Robert J. Powell, III

ContactRobert Powell is the editor of Retirement Weekly, a Marketwatch/Wall Street Journal Digital Network publication. Powell also serves as a columnist for MarketWatch, writing about retirement and investing. Powell is also the editor of the Retirement Management Journal and the curriculum director of Boston University's Online Retirement Management Program.
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Advisors React to FINRA’s New Suitability Rule; Problems Likely For Dually Registered Advisors edit
Wednesday, July 11, 2012 19:00

Tags: dually registered | registered reps | RIAs

It’s official. FINRA Rule 2111, which was approved by the Securities and Exchange Commission (SEC) in November 2010, and went into effect this week, July 9, 2012 to be precise, is now the law, or should we say, the rule of the broker-dealer land.

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For those unfamiliar, it’s the rule that governs suitability, and it applies to registered representatives and dually registered advisors, and their firms.

The previous suitability rule (Rule 2310) – sometimes referred to as the ‘know your customer’ rule, stated:

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.

Under the new Rule 2111, there is a broadening of scope of what constitutes a “recommendation” by including the recommendation of either an “investment strategy” or “transaction” that involves a security or securities. An associated person shall:

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.

The Financial Planning Association (FPA) stated in a notice sent out this week what the changes mean to members of the association.

“The rule expands the information that an associated person must attempt to gather to determine suitability to include age, investment experience, time horizon, liquidity needs and risk tolerance. A member or associated person must make reasonable efforts to obtain and analyze the factors unless they have ‘a reasonable basis to believe, documented in writing’ that such omitted factor(s) is not relevant to suitability.

“Additionally, Rule 2111 expands a broker-dealer’s suitability obligations by defining three separate suitability assessments that the associated person is required to undertake. These three components of the overall suitability analysis require the associated person to have an understanding of the recommendation, of the customer’s investment profile, and of the customer’s overall portfolio and transaction history before any recommendation is made.

“Reasonable-Basis Suitability: This is general product suitability. The member/associated person must ‘have a reasonable basis to believe, based upon reasonable diligence, that the recommendation is suitable for at least some investors.’ The amount of due diligence required to form a ‘reasonable basis’ will vary depending on each customer, including the complexity of the product at issue and the associated person’s familiarity with the security or investment strategy. Reasonable due diligence requires that a member or associated person must at least understand the potential risks and rewards before making any recommendations about a particular security or strategy.

“Customer-Specific Suitability: This is what was traditionally considered a suitability analysis, but it is now done based on Rule 2111 instead of Rule 2310.

“Quantitative Suitability: This can be viewed as frequency of trading suitability. This obligation requires an associated person who has de facto or actual control over a customer account to have ‘a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together in light of the customer’s investment profile.’

“The rule also makes it clear that the term ‘investment strategy’ is to be interpreted broadly and covers explicit recommendations to hold a security, not just those to buy or sell a security.”

Here’s FINRA’s guidance on Rule 2111.

For this report, we asked RIAs, dually registered advisors, and registered reps about FINRA’s new suitability rule: What’s good about it? What’s bad? And does it help investors? Here’s what they had to say.

FINRA’s new rule won’t affect RIAs since they are not regulated – or at least they’re not at the moment– by FINRA. But it will affect dually registered advisors in at least three significant ways according Ron Rhoades, JD, CFP, who is chair of the financial planning program and an assistant professor at Alfred State College, SUNY, as well as the chair of NAPFA.

First, they will have to document ‘hold’ recommendations, and be potentially on the hook for such recommendations, Rhoades says.

Second, the emphasis of FINRA in acting in the client's ‘best interests’ is likely to cause a lot of confusion as to whether fiduciary duties apply, Rhoades says.

And third, and perhaps most important, FINRA's imposition of requirements regarding suitability of ‘investment strategy’ may - just possibly may - be interpreted at some future time to require due diligence on investment strategies, communication to clients of a portfolio investment strategy, and the like, Rhoades says.

“This sounds a lot like non-incidental advice,” says Rhoades.  “In fact, I would say that communicating a strategic asset allocation plan, or tactical asset allocation plan, to a client, is an ‘investment advisory’ activity likely leading to the imposition of fiduciary status under state common law ... especially if an ongoing relationship with a client is established (and regardless of whether the customer's accounts are defined to be ‘brokerage accounts’ and not ‘investment advisory’ accounts).  As a result, I see registered representatives using Investment Policy Statements.  I also see them seeking, perhaps, to avoid the issue (and ambiguity) of whether they may be considered fiduciaries, and just using their investment advisory platforms more.”

For his part, Richard C. Salmen, CFP, CFA, EA, a senior vice president and senior advisor with GTRUST Financial Partners, says FINRA’s motives are somewhat clear with regard to the new suitability rule. “It’s not a big stretch, in my opinion, that FINRA promulgated this new rule in order to step closer to a fiduciary standard without really going there,” he says.

His biggest concern though is the ambiguity of the rule for registered reps and dually registered reps around the term “reasonable diligence.”

“Those types of ambiguous terms generally have to go through a series of rulings and interpretations before we really know what the new standard is,” Salmen says. “That is not really a knock against FINRA, just against the use of such terms when setting standards.”

Of course, FINRA’s new rule, while it might be step closer to a fiduciary standard, still falls short of being the real deal, and some say it creates more confusion than not. “These rules are supposed to simplify but they just seen to get widened instead,” says Dave Caruso, CFP, founding chairman and managing director of Coastal Capital Group. “I think we need a common single voice and interpretation for the public to understand. But it’s like politics in that it’s talked about but never seems to get resolved, even with the important stuff.”

It might not get resolved, but hope can and does spring eternal. “I look forward to the day when all who give investment advice to the public are held to a standard of putting the client’s interests first regardless of compensation method,” says Salmen.

What are your thoughts on how this will affect your practice? Do you think it will affect the SEC’s current efforts to create a fiduciary rule for everyone who provides investment advice? Comment below.

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