Home » Articles » What is FINRA Rule 2111 and Investment Suitability?
Among the most common complaints made against a broker by a customer is that the broker gave the customer “unsuitable” investment advice. Defining what, exactly, the term “suitability” means in the context of a broker-dealer and client relationship is more art than science. Suitability is a term that is used frequently in the financial services arena, especially when investment professionals are recommending or selling securities to customers. While the term is routinely used in the securities industry, oftentimes clients of securities firms have little understanding of what suitability is and what it is not.
What is suitability?
Suitability, as it relates to retail investors, is codified in FINRA Rule 2111(a) which is aptly entitled “Suitability.” Rule 2111 (“Suitability Rule”) states:
A member or 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 upon 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.
In addition to the above Suitability Rule itself, FINRA offers supplementary materials relating to the Rule which serve as further explanation of the Rule and its protections for investors. The relevant additional guidance from FINRA is as follows.
2111.01 – General Principles. Implicit in all member and associated person relationships with customers and others is the fundamental responsibility for fair dealing. Sales efforts must therefore be undertaken only on a basis that can be judged as being within the ethical standards of FINRA Rules, with particular emphasis on the requirement to deal fairly with the public. The Suitability Rule is fundamental to fair dealing and is intended to promote ethical sales practices and high standards of professional conduct.
2111.02 – Disclaimers. A member or associated person cannot disclaim any responsibilities under the Suitability Rule.
2111.03 – Recommended Strategies. The phrase “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. However, the following communications are excluded from the coverage of Rule 2111 as long as they do not include (standing alone or in combination with other communications) a recommendation of a particular security or securities:
- General financial and investment information, including (i) basic investment concepts, such as risk and return, diversification, dollar cost averaging, compounded return, tax deferred investment, (ii) historic differences in the return of asset classes (e.g., equities, bonds, or cash) based on standard market indices, (iii) effects of inflation, (iv) estimates of future retirement income needs, and (v) assessment of a customer’s investment profile;
- Descriptive information about an employer-sponsored retirement or benefit plan, participation in the plan, the benefits of plan participation, and the investment options available under the plan;
- Asset allocation models that are (i) based on generally accepted investment theory, (ii) accompanied by disclosures of all material facts and assumptions that may affect a reasonable investor’s assessment of the asset allocation model or any report generated by such model, and (iii) in compliance with Rule 2214 (Requirements for the Use of Investment Analysis Tools) if the asset allocation model is an “investment analysis tool” covered by Rule 2214; and
- Interactive investment materials that incorporate the above.
2111.04 – Customer’s Investment Profile. A member or associated person shall make a recommendation covered by this Rule only if, among other things, the member or associated person has sufficient information about the customer to have a reasonable basis to believe that the recommendation is suitable for that customer. The factors delineated in Rule 2111(a) regarding a customer’s investment profile generally are relevant to a determination regarding whether a recommendation is suitable for a particular customer, although the level of importance of each factor may vary depending on the facts and circumstances of the particular case. A member or associated person shall use reasonable diligence to obtain and analyze all of the factors delineated in Rule 2111(a) unless the member or associated person has a reasonable basis to believe, documented with specificity, that one or more of the factors are not relevant components of a customer’s investment profile in light of the facts and circumstances of the particular case.
2111.05 – Components of Suitability Obligations. Rule 2111 is composed of three main obligations: reasonable-basis suitability, customer-specific suitability, and quantitative suitability.
- The reasonable-basis obligation requires a member or associated person to have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some In general, what constitutes reasonable diligence will vary depending on, among other things, the complexity of and risks associated with the security or investment strategy and the member’s or associated person’s familiarity with the security or investment strategy. A member’s or associated person’s reasonable diligence must provide the member or associated person with an understanding of the potential risks and rewards associated with the recommended security or strategy. The lack of such an understanding when recommending a security or strategy violates the Suitability Rule.
- The customer-specific obligation requires that a member or associated person have a reasonable basis to believe that the recommendation is suitable for a particular customer based on that customer’s investment profile, as delineated in Rule 2111(a).
- Quantitative suitability requires a member or associated person who has actual or de facto control over a customer account to have a reasonable basis for believing that a series of recommended 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 investment profile, as delineated in Rule 2111(a). No single test defines excessive activity, but factors such as the turnover rate, the cost-equity ratio, and the use of in-and-out trading in a customer’s account may provide a basis for a finding that a member or associated person has violated the quantitative suitability obligation.
2111.06 – Customer’s Financial Ability. Rule 2111 prohibits a member or associated person from recommending a transaction or investment strategy involving a secuirtiy or securities or the continuing purchase of a security or securities or use of an investment strategy involving a security 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.
Like all FINRA Rules, the Suitability Rule codifies requirements imposed upon member firms (i.e. brokerage firms) and its associated persons (i.e. brokers and financial advisors) and governs their dealing with customers. One of the most important features of the Suitability Rule is its requirement that brokers have a duty to make sure that all investments recommended to clients are suitable.
What does it really mean?
Let’s look at what the rule does not specifically address: Losses. Just because an investment is suitable, it doesn’t necessarily mean that the investment is advisable or that it will be profitable for the client. Conversely, just because a recommendation made by a broker to a client results in the purchase of a security that decreases in value, that does not, in and of itself, mean that the recommendation to purchase the security was unsuitable.
The Suitability Rule also generally does not cover self-directed transactions (for example, a situation in which the client the client has an investment idea, makes the purchase, and she does not “run it by” her broker first nor have any interaction with any financial professionals). In that case, typically there is no recommendation; therefore, there is no concurrent obligation that the investment be suitable as there would have been if the broker had provided the recommendation. Note: In the self-directed example above, the broker-dealer still has other important obligations to the client that are not addressed in this writing.
So, we now know that generally there must be a recommendation by a broker to a client to trigger the Suitability Rule. Let’s now assume that a client comes to a brokerage firm with $100,000 to invest and the client asks his broker what he should do. What does the Suitability Rule demand? At a minimum, there needs to be a serious conversation between the broker and the client during which the broker learns pertinent information about the client before making any recommendation. Much the same way that a doctor cannot diagnose and treat a patient without first examining the patient and learning the patient’s medical history, so, too, must a broker get to know her client and act accordingly (as explained in Rule 2111.04 above). Note: A separate rule (FINRA Rule 2090) further governs a broker’s duty to know her client.
Knowing the client
During the “know your client” conversations, the broker needs to learn many things about the client. Among others, the broker should know the answers to questions like these:
- What does the client want to do with the funds?
- What are the client’s goals, needs, objectives?
- What is the client’s investment time horizon?
- Is the investment for retirement, down payment for buying a home, saving for a child’s future college expenses?
- Does the client need an income from the investment, if so, when, how much?
- How old is the client?
- Does the client work?
- How much money does the client make per year?
- What is the client’s profession?
- How long has the client been employed?
- How long does the client intend to continue working?
- How much does the investment amount at issue represent of the client’s total net worth?
- What is the client’s total net worth?
- What is the client’s tax bracket?
- Does the client have any prior investment experience? If so, what is the client’s experience?
Hopefully, these few questions give you a general idea of what the conversation between a broker and a client should consist of.
Having the conversation between broker and client is only the first step in the suitability analysis. Only after a broker knows her client well can she endeavor to make a suitable recommendation.
Unsuitable investment strategies
It is important to note that the Suitability Rule explicitly states that both individual investments and investment strategies are to be considered in a suitability analysis (as explained in Rule 2111.03 above).
For example: Let’s say that a client owns $10,000 of Ford stock, which is a suitable position for this client’s account. If a broker recommends that the client invest another $10,000 in General Motors stock, that may be unsuitable. But why? If one domestic automaker’s stock is suitable, how could another’s be unsuitable? The answer is that there is no bright line rule and it certainly could be suitable, but (for instance) if the client in question only had $20,000 in total assets to invest, it would likely be unsuitable for the broker to recommend that the client place 100% of his investable assets in one sector of the domestic equity market (e.g., stock in US automakers). Such an over-concentration in a market sector is potentially unsuitable. Further, it is very rarely suitable for a client to be invested in an all equity portfolio. Prudent investment principles dictate diversification across asset type (e.g., fixed income and equity investments) and diversification within asset types (e.g., foreign and domestic equity and/or fixed income investments), as well as further diversification such as small cap, medium cap and large cap equities and/or fixed income investments.
In short, while there is no bright line rule that explicitly states which investments are suitable and which are not, FINRA Rule 2111 gives detailed guidelines as to what type of investment recommendations are suitable.
Unfortunately for the investing public, far too often, brokers either don’t understand the rules or simply don’t care to follow them.
Types of suitability cases
In our practice of recovering money for investors against the brokerage firms who have caused them to suffer severe losses from unsuitable investment advice, the attorneys at ChapmanAlbin have seen a great many different types of suitability cases. The cases range in severity and include instances in which a broker unsuitably overloads a retiree’s investment accounts with far-too-risky investments, causing the retiree to suffer drastic losses and no longer be able use income from investments to provide for life’s necessities in retirement. ChapmanAlbin attorneys have recovered money for clients whose accounts were so unsuitably and frequently traded (“churned”) that they would have had to make more than a 130% return in a year before the account would be profitable.
While no two suitability cases are ever exactly alike because no two clients are ever exactly alike, there are common themes that often permeate suitability cases. The two most common themes in suitability cases are the greed and/or ignorance of the broker or advisor.
The greed component is easy to spot. Brokers and financial advisors deserve to be paid fairly for their work, and their compensation should be open and transparent. Whether the broker or advisor receives a commission, a management fee, or an hourly fee, the fee should be fair and understood by the client. Unfortunately, that is not always the case. Whether it is a broker selling a high-commission product to a client when a low-commission product would work just as effectively, or a broker setting up an actively traded account as a commissionable account instead of a managed account, some brokers put their clients in positions where the investments sold to the client are more financially advantageous to the broker than the client. If the greed of a broker causes the client to be sold an unsuitable investment, that is actionable.
Similarly, and just as troublesome, is the case of a lazy or ignorant broker who makes unsuitable investment recommendations to a customer. It could be a broker’s misguided belief that all clients want or need the same thing (i.e. “to make money”), therefore all clients want or need the same kind of investments regardless of the risks associated, or it could be a broker who just doesn’t understand all of the features associated with a complicated investment product like a leveraged or inverse exchange traded fund (“ETF”) and recommends the investment to a client for whom it is unsuitable. Regardless of the reason, if a client receives unsuitable investment advice and loses money as a result, that is actionable.
What should I do if I made an unsuitable investment?
If you are an investor that suffered significant losses as a result of unsuitable investment advice that you received, you may be entitled to a recovery by filing claims in FINRA Arbitration against the brokerage firm responsible for supervising your advisor.
If you would like a free, no obligation, initial consultation regarding your potential claims, please call our office today to speak with an attorney experienced in representing investors in FINRA arbitration proceedings.