FINRA’s new suitability rule, FINRA Rule 2111, will take effect on July 9, 2012. On May 18, 2012, FINRA provided guidance on the new rule by responding to broker-dealer questions, in Regulatory Notice 12-25. This guidance is in addition to the guidance provided in two prior notices, Regulatory Notice 11-02 and Regulatory Notice 11-25.
Some key takeaways:
Acting in a Customer’s Best Interest
-When a broker-dealer makes a recommendation, they must not place their own interests ahead of the customer’s.
-Marketing and offering materials do not count as “recommendations” subject to the suitability rule. See prior notices for further info on what does count as a “recommendation.”
-Implicit recommendations to trade, such as trading on the customer’s behalf without informing them, require a suitability determination. Explicit recommendations to trade or to hold securities also require a suitability determination. Implicit recommendations to hold (i.e. when the broker-dealer remains silent about the customer’s holdings) do not trigger the suitability requirement.
-A call center informing a customer that they can keep their account with a firm does not constitute a recommendation.
-Broker-dealers still have suitability obligations when recommending private placements – this was not changed by the JOBS Act.
-The suitability rule applies to anyone the broker-dealer makes a recommendation to besides another broker-dealer. This includes potential investors that do not currently have accounts with the firm.
-Communications are not subject to the suitability rule if they 1) do not recommend a particular security or group of securities, and 2) are based on an acceptable asset allocation model. For example, suggestions to invest certain percentages of assets in equities or in fixed-income securities would not generally be subject to the rule, but more specific recommendations would be subject to the rule.
Risk-Based Approach to Documenting Compliance With Suitability Obligations
-The extent to which the firm needs to document suitability compliance depends on the risk and complexity of the recommended security/strategy. Recommendations of riskier, more complex securities/strategies are more likely to require documentation.
-Explicit hold recommendations should be documented for certain securities where holding them would be particularly unusual or risky.
-Firms can choose how they want to document hold recommendations.
-The customer info described in the rule only needs to be acquired if/when the broker-dealer makes recommendations.
-Asking a customer for their info is usually good enough, though the broke-dealer may not rely on the customer’s response if there are “red flags” indicating the info may be inaccurate.
-Broker-dealers must use reasonable diligence when trying to get customer info. If they do not get all the info, firms must carefully consider whether they understand the customer well enough to analyze the suitability of an investment before making a recommendation.
-Broker-dealers must consider all information disclosed by a customer in connection with a recommendation when making a suitability analysis.
-If a customer has multiple goals that appear inconsistent, the firm should clarify/reconcile the customer’s goals.
-A broker-dealer may consider the experience of an account manager when making recommendations.
-A broker may make recommendations based on a customer’s overall portfolio, including investments held at other institutions, if the customer give their approval and the broker knows the details of the customer’s overall portfolio.
-The reasonable-basis suitability determination has two components.
1) The broker must understand the recommended security or strategy and the risks involved.
2) The broker must determine whether the recommendation is suitable for at least some investors.
-The quantitative suitability obligation prohibits churning.
-FINRA has not endorsed or approved any “Institutional Suitability Certificates.”
-The new suitability rule does not use the old rule’s definition of an “institutional customers” – it instead uses the more common definition of an “institutional account.”
-The new institutional customer exemption requires an affirmation from the institutional customer that they are exercising independent judgment. The broker-dealer must also have reasonable basis to believe that the institutional customer is capable of independently evaluating investment risks.
-If the institutional customer does not meet both conditions (capable of evaluating risk and affirming that they will exercise independent judgment) for all of the broker-dealer’s recommendations, the broker-dealer may narrow the scope of the types of securities/strategies it recommends so as to meet the institutional customer exemption.
-The firm may use a risk-based approach to documenting an affirmation from an institutional customer. The affirmation does not need to be in writing.
Source: FINRA Regulatory Notice 12-25
This alert applies to the Series 6, Series 7, Series 24, Series 26, Series 55, Series 62, Series 79, and Series 82.