What Does Unsuitability Mean in Securities Law?
If an investment is unsuitable, it means that it is not fitting or appropriate for you. In securities law, what makes something unsuitable?
The Financial Industry Regulatory Authority (FINRA) is the largest independent regulator for all brokerage firms doing business in the United States. FINRA sets a suitability standard, and that standard obligates brokers to make recommendations they believe effectively suit the interests of their clients.
What Makes an Investment Suitable?
FINRA governs general suitability obligations for brokers. FINRA Rule 2111 sets out three components of suitability obligations: reasonable-basis suitability, customer-specific suitability, and quantitative suitability.
1. Customer-Basis Suitability
Information on a customer’s age, financial situation, investment objectives, investment experience, and risk tolerance should all inform a broker’s decision to recommend a particular security to their client.
- The cost of the investments may be too high or too high-risk for a retired client who relies on their brokerage account for income.
- Investors might need to access their funds in an emergency, which means that investments should not be too illiquid, meaning investors cannot cash out without incurring significant fees.
- Like non-traded REITs and leveraged ETFs, complex investments should be left to investors with more trading experience.
2. Reasonable-Basis Suitability
Reasonable-basis suitability means that the investor is either capable of evaluating the risks associated with an investment themselves or has agreed to let their broker assess the risks for them. If the broker does not understand an investment, they cannot recommend it to their clients.
3. Quantitative Suitability: Excessive Trading and Churning
FINRA 2111 also requires brokers to recommend quantitatively suitable investments–meaning the number of securities transactions must make sense for the investor. Each securities transaction comes with fees, so too many trades will make it more difficult for an investor to profit. Suitability also includes making sure transaction costs are not excessive.
Executing too many transactions in an investor’s account is called “churning” or “excessive trading.” Brokers might engage in this type of misconduct to generate more commissions for themselves.
Does FINRA Require Brokers to Work in their Clients’ Best Interest?
Yes. Regulation Best Interest (BI) is a Securities and Exchange Commission rule that requires broker-dealers to only recommend financial products to their customers that are in their customers’ best interests, and to clearly identify any potential conflicts of interest and financial incentives the broker firm may have for the sale of those products.
The Regulation BI falls under the Securities and Exchange Act of 1934 and establishes a standard of conduct for brokers and brokerage firms when recommending any securities transaction or investment strategy. Regulation BI was put into place in 2020.
Previous to Regulation BI, brokers were only held to the suitability standard – meaning that when brokers advised their clients, they only had to recommend investments that were suitable but not necessarily in their clients’ best interest. Of course, some financial advisors have always and continue to be considered fiduciaries and are treated to heightened standards and requirements.
Regulation BI addresses several issues that affect investors and their professional relationship with financial professionals, such as disclosures about products and services, the conduct of broker firms, and how information is given. The goal is to help investors make better, informed decisions, as well as to protected investors.
What is a Fiduciary?
A fiduciary is a person that acts on another’s behalf, putting the clients’ interests ahead of his own while preserving good faith and trust. Brokers and financial advisors are arguable fiduciaries, but jurisdictions can apply this differently. Regardless, brokers must adhere to FINRA 2111 and seek to act in their clients’ best interests.This is the main safeguard between investors and reckless brokers. Investors should always keep in mind that although brokers are obligated to recommend investments that they believe are suitable for the investor, it does not automatically mean the recommendations are best for the investor.
What Happens When a Broker Recommends an Unsuitable Investment?
Unfortunately, brokers often fail to uphold the duty to make suitable investments. As a result, unsuitable investment claims are among the most common FINRA arbitration cases. When an investor can show that a broker recommended an unsuitable investment, the firm may be liable to pay an investor back for their losses.
What Happens in a Suitability Arbitration Case?
When investors believe their broker recommended an unsuitable investment, they should enter a Statement of Claim with FINRA and begin the arbitration process.
Investors should also take proactive steps to avoid unsuitable investment recommendations in the first place. Before working with an investor, an investor should make sure to review their broker’s FINRA BrokerCheck record. Certain investors have multiple investor disputes on their record that allege they recommended unsuitable investments. Investors should always be wary of brokers who have been involved in suitability disputes.
If you discover your broker has a significant history of unsuitable recommendations, consider taking your business elsewhere.
My Broker Recommended Unsuitable Investments – What’s Next?
Investors who believe their broker may have recommended unsuitable investments should speak to a securities attorney and start gathering the documentation they will need to bolster their claim. If you specifically stated you wanted low-risk investments and then end up with a portfolio full of illiquid, high-risk securities, you may have an especially good case for FINRA arbitration. Contact the securities attorneys of Patil Law for a free case evaluation today: Call 800-950-6553 or email cp@patillaw.com for a free case evaluation.