New Suitability and Know Your Customer Rules Will Benefit Investors

Posted on April 4th, 2011 at 2:01 PM

The Securities and Exchange Commission (SEC) has approved two rules proposed by the Financial Industry Regulatory Authority (FINRA) which will benefit investors.  The new rules, FINRA Rule 2090 and FINRA Rule 2111, take effect in October, 2011.  As FINRA states in its Regulatory Notice 11-02, the new rules “retain the core features” of the current rules and “at the same time strengthen, streamline and clarify them.”  Let’s examine the important aspects of the new rules.

            First, new Rule 2090, the “Know Your Customer” rule, applies to the opening and the maintenance of every account.  The rule requires financial services firms (and their advisers) to “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.”  The new rule defines “essential facts” as, for example, facts that are required to effectively service the account.  Those would include, for example, the kinds of facts pertaining to suitability considerations, discussed below.

            An important aspect of new Rule 2090 is its emphasis on requiring Know Your Customer information not just at the time that the account was opened, but also throughout the life of the account relationship with the customer, so that the account may be effectively serviced and supervised.  In this regard, FINRA notes in Regulatory Notice 11-02 that a firm’s relationship with its customers is “dynamic”.  As a result, FINRA will require firms to “verify” the essential facts (and the suitability rule considerations) “at intervals reasonably calculated to prevent and detect any mishandling of a customer’s account that might result from the customer’s change in circumstances.”  The reasonableness of the verification frequency will “depend on the facts and circumstances of the particular case.”

            Second, new Rule 2111, the “Suitability” rule, adds important protections for investors.  The new rule requires financial services firms and their advisers to “have a reasonable basis to believe that a recommended transaction or investment strategy…is suitable for the customer” based upon information obtained, such as “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.”  The new rule has several important aspects.

            One important aspect relates to the fact that the new rule explicitly applies to recommended investment strategies involving a security or securities.  FINRA states in Regulatory Notice 11-02 that the term “strategy” is to be interpreted broadly, and that the rule is triggered when a firm or adviser recommends a security or a strategy regardless of whether the recommendation results in a transaction.  Most critical, FINRA states that “the term ‘strategy’ would capture a broker’s explicit recommendation to hold a security or securities.”  FINRA explains that it is reasonable to hold firms and their advisers responsible for “hold recommendations” because customers may rely on them for their expertise.  Such hold recommendations, of course, frequently were made preceding and during the market downturn in 2008, causing investors to lose substantial sums, for which securities arbitration may be an option for recovery.

            Another important aspect of Rule 2111 relates to the investor’s profile.  The new rule expands the list of explicit types of information to analyze as part of the suitability analysis.  As FINRA puts it, “The new rule essentially adds age, investment experience, time horizon, liquidity needs and risk tolerance to the existing list….”  Those types of information, coupled with the information listed under the current rule (financial status, tax status and investment objectives), “generally are relevant (and often are critical)” to the suitability analysis.  As a result, FINRA will require that firms and their advisers “document with specificity their reasonable basis for believing that a factor is not relevant in order to be relieved of the obligation to seek to obtain information about that factor.”

            Indeed, for emphasis FINRA adds a separate section to the new rule entitled Customer’s Financial Ability.  The rule reads: “Rule 2111 prohibits a member or associated person from recommending a transaction or investment strategy involving a security or securities or the continuing purchase of a security or securities or use of an investment strategy involving a security or securities unless the member or associated person has a reasonable basis to believe that the customer has the financial ability to meet such a commitment.”  This new rule thus envisions situations in which an investment recommendation is unsuitable for an investor because he or she cannot afford to lose his or her principal.  Another application of the new rule would be an investment purchase on margin, where the investor cannot afford to meet a margin call.

            Still another important aspect of the rule relates to FINRA’s formal pronouncement that there are three main kinds of suitability obligations.  These are “reasonable-basis suitability”, “customer-specific suitability” and “quantitative suitability.”  The first duty relates to the determination that the security or investment strategy recommendation is suitable for at least some investors.  The second duty relates to the determination that the security or investment recommendation is suitable for the particular investor at issue.  And the third duty relates to the determination that the amount of the transactions is suitable.  FINRA comments that it will consider factors such as “turnover rate, cost-equity ratio and use of in-and-out trading” in an account to determine if the transactions were excessive.

            A final important aspect of Rule 2111 relates to institutional investors.  FINRA has maintained its approach to more lightly regulating conduct between advisers and their institutional investor clients.  Accordingly, firms and their advisers need not determine that a particular institutional investor is suitable for a recommended transaction or investment strategy, provided that the institutional investor “is capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies, and whether the institutional customer affirmatively acknowledges that it is exercising independent judgment.”   Nonetheless, FINRA has not diminished the firm’s and adviser’s duties with respect to reasonable-basis suitability.  This duty applies in full force and pertains to understanding the securities and the investment strategies recommended.  In those situations, FINRA states that firms and their advisers must understand the “potential risks and rewards associated with the recommended security or strategy.”  Likewise, FINRA states that the quantitative suitability duty still may apply to a firm and its adviser, prohibiting “an unsuitable number of transactions in those circumstances where it has control over the account.”

            In conclusion, new FINRA Rule 2090 related to knowing your customer and new FINRA Rule 2111 related to suitability will provide additional protections to investors.  That’s good news for both individual and institutional investors!


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