FINRA RULES INCH TOWARD HOLDING BROKERS FULLY ACCOUNTABLE TO THEIR CUSTOMERS

Later this year, the Financial Industry Regulatory Authority ("FINRA") will put in effect new rules of conduct that narrow the gap between brokers' duties and investors' expectations of their brokers' responsibility. Many investors would be surprised to learn that licensed brokers generally do not owe a duty to act in the best interests of their customers. Instead, 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 is true even where customers place exclusive reliance on their brokers and always follow their recommendations. The Securities and Exchange Commission has 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 o n 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. Additioally, 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.

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