It looks like broker-dealers are failing in their due diligence efforts on clients, as required by FINRA’s new Rule 2090. (FINRA is the largest non-governmental regulator of all securities firms doing business in the United States, and handles nearly every aspect of securities-related matters, from registering and educating industry participants, to writing and enforcing rules and the federal securities laws.)
According to several industry reports, the most violated rule this year has been a failure by broker-dealers to comply with FINRA’s know-your-customer obligations, now under Rule 2090 issued in July 2012. The rule, which is generally modeled after the former NYSE Rule 405(1), requires firms to use reasonable diligence regarding the opening and maintenance of every account in order to “know the essential facts concerning every customer.” The rule explains that “essential facts” are those required to:
- effectively service the customer’s account;
- act in accordance with any special handling instructions for the account;
- understand the authority of each person acting on behalf of the customer; and
- comply with applicable laws, regulations, and rules.
The know-your-customer requirements arise at the beginning of the relationship and do not depend on whether the broker has made a recommendation. Unlike the former NYSE Rule 405, Rule 2090 does not specifically address orders, supervision or account opening, which are areas that are explicitly covered by other rules.
In conjunction with this know-your-customer rule, FINRA has adopted transaction suitability Rule 2111, framed after the former NASD Rule 2310, which requires that a firm or associated person “have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile.” According to FINRA, the measures constituting a reasonable diligence will vary depending on, among other factors, the complexity of and risks associated with the security or investment strategy and the firm’s or associated person’s familiarity with the security or investment strategy.
Rule 2111 further defines a customer’s investment profile, specifying that it includes, but is not limited to, the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation. Accordingly, a broker must attempt to obtain and analyze a broad array of customer-specific factors, and also determine quantitative suitability if the broker has actual or de facto control over a customer account.
FINRA now makes it clear that a broker must have a firm understanding of both the product and the customer, and that the lack of such an understanding itself violates the suitability rule.