The New Know Your Customer and Suitability Rule

June 19, 2012 by Thomas F. Burke, P.C.

The new Financial Industry Regulatory Authority ("FINRA") Rule 2090 "Know Your Customer" and Rule 2111 "Suitability" will become effective on July 9, 2012. The new rules are based on former National Association of Securities Dealers ("NASD") and New York Stock Exchange ("NYSE") Rules.

 

New FINRA Rule 2090 is derived from former NYSE Rule 405(1). The new rule requires every member to use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer. For purposes of the Rule, the "essential facts" concerning a customer are those that enable the member to effectively service the customer's account, in accordance with any specific handling instructions and in compliance with all applicable laws, regulations and rules. In other words, the new Rule requires each member to gather essential information about the customer, retain the information, and update it while maintaining the account. This requirement must be adhered to by the member even if the broker has not yet made a recommendation to the customer.

New FINRA Rule 2011 is modeled after NASD Rule 2310. The new rule requires that every member or associated person of a member have a reasonable basis to believe that a recommended transaction or investment strategy is suitable for the customer based on the information diligently obtained pertaining to the customer's profile. Factors relating to a customer's profile which must be considered, which have been expanded from NASD Rule 2310, are set forth in the new FINRA Rule. There is no definition of what constitutes a "recommendation" in FINRA Rules. It has been defined by the facts and circumstances of the communication on a case by case basis. Factors to be considered are the the communication's content, context, and presentation to determine if the associated person was suggesting that the customer take action or refrain from taking action. Also important is the degree that the associated person tailored the conversations to the customer. Furthermore, a series of conversations relating to multiple actions can amount to a recommendation.

There are three distinct obligations on the associated person related to suitability: (1) he must have a reasonable basis to believe that the recommendation is suitable in some situations, after a due diligence investigation. The associated person must understand the risks and rewards associated with the investment security or strategy; (2) he must have a reasonable basis to believe that the investment is suitable for the individual customer based on the customer's profile; and (3) if the associated person has control over the account, either actual or de facto control, the associate person must have a reasonable basis to believe that the transactions for the account are not excessive in light of the customer's profile.

Although industry rules may be used as proof of violations of wrongdoing by regulatory agencies in enforcement matters, a majority of courts have ruled that customers cannot base civil complaints on violations of industry rules. However, it is well-settled that industry rules are evidence of the standard of care and may be used to support claims for negligence, breach of fiduciary duty, fraud and punitive damages.

Thomas F. Burke has been handling securities litigation in state and federal courts and in arbitration forums since 1983. If you feel that you have received unsuitable trade recommendations, please contact Mr. Burke at 312/362-1300.

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