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. A4.2. A9.3. 46 FINRA made similar points regarding recommended investment strategies on several occasions under the predecessor suitability rule. The answer depends on the facts and circumstances of the particular case. 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. Corp., AWC No. [Notice 12-25 (FAQ 23)]. Reg. 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. May 20, 1999) (holding that FINRA's requirement that registered representatives act in a manner consistent with just and equitable principles of trade applies to all unethical business conduct, regardless of whether the conduct involves securities); Vail v. SEC, 101 F.3d 37, 39 (5th Cir. C3A040016 (Mar. What constitutes a "customer" for purposes of the suitability rule? LEXIS 13, at *12 (NAC Aug. 9, 2004) ("[A] broker's recommendations must serve his client's best interests[,]" and the "test for whether a broker's recommendation[s are] suitable is not whether the client acquiesced in them, but whether the broker's recommendations were consistent with the client's financial situation and needs. A8.1. FINRA emphasizes, however, that a high level of liquidity does not, in and of itself, mean that the recommended product is suitable for all customers. ]"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. 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. 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." In other cases, the institutional customer may have general capability, but may not be able to understand a particular type of instrument or its risk. Q3.9. What is the nature of the obligation under the suitability rule created by a hold recommendation? 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. 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. This document consolidates the questions and answers in Regulatory Notices 12-55, 12-25 and 11-25, organized by topic. See, e.g., FINRA Rule 2010 (requiring that a broker-dealer, "in the conduct of its business, shall observe high standards of commercial honor and just and equitable principles of trade"); FINRA Rule 2020 (prohibiting use of manipulative, deceptive or other fraudulent devices); FINRA Rule 2090 (effective July 9, 2012) (requiring broker-dealers to use reasonable diligence, in regard to the opening and maintenance of every account, to know and retain the essential facts concerning every customer to effectively service customer accounts, act in accordance with any special handling instructions, understand the authority of each person acting on behalf of customers, and comply with applicable laws, regulations, and rules); FINRA Rule 2330 (imposing heightened suitability, disclosure, supervision, and training obligations regarding variable annuities); FINRA Rule 2360 (requiring heightened account opening and suitability obligations regarding options); FINRA Rule 2370 (requiring heightened account opening and suitability obligations regarding securities futures); NASD Rule 2210 (recently approved as FINRA Rule 2210, see 77 Fed. In this regard, firms should note that, as an allocation recommendation becomes narrower or more specific, the recommendation gets closer to becoming a recommendation of particular securities and, thus, subject to the suitability rule, depending on a variety of factors (including the number of issuers that fall within the broker-dealer's allocation recommendation).55 Accordingly, broker-dealers should assess whether allocation recommendations involving certain types of sub-categories of broader market sectors or even more limited groupings are so specific or narrow that they constitute recommendations of particular securities.56, Q4.8. See SEA Rule 17a-3(a)(17)(i)(B)(1). See, e.g., NASD Rules 1014, 1021 and 1031, and FINRA Rule 1240. A3.7. However, please be aware that, in case of any misunderstanding, the rule language prevails. Does the new rule cover a "hold" recommendation regarding securities that the broker did not originally recommend? LEXIS 38, at *17 (NAC Dec. 3, 2001) ("Turnover rates between three and five have triggered liability for excessive trading"). A broker-dealer cannot make assumptions about customer-specific factors for which the customer declines to provide information.22 Furthermore, when customer information is unavailable despite a broker-dealer's reasonable diligence, the firm must carefully consider whether it has a sufficient understanding of the customer to properly evaluate the suitability of a recommendation.23 As with the predecessor rule [NASD Rule 2310], however, the new rule would not prohibit a broker-dealer from making a recommendation in the absence of certain customer-specific factors as long as the firm has enough information about the customer to have a reasonable basis to believe the recommendation is suitable. A firm may use a risk-based approach to evidencing compliance with the suitability rule. 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. 30, 32 n.11 (1992) (stating that transactions a broker effects for a discretionary account are implicitly recommended). No. 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. 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. 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. What is a firm's responsibility when customers indicate that they have multiple investment objectives that appear inconsistent? 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." However, this standard does require that the system be a product of sound thinking and within the bounds of common sense, taking into consideration the factors that are unique to a member's business." New FAQs will be identified when added. 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. For example, the recommendation of a large-cap, value-oriented equity security generally would not require written documentation as to the recommendation. A broker whose motivation for recommending one product over another was to receive larger commissions. 1096, 1100, 2002 SEC LEXIS 1909, at *5-6 (2002) (same), aff'd, 77 F. App'x 2 (1st Cir. Can you provide some examples of what would and would not be considered an "investment strategy" under the rule? What is the scope of the term "strategy" as used in FINRA Rule 2111? [Notice 11-25 (FAQ 4)]. Firms should use a similar approach to analyzing whether particular recommendations are eligible for the Rule 2111.03 safe-harbor provision. However, 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. 57 FINRA Rule 2111.05(a). 1990); Arceneaux v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 767 F.2d 1498, 1502 (11th Cir. The following frequently asked questions (FAQs) provide guidance on FINRA Rule 2111 (Suitability). Some third-party vendors have created and aggressively marketed proprietary "Institutional Suitability Certificates" to facilitate compliance with the new institutional-customer exemption. A3.5. 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 However, despite the SECs adoption of a new standard of care, FINRA Rule 2111 remained in place as the applicable suitability standard. Thus, the new rule's "hold" language would not apply when a broker remains silent regarding security positions in an account. Q3.12. No. No. "); F.J. Kaufman and Co., 50 S.E.C. In relation to a customer affirmatively indicating the intention to exercise independent judgment, negative consent will not suffice, but the affirmative indication does not necessarily have to be in writing. [Notice 12-25 (FAQ 19)]. Members' Responsibilities Regarding Deferred Variable Annuities Selected Notices: 07 1990). 72 Epstein, 2009 SEC LEXIS 217, at *72; see also Sathianathan, 2006 SEC LEXIS 2572, at *23. FINRA expects a firm to be capable of explaining how an asset allocation model that it uses is consistent with generally accepted investment theory. Firms' supervisory policies and procedures must be reasonably designed to ensure that their brokers comply with this important requirement.59, Q5.2. A8.2. 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. Rule 2111 identifies the three main suitability obligations: reasonable basis, customer specific and quantitative suitability. 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). 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. 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. "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. 1304, 1311, 1997 SEC LEXIS 762, at *19 (1997). 20 FINRA notes that there are SEC and other FINRA rules that explicitly require specific types of documentation. 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. 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. What types of "hold" recommendations should firms consider documenting? How should a firm document "hold" recommendations? [Notice 12-25 (FAQ 11)]. 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. The rule states that it applies to explicit recommendations to hold. 7, 1997) ("A broker has a duty to make recommendations based upon the information he has about his customer, rather than based on speculation. The factors that must exist for an institutional customer to qualify for the exemption may, depending on the facts, negate some of the elements relevant to a showing of a broker's "control" over the account. What if a customer refuses to provide certain customer-specific information? L. No. 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 Has FINRA endorsed or approved any of these certificates? 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. Id. 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? denied, 130 S.Ct. 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. 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. Can a broker make recommendations based on a customer's overall portfolio, including investments held at other financial institutions? 53 FINRA Rule 2111.03. 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. Firms may continue to use such approaches. Apply when a broker remains silent regarding security positions in an account of. Are eligible for the rule language prevails that it applies to explicit recommendations to hold,! Multiple investment objectives that appear inconsistent securities that the broker did not originally recommend facts and circumstances the! Based on a customer 's overall portfolio, including investments held at other financial institutions refuses to certain. A broker remains silent regarding security positions in an account security generally not. 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Have multiple investment objectives that appear inconsistent `` investment strategy '' as used in FINRA rule 1240 ''!
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