suitability

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: NASAA identifies compliance violations, best practices

A NASAA report outlines the most common broker-dealer violations and offers best practices in ten areas to help broker-dealers avoid mistakes. Continue reading

A NASAA report outlines the most common broker-dealer violations and offers best practices in ten areas to help broker-dealers avoid mistakes.

The most common areas of violations involved books and records, supervision, and sales practices. Less common were violations related to licensing and registration, and the most uncommon type of violations were those related to operations. The top five violation types were as follows: “failure to follow written supervisory policies and procedures, suitability, correspondence/e-mail, maintenance of customer account information, and internal audits.”

NASAA identified best practices in ten areas – summaries of those practices follow.

-Suitability: Know your customer, know your products.

-Staffing and Expertise: Make sure there is enough staff with appropriate training/experience for the size of the firm and the scope of business activities. Also, have and enforce written supervisory procedures.

-Exception Reports: Introducing brokers must get exception reports from clearing brokers and deal with any red flags that come up.

-Branch Office Audits: Have a good, well-documented audit program with unannounced visits.

-Selling Away: Monitor agents selling away. If an agent applies to sell away and gets denied, make sure they don’t do so anyway.

-Outside Business Activity: Outside business requests must be approved before the activity occurs and must be reported on the agent’s U4.

-Advertisements: Ads must be fair and approved by the broker-dealer and/or FINRA. Seminars must be approved by the broker-dealer.

-Correspondence: Keep copies of outside communications on record.

-Customer Complaints: Investigate and respond appropriately to any complaint. Update the U4 of involved agents if necessary.

-Working with Seniors: Develop practices for working with elderly customers.

Source: Coordinated Examinations Identify Top BD Compliance Violations

This alert applies to the Series 24, Series 26, Series 7, Series 65, and Series 66.

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. 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

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

Exam Alert: NASAA develops list of “Best Practices”

A 2010 NASAA review of broker-dealers found that the three most common compliance problem areas were failure to follow supervisory policy, Continue reading

A 2010 NASAA review of broker-dealers found that the three most common compliance problem areas were failure to follow supervisory policy, advertising and sales literature, and suitability issues. NASAA developed a list of ten best practices and released them in October of 2010. The recommendations focus on suitability, exception reports, supervisory procedures, and communications. Relevant to Series 6, Series 7, Series 63, Series 65, Series 66, Series 24, Series 26, Series 62 and Series 79. The list can be found here: http://www.nasaa.org/NASAA_Newsroom/Current_NASAA_Headlines/13382.cfm.