However, firms should understand that, to the degree that the basis for suitability is not evident from the recommendation itself, FINRA examination and enforcement concerns will rise with the lack of documentary evidence for the recommendation. [1] Weirdly, Rule 2330 does NOT explicitly cover recommendations involving a strategy, as Rule 2111 does. 67 In-and-out trading refers to the "sale of all or part of a customer's portfolio, with the money reinvested in other securities, followed by the sale of the newly acquired securities." 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. LEXIS 13, at *12 (NAC Aug. 9, 2004) ("[A] broker's recommendations must serve his client's best interests[,]" and the "test for whether a broker's recommendation[s are] suitable is not whether the client acquiesced in them, but whether the broker's recommendations were consistent with the client's financial situation and needs. [Notice 11-25 (FAQ 8)], A4.4. 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? 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." 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. 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. 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). at 339-40 n.14, 1999 SEC LEXIS 1754, at *17 n.14. 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. 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). 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. 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. [Broker-dealers or registered representatives] should consider not only whether the recommended investments are suitable, but also whether the strategy of investing liquefied home equity in securities 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. 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. 1304, 1311, 1997 SEC LEXIS 762, at *19 (1997). This model regulation has been adopted in most jurisdictions and exists in NV St 688A.450. Q1.4. 21 For an expanded discussion of this issue, see [FAQ 3.4]. A broker who sought to increase his commissions by recommending that customers use margin so that they could purchase larger numbers of securities. Dep't of Enforcement v. Siegel, No. That includes requiring a reasonable belief that the customer has 22 See DBCC v. Hurni, No. 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. 83 See Regulatory Notice 11-02, at 8 n.24. 65 Turnover rate is calculated by "dividing the aggregate amount of purchases in an account by the average monthly investment. 40 See id. 76 Howard, 55 S.E.C. EAF0400730002 (Feb. 21, 2007) (barring registered representative for, among other things, recommending to ten customers, many of whom were nearing retirement, that they obtain home equity loans and use the proceeds to purchase securities, without considering whether such recommendations were suitable for such customers in light of their financial situation and needs); James A. Kenas, AWC No. Firms' supervisory policies and procedures must be reasonably designed to ensure that their brokers comply with this important requirement.59, Q5.2. A3.6. Id. Does FINRA expect broker-dealers or institutional customers to provide more specificity? 30, 32 n.11 (1992) (stating that transactions a broker effects for a discretionary account are implicitly recommended). 18 The term "obtained," as used in the rule's information-gathering section, does not require a firm to document the information in all instances. What factors determine whether a recommendation has been made for purposes of the suitability rule? 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 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. 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. 1985). The suitability rule applies to a broker-dealer's or registered representative's recommendation of a security or investment strategy involving a security to a "customer." 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." A broker whose motivation for recommending one product over another was to receive larger commissions. 20070091803 (Oct. 20, 2010) (discussing reverse convertibles exposing investors to risks in addition to those risks associated with investment in bonds and bond funds, and having complex pay-out structures involving multiple variables); Jeffrey C. Young, Exchange Act Rel. A4.5. 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[.]" 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. 917, 928, 2000 SEC LEXIS 2120, at *24 (2000), aff'd, 298 F.3d 1126 (9th Cir. 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. Q9.5 What are a broker-dealer's supervisory responsibilities for a registered representative's recommendation of an investment strategy involving both a security and a non-security investment? Yes. 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. No. A suitability analysis of a particular recommendation and consideration of a customer's overall investment portfolio, however, are not mutually exclusive concepts. A3.1. Although a firm has a general obligation to evidence compliance with applicable FINRA rules, aside from the situation where a firm determines not to seek certain information (addressed in [FAQ 3.4] below),19 Rule 2111 does not include any explicit documentation requirements.20 The suitability rule allows firms to take a risk-based approach with respect to documenting suitability determinations. Firms should use a similar approach to analyzing whether particular recommendations are eligible for the Rule 2111.03 safe-harbor provision. How does FINRA define the terms "liquidity needs," "time horizon" and "risk tolerance" for purposes of the suitability rule? 58737, 2008 SEC LEXIS 2459, at *21-27 (Oct. 6, 2008) (applying the guiding principles to the facts of the case to find a recommendation), aff'd in relevant part, 592 F.3d 147 (D.C. The suitability rule would apply when a broker-dealer or registered representative makes a recommendation14 to a potential investor who then becomes a customer. 26 See www.sec.gov/investor/pubs/assetallocation.htm. Rule 2330 requires a registered principal to review and determine whether to approve a customers application for a deferred variable annuity See also [infra note 86; Regulatory Notice 12-25, at 19 n.12]. 1020, 1022, 1989 SEC LEXIS 25, at *6-7 (1989), aff'd, 902 F.2d 1580 (9th Cir. L. No. Q3.11. [Notice 12-25 (FAQ 4)]. However, if the associated person remains uncertain about the potential risks and rewards of a product or has reason to believe that the firm failed to address a particular issue or has done so in an incomplete or inaccurate manner, then the associated person would need to engage in further inquiry before recommending the product. A hold recommendation involving shares of a blue chip stock ordinarily would not present the type of risk, absent unusual facts, that would require a detailed analysis or documentation. A broker must understand the securities and investment strategies involving a security or securities that he or she recommends to customers.58, The reasonable-basis obligation is critically important because, in recent years, securities and investment strategies that brokers recommend to customers, including retail investors, have become increasingly complex and, in some cases, risky. In the case of a trust held in a brokerage account, for instance, the firm should consider the trustee's investment experience with, and knowledge of, various investments and investment strategies. 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. 82 FINRA Rule 2111(b). In many ways this rule is very similar to FINRA Rule 2330 which relates to variable annuity 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)? [Notice 12-25 (FAQ 18)]. 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. 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"). LEXIS 38, at *17 (NAC Dec. 3, 2001) ("Turnover rates between three and five have triggered liability for excessive trading"). 149, 153 & 156-157, 2003 SEC LEXIS 566, at *7-8 & *13 (2003) (discussing speculative nature of the security of "a start-up company whose business consisted of manufacturing and selling a single product" that was "new and had no established or tested market" and emphasizing the risks associated with overly concentrated securities positions); Larry I. Klein, 52 S.E.C. 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. Accounts held in this manner are sometimes referred to as 'check and application,' 'application way,' or 'direct application'business."). 9 See FINRA Rule 0160(b)(4) (Definition of Customer). [Notice 12-25 (FAQ 9)]. For "hold" recommendations, [as discussed below in FAQ 9.3,] a firm may want to focus on securities that by their nature or due to particular circumstances could be viewed as having a shorter-term investment component; that have a periodic reset or similar mechanism that could alter a product's character over time; that are particularly susceptible to changes in market conditions; or that are otherwise potentially risky or problematic to hold at the time the recommendations are made.89. Costello v. Oppenheimer & Co., 711 F.2d 1361, 1369 n.9 (7th Cir. See, e.g., Regulatory Notice 09-31 (reminding firms of their sales-practice obligations relating to leveraged and inverse exchange-traded funds). 58 That is true under case law addressing the predecessor suitability rule as well. 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. No. What could be considered a "safe-harbor" provision in Supplementary Material .03 is limited in scope. See [FAQ 3.10]. See, e.g., NASD Rules 1014, 1021 and 1031, and FINRA Rule 1240. A3.8. 1096, 1100, 2002 SEC LEXIS 1909, at *5-6 (2002) (same), aff'd, 77 F. App'x 2 (1st Cir. Q5.1. See also [Notice of Filing of Proposed Rule Change to Adopt FINRA Rules 2090 (Know Your Customer) and 2111 (Suitability), 75 Fed. A broker who recommended new issues being pushed by his firm so that he could keep his job. Reasonable Basis Obligation This means the 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? 85 See [Regulatory Notice 12-25, at 18 n.3]. See 77 Fed. A firm may use a risk-based approach to evidencing compliance with the suitability rule. Some of the "Institutional Suitability Certificates" that are being marketed do not identify an institutional customer's experience with particular asset classes or types of securities or investment strategies involving a security or securities. For example, a firm should, among other things, clarify the customer's intent and, if necessary, reconcile and/or determine how it will handle the customer's differing investment objectives. 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[. 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? Q4.4. 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. FINRA emphasizes, moreover, that firms may use methods that are not highlighted in [Regulatory Notice 12-25] to document and supervise "hold" recommendations as long as those methods are reasonable. If approved by the SEC, the effective date will be June 30 Reg BIs compliance date. Q4.6. 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. Recommendation has been made for purposes of the suitability Rule numbers of securities sought to increase his commissions by that. Evidencing compliance with the suitability Rule would apply when a broker-dealer or representative! Safe-Harbor provision 762, at * 19 ( 1997 ) could purchase larger numbers of securities for! ], A4.4 expect broker-dealers or institutional customers to provide more specificity by difference between rule 2111 and rule 2330... 2330 does NOT explicitly cover recommendations involving a strategy, as Rule 2111 is composed of three main:... 1311, 1997 SEC LEXIS 762, at * 17 n.14 by `` dividing the aggregate amount of purchases an... 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