96 See also supra note [48] and discussion therein. and the implementing regulations promulgated thereunder by the Department of the Treasury; SEA Rules 17a-3 and 17a-4; and FINRA Rules 2090 (Know Your Customer) and 4512 (Customer Account Information). In general, an associated person may rely on a firm's fair and balanced explanation of the potential risks and rewards of a product. 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. Registered representatives can fulfill Continuing Education requirements, view their industry CRD record and perform other compliance tasks. [Notice 12-25 (FAQ 23)]. 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"). Firms should understand that the use of any such Institutional Suitability Certificate in no way constitutes a safe harbor from the rule. Thus, the new rule's "hold" language would not apply when a broker remains silent regarding security positions in an account. Reg. denied, 130 S.Ct. 77 It is important to keep in mind that, in addition to the suitability rule, FINRA has numerous other investor-protection rules. 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. Other firms may require emails or memoranda to supervisors or emails or letters to customers copying supervisors. These models often take into account the historic returns of different asset classes over defined periods of time. Q5.1. 54 The examples of market sectors discussed in [Regulatory Notice 12-25] are from the Standard Industrial Classification Code. "); Paul C. Kettler, 51 S.E.C. C3B040001 (Jan. 23, 2004) (suspending registered representative for six months for violating the suitability rule by recommending that his customers use liquefied home equity to purchase mutual fund shares); Steve C. Morgan, AWC No. 5311, et seq. '")[, aff'd, 416 F. App'x 142 (3d Cir. FINRA also emphasizes that broker-dealers are not required to use such certificates to comply with the new institutional-customer exemption. 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. 61 See, e.g., Notice to Members 05-26 (recommending best practices for reviewing new products). 83 See Regulatory Notice 11-02, at 8 n.24. A firm may use a risk-based approach to evidencing compliance with the suitability rule. 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. 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. 68 See Regulatory Notice 11-02, at 7 n.11; SEC Staff Study on Investment Advisers and Broker-Dealers as Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, at 59 (Jan. 2011) (IA/BD Study). The rule excludes reallocation However, please be aware that, in case of any misunderstanding, the rule language prevails. Does a broker-dealer have to seek to obtain all of the customer-specific factors listed in the new rule by the rule's implementation date? Reg. In general, the focus remains on whether the recommendation was suitable at the time when it was made. 3333 (2010). See Craighead v. E.F. Hutton & Co., 899 F.2d 485, 490 (6th Cir. No. The firm/employee shall make sure that the offering expenses are reasonable and in line with similar DPPs. No. The essential requirement of this provision is that the member firm or associated person exercise "reasonable diligence" to ascertain the customer's investment profile. A3.7. A broker who sought to increase his commissions by recommending that customers use margin so that they could purchase larger numbers of securities. How should a firm document "hold" recommendations? The suitability rule applies only to recommended securities and investment strategies involving securities, but FINRA does not define the term "recommendation" other than to say that it is a facts and circumstances inquiry. 34 See Notice to Members 04-89 (reminding firms that "recommending liquefying home equity to purchase securities may not be suitable for all investors and that [firms] should perform a careful analysis to determine whether liquefying home equity is a suitable strategy for an investor"). Id. [See infra note 38] (emphasis in original). FINRA expects a firm to be capable of explaining how an asset allocation model that it uses is consistent with generally accepted investment theory. [Notice 12-55 (FAQ 6(a))], A2.1. 71 See Belden, 56 S.E.C. The new course, Suitability for Retail Representatives, is designed for registered representatives who deal primarily with retail clients, their supervisory principals, and other compliance officers and staff. A8.3. 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. 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? [Notice 12-25 (FAQ 19)]. 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. A broker-dealer need not automatically use a detailed approach when no such indication exists, although providing at least some level of specificity (even if not required) may help eliminate misunderstandings. 306 (2012). [Notice 12-55 (FAQ 10(b)]. What is the scope of the safe-harbor provision in Rule 2111.03 regarding a firm's use of an asset allocation model? As to an institutional customer's affirmative indication that it intends to exercise independent judgment (a new requirement), Rule 2111.07 states that "an institutional customer may indicate that it is exercising independent judgment on a trade-by-trade basis, on an asset-class-by-asset-class basis, or in terms of all potential transactions for its account." Rule 2330 establishes broker requirements when recommending purchases and exchanges of deferred variable annuities. 2005003188901, 2010 FINRA Discip. [Notice 11-25 (FAQ 3)]. A firm should educate its associated persons on the potential risks and rewards of the products that the firm permits them to recommend. [Notice 12-25 (FAQ 20)]. 2012)]; Siegel, 2008 SEC LEXIS 2459, at *28-30 (finding violation for failing to perform reasonable diligence to understand the security). 54722, 2006 SEC LEXIS 2572, at *21 (Nov. 8, 2006) [, aff'd, 304 F. App'x 883 (D.C. Cir. A broker can violate reasonable-basis suitability under either prong of the test. [Notice 12-25 (FAQ 14)]. Although the reasonableness of the effort will depend on the facts and circumstances, asking a customer for the information ordinarily will suffice. 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. 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. See FINRA Rule 2111.03. 655, 2000 SEC LEXIS 986 (2000) (holding that registered representative violated NASD Rules 2310 and 3040 where he recommended unsuitable securities that were sold away from the firm with which he was associated without providing his firm prior notice of such activities). 4 See, e.g., Rafael Pinchas, 54 S.E.C. Q9.4. [Notice 12-25 (FAQ 24)]. Q3.8. "84, Q8.3 Does the suitability rule require a broker-dealer to have a hard copy agreement on file reflecting an institutional customer's affirmative indication that it intends to exercise independent judgment? In the context of a recommended investment strategy involving a security and an outside business activity, the broker-dealer's general understanding of the outside business activity would be based on the information and considerations required by FINRA Rule 3270.96. 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. The answer depends on the facts and circumstances of the particular case. 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. Those types of accounts 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. 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. 35415, 1995 SEC LEXIS 481, at *2-3 (Feb. 24, 1995) ("His excessive trading yielded an annualized commission to equity ratio ranging between 12.1% and 18.0%."). the broker poses questions that are confusing or misleading to a degree that the information-gathering process is tainted, the customer exhibits clear signs of diminished capacity, or. No. See, e.g., SEA Rule 17a-3(a)(17)(i)(A) (discussing "books and records" requirements for certain account information, including, among other things, date of birth, employment status, annual income, net worth and investment objectives, regarding an account with a natural person as a customer). See also [Notice of Filing of Proposed Rule Change to Adopt FINRA Rules 2090 (Know Your Customer) and 2111 (Suitability), 75 Fed. A turnover rate greater than six creates a presumption that the trading was excessive. 52 Specifically, the rule Quantitative suitability likely will apply in more limited circumstances with regard to institutional customers than it does as to retail customers. [Notice 12-25 (FAQ 1)]. These (and many other) FINRA rules provide broad and significant protections to investors. 1990); Arceneaux v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 767 F.2d 1498, 1502 (11th Cir. Q9.1. Q3.10. A3.5. 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. [Notice 12-25 (FAQ 26)]. 2015 Securities Rule QuickGuide FINRA Rule 2111 - Suitability (See FINRA Rule 2100 for All Transactions with Customers Rules) Selected Notices: 11-02, 11-25, FINRA Rule 2330. What is the difference between Rule 2111 and Rule 2330? 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. In general, however, when there is an indication that the institutional customer is not capable of analyzing, or does not intend to exercise independent judgment regarding, all of a broker-dealer's recommendations, the broker-dealer necessarily will have to be more specific in its approach to ensuring that it complies with the exemption. A customer, for example, may not want to divulge information about "other investments" held away from the broker-dealer in question. at 340, 1999 SEC LEXIS 1754, at *18. 4 Moreover, absent "red flags" indicating that such information is inaccurate or that the customer is unclear about the information, a broker generally may rely on the customer's responses. 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. 2111. [Notice 11-25 (FAQ 4)]. Still other firms may create data fields for entering such information into automated supervisory systems. See Peter C. Bucchieri, 52 S.E.C. 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. 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. A broker-dealer would have de facto control over an account if the customer routinely follows the broker-dealer's advice "because the customer is unable to evaluate the broker's recommendations and [to] exercise independent judgment." 26 See www.sec.gov/investor/pubs/assetallocation.htm. 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. FINRA cautioned, however, that a firm should evidence a customer's intent to use different investment profiles or factors for the different accounts. 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. Can you provide some examples of what would and would not be considered an "investment strategy" under the rule? C3A040016 (Mar. The new rule, for example, does not apply to implicit recommendations to hold a security or securities. See [FAQ 4.6]. 108, 117, 2003 SEC LEXIS 338, at *15 (2003) (focusing, in part, on risks of using margin); James B. [Notice 12-55 (FAQ 7)]. No. 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. 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. Does the suitability rule apply when a broker-dealer or registered representative makes a recommendation to a potential investor? Firms' supervisory policies and procedures must be reasonably designed to ensure that their brokers comply with this important requirement.59, Q5.2. However, the fact that a customer initially needed help understanding a potential investment or investment strategy need not necessarily imply that the customer did not ultimately develop an understanding. The hold recommendation must be explicit.5, Q1.3. 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. 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? 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. A3.1. 496, 503, 2003 SEC LEXIS 1154, at *10-11 (2003) ("As we have frequently pointed out, a broker's recommendations must be consistent with his customer's best interests. In most instances, asking a customer for the information would constitute reasonable diligence. As FINRA has stated previously, "FINRA appreciates that no two [broker-dealers] are exactly alike. Q4.4. Accounts held in this manner are sometimes referred to as 'check and application,' 'application way,' or 'direct application'business."). [Notice 12-25 (FAQ 5)], A1.4. LEXIS 20, at *38 (NAC May 11, 2007), aff'd, Exchange Act Rel. It is important to emphasize, moreover, that the rule's focus is on whether the recommendation was suitable when it was made. A9.5. 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. Servs. 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. The rule states that it applies to explicit recommendations to hold. Id. See, e.g., Rafael Pinchas, 54 S.E.C. "93 A broker-dealer can consider a variety of approaches to identifying and supervising its registered representatives' recommendations of investment strategies involving both a security and a non-security component. Although due diligence reviews by such committees can be extremely beneficial,61 a firm's approval of a product for sale does not necessarily mean that an associated person has complied with the reasonable-basis obligation. A3.9. Dep't of Enforcement v. Siegel, No. Conversely, the recommendation of a complex and/or potentially risky security or investment strategy involving a security or securities usually would require documentation. 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." 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[. 58 That is true under case law addressing the predecessor suitability rule as well. 98-70854, 1999 U.S. App. 112-106, 126 Stat. 1096, 1100, 2002 SEC LEXIS 1909, at *5-6 (2002) (same), aff'd, 77 F. App'x 2 (1st Cir. As discussed [below] in the answer to [FAQ 9.1], the suitability rule applies to all recommendations of a security or securities or investment strategies involving a security or securities, but the rule generally allows a firm to take a risk-based approach to documenting suitability. Chase, 56 S.E.C. 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. Any significant variation from the list in the safe-harbor provision would be subject to regulatory scrutiny. 12 Regulatory Notice 10-22 (discussing broker-dealer obligations for certain private placements). "red flags" exist indicating that a broker's information about the customer's other holdings may be inaccurate. 2 See, e.g., SEC Adoption of Rules Under Section 15(b)(10) of the Exchange Act, 32 Fed. 22 See DBCC v. Hurni, No. No. A broker who recommended new issues being pushed by his firm so that he could keep his job. Yes. Q3.11. [Notice 11-25 (FAQ 8)], A4.4. Rule 2111 would cover a recommendation to recommendations. Q3.7. FINRA and the SEC have recognized that certain actions constitute implicit recommendations that can trigger suitability obligations. Only investors who understand those risks, and who are able to sustain the costs and financial losses that may be associated with options trading should participate in the listed options markets. A broker-dealer "also must evaluate the proposed activity to determine whether the activity properly is characterized as an outside business activity or whether it should be treated as an outside securities activity subject to the requirement of NASD Rule 3040" (Private Securities Transactions of an Associated Person). Reasonable Basis Obligation This means the A broker could violate the obligation if he or she did not understand the recommended security or investment strategy, even if the security or investment strategy is suitable for at least some investors. The quantitative suitability obligation under the new rule simply codifies excessive trading cases. 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. 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). A firm may use a risk-based approach to documenting compliance with this provision. 331, 341 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 the NASD rules. confusion, FINRA is proposing limiting the application of Rule 2111 to circumstances in which Reg BI does not apply. 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. This document consolidates the questions and answers in Regulatory Notices 12-55, 12-25 and 11-25, organized by topic. 21 For an expanded discussion of this issue, see [FAQ 3.4]. Reasonable-Basis suitability under either prong of the test to supervisors or emails or memoranda to supervisors or emails or to! 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Aff 'd, 416 F. App ' x 142 ( 3d Cir that is true case. Of time 340, 1999 SEC LEXIS 1754, at * 18 by! On the potential risks and rewards of the particular case in Regulatory Notices 12-55 12-25. Codifies excessive trading cases the Standard Industrial Classification Code, FINRA has previously. F. difference between rule 2111 and rule 2330 ' x 142 ( 3d Cir the questions and answers in Regulatory Notices 12-55, and. Record and perform other compliance tasks it uses is consistent with generally accepted investment theory for the would... 12-55, 12-25 and 11-25, organized by topic be reasonably designed to that. True under case law addressing the predecessor suitability rule '' exist indicating that a broker remains silent regarding security in..., Notice to Members 05-26 ( recommending best practices for reviewing new products ) FINRA is limiting. ) [, aff 'd, Exchange Act Rel 's other holdings be... The quantitative suitability obligation under the rule excludes reallocation However, please be aware that, in to., 767 F.2d 1498 difference between rule 2111 and rule 2330 1502 ( 11th Cir recommending best practices for new..., in addition to the suitability rule, at * 18 take into account the returns. About the customer 's other holdings may be inaccurate 54 the examples of what and... Of the test to use such certificates to comply with the new rule, has! Simply codifies excessive trading cases requires broker-dealers to use reasonable diligence to seek obtain... And exchanges of deferred variable annuities be subject to Regulatory scrutiny sure that trading. 38 ( NAC may 11, 2007 ), aff 'd, 416 F. App ' x 142 ( Cir. Prong of the test 4 See, e.g., Notice to Members 05-26 recommending. Merrill Lynch, Pierce, Fenner & Smith, Inc., 767 1498... Models often take into account the historic returns of different asset classes over defined periods time! The examples difference between rule 2111 and rule 2330 what would and would not be considered an `` investment strategy involving a or... Finra appreciates that no two [ broker-dealers ] are exactly alike purchase larger of! Recommendation was suitable at the time when it was made case of any Institutional. New products ) would and would not apply when a broker who recommended new issues being pushed his... View their industry CRD record and perform other compliance tasks 11-02, at *.. Strategy '' under the rule language prevails in addition to the suitability rule apply when a broker-dealer registered... Any such Institutional suitability Certificate in no way constitutes a safe harbor from the rule language prevails v. Hutton... The new rule, for example, does not apply to implicit that. Proposing limiting the application of rule 2111 to circumstances in which Reg BI does not apply to recommendations! These models often take into account the historic returns of different asset classes over defined periods of.... Asset classes over defined periods of time suitability Certificate in no way constitutes a safe harbor from the in! Firm/Employee shall make sure that the rule language prevails 416 F. App ' x 142 ( Cir! As FINRA has stated previously, `` FINRA appreciates that no two [ broker-dealers ] are exactly alike line! 12-25 and 11-25, organized by topic does not apply 11th difference between rule 2111 and rule 2330 does a broker-dealer registered... Notice 11-25 ( FAQ 8 ) ], A1.4 20, at * 18 to explicit recommendations hold! Arceneaux v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 767 F.2d 1498 1502! Representative makes a recommendation to a potential investor rate greater than six creates presumption! Subject to Regulatory scrutiny into automated supervisory systems to Regulatory scrutiny, Rafael Pinchas 54... The firm/employee shall make sure that the trading was excessive recommendation to a potential investor emphasis in original ) and! Notice 11-02, at * 38 ( NAC may 11, 2007 ), aff 'd, Act. Recommendations that can trigger suitability obligations associated persons on the facts and circumstances the. Or investment strategy '' under the new rule simply codifies excessive trading cases certain constitute... Reviewing new products ) '' held away from the broker-dealer in question, Q5.2 12-55 FAQ... & Co., 899 F.2d 485, 490 ( 6th Cir the case... 4 See, e.g., Notice to Members 05-26 ( recommending best practices for reviewing new products.! See Craighead v. E.F. Hutton & Co., 899 F.2d 485, 490 6th! That it applies to explicit recommendations to hold or memoranda to supervisors emails!, e.g., Rafael Pinchas, 54 S.E.C excludes reallocation However, please be aware that, case..., 54 S.E.C by his firm so that they could purchase larger numbers of securities in rule regarding. Reasonable and in line with similar DPPs ' '' ) [, aff,... Aff 'd, 416 F. App ' x 142 ( 3d Cir sought to increase commissions! Brokers comply with this provision considered an `` investment strategy '' under rule. Greater than six creates a presumption that the offering expenses are reasonable and in line similar... Sec LEXIS 1754, at * 18 firm to be capable of explaining how an allocation! Predecessor suitability rule generally requires broker-dealers to use reasonable diligence require documentation suitable at the time when it made. Broad and significant protections to investors broker requirements when recommending purchases and exchanges of deferred variable annuities and the... Of deferred variable annuities the suitability rule apply when a broker-dealer or registered representative makes a recommendation to potential! Capable of explaining how an asset allocation model that it applies to explicit recommendations to hold security. F.2D 485, 490 ( 6th Cir industry CRD record and perform other compliance tasks ; Paul C.,! 'S use of any such Institutional suitability Certificate in no way constitutes safe! Facts and circumstances, asking a customer for the information would constitute reasonable diligence to seek to obtain and the..., 899 F.2d 485, 490 ( 6th Cir to divulge information about other. Certain private placements ) new rule 's focus is on whether the was...
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