The following frequently asked questions (FAQs) provide guidance on FINRA Rule 2111 (Suitability). [Notice 12-25 (FAQ 26)]. 73 Robin B. McNabb, 54 S.E.C. SEA Rule 17a-3(a)(17)(i)(C). 85 See [Regulatory Notice 12-25, at 18 n.3]. If approved by the SEC, the effective date will be June 30 Reg BIs compliance date. No. Does the new rule's "investment strategy" language cover a registered representative's recommendation involving both a security and a non-security investment? 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. See SEA Rules 17a-3(a)(6) and 17a-4(b)(1) and (b)(4). For instance, some relatively liquid products can be complex and/or risky and therefore unsuitable for some customers. Does FINRA expect broker-dealers or institutional customers to provide more specificity? 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. 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." 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. 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. 11 Regulatory Notice 08-35, at 2 (stating that direct participation programs (DPPs) and unlisted real estate investment trusts (REITs) are referred to as "investment programs"). [Notice 12-25 (FAQ 8)], A4.7. Rule 2111 requires that the suitability assessment be "based on the information obtained through the reasonable diligence of the member or associated person to ascertain the What is the FINRA Rule 2330? [Notice 12-25 (FAQ 9)]. 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. 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. A4.2. If you 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. Q1.4. 52 Specifically, the rule [FINRA Rule 2214 replaced NASD IM-2210-6 (Requirements for the Use of Investment Analysis Tools)]. Accordingly, a [firm] must perform appropriate due diligence to ensure that it understands the nature of the product, as well as the potential risks and rewards associated with the product."). 108, 117, 2003 SEC LEXIS 338, at *15 (2003) (focusing, in part, on risks of using margin); James B. 5 FINRA previously responded to questions regarding whether the absence of a sell order in a discretionary account amounts to an implicit hold recommendation covered by the rule. 20 FINRA notes that there are SEC and other FINRA rules that explicitly require specific types of documentation. Id. Reg. 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. New FAQs will be identified when added. [Notice 12-55 (FAQ 6(a))], A2.1. The suitability rule applies only to recommended securities and investment strategies involving securities, but FINRA does not define the term "recommendation" other than to say that it is a facts and circumstances inquiry. 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. Q9.1. 1304, 1311, 1997 SEC LEXIS 762, at *19 (1997). A3.10. For instance, the rule would cover a recommendation to purchase securities using margin33 or liquefied home equity34 or to engage in day trading,35 irrespective of whether the recommendation results in a transaction or references particular securities. Quantitative suitability likely will apply in more limited circumstances with regard to institutional customers than it does as to retail customers. No. 1990). 3333 (2010). Id. These are only examples of how some firms may document "hold" recommendations if necessary. denied, 130 S.Ct. [Broker-dealers] have different business models; offer divergent services, products and investment strategies; and employ distinct approaches to complying with applicable regulatory requirements. "); Paul C. Kettler, 51 S.E.C. 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. 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. 513, 515, 1993 SEC LEXIS 1521, at *5 (1993) (discussing risky nature of investing in a company that had a history of operating losses and concentrated its assets in illiquid holdings in other unproven start-up companies in the same industry); Gordon S. Venters, 51 S.E.C. 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." FINRA has not approved or endorsed any third-party Institutional Suitability Certificates and has not contracted with any third-party vendor to create such certificates on FINRA's behalf. No. As noted above in the answer to [FAQ 8.1], FINRA has not endorsed or promoted any certificate. However, firms should understand that, to the degree that the basis for suitability is not evident from the recommendation itself, FINRA examination and enforcement concerns will rise with the lack of documentary evidence for the recommendation. 40 See id. In general, FINRA would not view those communications as "hold" recommendations for purposes of the rule because the firm's call center is not responding to the question of whether the customer should hold the securities, but rather whether the customer can continue to maintain them at the firm. The new rule does not apply to implicit recommendations to hold. What constitutes a "customer" for purposes of the suitability rule? 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. Numerous Regulatory Notices and cases discuss various types of complex and/or potentially risky securities and investment strategies involving a security or securities. 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. "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." 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. The firm, however, also must consider factors such as the trust's investment objectives, time horizon and risk tolerance to complete the suitability analysis. 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. Q4.4. A firm may use a risk-based approach to documenting compliance with this provision. 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. No. A broker who recommended speculative securities that paid high commissions because he felt pressured by his firm to sell the securities. 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). 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. Pinchas, 54 S.E.C. 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. LEXIS 15, at *9 (NBCC Mar. Q3.8. A broker can violate reasonable-basis suitability under either prong of the test. denied, 130 S.Ct. A3.8. 2010)]; Dane S. Faber, 57 S.E.C. What could be considered a "safe-harbor" provision in Supplementary Material .03 is limited in scope. A broker whose mutual fund recommendations were "designed 'to maximize his commissions rather than to establish an appropriate portfolio' for his customers. Reasonable Basis Obligation This means the "); Paul C. Kettler, 51 S.E.C. See SEA Rule 17a-3(a)(17)(i)(A). [Notice 12-25 (FAQ 5)], A1.4. 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? It is important to emphasize, moreover, that the rule's focus is on whether the recommendation was suitable when it was made. In general, an associated person may rely on a firm's fair and balanced explanation of the potential risks and rewards of a product." A [broker-dealer's] reasonable diligence must provide [it] with an understanding of the potential risks and rewards associated with the recommended security or strategy." 69 Raghavan Sathianathan, Exchange Act Rel. These (and many other) FINRA rules provide broad and significant protections to investors. (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). Rule 2111 identifies the three main suitability obligations: reasonable basis, customer specific and quantitative suitability. A broker whose motivation for recommending one product over another was to receive larger commissions. 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. Reasonable Basis Obligation This means the 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. 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. Q3.9. [Notice 12-25 (FAQ 4)]. 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. 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 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. 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? 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? Q3.12. 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. FINRA cautioned, however, that a firm should evidence a customer's intent to use different investment profiles or factors for the different accounts. The JOBS Act removes certain marketing impediments but not a broker-dealer's suitability obligations. Once a broker-dealer identifies a recommended investment strategy involving both a security and a non-security investment, the broker-dealer's suitability obligations apply to the security component of the recommended strategy95 but its suitability analysis also must be informed by a general understanding of the non-security component of the recommended investment strategy. 2008015651901 (Dec. 15, 2011) (stating that "[r]everse convertibles are complex structured products that combine a debt instrument and put option into one product," the repayment of principal is linked to the performance of an underlying asset, such as a stock, a basket of stocks or an index, which is generally unrelated to the issuer of the note, and at maturity, if the value of the underlying asset has fallen below a certain level, the investor may receive less than a full return of principal); Chase Invs. Although the reasonableness of the effort will depend on the facts and circumstances, asking a customer for the information ordinarily will suffice. In many circumstances, the answer is yes. 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]."). 62 See FINRA Rule 2111.05(a). 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. 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 firm/employee shall make sure that the offering expenses are reasonable and in line with similar DPPs. FINRA Rule 2111 does not define the terms. C3A960029, 1999 NASD Discip. In addition, documentation by itself does not cure an otherwise unsuitable recommendation. 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. 21 For an expanded discussion of this issue, see [FAQ 3.4]. See also Donna M. Vogt, AWC No. [Notice 12-25 (FAQ 16)]. 562, 565, 1995 LEXIS 3452, at *9 (1995) (remarking that securities of companies "with a limited history of operations and no profitability" are speculative); David J. Dambro, 51 S.E.C. confusion, FINRA is proposing limiting the application of Rule 2111 to circumstances in which Reg BI does not apply. 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