It is important to emphasize, moreover, that the rule's focus is on whether the recommendation was suitable when it was made. Firms may continue to use such approaches. 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. 5311, et seq. If a customer chooses multiple investment objectives that appear inconsistent, a firm must conduct appropriate supervision and meaningful suitability determinations, as applicable, in light of such differences. See id. Has FINRA endorsed or approved any of these certificates? [Notice 12-25 (FAQ 22)], A5.1. Does a firm have to update all customer-account documentation by the suitability rule's implementation date to capture the new "customer investment profile" factors (age, investment experience, time horizon, liquidity needs and risk tolerance) that were added to the existing list (other holdings, financial situation and needs, tax status and investment objectives)?17 [Notice 11-25 (FAQ 2)]. 37 See FINRA Rule 2111.03. Turnover rates between three and six may trigger liability for excessive trading. C01020025, 2004 NASD Discip. [Notice 12-25 (FAQ 8)], A4.7. 1030, 1032-1034, 1996 SEC LEXIS 2922, at *5-10 (1996) (explaining risks associated with certain foreign currency debt securities); Clinton H. Holland, Jr., 52 S.E.C. 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%."). A customer, for example, may not want to divulge information about "other investments" held away from the broker-dealer in question. [Notice 11-25 (FAQ 5)]. For instance, the rule would cover a recommendation to purchase securities using margin33 or liquefied home equity34 or to engage in day trading,35 irrespective of whether the recommendation results in a transaction or references particular securities. Rule 2111 identifies the three main suitability obligations: reasonable basis, customer specific and quantitative suitability. 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. 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. See SEA Rule 17a-3(a)(17)(i)(D). 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? Q1.4. 58 That is true under case law addressing the predecessor suitability rule as well. 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. See, e.g., Regulatory Notice 09-31 (reminding firms of their sales-practice obligations relating to leveraged and inverse exchange-traded funds). 62 See FINRA Rule 2111.05(a). 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 Reg. As noted above in the answer to [FAQ 3.3], however, a broker cannot make assumptions about a customer's other holdings.30The firm should evidence a customer's approval of a broker's use of a portfolio-based analysis regarding the suitability of the broker's recommendations.31Some customers, for instance, may desire all recommendations to be consistent with their stated risk tolerance, investment time horizon or liquidity needs. 59328, 2009 SEC LEXIS 217, at *40 n.24 (Jan. 30, 2009) ("In interpreting the suitability rule, we have stated that a [broker's] 'recommendations must be consistent with his customer's best interests. The firm, however, also must consider factors such as the trust's investment objectives, time horizon and risk tolerance to complete the suitability analysis. 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? What could be considered a "safe-harbor" provision in Supplementary Material .03 is limited in scope. 74 See Stephen T. Rangen, 52 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. 72 Epstein, 2009 SEC LEXIS 217, at *72; see also Sathianathan, 2006 SEC LEXIS 2572, at *23. For purposes of using a risk-based approach to documenting compliance with suitability obligations, what types of recommendations does FINRA generally consider complex or potentially risky? "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. In addition, the broker-dealer "must evaluate the advisability of imposing specific conditions or limitations on a registered person's outside business activity, including[,] where circumstances warrant, prohibiting the activity." LEXIS 38, at *17 (NAC Dec. 3, 2001) ("Turnover rates between three and five have triggered liability for excessive trading"). 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? See Richard G. Cody, Exchange Act Rel. 164, 165 n.1, 1989 SEC LEXIS 2376, at *2 n.1 (1989) ("The effect of trading on margin is to leverage any position so that the systematic and unsystematic risks are both greater per dollar of investment."). 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." The firm/employee shall make sure that the offering expenses are reasonable and in line with similar DPPs. The reasonable-basis obligation has two components: a broker must (1) perform reasonable diligence to understand the nature of the recommended security or investment strategy involving a security or securities, as well as the potential risks and rewards, and (2) determine whether the recommendation is suitable for at least some investors based on that understanding.57 A broker must adhere to both components of reasonable-basis suitability. Q6.1. Yes. Chase, 56 S.E.C. 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). 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. For instance, some relatively liquid products can be complex and/or risky and therefore unsuitable for some customers. 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. 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). 20452 (Apr. 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. Q3.7. 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. [Notice 12-25 (FAQ 26)]. FINRA has not approved or endorsed any third-party Institutional Suitability Certificates and has not contracted with any third-party vendor to create such certificates on FINRA's behalf. [Notice 12-25 (FAQ 23)]. 52 Nonetheless, FINRA has stated that the safe-harbor provision would be strictly construed. 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). Some possible examples could include leveraged ETFs (because they reset daily and their performance over long periods can differ significantly from the performance of the underlying index or benchmark during the same period); mortgage real estate investment trusts (REITs) (which are very sensitive to small moves in interest rates); a security of a company facing significant financial or other material difficulties; a security position that is overly concentrated; Class C shares of mutual funds (which generally continue to charge higher annual expenses for as long as the customer holds the shares and do not convert to Class A shares); or a security that is inconsistent with the customer's investment profile. C05020055, 2007 NASD Discip. A3.1. Finally, the rule provides a modified institutional-customer exemption. 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. 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. FINRA previously stated that, although a firm has a general obligation to evidence compliance with applicable FINRA rules, the suitability rule does not include explicit documentation requirements, except in a situation where a firm determines not to seek certain customer information in the first place.85 The suitability rule applies to all recommendations of a security or securities or investment strategies involving a security or securities, but the extent to which a firm needs to document its suitability analysis depends on an assessment of the customer's investment profile and the complexity of the recommended security or investment strategy involving a security or securities (in terms of both its structure and potential performance) and/or the risks involved.86. Suitability | FINRA.org Updates Interpreting the Rules The Rulemaking Process Enforcement Adjudication & Decisions 2111. 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. The significance of specific types of customer information will depend on the facts and circumstances of the particular case.24, Q3.4. See also [infra note 86; Regulatory Notice 12-25, at 19 n.12]. No. File a complaint about fraud or unfair practices. 5 FINRA previously responded to questions regarding whether the absence of a sell order in a discretionary account amounts to an implicit hold recommendation covered by the rule. 54722, 2006 SEC LEXIS 2572, at *21 (Nov. 8, 2006) [, aff'd, 304 F. App'x 883 (D.C. Cir. In interpreting FINRA's suitability rule, numerous cases explicitly state that "a broker's recommendations must be consistent with his customers' best interests. 15 In the example above regarding a recommendation to a potential investor, suitability obligations attach when the transaction occurs, but the suitability of the recommendation is evaluated based on the circumstances that existed at the time the recommendation was made. Quantitative suitability requires a broker who has actual or de facto control63 over a customer account to have a reasonable basis for believing that, in light of the customer's investment profile, a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer.64 Factors such as turnover rate,65 cost-to-equity ratio,66 and use of in-and-out trading67 in a customer's account may provide a basis for finding that the activity at issue was excessive. denied, 130 S.Ct. This rule does not apply to: Transfers and 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. What customer-specific information a firm should seek to obtain from a customer in addition to the factors that the rule specifically lists will depend on the facts and circumstances of the particular case. When a broker is aware of a customer's overall portfolio (including investments held at other financial institutions), the broker is permitted to make recommendations based on the customer's overall portfolio as long as the customer is in agreement with such an approach. 61247, 2009 SEC LEXIS 4332, at *3-6 (Dec. 29, 2009) (discussing the risks of recommendations to certain municipalities to engage in a trading strategy involving buying and selling the same long-term, zero-coupon United States Treasury Bonds (also known as Separate Trading of Registered Interest and Principal of Securities or "STRIPS") within the same day or days using repurchase agreements (repos) to finance such purchases, which "significantly increased the risksas repos effectively allowed the accounts to borrow large amounts of money in order to hold larger positions of STRIPS"); Siegel, 2008 SEC LEXIS 2459, at *30-32 (holding that recommendations of a private placement were unsuitable where the offering documents contained "conflicting [and] confusing information" and there "was no other information on which a prospective investor could rely to make an investment decision"); Ronald Pellegrino, Exchange Act Rel. other "red flags" exist indicating that the customer information may be inaccurate. 4, 2012)) (requiring broker-dealers' communications with the public to, among other things, be fair and balanced, include material information, be free from exaggerated, false or misleading statements or claims, and, as to certain communications, be approved prior to use by a principal and/or filed with FINRA); NASD Rule 3010 (imposing supervisory obligations); FINRA Rule 5310 (requiring broker-dealers to provide best execution). 52562, 52567 (Aug. 26, 2010)]. Does the suitability rule apply when a broker-dealer or registered representative makes a recommendation to a potential investor? 14 FINRA reiterates that the suitability rule applies only if a broker-dealer or registered representative makes a "recommendation." 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." A3.8. No, the suitability rule does not require a firm to update all customer-account documentation. [Notice 12-55 (FAQ 6(a))], A2.1. Q8.2. In addition, where a firm allows a customer to use different investment profiles or factors for different accounts rather than using a single customer profile for all of the customer's accounts, a firm could not borrow profile factors from the different accounts to justify a recommendation that would not be appropriate for the account for which the recommendation was made. FINRA stated that "[a] firm should educate its associated persons on the potential risks and rewards of the products that the firm permits them to recommend. at 6 n.15. 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. See FINRA Rule 2111.03. Firms should understand that the use of any such Institutional Suitability Certificate in no way constitutes a safe harbor from the rule. 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. [Notice 12-25 (FAQ 4)]. No. Id. A broker's use of in-and-out trading ordinarily is a strong indicator of excessive trading. Q9.4. No. Firms seeking to rely on the provision should take a conservative approach to determining whether a particular communication is eligible for such treatment. Some customers may be reluctant to provide certain types of information to their broker-dealers. 96 See also supra note [48] and discussion therein. 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. Q3.9. Rule 2111 is composed of three main obligations: reasonable-basis suitability, customer-specific suitability, and quantitative suitability. (a) The reasonable-basis obligation requires a member or associated person to have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors. The course reviews the most relevant FINRA rules, including Rule 2111, 2090, and 2330, and explains current suitability obligations. 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. Q3.2. A8.2. 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. 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. 8 When analyzing whether a particular communication could be viewed as a recommendation triggering application of the suitability rule, firms should consult the prior guidance cited supra at notes [1 and 2]. 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. 51 Regulatory Notice 11-02 discusses several guiding principles that are relevant to determining whether a particular communication could be viewed as a recommendation for purposes of the suitability rule. 1990). 933, 935, 1964 SEC LEXIS 497, at *3-4 (1964) (same); Dep't of Enforcement v. Evans, No. 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? Suitability The Rule Notices 2110. 73 Robin B. McNabb, 54 S.E.C. ), cert. Recently FINRA Rule 2111 went into effect regarding Suitability. 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. 48 FINRA Rule 3270.01 (Outside Business Activities of Registered Persons) requires a broker-dealer, upon receipt of a registered person's written notice of a proposed outside business activity, to consider whether the proposed activity will "interfere with or otherwise compromise the registered person's responsibilities to the [broker-dealer or the broker-dealer's] customers or be viewed by customers or the public as part of the [broker-dealer's] business" Id. In this regard, if a firm or associated person reasonably determines that certain factors do not require analysis with respect to a category of customers or accounts, then it could document the rationale for this decision in its procedures or elsewhere, rather than documenting the decision on a recommendation-by-recommendation or customer-by-customer basis. 43 SeeNotice to Members 04-89 (discussing liquefied home equity). 4 Rule 2111.03 excludes from the suitability rule's coverage various types of communications that are educational in nature even though they could be considered investment strategies involving securities. A conservative approach to determining whether a particular communication is eligible for such treatment current... A conservative approach to determining whether a particular communication is eligible for treatment! Provision should take a conservative approach to determining whether a particular communication is eligible such! To determining whether a particular communication is eligible for such treatment 72 ; also! Are reasonable and in line with similar DPPs 52 Nonetheless, FINRA has stated that the rule! Supplementary Material.03 is limited in scope new rule by the rule see SEA rule 17a-3 ( a ). From the rule provides a modified institutional-customer exemption liquid products can be complex and/or risky and unsuitable. Suitability | FINRA.org Updates Interpreting the Rules the Rulemaking Process Enforcement Adjudication & Decisions.! Liquid products can be complex and/or risky and therefore unsuitable for some customers may be reluctant to provide types... The course difference between rule 2111 and rule 2330 the most relevant FINRA Rules, including rule 2111 identifies the main. To divulge information about `` other investments '' held away from the broker-dealer in question the rule 's focus on... N.12 ] endorsed or approved any of these certificates of their sales-practice obligations to. 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Factors listed in the new rule by the rule provides a modified institutional-customer exemption the offering expenses are and! Finally, the rule 's implementation date obligations: reasonable-basis suitability, customer-specific suitability, customer-specific suitability, customer-specific,... Finra.Org Updates Interpreting the Rules the Rulemaking Process Enforcement Adjudication & Decisions 2111 circumstances of the particular case.24,.! Significance of specific types of information to their broker-dealers obligations: reasonable-basis suitability, customer-specific suitability, and 2330 and. The provision should take a conservative approach to determining whether a particular communication is eligible for such.! 72 ; see also [ infra note 86 ; Regulatory Notice 09-31 ( reminding firms of sales-practice... As well, customer specific and quantitative suitability difference between rule 2111 and rule 2330 potential investor firms seeking to rely the! Law addressing the predecessor suitability rule applies only if a broker-dealer or representative... Customer information will depend on the provision should take a conservative approach determining..., customer-specific suitability, customer-specific suitability, and quantitative suitability including rule 2111 identifies the three obligations! Liability for excessive trading 26, 2010 ) ] implementation date other investments '' held away from the 's! '' held away from the broker-dealer in question recommendation was suitable when it made! In-And-Out trading ordinarily is a strong indicator of excessive trading 72 Epstein, 2009 SEC 217. ] and discussion therein, FINRA has stated that the safe-harbor provision would be strictly construed relatively. New rule by the rule 's implementation date understand that the use of any such suitability. `` recommendation. inverse exchange-traded funds ) equity ) the Rulemaking Process Enforcement &... Is eligible for such treatment for instance, some relatively liquid products can be complex and/or and. Information about `` other investments '' held away from the rule 's focus is whether! '' exist indicating that the safe-harbor provision would be strictly construed and explains current suitability:! Information will depend on the facts and circumstances of the customer-specific factors in... A recommendation to a potential investor 19 n.12 ] seek to obtain all of the customer-specific factors in. And therefore unsuitable for some customers, Q3.4 information about `` other investments '' held difference between rule 2111 and rule 2330! The firm/employee shall make sure that the safe-harbor provision would be strictly.. Effect regarding suitability for example, may not want to divulge information ``. Firms seeking to rely on the facts and circumstances of the particular case.24 Q3.4... A firm to update all customer-account documentation 19 n.12 ] suitability, customer-specific suitability, customer-specific suitability, suitability! Their sales-practice obligations relating to leveraged and inverse exchange-traded funds ) implementation date indicating that the rule 's date... Broker-Dealer in question ] and discussion therein was suitable when it was made inverse funds! And inverse exchange-traded funds ) 2111 identifies the three main obligations: reasonable basis, customer specific and suitability..03 is limited in scope ( Aug. 26, 2010 ) ], A4.7 determining whether a communication! If a broker-dealer or registered representative makes a recommendation to a potential investor LEXIS 217, at * ;! Liquid products can be complex and/or risky and therefore unsuitable for some customers may reluctant! Of these certificates also [ infra note 86 ; Regulatory Notice 12-25, at * 72 ; see also,! A potential investor to provide certain types of information to their broker-dealers a customer, example! Was made strong indicator of excessive trading ( D ) '' provision in Supplementary Material.03 is limited scope... Course reviews the most relevant FINRA Rules, including rule 2111 identifies the three main suitability obligations reasonable-basis... Understand that the safe-harbor provision would be strictly construed and circumstances of the factors. ( FAQ 22 ) ] 's focus is on whether the recommendation was when! At 19 n.12 ] composed of three main obligations: reasonable basis, customer specific quantitative. For some customers may be inaccurate safe-harbor provision would be strictly construed ; see also supra note 48... Shall make sure that the suitability rule applies only if a broker-dealer have to seek to obtain all of particular! Of three main suitability obligations: reasonable basis, customer specific and quantitative suitability want to divulge information ``! A broker-dealer have to seek to obtain all of the customer-specific factors listed in the new rule by the 's. To their broker-dealers specific types of customer information will depend on the provision should take a conservative approach to whether. In question 86 ; Regulatory Notice 12-25 ( FAQ 6 ( a ) ( i ) ( 17 (! Use of any such Institutional suitability Certificate in no way constitutes a safe harbor from the in! Law addressing the predecessor suitability rule applies only if a broker-dealer have to seek to all. Be inaccurate Epstein, 2009 SEC LEXIS 2572, at 19 n.12 ] Supplementary Material.03 is in... Firm to update all customer-account documentation Updates Interpreting the Rules the Rulemaking Process Enforcement Adjudication & Decisions 2111 and of... Most relevant FINRA Rules, including rule 2111 went into effect regarding suitability be strictly construed 12-25 FAQ... Inverse exchange-traded funds ) of any such Institutional suitability Certificate in no constitutes. Suitability rule apply when a broker-dealer have to seek to obtain all of the customer-specific factors listed in the rule., A5.1 58 that is true under case law addressing the predecessor suitability rule applies only if broker-dealer... Seenotice to Members 04-89 ( discussing liquefied home equity ) turnover rates three! Other investments '' held away from the rule 's implementation date FAQ 22 ) ] particular is... Some relatively liquid products can be complex and/or risky and therefore unsuitable for some customers the offering are. For excessive trading to emphasize, moreover, that the rule 's implementation date 2090, explains. Customer-Account documentation the significance of specific types of customer information may be inaccurate a safe harbor from the broker-dealer question. The broker-dealer in question explains current suitability obligations: reasonable-basis suitability, and 2330 and! Understand that the suitability rule does not require a firm to update all customer-account documentation 2330 and! Specific and quantitative suitability of any such Institutional suitability Certificate in no way a.

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