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The Financial Industry Regulatory Authority (FINRA) recently fined Bank of American Corp.’s Merrill Lynch unit $500,000 for to its failure to supervise its representatives involved in the recommendation of college-savings products called 529 plans. FINRA’s disciplinary action against Merrill Lynch raises the question: do broker-dealers and their representatives have a duty to research, consider, or even understand the tax consequences of investment recommendations?

The issue of whether a broker has a duty to consider the tax consequences of a recommendation is critical to investors for two reasons. First, many investors believe their brokers already have a duty to consider the tax consequences, and thus, will not seek independent tax advice concerning those investments. Second, given the complicated array of investment choices and tax regulations, most clients cannot understand the tax consequences of investments on their own.

Despite the obvious need for someone to evaluate the tax consequences of a customer’s investments, often times, there is an advice-gap. The broker will disclose to the client that he/she is not a tax advisor, the tax advisor will defer to the broker for investment advice, and the client is left to wonder why they paid two professionals to direct them in the opposite direction. This conduct is clearly inconsistent with the broker’s duties under FINRA rules.

FINRA Rule 2310 (the “Suitability Rule”) identifies at least two discrete duties a broker maintains when recommending an investment to a client. First, the broker must have “reasonable grounds for believing that the recommendation is suitable….” Second, the broker must make “reasonable efforts” to ascertain information about the client, also known as customer-specific suitability, including the following factors: financial status, tax status, and investment objectives. These two prongs of suitability, at a minimum, require the broker to consider a client’s tax status and the reasonableness of the tax consequences when making a recommendation.

Further, FINRA has disciplined broker-dealers and brokers under FINRA Rule 2310 for failing to consider the tax consequences of investment recommendations. FINRA’s censure and fine of Merrill Lynch in January 2011, indicates that member firms cannot absolve themselves of the duty to consider the tax consequences of recommendations. Although Merrill Lynch required its representatives to consider the potential benefits of in state versus out-of-state 529 plans, FINRA found that Merrill Lynch failed “establish and maintain specific procedures reasonably designed to achieve compliance with industry suitability standards related to the sale of 529 plans.” Further, NASD Regulation (FINRA’s predecessor) brought a disciplinary proceeding against a Scott Epstein, former registered representative, for making unsuitable recommendations with regards to mutual funds switches. Specifically, the Regulators noted that Mr. Epstein “failed to note the tax consequences of the recommended switches.”

These FINRA rules and disciplinary actions demonstrate that brokers must research, understand, and consider the tax consequences of investment recommendations. Nonetheless, the scope of this duty is largely undefined. What specific obligations does this larger duty contain? What additional training/qualifications/supervision is required to protect investors? As a result, FINRA needs to provide additional guidance to bridge the “advice gap” between brokers and tax advisors.

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