FINRA Rule 2111
FINRA Rule 2111 requires regulated securities professionals to only conduct trades and transactions that are suitable for the customer. In order to do this, broker-dealers have to take steps to understand their customers’ needs and desires, their risk tolerance, and the investment goals that they have. They also have to be familiar with the investment strategy or securities that they are recommending. Additionally, Rule 2111 requires brokers to take into account the transactional fees that they would be charging for a given series of trades when deciding whether an investment strategy is suitable for the customer.
Rule 2111 is one of the FINRA Rules that securities professionals and brokerage firms have to consider every single day, and for every single transaction that they process. The securities litigation and FINRA defense lawyers at the national law firm Oberheiden P.C. have helped brokerage firms come up with compliance protocols that keep it in line with Rule 2111’s obligations and have defended firms and securities professionals who have been accused of breaking the Rule.
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The Basics of FINRA Rule 2111
FINRA Rule 2111 is one of the many rules that the Financial Industry Regulatory Authority (FINRA) has adopted to self-regulate the securities industry under the watchful eye of the U.S. Securities and Exchange Commission (SEC).
At the heart of Rule 2111 is the requirement that securities professionals “have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer.” The rest of the Rule expands on this requirement and explains how it works for institutional investors.
The supplementary material provided by FINRA for Rule 2111 indicates that there are three major obligations under the Rule:
- Establishing a reasonable basis to believe the trade is suitable,
- Understanding the customer, and
- Quantitative suitability.
Each is worthy of a fuller explanation.
1. Establishing a Reasonable Basis to Determine the Suitability of a Trade
Securities professionals have to conduct reasonable diligence to determine whether an investment strategy is suitable to at least some investors. The focus of this aspect of Rule 2111 is on the understanding that the securities professional has of the trade, transaction, series of transactions, or overall investment strategy. This includes understanding:
- The complexity of the trade
- Any risks associated with the security or investment strategy
- The securities professional’s familiarity with the transaction
Not having a reasonable basis to believe that the trade is suitable or not understanding the risks and rewards of the investment strategy violates Rule 2111.
2. Understanding the Customer’s Needs
In order to know that an investment strategy is suitable for the customer, broker-dealers need to understand their customer. Rule 2111 refers to the customer’s “investment profile” and lists several key components of it. They include the customer’s:
- Investment portfolio and the other assets in it
- Needs and interests
- Financial situation
- Tax status
- Investment objectives
- Experience in investing
- Time horizon for the investment strategy
- Liquidity needs
- Risk tolerance
This is not an exclusive list. FINRA also makes it clear that any other information that the customer provides needs to be taken into account by the securities professional when determining whether an investment is suitable and in compliance with Rule 2111.
3. Ensuring Quantitative Suitability of Trading
While the bulk of the work of complying with Rule 2111 is focused on ensuring that the investment scheme is suitable for the customer’s needs, securities professionals also have to take steps to form a reasonable basis for believing that a series of transactions is quantitatively suitable for the customer, as well.
Transactions incur fees. Those fees can stack up. To comply with Rule 2111, securities professionals have to ensure that transactions that are suitable in isolation are still suitable when viewed in the aggregate. Factors for making this determination include:
- The customer’s investment profile
- Turnover rate
- Cost-equity ratio
- Use of in-and-out trading
Rule 2111 and Institutional Investors
FINRA Rule 2111(b) focuses on how suitability works when the account is an institutional account under Rule 4512(c). These are accounts that are owned by a:
- Savings and loan association
- Insurance company
- Registered investment company
- Investment advisor who is registered either with the SEC or a state securities commission
- Individual person, trust, partnership, or corporate entity with assets in excess of $50 million
When it is an institutional account, securities professionals satisfy their suitability obligations under FINRA Rule 2111 if they:
- Have a reasonable basis to believe that the customer can evaluate investment risks independently, both in general and in regards to the particular transactions being conducted, and
- The customer affirmatively indicates that it is exercising independent judgment over the broker-dealer’s recommendations.
When the institutional customer has delegated this evaluation and judgment to an agent, such as a bank or investment adviser, the securities professional still has to take these steps, but apply them to the agent, instead.
The Intersection of Rule 2111 and the SEC’s Regulation Best Interests
In June, 2020, FINRA amended its Rule 2111 regarding suitability to bring the Rule in line with the SEC’s Regulation Best Interest (17 C.F.R. § 240.15l-1).
SEC’s Regulation Best Interest requires securities professionals to act in the best interests of retail customers when recommending securities transactions or investment strategies.
FINRA’s amendment to Rule 2111 (SR-FINRA-2020-007) stated that the suitability standard imposed by Rule 2111 is a lower standard than the best interests standard imposed by the SEC. Therefore, when the account is held by a retail customer, meeting the requirements of Rule 2111 did not necessarily mean that the securities professional is complying with the SEC’s demands. There are limited circumstances where an investment strategy or transaction is suitable for retail investors, but is still not in their best interests. Conversely, satisfying the SEC’s best interests standard automatically satisfies FINRA’s suitability requirement.
Frequently Asked Questions About FINRA Rule 2111 and Oberheiden P.C.’s Law Practice
What is a “Recommendation”?
An important limitation to FINRA Rule 2111 is that it only applies to “recommendations.” These are communications between a regulated securities professional and a customer that advise particular trades or investment strategies, such as an explicit recommendation to buy or sell a security. However, the following communications are not “recommendations” if they do not, alone or in conjunction with other communications, recommend particular transactions or investment decisions:
- Providing general investing or financial information, such as informational articles that cover topics like:
- Risk and return
- Compounded return
- Tax deferred investments
- Historic differences in the returns of certain types of assets
- Assessments of a customer’s investment profile
- Information about an employer-sponsored retirement or other benefit plan
- Asset allocation models, so long as they are:
- Based on generally-accepted investment strategies,
- Accompanied by adequate disclosures, and
- In compliance with FINRA Rule 2214.
These types of communications do not have to meet the suitability requirements of Rule 2111.
What are Some Examples of Unsuitable Strategies or Transactions?
FINRA Rule 2111 relies heavily on vague words and phrases like “suitability” and “reasonable basis for belief.” These amorphous terms mean that there are few clear cut and definite violations of the Rule. They also mean that you could face sanctions for violating Rule 2111 even when you think that you were complying with it.
However, a few investment strategies and transactions that are likely to be deemed unsuitable include:
- Creating an investment portfolio that is not going to mature before the time horizon
- Loading an account with risky investments right at the last moment
- Adopting an investment strategy that needlessly accumulates transactions and the fees associated with them, also known as “account churning”
- Using the same investment strategy for all customers
Why Should I Hire Oberheiden P.C.?
Because Oberheiden P.C. is a national law firm filled solely with senior level attorneys that practice predominantly in federal court, where many securities cases are filed.
When you go to another law firm, chances are that your case will not be handled by the senior associate or partner whose experience and talents attracted you to the firm. Instead, it will get delegated to an associate further down the ladder – an associate with far less experience handling securities cases. In many cases, the majority of the legal work is actually done by a paralegal instead of a lawyer.
That does not happen at Oberheiden P.C. All of our personnel are senior lawyers with extensive experience in securities litigation. Furthermore, and unlike other lawyers, they practice more in federal court than in state court. That intimate familiarity with the process allows our attorneys to better serve our securities clientele.
Why Don’t You Call Yourselves the Best FINRA Defense Firm?
We would rather let our clients’ testimonials say those sorts of things about our firm.
FINRA Defense and Compliance Attorneys at Oberheiden P.C.
Complying with the demands of FINRA Rule 2111 requires constant vigilance and awareness. Securities professionals need to keep the suitability rules at the front of their mind whenever they recommend an investment strategy or transaction, and need to be diligent in learning as much as they can about a customer and his or her needs – including when those needs and concerns change over time.
If you need legal assistance complying with FINRA Rule 2111, or if you or your brokerage firm has been accused of violating the Rule, call the FINRA attorneys at Oberheiden P.C. at (888) 680-1745 or contact them online.