FINRA’s Suitability Rule Is No Match For California’s Rule

FINRA’s New Rule

Beginning on July 9, 2012, broker-dealers will be subject to FINRA’s new suitability rule.  Rule 2111(a) requires FINRA members and their associated person to 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’s Notice to Members 11-25, the new rule retains the core features of the previous NASD and NYSE rules covering the same subject areas and codify well-settled interpretations of those rules.

The California Rule

Here in California, the Commissioner has had a suitability rule for broker-dealers and agents for more than three decades.  Rule 260.218.2 provides:

Any broker-dealer and any agent employed by such a broker-dealer who recommends to a customer the purchase, sale or exchange of any security shall have reasonable grounds to believe that the recommendation is not unsuitable for such customer on the basis of information furnished by such customer after reasonable inquiry concerning the customer’s investment objectives, financial situation and needs, and any other information known by such broker-dealer or agent.

Being Pretty and Being Not Ugly Are Not The Same

Both suitability rules are triggered by recommendations and both require an objective belief.  The rules, however, are 180° apart on what the broker-dealer is required to believe. FINRA requires a belief that the investment is suitable while the Commissioner requires a belief that the investment is not unsuitable.  If you question whether there is any difference between these two standards, ask yourself whether you would prefer to have someone believe that you are pretty or believe that you are not ugly.  In practice, however, this difference between the two rules shouldn’t lead to different results in most cases.

No Exemption in California for Institutional Accounts

A more significant difference between the two rules is the fact that FINRA includes an exemption to customer-specific suitability regarding institutional accounts (as defined in Rule NASD Rule 3110(c)(4) provided specified conditions are met.  The Commissioner’s rule includes no similar exemption.  The new exemption is broader than that included in the soon to be replaced NASD Rule 2310.  Thus, it remains to be seen whether the lack of conformity between FINRA’s and the Commissioner’s rule will present any issues for broker-dealers registered in California. (Recently the Securities Industry and Financial Markets Association (aka SIFMA) announced that it has developed a form of institutional account certificate for purpose of the new FINRA rule.  It is available here.)

Double Negatives are Not Unambiguous

The use of double negatives is usually cited as a case of improper grammar in common American speech.  The SEC’s Plain English Rule (17 CFR § 230.421(d)(2)(vi), for example, enjoins the use of multiple negatives.  However, H.L. Mencken in The American Language noted that the use of compound negatives “is of great antiquity and was once quite respectable”.  He cites examples from Chaucer’s Canterbury Tales (“He nevere yet no vileynye ne sayde . . .”), Shakespeare’s Romeo and Juliet (“thou expectedst not, nor I looked not for . . .”), and even the Congressional Record (““without hardly an exception”).  Each of these, however, is an example of the use of a double negative for emphasis.  When someone says “I didn’t hear nothing”, it is to emphasize that nothing was heard.  In logic and rhetoric, double negatives cancel each other and yield a positive.  This ambiguity and the grammatical stigma attached to the use double negatives militates in favor of eschewing their use in regulations and statutes.

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