Exam Alert: FINRA provides additional guidance on suitability rule

FINRA has provided additional guidance on its suitability rule. The new guidance redefines the terms “customer” and “investment strategy” and clarifies when the rule applies to recommendations involving non-security investments. FINRA has also created a webpage that addresses suitability issues. Continue reading

FINRA has provided additional guidance on its suitability rule (original guidance covered here). The new guidance redefines the terms “customer” and “investment strategy” and clarifies when the rule applies to recommendations involving non-security investments. FINRA has also created a webpage that addresses suitability issues.

The guidance states that “in general, for the purposes of the suitability rule, the term customer includes a person who is not a broker or dealer who opens a brokerage account at a broker-dealer or purchases a security for which the broker-dealer receives or will receive, directly or indirectly, compensation even though the security is held at an issuer, the issuer’s affiliate or a custodial agent (e.g., ‘direct application’ business, ‘investment program’ securities, or private placements), or using another similar arrangement.”  The suitability rule only applies to a recommendation made to a potential investor if the potential investor becomes a customer.

An “investment strategy” refers to a recommendation to invest in specific types of securities. However, a recommendation to invest in “equity” or “fixed income” securities would not generally be considered an investment strategy – the type of security must be more specific than those categories. An explicit recommendation to hold securities would be considered an investment strategy, as would a recommendation to continue an existing investment strategy.

The suitability rule only applies to non-security investments to the extent that the non-security investment is involved with a securities transaction (e.g. recommending that a customer sell a non-security investment to buy securities, or vice versa). The notice also provides comments on broker-dealer supervisory obligations regarding investment strategies that involve both securities and non-security investments.

Source: FINRA Regulatory Notice 12-55: Guidance on FINRA’s Suitability Rule

This alert applies to the Series 6, Series 79, Series 62, Series 24, Series 26, Series 55, Series 99, Series 7, and Series 82.

Exam Alert: MSRB revises definition of sophisticated municipal market professional

Effective July 9, 2012, the MSRB will modify its definition of a sophisticated municipal market professional (SMMP), bringing an MSRB interpretive notice in line with the new FINRA suitability rule for institutional customers. Continue reading

Effective July 9, 2012, the MSRB will modify its definition of a sophisticated municipal market professional (SMMP), bringing an MSRB interpretive notice in line with the new FINRA suitability rule for institutional customers.  Specifically, the new notice will define an SMMP as an institutional customer that 1) the dealer has a reasonable basis to believe can independently evaluate investment risks and market value, and 2) affirms that it is using independent judgment when considering the dealer’s recommendations.  The revised definition permits natural persons with at least $50 million in assets to be considered institutional customers.  The revised definition eliminates a provision that requires a minimum investment of $100 million in municipal securities in order to be considered an institutional customer.

The MSRB notice also changes how Rule G-17 applies to transactions with SMMPs.  The Rule G-17 requires broker-dealers to deal fairly when engaged in municipal securities activities.  The rule has been interpreted to require a dealer to, prior to selling a security to a customer, disclose all material information known to the dealer about the security along with all material information reasonably accessible to the market from established industry sources.  Existing MSRB policy states that the requirement to disclose information from established sources is considered satisfied if the customer is an SMMP and the trade is not recommended by the dealer.  The new policy states that the requirement to disclose information from established sources is fulfilled if the customer is an SMMP, regardless of whether the trade is recommended.

Sources:

MSRB Receives SEC Approval on Revised Definition of Sophisticated Municipal Market Professional

MSRB Notice 2012-27

This alert applies to the Series 7.

Exam Alert: FINRA provides guidance on its new suitability rule

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. Continue reading

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.

 

Recommendation

-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.

 

Customer

-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.

 

Investment Strategy

-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.

 

Information-Gathering Requirements

-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.

 

Reasonable-Basis Suitability

-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.

 

Quantitative Suitability

-The quantitative suitability obligation prohibits churning.

 

Institutional-Customer Exemption

-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.

Exam Alert: FINRA recommends heightened supervision for complex products

On January 17, 2012, FINRA highlighted the need for firms to have adequate supervisory and compliance programs in place in order for registered representatives to recommend complex products. FINRA identified several characteristics that may cause a product to be considered “complex,” such as embedded derivatives or contingencies. The notice states that agents should determine suitability, consider the customer’s financial sophistication, discuss the products with the customer, and consider alternative investments that could meet the customer’s goals. The firm should also review the performance of the products and train the agents about the products. Continue reading

On January 17, 2012, FINRA highlighted the need for firms to have adequate supervisory and compliance programs in place in order for registered representatives to recommend complex products.  FINRA identified several characteristics that may cause a product to be considered “complex,” such as embedded derivatives or contingencies.  The notice states that agents should determine suitability, consider the customer’s financial sophistication, discuss the products with the customer, and consider alternative investments that could meet the customer’s goals.  The firm should also review the performance of the products and train the agents about the products.

Source: FINRA Regulatory Notice 12-03

This alert applies to the Series 6, Series 7, Series 24, Series 26, Series 55, Series 62, Series 79, Series 82, Series 99, Series 63, Series 65, and Series 66.

Exam Alert: FINRA pushes back implementation date for higher customer care standards

FINRA has changed the date on which its new know-your-customer and suitability rules will take effect. The new effective date is Continue reading

FINRA has changed the date on which its new know-your-customer and suitability rules (previously mentioned in this exam alert) will take effect.  The new effective date is July 9, 2012.  FINRA has also answered questions from firms about the new rules; the questions and answers may be found here.

http://www.finra.org/Industry/Regulation/Notices/2011/P123702

Exam Alert: FINRA to hold broker-dealers to a higher standard of customer care

Effective October 7, 2011, broker-dealers must adhere to stricter know-your-customer and suitability standards than before. The new rules require Continue reading

Effective October 7, 2011, broker-dealers must adhere to stricter know-your-customer and suitability standards than before.  The new rules require that consideration be given to a customer’s age, investment experience, time horizon, liquidity needs and risk tolerance, in addition to factors that were already required to be considered (other holdings, financial situation and needs, tax status and investment objectives).  These new requirements are similar to the fiduciary standard used by investment advisers. Relevant to the Series 7, Series 66, Series 24, Series 62 and Series 79 exam.

http://www.finra.org/Industry/Regulation/Notices/2011/P122779