FINRA recently released its regulatory and examination priorities for 2013, highlighting several areas where FINRA will focus its resources, including suitability under FINRA Rule 2111, complex products and debt instruments, and appropriate risk analysis and disclosures. 

Lackluster performance in the equity market has caused more investors to turn to the debt markets to increase yields on their investments. FINRA warns that investors’ “yield-chasing behaviors” do not come without risks, and FINRA believes that firms and registered representatives are in a better position to understand and disclose these risks to investors. The new suitability rule, Rule 2111, provides an apt framework for firms and registered representatives to ensure that they are addressing FINRA’s regulatory and examination priorities by understanding their products and customers better.

A Closer Look at FINRA’s Priorities and Rule 2111

FINRA Rule 2111 requires that a member have a “reasonable basis” to recommend a transaction or investment strategy to a customer. Two parts of the suitability analysis are particularly important: “reasonable-basis suitability”—the determination that an investment is appropriate for some investors and “customer-specific suitability”—the determination that the investment is suitable for a particular investor.

Customer-Specific Suitability

To meet its obligation to provide suitable recommendations to individual customers, members must use reasonable diligence to gather information about the customer, including the non-exhaustive list of factors discussed in Rule 2111(a): age, investments, financial situation and needs, tax status, objectives, experience, investment time horizon, liquidity needs, and risk tolerance. Of these factors, FINRA’s priorities have placed critical importance on understanding a customer’s risk tolerance. 

Given the shift from investments in the equity market to investments in the debt market, FINRA has honed in on three particular risks presented by the debt market. Firms and registered representatives should understand and be able to assess three key areas of risk for their customers:

  • “market risk” as it relates to interest-rate sensitive investments and customer risk tolerance;
  • “credit risk” where the creditworthiness of parties to a transaction is not readily apparent and may not comport with customer risk tolerance; and
  • “liquidity risk” of investments that are not easily liquidated for customers who may need access to cash.

It is critical that the firm or registered representative understands these three risk categories and why certain investment products may carry additional risk. Armed with an understanding of these risks and a customer’s risk tolerance, firms and registered representatives will be better able to make a recommendation that is tailored to a customer’s risk tolerance and suitable under Rule 2111.

Reasonable-Basis Suitability

FINRA also has identified a number of products that, while not problematic on their face, may cause firms to run afoul of Rule 2111’s “reasonable-basis” suitability requirement. Achieving an understanding of these products dovetails Rule 2111’s requirement that a firm engage in reasonable diligence to determine that a particular investment may be suitable for some investors. After conducting reasonable diligence, a firm should understand “the complexity of and risks associated with the [investment product],” which enables the firm to educate registered representatives who ultimately make recommendations to customers. The failure to properly understand a product when making a recommendation to a customer violates Rule 2111.

The following types of products have been specifically identified by FINRA as warranting a closer look before offering the investment product to any customer:

  • customer:
  • business development companies
  • leveraged loan products
  • commercial mortgage-backed securities
  • high-yield debt instruments
  • structured products
  • exchange-traded funds and notes
  • non-traded REITs
  • closed-end funds
  • municipal securities
  • variable annuties

FINRA examiners will look for firms to demonstrate they have done reasonable diligence on these products, educated their registered representative about the products, and have adequately disclosed risks to the customer. Accordingly, firms may want to consider additional training for personnel who perform due diligence on complex products and to registered representatives who must disclose and explain the risk to customers.With FINRA’s priorities in mind, the following strategies may help alleviate the potential risk to the firm or registered representative of arbitrations, future customer disputes, or problems during examinations.

  • Product-level due diligence:  investigation, documentation and analysis of known risks about complex products and debt instruments that demonstrate to regulators that the firm has reasonably considered the risks and rewards of certain products to customers;
  • Risk-disclosure guidelines:  developing and implementing a standard method for registered representatives to disclose and explain risks of complex products and debt instruments to customers; and
  • Education and testing:  creating educational programs and materials for registered representatives to attend, as well as metrics to assess registered representatives’ knowledge of risks and ability to explain risks to customers in plain English.

For firms and registered representatives it is worth additional time and effort to ensure that the investment products offered to investors “match up” with their investment goals without exposing the investor to more risk than they would otherwise tolerate. FINRA will be looking to firms and registered representatives to do the leg work on risk assessment and suitable recommendations. Getting ahead of the curve in implementing strategies could save a firm time and money in working with FINRA in 2013.