Posted by Susan Mangiero on October 13, 2012

Given the confusion about suitability versus fiduciary duty, Wilson Elser attorney Janene Marasciullo (with assistance from Attorney Paula Toomey ) sheds light on these timely and important topics. In Sellers Beware: FINRA’s New Suitability Rule and the Sale of Complex Investments (Securities Regulation & Law Report . October 15, 20212), the point is made that FINRA’s new suitability mandate, Rule 2111 — and a related supplement — addresses continued concern over the sale of complex products to retail investors by imposing certain restrictions on anyone who seeks to sell such products.

Firms must perform sufficient due diligence about a product to understand the risk-return characteristics and then decide whether a product is suitable and for whom the product may be a good fit. This of course requires that a registered representative fully understands his or her client base so that an assessment can be made alongside a product review. Factors to consider under NASD Rule 2310 include a customer’s portfolio, income, needs, tax exposure and investment objectives. NASD Rule 2111 expand’s the nature of a client review to consider a multitude of factors such as liquidity, risk tolerance, time horizon and investment experience. When not all factors are considered germane to the client profile, Attorney Marasciullo explains that a registered professional must document why some issues are not being addressed. For example, an assessment of illiquidity may not be needed if a product trades in an active secondary market. Nevertheless, the seller would have to explain why an analysis of liquidity was excluded.

Pursuant to new mandates, the concept of a reasonable-basis suitability review will result in a significant increase in documentation by the sellers, especially for an organization that sells complex or alternative investments such as private placements, real estate investment trusts and/or structured products. As laid out in this primer, the author explains that FINRA wants a firm to demonstrate a solid understanding of factors such as:

• Liquidity of a product;
• Track record of an issuer;
• Creditworthiness of the issuer and related counterparties;
• Unique tax, legal or economic attributes;
• Appropriateness of risks taken in anticipation of estimated return; and the
• Costs and fees charged to the investor.

It is clear that the due diligence process must be ongoing and not a single point in time exercise. No doubt this will add to the growing compliance costs for registered investment advisor (RIA) firms and broker-dealers. It could in turn further the trend towards a roll-up of smaller wealth management firms into larger enterprises with more capital and a robust operational infrastructure.

The author rightly points out that the sale of complex financial products may not be a strategic fit for every business. Besides the obvious rise in compliance costs and the need to create and implement new training programs, firms will want to assess whether they have the financial wherewithal and appetite to support customer disputes should ill-performance occur later on. Attorney Marasciullo writes that The need for an exit strategy is particularly important due to the continuing due diligence obligation and the potential liability for hold recommendations. Because many complex products are illiquid, firms should seriously consider whether they have the financial ability to repurchase the products in the event that continuing due diligence forecloses a hold recommendation.

For further reading, check out the following items: