Recent changes to FINRA’s suitability rule may have implications for the futures industry. The futures industry has never had a suitability rule. In 1978, the U.S. Commodity Futures Trading Commission (CFTC) considered adopting one but decided against it, opting instead to impose on a Series 3 broker a robust duty to disclose the risks and let the customer decide whether to engage in futures trading.1 When the NFA adopted Compliance Rule 2-30, it followed the CFTC’s lead: “Once … the customer has been given adequate disclosure, the customer is free to make the decision whether to trade futures and the Member is permitted to accept the account.” 2
In contrast, the bedrock obligation of a Series 7 securities broker has been the duty to make suitable recommendations. The responsibility for determining whether a particular security transaction is right for a customer is placed on the broker—not the customer. Indeed, in 2012, FINRA’s enhanced suitability rule became effective.3 The new Rule 2111 now expands the scope of a Series 7 broker’s obligation (or expressly incorporates prior regulatory interpretations—depending on your point of view) to include having “a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities, is suitable for the customer.”4 The duty is now “triggered when [the broker] recommends a security or strategy regardless of whether the recommendation results in a transaction.” FINRA Regulatory Notice 11-02.
FINRA Rule 2111 may have opened the door in futures litigation to argue that a broker who holds both Series 7 and Series 3 licenses has a suitability obligation even if the customer traded only futures. The argument is that the dually-licensed broker’s initial decision to direct the customer to the futures markets to accomplish his or her investment objective instead of using a security is, itself, subject to Rule 2111’s “investment strategy” language.
Under Rule 2111, the suitability determination includes not just specific transactions but also “investment strategies.” FINRA has stated that “the term ‘strategy’ should be interpreted broadly.”5 For instance, it includes a recommendation to sell securities and use the proceeds to invest in non-securities products. Yes, it includes using the proceeds to trade futures products or an investment strategy that involves a combination of securities and futures; for example, hedging a stock portfolio with futures options.6 It may even apply to a recommendation to allocate a certain percentage of his or her portfolio to managed futures, depending on how specific the discussion gets.7
Suppose a customer comes to a dually-licensed broker and says, “I think the price of gold is going to spike, what should I do?” A Series 3 broker can recommend buying gold futures, buying gold calls or selling gold puts. But, a dually-licensed broker has a broader choice of investment products that he or she can recommend. In this example, a Series 7 broker may also recommend buying stock in a gold mining company or shares of a gold ETF. Is the recommendation to use futures products instead of securities an “investment strategy” that subjects the dually-licensed broker to a suitability duty?8
As seductive as this argument is, to impose a suitability obligation on dually-licensed brokers via the back-door where the customer only trades futures, is ill-conceived. FINRA’s over-haul of its suitability rule created an opportunity for the CFTC to revisit its decision not to adopt such a rule. Indeed, after 2008, in an environment where the conduct of investment professionals is being severely scrutinized, a change would be easy to implement. But, the fact remains that the futures industry still does not have a suitability rule. Further, closer analysis of Rule 2111 shows that it should not be applied to impose a suitability obligation on a dually-licensed broker whose customer trades only futures products.
As noted, Rule 2111 applies to recommendations of a security or investment strategy involving a security to a customer. The Rule requires that the plaintiff or claimant be a securities customer for Rule 2111 to apply. FINRA Regulatory Notice 12-55 defines a “customer” as “a person who … opens a brokerage account at a broker-dealer or purchases a security for which the broker-dealer receives or will receive, directly or indirectly compensation ….” In our hypothetical, if a dually licensed broker recommends buying gold futures or trading gold options, the customer is a futures customer but is not a securities “customer” as defined by FINRA, so the securities suitability rule does not apply. The customer has not opened a securities brokerage account at a broker-dealer and the dually-licensed broker has not received compensation from selling a security. Alternatively, if the customer decides on his or her own to liquidate securities positions and apply the proceeds toward gold futures or options, FINRA has said that the new suitability rule does not apply. “If the recommended investment strategy does not have a security component, the suitability rule would not apply. Id. The suitability rule applies only when the recommended investment strategy involves a security or securities ….” Id.
To conclude, the security industry’s suitability rule continues to serve that industry well given the broad range of securities products and the varying risks associated with each product. The securities suitability concept, however, never has been and should not now be applied to dually-licensed brokers who recommend only futures products even with the expanded language of FINRA Rule 2111.
©Kenneth F. Berg (Jan. 2014). All rights reserved.
Ulmer & Berne LLP, 500 W. Madison, Suite 3600, Chicago, IL 60661, 312-658-6506, kberg@ulmer.com.
*Christopher Seps, associate at Ulmer & Berne LLP, contributed to this article.
Ken has extensive experience in complex commercial and business litigation representing financial institutions. His expertise includes bank and broker-dealer defense; FCM/IB defense; SEC, CFTC, FINRA, NFA, and Exchange investigations and enforcement actions; trade secrets/unfair competition; and contract disputes. He has defended securities and commodities class actions in New York and Chicago federal courts. He also regularly represents financial institutions in arbitration actions at the NFA, FINRA, and AAA. Ken has achieved the highest rating, AV Preeminent, from Martindale-Hubbell and has been named an Illinois Super Lawyer.
[1] See 42 Fed. Reg. 44742, 44743-45 (Sept. 6, 1977); 43 Fed. Reg. 31886, 31889 (Jul. 24, 1978); T.J. Snider Regulation of the Commodities Futures and Options Markets Vol. 2, § 12.38 (2d ed. 1997).
[2]NFA Interpretive Notice ¶ 9004 (rev. Jan. 3 2011) (italics added). Some have argued that the NFA’s “know-your-customer” Rule 2-30 is the same as a suitability rule. It is not, however. The KYC rule obligates the broker to gather basic financial information about the customer, but it does not allocate to the broker the final decision on whether to trade futures. As Interpretive Notice ¶ 9004 makes clear—that decision ultimately remains with the customer, unlike with a suitability rule that places the obligation on the broker. Further, since all futures trading is speculative (except where the customer is a bona fide hedger), meaningful distinctions between the risks of futures products and trading strategies cannot be made, so it makes no sense to impose a duty on a Series 3 broker to determine whether a specific futures product or a particular futures trading strategy is inappropriate for a specific customer but another product or strategy is appropriate.
[3]The prior rule NASD Rule 2310 said “in recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer ….”
[4]FINRA Rule 2111. FINRA has recently published a very helpful FAQ combining and synthesizing its prior Regulatory Notices 11-25, 12-25 and 12-55 on suitability. It can be found at www.finra.org/industry/issues/suitability/ (hereinafter cited as “FAQ”).
[5]See FINRA Rule 2111.03.
[6]Other FINRA rules may also be implicated; such as, FINRA Rule 2010 (Standards of Commercial Honor and Principles of Trade); FINRA Rule 2210 (Communications with the Public); and FINRA Rule 3270 (Outside Business Activities of Registered Persons).
[7]FAQ at 10 n.55-56.
8Other situations where the dually-licensed broker might face a suitability lawsuit include recommending trading options on the S&P 500 Index (futures) instead of options on the S&P 100 Index (security) to a customer with a firm opinion on market direction. The FINRA 2111 suitability argument can also surface where a broker recommends a commodity pool because even though the pool is trading futures products, the purchase of pool shares is a security. Similarly, single-stock futures, which are regulated both as securities and futures, may open the door to a suitability claim. See FINRA Regulatory Notice 10-51 (notice on strategies that involve “commodity futures-linked securities”).