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On May 18, 2012, the Financial Industry Regulatory Authority (FINRA) announced further guidance on its new rules concerning Know Your Customer and Suitability of Investment Recommendations. FINRA Rules 2111 and 2090 are modeled after former NASD Rule 2310 (Suitability) and former NYSE Rule 405(1) (Know Your Customer). These new rules retain the core features of the previous rules while codifying a number of important interpretations of the rules and imposes new obligations on broker-dealers. These new rules become effective on July 9, 2012. Investors who have suffered investment losses in their securities accounts maintained at FINRA member broker-dealers should consult with an attorney experienced in broker-dealer securities law to determine their rights under the new FINRA rules. Pearson Warshaw attorneys have extensive experience in FINRA arbitrations brought on behalf of investors.

New FINRA Rule 2111 clarifies and expands a broker-dealer’s obligation when making recommendations on the purchase or sale of securities. A significant change from the former rule is that Rule 2111 now explicitly covers any recommendation to “hold” a securities position. Other significant changes or clarifications include:

  • Reasonable-Basis Suitability –– Broker must perform reasonable diligence to understand the nature of the recommended security or investment strategy, as well as the potential risks and rewards of the particular security or strategy. Based upon such analysis the broker must determine if the recommended investment is at least suitable for some investors.
  • Customer-Specific Suitability – Broker must have a reasonable basis to believe that a security or investment strategy recommendation is suitable for the particular customer based upon that customer’s investment profile.
  • Quantitative Suitability – Broker who controls a customer’s account must have a reasonable basis to believe that a series of recommended securities transactions are not excessive.

A further significant change in the suitability rule is an expanded explicit list of customer-specific factors that firms must obtain and consider in determining a customer’s investment profile. The new rule adds age, investment experience, time horizon, liquidity needs and risk tolerance to list of specific factors that must be considered before making investment recommendations.

As with the securities laws in general and the suitability obligations of brokers specifically, understanding your rights as a customer is a legal and fact intensive inquiry. For example, the Reasonable-Basis Suitability analysis brokers are required to make under Rule 2111 requires that the broker understand the recommended investment strategy. With increasingly complex investment products offered by Wall Street firms such as derivative hedging strategies or 2X inversed EFTs many brokers have limited understanding of the securities and investment strategies they recommend. The recent hedging loss sustained by J.P. Morgan Chase, the largest U.S. bank, shows the degree to which even the most sophisticated investors fail to understand the true risks a specific strategy entails.

Investors who wish to discuss their individual situation can contact Pearson Warshaw’s at [email protected] or at (818) 788-8300. For additional information about the new FINRA Rule 2111, see FINRA Regulatory Notice 12-25, “Suitability.” For a copy of that notice click here.