Reasonable Basis Obligation This means the Thus, the new rule's "hold" language would not apply when a broker remains silent regarding security positions in an account. Where, for example, a registered representative makes a recommendation to purchase a security to a potential investor, the suitability rule would apply to the recommendation if that individual executes the transaction through the broker-dealer with which the registered representative is associated or the broker-dealer receives or will receive, directly or indirectly, compensation as a result of the recommended transaction.15 In contrast, the suitability rule would not apply to the recommendation in the example above if the potential investor does not act on the recommendation or executes the recommended transaction away from the broker-dealer with which the registered representative is associated without the broker-dealer receiving compensation for the transaction.16, Q3.1. FINRA BrokerCheck, moreover, allows investors to review the professional and disciplinary backgrounds of firms and brokers online. The rule explicitly states that the term "strategy" should be interpreted broadly.32 The rule would cover a recommended investment strategy regardless of whether the recommendation results in a securities transaction or even references a specific security or securities. Should the investment experience of a guardian, custodian, trustee or similarly situated third party managing an account be taken into consideration when making account recommendations? 496, 503, 2003 SEC LEXIS 1154, at *10-11 (2003) ("As we have frequently pointed out, a broker's recommendations must be consistent with his customer's best interests. FINRA explained that, although due diligence reviews by such committees can be extremely beneficial (see, e.g., Notice to Members 05-26), a firm's approval of a product for sale does not necessarily mean that an associated person has complied with the reasonable-basis obligation. [Notice 12-25 (FAQ 15)], A3.2. 2010), cert. Reg. Does the new rule cover a "hold" recommendation regarding securities that the broker did not originally recommend? See, e.g., FINRA Rule 2010 (Standards of Commercial Honor and Principles of Trade); FINRA Rule 3270 (Outside Business Activities of Registered Persons); Rule 2210 (Communications with the Public); see also Ialeggio v. SEC, No. 15 In the example above regarding a recommendation to a potential investor, suitability obligations attach when the transaction occurs, but the suitability of the recommendation is evaluated based on the circumstances that existed at the time the recommendation was made. The significance of specific types of customer information will depend on the facts and circumstances of the particular case.24, Q3.4. "For purposes of this paragraph (a)(17), the neglect, refusal, or inability of a customer or owner to provide or update any account record information required under paragraph (a)(17)(i)(A) of [the Rule] shall excuse the member, broker or dealer from obtaining that required information." ; Regulatory Notice 11-02, at 4-5. Id. [Notice 12-55 (FAQ 6(a))], A2.1. The following frequently asked questions (FAQs) provide guidance on FINRA Rule 2111 (Suitability). The absence of some customer information that is not material under the circumstances generally should not affect a firm's ability to make a recommendation. Those types of accounts Yes. FINRA IS A REGISTERED TRADEMARK OF THE FINANCIAL INDUSTRY REGULATORY AUTHORITY, INC. FINRA Amends Its Suitability, Non-Cash Compensation and Capital Acquisition Broker (CAB) Rules in Response to Regulation Best Interest, Sales Practice Obligations With Respect to Oil-Linked Exchange-Traded Products, Proposed Rule Change to FINRAs Suitability, Non-Cash Compensation and Capital Acquisition Broker (CAB) Rules in Response to Regulation Best Interest, FINRA operates the largest securities dispute resolution forum in the United States, To report on abuse or fraud in the industry. (Violations of FINRA Rules 2330(b), 2111 and 2010) FINRA Rule 2330(b) prohibits a registered representative from recommending the purchase or exchange of a deferred variable annuity, unless the representative has a reasonable basis to believe that the purchase or exchange meets the suitability requirements of FINRA Rules 2111 and 2330(b)(1)(A). [Notice 12-25 (FAQ 13)], A9.2. 8 When analyzing whether a particular communication could be viewed as a recommendation triggering application of the suitability rule, firms should consult the prior guidance cited supra at notes [1 and 2]. Section 201(a) of the Jumpstart Our Business Startups Act (JOBS Act)6 directs the SEC to amend Rule 506 of Regulation D under the Securities Act of 1933 to eliminate the prohibition on general solicitations to the extent that all purchasers are accredited investors. In relation to a customer affirmatively indicating the intention to exercise independent judgment, negative consent will not suffice, but the affirmative indication does not necessarily have to be in writing. 1030, 1032-1034, 1996 SEC LEXIS 2922, at *5-10 (1996) (explaining risks associated with certain foreign currency debt securities); Clinton H. Holland, Jr., 52 S.E.C. 16 Depending on the facts and circumstances, a registered representative's recommendation to a potential investor also could raise concerns under, among other rules, FINRA Rule 2010 (Standards of Commercial Honor and Principles of Trade); FINRA Rule 2020 (Use of Manipulative, Deceptive or Other Fraudulent Devices); Rule 2210 (Communications with the Public); and NASD Rule 3040 (Private Securities Transactions of an Associated Person); see also Dep't of Enforcement v. Salazar, No. For purposes of using a risk-based approach to documenting compliance with suitability obligations, what types of recommendations does FINRA generally consider complex or potentially risky? 35415, 1995 SEC LEXIS 481, at *2-3 (Feb. 24, 1995) ("His excessive trading yielded an annualized commission to equity ratio ranging between 12.1% and 18.0%."). at 340, 1999 SEC LEXIS 1754, at *18. However, firms should understand that, to the degree that the basis for suitability is not evident from the recommendation itself, FINRA examination and enforcement concerns will rise with the lack of documentary evidence for the recommendation. Absent an agreement, course of conduct or unusual fact pattern that might alter the normal broker-customer relationship, a hold recommendation would not create an ongoing duty to monitor and make subsequent recommendations.49, Q4.5. 61247, 2009 SEC LEXIS 4332, at *3-6 (Dec. 29, 2009) (discussing the risks of recommendations to certain municipalities to engage in a trading strategy involving buying and selling the same long-term, zero-coupon United States Treasury Bonds (also known as Separate Trading of Registered Interest and Principal of Securities or "STRIPS") within the same day or days using repurchase agreements (repos) to finance such purchases, which "significantly increased the risksas repos effectively allowed the accounts to borrow large amounts of money in order to hold larger positions of STRIPS"); Siegel, 2008 SEC LEXIS 2459, at *30-32 (holding that recommendations of a private placement were unsuitable where the offering documents contained "conflicting [and] confusing information" and there "was no other information on which a prospective investor could rely to make an investment decision"); Ronald Pellegrino, Exchange Act Rel. FINRA stated that, "[t]o the extent that a customer account at a broker-dealer can be discretionary under applicable federal securities laws, the suitability rule generally would not apply where a firm refrains from selling a security." Q3.8. 297, 310, 2004 SEC LEXIS 277, at *23-24 (2004) (stating that a "broker's recommendations must be consistent with his customer's best interests" and are "not suitable merely because the customer acquiesces in [them]"); Wendell D. Belden, 56 S.E.C. However, where a broker-dealer's or registered representative's recommendation does not refer to a security or securities, the suitability rule is not applicable. Yes. Vincent Apicella, Stock Focus: "Dogs of the Dow" Companies, Forbes.com (May 29, 2001). A1.3. See also [infra note 86; Regulatory Notice 12-25, at 19 n.12]. Id. 471, 475, 1999 SEC LEXIS 2685, at *7 (1999). Brokers cannot fulfill their suitability responsibilities to customers (including both their reasonable-basis and customer-specific obligations) when they fail to understand the securities and investment strategies they recommend. The significance of specific types of customer information generally will depend on the facts and circumstances of the particular case, including the nature and characteristics of the product or strategy at issue. 54722, 2006 SEC LEXIS 2572, at *21 (Nov. 8, 2006) [, aff'd, 304 F. App'x 883 (D.C. Cir. No. Does a firm have to update all customer-account documentation by the suitability rule's implementation date to capture the new "customer investment profile" factors (age, investment experience, time horizon, liquidity needs and risk tolerance) that were added to the existing list (other holdings, financial situation and needs, tax status and investment objectives)?17 [Notice 11-25 (FAQ 2)]. A9.5. In addition to the definitional change, the new institutional-customer exemption focuses on two factors: (1) whether a broker "has a reasonable basis to believe the institutional customer is capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies involving a security or securities" (a factor used in the predecessor rule), and (2) whether "the institutional customer affirmatively indicates that it is exercising independent judgment" (a new requirement).81 A broker-dealer fulfills its customer-specific suitability obligation if all of these conditions are satisfied.82. 52 Specifically, the rule A broker-dealer's supervisory system must be reasonably designed to achieve compliance with applicable securities laws, regulations and FINRA rules.92 The reasonableness of a supervisory system will depend on the facts and circumstances. The new suitability rule requires that a recommended investment strategy involving a security or securities must be suitable. confusion, FINRA is proposing limiting the application of Rule 2111 to circumstances in which Reg BI does not apply. A recommendation to hold securities, maintain an investment strategy involving securities or use another investment strategy involving securitiesas with a recommendation to purchase, sell or exchange securitiesnormally would not create an ongoing duty to monitor and make subsequent recommendations. 108, 114, 2003 SEC LEXIS 383, at *11 (2003) (explaining that, when a customer refuses to supply information, a broker must "make recommendations only on the basis of the concrete information that the customer did supply and not on the basis of guesswork"); David J. Dambro, 51 S.E.C. Does the elimination of the general solicitation prohibition mean that broker-dealers no longer have suitability obligations regarding private placements? 1096, 1100, 2002 SEC LEXIS 1909, at *5-6 (2002) (same), aff'd, 77 F. App'x 2 (1st Cir. How much of a duty does a firm have to pursue "any other information the customer may disclose" to see if it has suitability implications? 53 FINRA Rule 2111.03. Recently FINRA Rule 2111 went into effect regarding Suitability. See Richard G. Cody, Exchange Act Rel. Some of the "Institutional Suitability Certificates" that are being marketed do not identify an institutional customer's experience with particular asset classes or types of securities or investment strategies involving a security or securities. Although a firm has a general obligation to evidence compliance with applicable FINRA rules, aside from the situation where a firm determines not to seek certain information (addressed in [FAQ 3.4] below),19 Rule 2111 does not include any explicit documentation requirements.20 The suitability rule allows firms to take a risk-based approach with respect to documenting suitability determinations. Cir. FINRA has not approved or endorsed any third-party Institutional Suitability Certificates and has not contracted with any third-party vendor to create such certificates on FINRA's behalf. A3.6. The rule expands the definition of what is a recommendation to include investment strategies and also expands the amount of information to be collected for each recommendation. 40 See id. Pinchas, 54 S.E.C. [Notice 12-25 (FAQ 24)]. Is the quantitative suitability obligation under the new rule any different from the excessive trading line of cases under the predecessor rule? 4 5 FINRA previously responded to questions regarding whether the absence of a sell order in a discretionary account amounts to an implicit hold recommendation covered by the rule. 2008015078603 (Nov. 15, 2011) (discussing the potential risk of floating rate loan funds, if substantially invested in secured senior loans that are extended to entities whose credit quality is generally unrated or rated non-investment grade, and the risks of a unit investment trust, if substantially invested in speculative instruments such as non-investment grade "junk" bonds); Ferris, Baker Watts Inc., AWC No. SEA Rule 17a-3(a)(17)(i)(C). Some customers, moreover, desire portfolios made up of securities with different levels of liquidity, risk and time horizons. 58737, 2008 SEC LEXIS 2459, at *21-27 (Oct. 6, 2008) (applying the guiding principles to the facts of the case to find a recommendation), aff'd in relevant part, 592 F.3d 147 (D.C. A firm's analysis of whether the identification of a more limited universe of fixed-income securities constitutes a recommendation of particular securities may, depending on the facts and circumstances, differ from its assessment regarding equity securities. Id. 1990). Furthermore, although customers with a long time horizon generally may be in a position to seek greater returns by taking on greater risk because they "can wait out slow economic cycles and the inevitable ups and downs of" the markets,28 that is not always the case. 13 Nothing in this guidance shall be construed as altering a broker-dealer's obligations under applicable federal laws, regulations and rules or other FINRA rules, including, but not limited to, Sections 9, 10(b) and 15(c) of the Securities Exchange Act of 1934, Section 17(a) of the Securities Act of 1933, the Bank Secrecy Act, 31 U.S.C. The rule also explicitly covers recommended investment strategies involving securities, including recommendations to "hold" securities. 29 FINRA also previously stated that a customer with multiple accounts at a single firm could have different investment profiles or investment-profile factors (e.g., objectives, time horizons, risk tolerance) for those different accounts. Rule 2111 would cover a recommendation to purchase securities using margin or liquefied home equity or to engage in day trading, irrespective of whether the Each firm has a general obligation to evidence compliance with applicable FINRA rules. 20070091803 (Oct. 20, 2010) (discussing reverse convertibles exposing investors to risks in addition to those risks associated with investment in bonds and bond funds, and having complex pay-out structures involving multiple variables); Jeffrey C. Young, Exchange Act Rel. Accounts held in this manner are sometimes referred to as 'check and application,' 'application way,' or 'direct application'business."). 11637, 11638 (Aug. 11, 1967) (noting that the SEC's now-rescinded suitability rule would not apply to "general distribution of a market letter, research report or other similar material"); Suitability Requirements for Transactions in Certain Securities, 54 Fed. In this regard, firms should note that, as an allocation recommendation becomes narrower or more specific, the recommendation gets closer to becoming a recommendation of particular securities and, thus, subject to the suitability rule, depending on a variety of factors (including the number of issuers that fall within the broker-dealer's allocation recommendation).55 Accordingly, broker-dealers should assess whether allocation recommendations involving certain types of sub-categories of broader market sectors or even more limited groupings are so specific or narrow that they constitute recommendations of particular securities.56, Q4.8. 12, 2012) (finding that registered representative violated NASD Rules 2310 and 3040 when he recommended unsuitable private securities transactions to investors who were not his firm's customers, received compensation in relation to the transactions and failed to notify his firm of such activity); Maximo J. Guevara, 54 S.E.C. 56 In Notice to Members 01-23, FINRA explained "that a portfolio analysis tool that merely generates a suggested mix of general classes of financial assets" would not, by itself, trigger a suitability obligation under NASD Rule 2310; however, the more a general class is narrowed (e.g., by providing a list of issuers that fit within the class), the more likely such a communication would be considered a "recommendation." C07960035, 1997 NASD Discip. No. Some customers with long time horizons may not desire to take on such risk and others, because of considerations outside their time horizons, are unable to do so. Nothing in this guidance, however, relieves a firm from having to ensure that the investment profiles or factors accurately reflect the customer's decisions. No. Rule 2111 requires that the suitability assessment be "based on the information obtained through the reasonable diligence of the member or associated person to ascertain the Suitability | FINRA.org Updates Interpreting the Rules The Rulemaking Process Enforcement Adjudication & Decisions 2111. FINRA previously has provided guiding principles that firms and registered representatives could consider when determining whether a particular communication could be viewed as a recommendation for purposes of the suitability rule. at 339-40 n.14, 1999 SEC LEXIS 1754, at *17 n.14. 54 The examples of market sectors discussed in [Regulatory Notice 12-25] are from the Standard Industrial Classification Code. Firms' supervisory policies and procedures must be reasonably designed to ensure that their brokers comply with this important requirement.59, Q5.2. Does the suitability rule apply when a broker-dealer or registered representative makes a recommendation to a potential investor? Can you provide some examples of what would and would not be considered an "investment strategy" under the rule? See [FAQ 3.10]. FINRA previously stated that, although a firm has a general obligation to evidence compliance with applicable FINRA rules, the suitability rule does not include explicit documentation requirements, except in a situation where a firm determines not to seek certain customer information in the first place.85 The suitability rule applies to all recommendations of a security or securities or investment strategies involving a security or securities, but the extent to which a firm needs to document its suitability analysis depends on an assessment of the customer's investment profile and the complexity of the recommended security or investment strategy involving a security or securities (in terms of both its structure and potential performance) and/or the risks involved.86. A risk-based approach also may lead a firm to pay particular attention to hold recommendations where, at the time the recommendation is made, a customer's account has a heavy concentration in a particular security or industry sector or the security or securities in question are inconsistent with the customer's investment profile.90 The same approach applies to other recommended strategies. 82 FINRA Rule 2111(b). [Notice 12-55 (FAQ 6(b))], A2.2. The institutional-customer exemption does not apply to reasonable-basis and quantitative suitability. However, the fact that a customer initially needed help understanding a potential investment or investment strategy need not necessarily imply that the customer did not ultimately develop an understanding. In all cases, the suitability rule applies to recommendations, but the extent to which a firm needs to evidence suitability generally depends on the complexity of the security or strategy in structure and performance and/or the risks involved. ", A broker who recommended "that his customers purchase promissory notes to give him money to use in his business.". No. FINRA explained in one instance under the predecessor rule that "recommending liquefying home equity to purchase securities may not be suitable for all investors. [Broker-dealers or registered representatives] should consider not only whether the recommended investments are suitable, but also whether the strategy of investing liquefied home equity in securities is suitable." The new suitability rule (as with the predecessor rule) requires a broker to seek to obtain and analyze a customer's other investments. LEXIS 10362, *4-5 (9th Cir. The suitability rule applies only to recommended securities and investment strategies involving securities, but FINRA does not define the term "recommendation" other than to say that it is a facts and circumstances inquiry. 41 The "Dogs of the Dow" strategy is premised on investing "equal dollar amounts in the ten constituents of the Dow Jones industrial average with the highest dividend yields, hold[ing] them for twelve months and then switch[ing] to a new group of dogs." Reg. Firms should use a similar approach to analyzing whether particular recommendations are eligible for the Rule 2111.03 safe-harbor provision. A broker's use of in-and-out trading ordinarily is a strong indicator of excessive trading. The answer depends on the facts and circumstances of the particular case. The rule excludes reallocation In many circumstances, the answer is yes. ), cert. 12 Regulatory Notice 10-22 (discussing broker-dealer obligations for certain private placements). A9.4. FINRA stated that "[a] firm should educate its associated persons on the potential risks and rewards of the products that the firm permits them to recommend. The quantitative suitability obligation under the new rule simply codifies excessive trading cases. 164, 165 n.1, 1989 SEC LEXIS 2376, at *2 n.1 (1989) ("The effect of trading on margin is to leverage any position so that the systematic and unsystematic risks are both greater per dollar of investment."). What types of "hold" recommendations should firms consider documenting? In limited circumstances, FINRA and the SEC have recognized that certain actions constitute implicit recommendations that can trigger suitability obligations. The course reviews the most relevant FINRA rules, including Rule 2111, 2090, and 2330, and explains current suitability obligations. A8.2. No. In addition, FINRA explained that, where a firm allows a customer to use different investment profiles or factors for different accounts rather than using a single customer profile for all of the customer's accounts, a firm could not borrow profile factors from the different accounts to justify a recommendation that would not be appropriate for the account for which the recommendation was made. Notices, Proposed Rules, Rules, and Presidential Documents published in the 42 The rule would apply, for instance, to a registered representative's recommendation to a customer to purchase shares of high dividend companies even though the registered representative does not mention a particular high dividend company. See, e.g., NASD Rules 1014, 1021 and 1031, and FINRA Rule 1240. FINRA cautioned, however, that a firm should evidence a customer's intent to use different investment profiles or factors for the different accounts. 68 See Regulatory Notice 11-02, at 7 n.11; SEC Staff Study on Investment Advisers and Broker-Dealers as Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, at 59 (Jan. 2011) (IA/BD Study). FINRA cautioned, however, that, "if the associated person remains uncertain about the potential risks and rewards of a product, or has reason to believe that the firm failed to address a particular issue or has done so in an incomplete or inaccurate manner, then the associated person would need to engage in further inquiry before recommending the product." Accordingly, a broker-dealer could choose to seek to obtain and analyze the customer-specific factors listed in Rule 2111 when it makes new recommendations to customers (regardless of whether they are new or existing customers).21, Q3.3. A3.1. FINRA emphasizes, however, that a high level of liquidity does not, in and of itself, mean that the recommended product is suitable for all customers. Still other firms may create data fields for entering such information into automated supervisory systems. Moreover, absent "red flags" indicating that such information is inaccurate or that the customer is unclear about the information, a broker generally may rely on the customer's responses. Yes. 4, 2012). However, as explained in FAQ [1.2], the rule would not cover an implicit recommendation to hold. Although due diligence reviews by such committees can be extremely beneficial,61 a firm's approval of a product for sale does not necessarily mean that an associated person has complied with the reasonable-basis obligation. Where the hold recommendation involves an overly concentrated position in a security, however, documentation usually would be necessary, even if the broker did not originally recommend the purchase of the security. 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