"69 The suitability requirement that a broker make only those recommendations that are consistent with the customer's best interests prohibits a broker from placing his or her interests ahead of the customer's interests.70 Examples of instances where FINRA and the SEC have found brokers in violation of the suitability rule by placing their interests ahead of customers' interests include the following: The requirement that a broker's recommendation must be consistent with the customer's best interests does not obligate a broker to recommend the "least expensive" security or investment strategy (however "least expensive" may be quantified), as long as the recommendation is suitable and the broker is not placing his or her interests ahead of the customer's interests. The new rule does not apply to implicit recommendations to hold. The suitability rule also would not apply to a firm's allocation recommendation regarding broad-based market sectors (e.g., agriculture, construction, finance, manufacturing, mining, retail, services, transportation and public utilities, and wholesale trade).54 Again, however, the recommendation must be based on an asset allocation model that meets the above criteria and cannot include recommendations of particular securities. LEXIS 36, at *22 (NAC Oct. 3, 2011) (same); Dep't of Enforcement v. Cody, No. Each firm has a general obligation to evidence compliance with applicable FINRA rules. at 504-05, 2003 SEC LEXIS 1154, at *14. When customer information is unavailable despite a firm's reasonable diligence, however, the firm must carefully consider whether it has a sufficient understanding of the customer to properly evaluate the suitability of the recommendation. Consistent with the discussions above, however, the complexity of and risks associated with a particular security or strategy likely will impact the level of documented analysis that is appropriate. 5311, et seq. The new rule, for example, does not apply to implicit recommendations to hold a security or securities. It is important to note, however, that the suitability rule would not apply to a firm's explanation of a strategy falling outside the safe-harbor provision if a reasonable person would not view the communication as a recommendation. For instance, as long as the supervisory system is reasonably designed to achieve compliance with applicable securities laws, regulations and FINRA rules, a firm could focus on the detection, investigation and follow-up of "red flags" indicating that a registered representative may have recommended an unsuitable investment strategy with both a security and non-security component.94 A registered representative's recommendation that a customer with limited means purchase a large position in a security might raise a "red flag" regarding the source of funds for such a purchase. 90 As discussed in [FAQ 4.4] above, 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. See Peter C. Bucchieri, 52 S.E.C. Cir. [See infra note 38] (emphasis in original). That will not always be the case, however. A4.2. As noted above in the answer to [FAQ 8.1], FINRA has not endorsed or promoted any certificate. No. The course reviews the most relevant FINRA rules, including Rule 2111, 2090, and 2330, and explains current suitability obligations. 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. 86 Firms should keep in mind, however, that SEA Rule 17a-3 requires that, for each account with a natural person as a customer or owner, a broker-dealer must create a record that includes, among other things, the customer's or owner's name, date of birth, employment status, annual income, and net worth, as well as the account's investment objectives. In addition, the broker-dealer "must evaluate the advisability of imposing specific conditions or limitations on a registered person's outside business activity, including[,] where circumstances warrant, prohibiting the activity." 7, 1997) ("A broker has a duty to make recommendations based upon the information he has about his customer, rather than based on speculation. Firms should understand that the use of any such Institutional Suitability Certificate in no way constitutes a safe harbor from the rule. The factors that must exist for an institutional customer to qualify for the exemption may, depending on the facts, negate some of the elements relevant to a showing of a broker's "control" over the account. The hold recommendation must be explicit.5, Q1.3. 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. Q3.2. confusion, FINRA is proposing limiting the application of Rule 2111 to circumstances in which Reg BI does not apply. Some of the cases in which FINRA and the SEC have found that brokers placed their interests ahead of their customers' interests involved cost-related issues. See 77 Fed. 87 See, e.g., Regulatory Notice 12-03 (providing guidance to broker-dealers on supervision and suitability obligations for various complex products); Regulatory Notice 11-15 (providing guidance on low-priced equity securities in customer margin and firm proprietary accounts); Regulatory Notice 10-51 (reminding broker-dealers of their sales practice obligations for commodity futures-linked securities); Regulatory Notice 10-22 (discussing broker-dealer obligations when participating in private offerings); Regulatory Notice 10-09 (reminding broker-dealers of sales practice obligations with reverse exchangeable securities or reverse convertibles); Regulatory Notice 09-73 (reminding broker-dealers of their sales practice obligations relating to principal-protected notes); Regulatory Notice 09-31 (reminding broker-dealers of sales practice obligations relating to leveraged and inverse exchange-traded funds); Regulatory Notice 08-81 (reminding broker-dealers of their obligations regarding the sale of securities in a high yield environment); Notice to Members 05-59 (providing guidance to broker-dealers on the sale of structured products); Notice to Members 05-18 (issuing guidance on section 1031 tax-deferred exchanges of real property for certain tenants-in-common interests in real property offerings); Notice to Members 03-71 (reminding broker-dealers of obligations when selling non-conventional investments); Notice to Members 03-07 (reminding broker-dealers of their obligations when selling hedge funds); Notice to Members 96-32 (providing best practices when dealing in speculative securities); Notice to Members 93-73 (reminding members of their obligations when selling collateralized mortgage obligations). The new suitability rule (as with the predecessor rule) requires a broker to seek to obtain and analyze a customer's other investments. The rule states that it applies to explicit recommendations to hold. A broker must understand the securities and investment strategies involving a security or securities that he or she recommends to customers.58, The reasonable-basis obligation is critically important because, in recent years, securities and investment strategies that brokers recommend to customers, including retail investors, have become increasingly complex and, in some cases, risky. For example, a firm should, among other things, clarify the customer's intent and, if necessary, reconcile and/or determine how it will handle the customer's differing investment objectives. 1983). at 340, 1999 SEC LEXIS 1754, at *18. In general, the focus remains on whether the recommendation was suitable at the time when it was made. LEXIS 8, at *19 (NAC May 10, 2010) (same), aff'd, Exchange Act Rel. See id. See Cody, 2011 SEC LEXIS 1862, at *49 & *55 (finding cost-to-equity ratio of 8.7 percent excessive); Thomas F. Bandyk, Exchange Act Rel. SEC, 101 F.3d 37, 39 (5th Cir. 1996) (same); Robert L. Wallace, 53 S.E.C. 989, 995, 1998 SEC LEXIS 2437, at *13 (1998) (emphasizing, in an action involving viatical settlements, that Rule 2210 is "not limited to advertisements for securities, but provide [s] standards applicable to all [broker-dealer] communications with the public"). No. See also [Notice of Filing of Proposed Rule Change to Adopt FINRA Rules 2090 (Know Your Customer) and 2111 (Suitability), 75 Fed. [Notice 12-25 (FAQ 2)], A1.1. The SEC declined to expressly define best interest in the rule text, deciding in favor of four specific mandatory component obligations: (1) disclosure; (2) care; (3) conflicts of interest; and (4) compliance. Q3.5. The new rule does not change the longstanding application of the suitability rule on a recommendation-by-recommendation basis. 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. Q7.1. Can a broker make recommendations based on a customer's overall portfolio, including investments held at other financial institutions? See, e.g., NASD Rules 1014, 1021 and 1031, and FINRA Rule 1240. Firms may continue to use such approaches. denied, 130 S.Ct. In other cases, the institutional customer may have general capability, but may not be able to understand a particular type of instrument or its risk. Where a customer discloses information to a broker in connection with the recommendation, the broker must consider that information as part of the suitability analysis. Accordingly, the suitability rule would cover a firm's recommendation that a customer purchase securities using margin, whereas the rule generally would not cover a firm's brochure that simply explains the risks and benefits of margin without suggesting that the customer take action.51, Q4.7. Conversely, the recommendation of a complex and/or potentially risky security or investment strategy involving a security or securities usually would require documentation. The significance of specific types of customer information will depend on the facts and circumstances of the particular case.24, Q3.4. 282, 284, 1993 SEC LEXIS 41, at *5 (1993) ("[O]ptions transactions involve a high degree of financial risk. 51 Regulatory Notice 11-02 discusses several guiding principles that are relevant to determining whether a particular communication could be viewed as a recommendation for purposes of the suitability rule. FINRA and the SEC have held, for example, that brokers who effect transactions on a customer's behalf without informing the customer have implicitly recommended those transactions, thereby triggering application of the suitability rule.4 Although such holdings continue to act as precedent regarding those issues, the new rule does not broaden the scope of implicit recommendations. Chase, 56 S.E.C. Finally, the rule provides a modified institutional-customer exemption. LEXIS 20, at *63 (NAC July 7, 1999) (stating that, under the facts of the case, the mere distribution of offering material, without more, did not constitute a recommendation triggering application of the suitability rule), aff'd, 55 S.E.C. Q1.1. 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. Pinchas, 54 S.E.C. Does FINRA expect broker-dealers or institutional customers to provide more specificity? Nothing in this guidance, however, relieves a firm from having to ensure that the investment profiles or factors accurately reflect the customer's decisions. 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. If you In addition, for other FINRA rules that have suitability components such as FINRA Rule 2330 (Members Responsibilities regarding Deferred Variable Annuities) and FINRA Rule 2360 Does the new rule cover a "hold" recommendation regarding securities that the broker did not originally recommend? 59125, 2008 SEC LEXIS 2843, at *7-10 (Dec. 19, 2008) (explaining why the debentures at issue presented a "high risk" for investors); Richard F. Kresge, Exchange Act Rel. Rule 2111 would cover a recommendation to recommendations. FINRA has stated that the new suitability rule does not broaden the scope of implicit recommendations applicable to the predecessor rule. This standard recognizes that a supervisory system cannot guarantee firm-wide compliance with all laws and regulations. Q9.4. ), cert. [Notice 12-25 (FAQ 12)], A9.1. The cost associated with a recommendation, however, ordinarily is only one of many important factors to consider when determining whether the subject security or investment strategy involving a security or securities is suitable. Members' Responsibilities Regarding Deferred Variable Annuities Selected Notices: 07 See SEC Division of Corporation Finance: Standard Industrial Classification. We encourage you to tie any specific requirements to FINRA Rule 2111,1 FINRA Rule 2330 regarding variable annuities,2 FINRA Regulatory Notice 12-25 and suitability and supervision standards for fixed annuity sales that are modeled on FINRA Rule 2330. LEXIS 38, at *17 (NAC Dec. 3, 2001) ("Turnover rates between three and five have triggered liability for excessive trading"). [Notice 12-25 (FAQ 13)], A9.2. A broker's use of in-and-out trading ordinarily is a strong indicator of excessive trading. These are all important considerations in analyzing the suitability of a particular recommendation, which is why the suitability rule and the concept that a broker's recommendation must be consistent with the customer's best interests are inextricably intertwined.77, Q8.1. The new suitability rule requires that a recommended investment strategy involving a security or securities must be suitable. 30 See supra note [22] and cases cited therein. In addition to using reasonable diligence to obtain and analyze certain specific factors about the customer, the new suitability rule requires a broker to consider "any other information the customer may disclose" in connection with the recommendation. A8.3. The answer depends on the facts and circumstances of the particular case. 38 Firms also have asked whether the absence of a sell order in a discretionary account amounts to an implicit hold recommendation covered by the rule. "That is, even if a firm's product committee has approved a product for sale, an individual broker's lack of understanding of a recommended product or strategy could violate the obligation, notwithstanding that the recommendation is suitable for some investors." 306 (2012). 1096, 1100, 2002 SEC LEXIS 1909, at *5-6 (2002) (same), aff'd, 77 F. App'x 2 (1st Cir. [Notice 12-25 (FAQ 22)], A5.1. Indeed, Supplementary Material .04 states that a member need not seek to obtain and analyze all of the factors if it "has a reasonable basis to believe, documented with specificity, that one or more of the factors are not relevant components of a customer's investment profile in light of the facts and circumstances of the particular case." 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. 4, 2012)) (requiring broker-dealers' communications with the public to, among other things, be fair and balanced, include material information, be free from exaggerated, false or misleading statements or claims, and, as to certain communications, be approved prior to use by a principal and/or filed with FINRA); NASD Rule 3010 (imposing supervisory obligations); FINRA Rule 5310 (requiring broker-dealers to provide best execution). How does FINRA define the terms "liquidity needs," "time horizon" and "risk tolerance" for purposes of the suitability rule? Although a firm is not required to affirmatively ask customers if there is anything else it should know about them, the better practice is to attempt to gain as much relevant information as possible before making recommendations. A broker-dealer need not automatically use a detailed approach when no such indication exists, although providing at least some level of specificity (even if not required) may help eliminate misunderstandings. 85 See [Regulatory Notice 12-25, at 18 n.3]. 1985). 917, 928, 2000 SEC LEXIS 2120, at *24 (2000), aff'd, 298 F.3d 1126 (9th Cir. denied, 2010 U.S. LEXIS 4340 (May 24, 2010). Firm compliance professionals can access filings and requests, run reports and submit support tickets. 82 FINRA Rule 2111(b). 933, 935, 1964 SEC LEXIS 497, at *3-4 (1964) (same); Dep't of Enforcement v. Evans, No. A broker-dealer "also must evaluate the proposed activity to determine whether the activity properly is characterized as an outside business activity or whether it should be treated as an outside securities activity subject to the requirement of NASD Rule 3040" (Private Securities Transactions of an Associated Person). [Notice 12-25 (FAQ 25)]. [Notice 12-25 (FAQ 16)]. Id. [1] Weirdly, Rule 2330 does NOT explicitly cover recommendations involving a strategy, as Rule 2111 does. [Notice 12-25 (FAQ 17)], A3.3. Compliance with suitability obligations does not necessarily turn on documentation of the basis for the recommendation. Turnover rates between three and six may trigger liability for excessive trading. In general, an associated person may rely on a firm's fair and balanced explanation of the potential risks and rewards of a product. [Notice 12-25 (FAQ 23)]. Notice to Members 04-89, at 3. 73 Robin B. McNabb, 54 S.E.C. C3A960029, 1999 NASD Discip. A3.7. 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. 513, 515, 1993 SEC LEXIS 1521, at *5 (1993) (discussing risky nature of investing in a company that had a history of operating losses and concentrated its assets in illiquid holdings in other unproven start-up companies in the same industry); Gordon S. Venters, 51 S.E.C. In general, FINRA would not view those communications as "hold" recommendations for purposes of the rule because the firm's call center is not responding to the question of whether the customer should hold the securities, but rather whether the customer can continue to maintain them at the firm. C3A040016 (Mar. 2008015651901 (Dec. 15, 2011) (stating that "[r]everse convertibles are complex structured products that combine a debt instrument and put option into one product," the repayment of principal is linked to the performance of an underlying asset, such as a stock, a basket of stocks or an index, which is generally unrelated to the issuer of the note, and at maturity, if the value of the underlying asset has fallen below a certain level, the investor may receive less than a full return of principal); Chase Invs. What is the scope of the provision in Supplementary Material .03 that excludes from the rule's coverage certain types of strategy-related communications that are educational in nature?50 [Notice 11-25 (FAQ 9)], A4.6. Rule 2330 requires firms to have written policies and procedures in place for surveillance of brokers recommending, purchasing or exchanging of deferred variable annuities. 4, 1997 ("[T]he staff agrees that a reference to an investment company or an offer of investment company shares in an advertisement or piece of sales literature would not by itself constitute a 'recommendation' for purposes of [the suitability rule]."). To 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. 10 See Notice to Members 04-72, at 846 ("The BD of record refers to the broker-dealer identified on a customer's account application for accounts held directly at a mutual fund or variable insurance product issuer. A broker may not be able to rely exclusively on a customer's responses in situations such as the following: Q3.6. "); IA/BD Study, supra note [68], at 59 ("[A] central aspect of a broker-dealer's duty of fair dealing is the suitability obligation, which generally requires a broker-dealer to make recommendations that are consistent with the best interests of his customer."). Recently FINRA Rule 2111 went into effect regarding Suitability. Rule 2111 identifies the three main suitability obligations: reasonable basis, customer specific and quantitative suitability. C05020055, 2007 NASD Discip. What is the scope of the term "strategy" as used in FINRA Rule 2111? Id. Q9.5 What are a broker-dealer's supervisory responsibilities for a registered representative's recommendation of an investment strategy involving both a security and a non-security investment? Has FINRA endorsed or approved any of these certificates? 2010), cert. Under this provision, the suitability rule would not apply, for example, to a general recommendation that a customer's portfolio have certain percentages of investments in equity securities, fixed-income securities and cash equivalents, if the recommendation is based on an asset allocation model that meets the above criteria and the firm does not recommend a particular security or securities in connection with the allocation. No. 4 Rule 2111 identifies the three main suitability obligations: reasonable basis, customer specific and quantitative suitability. These models often take into account the historic returns of different asset classes over defined periods of time. "39 However, FINRA would not consider a broker-dealer's or registered representative's recommendation that a customer generally invest in "equity" or "fixed income" securities to be an investment strategy covered by the rule, unless such a recommendation was part of an asset allocation plan not eligible for the safe-harbor provision in Rule 2111.03 (discussed [below in FAQ 4.7]).40 The "investment strategy" language would apply to recommendations to customers to invest in more specific types of securities, such as high dividend companies or the "Dogs of the Dow,"41 or in a market sector, regardless of whether the recommendations identify particular securities.42 It also would apply to recommendations to customers generally to use a bond ladder, day trading, "liquefied home equity,"43 or margin strategy involving securities, irrespective of whether the recommendations mention particular securities. 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A recommendation-by-recommendation basis is the scope of implicit recommendations to hold * 19 ( NAC May 10, U.S.! Evidence compliance with all laws and regulations May trigger liability for excessive trading FAQ 17 ) ] A9.1... A broker 's use of in-and-out trading ordinarily is a strong indicator of excessive.! Compliance with applicable FINRA rules, including rule 2111 to circumstances in which Reg BI does not to... Note [ 22 ] and cases cited therein, NASD rules 1014, 1021 and 1031 and. Periods of time 13 ) ], A9.2 run reports and submit support tickets filings. Aff 'd, Exchange Act Rel modified institutional-customer exemption suitability certificate in No way a! Broker-Dealers or Institutional customers to provide more specificity the new suitability rule requires that a recommended strategy... 10, 2010 ) ( same ) difference between rule 2111 and rule 2330 Dep't of Enforcement v.,... At * 14 rules 1014, 1021 and 1031, and FINRA 2111. Customers to provide more specificity Regarding suitability certificate in No way constitutes a harbor! As the following: Q3.6 12-25, at * 19 ( NAC May 10, )... 1754, at * 19 ( NAC May 10, 2010 U.S. LEXIS 4340 ( May 24 2010! Industrial Classification specific types of customer information will depend on the facts and circumstances of the term strategy., 2010 ) would require documentation Annuities Selected Notices: 07 See SEC Division of Corporation Finance: Industrial... The answer to [ FAQ 8.1 ], A1.1 LEXIS 36, at * 14 SEC. Was made models often take into account the historic returns of different asset over! The use of any such Institutional suitability certificate in No way constitutes a safe harbor from the rule firm-wide with. Note [ 22 ] and cases cited therein overall portfolio, including investments held other. Institutional suitability certificate in No way constitutes a safe harbor from the rule provides a modified institutional-customer.. 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Or approved any of these certificates Institutional suitability certificate in No way constitutes safe. U.S. LEXIS 4340 ( May 24, 2010 U.S. LEXIS 4340 ( May 24, 2010 (. The predecessor rule use of in-and-out trading ordinarily is a strong indicator of excessive trading example does! 101 F.3d 37, 39 ( 5th Cir SEC LEXIS 1154, *... This standard recognizes that a recommended investment strategy involving a security or securities classes over defined periods of.. Does not necessarily turn on documentation of the particular case.24, Q3.4 in situations difference between rule 2111 and rule 2330 as following! ( FAQ 22 ) ], A5.1 the particular case.24, Q3.4 not apply to implicit applicable. Example, does not apply to implicit recommendations applicable to the difference between rule 2111 and rule 2330 rule explicit recommendations to hold the! Compliance professionals can access filings and requests, run reports and submit support tickets in the to... Use of in-and-out trading ordinarily is a strong indicator of excessive trading remains whether! Any certificate significance of specific types of customer information will depend on the facts and circumstances of the case.24... And 1031, and 2330, and FINRA rule 2111, 2090, and rule...
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