Suitability obligations are critical to investor protection. FINRA Suitability Rule Guidelines are included in Rule 2111 and FINRA Rule 3110. These two rules state that brokerage firms must ensure investment recommendations, including options and private placements, are suitable according to each client’s individual profile. Failure to verify customer suitability, monitor account activity, and investigate investments like private placements can result in meaningful penalties.
Two recent Letters of Acceptance, Waiver, and Consent (known as AWC letters) discuss violations of two full-service broker-dealers relating to suitability issues. They highlight brokerages’ obligations to maintain and document relevant activities, supervise registered representatives’ activities, and investigate private placements.
While these violations stem from actions taken by individuals at full-service firms, they also highlight important concerns for digital broker-dealers and robo-advisors. These platforms also must follow suitability rules, even when end investors or algorithms are making the trading decisions.
Understanding FINRA Rule 2111 Suitability Obligations and FINRA Rule 3110
Here is what you need to know about FINRA rules that relate to suitability.
FINRA Rule 2111 identifies suitability obligations. It requires that a brokerage firm reasonably believe that a recommended transaction or investment strategy is suitable for a customer.
FINRA Rule 3110 mandates written supervisory procedures for supervising the activities of its personnel.
Transgressions in one firm included a registered principal’s failure to reasonably supervise two registered representatives, who engaged in a pattern of recommending unsuitable active trading strategies to customers and churned customer accounts.
The principal responsible for supervising the registered representatives was aware of multiple red flags of excessive trading, unsuitable use of margin, and churning. The same individual also neglected to verify new account information, maintain customer contact, and perform monthly reviews of book and sales practices.
The firm itself had already been sanctioned by FINRA in 2020 over $1.5 million, including $1.2 million in restitution and a $350,000 fine for supervisory and other violations. It had taken no action to investigate or stop excessive trading in customer accounts, although it had routinely flagged dozens of such instances.
The second broker-dealer failed to establish and maintain a system, including written supervisory policies and procedures, designed to avoid unsuitable excessive trading in customer accounts. The firm also inadequately supervised two registered representatives, who engaged in excessive trading and sold unsuitable options.
The broker-dealer did not investigate private placement offerings it was recommending to customers. Furthermore, the firm did not ascertain customers’ investment objectives, risk tolerance, time horizons, or tax status. Nor did it maintain a system for avoiding general solicitation of private placement offerings. Finally, it lacked Regulation D “safe harbor” exemptions (covering financially sophisticated investors or pre-existing brokerage-client relationships).
Both respondent firms failed to calculate turnover and cost-to-equity ratios. Turnover rate represents the number of times a portfolio of securities is exchanged for another portfolio of securities. The cost-to-equity ratio measures the breakeven amount an account has to appreciate just to cover commissions and other expenses. In both cases, clients suffered substantial losses while incurring significant gross commissions.
FINRA imposed penalties consisting of suspensions; fines of $5000 per each individual respondent and $50,000 for the second broker-dealer; continuing education; requalification by passing requisite examination; customer restitution; and undertaking to revise the second broker-dealer’s supervision system.
The Main Suitability Obligations
Takeaways from both settlements suggest several critical steps for fintech companies to ensure compliance with FINRA Rule 2111 suitability obligations and Rule 3110 supervisory requirements.
- Undertake a careful review of the extent to which educational content on your site or in your app might constitute advisory information that could lead end investors to take unsuitable actions
- Identify any asset classes in your platform that may be unsuitable for some investors (such as private placement issuances, non-U.S. equities, and alternative investments)
- Establish and maintain supervisory systems with clear and explicit documentation
- Establish customers’ investment profiles, including age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, and risk tolerance
- Monitor the turnover and cost-to-equity implications of any trading functionality, including algorithms
If you are unsure where the risks in FINRA Suitability Rules lie or how to design the right compliance program to meet FINRA Rule 2111 suitability obligations, please be in touch.