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Broker-dealer advises retail clientsFinancial professionals who recommend clients buy a security or financial product are held to ethical standards that can be enforced by law. One such standard is known as the suitability rule, which is described in Rule 2111 of the Financial Industry Regulatory Authority (FINRA). It requires that every recommendation by investment broker-dealers must consider a client’s age, objectives, experience, risk tolerance and other traits so recommendations are suitable for a specific client. Recently, though, that standard has been raised for working with certain clients. Here’s what you need to know about this rule and how the change may affect you.

Prior to June 2020, FINRA’s Rule 2111 required that a broker-dealer or associated person “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 firm or associated person to ascertain the customer’s investment profile.”

Three-Fold Test of the Suitability Rule

Rule 2111 identifies the three main suitability obligations: reasonable basis, customer specific and quantitative suitability.

Reasonable Basis Obligation

This means the broker has to have a reasonable basis to believe the recommendation might be suitable for at least some investors. A broker can fulfill the reasonable basis obligation by doing enough due diligence to understand the investment and be satisfied that it is fit to be sold to the general public.

Customer Specific Obligation

In addition to making sure that an investment might be suitable for at least some people, the broker must determine that the investment is suitable for a specific customer. To do this they need to consider the customer’s:

  • Age
  • Other investments
  • Financial situation and needs
  • Tax status
  • Investment objectives
  • Investment experience
  • Investment time horizon
  • Liquidity needs
  • Risk tolerance

Further, FINRA says the broker must consider any other information disclosed by the customer that could bear on the question of suitability. Gathering this information is typically done when the customer fills out a questionnaire used to create an investor profile.

Quantitative Obligation

The quantitative obligation is intended to limit the practice of churning, or conducting excessive buy and sell trades in order to generate more commissions for the broker. It states that a series of transactions may be unsuitable even if each of them is suitable when viewed alone. To determine quantitative suitability, the broker is supposed to consider the investment profile.

This suitability standard meant that if there were two equally suitable securities to recommend to a client, the broker could recommend the one that offered him a greater commission or fee, which of course would be paid by the client.

Regulation Best Interest

Stock chartFINRA’s decision to adopt the Security and Exchange Commission’s Regulation Best Interest in June 2020 addresses the same conduct with respect to retail customers that it addresses by Rule 2111, but employs a best interest – rather than a suitability – standard. A broker-dealer is now required to comply with both Regulation Best Interest and Rule 2111 regarding recommendations to retail customers.

If two securities are equally suitable for a client, to consider a hypothetical case, but security has a lower commission or fee, then the broker must recommend the less expensive of the two otherwise equal options.

Compliance with Reg BI results in compliance with Rule 2111 “because a broker-dealer that meets the best interest standard would necessarily meet the suitability standard,” FINRA says.

Brokers are supposed to follow the recently enhanced suitability rule when advising ordinary members of the investing public, but rules are looser when the client is an institution such as a bank or another investment company. If broker has a reasonable basis for thinking that an institutional investor is capable of evaluating risks and the institution indicates that it is exercising its own independent judgement, that is enough to satisfy Rule 2111.

What’s a Recommendation?

Only certain communications from a broker to a client are considered to be recommendations and thus subject to Rule 2111. If a broker calls a client with a stock tip advising purchase, that would be considered a recommendation and subject to the rule. Similarly, an online investment portfolio management tool that suggests securities for clients to buy and sell would also be a covered recommendation.

More generic, non-targeted communications aren’t considered recommendations. For instance, a web-based library that contains research reports on securities would not have to follow Rule 2111.

FINRA also exempts general financial and investment information including material on basic investment concepts such as diversification and dollar-cost averaging. Statistics on historical differences in the returns of various asset classes also are not considered recommendations. Brokers can discuss the effects of inflation, projections of future financial needs in retirement, information about company retirement plans and benefits of such plans without having to consider suitability.

Brokers also avoid making recommendations that come under the enhanced suitability rule if they are discussing asset allocation models based on generally accepted investment theories. However, they do have to disclose the assumptions the models use and how those might affect an investor’s assessments.

The Bottom Line

Broker-dealer prepares recommendations for clients

Rule 2111 is intended to encourage fair practices, including keeping brokers from selling merely suitable investments and conducting excessive trades to boost commissions when they work with retail clients. Ask your financial advisor if he or she is bound to adhere to the best interest standard in making investment recommendations. The enhanced suitability requirements in FINRA’s Rule 2111 now require broker-dealers to make only recommendations that are in the best interest of their retail clients. This calls for considering a client’s investment profile, including age, objective, financial capacity and risk tolerance as well as recommending the security that is both optimal and least expensive for retail investors.

Tips for Investing

  • Any time you are considering making an investment decision, it’s a good idea to talk it over with an experienced financial advisor. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
  • If you are ready to start investing, you might start by checking out our investment calculator to gauge the risk and potential returns of specific asset allocations.

Photo credit: ©iStock.com/Prostock-Studio, ©iStock.com/MicroStockHub, ©iStock.com/Ridofranz

Mark Henricks Mark Henricks has reported on personal finance, investing, retirement, entrepreneurship and other topics for more than 30 years. His freelance byline has appeared on CNBC.com and in The Wall Street Journal, The New York Times, The Washington Post, Kiplinger’s Personal Finance and other leading publications. Mark has written books including, “Not Just A Living: The Complete Guide to Creating a Business That Gives You A Life.” His favorite reporting is the kind that helps ordinary people increase their personal wealth and life satisfaction. A graduate of the University of Texas journalism program, he lives in Austin, Texas. In his spare time he enjoys reading, volunteering, performing in an acoustic music duo, whitewater kayaking, wilderness backpacking and competing in triathlons.
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