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. No. 333 (2010). SEA Rule 17a-3(a)(17)(i)(C). 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. [Notice 11-25 (FAQ 3)]. 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"). Registered representatives can fulfill Continuing Education requirements, view their industry CRD record and perform other compliance tasks. 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. 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. ), cert. 61 See, e.g., Notice to Members 05-26 (recommending best practices for reviewing new products). Harry Gliksman, 54 S.E.C. 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. [Notice 12-25 (FAQ 5)], A1.4. Q3.2. That will not always be the case, however. [Notice 12-25 (FAQ 13)], A9.2. A customer could proceed in such a manner, but a firm should evidence the customer's intent to use different investment profiles or investment-profile factors for the different accounts. denied, 130 S.Ct. 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. Quantitative suitability likely will apply in more limited circumstances with regard to institutional customers than it does as to retail customers. A customer, for example, may not want to divulge information about "other investments" held away from the broker-dealer in question. Is the quantitative suitability obligation under the new rule any different from the excessive trading line of cases under the predecessor rule? [Notice 12-25 (FAQ 2)], A1.1. 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). [1] Weirdly, Rule 2330 does NOT explicitly cover recommendations involving a strategy, as Rule 2111 does. 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. 30 See supra note [22] and cases cited therein. [Notice 12-25 (FAQ 22)], A5.1. ", A broker who recommended "that his customers purchase promissory notes to give him money to use in his business.". A suitability analysis of a particular recommendation and consideration of a customer's overall investment portfolio, however, are not mutually exclusive concepts. 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 62 See FINRA Rule 2111.05(a). 37 See FINRA Rule 2111.03. In that regard, and as explained above in the answer to [FAQ 1.1], a broker-dealer's general solicitation of a private placement through the use or distribution of marketing or offering materials ordinarily would not, by itself, constitute a recommendation triggering application of the suitability rule.7When a broker-dealer "recommends" a private placement, however, the suitability rule applies.8, Q2.1. 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. 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. Q4.6. 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. [Notice 12-55 (FAQ 6(b))], A2.2. Q4.1. 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. A3.5. 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. Q8.2. Rule 2330 requires firms to have written policies and procedures in place for surveillance of brokers recommending, purchasing or exchanging of deferred variable annuities. 331, 341 n.22, 1999 SEC LEXIS 1754, at *20 n.22 (1999) ("Transactions that were not specifically authorized by a client but were executed on the client's behalf are considered to have been implicitly recommended within the meaning of [FINRA's suitability rule]. 88 See, e.g., Cody, 2011 SEC LEXIS 1862, at *36-40 (discussing non-investment grade securities); Wells Fargo Invs., LLC, AWC No. The significance of specific types of customer information will depend on the facts and circumstances of the particular case.24, Q3.4. 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."). Id. Servs. Q3.12. 1983). FINRA cautioned, however, that a firm should evidence a customer's intent to use different investment profiles or factors for the different accounts. That is true regardless of whether the associated person previously recommended the purchase of the securities, the customer purchased them without a recommendation, or the customer transferred them into the account from another firm where the same or a different associated person had handled the account.38, Q4.2. 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." Pinchas, 54 S.E.C. It also is important to note that, where an institutional customer has delegated decisionmaking authority to an agent, such as an investment adviser or a bank trust department, Rule 2111(b) makes clear that the factors relevant to determining whether the customer meets the criteria for the institutional-customer exemption will be applied to the agent. 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. Reasonable Basis Obligation This means the 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. Would a broker, for example, be responsible for a hold recommendation involving blue chip stocks that a customer transferred into an account at the broker-dealer? Can a broker who does not understand the risks associated with a recommendation violate the reasonable-basis obligation even if the recommendation is suitable for some investors? What is the difference between Rule 2111 and Rule 2330? A3.1. However, as explained in FAQ [1.2], the rule would not cover an implicit recommendation to hold. "); 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."). 76 Howard, 55 S.E.C. Q9.4. 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. 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.49, Q4.5. 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. A8.3. Id. As discussed above, aside from the instances when a firm determines not to seek certain information (addressed in [FAQ 3.4]), FINRA Rule 2111 does not impose explicit documentation requirements. 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]."). [Notice 12-25 (FAQ 3)], A1.2. [FINRA Rule 2214 replaced NASD IM-2210-6 (Requirements for the Use of Investment Analysis Tools)]. These (and many other) FINRA rules provide broad and significant protections to investors. 77 It is important to keep in mind that, in addition to the suitability rule, FINRA has numerous other investor-protection rules. In many circumstances, the answer is yes. 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. No. A turnover rate greater than six creates a presumption that the trading was excessive. 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. 20452 (Apr. 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? 4 See, e.g., Rafael Pinchas, 54 S.E.C. A9.3. C07960035, 1997 NASD Discip. [Notice 12-25 (FAQ 23)]. See FINRA Rule 2111.03. [Notice 12-25 (FAQ 9)]. 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. 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. 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. Would a recommendation to maintain an asset mix that was based on an asset allocation model that meets the criteria described in the rule fall within the safe-harbor provision in Rule 2111.03? A3.6. Recently FINRA Rule 2111 went into effect regarding Suitability. 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. 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. FINRA Rule 2111 does not define the terms. FINRA has stated that the new suitability rule does not broaden the scope of implicit recommendations applicable to the predecessor rule. 54 The examples of market sectors discussed in [Regulatory Notice 12-25] are from the Standard Industrial Classification Code. Chase, 56 S.E.C. 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 471, 475, 1999 SEC LEXIS 2685, at *7 (1999). 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. What is the scope of the safe-harbor provision in Rule 2111.03 regarding a firm's use of an asset allocation model? Some firms may create "hold" tickets and some may add "hold" sections to existing order tickets. See SEA Rule 17a-3(a)(17)(i). What types of "hold" recommendations should firms consider documenting? 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. 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 constitutes "reasonable diligence" in attempting to obtain the customer-specific information? These models often take into account the historic returns of different asset classes over defined periods of time. 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. at 1100, 2002 SEC LEXIS 1909, at *6-7. "); Paul C. Kettler, 51 S.E.C. 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." Id. Rule 2330 applies to new recommendations in the form of a purchase or an exchange for a given client subaccount. Turnover rates between three and six may trigger liability for excessive trading. 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. 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. Reg. As FINRA has stated previously, "FINRA appreciates that no two [broker-dealers] are exactly alike. 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. Q3.5. Id. 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. 13 Nothing in this guidance shall be construed as altering a broker-dealer's obligations under applicable federal laws, regulations and rules or other FINRA rules, including, but not limited to, Sections 9, 10(b) and 15(c) of the Securities Exchange Act of 1934, Section 17(a) of the Securities Act of 1933, the Bank Secrecy Act, 31 U.S.C. How should a firm document "hold" recommendations? Id. "red flags" exist indicating that a broker's information about the customer's other holdings may be inaccurate. 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. FINRA explained in one instance under the predecessor rule that "recommending liquefying home equity to purchase securities may not be suitable for all investors. 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. Costello v. Oppenheimer & Co., 711 F.2d 1361, 1369 n.9 (7th Cir. 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. 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[.]" This document consolidates the questions and answers in Regulatory Notices 12-55, 12-25 and 11-25, organized by topic. Arbitration and mediation case participants and FINRA neutrals can view case information and submit documents through this Dispute Resolution Portal. Thus, identifying a more limited universe of debt issuers may not constitute a recommendation if such issuers have many debt securities outstanding, of many maturities, and having distinct structures or features. 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"). No. LEXIS 20, at *38 (NAC May 11, 2007), aff'd, Exchange Act Rel. FINRA IS A REGISTERED TRADEMARK OF THE FINANCIAL INDUSTRY REGULATORY AUTHORITY, INC. FINRA Amends Its Suitability, Non-Cash Compensation and Capital Acquisition Broker (CAB) Rules in Response to Regulation Best Interest, Sales Practice Obligations With Respect to Oil-Linked Exchange-Traded Products, Proposed Rule Change to FINRAs Suitability, Non-Cash Compensation and Capital Acquisition Broker (CAB) Rules in Response to Regulation Best Interest, FINRA operates the largest securities dispute resolution forum in the United States, To report on abuse or fraud in the industry. [Notice 12-25 (FAQ 17)], A3.3. 21 For an expanded discussion of this issue, see [FAQ 3.4]. Unless the facts indicate that an associated person's failure to sell securities in a discretionary account was intended as or tantamount to an explicit recommendation to hold, FINRA would not view the associated person's inaction or silence in such circumstances as a recommendation to hold the securities for purposes of the suitability rule. [Notice 12-25 (FAQ 20)]. 306 (2012). The rule states that it applies to explicit recommendations to hold. 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. [Notice 12-25 (FAQ 11)]. 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. 53 FINRA Rule 2111.03. What is the scope of the term "strategy" as used in FINRA Rule 2111? Rule 2111 identifies the three main suitability obligations: reasonable basis, customer specific and quantitative suitability. 58737, 2008 SEC LEXIS 2459 (Oct. 6, 2008), aff'd in relevant part, 592 F.3d 147 (D.C. Cir. 6 Pub. Notice to Members 04-89, at 3. A4.2. See also Donna M. Vogt, AWC No. Yes. See also [infra note 86; Regulatory Notice 12-25, at 19 n.12]. 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. 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. 1996) (same); Robert L. Wallace, 53 S.E.C. As discussed above in the answer to [FAQ 4.7], Rule 2111.03 provides a safe harbor for firms' use of asset allocation models that are, among other things, based on "generally accepted investment theory." Firm compliance professionals can access filings and requests, run reports and submit support tickets. A broker can violate reasonable-basis suitability under either prong of the test. "); F.J. Kaufman and Co., 50 S.E.C. No. No. The rule explicitly states that the term "strategy" should be interpreted broadly.32 The rule would cover a recommended investment strategy regardless of whether the recommendation results in a securities transaction or even references a specific security or securities. Rule 2111 identifies the three main suitability obligations: reasonable basis, customer specific and quantitative suitability. 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. Firms may continue to use such approaches. 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. 1096, 1100, 2002 SEC LEXIS 1909, at *5-6 (2002) (same), aff'd, 77 F. App'x 2 (1st Cir. 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.
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