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. A firm may use a risk-based approach to documenting compliance with this provision. 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. Firms do not have to document or individually approve every "hold" recommendation.91 As with recommendations of other types of investment strategies or of purchases, sales or exchanges of securities, firms may use a risk-based approach to documenting and supervising "hold" recommendations. 471, 475, 1999 SEC LEXIS 2685, at *7 (1999). 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. Broker-dealers also must demonstrate to FINRA, through the membership application process, that they are capable of complying with FINRA rules and the federal securities laws, and their registered persons generally must pass one or more examinations to evidence competence in the areas in which they will work and must comply with important continuing education requirements. 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). 94 In Notice to Members 99-45, FINRA said that the supervision rule "requires that a [firm's] supervisory system be reasonably designed to achieve compliance with applicable laws and regulations. FINRA is aware that some firms currently ask customers for relevant information without using the exact rule terminology or separately designating factors (e.g., investment objectives that include a risk-tolerance component that is not separately labeled as such). 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. FINRA previously issued written guidance on a customer's capability of analyzing risks (a factor used in both the predecessor and new suitability rules).83 FINRA stated that a broker-dealer may conclude in some cases that a customer is not capable of making independent investment decisions in general. 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. In general, a customer's investment profile would include the customer's age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs and risk tolerance. 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. Reg. "); 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."). the broker poses questions that are confusing or misleading to a degree that the information-gathering process is tainted, the customer exhibits clear signs of diminished capacity, or. A3.7. 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." Harry informs Sally that the Rule 2330 calls for proper review from the member before submitting the application for a deferred variable annuity to the insurance company. Turnover rates between three and six may trigger liability for excessive trading. 917, 928, 2000 SEC LEXIS 2120, at *24 (2000), aff'd, 298 F.3d 1126 (9th Cir. 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]."). Some third-party vendors have created and aggressively marketed proprietary "Institutional Suitability Certificates" to facilitate compliance with the new institutional-customer exemption. 30 See supra note [22] and cases cited therein. [Notice 12-25 (FAQ 16)]. As described in greater detail in FAQ [4.7], there is a safe harbor for certain types of educational information and asset allocation models that otherwise could be considered investment strategies captured by the new rule. [Notice 12-25 (FAQ 5)], A1.4. 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. 1996) (same); Robert L. Wallace, 53 S.E.C. LEXIS 10362, *4-5 (9th Cir. Nothing in this guidance, however, relieves a firm from having to ensure that the investment profiles or factors accurately reflect the customer's decisions. In general, however, when there is an indication that the institutional customer is not capable of analyzing, or does not intend to exercise independent judgment regarding, all of a broker-dealer's recommendations, the broker-dealer necessarily will have to be more specific in its approach to ensuring that it complies with the exemption. 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. See 77 Fed. The suitability rule generally requires broker-dealers to use reasonable diligence to seek to obtain and analyze the customer-specific factors listed in the rule. FINRA has extensively addressed those guiding principles in past Regulatory Notices, and cases have applied them to specific facts.1 Some SEC releases and FINRA cases and interpretive letters also have explained that a broker-dealer's use or distribution of marketing or offering materials ordinarily would not, by itself, constitute a "recommendation" for purposes of the suitability rule.2 The prior guidance and interpretations generally remain applicable,3 and firms and brokers should review those existing resources for assistance in understanding the breadth of the term "recommendation. Notice to Members 04-89, at 3. The new rule, for example, does not apply to implicit recommendations to hold a security or securities. Suitability The Rule Notices 2110. Registered representatives can fulfill Continuing Education requirements, view their industry CRD record and perform other compliance tasks. Recently FINRA Rule 2111 went into effect regarding Suitability. No. ]"52 Specifically, the rule provides a safe harbor for firms' use of "[a]sset allocation models that are (i) based on generally accepted investment theory, (ii) accompanied by disclosures of all material facts and assumptions that may affect a reasonable investor's assessment of the asset allocation model or any report generated by such model, and (iii) in compliance with [FINRA Rule 2214] (Requirements for the Use of Investment Analysis Tools), if the asset allocation model is an 'investment analysis tool' covered by [FINRA Rule 2214]."53. Does the new rule cover a "hold" recommendation regarding securities that the broker did not originally recommend? The suitability rule would not apply, for instance, if a registered representative recommends a non-security investment as part of an outside business activity and the customer separately decides on his or her own to liquidate securities positions and apply the proceeds toward the recommended non-security investment.48 Where a customer, absent a recommendation by a registered representative, decides on his or her own to purchase a non-security investment and then asks the registered representative to recommend which securities he or she should sell to fund the purchase of the non-security investment, the suitability rule would apply to the registered representative's recommendation regarding which securities to sell but not to the customer's decision to purchase the non-security investment. For example, the recommendation of a large-cap, value-oriented equity security generally would not require written documentation as to the recommendation. That is true regardless of whether the associated person previously recommended the purchase of the securities, the customer purchased them without a recommendation, or the customer transferred them into the account from another firm where the same or a different associated person had handled the account.38, Q4.2. See, e.g., FAQ [1.1] (discussing the term "recommendation" and citing various resources that explain the guiding principles that firms could use when analyzing whether a communication constitutes a recommendation); Regulatory Notice 11-02, at 2-3 (discussing FINRA's guiding principles); Regulatory Notice 10-06, at 3-4 (providing guidance on recommendations made on blogs and social networking websites); Notice to Members 01-23 (announcing the guiding principles and providing examples of communications that likely do and do not constitute recommendations); Michael F. Siegel, Exchange Act Rel. Q6.1. 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. The rule thus explicitly permits a suitability analysis to be performed within the context of a customer's other investments. Rule 2111 identifies the three main suitability obligations: reasonable basis, customer specific and quantitative suitability. Yes. 112-106, 126 Stat. A6.1. Quantitative suitability likely will apply in more limited circumstances with regard to institutional customers than it does as to retail customers. However, despite the SECs adoption of a new standard of care, FINRA Rule 2111 remained in place as the applicable suitability standard. Reasonable Basis Obligation This means the 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. 306 (2012). A3.12. Can a customer with multiple accounts at a single firm have different investment profiles or investment-profile factors (e.g., objectives, time horizons, risk tolerance) for those different accounts? Q4.1. 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? 96 See also supra note [48] and discussion therein. Would a recommendation to maintain an asset mix that was based on an asset allocation model that meets the criteria described in the rule fall within the safe-harbor provision in Rule 2111.03? The rule, moreover, identifies the three main suitability obligations: reasonable-basis, customer-specific, and quantitative suitability. This position is consistent with requirements under the previous suitability rule. FINRA, however, offers the following guidelines: FINRA recognizes that there can be an inverse relationship between an investment time horizon and liquidity needs in that the longer a customer's time horizon, the less the need for liquidity. See also Donna M. Vogt, AWC No. Q3.2. Each firm has a general obligation to evidence compliance with applicable FINRA rules. Firms must attempt to obtain and analyze relevant customer-specific information. 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 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 In addition, documentation by itself does not cure an otherwise unsuitable recommendation. 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. denied, 130 S.Ct. No. 37 See FINRA Rule 2111.03. Q5.1. [Notice 12-25 (FAQ 22)], A5.1. Moreover, the relative importance of the issuers to other factors in making fixed-income investment decisions varies depending on the total mix of the relevant facts and circumstances. Firms' supervisory policies and procedures must be reasonably designed to ensure that their brokers comply with this important requirement.59, Q5.2. How should a firm document "hold" recommendations? A firm should educate its associated persons on the potential risks and rewards of the products that the firm permits them to recommend. 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. As discussed above in the answer to [FAQ 4.7], Rule 2111.03 provides a safe harbor for firms' use of asset allocation models that are, among other things, based on "generally accepted investment theory." The quantitative suitability obligation under the new rule simply codifies excessive trading cases. confusion, FINRA is proposing limiting the application of Rule 2111 to circumstances in which Reg BI does not apply. 34 See Notice to Members 04-89 (reminding firms that "recommending liquefying home equity to purchase securities may not be suitable for all investors and that [firms] should perform a careful analysis to determine whether liquefying home equity is a suitable strategy for an investor"). The new rule does not change the longstanding application of the suitability rule on a recommendation-by-recommendation basis. Does the new rule's "investment strategy" language cover a registered representative's recommendation involving both a security and a non-security investment? 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. A broker could violate the obligation if he or she did not understand the recommended security or investment strategy, even if the security or investment strategy is suitable for at least some investors. Other firms may require emails or memoranda to supervisors or emails or letters to customers copying supervisors. The course reviews the most relevant FINRA rules, including Rule 2111, 2090, and 2330, and explains current suitability obligations. File a complaint about fraud or unfair practices. A3.8. The rule states that certain communications "are excluded from the coverage of Rule 2111 as long as they do not include (standing alone or in combination with other communications) a recommendation of a particular security or securities[.]" Q1.1. In general, the more complex and risky the strategy, the more the firm using a risk-based approach should focus on the recommendation. No. A3.10. The rule excludes reallocation LEXIS 20, at *38 (NAC May 11, 2007), aff'd, Exchange Act Rel. C3A040016 (Mar. [Notice 12-25 (FAQ 4)]. [Notice 11-25 (FAQ 3)]. The rule requires that a broker seek to obtain18 and consider relevant customer-specific information when making a recommendation. In that context, a firm may want to focus on hold recommendations involving securities that by their nature or due to particular circumstances could be viewed as having a shorter-term investment component, that have a periodic reset or similar mechanism that could alter the product's character over time, that are particularly susceptible to changes in certain market conditions, or that are otherwise potentially risky to hold at the time when the recommendations are made. The new rule does not apply to implicit recommendations to hold. 3 The discussions (and examples provided) in previous Regulatory Notices, cases, interpretive letters, and SEC releases remain applicable to the extent that they are not inconsistent with Rule 2111. As noted above in the answer to [FAQ 8.1], FINRA has not endorsed or promoted any certificate. The new Rule 2111 incorporates the general concepts previously contained in NASD IM-2310-3 and provides that firms and brokers now will be deemed to have satisfied The average monthly investment is the cumulative total of the net investment in the account at the end of each month, exclusive of loans, divided by the number of months under consideration." A8.2. FINRA BrokerCheck, moreover, allows investors to review the professional and disciplinary backgrounds of firms and brokers online. FINRA Rule 2330 applies to initial recommendations involving purchasing and exchanging deferred variable annuities and new subaccount allocation. Rule 2330 applies to new recommendations in the form of a purchase or an exchange for a given client subaccount. This rule does not apply to: Any qualified plan under Section 3 (a) (12) (C) of the Exchange Act or under Sections 403 (b), 457 (b), or 457 (f) of the IRS [Notice 12-55 (FAQ 6(a))], A2.1. FINRA has stated that the new suitability rule does not broaden the scope of implicit recommendations applicable to the predecessor rule. 26 See www.sec.gov/investor/pubs/assetallocation.htm. at 1100, 2002 SEC LEXIS 1909, at *6-7. "); F.J. Kaufman and Co., 50 S.E.C. No. 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). 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. Firms seeking to rely on the provision should take a conservative approach to determining whether a particular communication is eligible for such treatment. Some possible examples could include leveraged ETFs (because they reset daily and their performance over long periods can differ significantly from the performance of the underlying index or benchmark during the same period); mortgage real estate investment trusts (REITs) (which are very sensitive to small moves in interest rates); a security of a company facing significant financial or other material difficulties; a security position that is overly concentrated; Class C shares of mutual funds (which generally continue to charge higher annual expenses for as long as the customer holds the shares and do not convert to Class A shares); or a security that is inconsistent with the customer's investment profile. [Notice 12-25 (FAQ 25)]. [Notice 11-25 (FAQ 7)]. What is a firm's responsibility when customers indicate that they have multiple investment objectives that appear inconsistent? 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. No. Only investors who understand those risks, and who are able to sustain the costs and financial losses that may be associated with options trading should participate in the listed options markets. "); Daniel R. Howard, 55 S.E.C. 45 While the suitability rule applies only to recommendations involving a security or securities, other FINRA rules potentially apply, depending on the facts of the particular case, to broker-dealers' or registered representatives' conduct that does not involve securities. For example, FINRA and the SEC have held that associated persons who effect transactions on a customer's behalf without informing the customer have implicitly recommended those transactions, thereby triggering application of the suitability rule. While the rule lists some of the aspects of a typical investment profile, not every factor may be relevant to all situations. denied, 130 S.Ct. 2012)]; Siegel, 2008 SEC LEXIS 2459, at *28-30 (finding violation for failing to perform reasonable diligence to understand the security). 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. 1020, 1022, 1989 SEC LEXIS 25, at *6-7 (1989), aff'd, 902 F.2d 1580 (9th Cir. The suitability rule does not prescribe the manner in which a firm must document "hold" recommendations when documentation may be necessary. 25 For purposes of considering liquidity needs in the context of FINRA Rule 2111, examples of possible liquid investments include money market funds, Treasury bills and many blue-chip stocks, exchange-traded funds and mutual funds. What further action a broker-dealer will need to take will depend on the facts and circumstances of the particular case. As a general matter, these terms are to be understood commensurate with their meaning in financial analysis. FINRA cautioned, however, that a firm should evidence a customer's intent to use different investment profiles or factors for the different accounts. C01020025, 2004 NASD Discip. 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. In that regard, and as explained above in the answer to [FAQ 1.1], a broker-dealer's general solicitation of a private placement through the use or distribution of marketing or offering materials ordinarily would not, by itself, constitute a recommendation triggering application of the suitability rule.7When a broker-dealer "recommends" a private placement, however, the suitability rule applies.8, Q2.1. 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. Report a concern about FINRA at 888-700-0028, Securities Industry Essentials Exam (SIE), Financial Industry Networking Directory (FIND), www.sec.gov/investor/pubs/assetallocation.htm, SEC Division of Corporation Finance: Standard Industrial Classification. A3.4. No. See also [Regulatory Notice 11-25, at 9 n.6]. 49 Similarly, and as noted previously, the absence of a recommendation to sell would not amount to a hold recommendation subject to the rule. Those types of accounts New FAQs will be identified when added. Reasonable-basis suitability has two main components: a broker must (1) perform reasonable diligence to understand the potential risks and rewards associated with a recommended security or strategy and (2) determine whether the recommendation is suitable for at least some investors based on that understanding. 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. No. 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. [Notice 12-55 (FAQ 6(b))], A2.2. 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. See SEA Rule 17a-3(a)(17)(i)(B)(1). "); Paul C. Kettler, 51 S.E.C. [Notice 12-25 (FAQ 3)], A1.2. 655, 2000 SEC LEXIS 986 (2000) (holding that registered representative violated NASD Rules 2310 and 3040 where he recommended unsuitable securities that were sold away from the firm with which he was associated without providing his firm prior notice of such activities). Accounts held in this manner are sometimes referred to as 'check and application,' 'application way,' or 'direct application'business."). 9, 2004) (suspending registered representative for six months and ordering him to pay restitution of more than $15,000 for recommending that a retired couple use liquefied home equity to purchase a variable annuity). FINRA's supervision rules do not dictate the exact manner in which a broker-dealer must supervise its registered representatives' recommendations of investment strategies involving a security and a non-security investment. As to an institutional customer's affirmative indication that it intends to exercise independent judgment (a new requirement), Rule 2111.07 states that "an institutional customer may indicate that it is exercising independent judgment on a trade-by-trade basis, on an asset-class-by-asset-class basis, or in terms of all potential transactions for its account." LEXIS 8, at *19 (NAC May 10, 2010) (same), aff'd, Exchange Act Rel. [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." Id. 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]. This rule does not apply to: Transfers and The term also would capture an explicit recommendation to hold a security or securities.36 While a decision to hold might be considered a passive strategy, an explicit recommendation to hold does constitute the type of advice upon which a customer can be expected to rely. EAF0400730002 (Feb. 21, 2007) (barring registered representative for, among other things, recommending to ten customers, many of whom were nearing retirement, that they obtain home equity loans and use the proceeds to purchase securities, without considering whether such recommendations were suitable for such customers in light of their financial situation and needs); James A. Kenas, AWC No. [Notice 11-25 (FAQ 10)]. A7.1. Can you provide some examples of what would and would not be considered an "investment strategy" under the rule? Firm compliance professionals can access filings and requests, run reports and submit support tickets. Q9.4. Some firms may create "hold" tickets and some may add "hold" sections to existing order tickets. 33 For certain requirements related to margin, see FINRA Rule 2264. See [FAQ 4.1], Regulatory Notice 11-02, at 3. 1096, 1100, 2002 SEC LEXIS 1909, at *5-6 (2002) (same), aff'd, 77 F. App'x 2 (1st Cir. at 295. ), cert. 64565, 2011 SEC LEXIS 1862, at *30-32 (May 27, 2011) (stating that a broker can violate reasonable-basis suitability by failing to perform a reasonable investigation of the recommended product and to understand its risks even though the recommendation is otherwise suitable) [aff'd, 693 F. 3d 251 (1st Cir. LEXIS 15, at *9 (NBCC Mar. 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. 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. Understanding FINRA Rule 2111: Suitability Unreported Opinions Index | Maryland Courts There is no end date. 31 Firms should note, however, that SEA Rule 17a-3 requires that, for each account with a natural person as a customer or owner, a broker-dealer generally must create a record that includes, among other things, the account's investment objectives. at 340, 1999 SEC LEXIS 1754, at *18. The rule would apply, for example, when an associated person meets with a customer during a quarterly or annual investment review and explicitly advises the customer not to sell any securities in or make any changes to the account or portfolio. ), cert. FINRA and the SEC have recognized that certain actions constitute implicit recommendations that can trigger suitability obligations. 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. A broker can violate reasonable-basis suitability under either prong of the test. 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. See SEA Rule 17a-3(a)(17)(i). However, a customer may have a long time horizon, but also may need or want to invest all or a portion of his or her portfolio in liquid assets to pay for unexpected expenses or take advantage of unforeseen opportunities. Still other firms may create data fields for entering such information into automated supervisory systems. The following frequently asked questions (FAQs) provide guidance on FINRA Rule 2111 (Suitability). Id. A8.3. If a customer chooses multiple investment objectives that appear inconsistent, a firm must conduct appropriate supervision and meaningful suitability determinations, as applicable, in light of such differences. 73 Robin B. McNabb, 54 S.E.C. 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. See FINRA Rule 2111.03. As with many obligations under various rules, a firm will need to make some judgment calls on the types of recommendations that it should document under FINRA's suitability rule. 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. The institutional-customer exemption does not apply to reasonable-basis and quantitative suitability. 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. the customer wants each individual recommendation to be consistent with his or her investment profile or particular factors within that profile; the broker is unaware of the customer's overall portfolio; or. Q9.3. 933, 935, 1964 SEC LEXIS 497, at *3-4 (1964) (same); Dep't of Enforcement v. Evans, No. 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." C07000003, 2001 NASD Discip. Numerous Regulatory Notices and cases discuss various types of complex and/or potentially risky securities and investment strategies involving a security or securities. No. 5311, et seq. [Notice 12-25 (FAQ 11)]. The firm, however, also must consider factors such as the trust's investment objectives, time horizon and risk tolerance to complete the suitability analysis. [Notice 12-25 (FAQ 23)]. 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%."). 108, 117, 2003 SEC LEXIS 338, at *15 (2003) (focusing, in part, on risks of using margin); James B. LEXIS 38, at *17 (NAC Dec. 3, 2001) ("Turnover rates between three and five have triggered liability for excessive trading"). 45402, 2002 SEC LEXIS 284, at *20-21 & n.10 (Feb. 6, 2002) (holding that the defendant broker "controlled" the account because he essentially was a co-conspirator with the institutional customer's investment officer, who was authorized to place orders for the institutional customer's account). In many ways this rule is very similar to FINRA Rule 2330 which relates to variable annuity Rule 2330 applies to new recommendations in the form of a purchase or an exchange for a given client subaccount. 292, 293-94, 1993 SEC LEXIS 3645, at *3-5 (1993) (discussing risky nature of investing in a company when that company "was losing money, had never paid a dividend, and its prospects were totally speculative"); Patrick G. Keel, 51 S.E.C. 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. 23 Investment profile is a defined term under the proposed rule that includes age, other investments, financial situation, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information a retail investor might disclose in connection with a recommendation. Q3.10. The account record requirements in paragraph (a)(17)(i)(A) of the Rule apply only to accounts for which the broker or dealer is, or within the past 36 months has been, required to make a suitability determination. 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. What is the scope of the term "strategy" as used in FINRA Rule 2111? Rule 2330 requires firms to have written policies and procedures in place for surveillance of brokers recommending, purchasing or exchanging of deferred variable annuities. FINRA emphasizes, moreover, that firms may use methods that are not highlighted in [Regulatory Notice 12-25] to document and supervise "hold" recommendations as long as those methods are reasonable. To meet its suitability obligations, a firm must obtain and analyze enough customer information to have a reasonable basis to believe the recommendation is suitable. 14 FINRA reiterates that the suitability rule applies only if a broker-dealer or registered representative makes a "recommendation." 4 Q7.1. 72 Epstein, 2009 SEC LEXIS 217, at *72; see also Sathianathan, 2006 SEC LEXIS 2572, at *23. denied, 2010 U.S. LEXIS 4340 (May 24, 2010). 2111. What customer-specific information a firm should seek to obtain from a customer in addition to the factors that the rule specifically lists will depend on the facts and circumstances of the particular case. 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. "red flags" exist indicating that a broker's information about the customer's other holdings may be inaccurate. Does a firm have to use the exact rule terminology when seeking to obtain customer-specific information? Pinchas, 54 S.E.C. What if a customer refuses to provide certain customer-specific information? Rule 2111(b) replaces the previous rule's definition of "institutional customer" with the more common definition of "institutional account" in FINRA's "books and records" rule, Rule 4512(c).78 "Institutional account" means the account of a bank, savings and loan association, insurance company, registered investment company, registered investment adviser or any other person (whether a natural person, corporation, partnership, trust or otherwise) with total assets of at least $50 million.79 In regard to the "other person" category, the monetary threshold generally changed from at least $10 million invested in securities and/or under management used in the predecessor rule to at least $50 million in assets in the new rule.80 Moreover, the definition now includes natural persons who meet such criteria. The suitability rule applies to a broker-dealer's or registered representative's recommendation of a security or investment strategy involving a security to a "customer." See id. The essential requirement of this provision is that the member firm or associated person exercise "reasonable diligence" to ascertain the customer's investment profile. The rule states that it applies to explicit recommendations to hold. The new suitability rule (as with the predecessor rule) requires a broker to seek to obtain and analyze a customer's other investments. In addition, the term would capture an explicit recommendation to hold a security or securities or to continue to use an investment strategy involving a security or securities.44 The rule would apply, for example, when a registered representative meets (or otherwise communicates) with a customer during a quarterly or annual investment review and explicitly advises the customer not to sell any securities in or make any changes to the account or portfolio or to continue to use an investment strategy. 1 See, e.g., Regulatory Notice 11-02, at 2-3 (discussing FINRA's guiding principles that firms and brokers should consider when determining whether a particular communication could be considered a "recommendation" for purposes of the suitability rule); Regulatory Notice 10-06, at 3-4 (providing guidance on recommendations made on blogs and social networking websites); Notice to Members 01-23 (announcing the guiding principles and providing examples of communications that likely do and do not constitute recommendations); Michael F. Siegel, Exchange Act Rel. Firms and brokers may want to consult those Regulatory Notices87 and cases88 when considering the types of recommended securities and investment strategies involving securities that they should document. ; Regulatory Notice 11-02, at 4-5. Corp., AWC No. The suitability rule applies on a recommendation-by-recommendation basis. 62 See FINRA Rule 2111.05(a). 2015 Securities Rule QuickGuide FINRA Rule 2111 - Suitability (See FINRA Rule 2100 for All Transactions with Customers Rules) Selected Notices: 11-02, 11-25, FINRA Rule 2330. 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. 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. 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. What constitutes a "customer" for purposes of the suitability rule? 2 See, e.g., SEC Adoption of Rules Under Section 15(b)(10) of the Exchange Act, 32 Fed. Cir. 40 See id. 6693, 6696 (Feb. 14, 1989) (stating that proposed SEA Rule 15c2-6, which would have required documented suitability determinations for speculative securities, "would not apply to general advertisements not involving a direct recommendation to the individual"); DBCC v. Kunz, No. The firm/employee shall make sure that the offering expenses are reasonable and in line with similar DPPs. 20452 (Apr. FINRA expects a firm to be capable of explaining how an asset allocation model that it uses is consistent with generally accepted investment theory. 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). Thus, the new rule's "hold" language would not apply when a broker remains silent regarding security positions in an account. Reg. [Notice 12-25 (FAQ 24)]. See Peter C. Bucchieri, 52 S.E.C. 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. 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. 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. 2003); Powell & McGowan, Inc., 41 S.E.C. 82 FINRA Rule 2111(b). Q1.4. 52 Specifically, the rule By way of background, the new suitability rule modifies the institutional-customer exemption that existed under the predecessor rule (NASD IM-2310-3). and the implementing regulations promulgated thereunder by the Department of the Treasury; SEA Rules 17a-3 and 17a-4; and FINRA Rules 2090 (Know Your Customer) and 4512 (Customer Account Information). "); see also Jack H. Stein, 56 S.E.C. Vincent Apicella, Stock Focus: "Dogs of the Dow" Companies, Forbes.com (May 29, 2001). 53 FINRA Rule 2111.03. As noted above in the answer to [FAQ 3.3], however, a broker cannot make assumptions about a customer's other holdings.30The firm should evidence a customer's approval of a broker's use of a portfolio-based analysis regarding the suitability of the broker's recommendations.31Some customers, for instance, may desire all recommendations to be consistent with their stated risk tolerance, investment time horizon or liquidity needs. 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. See, e.g., SEA Rule 17a-3(a)(17)(i)(A) (discussing "books and records" requirements for certain account information, including, among other things, date of birth, employment status, annual income, net worth and investment objectives, regarding an account with a natural person as a customer). What are the conditions under which an implicit recommendation can trigger the suitability rule? Similarly, a registered representative's recommendation that a "buy and hold" customer with an investment objective of income liquidate large positions in blue chip stocks paying regular dividends might raise a "red flag" regarding whether that recommendation is part of a broader investment strategy. Firms should understand that the use of any such Institutional Suitability Certificate in no way constitutes a safe harbor from the rule. Some customers, moreover, desire portfolios made up of securities with different levels of liquidity, risk and time horizons. 83 See Regulatory Notice 11-02, at 8 n.24. No. Note: With this guidance, FINRA attempts to present information in a format that is easily understandable. 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." An explicit recommendation to hold is tantamount to a "call to action" in the sense of a suggestion that the customer stay the course with the investment. The answer depends on the facts and circumstances of the particular case. In interpreting FINRA's suitability rule, numerous cases explicitly state that "a broker's recommendations must be consistent with his customers' best interests. 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. 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. C07960035, 1997 NASD Discip. However, as explained in FAQ [1.2], the rule would not cover an implicit recommendation to hold. Members' Responsibilities Regarding Deferred Variable Annuities Selected Notices: 07 A3.9. [Notice 12-25 (FAQ 18)]. 55 When a broker-dealer recommends an allocation strategy that includes an allocation in fixed-income securities, FINRA recognizes that a number of additional factors would be relevant in determining if the broker-dealer has "recommended" particular debt securities. A broker who recommended speculative securities that paid high commissions because he felt pressured by his firm to sell the securities. A4.8. Id. The reasonable-basis obligation has two components: a broker must (1) perform reasonable diligence to understand the nature of the recommended security or investment strategy involving a security or securities, as well as the potential risks and rewards, and (2) determine whether the recommendation is suitable for at least some investors based on that understanding.57 A broker must adhere to both components of reasonable-basis suitability. C3B040001 (Jan. 23, 2004) (suspending registered representative for six months for violating the suitability rule by recommending that his customers use liquefied home equity to purchase mutual fund shares); Steve C. Morgan, AWC No. Importantly, while Reg BI, like Rule 2111, requires that a recommendation must be based on information reasonably known to the associated person (based on her reasonable 282, 284, 1993 SEC LEXIS 41, at *5 (1993) ("[O]ptions transactions involve a high degree of financial risk. 3333 (2010). 69 Raghavan Sathianathan, Exchange Act Rel. Does a broker-dealer have to seek to obtain all of the customer-specific factors listed in the new rule by the rule's implementation date? 513, 516-17, 1993 SEC LEXIS 1521, at *9-10 (1993) (same). However, when a broker-dealer or registered representative makes a recommendation to a customer (as opposed to a potential investor), suitability obligations attach at the time the recommendation is made, irrespective of whether a transaction occurs. Harry Gliksman, 54 S.E.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. Firms may continue to use such approaches. Pinchas, 54 S.E.C. 55988, 2007 SEC LEXIS 1407, at *21-23 (June 29, 2007) (describing the speculative nature of three low-priced securities at issue); Faber, 2004 SEC LEXIS 277, at *25 (discussing speculative nature of the security of a company that "had no revenues and had never showed any profits"); Jack H. Stein, 56 S.E.C. This standard recognizes that a supervisory system cannot guarantee firm-wide compliance with all laws and regulations. The rule also explicitly covers recommended investment strategies involving securities, including recommendations to "hold" securities. See, e.g., Rafael Pinchas, 54 S.E.C. "); Paul C. Kettler, 51 S.E.C. A customer, for example, may not want to divulge information about "other investments" held away from the broker-dealer in question. Does the suitability rule apply when a broker-dealer or registered representative makes a recommendation to a potential investor? Quantitative suitability requires a broker who has actual or de facto control63 over a customer account to have a reasonable basis for believing that, in light of the customer's investment profile, a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer.64 Factors such as turnover rate,65 cost-to-equity ratio,66 and use of in-and-out trading67 in a customer's account may provide a basis for finding that the activity at issue was excessive. 2008)]; see also Scott Epstein, Exchange Act Rel. For example, a firm may conclude that age is irrelevant regarding all customers that are entities or liquidity needs are irrelevant regarding all customers for whom only liquid securities will be recommended. As FINRA has stated previously, "FINRA appreciates that no two [broker-dealers] are exactly alike. Regulatory Notice 11-02 and a recent SEC staff study on investment adviser and broker-dealer sales-practice obligations cite cases holding that brokers' recommendations must be consistent with their customers' "best interests. The hold recommendation must be explicit.5, Q1.3. difference between rule 2111 and rule 2330 on Enero 16, 2021 Section 2 of the Order of the Supreme Court, dated Dec. 4, 1967, provided: "That the foregoing rules shall take effect on ", A broker who recommended "that his customers purchase promissory notes to give him money to use in his business.". 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