The Financial Industry Regulatory Authority (FINRA) and its predecessor (the NASD) have historically required that a financial advisor have a reasonable basis to believe a recommended “purchase, sale or exchange of any security” was suitable for an investor before recommending it, NASD Rule 2310.
On July 9, 2012, NASD Rule 2310 was replaced by FINRA Rule 2111 (Suitability). With the new rule, FINRA has expanded its suitability requirement to any: “recommended transaction or investment strategy involving a security or securities . . . based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile.” The new rule expands the suitability requirements, making it more clear that recommended transactions and investment strategies must be suitable at all times, not simply when the transaction is made. The official comments to Rule 2111 explain: ” ‘investment strategy involving a security or securities’ used in this Rule is to be interpreted broadly and would include, among other things, an explicit recommendation to hold a security or securities.”
OLD NASD RULE 2310:
2310. Recommendations to Customers (Suitability)
(a) In recommending to a customer the purchase, sale or exchange of any security, a member shall 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.
(b) Prior to the execution of a transaction recommended to a non-institutional customer, other than transactions with customers where investments are limited to money market mutual funds, a member shall make reasonable efforts to obtain information concerning:
(1) the customer’s financial status;
(2) the customer’s tax status;
(3) the customer’s investment objectives; and
(4) such other information used or considered to be reasonable by such member or registered representative in making recommendations to the customer.
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NEW FINRA RULE 2111:
(a) A member or an associated person must 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 member or associated person to ascertain the customer’s investment profile. A customer’s investment profile includes, but is not limited to, the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation.
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Moreover, as the comments explain, FINRA Rule 2111 (Suitability) is composed of three main obligations:
- Reasonable-basis requirement—a broker must have a reasonable basis, after performing reasonable research into the dynamics of a security or investment strategy, to believe that an investment recommendation is proper for at least some investors. A broker must have a baseline level of understanding of the risks and rewards associated with a security or an investment strategy.
- Customer-specific requirement—the belief that a specific security or investment strategy is suitable for a client must be based on that client’s individual investment profile.
- Quantitative requirement—a broker with actual or de facto control of a client’s account must have a reasonable basis for believing a series of transactions are suitable when considered together in the context of the client’s profile. For example, a broker must not recommend or execute excessive transactions to boost his fees and/or commissions. There is no fixed formula for determining what is excessive, but turnover rate, the cost-equity ratio, and the presence of in-and-out trading in the same security are factors to be considered.
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