The new suitability and Know-Your-Customer rules will present FINRA with the opportunity to bring a variety of enforcement actions against both firms and registered representatives. The types of cases will likely be similar to enforcement actions that FINRA has brought under the existing rules.
- (Check out Part 1: Ready or Not, Here Comes FINRA’s New Rules on Suitability)
- (Check out Part 2: Understanding FINRA’s New Rules: Knowing-Your-Customer and Practical Considerations on Suitability)
Such cases have been a significant part of FINRA’s enforcement docket. For example, FINRA reported 53 cases involving alleged suitability violations in 2010. These cases resulted in $3.75 million in fines, the fourth-largest amount for any category of case in 2010. Although suitability cases again resulted in the fourth-largest amount of fines in 2011, the total sanctions in those cases jumped to $7.7 million, an increase of 105% from 2010.
Similarly, the number of suitability cases FINRA reported in 2011 doubled to 106. This increase in annual sanctions was partially driven by two fines in excess of $2 million, while the largest fine in a 2010 suitability case was $900,000.
Historically, when FINRA has brought disciplinary actions regarding suitability, it focused on a variety of issues. With regard to firms, charges have included the following:
- Providing inadequate firm procedures;
- Failing to enforce the firm’s procedures;
- Performing inadequate due diligence regarding a product;
- Failing to review the suitability of certain types of transactions;
- Insufficiently training representatives and personnel about complex products; and
- Failing to supervise registered representatives who engaged in unsuitable transactions.
Individual registered representatives have been charged for: i) making recommendations that were unsuitable because the product did not meet the customer’s investment objective or needs; ii) investing in unsuitable concentrations of a customer’s portfolio in risky or illiquid products; and iii) excessive trading. Firms have sometimes been found vicariously liable for these acts of its individual representatives.
Enforcement actions associated with FINRA’s new rules may arise in several contexts, including deficiencies detected through routine or targeted examinations (formerly known as sweeps) and investigations begun for numerous reasons including due to complaints made by customers, third parties and whistleblowers. Certain of FINRA’s enforcement actions will likely be similar to its prior cases. In addition, FINRA will likely bring enforcement actions directly related to the implementation of the new rules. The following are examples of potential enforcement actions:
- Failure to draft or implement adequate policies, procedures and/or systems. Shortly after FINRA adopts new rules, it often examines firms for implementation of procedures to comply with the rules. Inadequacies sometimes result in cautionary action letters. Over time, FINRA often becomes less lenient and brings formal disciplinary actions for such failures. In addition, failures to draft or implement adequate policies, procedures and/or systems can escalate to formal disciplinary proceedings when such deficiencies result in or provide an opportunity for customer harm. So, during examinations or formal investigations, FINRA will likely assess the reasonableness of adopted policies, procedures and systems to determine if they are sufficiently detailed to comply with applicable requirements. Further, FINRA will probably assess the adequacy and functionality of supporting systems and tools (e.g., surveillance systems, client data repositories, data retention systems, forms and order tickets). Under the prior suitability rule, FINRA brought similar enforcement actions.
- Failure to conduct and evidence suitability and know-your-customer assessments for customers, transactions and strategies, and substantive suitability and assessment failures.
One of the key components of the new rule is the requirement to gather additional facts about customers, transactions and strategies. FINRA will likely bring enforcement actions against firms and registered representatives for failures related to these activities. In the past, FINRA has brought enforcement actions for such failures in connection with Rule 2310. It is likely that FINRA will bring additional cases under the new rules because firms and representatives will now be responsible for gathering additional facts and applying them to additional situations such as hold recommendations and investment strategies.
- Failure to conduct and evidence due diligence. As discussed above, FINRA’s new rules will now specifically require that firms perform reasonable due diligence to understand the risks and rewards of a particular investment or investment strategy. Firms that fail to have adequate policies and procedures or that perform due diligence unreasonably may be sanctioned for those failures.
- Failure to implement reasonably designed technology for data collection, supervisory reviews and record retention. The new rules may require firms to implement new technologies and if firms fail in this regard, they may be disciplined. FINRA will also likely assess how firms respond to red flags identified by their systems. FINRA has sanctioned firms previously for such failures.
- Failure to provide training to personnel regarding new requirements. Some firm will likely train their personnel on the new rules. As in the past, if FINRA finds deficiencies in such training, it will bring enforcement actions.
As can be seen, the new rules will create many opportunities for FINRA to bring enforcement actions against firms, principals and registered representatives. Firms may want to consider such potential actions as they draft and implement new policies and procedures and as they train their personnel.
Under the new FINRA Rules 2111 and 2090 that have taken effect on July 9, 2012, firms should review their current client-gathering information procedures, client record-keeping systems, and supervisory review procedures with these rules in mind. Firms should assess whether and where changes are required and work with legal counsel to adapt firm policies and procedures to the new rules. Firms may also want to update their training procedures to ensure that associated persons understand the new know-your-customer and suitability obligations.
These pieces are excerpted from an article published in Thomson Reuters’s Wall Street Lawyer and authored by Clifford Kirsch, a partner and member of the financial services practice group in the New York office of the law firm Sutherland Asbill & Brennan; S. Lawrence Polk, a partner and member of Sutherland’s litigation practice group in the firm’s Atlanta office; Brian Rubin, a partner and member of the litigation practice group in the firm’s Washington, D.C. office; and Avital Stadler, a counsel and member of the firm’s litigation practice group in Atlanta.