Inside the Litigation Lion

How the SEC and FINRA are in Danger of Destroying Their Own Industry

By instituting the impending FINRA Rule 2111 (a.k.a. the Suitability Rule), FINRA and the SEC are, as they claim, attempting to improve the efficiency of the securities industry. However, while it may offer more protection for consumers, the harsh and overbearing requirements mandated by the rule are set to slowly poison the entities that make the wheels of the securities industry turn, the broker-dealers.

This new rule, which officially takes effect July 9th, 2012, will tighten the requirements of the previous suitability rule (NASD Rule 2310) by requiring broker-dealers to take extremely detailed and in-depth steps when recommending securities or investment strategies to customers. On paper this seems relatively harmless, but in reality this rule will prove to be the SEC and FINRA bringing the proverbial hammer down upon the broker-dealers’ nail, and the results are sure to prove detrimental to not only the broker-dealers, but the securities industry in its entirety. Whereas prior to the rule, broker-dealers were required to make recommendations based on a set of required data provided by the customers, under this new rule, broker-dealers will be shouldered with the laborious responsibility of gathering a multitude of information about each individual customer. The rule provides an explicit and overly-encompassing list of factors (which were not required prior to the imposition of this rule) that broker-dealers will now be required to compile into a personalized investment profile to give to the customers.

For example, the suitability rule, since its inception, solely required the broker to fully know the stock he was recommending at the time of its recommendation.  The new rule goes far beyond that requirement.  It mandates that the broker know every security in the account and make a suitability assessment on those securities, even if the customer brought them into the account from another firm.  Thus, when a broker now transfers an account, he or she has an obligation to go through the entire list of securities in the customer’s account, even though the broker never recommended those investments, to determine whether those securities are suitable.  And if the broker believes those securities recommended by others are not suitable, he must make sure the customer sells them.  Thus, the suitability rule no longer applies to just recommendations but to every security in the account no matter how or when obtained.

Another problematic component of the new suitability rule is its inclusion of "investment strategies."  That is, the new rule requires the broker to insure that suitability rules apply to recommendations for "investment strategies" not just recommendations to buy or sell securities. The rule will also even apply as to why a customer should maintain a “hold” position on each of his or her securities. This broadens the criteria for evaluating suitability to include age, investment experience, time horizon, other investments, and risk tolerance – information that is typically found on the client’s new account form. Not only are the obligations burdensome, but they will increase firms’ costs and expenses. Thus, to protect themselves, firms will be forced to not only update their current procedures, but also modify automated systems and educate their associated persons regarding compliance with the new rule.

The rule also contains a burdensome “reasonable basis” provision, requiring broker-dealers to use a test of reasonable diligence (a time consuming process) when gathering and analyzing the required information to determine whether a strategy would suit a potential investor. By increasing the amount of information that a broker-dealer needs to compile and holding them to a higher standard when compiling it, it significantly increases the likelihood that the broker-dealers will be subject to fines for minimal discrepancies and harmless miscalculations. When the previous version of the Suitability Rule was enacted, the amount in suitability-related fines jumped from $3.75 million in 2010 to $7.7 million in 2011, leading some to believe that the rule was enacted with the not-so secret intention of allowing the SEC and FINRA to improve their reputation by cracking down and distributing fines for these infinitesimal errors. With the stricter measures in the newest Suitability Rule, the SEC and FINRA have all but ensured that those fines will see even more of a significant increase.

Additionally, the burden on the broker dealers will extend not just to the depth of required information, but also to the massive quantity of this information that these firms need to spend their time gathering. Under this new rule, FINRA broadly defines “customer” as anyone who is not a broker dealer. Therefore even those individuals or companies who have not established a formal broker-customer relationship with a broker-dealer can still require those broker-dealers to go through the tedious information-gathering process when making recommendations, even if these customers are only potential investors. This obviously puts the broker-dealers at a serious risk of losing business. The time, effort and money spent to provide a completely comprehensive report to these potential customers does not come with any protection in a situation where those customers would take their newly acquired comprehensive data, which the broker-dealers slaved over for countless hours, and shop around for a better deal. It is disadvantageous and discouraging for the broker-dealers to even bother with these types of clients, but the Suitability Rule leaves them no choice but to tediously compile the information and hope for the best.

Aside from the depth and quantity of information they will be saddled with acquiring under the Suitability Rule, these broker-dealers also will be forced to incur significant overhead costs. In order to comply with the rule, entire information systems will need to be updated and modified, compliance departments will have to be beefed up, and countless hours will be spent training employees and associates on the new procedures. These costs could prove overwhelming for many smaller firms or broker-dealers, but they are costs that are unfortunately necessary under the new Suitability Rule.

The SEC and FINRA created the Suitability Rule with the publicly-professed intention of improving the efficiency of the securities industry. However what they have actually done is create a plethora of time consuming and costly obstacles for the broker-dealers which, when the law is put into use on July 9th, will undoubtedly prove detrimental to the securities industry as a whole.

Richard Roth is the founder and president of The Roth Law Firm, PLLC, a boutique litigation firm that concentrates in litigating securities arbitrations and SEC/FINRA enforcement actions.

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Richard Roth

Richard Roth is the founder and president of The Roth Law Firm, PLLC, a boutique litigation firm that concentrates in litigating securities arbitrations and SEC/FINRA enforcement actions. He...
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