitable” investments. The Financial Industry Regulatory Authority, or “FINRA” sets the standards in the brokerage industry for the suitable sale of investments to brokerage clients. FINRA’s suitability rule contains three primary brokerage responsibilities: 1. To perform reasonable-basis suitability analysis, 2. To perform customer-specific suitability analysis, and 3. To perform quantitative suitability analysis.
Reasonable-Basis Suitability: All brokers and broker-dealers must have a reasonable basis to believe, based on appropriate research and diligence, that all recommendations are suitable for at least some investors. FINRA recognizes that there are some investment products and strategies that are inappropriate for all investors and other investments that are only appropriate for a very small group of investors.
The standards for reasonable diligence vary depending on the complexity of the investment product or the investment strategy employed. Regardless of the specific product or investment strategy being recommended, investment advisers and broker-dealers must properly convey the potential risks and rewards associated with the recommended security or strategy before bringing it to an investor’s attention. Therefore, the broker-dealer at a minimum must fully understand all of the contours of the investments it recommends to its clients to meet the most basic of suitability requirements.
Customer-Specific Suitability: All brokers and broker-dealers must have a reasonable basis to believe that the recommended investment strategy is suitable for the particular customer. All sales efforts must be reasonable and appropriate for the investor based upon the investor’s risk tolerance, investment objectives, age, tax consequences, financial circumstances, other investment holdings, and experience. An advisor must attempt to obtain and analyze a broad array of customer-specific factors to provide suitable investment advice. This prong of the suitability rule requires detailed and specific analysis of the customer and his or her specific situation and to create an investment recommendation that is tailored to the client.
Quantitative Suitability: Under FINRA’s Rule 2111 quantitative suitability prong “a broker who has control over a customer account must have a reasonable basis to believe that a series of recommended securities transactions are not excessive.” Essentially, all brokers and broker-dealers must have a reasonable basis for recommending a series of 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 objectives. Thus, while a small investment in a particular product may be suitable for the investor, a large portfolio concentration in the same or similar products may be unsuitable for the same investor.
In addition, the pattern and type of securities activity in the account can also be unsuitable for the investor. Arbitrators are not required to use a single to determine whether a broker excessively traded a client’s account. Many factors can be used to determine whether an account has been excessively traded by a broker such as turnover rate, cost-equity ratio, and use of in-and-out trading tactics indicate excessive activity that violates quantitative suitability standards. This prong of the suitability rule is similar to the analysis of a churning claim. Churning, or excessive trading, when a broker-dealer buys and sells securities for the purpose of generating commissions for the broker’s benefit. The real difference between a churning claim and a claim for excessive trading under FINRA’s suitability rule is that “scienter,” or intent, is not a necessary element to establish an excessive trading violation.
Institutional- Investor Exemption: Under FINRA Rule 2111(b), a broker or broker-dealer fulfills the customer-specific suitability obligation for institutional investors differently than with individual customers. For institutional customers the broker or broker-dealer must have a reasonable basis to believe the institutional customer is capable of evaluating investment risks independently, both in general and with regard to particular investment strategies and also the institutional customer must affirmatively indicate that it is exercising independent judgment in evaluating the broker’s recommendations.
The foregoing rules play a crucial role in protecting investors from unscrupulous sales tactics. However, far too often brokers do not understand the risks of the investments they recommend or their client’s investment goals, or place large bets on unsuitable strategies. The attorneys at Gana Weinstein LLP can help you to analyze your account holdings and determine whether your adviser’s recommendations were unsuitable.