If you've wondered, as we have, exactly what it says, wonder no more

May 5, 2010 — 4:57 AM UTC by Elizabeth MacBride

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Here at RIABiz we’ve been watching, fascinated as the rest of the country, while the Goldman Sachs hearings expose the inner workings of Wall Street. The strangest part of the drama is that two years ago, Goldman was being toasted for the very practices that the Senators are hammering the company’s executives about now. It appears the push-me, pull-you relationship between Wall Street and the government is about to evolve, once again. At issue is the suitability standard, which loosely governs the conduct of broker-dealers. We went looking for as close to an exact definition of the existing standard as we could find. This is what we came up with. Incidentally, the Compact Oxford English Dictionary says suitable means, “right or appropriate for a particular person, purpose, or situation.”

Brooke’s Note: Elizabeth wrote the counterpart article to this one a while ago. See: How 10 top groups define 'fiduciary’ and where it’s all headed

The suitability rule, as defined by NASD, precursor to FINRA

Recommendations to Customers (Suitability):

(a) In recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.

(b) Prior to the execution of a transaction recommended to a non-institutional customer, other than transactions with customers where investments are limited to money market mutual funds, a member shall make reasonable efforts to obtain information concerning:

  1. the customer’s financial status;
  2. the customer’s tax status;
  3. the customer’s investment objectives; and
  4. such other information used or considered to be reasonable by such member or registered representative in making recommendations to the customer.

(c) For purposes of this Rule, the term “non-institutional customer” shall mean a customer that does not qualify as an “institutional account” under Rule 3110©(4).

Source: Securities Industry and Financial Markets Association

Case law used as reference by the SEC

“A broker may recommend the purchase or sale of any security to a customer only if the broker has reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.” F.J. Kaufman and Co., Exch. Act Rel. No. 27535, 50 SEC 164 (Dec. 13, 1989) (citations omitted); see also Hanly v. SEC, 415 F.2d 589, 597 (2d Cir.1969) (a broker-dealer “cannot recommend a security unless there is an adequate and reasonable basis for such recommendation.”).

“The suitability rule thus requires a broker-dealer to make a customer-specific determination of suitability and to tailor his recommendations to the customer’s financial profile and investment objectives.” F.J. Kaufman and Co., supra.

“The reasonableness of any recommendation is predicated on a registered representative’s understanding of the potential risks and rewards inherent in that recommendation.” Michael Frederick Siegel, Exch. Act Rel. No. 58737 (October 6, 2008) (citation omitted).

“A broker may violate the suitability rule if he fails so fundamentally to comprehend the consequences of his own recommendation that such recommendation is unsuitable for any investor, regardless of the investor’s wealth, willingness to bear risk, age, or other individual characteristics.” Id. citing F.J. Kaufman and Co., Exch. Act Rel. No. 27535, 50 SEC 164 (Dec. 13, 1989).

Source: SEC

National Association of State Securities Regulators’ rule on unethical business practices of broker-dealers and agents

Recommending to a customer the purchase, sale or exchange of any security without reasonable grounds to believe that such transaction or recommendation is suitable for the customer based upon reasonable inquiry concerning the customer’s investment objectives, financial situation and needs, and any other relevant information known by the broker-dealer.

“States, of course, are free to adopt their own provision or to use this one. It is also common for state rules/regs to contain a prohibition against violating a rule of a self regulatory organization,” spokesman Bob Webster said.

Source: NASSA (NASSA’s model rules are available here. )

Ron Rhoades, RIABiz’s One-Man Think Tank columnist (excerpt from his explanation of the legal issues playing out in the Goldman Sachs hearings)

I get asked about suitability a lot. I explain, to regulators, that it basically is a rule that prevents harm from being done to a customer in an otherwise arms-length relation with a broker. The suitability rule says (in simple terms) that “the investment must, from the standpoint of its riskiness, be OK for this particular customer, taking into consideration the circumstances of the customer and the customer’s portfolio as a whole.”

The suitability obligation consists of two inter-related dimensions. The first is “know-your-customer” suitability, which focuses on the circumstances of the particular customer. The second is “know-your-security” suitability (also called “reasonable-basis suitability”), which focuses on the characteristics of the recommended security.

Yet, a “suitable investment” is one that is “just OK” from the standpoint of the investment product’s risk characteristics, as pertaining to that customer. The BD is generally not required, as part of suitability, to consider the fees, costs, nor tax efficiency of an investment product.

No ongoing duty

Nor is the broker required to monitor the investment. A salient feature of a BD’s obligations under the suitability doctrine, generally, is that they flow from the recommendation of a securities transaction to the customer. After execution of the recommended transaction the BD generally possesses no ongoing duty with respect to the security purchased. However, there exists some authority that taking an unsolicited order for a security, which the BD knows or should know is so egregiously unsuitable for the client that it should not be permitted, or permitting an investor to pursue a course of conduct – such as margin trading on Internet stocks – can form a basis for BD liability. At the minimum, a “duty to warn” the customer of undue risks may exist. For this reason full-service and discount BDs often limit the products on their platform, or permit only certain pre-qualified clients to access certain types of products or trading strategies.



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