Unsuitable Trading

An associated person has a duty to recommend suitable investments and investment strategies in light of the customer’s investment profile. The requirement to recommend suitable investments is commonly known as the suitability rule and is codified under FINRA Rule 2111(a), which states:

A member or an associated person must 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. 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 member or associated person in connection with such recommendation.

(Rule 2111(b) carves out an exception for institutional investors, who are described as customers with at least $50 million in assets)

Rule 2090, also known as the “Know Your Customer Rule,” outlines other duties related to assessing suitability, particularly the requirement that firms exercise reasonable diligence to know their clients. Rule 2090 states, “Every member shall use reasonable diligence, regarding the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer and concerning the authority of each person acting on behalf of such customer.” At the heart of Rule 2090 rests the notion that firms should use reasonable diligence to apprise themselves of the details of an investor’s objectives and risk profile. The information collected (and retained) from a reasonably diligent inquiry then forms the basis for recommending a suitable investment or investment strategy.

The notes appended to Rule 2111 indicate that the suitability requirement of the rule is composed of three main obligations:

• reasonable basis suitability - the investment is suitable for at least some customers;
• customer specific suitability - the investment is suitable for the specific customer to whom the recommendation is being made; and
• quantitative suitability - an associated person who has actual or de facto control over an account must determine that a series of transactions in an account are suitable for the customer (this is essentially directed at prohibiting churning/excessive trading).

Based on a reading of Rule 2111 (a), a suitable investment strategy is determined on a customer-by-customer basis that should be attuned to the customer’s investment objectives and risk profile. As such, what constitutes a reasonable and suitable investment or investment strategy is largely fact dependent and can vary depending on the complexity of the portfolio, the customer’s investment profile and the risks associated with the security or investment strategy.

In addition to focusing on the actual investment strategy or security being recommended to the customer, the suitability rule also requires that an associated person articulate the potential risks and rewards associated with the recommendation. As such a suitable strategy is one that is reasonable and suitable but is also understood by the customer. When a security or investment strategy is proposed without an understanding by the customer of its associated risks and rewards the associated person violates the suitability rule.

Violations of the suitability rule can involve various types of conduct by associated persons. One of the more common examples involves an associated person who recommends a security or investment strategy when a customer does not have the financial ability to incur the risk associated with the product. Under these circumstances, an associated person may not have conducted a reasonably diligent inquiry or may be suggesting an investment for their personal gain. In either case, it would be an unsuitable recommendation. Further, associated persons have been found to violate the suitability rule when a security or investment strategy does not meet the customer’s financial needs or expressed objectives. In addition to not meeting the customer’s objectives, a security or investment strategy will always be considered unsuitable when the customer is not apprised of the risk associated with the investment.

Under any of the circumstances outlined above, an associated person could be found liable for recommending an unsuitable security or investment strategy if he or she is unable to establish that a reasonably diligent inquiry was conducted and that advice provided was reasonable and thus suitable for the customer. In the event the security or investment strategy recommended is found unsuitable, an associated person and his or her firm could be held liable for losses arising from an unsuitable security or investment strategy recommended to the customer.