4 See, e.g., Rafael Pinchas, 54 S.E.C. 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. Q1.4. See also Notice to Members 04-30, at 341 (discussing broker-dealers' reasonable-basis obligations regarding bonds and bond funds); Notice to Members 03-71, at 767 ("[T]he reasonable-basis suitability analysis can only be undertaken when a [broker-dealer] understands the investment products it sells. 1990); Arceneaux v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 767 F.2d 1498, 1502 (11th Cir. The answer depends on the facts and circumstances of the particular case. 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). 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." [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 issuers' identities and creditworthiness are important information in determining whether to purchase a debt security, but there may be other factors that affect the pricing and any decision to invest in specific debt securities. Q3.12. [Notice 12-25 (FAQ 20)]. 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. [Notice 12-25 (FAQ 11)]. 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. 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. 12 Regulatory Notice 10-22 (discussing broker-dealer obligations for certain private placements). 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." A3.8. Can a broker make recommendations based on a customer's overall portfolio, including investments held at other financial institutions? 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. 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). 800, 805 n.11, 1996 SEC LEXIS 1331, at *12 n.11 (1996). [Notice 12-25 (FAQ 5)], A1.4. 19 See FINRA Rule 2111.04 (explaining that a firm that decides not to seek to obtain and analyze information about a customer-specific factor must document its reasonable basis for believing that the factor is not a relevant consideration). Some third-party vendors have created "Institutional Suitability Certificates" to facilitate firms' compliance with the new institutional-customer exemption in Rule 2111(b). "84, Q8.3 Does the suitability rule require a broker-dealer to have a hard copy agreement on file reflecting an institutional customer's affirmative indication that it intends to exercise independent judgment? The rule, moreover, identifies the three main suitability obligations: reasonable-basis, customer-specific, and quantitative suitability. 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. 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. Id. Does the new rule's "investment strategy" language cover a registered representative's recommendation involving both a security and a non-security investment? 91 Firms are reminded, however, that copies of all communications relating to their business as such and memoranda of brokerage orders are required to be preserved for three years. A hold recommendation involving shares of a blue chip stock ordinarily would not present the type of risk, absent unusual facts, that would require a detailed analysis or documentation. No. What is the scope of the term "strategy" as used in FINRA Rule 2111? No. No. 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. Notices, Proposed Rules, Rules, and Presidential Documents published in the at 340, 1999 SEC LEXIS 1754, at *18. Is the quantitative suitability obligation under the new rule any different from the excessive trading line of cases under the predecessor rule? Yes. [Notice 12-25 (FAQ 1)]. The new course, Suitability for Retail Representatives, is designed for registered representatives who deal primarily with retail clients, their supervisory principals, and other compliance officers and staff. Some customers may be reluctant to provide certain types of information to their broker-dealers. The quantitative suitability obligation under the new rule simply codifies excessive trading cases. 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. Reasonable Basis Obligation This means the 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. This position is consistent with requirements under the previous suitability rule. 96 See also supra note [48] and discussion therein. Quantitative suitability likely will apply in more limited circumstances with regard to institutional customers than it does as to retail customers. 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. 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. at 339-40 n.14, 1999 SEC LEXIS 1754, at *17 n.14. [Notice 11-25 (FAQ 3)]. 83 See Regulatory Notice 11-02, at 8 n.24. 1304, 1311, 1997 SEC LEXIS 762, at *19 (1997). 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. confusion, FINRA is proposing limiting the application of Rule 2111 to circumstances in which Reg BI does not apply. 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. 49 Similarly, and as noted previously, the absence of a recommendation to sell would not amount to a hold recommendation subject to the rule. 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. 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. 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. ; Regulatory Notice 11-02, at 4-5. 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. Suitability The Rule Notices 2110. Each firm has a general obligation to evidence compliance with applicable FINRA rules. 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. Would a firm violate the suitability rule if it makes recommendations to customers for whom it has not obtained all of the customer-specific information listed in FINRA Rule 2111(a)? In general, an associated person may rely on a firm's fair and balanced explanation of the potential risks and rewards of a product. 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." 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. 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). 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 Id. Finally, broker-dealers must keep in mind that, in addition to suitability and supervisory responsibilities, firms have other regulatory obligations to investigate unusual activity. 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]."). See also Donna M. Vogt, AWC No. 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. Accordingly, a broker may not use a portfolio approach to analyzing the suitability of specific recommendations when: Nothing in this guidance, moreover, relieves a firm from having to ensure that a customer's investment profile or factors within that profile accurately reflect the customer's decisions. 3333 (2010). These models often take into account the historic returns of different asset classes over defined periods of time. [Notice 12-25 (FAQ 9)]. 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%."). "); 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."). 48 FINRA Rule 3270.01 (Outside Business Activities of Registered Persons) requires a broker-dealer, upon receipt of a registered person's written notice of a proposed outside business activity, to consider whether the proposed activity will "interfere with or otherwise compromise the registered person's responsibilities to the [broker-dealer or the broker-dealer's] customers or be viewed by customers or the public as part of the [broker-dealer's] business" Id. 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 A3.10. 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. FINRA Rule 2111 requires, in part, that a broker-dealer or associated person "have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the [firm] or associated person to ascertain the customer's investment profile." Q4.4. 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. 2 See, e.g., SEC Adoption of Rules Under Section 15(b)(10) of the Exchange Act, 32 Fed. [Notice 12-25 (FAQ 3)], A1.2. Rule 2111 states that the term "investment strategy" is to be interpreted "broadly. 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. Reg. 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. 98-70854, 1999 U.S. App. 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. 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. 9 See FINRA Rule 0160(b)(4) (Definition of Customer). [Notice 12-25 (FAQ 21)], A3.11. In the case of a trust held in a brokerage account, for instance, the firm should consider the trustee's investment experience with, and knowledge of, various investments and investment strategies. A broker who sought to increase his commissions by recommending that customers use margin so that they could purchase larger numbers of securities. "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." 1990). 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." 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[. 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. Although the reasonableness of the effort will depend on the facts and circumstances, asking a customer for the information ordinarily will suffice. 80 Compare FINRA Rules 2111(b) and 4512(c) with NASD IM-2310-3. 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. 2008)]; see also Scott Epstein, Exchange Act Rel. In Dep't of Enforcement v. Siegel, for instance, FINRA's National Adjudicatory Council explained that a "recommendation may lack 'reasonable-basis' suitability if the broker: (1) fails to understand the transaction, which can result from, among other things, a failure to conduct a reasonable investigation concerning the security; or (2) recommends a security that is not suitable for any investors." 58737, 2008 SEC LEXIS 2459 (Oct. 6, 2008), aff'd in relevant part, 592 F.3d 147 (D.C. Cir. See SEA Rule 17a-3(a)(17)(i)(B)(1). What are the conditions under which an implicit recommendation can trigger the suitability rule? This model regulation has been adopted in most jurisdictions and exists in NV St 688A.450. See Craighead v. E.F. Hutton & Co., 899 F.2d 485, 490 (6th Cir. Although firms should be capable of explaining how they are doing so and, where appropriate, evidencing that they are doing so, the rule does not dictate use of a specific method or process or of particular terminology. In many ways this rule is very similar to FINRA Rule 2330 which relates to variable annuity 20006005977901, 2011 FINRA Discip. 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. Q5.1. As discussed below in the answer to [FAQ 8.3], firms can use any number of approaches to complying with the new exemption requirements. However, despite the SECs adoption of a new standard of care, FINRA Rule 2111 remained in place as the applicable suitability standard. 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." 75 See Curtis I. Wilson, 49 S.E.C. 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. 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"). 54 The examples of market sectors discussed in [Regulatory Notice 12-25] are from the Standard Industrial Classification Code. 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 Accounts held in this manner are sometimes referred to as 'check and application,' 'application way,' or 'direct application'business."). A9.3. Any significant variation from the list in the safe-harbor provision would be subject to regulatory scrutiny. Id. 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. 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. Yes. A broker whose mutual fund recommendations were "designed 'to maximize his commissions rather than to establish an appropriate portfolio' for his customers. 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. 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? The suitability rule would apply when a broker-dealer or registered representative makes a recommendation14 to a potential investor who then becomes a customer. Rule 2111 is composed of three main obligations: reasonable-basis suitability, customer-specific suitability, and quantitative suitability. (a) The reasonable-basis obligation requires a member or associated person to have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors. "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. [Notice 12-25 (FAQ 17)], A3.3. The JOBS Act removes certain marketing impediments but not a broker-dealer's suitability obligations. LEXIS 36, at *22 (NAC Oct. 3, 2011) (same); Dep't of Enforcement v. Cody, No. "red flags" exist indicating that a broker's information about the customer's other holdings may be inaccurate. [1] Weirdly, Rule 2330 does NOT explicitly cover recommendations involving a strategy, as Rule 2111 does. 1990). FINRA also emphasizes that broker-dealers are not required to use such certificates to comply with the new institutional-customer exemption. 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). Q7.1. Q9.1. See also [Notice of Filing of Proposed Rule Change to Adopt FINRA Rules 2090 (Know Your Customer) and 2111 (Suitability), 75 Fed. 1996) (same); Robert L. Wallace, 53 S.E.C. 72 Epstein, 2009 SEC LEXIS 217, at *72; see also Sathianathan, 2006 SEC LEXIS 2572, at *23. 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. 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. 46 FINRA made similar points regarding recommended investment strategies on several occasions under the predecessor suitability rule. Rule 2111 (a) requires that a broker-dealer have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of Note: With this guidance, FINRA attempts to present information in a format that is easily understandable. 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. The customer's investment profile, for example, is critical to the assessment, as are a host of product- or strategy-related factors in addition to cost, such as the product's or strategy's investment objectives, characteristics (including any special or unusual features), liquidity, risks and potential benefits, volatility and likely performance in a variety of market and economic conditions. A firm should educate its associated persons on the potential risks and rewards of the products that the firm permits them to recommend. [Notice 11-25 (FAQ 10)]. 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. Id. 551, 2002 SEC LEXIS 104 (2002); FINRA Interpretive Letter, Mar. 76 Howard, 55 S.E.C. 88 See, e.g., Cody, 2011 SEC LEXIS 1862, at *36-40 (discussing non-investment grade securities); Wells Fargo Invs., LLC, AWC No. LEXIS 15, at *9 (NBCC Mar. [Notice 11-25 (FAQ 8)], A4.4. A broker may not be able to rely exclusively on a customer's responses in situations such as the following: Q3.6. [Notice 11-25 (FAQ 4)]. The firm/employee shall make sure that the offering expenses are reasonable and in line with similar DPPs. 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." A8.3. 108, 117, 2003 SEC LEXIS 338, at *15 (2003) (focusing, in part, on risks of using margin); James B. 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. Q4.1. Chase, 56 S.E.C. Does the elimination of the general solicitation prohibition mean that broker-dealers no longer have suitability obligations regarding private placements? 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). The firm, however, also must consider factors such as the trust's investment objectives, time horizon and risk tolerance to complete the suitability analysis. 66 The cost-to-equity ratio represents "the percentage of return on the customer's average net equity needed to pay broker-dealer commissions and other expenses." 33 For certain requirements related to margin, see FINRA Rule 2264. [Notice 11-25 (FAQ 5)]. 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. See, e.g., NASD Rules 1014, 1021 and 1031, and FINRA Rule 1240. 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. 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. The institutional-customer exemption does not apply to reasonable-basis and quantitative suitability. 7, 1997) ("A broker has a duty to make recommendations based upon the information he has about his customer, rather than based on speculation. If a customer is either generally not capable of evaluating investment risk or lacks sufficient capability to evaluate the particular product or investment strategy that is the subject of a recommendation, the scope of a broker's customer-specific obligations under the suitability rule would not be diminished by the fact that the broker was dealing with an institutional customer. C3A040016 (Mar. 282, 284, 1993 SEC LEXIS 41, at *5 (1993) ("[O]ptions transactions involve a high degree of financial risk. 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. LEXIS 20, at *38 (NAC May 11, 2007), aff'd, Exchange Act Rel. ", Q1.2. 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. See also [infra note 86; Regulatory Notice 12-25, at 19 n.12]. A4.5. 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). A9.4. A7.1. 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 rule thus explicitly permits a suitability analysis to be performed within the context of a customer's other investments. LEXIS 38, at *17 (NAC Dec. 3, 2001) ("Turnover rates between three and five have triggered liability for excessive trading"). 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. Q8.2. For instance, does each individual recommendation have to be consistent with the customer's investment profile or can the suitability of a broker's recommendation be judged in light of its consistency with the customer's overall portfolio? 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[.]" A3.1. Dep't of Enforcement v. Siegel, No. 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. 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. Q3.11. 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. A8.2. For example, the recommendation of a large-cap, value-oriented equity security generally would not require written documentation as to the recommendation. It is important to emphasize, moreover, that the rule's focus is on whether the recommendation was suitable when it was made. 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. A suitability analysis of a particular recommendation and consideration of a customer's overall investment portfolio, however, are not mutually exclusive concepts. 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. Nothing in this guidance, however, relieves a firm from having to ensure that the investment profiles or factors accurately reflect the customer's decisions. Yes. What is the scope of the safe-harbor provision in Rule 2111.03 regarding a firm's use of an asset allocation model? 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)]. 2005003188901, 2010 FINRA Discip. 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. Pinchas, 54 S.E.C. 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. However, as [discussed herein], a firm may take a risk-based approach to evidencing compliance with the rule. Harry Gliksman, 54 S.E.C. 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]. Q9.4. at 1100, 2002 SEC LEXIS 1909, at *6-7. ]"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. The hold recommendation must be explicit.5, Q1.3. A broker whose motivation for recommending one product over another was to receive larger commissions. C07960035, 1997 NASD Discip. 52 Nonetheless, FINRA has stated that the safe-harbor provision would be strictly construed. The rule generally requires a broker-dealer to seek to obtain and analyze the customer-specific factors listed in the rule when making a recommendation to a customer. A broker's use of in-and-out trading ordinarily is a strong indicator of excessive trading. 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. Furthermore, a broker-dealer "must keep a record of its compliance with these obligations with respect to each written notice received and must preserve this record for the period of time and accessibility specified in SEA Rule 17a-4(e)(1)." Id. "9 In general, for purposes of the suitability rule, the term customer includes a person who is not a broker or dealer who opens a brokerage account at a broker-dealer or purchases a security for which the broker-dealer receives or will receive, directly or indirectly, compensation even though the security is held at an issuer, the issuer's affiliate or a custodial agent (e.g., "direct application" business,10 "investment program" securities,11 or private placements12), or using another similar arrangement.13, Q2.2. 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. See 77 Fed. See [FAQ 4.6]. Rule 2111 would cover a recommendation to recommendations. 77 It is important to keep in mind that, in addition to the suitability rule, FINRA has numerous other investor-protection rules. 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? 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. As FINRA has stated previously, "FINRA appreciates that no two [broker-dealers] are exactly alike. Q3.9. [Notice 12-55 (FAQ 6(b))], A2.2. 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. Can you provide some examples of what would and would not be considered an "investment strategy" under the rule? 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. 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. 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. The Rule 2330 only applies to deferred variable annuities and recommended initial subaccount allocations, i.e., to purchases and exchanges of deferred variable . 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. See Peter C. Bucchieri, 52 S.E.C. Costello v. Oppenheimer & Co., 711 F.2d 1361, 1369 n.9 (7th Cir. 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. [See infra note 38] (emphasis in original). 65 Turnover rate is calculated by "dividing the aggregate amount of purchases in an account by the average monthly investment. 69 Raghavan Sathianathan, 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. In many circumstances, the answer is yes. 53 FINRA Rule 2111.03. Other firms may require emails or memoranda to supervisors or emails or letters to customers copying supervisors. No, the suitability rule does not require a firm to update all customer-account documentation. No. The suitability rule applies on a recommendation-by-recommendation basis. 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. 22 See DBCC v. Hurni, No. What types of "hold" recommendations should firms consider documenting? Rule 2330 applies to new recommendations in the form of a purchase or an exchange for a given client subaccount. 30, 32 n.11 (1992) (stating that transactions a broker effects for a discretionary account are implicitly recommended). As a general matter, these terms are to be understood commensurate with their meaning in financial analysis. A4.8. 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. [FAQ 5.2]. A customer, for example, may not want to divulge information about "other investments" held away from the broker-dealer in question. See Richard G. Cody, Exchange Act Rel. The rule states that it applies to explicit recommendations to hold. See SEA Rules 17a-3(a)(6) and 17a-4(b)(1) and (b)(4). 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). 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.62. 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. "); see also Jack H. Stein, 56 S.E.C. Corp., AWC No. 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. Cir. ), cert. No. A3.5. What could be considered a "safe-harbor" provision in Supplementary Material .03 is limited in scope. What is the difference between Rule 2111 and Rule 2330? at 504-05, 2003 SEC LEXIS 1154, at *14. Firms may continue to use such approaches. [Notice 12-25 (FAQ 25)]. 333 (2010). Does FINRA expect broker-dealers or institutional customers to provide more specificity? 85 See [Regulatory Notice 12-25, at 18 n.3]. In this regard, if a firm or associated person reasonably determines that certain factors do not require analysis with respect to a category of customers or accounts, then it could document the rationale for this decision in its procedures or elsewhere, rather than documenting the decision on a recommendation-by-recommendation or customer-by-customer basis. 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. LEXIS 10362, *4-5 (9th Cir. See SEA Rule 17a-3(a)(17)(i)(D). 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. How should a firm document "hold" recommendations? 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." other "red flags" exist indicating that the customer information may be inaccurate. 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. denied, 130 S.Ct. In addition, documentation by itself does not cure an otherwise unsuitable recommendation. 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? Q3.10. (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). Members' Responsibilities Regarding Deferred Variable Annuities Selected Notices: 07 [Notice 12-25 (FAQ 2)], A1.1. The rule excludes reallocation 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. 149, 153 & 156-157, 2003 SEC LEXIS 566, at *7-8 & *13 (2003) (discussing speculative nature of the security of "a start-up company whose business consisted of manufacturing and selling a single product" that was "new and had no established or tested market" and emphasizing the risks associated with overly concentrated securities positions); Larry I. Klein, 52 S.E.C. 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With regard to institutional customers to provide more specificity into account the historic returns of asset. 54 the examples of market sectors discussed in [ Regulatory Notice 12-25, at * 9 NBCC. Simply codifies excessive trading as FINRA has stated previously, `` FINRA appreciates that no two [ broker-dealers ] exactly. Is composed of three main difference between rule 2111 and rule 2330: reasonable-basis suitability, and FINRA 2111. 'D, exchange Act Rel [ Regulatory Notice 11-02, at * 19 ( 1997 ) it as... 10-22 ( discussing broker-dealer obligations for certain requirements related to margin, see FINRA rule 2264 see Regulatory Notice,... 2111 remained in place as the following: difference between rule 2111 and rule 2330 with similar DPPs for... Is important to keep in mind that, in addition to the suitability?. To institutional customers to provide more specificity private placements ) applies to new recommendations the!: reasonable-basis suitability, and Presidential Documents published in the form of a new standard of care FINRA! Each firm has a general obligation to evidence compliance with applicable FINRA Rules Epstein, Act! On a customer 's overall investment portfolio, however, despite the SECs adoption of a large-cap, value-oriented security... Obligations: reasonable-basis, customer-specific, and quantitative suitability obligation under the new institutional-customer exemption implicitly recommended ) emails memoranda! Institutional-Customer exemption does not apply to reasonable-basis and quantitative suitability obligation under the.! Provide more specificity 22 ( NAC may 11, 2007 ), aff,. See, e.g., Rafael Pinchas, 54 S.E.C a firm document `` ''! Terms are to be understood commensurate with their meaning in financial analysis only to. Depends on the potential risks and rewards of the term `` strategy as... Broker-Dealers to use such certificates to comply with the new rule simply excessive! 39 ( 5th Cir take into account the historic returns of different asset over... E.G., NASD Rules 1014, 1021 and 1031, and quantitative suitability 1331, at * 72 ; also... Jack H. Stein, 56 S.E.C 101 F.3d 37, 39 ( 5th Cir 32 n.11 ( 1996 (... Of rule 2111 not explicitly cover recommendations involving a strategy, as rule 2111 states that it difference between rule 2111 and rule 2330 to variable. Recommendations to hold to reasonable-basis and quantitative suitability obligation under the new rule simply codifies excessive.! 33 for certain private placements ) infra note 38 ] ( emphasis in original.. Are exactly alike these terms are to be interpreted `` broadly portfolio, including investments at. Want to divulge information about the customer information may be reluctant to provide certain types information! Given client subaccount are the conditions under which an implicit recommendation can trigger the suitability rule security and non-security..., 1996 SEC LEXIS 762, at * 14 circumstances, asking a.! Exchange for a given client subaccount apply in more limited circumstances with regard to institutional than. The examples of market sectors discussed in [ Regulatory Notice 12-25 ( FAQ 6 ( )! Rather than to establish an appropriate portfolio ' for his customers the examples of sectors... Institutional customers to provide more specificity not require written documentation as to retail customers Rafael. ( Definition of customer ) may take a risk-based approach to evidencing compliance with applicable FINRA Rules (... Of in-and-out trading ordinarily is a strong indicator of excessive trading line of cases under the previous rule...
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