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. 12, 2012) (finding that registered representative violated NASD Rules 2310 and 3040 when he recommended unsuitable private securities transactions to investors who were not his firm's customers, received compensation in relation to the transactions and failed to notify his firm of such activity); Maximo J. Guevara, 54 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)." However, as explained in FAQ [1.2], the rule would not cover an implicit recommendation to hold. New FAQs will be identified when added. See Peter C. Bucchieri, 52 S.E.C. In many ways this rule is very similar to FINRA Rule 2330 which relates to variable annuity Some customers may be reluctant to provide certain types of information to their broker-dealers. Q5.1. A broker who recommended speculative securities that paid high commissions because he felt pressured by his firm to sell the securities. Suitability | FINRA.org Updates Interpreting the Rules The Rulemaking Process Enforcement Adjudication & Decisions 2111. 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. 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. 80 Compare FINRA Rules 2111(b) and 4512(c) with NASD IM-2310-3. (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). Reasonable-basis suitability has two main components: a broker must (1) perform reasonable diligence to understand the potential risks and rewards associated with a recommended security or strategy and (2) determine whether the recommendation is suitable for at least some investors based on that understanding. These models often take into account the historic returns of different asset classes over defined periods of time. 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 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. Q7.1. 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. The new rule does not apply to implicit recommendations to hold. Reg. 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. Id. [See infra note 38] (emphasis in original). While the rule lists some of the aspects of a typical investment profile, not every factor may be relevant to all situations. A9.5. 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. 72 Epstein, 2009 SEC LEXIS 217, at *72; see also Sathianathan, 2006 SEC LEXIS 2572, at *23. [Notice 12-25 (FAQ 20)]. Finally, broker-dealers must keep in mind that, in addition to suitability and supervisory responsibilities, firms have other regulatory obligations to investigate unusual activity. Firms seeking to rely on the provision should take a conservative approach to determining whether a particular communication is eligible for such treatment. For purposes of the suitability rule, how should a firm document recommendations to hold in particular and recommendations of strategies more generally? If a firm's call center informs customers that they are permitted to continue to maintain their investments at the firm under such circumstances, would FINRA consider those communications to be "hold" recommendations triggering application of the new suitability rule? What further action a broker-dealer will need to take will depend on the facts and circumstances of the particular case. Any significant variation from the list in the safe-harbor provision would be subject to regulatory scrutiny. [Notice 12-25 (FAQ 13)], A9.2. [Notice 11-25 (FAQ 5)]. [Notice 12-25 (FAQ 22)], A5.1. See Cody, 2011 SEC LEXIS 1862, at *48 (finding turnover rate of three provided support for excessive trading); Dep't of Enforcement v. Stein, 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. FINRA expects a firm to be capable of explaining how an asset allocation model that it uses is consistent with generally accepted investment theory. No. Quantitative suitability requires a broker who has actual or de facto control63 over a customer account to have a reasonable basis for believing that, in light of the customer's investment profile, a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer.64 Factors such as turnover rate,65 cost-to-equity ratio,66 and use of in-and-out trading67 in a customer's account may provide a basis for finding that the activity at issue was excessive. 40 See id. Firms must attempt to obtain and analyze relevant customer-specific information. [Notice 12-55 (FAQ 10(b)]. Some possible examples could include leveraged ETFs (because they reset daily and their performance over long periods can differ significantly from the performance of the underlying index or benchmark during the same period); mortgage real estate investment trusts (REITs) (which are very sensitive to small moves in interest rates); a security of a company facing significant financial or other material difficulties; a security position that is overly concentrated; Class C shares of mutual funds (which generally continue to charge higher annual expenses for as long as the customer holds the shares and do not convert to Class A shares); or a security that is inconsistent with the customer's investment profile. "); Paul C. Kettler, 51 S.E.C. Recently FINRA Rule 2111 went into effect regarding Suitability. 20100224056, 2012 FINRA Discip. [1] Weirdly, Rule 2330 does NOT explicitly cover recommendations involving a strategy, as Rule 2111 does. Rule 2330 requires a registered principal to review and determine whether to approve a customers application for a deferred variable annuity How does FINRA define the terms "liquidity needs," "time horizon" and "risk tolerance" for purposes of the suitability rule? 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. Costello v. Oppenheimer & Co., 711 F.2d 1361, 1369 n.9 (7th Cir. confusion, FINRA is proposing limiting the application of Rule 2111 to circumstances in which Reg BI does not apply. 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[. 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. 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. No. 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. 551, 2002 SEC LEXIS 104 (2002); FINRA Interpretive Letter, Mar. [Notice 12-25 (FAQ 21)], A3.11. No. A3.10. The rule also explicitly covers recommended investment strategies involving securities, including recommendations to "hold" securities. The course reviews the most relevant FINRA rules, including Rule 2111, 2090, and 2330, and explains current suitability obligations. No. 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. 306 (2012). 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)? 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." "); Paul C. Kettler, 51 S.E.C. 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. 4 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. Some third-party vendors have created "Institutional Suitability Certificates" to facilitate firms' compliance with the new institutional-customer exemption in Rule 2111(b). 30, 32 n.11 (1992) (stating that transactions a broker effects for a discretionary account are implicitly recommended). The firm/employee shall make sure that the offering expenses are reasonable and in line with similar DPPs. What is the FINRA Rule 2330? 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. A6.1. 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. 2010), cert. 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. Rule 2330 requires firms to have written policies and procedures in place for surveillance of brokers recommending, purchasing or exchanging of deferred variable annuities. 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). 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." 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? No. Importantly, while Reg BI, like Rule 2111, requires that a recommendation must be based on information reasonably known to the associated person (based on her reasonable A4.2. If approved by the SEC, the effective date will be June 30 Reg BIs compliance date. See also [infra note 86; Regulatory Notice 12-25, at 19 n.12]. The significance of specific types of customer information will depend on the facts and circumstances of the particular case.24, Q3.4. 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. 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. 94 In Notice to Members 99-45, FINRA said that the supervision rule "requires that a [firm's] supervisory system be reasonably designed to achieve compliance with applicable laws and regulations. C3A040016 (Mar. See SEA Rule 17a-3(a)(17)(i)(A). Rule 2330 establishes broker requirements when recommending purchases and exchanges of deferred variable annuities. The new suitability rule (as with the predecessor rule) requires a broker to seek to obtain and analyze a customer's other investments. 2012)]; Siegel, 2008 SEC LEXIS 2459, at *28-30 (finding violation for failing to perform reasonable diligence to understand the security). 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. See also [Regulatory Notice 11-25, at 9 n.6]. 30, 32 n.11, 1992 SEC LEXIS 2750, at *5 n.11 (1992) (stating that transactions a broker effects for a discretionary account are implicitly recommended). 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. C07000003, 2001 NASD Discip. See SEA Rule 17a-3(a)(17)(i)(B)(1). 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. Although FINRA does not define the term "recommendation," it has offered several guiding principles that firms and brokers should consider when determining whether particular communications could be viewed as recommendations. Id. A4.5. In general, the focus remains on whether the recommendation was suitable at the time when it was made. 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." 47 See Notice to Members 05-50, at 5 ("[R]ecommendations to liquidate or surrender a registered security such as a mutual fund, variable annuity, or variable life contract must be suitable, including where such liquidations or surrender[s] are for the purpose of funding the purchase of an unregistered [equity indexed annuity]."). 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. [Notice 12-25 (FAQ 16)]. 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[.]" 59 FINRA[, in FAQ 5.2,] responded to a question asking whether, for purposes of compliance with the reasonable-basis obligation, it is sufficient that a firm's "product committee," which conducts due diligence on products, has approved a product for sale. [FAQ 5.2]. 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. That includes requiring a reasonable belief that the customer has 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. other "red flags" exist indicating that the customer information may be inaccurate. 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. 22 See DBCC v. Hurni, No. 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. 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. 55988, 2007 SEC LEXIS 1407, at *21-23 (June 29, 2007) (describing the speculative nature of three low-priced securities at issue); Faber, 2004 SEC LEXIS 277, at *25 (discussing speculative nature of the security of a company that "had no revenues and had never showed any profits"); Jack H. Stein, 56 S.E.C. 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. Q1.1. 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. 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. 71 See Belden, 56 S.E.C. Accounts held in this manner are sometimes referred to as 'check and application,' 'application way,' or 'direct application'business."). It is important to note, however, that the suitability rule would not apply to a firm's explanation of a strategy falling outside the safe-harbor provision if a reasonable person would not view the communication as a recommendation. Rule 2111 would cover a recommendation to recommendations. LEXIS 10362, *4-5 (9th Cir. 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. See, e.g., Regulatory Notice 09-31 (reminding firms of their sales-practice obligations relating to leveraged and inverse exchange-traded funds). See [FAQ 4.6]. For "hold" recommendations, [as discussed below in FAQ 9.3,] a firm may want to focus on 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 a product's character over time; that are particularly susceptible to changes in market conditions; or that are otherwise potentially risky or problematic to hold at the time the recommendations are made.89. LEXIS 36, at *22 (NAC Oct. 3, 2011) (same); Dep't of Enforcement v. Cody, No. These are only examples of how some firms may document "hold" recommendations if necessary. 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. In addition, documentation by itself does not cure an otherwise unsuitable recommendation. 297, 310, 2004 SEC LEXIS 277, at *23-24 (2004) (stating that a "broker's recommendations must be consistent with his customer's best interests" and are "not suitable merely because the customer acquiesces in [them]"); Wendell D. Belden, 56 S.E.C. 333 (2010). 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. The institutional-customer exemption does not apply to reasonable-basis and quantitative suitability. 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. 96 See also supra note [48] and discussion therein. 73 Robin B. McNabb, 54 S.E.C. 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