Financial Advisers, including stockbrokers and financial planners, must abide by the suitability rules imposed by FINRA (the National Association of Securities Dealers (NASD) and the New York Stock Exchange (NYSE)). Consider these obligations in the event that your clients have suffered losses at the hands of a financial adviser. According to FINRA and NASD Conduct Rule 2310, an investment recommendation must be both suitable for a client and have a reasonable basis.

Although most broker dealer Respondents will argue that there is no private right of action for violation of NASD rules, violations of those rules may be considered relevant for purposes of Rule 10b-5 unsuitability claims. GMS Group, LLC v. Benderson, 326 F.3d 75,82 (2nd. Cir. 2003). To establish a claim under Rule 10b-5 for unsuitability, a claimant must prove (1) the broker recommended (or in the case of a discretionary account purchased securities which are unsuitable in light of the investor’s objectives; (2) the broker recommended or purchased the securities with an intent to defraud or with reckless disregard for the investor’s interests; and (3) the broker exercised control over the investor’s account. O’ Connor v. R.F.Lafferty & Co. Inc. 965 F.2d 893, 898 (10th Cir.1992). Recklessness is defined as conduct that is an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it.For further support of items 2 & 3, please see Churning Analysis section i.e. scienter and control (see discussion of de facto control).

The cornerstones of a more common suitability claim in arbitration, however, are NASD Rule 2310 and NYSE Rule 405. Violations of these industry rules and practices give rise to a common law claim for negligence; NASD rules evidence the standard of care a member should achieve. Further, these rules set out the general standards of industry conduct and are evidence of the code of procedure by which broker/dealers must abide in dealing with their customers.

Respondents’ recommendation[s] must be judged in light of the information available to [them] after reasonable inquiry as to [Claimants’> situation at the time of the recommendation[s] and not by reference to subsequent events. Id. (emphasis added). Section 15(b) (10) Securities Exchange Act of 1934, Exchange Act Release No. 8135, 1967 SEC Lexis 64 (July 27, 1967).

In July of 2012, the Financial Industry Regulatory Authority (FINRA) put into effect new rules of conduct that narrow the gap between brokers’ duties and investors’ expectations of their brokers’ responsibility.

Many Respondent’s in arbitration try to convince arbitration panels that licensed brokers generally do not owe a duty to act in the best interests of their customers. Instead, they argue that the duty of a broker to a customer with a non-discretionary account has been much more limited: only to recommend investments that are suitable in light of their client’s objectives, financial needs and circumstances. This, they contend, is true even where customers place exclusive reliance on their brokers and always follow their recommendations. Finally there is regulatory clarification.

The Securities and Exchange Commission approved new FINRA Rule 2111, an updated version of the old NASD Rule 2310 (Suitability) requires brokers and their firms 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 member or associated person to ascertain the customer’s investment profile.

FINRA’s new Rule 2111 expands a broker’s responsibility toward the customer. While not reaching the level of requiring brokers to act in their customers’ best interests, the new standard is an improvement in the protection of investors because it will explicitly cover situations that industry members have historically opposed. Specifically, the new suitability standard will no longer apply only to recommendations concerning the purchase or sale of a security. Rather, it now applies also to the recommendation of investment strategies. Additionally, the new rule directly applies the suitability standard to a broker’s recommendation to hold a security, rather than just to purchase or sell a security. This expansion nullifies years of denials by brokers and their firms that a recommendation to hold a security constitutes actionable behavior. It recognizes the reality that investors sometimes refrain from executing a transaction on the advice and recommendation of their adviser.

The rule further explains the three primary suitability obligations of a broker. First, a broker must make a reasonable-basis suitability determination, based on reasonable diligence, that the recommendation is suitable for at least some investors. What constitutes reasonable diligence, however, is undefined, and depends on a variety of factors such as the complexity, the risks and the rewards associated with the security or the investment strategy. Second, assuming the recommendation is suitable for at least some investors, a broker must then make a customer-specific suitability determination to ensure that the recommendation is suitable for a particular customer based on his or her investment profile. Finally, where brokers exercise actual or de factor control over a customer’s account, they must have a reasonable basis for believing that a series of recommended transactions, even if individually suitable, are not collectively unsuitable for the customer. Factors relevant to this determination are turnover ratio, cost-equity ratio and the existence of short-term trading.

The new rule is undoubtedly an improvement over the former suitability rule, and will benefit investors in their interactions with their brokers, and in customer arbitration claims where their brokers have violated the rules. The benefits of the revisions, however, are mitigated by the new rule’s limitations. For example, the rule leaves much ambiguity regarding the precise contours of a broker’s obligations. Additionally, the duty is only triggered by a recommendation of the broker, as opposed to an adviser acting under a fiduciary duty, who in required in all respects to provide guidance in the client’s best interests. While the regulatory trends appear to favor protecting investors, much work still needs to be done, and investors must remain vigilant to ensure their advisers are recommending securities and investment strategies that are appropriate for their purposes.

RULE 2310 PROVIDES IN RELEVANT PART:

2310. Recommendations to Customers (Suitability)

(a) In recommending to a customer the purchase, sale or exchange of any security, a member should have reasonable grounds for believing that the recommendation is suitable for such customer upon 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 those with customers where investments are limited to money-market mutual funds, a member shall make every effort to obtain information concerning:

i. The customer’s financial status;

ii. The customers tax status;

iii. The customer’s investment objectives;

iv. Such other information used or considered to be reasonable by such member or registered representative in making recommendations to the customer (age and health for example).

The suitability of the investor must be, by industry rule and written procedure of at least every major wire house firm, established before the account makes its first investment.

In 2010, FINRA has consolidated the rules of the NYSE and NASD into new FINRA Conduct Rules:

Rule 2310 will be replaced with new FINRA Rule 2111 — The new rule adds the concept of a strategy as opposed to merely making a securities recommendation. It also breaks down suitability into three main obligations. Reasonable basis (firms must have a reasonable basis to believe, based on adequate due diligence, that a recommendation is suitable at least for some investors), customer specific (firms must have reasonable grounds to believe a recommendation is suitable for the specific investor and that a firm refrain for recommending purchases beyond the customer’s capability) and quantitative (firms or associated persons who have actual or de facto control over a customer account must have a reasonable basis to believe the number of recommended transactions within a certain period is not excessive and unsuitable for the customer when taken together, in light of the customer’s profile). Clearly the new suitability rules have strengthened significance in promoting fair dealing with customers, ethical sales practices as well as encouraging just and equitable principles of trade and communications with the public.

Rule 2111 also addresses changes regarding the gathering and use of information as part of the suitability analysis. For instance, the information that must be analyzed in determining whether a recommendation is suitable would include not only information disclosed by the customer in response to reasonable due diligence in obtaining it, but also information about the customer that is known by the member or associated person. This would include information about the client’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs and risk tolerance, as well as any other information the member or associated person considers to be reasonable in making recommendations. Finally, 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 if such recommendation is inconsistent with the reasonable expectation that the customer has the financial ability to meet such a commitment.

Rule 405 of the NYSE (the know your customer rule) has now been replaced by FINRA Rule 2090, capturing the main ethical standard of the former rule. Firms would be required to use due diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer (including the customer’s financial profile and investment objectives or policy), and concerning the authority of each person acting on behalf of such customer This information may be used to aid the firm in all aspects of the customer/broker relationship, including, among other things, determining whether to approve the account, where to assign the account, whether to extend margin (and the extent thereof) and whether the customer has the financial ability to pay for transactions. The obligation arises at the beginning of the customer/broker relationship and does not depend on whether a recommendation has been made. FINRA Notices (like #09-25) and other public pronouncements have stated that a similar know-your-customer obligation is embedded in the just and equitable principles of NASD Rule 2110 (Now FINRA Rule 2010).

To put this more simply, after reasonable basis suitability had been established, one could compare the suitability obligation of the broker to the customer, to a 3 legged stool:

1. Background

A. Age, marital status, number of dependents, health, educational experience