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. 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. A6.1. 73 Robin B. McNabb, 54 S.E.C. No. 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). The safe-harbor provision in Rule 2111.03 would apply to a recommendation to maintain a generic asset mix based on an asset allocation model that meets the criteria described in the rule if the firm does not explicitly recommend that the customer "hold" the specific securities that make up the allocation. 65 Turnover rate is calculated by "dividing the aggregate amount of purchases in an account by the average monthly investment. However, please be aware that, in case of any misunderstanding, the rule language prevails. The institutional-customer exemption does not apply to reasonable-basis and quantitative suitability. See also [Regulatory Notice 11-25, at 9 n.6]. This position is consistent with requirements under the previous suitability rule. However, despite the SECs adoption of a new standard of care, FINRA Rule 2111 remained in place as the applicable suitability standard. What further action a broker-dealer will need to take will depend on the facts and circumstances of the particular case. For example, the recommendation of a large-cap, value-oriented equity security generally would not require written documentation as to the recommendation. 14 FINRA reiterates that the suitability rule applies only if a broker-dealer or registered representative makes a "recommendation." A3.9. 5311, et seq. 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)? A broker's use of in-and-out trading ordinarily is a strong indicator of excessive trading. Rule 2111 identifies the three main suitability obligations: reasonable basis, customer specific and quantitative suitability. See Richard G. Cody, Exchange Act Rel. A1.3. Q3.9. A3.1. 2008)]; see also Scott Epstein, Exchange Act Rel. 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. 31 Firms should note, however, that SEA Rule 17a-3 requires that, for each account with a natural person as a customer or owner, a broker-dealer generally must create a record that includes, among other things, the account's investment objectives. Id. No. 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. 20452 (Apr. 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. Does the new rule cover a "hold" recommendation regarding securities that the broker did not originally recommend? 16 Depending on the facts and circumstances, a registered representative's recommendation to a potential investor also could raise concerns under, among other rules, FINRA Rule 2010 (Standards of Commercial Honor and Principles of Trade); FINRA Rule 2020 (Use of Manipulative, Deceptive or Other Fraudulent Devices); Rule 2210 (Communications with the Public); and NASD Rule 3040 (Private Securities Transactions of an Associated Person); see also Dep't of Enforcement v. Salazar, No. 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. Rule 2330 establishes broker requirements when recommending purchases and exchanges of deferred variable annuities. However, as explained in FAQ [1.2], the rule would not cover an implicit recommendation to hold. 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? 88 See, e.g., Cody, 2011 SEC LEXIS 1862, at *36-40 (discussing non-investment grade securities); Wells Fargo Invs., LLC, AWC No. 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. The quantitative suitability obligation under the new rule simply codifies excessive trading cases. 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." "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. Recently FINRA Rule 2111 went into effect regarding Suitability. 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. 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. 7, 1997) ("A broker has a duty to make recommendations based upon the information he has about his customer, rather than based on speculation. [Notice 12-55 (FAQ 6(b))], A2.2. In regard to the type or form of documentation that may be needed, the facts and circumstances must inform that decision. 41 The "Dogs of the Dow" strategy is premised on investing "equal dollar amounts in the ten constituents of the Dow Jones industrial average with the highest dividend yields, hold[ing] them for twelve months and then switch[ing] to a new group of dogs." [Notice 11-25 (FAQ 3)]. LEXIS 15, at *9 (NBCC Mar. 71 See Belden, 56 S.E.C. 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. 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"). The factors that must exist for an institutional customer to qualify for the exemption may, depending on the facts, negate some of the elements relevant to a showing of a broker's "control" over the account. 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. at 504-05, 2003 SEC LEXIS 1154, at *14. No. 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. 6 Pub. See SEA Rule 17a-3(a)(17)(i). See id. Q3.2. Nothing in this guidance, however, relieves a firm from having to ensure that the investment profiles or factors accurately reflect the customer's decisions. 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. [Notice 12-25 (FAQ 20)]. Under these circumstances, the suitability of a broker's recommendation may be analyzed on the basis of whether the customer's overall portfolio, considering any changes to the portfolio that flow from the broker's recommendation, aligns with the customer's investment profile.29. ), cert. 53 FINRA Rule 2111.03. SEA Rule 17a-3 also states that the broker-dealer must furnish such customer or owner a copy of the required account record information or alternative document with all information required by SEA Rule 17a-3(a)(17)(i)(A), including an explanation of any terms regarding investment objectives, for verification within 30 days of account opening and at least once every 36 months thereafter. Firms should use a similar approach to analyzing whether particular recommendations are eligible for the Rule 2111.03 safe-harbor provision. In addition to the definitional change, the new institutional-customer exemption focuses on two factors: (1) whether a broker "has a reasonable basis to believe the institutional customer is capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies involving a security or securities" (a factor used in the predecessor rule), and (2) whether "the institutional customer affirmatively indicates that it is exercising independent judgment" (a new requirement).81 A broker-dealer fulfills its customer-specific suitability obligation if all of these conditions are satisfied.82. A3.6. FINRA and the SEC have recognized that certain actions constitute implicit recommendations that can trigger suitability obligations. The rule also explicitly covers recommended investment strategies involving securities, including recommendations to "hold" securities. See [FAQ 4.6]. 2111. What if a customer refuses to provide certain customer-specific information? Has FINRA endorsed or approved any of these certificates? Id. For example, a firm may conclude that age is irrelevant regarding all customers that are entities or liquidity needs are irrelevant regarding all customers for whom only liquid securities will be recommended. Q3.5. 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. 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 addition, documentation by itself does not cure an otherwise unsuitable recommendation. Notice to Members 04-89, at 3. 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. 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. What factors determine whether a recommendation has been made for purposes of the suitability rule? 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. 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? The customer's investment profile, for example, is critical to the assessment, as are a host of product- or strategy-related factors in addition to cost, such as the product's or strategy's investment objectives, characteristics (including any special or unusual features), liquidity, risks and potential benefits, volatility and likely performance in a variety of market and economic conditions. A broker can violate reasonable-basis suitability under either prong of the test. 62 See FINRA Rule 2111.05(a). [Notice 11-25 (FAQ 8)], A4.4. That includes requiring a reasonable belief that the customer has ), cert. That is, even if a firm's product committee has approved a product for sale, an individual broker's lack of understanding of a recommended product or strategy could violate the obligation, notwithstanding that the recommendation is suitable for some investors.62. [Notice 12-25 (FAQ 8)], A4.7. 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. See, e.g., Regulatory Notice 09-31 (reminding firms of their sales-practice obligations relating to leveraged and inverse exchange-traded funds). A4.5. 333 (2010). "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. 4, 1997 ("[T]he staff agrees that a reference to an investment company or an offer of investment company shares in an advertisement or piece of sales literature would not by itself constitute a 'recommendation' for purposes of [the suitability rule]."). 2 See, e.g., SEC Adoption of Rules Under Section 15(b)(10) of the Exchange Act, 32 Fed. 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? Numerous Regulatory Notices and cases discuss various types of complex and/or potentially risky securities and investment strategies involving a security or securities. 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. See FINRA Rule 2111.03. 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 4)]. [Notice 12-25 (FAQ 17)], A3.3. Firms may continue to use such approaches. FINRA Rule 2111 does not define the terms. The new rule does not apply to implicit recommendations to hold. denied, 130 S.Ct. 37 See FINRA Rule 2111.03. See, e.g., Rafael Pinchas, 54 S.E.C. 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. Customer specific and quantitative suitability '' securities: reasonable basis, customer specific and suitability. Rule simply codifies excessive trading cases a `` recommendation. 2111 identifies the main! Only if a broker-dealer will need to take will depend on the facts and circumstances must inform that.... 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