How "suitable" is the language of suitability in the modern era?

• Author: Lichtor, Michelle

1. INTRODUCTION II. BACKGROUND A. Registration with FINRA B. NASD Rule 2310 C. The Obligation to Perform Due Diligence III. ANALYSIS A. Applicability of the Suitability Rule to Investment Strategies B. The Scope of Customers' Investment Profiles C. The Three Types of Suitability Obligations 1. Reasonable Basis Obligation 2. Customer-Specific Obligation 3. Quantitative Suitability Obligation D. Broker-Dealer Recommendations to Institutional Customers E. FINRA's Definition of the Terms "Suitability" and "Customer" IV. RECOMMENDATION A. Using the Suitability Rule to Define Broker-Dealers' Fiduciary Duties B. The Ambiguity of FINRA's Definition of "Customer" V. CONCLUSION I. INTRODUCTION

   In the wake of the recent financial crisis, consumer protection has become a top priority for U.S. lawmakers. (1) The passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in 2010 is a symbol of the government's commitment to the issue. The statute gives the Securities and Exchange Commission (SEC) the power to harmonize the standards of conduct to which the SEC holds investment advisers and broker-dealers and allows the SEC to impose a fiduciary duty on both. (2) As it stands, broker-dealers and investment advisers are subject to different regulatory regimes and different standards of conduct. While investment advisers have a fiduciary duty to clients under the Investment Advisers Act of 1940, broker-dealers have a suitability duty under self-regulatory organization rules. (3) As explained in further detail below, broker-dealers' duties to clients are less comprehensive than investment advisers' fiduciary duties because broker-dealers' duties are not ongoing and, at least in the past, have not been interpreted as requiring broker-dealers to necessarily act in the "best interests of clients." (4) However, unsophisticated retail investors do not understand this, expecting anyone who provides them with financial advice to act in their best interests. (5) Addressing the discrepancy between retail investors' perception and reality is crucial because they rely on the financial advice given to them by both broker-dealers and investment advisers when making trading decisions. (6)

   Part II of this Note discusses the difference between investment advisers and broker-dealers, both in terms of the regulatory structure that governs them and the role that each plays in customers' financial lives. Even after Dodd-Frank, which authorized the SEC to harmonize the duties applicable to broker-dealers and investment advisors, regulators continue to hold investment advisers to an arguably higher standard of care than broker-dealers when making recommendations to their clients. Part II addresses the regulatory structure that applies to broker-dealers and the essential role that self-regulatory organizations (SROs), particularly the Financial Industry Regulatory Authority (FINRA), play in this framework. Finally, Part II describes broker-dealers' suitability obligation to their customers under National Association of Securities Dealers (NASD) Rule 2310, the predecessor to FINRA Rule 2111. (7)

   Part III analyzes FINRA Rule 2111. Rule 2111 details broker-dealers' obligation to ensure that their recommendations to customers are appropriate given those customers' investment profiles. The rule expands, clarifies, and strengthens broker-dealers' obligations to their customers. However, some ambiguity remains.

   Part IV recommends clarifying broker-dealers' obligations further by phrasing the rule in terms of fiduciary duties, with the bounds of those duties in large part defined by the contours of the suitability rule. By doing this, FINRA would bring broker-dealers' obligations in line with the tasks that they perform as well as with customer expectations. This would also be consistent with the direction in which regulation of broker-dealers is already progressing. Moreover, using the suitability rule to define broker-dealers' fiduciary duty would address the ambiguity that accompanies the term "fiduciary duty" standing alone. Part IV also discusses the confusion introduced by FINRA's guidance as to the meaning of "customer" in the context of FINRA Rule 2111. Finally, Part V provides a short conclusion.

2. BACKGROUND

   According to the Securities Exchange Act of 1934 (the Exchange Act), a broker is "any person engaged in the business of effecting transactions in securities for the account of others." (8) The Exchange Act generally defines a dealer, on the other hand, as "any person engaged in the business of buying and selling securities ... for such person's own account through a broker or otherwise." (9) A broker-dealer, then, is someone who buys and sells securities for both her own account and the accounts of others. (10)

   In contrast, the Investment Advisers Act of 1940 defines investment advisers as:

   Any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities. (11) Essentially, investment advisers advise their clients about securities trading in exchange for a fee. (12) Although broker-dealers also advise their clients about investments in securities, Congress excludes them from regulation under the Investment Advisers Act so long as "such services [are] solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefor." (13)

   In the past, the distinction between investment advisers and broker-dealers was clearer than it is today because broker-dealers merely executed transactions upon their clients' instructions and did not provide investment advice. (14) Now, however, it is common for brokerage firms, much like financial advisers, to offer a package of services to clients that includes investment advice and an asset-based fee arrangement. (15) The regulatory distinction between broker-dealers and investment advisers is important because financial advisers have a fiduciary duty to their clients under the Investment Advisers Act, while broker-dealers have historically had a less comprehensive suitability duty to their clients under the Exchange Act and SRo rules. (16)

   Investment advisers' fiduciary duty consists of a duty of care and a duty of loyalty. (17) Their duty of care includes a suitability obligation and an obligation to find the best market for a recommended transaction (known as the duty of best execution). (18) In contrast, investment advisers' duty of loyalty consists of an obligation to act in customers' best interests and an obligation to disclose any conflicts of interest that the investment advisers cannot remove. (19) Broker-dealers also have a duty of best execution, (20) a suitability duty, (21) a duty to act fairly and equitably, (22) certain disclosure requirements, (23) and now, at least, a duty to act in customers' best interest. (24) However, they do not have a duty to disclose or eliminate all material conflicts of interest like investment advisers. (25) Nor do broker-dealers generally have an ongoing duty to oversee their customers' investments or investment portfolios after a recommendation has been made. (26) Thus, broker-dealers' obligations to customers have been less comprehensive in their scope than those of investment advisers. (27)

   1. Registration with FINRA

      FINRA is essential to the regulatory structure relating to broker-dealers because it is the largest SRO governing securities firms in the United States, and it makes rules for all public-facing U.S. broker-dealers. (28) FINRA's mission is to protect investors by regulating broker-dealer conduct, (29) enforcing its rules through fines, suspensions, or expulsions from the organization. (30) Almost all brokers must become members of FINRA before they can officially register with the SEC and engage in brokerage services in U.S. markets. (31)

      However, before 2007, most brokers generally had a choice to register with either the NYSE or the NASD. (32) NYSE Regulation, Inc., which was NYSE's enforcement arm and a wholly-owned subsidiary of NYSE LLC, and the NASD merged in 2007, largely to make regulation of broker-dealers more efficient, fair, and non-duplicative, as well as to make the American securities markets more competitive. (33) Because of the merger, FINRA must update and harmonize NASD and NYSE rules that used to separately govern broker-dealers. (34) This consolidation process continues today. (35)

      Indus. Regulatory Auth., http://www.finra.org/Industry/RegulatoryServices/ (last visited Oct. 3, 2013).

   2. NASD Rule 2310

      One of FINRA's main goals as an organization is to ensure that "any securities product promoted or sold to an investor is suitable for that investor's needs." (36) FINRA Rule 2111 codifies this goal. (37) FINRA intended Rule 2111 to "strengthen and clarify" its predecessors, NASD Rule 2310 and NYSE Rule 405(1). (38) However, FINRA modeled the current rule after NASD Rule 2310. (39)

      NASD Rule 2310 required broker-dealers to have "reasonable grounds for believing that" any recommendation to buy, sell, or exchange securities was suitable for a customer based upon "the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs." (40) Although the rule appeared to put the burden on customers to disclose all relevant information about their finances, the regulators interpreted the rule as requiring broker-dealers to, at minimum, ask their customers about their financial needs and goals before making a recommendation. (41) As for institutional investors, the NASD excused a broker-dealer from the obligation to ensure that a particular recommendation was suitable for a particular investor if the...