1304, 1311, 1997 SEC LEXIS 762, at *19 (1997). In interpreting FINRA's suitability rule, numerous cases explicitly state that "a broker's recommendations must be consistent with his customers' best interests. No. Some of the cases in which FINRA and the SEC have found that brokers placed their interests ahead of their customers' interests involved cost-related issues. 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. 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. 108, 117, 2003 SEC LEXIS 338, at *15 (2003) (focusing, in part, on risks of using margin); James B. FINRA Rule 2330 applies to initial recommendations involving purchasing and exchanging deferred variable annuities and new subaccount allocation. What is the scope of the term "strategy" as used in FINRA Rule 2111? 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. These (and many other) FINRA rules provide broad and significant protections to investors. 20452 (Apr. 83 See Regulatory Notice 11-02, at 8 n.24. This document consolidates the questions and answers in Regulatory Notices 12-55, 12-25 and 11-25, organized by topic. L. No. A3.12. That includes requiring a reasonable belief that the customer has For instance, does each individual recommendation have to be consistent with the customer's investment profile or can the suitability of a broker's recommendation be judged in light of its consistency with the customer's overall portfolio? See id. 43 SeeNotice to Members 04-89 (discussing liquefied home equity). 7, 1997) ("A broker has a duty to make recommendations based upon the information he has about his customer, rather than based on speculation. No. 49 Similarly, and as noted previously, the absence of a recommendation to sell would not amount to a hold recommendation subject to the rule. However, as [discussed herein], a firm may take a risk-based approach to evidencing compliance with the rule. 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. 70 See Epstein, 2009 SEC LEXIS 217, at *42 (stating that the broker's "mutual fund switch recommendations served his own interest by generating substantial production credits, but did not serve the interests of his customers" and emphasizing that the broker violated the suitability rule "when he put his own self-interest ahead of the interests of his customers"). A broker-dealer cannot make assumptions about customer-specific factors for which the customer declines to provide information.22 Furthermore, when customer information is unavailable despite a broker-dealer's reasonable diligence, the firm must carefully consider whether it has a sufficient understanding of the customer to properly evaluate the suitability of a recommendation.23 As with the predecessor rule [NASD Rule 2310], however, the new rule would not prohibit a broker-dealer from making a recommendation in the absence of certain customer-specific factors as long as the firm has enough information about the customer to have a reasonable basis to believe the recommendation is suitable. As described in greater detail in FAQ [4.7], there is a safe harbor for certain types of educational information and asset allocation models that otherwise could be considered investment strategies captured by the new rule. See, e.g., Regulatory Notice 09-31 (reminding firms of their sales-practice obligations relating to leveraged and inverse exchange-traded funds). A3.8. 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. What if a customer refuses to provide certain customer-specific information? The firm/employee shall make sure that the offering expenses are reasonable and in line with similar DPPs. This rule does not apply to: Transfers and LEXIS 10362, *4-5 (9th Cir. A broker whose mutual fund recommendations were "designed 'to maximize his commissions rather than to establish an appropriate portfolio' for his customers. "); Paul C. Kettler, 51 S.E.C. Does the firm have a duty, for example, to ask its customers if there is anything else it should know about them when collecting information for suitability purposes? 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. 64565, 2011 SEC LEXIS 1862, at *30-32 (May 27, 2011) (stating that a broker can violate reasonable-basis suitability by failing to perform a reasonable investigation of the recommended product and to understand its risks even though the recommendation is otherwise suitable) [aff'd, 693 F. 3d 251 (1st Cir. As discussed below in the answer to [FAQ 8.3], firms can use any number of approaches to complying with the new exemption requirements. [Notice 12-25 (FAQ 11)]. A customer, for example, may not want to divulge information about "other investments" held away from the broker-dealer in question. 20006005977901, 2011 FINRA Discip. The following frequently asked questions (FAQs) provide guidance on FINRA Rule 2111 (Suitability). 1990). 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. In general, the focus remains on whether the recommendation was suitable at the time when it was made. "); see also Jack H. Stein, 56 S.E.C. Vincent Apicella, Stock Focus: "Dogs of the Dow" Companies, Forbes.com (May 29, 2001). Id. In most instances, asking a customer for the information would constitute reasonable diligence. 52 Nonetheless, FINRA has stated that the safe-harbor provision would be strictly construed. 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. Firms do not have to document or individually approve every "hold" recommendation.91 As with recommendations of other types of investment strategies or of purchases, sales or exchanges of securities, firms may use a risk-based approach to documenting and supervising "hold" recommendations. LEXIS 20, at *38 (NAC May 11, 2007), aff'd, Exchange Act Rel. C3A960029, 1999 NASD Discip. Compliance with suitability obligations does not necessarily turn on documentation of the basis for the recommendation. ), cert. 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. 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. 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. 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. [1] Weirdly, Rule 2330 does NOT explicitly cover recommendations involving a strategy, as Rule 2111 does. 3 The discussions (and examples provided) in previous Regulatory Notices, cases, interpretive letters, and SEC releases remain applicable to the extent that they are not inconsistent with Rule 2111. In general, an associated person may rely on a firm's fair and balanced explanation of the potential risks and rewards of a product. The cost associated with a recommendation, however, ordinarily is only one of many important factors to consider when determining whether the subject security or investment strategy involving a security or securities is suitable. What is the nature of the obligation under the suitability rule created by a hold recommendation? Can you provide some examples of what would and would not be considered an "investment strategy" under the rule? The term also would capture an explicit recommendation to hold a security or securities.36 While a decision to hold might be considered a passive strategy, an explicit recommendation to hold does constitute the type of advice upon which a customer can be expected to rely. Does the suitability rule apply when a broker-dealer or registered representative makes a recommendation to a potential investor? See also [infra note 86; Regulatory Notice 12-25, at 19 n.12]. A9.3. 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). LEXIS 36, at *22 (NAC Oct. 3, 2011) (same); Dep't of Enforcement v. Cody, No. 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. Turnover rates between three and six may trigger liability for excessive trading. By way of background, the new suitability rule modifies the institutional-customer exemption that existed under the predecessor rule (NASD IM-2310-3). The firm, however, also must consider factors such as the trust's investment objectives, time horizon and risk tolerance to complete the suitability analysis. A4.8. However, despite the SECs adoption of a new standard of care, FINRA Rule 2111 remained in place as the applicable suitability standard. Q3.12. In addition, for other FINRA rules that have suitability components such as FINRA Rule 2330 (Members Responsibilities regarding Deferred Variable Annuities) and FINRA Rule 2360 While the rule lists some of the aspects of a typical investment profile, not every factor may be relevant to all situations. The suitability rule also would not apply to a firm's allocation recommendation regarding broad-based market sectors (e.g., agriculture, construction, finance, manufacturing, mining, retail, services, transportation and public utilities, and wholesale trade).54 Again, however, the recommendation must be based on an asset allocation model that meets the above criteria and cannot include recommendations of particular securities. [Notice 12-25 (FAQ 20)]. See SEA Rule 17a-3(a)(17)(i). 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. Q3.8. ), cert. 1990); Arceneaux v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 767 F.2d 1498, 1502 (11th Cir. Still other firms may create data fields for entering such information into automated supervisory systems. 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. Reg. 2 See, e.g., SEC Adoption of Rules Under Section 15(b)(10) of the Exchange Act, 32 Fed. [Notice 12-25 (FAQ 5)], A1.4. 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). 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." 471, 475, 1999 SEC LEXIS 2685, at *7 (1999). FINRA cautioned, however, that a firm should evidence a customer's intent to use different investment profiles or factors for the different accounts. Dep't of Enforcement v. Siegel, No. Where a broker did not recommend the original purchase of a security but explicitly recommends that the customer subsequently hold that security, the new suitability rule would apply. Reg. The new rule, for example, does not apply to implicit recommendations to hold a security or securities. 1990). Pinchas, 54 S.E.C. LEXIS 8, at *19 (NAC May 10, 2010) (same), aff'd, Exchange Act Rel. Quantitative suitability likely will apply in more limited circumstances with regard to institutional customers than it does as to retail customers. For purposes of the suitability rule, how should a firm document recommendations to hold in particular and recommendations of strategies more generally? A8.1. Rule 2111 would cover a recommendation to purchase securities using margin or liquefied home equity or to engage in day trading, irrespective of whether the 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. These ( and many other ) FINRA rules provide broad and significant protections investors... `` designed 'to maximize his commissions rather than to establish an appropriate '! Generally requires broker-dealers to use reasonable diligence to seek to obtain and analyze the customer-specific listed. With regard to institutional customers than it does as to retail customers LEXIS 2685, at * 22 ( may... 19 n.12 ] customer-specific information 9th Cir Enforcement v. 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