FINRA Rule 2111: suitability for small broker-dealers

Rule 2111 binds FINRA member firms and their associated persons each time they recommend a transaction or an investment strategy involving a security. The rule's core is the sentence quoted above: a reasonable basis to believe the recommendation is suitable, built on reasonable diligence into the customer's investment profile. Its supplementary material splits that duty in three: “Rule 2111 is composed of three main obligations: reasonable-basis suitability, customer-specific suitability, and quantitative suitability.”

The first obligation is about the product, not the customer. A recommendation has to be suitable “for at least some investors”, and the rule ties the diligence it takes to the product: what counts as reasonable diligence varies with “the complexity of and risks associated with the security or investment strategy” and with the firm's familiarity with it.

For a firm of a few representatives this is the shelf decision. Before a new product is recommended to anyone, someone at the firm should be able to show what they read about it and why they understood its risks. That note answers the reasonable-basis question for every customer who later buys it. Nor can a customer agreement move the duty: “A member or associated person cannot disclaim any responsibilities under the suitability rule.”

A broker-dealer now works under two recommendation standards, and the first question for any recommendation is which one governs it. FINRA answered in the rule itself. The line was added by the amendment FINRA lists as SR-FINRA-2020-007, effective June 30, 2020.

SEA Rule 15l-1 is Regulation Best Interest. A broker-dealer recommending a securities transaction or strategy, account recommendations included, to a retail customer “shall act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker, dealer, or natural person who is an associated person of a broker or dealer making the recommendation ahead of the interest of the retail customer.” The rule says that obligation is satisfied through four component obligations.

Which customers Regulation Best Interest covers is a question for its own text, which this guide does not restate: read the rule text at 17 CFR 240.15l-1 and settle with your compliance counsel which of your customers it covers. Write the answer into your procedures, because it decides which standard a principal checks each recommendation against.

Regulation Best Interest brings its own record. For each retail customer who gets a recommendation, the firm keeps “a record of all information collected from and provided to the retail customer pursuant to § 240.15l-1, as well as the identity of each natural person who is an associated person, if any, responsible for the account.” It is kept until at least six years after the earlier of the account closing or the information being collected, provided, replaced or updated (17 CFR 240.17a-3(a)(35)(i); 240.17a-4(e)(5)). Form CRS runs on its own clock and its own defined term, the retail investor: a broker-dealer delivers it before or at the earliest of a recommendation, placing an order, or opening a brokerage account (17 CFR 240.17a-14(c)(1)). Our Form CRS builder drafts the document. How suitability sits among a small member firm's other duties is mapped in FINRA compliance for small broker-dealers.

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The customer-specific obligation is only as good as what the firm knows about the customer. Rule 2111 names what that is: “A customer's investment profile 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 firm in connection with the recommendation.

A new-account form built for the SEC's account record rule already collects part of this, because 17a-3(a)(17) asks for some of the same facts on natural-person accounts. The overlap is partial, and the gap is where a profile goes thin.

Six of the nine have no line on the SEC record: other investments, tax status, investment experience, time horizon, liquidity needs and risk tolerance. A seventh, financial situation and needs, is covered only in part by income and net worth. A form built only to satisfy 17a-3 leaves those to chance, so add the missing lines to the new-account form itself rather than to a separate questionnaire nobody updates.

Two phrases in that sentence set the paperwork. “Obtain and analyze” means the factor is used, not only collected. “Documented with specificity” means a blank needs a reason written for this customer; a form-wide “not applicable” box is not one. The rule also allows that “the level of importance of each factor may vary depending on the facts and circumstances of the particular case”.

The rule covers a “recommended transaction or investment strategy involving a security or securities”, and FINRA reads the strategy part widely: it is “to be interpreted broadly and would include, among other things, an explicit recommendation to hold a security or securities.” A representative who explicitly tells a customer to keep holding a position has made a recommendation, and the suitability duty attaches to it.

The same paragraph lists four kinds of communication that fall outside the rule, “as long as they do not include (standing alone or in combination with other communications) a recommendation of a particular security or securities”.

For a small firm the list is a practical map of its education work. A retirement seminar on diversification and inflation sits inside the carve-out; the same seminar ending on “and this fund is how to do it” does not. The seminar slides are also a communication with the public, reviewed under a different rule, see FINRA Rule 2210.

The third obligation looks past the single trade. Each recommendation can pass on its own and the account can still fail, because the test is the pattern.

The rule gives no number. “No single test defines excessive activity”, it says, and then names three factors that “may provide a basis for a finding” that the obligation was broken. Any threshold a firm uses to flag an account is its own surveillance choice, not a figure from the rule.

A firm of a few people may have no surveillance desk, so the practical question is who looks at activity and how often. A principal reviewing every trade sees each transaction but not always the pattern; an exception report run across accounts sees the pattern. Those reports are records in their own right: a broker-dealer keeps reports produced to review for unusual activity in customer accounts “until eighteen months after the date the report was generated” (17 CFR 240.17a-4(e)(8)). Firms that want the alerts built for them compare trade surveillance software, and our guide to trade surveillance sets out what the rules ask of it.

Rule 2111(b) lets a firm meet the customer-specific obligation for an institutional account in a different way, and only that obligation. “Institutional account” is the term defined in Rule 4512(c): the account of a bank, savings and loan, insurance company or registered investment company; an SEC- or state-registered investment adviser; or “any other person (whether a natural person, corporation, partnership, trust or otherwise) with total assets of at least $50 million.”

Where the institution has handed its decisions to an agent, “such as an investment adviser or a bank trust department, these factors shall be applied to the agent.” The statement in condition two can be given “on a trade-by-trade basis, on an asset-class-by-asset-class basis, or in terms of all potential transactions for its account” (2111.07). The rule does not prescribe its form. A dated, written statement in the account file is the one that is easiest to produce later, so collect it that way.

Rule 2111 names almost no records of its own. Two phrases ask for paper: a factor left out of the profile must be “documented with specificity”, and an institutional customer must “affirmatively indicate” its independent judgment. The rest of a suitability file is built from the SEC's broker-dealer record rules, FINRA's account-record rule and the supervision rule. Test a file with the questions the rules themselves raise; each one has a paper that answers it.

Several of those papers have a retention period set by rule. The account record and the Reg BI record share one: “until at least six years after the earlier of the date the account was closed or the date on which the information was collected, provided, replaced, or updated.”

The account record also runs on a clock of its own. The customer gets a copy soon after opening and again at set intervals, which is the firm's regular chance to catch a profile that has gone stale.

Every period above is in our books and records retention calculator, and the full broker-dealer record list is in our guide to FINRA Rule 4511. Where the records sit matters too: broker-dealer records must be kept in a form 17a-4(f) accepts, covered in SEC Rule 17a-4 and WORM storage.

Put together, the rule and the record rules make a routine with seven moments in it. In a small firm several of them fall to the same principal, which is the argument for building them into the forms and systems the firm already uses rather than a separate suitability binder.

The principal's review in step four is the supervision rule at work, set out in our guide to FINRA Rule 3110. Firms that want the account records, review queue and procedures in one system compare broker-dealer compliance software. This guide explains the rule; it is not legal advice, and your compliance counsel should check your procedures against the full text on FINRA's Rule 2111 page.