Here’s How Finra Judges Your Suitability Standard
When it comes to determining if broker-dealers recommended a suitable investment strategy or product at the time of a transaction, Finra doesn’t have a prescriptive approach.
What Finra analyzes is the “reasonableness” of a broker-dealer’s investment or product suitability program, which doesn’t have to be “one-size-fits-all” for clients, Justin Triolo, associate district director for sales practice at Finra’s Long Island District Office, said at the self-regulator’s annual conference in Washington, D.C. in May.
Finra’s Rule 2111 requires broker-dealer firms or associated persons to have a reasonable basis to believe that a recommended transaction or investment strategy involving a security is suitable for the customer, based on the customer’s investor profile created from information obtained through the reasonable diligence.
According to Finra, a customer’s investment profile usually includes the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs and risk tolerance.
The rule also explicitly covers recommended investment strategies involving securities, including recommendations to “hold” securities. The rule, moreover, identifies the three main suitability obligations: reasonable-basis, customer-specific, and quantitative suitability.
Finra says the common weaknesses they see in broker-firms’ suitability processes include the lack of customer outreach by compliance teams or by supervisors; inadequate training on products and risks; inadequate supervisory comments for flagged activities; and incomplete, inconsistent or stale customer account information.
William Givens, executive director for product compliance at Morgan Stanley, says the firm doesn’t open new accounts if the customer fails to provide all the information required. And when Morgan Stanley gets all the necessary information, “it’s really important to keep data up to date and current,” he says.
Miriam Lefkowitz, chief legal officer at Summit Equities, a broker-dealer firm that has around 70 registered representatives, said “sometimes,” when customers don’t provide all the information in an account form, they are able to obtain the information elsewhere, such as in questionnaires or conversations with the customers.
The challenge with speaking to customers about topics like investment objectives and the investment process is they “don’t understand the terminology the way we do,” Lefkowitz said. “That happens all the time.”
In such cases, Lefkowitz said, the broker-dealers must ensure that both parties understand on the same level what is discussed in relation to the investment objective and investment process.
From a Finra exam perspective, the self-regulator is “seeing lack of consistency and completeness in the documentation that we are looking at,” which could lead to problems, according to Triolo.
Lefkowitz said Summit Equities always makes the effort to “make sure data points are relevant and check for discrepancies.”
A straw poll of the conference session attendees showed that around two-thirds have a new product committee and an approved list of products that contribute to the monitoring of product suitability. Around a fifth of those polled said they have only a new product committee or a vetting process. Around 5% of those polled said they have only an approved product list.
Those polled were most concerned – from a suitability perspective – about variable annuities (25%) and alternative investments or structured products (21%).
At Morgan Stanley, the approval of new products “always” includes communication among the legal, risk, compliance, financial and operations teams, according to Givens.
When it comes to reviewing the suitability of using complex products, Morgan Stanley starts by “interviewing heavy hitters” or those who recommend the products the most, and then they check the use of the products by “dabblers,” to make sure they understand the products, Givens said.
He adds that Morgan Stanley is “careful not to neglect training supervisors” when it comes to complex products.
“No mater how good your policies are, supervisors are important,” Lefkowitz chimed in.
The SEC’s proposed Regulation Best Interest also shied away from a prescriptive approach to determining what investment strategy or product is in the best interest of the customer.
At a Practising Law Institute event in April, Dalia Blass, director of the SEC’s Division of Investment Management, said a “principles-based standard can serve Main Street investors well.”
That approach would provide “valuable flexibility” in recognizing how customers vary from each other and how the industry may change over time, Blass said.
The SEC’s proposed Regulation Best Interest package establishes a best interest standard of conduct for broker-dealers, interprets the fiduciary standard for investment advisors, and creates a new Customer Relationship Summary form that will state if clients are dealing with a broker-dealer or an investment advisor.
The proposed rule requires broker-dealers to have a duty to act in the best interest of retail customers when making a recommendation – at the time the recommendation is made – without putting their own financial or other interest ahead of the retail customer. And broker-dealers are required to perform this duty by complying with disclosure, care and conflict of interest obligations.
Also at Finra’s annual conference, CEO Robert Cook said the self-regulator will have exam oversight on the requirements in the SEC’s Regulation Best Interest package that are relevant to broker-dealers.