FINRA's supervision rules do not dictate the exact manner in which a broker-dealer must supervise its registered representatives' recommendations of investment strategies involving a security and a non-security investment. 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. Q3.10. 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? Arbitration and mediation case participants and FINRA neutrals can view case information and submit documents through this Dispute Resolution Portal. Cost-to-equity ratios as low as 8.7 have been considered indicative of excessive trading, and ratios above 12 generally are viewed as very strong evidence of excessive trading. Similarly, a registered representative's recommendation that a "buy and hold" customer with an investment objective of income liquidate large positions in blue chip stocks paying regular dividends might raise a "red flag" regarding whether that recommendation is part of a broader investment strategy. 551, 2002 SEC LEXIS 104 (2002); FINRA Interpretive Letter, Mar. The rule requires that a broker seek to obtain18 and consider relevant customer-specific information when making a recommendation. 69 Raghavan Sathianathan, Exchange Act Rel. 5311, et seq. [Notice 12-25 (FAQ 19)]. 57 FINRA Rule 2111.05(a). That includes requiring a reasonable belief that the customer has What is a firm's responsibility when customers indicate that they have multiple investment objectives that appear inconsistent? "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. A1.3. [Notice 11-25 (FAQ 4)]. 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. LEXIS 38, at *17 (NAC Dec. 3, 2001) ("Turnover rates between three and five have triggered liability for excessive trading"). Rule 2330 requires a registered principal to review and determine whether to approve a customers application for a deferred variable annuity 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"). By way of background, the new suitability rule modifies the institutional-customer exemption that existed under the predecessor rule (NASD IM-2310-3). 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." 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." "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. 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. [Notice 12-25 (FAQ 3)], A1.2. [1] Weirdly, Rule 2330 does NOT explicitly cover recommendations involving a strategy, as Rule 2111 does. Rule 2330 applies to new recommendations in the form of a purchase or an exchange for a given client subaccount. The new rule explains that, "[i]n general, what constitutes reasonable diligence will vary depending on, among other things, the complexity of and risks associated with the security or investment strategy and the [broker-dealer's] familiarity with the security or investment strategy. What is the nature of the obligation under the suitability rule created by a hold recommendation? A3.10. 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. Yes. What are the conditions under which an implicit recommendation can trigger the suitability rule? Accordingly, the suitability rule would cover a firm's recommendation that a customer purchase securities using margin, whereas the rule generally would not cover a firm's brochure that simply explains the risks and benefits of margin without suggesting that the customer take action.51, Q4.7. 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. 1985). 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. 61 See, e.g., Notice to Members 05-26 (recommending best practices for reviewing new products). "); F.J. Kaufman and Co., 50 S.E.C. A6.1. This rule does not apply to: Transfers and 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. [FAQ 5.2]. "); see also Jack H. Stein, 56 S.E.C. A3.6. 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. Some firms may create "hold" tickets and some may add "hold" sections to existing order tickets. Registered representatives can fulfill Continuing Education requirements, view their industry CRD record and perform other compliance tasks. A suitability analysis of a particular recommendation and consideration of a customer's overall investment portfolio, however, are not mutually exclusive concepts. 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. 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. 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. [Notice 12-25 (FAQ 21)], A3.11. Rule 2111 states that the term "investment strategy" is to be interpreted "broadly. 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. 12 Regulatory Notice 10-22 (discussing broker-dealer obligations for certain private placements). "69 The suitability requirement that a broker make only those recommendations that are consistent with the customer's best interests prohibits a broker from placing his or her interests ahead of the customer's interests.70 Examples of instances where FINRA and the SEC have found brokers in violation of the suitability rule by placing their interests ahead of customers' interests include the following: The requirement that a broker's recommendation must be consistent with the customer's best interests does not obligate a broker to recommend the "least expensive" security or investment strategy (however "least expensive" may be quantified), as long as the recommendation is suitable and the broker is not placing his or her interests ahead of the customer's interests. No. 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"). 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). However, despite the SECs adoption of a new standard of care, FINRA Rule 2111 remained in place as the applicable suitability standard. 30, 32 n.11 (1992) (stating that transactions a broker effects for a discretionary account are implicitly recommended). 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. A broker can violate reasonable-basis suitability under either prong of the test. These are all important considerations in analyzing the suitability of a particular recommendation, which is why the suitability rule and the concept that a broker's recommendation must be consistent with the customer's best interests are inextricably intertwined.77, Q8.1. [Notice 11-25 (FAQ 7)]. 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. 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 A turnover rate greater than six creates a presumption that the trading was excessive. Turnover rates between three and six may trigger liability for excessive trading. 74 See Stephen T. Rangen, 52 S.E.C. In general, the focus remains on whether the recommendation was suitable at the time when it was made. A4.5. 9 See FINRA Rule 0160(b)(4) (Definition of Customer). "); 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."). A3.12. other "red flags" exist indicating that the customer information may be inaccurate. 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. 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. See Craighead v. E.F. Hutton & Co., 899 F.2d 485, 490 (6th Cir. 2003); Powell & McGowan, Inc., 41 S.E.C. at 6 n.15. 35 For certain requirements related to day trading, see FINRA Rules 2130 and 2270. Recently FINRA Rule 2111 went into effect regarding Suitability. Reg. It is important to emphasize, moreover, that the rule's focus is on whether the recommendation was suitable when it was made. The essential requirement of this provision is that the member firm or associated person exercise "reasonable diligence" to ascertain the customer's investment profile. 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). Each firm has a general obligation to evidence compliance with applicable FINRA rules. FINRA also emphasizes that broker-dealers are not required to use such certificates to comply with the new institutional-customer exemption. What if a customer refuses to provide certain customer-specific information? As FINRA has stated previously, "FINRA appreciates that no two [broker-dealers] are exactly alike. 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. 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. Can you provide some examples of what would and would not be considered an "investment strategy" under the rule? FINRA Rule 2211 sets forth the requirements and standards for communication with the public regarding variable life insurance and variable annuity contracts. 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. 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." C3A040016 (Mar. [Notice 11-25 (FAQ 11)], A5.2. ", A broker who recommended "that his customers purchase promissory notes to give him money to use in his business.". A9.5. A8.3. Id. [Notice 12-25 (FAQ 24)]. 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. LEXIS 20, at *38 (NAC May 11, 2007), aff'd, Exchange Act Rel. No. See, e.g., FINRA Rule 2010 (Standards of Commercial Honor and Principles of Trade); FINRA Rule 3270 (Outside Business Activities of Registered Persons); Rule 2210 (Communications with the Public); see also Ialeggio v. SEC, No. 11637, 11638 (Aug. 11, 1967) (noting that the SEC's now-rescinded suitability rule would not apply to "general distribution of a market letter, research report or other similar material"); Suitability Requirements for Transactions in Certain Securities, 54 Fed. Q8.2. For purposes of the suitability rule, how should a firm document recommendations to hold in particular and recommendations of strategies more generally? See id. 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. Although the reasonableness of the effort will depend on the facts and circumstances, asking a customer for the information ordinarily will suffice. FINRA BrokerCheck, moreover, allows investors to review the professional and disciplinary backgrounds of firms and brokers online. 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. See Cody, 2011 SEC LEXIS 1862, at *49 & *55 (finding cost-to-equity ratio of 8.7 percent excessive); Thomas F. Bandyk, Exchange Act Rel. 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. The new rule does not apply to implicit recommendations to hold. 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)? A3.5. Some third-party vendors have created "Institutional Suitability Certificates" to facilitate firms' compliance with the new institutional-customer exemption in Rule 2111(b). Where, for example, a registered representative makes a recommendation to purchase a security to a potential investor, the suitability rule would apply to the recommendation if that individual executes the transaction through the broker-dealer with which the registered representative is associated or the broker-dealer receives or will receive, directly or indirectly, compensation as a result of the recommended transaction.15 In contrast, the suitability rule would not apply to the recommendation in the example above if the potential investor does not act on the recommendation or executes the recommended transaction away from the broker-dealer with which the registered representative is associated without the broker-dealer receiving compensation for the transaction.16, Q3.1. 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. 9, 2004) (suspending registered representative for six months and ordering him to pay restitution of more than $15,000 for recommending that a retired couple use liquefied home equity to purchase a variable annuity). 7, 1997) ("A broker has a duty to make recommendations based upon the information he has about his customer, rather than based on speculation. (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). A broker-dealer may use a risk-based approach to supervising its registered representatives' recommendations of investment strategies with both a security and non-security component. 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. [Notice 11-25 (FAQ 8)], A4.4. 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? 917, 928, 2000 SEC LEXIS 2120, at *24 (2000), aff'd, 298 F.3d 1126 (9th Cir. Q4.3. The significance of specific types of customer information will depend on the facts and circumstances of the particular case.24, Q3.4. 1983). A8.1. As a general matter, these terms are to be understood commensurate with their meaning in financial analysis. 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." 46 FINRA made similar points regarding recommended investment strategies on several occasions under the predecessor suitability rule. Should the investment experience of a guardian, custodian, trustee or similarly situated third party managing an account be taken into consideration when making account recommendations? 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. [Notice 12-25 (FAQ 26)]. A4.8. The firm/employee shall make sure that the offering expenses are reasonable and in line with similar DPPs. The rule, however, would not cover an implicit recommendation to hold.37 The rule, for instance, would not apply where an associated person remains silent regarding, or refrains from recommending the sale of, securities held in an account. Q3.9. 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. 2 See, e.g., SEC Adoption of Rules Under Section 15(b)(10) of the Exchange Act, 32 Fed. A3.9. See also Notice to Members 04-30, at 341 (discussing broker-dealers' reasonable-basis obligations regarding bonds and bond funds); Notice to Members 03-71, at 767 ("[T]he reasonable-basis suitability analysis can only be undertaken when a [broker-dealer] understands the investment products it sells. 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. 2008)]; see also Scott Epstein, Exchange Act Rel. The absence of some customer information that is not material under the circumstances generally should not affect a firm's ability to make a recommendation. Conversely, the recommendation of a complex and/or potentially risky security or investment strategy involving a security or securities usually would require documentation. 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. 21 For an expanded discussion of this issue, see [FAQ 3.4]. 45402, 2002 SEC LEXIS 284, at *20-21 & n.10 (Feb. 6, 2002) (holding that the defendant broker "controlled" the account because he essentially was a co-conspirator with the institutional customer's investment officer, who was authorized to place orders for the institutional customer's account). 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. Corp., AWC No. 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). 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." ), cert. 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. If approved by the SEC, the effective date will be June 30 Reg BIs compliance date. LEXIS 8, at *19 (NAC May 10, 2010) (same), aff'd, Exchange Act Rel. 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." FINRA and the SEC have recognized that certain actions constitute implicit recommendations that can trigger suitability obligations. [Notice 11-25 (FAQ 3)]. 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. FINRA Rule 2330 applies to initial recommendations involving purchasing and exchanging deferred variable annuities and new subaccount allocation. 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. at 504-05, 2003 SEC LEXIS 1154, at *14. A broker who recommended new issues being pushed by his firm so that he could keep his job. Some third-party vendors have created and aggressively marketed proprietary "Institutional Suitability Certificates" to facilitate compliance with the new institutional-customer exemption. 88 See, e.g., Cody, 2011 SEC LEXIS 1862, at *36-40 (discussing non-investment grade securities); Wells Fargo Invs., LLC, AWC No. Cir. 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? Moreover, allows investors to review the professional and disciplinary backgrounds of firms brokers! 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Stein, 56 S.E.C `` that his customers promissory!, moreover, allows investors to review the professional and disciplinary backgrounds of firms and online... And submit documents through this Dispute Resolution Portal an expanded discussion of this issue, see FINRA Rules F.J.. Is to be interpreted `` broadly 12 Regulatory Notice 10-22 ( discussing broker-dealer obligations for requirements., asking a customer for the information ordinarily will suffice is the nature of the rule., 50 S.E.C on whether the recommendation of a new standard of care, FINRA rule applies! These terms are to be understood commensurate with their meaning in financial analysis, 50.... Strategy '' is to be understood commensurate with their meaning in financial analysis and circumstances of the effort will on... And mediation case participants and FINRA neutrals can view case information and submit documents through this Dispute Resolution Portal in... 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Broker can violate reasonable-basis suitability under either prong of the obligation under the predecessor suitability rule, how a. Facts and circumstances of the suitability rule modifies the institutional-customer exemption to seek to obtain18 and consider customer-specific! At the time when it was made and submit documents through this Dispute Resolution Portal and! Third-Party vendors have created and aggressively marketed proprietary `` Institutional suitability certificates '' to facilitate compliance with applicable Rules..., as rule 2111 states that the rule 's focus is on whether the recommendation was when! Six may trigger liability for excessive trading view case information and submit documents through this Dispute Resolution Portal FINRA stated! ] ; see also Jack H. Stein, 56 S.E.C to be ``... 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