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What is the NASD Conduct Rule 2310?

The NASD and NYSE Suitability Rules - An Asset for Investors

August, 2006

by Harvey R. Herman


Since the stock market bubble burst which occurred in the 2000 to 2001 time period, there has been a significant increase in the amount of litigation brought by investors against their financial representatives and security brokerage firms. The investors are often seeking to recover losses sustained in their brokerage accounts as a result of market losses.

Financial representatives and brokerage firms must comply with the suitability rules established by regulatory organizations such as the National Association of Securities Dealers (NASD) and the New York Stock Exchange (NYSE). Violation of the suitability rules can provide the investor with numerous causes of action including negligence, breach of contract and, in more serious situations, a claim based on Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, otherwise known as the Anti-Fraud provision.

NASD Conduct Rule 2310 Recommendations to Customers.

Rule 2310 is the NASD suitability rule and is contained in the NASD Manual. The suitability rule provides that when a financial representative recommends to an investor the purchase, sale or exchange of any security, a financial representative shall have reasonable grounds for believing that the recommendation is suitable for such investor upon the basis of the facts, if any, disclosed by such investor as to his or her other security holdings and as to his or her financial situation and needs. The rule sets forth the specific information that the financial representative is required to obtain before executing a transaction. The information which the financial representative is required to obtain is: 1) the investor’s financial status; 2) the investor’s tax status; 3) the investor’s investment objectives; and 4) such other information used or considered to be reasonable by such financial representative in making a securities recommendation to the investor.

The Securities Recommendation.

The suitability rule is applicable when a financial representative makes a security recommendation. The rule does not set forth or otherwise define the meaning of a securities recommendation. The issue of whether a communication between a financial representative and an investor constitutes a recommendation depends on the content, context and presentation of the communication. A communication which, for example, suggests that an investor act on information provided or which otherwise endorses the financial information provided by the financial representative to the investor would more likely be considered a recommendation. This should be contrasted to the situation where a financial representative simply transacts the trade initiated by an investor (acts as a “conduit”) or otherwise gathers financial information for an investor. In these type of situations, the communication will more likely be viewed as not being a recommendation. The determination of whether a communication is a recommendation is a factual consideration and thus a cause of action based on breach of the suitability rules is often asserted by investors in claims brought against the financial representative and the brokerage firm. It is also interesting to note that the suitability rule and the manner in which it is interpreted is constantly evolving and adopting to the methods in which security transactions are conducted. An example is a recently enacted suitability rule and policy statement pertaining to standards for on-line communications between financial representatives and investors.

Investor’s Specific Recommendation.

As set forth above, the suitability rules require that a financial representative obtain specific financial information from the investor. This information combined with the investor investment objectives and investment risk tolerance is the information on which a suitability determination needs to be made. The investor account opening documents contain questions designed to elicit the requisite information used as part of a suitability determination. This information is then normally sent to the brokerage firm’s compliance department. The compliance department has the supervisory responsibility to ensure that the transactions which subsequently occur in the account remain consistent with the investment objectives of the investor. The NASD has detailed rules which set forth the supervisory responsibility of the brokerage firm. NASD Rule 3010 Supervision specifies in detail the broad supervisory responsibilities which a brokerage firm has and must comply with in conducting its business. The brokerage firm can be held accountable for the actions of the financial representative under the legal theory of respondeat superior and can also be held individually liable for not complying with its supervisory responsibilities.

Reasonable Basis Tests.

In a broader sense, the suitability rule requires that a financial representative have an adequate and reasonable basis on which to recommend a security. Rule 2310 requires that the financial representative “have reasonable grounds for believing that the recommendation is suitable for such customer.” The Reasonable Basis test component requires that a financial representative make an informed determination that the recommended security is suitable for at least some investors as opposed to the specific investor’s needs. In other words, the financial representative is required to have a reasonable and informed basis on which to make a security recommendation. See, Frederick F. J. Kauffman & Company of Virginia, 50 S.E.C. 164; 1989 S.E.C. LEXIS 2376 (1989).

Learning Point:

The NASD suitability rules and other similar rules such as NYSE Rule 405 Diligence as to Accounts require that the financial representative “know the customer” in order to ensure that investors have an informed basis on which to purchase securities. The suitability rules are consistent with the underlying goals and objectives of the security laws which are to provide and promote the fair, ethical and full disclosure of material information to the investor and public at large. However, these rules are often used as a sword to support investor claims which would otherwise lack substantive merit. It is therefore important to know this rule in order to properly shield and defend the financial representative and brokerage firm from the increasing amount of investor lawsuits. •


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