Finra rule 2090: Meaning, Criticisms & Real-World Uses

What Is FINRA Rule 2090?

FINRA Rule 2090, often referred to as the "Know Your Customer" (KYC) rule, is a fundamental regulation in the broader realm of financial regulation within the financial industry. This rule mandates that member firms of the Financial Industry Regulatory Authority (FINRA), primarily broker-dealer firms, exercise "reasonable diligence" to ascertain and retain essential facts about every customer and concerning the authority of each person acting on behalf of such a customer³⁰, ³¹. The purpose of FINRA Rule 2090 is to enhance investor protection and facilitate regulatory compliance by ensuring that firms thoroughly understand their clients.

History and Origin

The concept of "knowing your customer" has long been an implicit obligation within the securities industry, embedded in general principles of fair dealing. FINRA Rule 2090, however, formally codified and strengthened this obligation. It was proposed by FINRA and subsequently approved by the U.S. Securities and Exchange Commission (SEC) alongside FINRA Rule 2111 (Suitability Rule) as part of the consolidated FINRA rulebook²⁹. The new rules became effective on July 9, 2012, replacing earlier, fragmented provisions, such as former NYSE Rule 405(1)²⁸. The intent behind FINRA Rule 2090 was to streamline, clarify, and enhance the critical due diligence responsibilities of firms regarding their customers²⁷.

Key Takeaways

FINRA Rule 2090 requires broker-dealers to exercise reasonable diligence to know and retain essential facts about their customers.
The rule applies to both the account opening process and the ongoing maintenance of accounts.
"Essential facts" include information necessary to effectively service the account, act on special instructions, understand customer authority, and comply with relevant laws.
Compliance with FINRA Rule 2090 is crucial for preventing financial crimes like fraud and supporting anti-money laundering efforts.
Firms must continuously monitor and update customer information throughout the customer relationship.

Interpreting FINRA Rule 2090

Interpreting FINRA Rule 2090 centers on the concept of "reasonable diligence" to gather "essential facts." Reasonable diligence implies that the effort expended to collect and verify customer data should be proportionate to the specific circumstances of the customer and the nature of the account. For instance, more complex investment strategies or higher-risk scenarios may necessitate a more extensive collection of customer information.

Essential facts are broadly defined as those needed to:

Effectively service the customer's account²⁶.
Act in accordance with any special handling instructions²⁵.
Understand the authority of each person acting on behalf of the customer²⁴.
Comply with applicable laws, regulations, and rules, including those related to anti-money laundering²², ²³.

This means understanding details such as a customer's investment objectives, risk tolerance, financial background, and employment status²⁰, ²¹. The obligation to "know your customer" is not a one-time event at account opening; it is continuous, requiring firms to update information as a customer's circumstances change over time¹⁹.

Hypothetical Example

Consider a new client, Sarah, who approaches a broker-dealer to open an investment account. Under FINRA Rule 2090, the broker-dealer must exercise reasonable diligence to collect essential facts about Sarah. This would involve:

Identity Verification: Obtaining Sarah's government-issued ID and verifying her identity.
Financial Profile: Asking about her annual income, net worth, liquid assets, and employment status.
Investment Goals: Discussing her short-term and long-term investment objectives, such as saving for retirement, a down payment on a house, or simply growth.
Risk Assessment: Ascertaining her risk tolerance through a questionnaire or discussion, determining if she is aggressive, moderate, or conservative.
Experience: Inquiring about her prior investment experience and knowledge of various financial products.
Authority: If Sarah designates someone else to trade on her behalf, the firm must verify that person's authority.

The firm documents all this information. Years later, if Sarah's financial situation drastically changes (e.g., she retires or inherits a large sum), FINRA Rule 2090 dictates that the firm should update her customer information to reflect these new facts and ensure the account is still serviced appropriately.

Practical Applications

FINRA Rule 2090 is integral to the daily operations of broker-dealers and has several critical applications:

Fraud Prevention: By verifying customer identities and understanding the source of funds, firms can detect and prevent financial crimes like identity theft, money laundering, and terrorist financing¹⁷, ¹⁸. This aligns with broader anti-money laundering (AML) regulations.
Suitability Determinations: The essential facts gathered under FINRA Rule 2090 form the basis for making suitable investment recommendations to clients, as required by FINRA Rule 2111¹⁶.
Account Servicing: Knowing a customer's specific needs, special handling instructions, or liquidity requirements allows firms to service accounts effectively and respond appropriately to customer requests¹⁴, ¹⁵.
Risk Management: Comprehensive customer profiles help firms assess and manage risks associated with individual accounts and their overall client base.
Regulatory Supervision: The rule ensures that firms maintain adequate records to demonstrate compliance during regulatory examinations. Non-compliance can lead to significant penalties, as evidenced by FINRA fines totaling $1.4 million issued to five major Wall Street firms (JP Morgan, Citigroup, LPL Financial, Morgan Stanley, and Merrill Lynch) in 2019 for failings related to custodial accounts and their supervision under Rule 2090¹², ¹³.

Limitations and Criticisms

While FINRA Rule 2090 serves as a cornerstone of investor protection, it is not without its challenges and criticisms. One common critique revolves around the subjective nature of "reasonable diligence" and "essential facts." What constitutes sufficient inquiry can be open to interpretation, potentially leading to inconsistent application across different firms or even within the same firm¹¹. This ambiguity can create compliance burdens, as firms grapple with the extent of data collection required to satisfy the rule's mandate.

Another limitation arises from the dynamic nature of customer circumstances. Although the rule requires ongoing monitoring, customers' financial situations and objectives can change rapidly, making it challenging for firms to maintain perfectly up-to-date customer information at all times. Furthermore, while the rule aims to prevent fraud and financial crimes, sophisticated schemes can still bypass even diligent KYC procedures. The administrative burden of collecting and maintaining extensive customer data, particularly for smaller broker-dealers, can also be a point of contention¹⁰.

FINRA Rule 2090 vs. FINRA Rule 2111

FINRA Rule 2090 (Know Your Customer) and FINRA Rule 2111 (Suitability) are often discussed together because they are highly complementary and work in tandem to protect investors. The primary distinction lies in their focus:

FINRA Rule 2090 focuses on the collection and retention of essential facts about the customer. It's about knowing who the customer is, their financial situation, and their investment objectives⁸, ⁹. This rule applies to the opening and maintenance of accounts, regardless of whether a recommendation is made⁷.
FINRA Rule 2111 focuses on the appropriateness of investment recommendations made to a customer. It requires a broker-dealer to have a reasonable basis to believe that a recommended transaction or investment strategy is suitable for a particular customer, based on that customer's investment profile⁵, ⁶.

Essentially, FINRA Rule 2090 provides the necessary foundation for FINRA Rule 2111. A firm cannot make a "suitable" recommendation under Rule 2111 without first having a thorough understanding of the customer's profile, which is obtained through compliance with FINRA Rule 2090.

FAQs

What are "essential facts" under FINRA Rule 2090?
"Essential facts" are the pieces of information a firm needs to properly service a customer's account, follow special instructions, understand who is authorized to act on the account, and comply with all relevant laws and regulations, including anti-money laundering rules³, ⁴. This typically includes details about a customer's financial situation, investment objectives, and investment experience.

Does FINRA Rule 2090 only apply when opening a new account?
No, FINRA Rule 2090 applies to both the account opening process and the ongoing maintenance of every account². This means firms have a continuous obligation to update and maintain accurate customer information throughout the entire relationship with the client.

Why is FINRA Rule 2090 important for investors?
FINRA Rule 2090 is crucial for investor protection because it helps ensure that broker-dealers understand their clients' financial situations and goals. This understanding enables firms to make appropriate investment recommendations, prevent fraudulent activities, and generally act in the client's best interest, fostering trust and transparency in the financial industry ¹.