Wednesday’s Word: Suitability

By Alex Hughes, Fall 2015 Student Intern

What is suitability?

Suitability is discussed in two industry code of conduct rules: NASD Rule 2310 and FINRA Rule 2111. The old suitability rule, NASD Rule 2310, applies to cases filed before July 9, 2012. NASD Rule 2310 provides in pertinent part:

  • 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.

The old rule defines suitability in terms of having a reasonable basis for a recommendation to a customer. In forming that reasonable basis, NASD Rule 2310(b) provides the member should obtain information about the customer’s:

  1. Financial status
  2. Tax status
  3. Investment objectives
  4. Other information considered to be reasonable.

The new suitability rule, FINRA Rule 2111, expounds on the old rule, and governs cases filed after July 9, 2012. FINRA Rule 2111(a) requires a member or associated person to have a reasonable basis for believing a recommended a transaction or investment strategy was suitable for the customer. Determining suitability under the new rule requires consideration of the customer’s:

  1. Age
  2. Other investments
  3. Financial situation and needs
  4. Tax status
  5. Investment objectives
  6. Investment experience
  7. Investment time horizon
  8. Liquidity needs
  9. Risk tolerance
  10. Other information the customer discloses.

FINRA Regulatory Notice 12-25 explains that the new suitability rule clarifies three main suitability obligations: reasonable-basis suitability, customer specific suitability, and quantitative suitability. Reasonable-basis suitability requires a broker to investigate the recommended security or investment strategy, like its risks and rewards, and to determine the recommendation is suitable for at least some investors. Customer-specific suitability requires a broker to have a reasonable basis for recommending the security or strategy to the customer based on the Rule 2111(a) factors. Quantitative suitability requires a broker to have a reasonable basis for believing a series of recommendations are not excessive. Essentially, suitability requires a broker to make recommendations that are in the best interests of the investor/customer, and to place those interests ahead of the broker’s own interests.

Why is suitability important?

According to The Practitioner’s Guide to Securities Arbitration, unsuitability claims are the most common claims submitted to FINRA arbitration. Unsuitability claims can be based on state securities statutes, common law, and industry code of conduct rules. Firms and brokers defend suitability claims by either arguing that the broker did not recommend the security or that the customer knew about the risks of the recommendation. Because suitability claims often come down to a “he-said, she-said” dispute, it is important for customers to know what suitability is and be aware of what information the broker needed and should have considered in order to make a reasonable recommendation. The SEC encourages customers who believe a broker made an unsuitable recommendation for them to submit a complaint.