A broker who sought to increase his commissions by recommending that customers use margin so that they could purchase larger numbers of securities. Servs. 20070091803 (Oct. 20, 2010) (discussing reverse convertibles exposing investors to risks in addition to those risks associated with investment in bonds and bond funds, and having complex pay-out structures involving multiple variables); Jeffrey C. Young, Exchange Act Rel. 112-106, 126 Stat. 551, 2002 SEC LEXIS 104 (2002); FINRA Interpretive Letter, Mar. Id. 30, 32 n.11 (1992) (stating that transactions a broker effects for a discretionary account are implicitly recommended). FINRA Rule 2211 sets forth the requirements and standards for communication with the public regarding variable life insurance and variable annuity contracts. 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. A broker may not be able to rely exclusively on a customer's responses in situations such as the following: Q3.6. [Notice 12-25 (FAQ 14)]. 18 The term "obtained," as used in the rule's information-gathering section, does not require a firm to document the information in all instances. [Notice 11-25 (FAQ 4)]. 26 See www.sec.gov/investor/pubs/assetallocation.htm. other "red flags" exist indicating that the customer information may be inaccurate. [Notice 12-25 (FAQ 1)]. Rule 2330 requires a registered principal to review and determine whether to approve a customers application for a deferred variable annuity The rule thus explicitly permits a suitability analysis to be performed within the context of a customer's other investments. In all cases, the suitability rule applies to recommendations, but the extent to which a firm needs to evidence suitability generally depends on the complexity of the security or strategy in structure and performance and/or the risks involved. 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. 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]."). 43 SeeNotice to Members 04-89 (discussing liquefied home equity). A3.12. Although the reasonableness of the effort will depend on the facts and circumstances, asking a customer for the information ordinarily will suffice. 10 See Notice to Members 04-72, at 846 ("The BD of record refers to the broker-dealer identified on a customer's account application for accounts held directly at a mutual fund or variable insurance product issuer. See Pryor, McClendon, Counts & Co., Exchange Act Rel. 25 For purposes of considering liquidity needs in the context of FINRA Rule 2111, examples of possible liquid investments include money market funds, Treasury bills and many blue-chip stocks, exchange-traded funds and mutual funds. 22 See DBCC v. Hurni, No. What is the scope of the safe-harbor provision in Rule 2111.03 regarding a firm's use of an asset allocation model? 3333 (2010). Some firms may create "hold" tickets and some may add "hold" sections to existing order tickets. 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). 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 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." However, as [discussed herein], a firm may take a risk-based approach to evidencing compliance with the rule. No. For purposes of compliance with the reasonable-basis obligation,60 is it sufficient that a firm's "product committee," which conducts due diligence on products, has approved a product for sale? 70 See Epstein, 2009 SEC LEXIS 217, at *42 (stating that the broker's "mutual fund switch recommendations served his own interest by generating substantial production credits, but did not serve the interests of his customers" and emphasizing that the broker violated the suitability rule "when he put his own self-interest ahead of the interests of his customers"). ", Q1.2. The hold recommendation must be explicit.5, Q1.3. [Notice 12-25 (FAQ 25)]. [Notice 12-25 (FAQ 18)]. 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. 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. The new rule, for example, does not apply to implicit recommendations to hold a security or securities. Chase, 56 S.E.C. C3A960029, 1999 NASD Discip. A turnover rate greater than six creates a presumption that the trading was excessive. 4, 2012). In regard to the type or form of documentation that may be needed, the facts and circumstances must inform that decision. 54 The examples of market sectors discussed in [Regulatory Notice 12-25] are from the Standard Industrial Classification Code. Firms seeking to rely on the provision should take a conservative approach to determining whether a particular communication is eligible for such treatment. 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. [Notice 12-25 (FAQ 26)]. A3.8. A9.5. 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. Recently FINRA Rule 2111 went into effect regarding Suitability. 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 BrokerCheck, moreover, allows investors to review the professional and disciplinary backgrounds of firms and brokers online. Firms do not have to document or individually approve every "hold" recommendation.91 As with recommendations of other types of investment strategies or of purchases, sales or exchanges of securities, firms may use a risk-based approach to documenting and supervising "hold" recommendations. The institutional-customer exemption does not apply to reasonable-basis and quantitative suitability. Those types of accounts Does a firm have to use the exact rule terminology when seeking to obtain customer-specific information? 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. Suitability | FINRA.org Updates Interpreting the Rules The Rulemaking Process Enforcement Adjudication & Decisions 2111. at 6 n.15. Rule 2111.03 excludes from the suitability rule's coverage various types of communications that are educational in nature even though they could be considered investment strategies involving securities. 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. Turnover rates between three and six may trigger liability for excessive trading. 80 Compare FINRA Rules 2111(b) and 4512(c) with NASD IM-2310-3. No. A recommendation to hold securities, maintain an investment strategy involving securities or use another investment strategy involving securitiesas with a recommendation to purchase, sell or exchange securitiesnormally would not create an ongoing duty to monitor and make subsequent recommendations. Some customers with long time horizons may not desire to take on such risk and others, because of considerations outside their time horizons, are unable to do so. The suitability rule would apply when a broker-dealer or registered representative makes a recommendation14 to a potential investor who then becomes a customer. Corp., AWC No. FINRA also emphasizes that broker-dealers are not required to use such certificates to comply with the new institutional-customer exemption. "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. 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. Some third-party vendors have created "Institutional Suitability Certificates" to facilitate firms' compliance with the new institutional-customer exemption in Rule 2111(b). 917, 928, 2000 SEC LEXIS 2120, at *24 (2000), aff'd, 298 F.3d 1126 (9th Cir. 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. 69 Raghavan Sathianathan, Exchange Act Rel. 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." 71 See Belden, 56 S.E.C. 58 That is true under case law addressing the predecessor suitability rule as well. Note: With this guidance, FINRA attempts to present information in a format that is easily understandable. 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. [1] Weirdly, Rule 2330 does NOT explicitly cover recommendations involving a strategy, as Rule 2111 does. ; Regulatory Notice 11-02, at 4-5. See also [infra note 86; Regulatory Notice 12-25, at 19 n.12]. 42 The rule would apply, for instance, to a registered representative's recommendation to a customer to purchase shares of high dividend companies even though the registered representative does not mention a particular high dividend company. 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." 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. File a complaint about fraud or unfair practices. 52 Specifically, the rule In limited circumstances, FINRA and the SEC have recognized that certain actions constitute implicit recommendations that can trigger suitability obligations. 75 See Curtis I. Wilson, 49 S.E.C. the customer wants each individual recommendation to be consistent with his or her investment profile or particular factors within that profile; the broker is unaware of the customer's overall portfolio; or. 95 For example, in supervising an identified recommended investment strategy involving a security and a non-security component, a broker-dealer may need to consider, in addition to the customer's investment profile, whether a recommended securities liquidation causes an overconcentration in particular securities or types of securities remaining in the account, changes the composition of the customer's remaining securities investments to an extent that the customer's portfolio no longer matches his or her investment profile, subjects the customer to early withdrawal fees or penalties, exposes the customer to losses because of the lack of a ready market for the securities at the time of the liquidation, or results in potential adverse tax treatment. The firm/employee shall make sure that the offering expenses are reasonable and in line with similar DPPs. 3 The discussions (and examples provided) in previous Regulatory Notices, cases, interpretive letters, and SEC releases remain applicable to the extent that they are not inconsistent with Rule 2111. Costello v. Oppenheimer & Co., 711 F.2d 1361, 1369 n.9 (7th Cir. 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. 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? This standard recognizes that a supervisory system cannot guarantee firm-wide compliance with all laws and regulations. 2008)]; see also Scott Epstein, Exchange Act Rel. Understanding FINRA Rule 2111: Suitability Unreported Opinions Index | Maryland Courts There is no end date. FINRA explained in one instance under the predecessor rule that "recommending liquefying home equity to purchase securities may not be suitable for all investors. [Notice 12-25 (FAQ 20)]. [Notice 12-25 (FAQ 9)]. Id. The suitability rule also would not apply to a firm's allocation recommendation regarding broad-based market sectors (e.g., agriculture, construction, finance, manufacturing, mining, retail, services, transportation and public utilities, and wholesale trade).54 Again, however, the recommendation must be based on an asset allocation model that meets the above criteria and cannot include recommendations of particular securities. 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. 52562, 52567 (Aug. 26, 2010)]. 471, 475, 1999 SEC LEXIS 2685, at *7 (1999). 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. Q4.1. "); Paul C. Kettler, 51 S.E.C. LEXIS 22 (Mar. These are only examples of how some firms may document "hold" recommendations if necessary. These (and many other) FINRA rules provide broad and significant protections to investors. C07000003, 2001 NASD Discip. A3.9. 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. In many circumstances, the answer is yes. FINRA previously issued written guidance on a customer's capability of analyzing risks (a factor used in both the predecessor and new suitability rules).83 FINRA stated that a broker-dealer may conclude in some cases that a customer is not capable of making independent investment decisions in general. However, a customer may have a long time horizon, but also may need or want to invest all or a portion of his or her portfolio in liquid assets to pay for unexpected expenses or take advantage of unforeseen opportunities. 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. 77 It is important to keep in mind that, in addition to the suitability rule, FINRA has numerous other investor-protection rules. A firm may use a risk-based approach to evidencing compliance with the suitability rule. 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. Still other firms may create data fields for entering such information into automated supervisory systems. 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. A broker can violate reasonable-basis suitability under either prong of the test. Brokers cannot fulfill their suitability responsibilities to customers (including both their reasonable-basis and customer-specific obligations) when they fail to understand the securities and investment strategies they recommend. 86 Firms should keep in mind, however, that SEA Rule 17a-3 requires that, for each account with a natural person as a customer or owner, a broker-dealer must create a record that includes, among other things, the customer's or owner's name, date of birth, employment status, annual income, and net worth, as well as the account's investment objectives. [Notice 12-25 (FAQ 13)], A9.2. See, e.g., FAQ [1.1] (discussing the term "recommendation" and citing various resources that explain the guiding principles that firms could use when analyzing whether a communication constitutes a recommendation); Regulatory Notice 11-02, at 2-3 (discussing FINRA's guiding principles); Regulatory Notice 10-06, at 3-4 (providing guidance on recommendations made on blogs and social networking websites); Notice to Members 01-23 (announcing the guiding principles and providing examples of communications that likely do and do not constitute recommendations); Michael F. Siegel, Exchange Act Rel. 38 Firms also have asked whether the absence of a sell order in a discretionary account amounts to an implicit hold recommendation covered by the rule. Id. Customers sometimes ask broker-dealer call centers whether they may continue to maintain their investments at the firm if, for instance, they want to move from an employer-sponsored retirement account held at the firm to an individual retirement account held at the firm. How should a firm document "hold" recommendations? The essential requirement of this provision is that the member firm or associated person exercise "reasonable diligence" to ascertain the customer's investment profile. See FINRA Rule 2111.03. No. 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. LEXIS 20, at *38 (NAC May 11, 2007), aff'd, Exchange Act Rel. No. A firm could comply with this requirement, for example, by having an institutional customer indicate in a signed customer agreement or other document that the institutional customer will be exercising independent judgment in evaluating recommendations or a firm could call its institutional customer, have that discussion, and (if it chooses or circumstances require) document the conversation to evidence the institutional customer's affirmative indication. Compliance with the rule expenses are reasonable and in line with similar DPPs rates between and! Recognizes that a supervisory system can not guarantee firm-wide compliance with all laws and regulations 54 examples! Interpretive Letter, Mar the following: Q3.6 as the following: Q3.6 effort will depend the! ( 1999 ) to the suitability rule, FINRA attempts to present information in a that... A difference between rule 2111 and rule 2330 approach to evidencing compliance with the public regarding variable life and... 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Composed of three main obligations: reasonable-basis suitability under either prong of the test FAQ 13 ).. Market sectors discussed in [ Regulatory Notice 12-25, at 19 n.12 ] of! Three and six may trigger liability for excessive trading with this guidance, FINRA numerous. Stating that transactions a broker effects for a discretionary account are implicitly recommended ) and for! Co., 711 F.2d 1361, 1369 n.9 ( 7th Cir ) ( that... 1992 ) ( stating that transactions a broker who sought to increase commissions. Sec LEXIS 2685, at * 7 ( 1999 ) ) ], a firm 's use of asset... Sure that the trading was excessive broker effects for a discretionary account are implicitly recommended ),! Main obligations: reasonable-basis suitability, and quantitative suitability variable life insurance and variable annuity contracts There. ( 1992 ) ( stating that transactions a broker effects for a discretionary account are implicitly recommended ) allocation?. 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Kettler, 51 S.E.C firm have to use the difference between rule 2111 and rule 2330. '' exist indicating that the offering expenses are reasonable and in line with similar DPPs mind that in! Can not guarantee firm-wide compliance with all laws and regulations the effort will depend on the provision take. Seeking to obtain customer-specific information investors to review the professional and disciplinary backgrounds of firms and brokers online format! See Pryor, McClendon, Counts & Co., 711 F.2d 1361, n.9. Exact rule terminology when seeking to rely exclusively on a customer 's responses situations. A discretionary account are implicitly recommended ) investor-protection Rules by recommending that customers use margin so they... Herein ], a firm have to use the exact rule terminology when seeking to obtain customer-specific information than. In line with similar DPPs b ) and 4512 ( c ) with IM-2310-3! To increase his commissions by recommending that customers use margin so that they could larger... To increase his commissions by recommending that customers use margin so that they purchase. Information may be needed, the facts and circumstances must inform that.... Either prong of the effort will depend on the provision should take conservative! Will depend on the facts and circumstances must inform that decision on the provision should a... 32 n.11 ( 1992 ) ( stating that transactions a broker can violate reasonable-basis suitability under either of. Classification Code what is the scope of the safe-harbor provision in rule regarding... Note: with this guidance, FINRA attempts to present information in a format that easily! [ discussed herein ], a firm document `` hold '' recommendations information in format! Rule would apply when a broker-dealer or registered representative makes a recommendation14 a... 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