In the following excerpt from the February 2013 PLUS Journal article “New Suitability Considerations In The Sale of Complex Financial Products,” authors Robert Usinger and Todd Kremin discuss considerations under FINRA Rule 2111, the “suitability rule.”
PLUS members can read this entire article in the PLUS Journal archives.
FINRA Rule 2111 (the “Suitability Rule”) became effective in July 2012, and expanded the scope of former NASD Rule 2310. The new Suitability rule generally requires that a firm 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 member or associated person to ascertain the customer’s investment profile.” The new Suitability Rule divides the suitability obligations and operates as a three prong test: Reasonable Basis Suitability, Customer Specific Suitability, and Quantitative Suitability. Each prong has its own distinct implications yet all must be considered, especially when selling complex products.
“Reasonable Basis” Suitability
Because many complex financial products have the potential for sudden and/or severe losses of principal, it is imperative that firms recommending these products document a thorough “reasonable basis” suitability analysis. To meet this requirement, a firm and its representatives must have a reasonable basis to believe, based on “reasonable diligence,” that a recommendation is suitable for at least some investors. The reasonable diligence performed must provide the firm with an understanding of the possible risks and rewards of the recommended security or investment strategy. Thus, it is important that a firm be prepared to demonstrate the “reasonable diligence” that it exercised in conducting this analysis by maintaining a robust “due diligence” file. Put simply, if a firm cannot demonstrate to regulators or claimants in arbitration that it conducted reasonable due diligence that resulted in an understanding of the material features and risks of the product, it may never have a chance to demonstrate how or why it determined that the product was suitable for a particular client.
A recent FINRA Dispute Resolution arbitration case involving a very sophisticated and experienced claimant is illustrative. . In April 2012, a FINRA Dispute Resolution arbitration panel found that the respondent firm failed to perform an adequate “reasonable basis” suitability determination before it sold collateralized bond obligations to James Zeigon, the former Chief Executive of Global Institutional Services for Deutsche Bank. It is hard to imagine a more sophisticated claimant than a very senior executive with one of the world’s largest financial services firms. Yet, the arbitration panel in Zeigon apparently based its decision, at least in part, on its finding that the subject investment was too complex for anybody. Indeed, if a former bank president, arguably someone on the outer fringes of sophistication, is not a suitable customer for collateralized bond obligations, is anyone? The product was not a Ponzi scheme or an otherwise unapproved sale. It may have been unsuitable for the majority of customers, but Zeigon was highly sophisticated. This has troubling implications for the ability to evaluate potential exposure for respondents in litigation against sophisticated claimants.
After the “Reasonable Basis” suitability determination is made, the broker must perform a “customer-specific” suitability analysis. This requires that a firm and its brokers have a reasonable basis to believe that the recommendation is suitable for a particular customer, based on the customer’s investment profile. Among other things, the new Suitability Rule expands the composition of the customer-specific investment profile by adding the five new factors to be considered in the suitability analysis: age, investment experience, time horizon, liquidity needs and risk tolerance. Thus, logic (and FINRA) advise that the customer-specific suitability analysis should not turn on any one factor, but, instead, consider the customer’s investment profile as a whole, especially as it relates to a specific product. Indeed, the suitability analysis for a traditional value-oriented mutual fund may be less involved than the analysis for a product that contains, for example, an embedded derivative component. Thus, it is critical that the broker’s analysis that a particular product is suitable for a particular client be well-documented, showing consideration for the customer’s investment profile. This prong is aligned with the prior suitability requirements under NASD Rule 2310 with which most broker-dealers were familiar.
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