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New FINRA rule seen as weakening brokerage defenses
July 11, 2012 / 1:47 PM / 5 years ago

New FINRA rule seen as weakening brokerage defenses

(Reuters) - A new securities industry rule that strengthens protections for investors could have a serious downside for the brokerages that advise them: fewer defenses in an arbitration.

The Financial Industry Regulatory Authority’s new rule, which took effect on Monday, requires securities and strategies that brokers recommend to be suitable for investors at all times, not just at the time of the transaction.

While brokerages have had nearly two years to prepare for the rule, the true test of their efforts will probably come months or even years from now, in arbitration cases from investors claiming they were sold unsuitable securities. Some of the arguments that brokerages have long relied on to fight investors in those cases will not pack the same punch anymore, lawyers say.

Among the biggest shift is FINRA’s clarification that even long-term strategies must be suitable based on factors such as the investor’s risk tolerance, liquidity needs and age. Brokerages have long managed to persuade arbitrators that the standard of a “suitable recommendation” applied only to recommendations for individual transactions.

This “ridiculous” defense led to a lot of arguing in arbitrations over whether the strategies were subject to the suitability rule, said Peter Mougey, a Pensacola, Florida, lawyer who represents investors in arbitration cases.

But the rule could also minimize the need for that type of defense for brokerages because of the more vigilant record-keeping they must do. Until now, “after-the-fact discussions” about the possible rationale for a recommendation were common, said Thomas Potter, a lawyer for Burr & Forman LLP in Nashville, Tennessee.

“Now you need to have in the file what you considered and how you considered it,” he said. Brokerages have been training their advisers to keep and store detailed notes that they can use during future client meetings and to defend themselves in possible legal cases.

The rule could motivate brokers who resisted taking notes to start doing it, leading to fewer problems, Potter said.


In particular, FINRA’s own written guidance about the rule could help investors in some of the most frustrating cases: those in which brokerages argue that an investor is “not a customer.”

FINRA rules require brokerages to arbitrate with customers who demand the process. But what constitutes a customer has been open to question.

Many brokerages, including Raymond James Financial Inc unit Morgan Keegan & Co, have successfully raised the defense in cases involving mutual funds and other securities that they have underwritten and branded under their own names, but sold through another firm.

The “not-a-customer” defense also arises when brokers persuade investors to transfer assets from company-sponsored pension plans to individual retirement accounts, said Atlanta-based lawyer Brian Smiley, who represents investors. That recommendation can have “horrifying consequences” because of the financial risks an investor takes when cashing in pension assets, but it is typically made before the investor has an account with the brokerage, Smiley said.

Still, guidance that FINRA published in May clearly states that customers include even prospective investors who do not have an account with a broker’s firm.

The battle over who is and is not a customer often takes place in court, where brokerages sue to stop arbitrations by saying the investors who file them are not customers.

Most judges who hear those arguments have never previously decided such a case, said Houston lawyer William Shepherd, who represents investors in arbitration. What is more, decisions in other cases to guide them are often inconsistent, he said.

The written guidance from FINRA could help sway a judge’s thinking in the investor’s favor, Shepherd said.


FINRA’s new rule can also weaken brokerages’ efforts to take advantage of gaps in state laws that have left investors vulnerable.

One of the biggest clarifications, for example, is that a recommendation to “hold” securities must be suitable, even though the advice does not require a transaction. Some states, such as California, already have this requirement, but laws in other states are not as clear.

And even in California, brokerage lawyers have often tried to convince arbitrators to follow the old, weaker FINRA rule, said Leonard Steiner, a Beverly Hills lawyer who represents investors.

Those arguments will be far less persuasive now that FINRA’s industrywide rule is in place, said Smiley, the Atlanta-based lawyer.

FINRA has appointed arbitrators to apply the standards that it sets, he said. “And they’re not optional standards, they’re mandatory.”

Reporting By Suzanne Barlyn; Editing by Jennifer Merritt and Lisa Von Ahn

Our Standards:The Thomson Reuters Trust Principles.
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