FINRA “Know Your Client” and Suitability Rules

Last summer (2012) FINRA came out with new Know Your Client (“KYC”) and Suitability Rules, which replaced NYSE Rule 405 (the old KYC Rule) and NASD Rule 2310 (the old Suitability Rule) applicable to securities brokers/dealers and firms.  The old rules were pretty unclear and the new rules help to clarify some points, but aren’t exactly as clear as they can be.  FINRA will have some wiggle room in applying them.

New FINRA Know Your Client Rule – 2090

The new FINRA Rule 2090 requires firms to use “reasonable diligence” with respect to opening and maintaining every account so that the firm knows the “essential facts” of every customer.  Rule 2090.01 defines the “essential facts” as those required to:

  • effectively service the customer’s account;
  • act in accordance with any special handling instructions;
  • understand the authority of each person acting on behalf of the customer;
  • comply with applicable rules, laws and regulations.

The new rule sets a changing standard as it applies to “maintaining” every account – which requires that the firm relationship with the client is “dynamic” and that the firm should be aware of changes in each customer’s situation.  This is independent, but seems related to, a firm’s obligation to update its customer information every 3 years (provided in another rule).

The KYC Rule still applies even if the firm isn’t making recommendations.  Unlike the predecssor rule, the new KYC rule does not address orders, supervision, or account opening, which are all covered by seperate existing rules.

New FINRA Suitability Rule – 2111

The new Suitability Rule requires that a firm “have a reasonable basis to belive 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] to ascertain the customer’s investment profile.” FINRA Rule 2111(a).  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 [firm] in connection with such recommendation.” Id.

The new Suitability Rule doesn’t apply until a broker/firm makes a recommendation.  The question is what is a “recomendation.”  The new Rule used a flexible “facts and circumstances” approach to determine what communications are a recommendation.  Whenever one of these “flexible” tests are used, you should watch out, there is a good deal of leeway into what can be found a recommendation.  A very important part of the new suitability rule is that it explicitly covers recommended investment strategies, as well as explicit recommendations to hold certain investments.  There are some exemptions as to what an investment strategy is, like certain asset allocation models.  FINRA wants to encourage brokers to hand out (free) educational material and services to customers.  In providing anything, brokers should be careful that the materials are truly educational and not a recommendation, and the individuals should be carefule that no specific recommendations are made when conducting educational services.

Reasonable Basis Suitability – This requires a look at the investment alone.  The firm, after reasonable diligence, must have a reasonable basis to believe that any recommendation is suitable at least for some investors.  This obligation can be boiled down to this question: Is this a suitable investment for anyone?  The firm must have an understanding of the potential risks and rewards of each potential investment.  If the risks are very high and the potential return is not, then maybe the potential investment is not right for anyone.

Customer-Specific Suitability – This is a subjective look at the customer/client’s investment profile as well as the investment.  It requires that a firm take the customer’s investment profile into account and only recommend investments that may suit that profile.  (There is an exemption for Instituational Investors for this obligation, but not for the two below).  This suitability obligation requires the firm to take into account the “essential facts” of the customer as they concern the potential investment.

Quantitative Suitability – This requires that the person with control over a client’s account have a reasonable basis that a recommended transaction or series of transactions (even if suitable when viewed individually) are not excessive and unsuitable for the client.  This will apply to churning, turnover rate, cost-equity ratios, use of in-and-out trading and other items.  This is a look at the client’s overall portfolio.

In summary remember three points:  The firm must know (1) what it is selling; (2) who it is selling it to, and; (3) why it is selling it to who it is selling it to.  The use of disclaimers is not enough.