What Does Unsuitability Mean in Securities Law?
Unsuitability means exactly what it sounds like – something that is not fitting or appropriate. In securities law, what makes something unsuitable?
The Financial Industry Regulatory Authority (FINRA) is the largest independent regulator for all brokerage firms doing business in the United States. FINRA sets a suitability standard, and that standard obligates brokers to make recommendations they believe effectively suit the interests of their clients.
What Makes an Investment Suitable?
FINRA governs general suitability obligations for brokers. FINRA Rule 2111 sets out three components of suitability obligations: reasonable-basis suitability, customer-specific suitability, and quantitative suitability.
1. Customer-Basis Suitability
Information on a customer’s age, financial situation, investment objectives, investment experience, and risk tolerance should all inform a broker’s decision to recommend a particular security to their client.
- The cost of the investments may be too high or too high-risk for a retired client who relies on their brokerage account for income.
- Investors might need to access their funds in an emergency, which means that investments should not be too illiquid, meaning investors cannot cash out without incurring significant fees.
- Like non-traded REITs and leveraged ETFs, complex investments should be left to investors with more trading experience.
2. Reasonable-Basis Suitability
Reasonable-basis suitability means that the investor is either capable of evaluating the risks associated with an investment themselves or has agreed to let their broker assess the risks for them. If the broker does not understand an investment, they cannot recommend it to their clients.
If they do, it could be the basis for a regulatory action or an investor dispute.
For example, on July 21, 2021, a broker consented to the findings that he recommended an unsuitable investment to his investors that he did not fully understand. In the Acceptance, Waiver, and Consent agreement FINRA alleged that the broker had recommended a type of security called a non-traditional exchange-traded fund (NT-ETF). Investors should not hold onto these investments beyond a single day of trading. The broker solicited the investments and let his investors hold the securities for an average of 400 days. In total, FINRA alleges that investors lost $80,000.
Because of the broker’s allegedly unsuitable recommendation, FINRA imposed a $5,000 fine and a three-month suspension.
3. Quantitative Suitability: Excessive Trading and Churning
FINRA 2111 also requires brokers to recommend quantitatively suitable investments–meaning the number of securities transactions must make sense for the investor. Each securities transaction comes with fees, so too many trades will make it more difficult for an investor to profit. Suitability also includes making sure transaction costs are not excessive.
Executing too many transactions in an investor’s account is called “churning” or “excessive trading.” Brokers might engage in this type of misconduct to generate more commissions for themselves.
Does FINRA Require Brokers to Work in their Clients’ Best Interest?
Surprisingly, no. Only Registered Investment Advisers (RIAs) are required to work in their client’s best interest. Every investor should know the difference between investment advisers and brokers.
- FINRA oversees brokers; the SEC oversees RIAs.
- Both brokers and RIAs might refer to themselves as “financial advisors.”
- Keep in mind that many financial advisors are registered as brokers and RIAs.
- Brokers do not have a fiduciary duty, unlike RIAs.
What is a fiduciary? A fiduciary is a person that acts on another’s behalf, putting the clients’ interests ahead of his own while preserving good faith and trust.
Brokers are not fiduciaries–a controversial fact of the securities industry. Still, brokers must adhere to FINRA 2111. For now, this is the main safeguard between investors and reckless brokers. Investors should always keep in mind that although brokers are obligated to recommend investments that they believe are suitable for the investor, it does not automatically mean the recommendations are best for the investor.
What Happens When a Broker Recommends an Unsuitable Investment?
Unfortunately, brokers often fail to uphold the duty to make suitable investments. As a result, unsuitable investment claims are among the most common FINRA arbitration cases. When an investor can show that a broker recommended an unsuitable investment, the firm may be liable to pay an investor back for their losses.
What Happens in a Suitability Arbitration Case?
When investors believe their broker recommended an unsuitable investment, they should enter a Statement of Claim with FINRA and begin the arbitration process.
Investors should also take proactive steps to avoid unsuitable investment recommendations in the first place. Before working with an investor, an investor should make sure to review their broker’s FINRA BrokerCheck record. Certain investors have multiple investor disputes on their record that allege they recommended unsuitable investments. Investors should always be wary of brokers who have been involved in suitability disputes.
For instance, on November 2, 2015, an investor alleged that their broker had recommended unsuitable investments that were too risky and illiquid – they allegedly had specified that they wanted safe, fixed-income investments. The investor sought $325,000, and the dispute settled for $172,500. As of September 2021, that same investor has two pending suitability disputes on his record – investors are collectively seeking to recover $1.2 million.
If you discover your broker has a significant history of unsuitable recommendations, consider taking your business elsewhere.
My Broker Recommended Unsuitable Investments – What’s Next?
Investors who believe their broker may have recommended unsuitable investments should speak to a securities attorney and start gathering the documentation they will need to bolster their claim. If you specifically stated you wanted low-risk investments and then end up with a portfolio full of illiquid, high-risk securities, you may have an especially good case for FINRA arbitration. Contact the securities attorneys of Kurta Law for a free case evaluation today: Call (877) 600-0098 or email email@example.com for a free case evaluation.