Academic journal article Journal of Corporation Law

How "Suitable" Is the Language of Suitability in the Modern Era?

Academic journal article Journal of Corporation Law

How "Suitable" Is the Language of Suitability in the Modern Era?

Article excerpt

I.   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 


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. …

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