CCO Action Alert: FINRA Suitability Rule Guidelines - FINRA Rule 2111 + FINRA Rule 3110

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.