Key Points:
- FINRA adopted a new suitability standard effective July 9, 2012.
- The new rule includes expanded guidance with respect to reasonable basis, recommended transactions or investment strategies and the customer's investment profile.
- A review of the new rule and related guidance is important from a best practices perspective to manage risk moving forward.
FINRA Rule 2310 entitled "Recommendations to Customers (Suitability)" has been the primary governing standard on the appropriateness of customer recommendations of securities transactions by registered representatives associated with FINRA member broker-dealers since the 1990s. Effective July 9, 2012, this rule was no longer applicable. After many months of discussion, commentary and, ultimately, approval by the SEC, FINRA will now introduce Rule 2111 entitled simply "Suitability." While the spirit of the new rule is consistent with its prior incarnation, the amended guidance is more detailed as to the considerations that must accompany recommendations to a customer. This greater degree of specificity requires that representatives and member firms must be aware of their additional duties and responsibilities and incorporate such awareness into their practice. Thus, a careful analysis of the language change is beneficial, if not crucial, for representatives to ensure compliance with the rule on an ongoing basis and to manage risk into the future.
As a starting point, the original rule stated:
In recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other securities holdings and as to his financial situation and needs.
The new Rule 2111 slightly expands this language to now state:
A member or an associated person must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer's investment profile.
As to each of these highlighted items, FINRA has made significant changes and/or additions to the previous version of the suitability rule. Many of these alterations are found in the "Supplementary Material," which now directly follows the suitability rule for the first time. Further clarification is found in recent regulatory notices 11-25 and 12-25 issued by FINRA.
Reasonable Basis
FINRA offers some clarification as to "reasonable basis" for suitability in Supplementary Material 2111.05 and Regulatory Notice 11-25. First, FINRA states that a broker must perform reasonable diligence to understand the potential risks and rewards associated with a recommended security or strategy. Second, a broker must determine whether the recommendation is suitable for at least some investors based on that understanding. A broker can violate reasonable basis suitability under either prong of the test. For example, even if a firm's product committee approved a product for sale, a broker's lack of understanding of a recommended product or strategy could violate the obligation, even if the recommendation is suitable for some investors. In general, a representative may rely on a firm's assessment of the potential risks and rewards of a product via a product committee or other due diligence process if such is " fair and balanced." However, the representative remains obligated to understand the potential risks and rewards of a product before recommending it. Moreover, a representative may not recommend a product if he has reason to believe that the firm failed to address certain issues or if their review appears to have been done in an incomplete or inaccurate manner.
Recommended Transaction or Investment Strategy
FINRA replaced the somewhat generic language as to "purchase, sale or exchange of any security" to a more wide-ranging application to any "recommended transaction or investment strategy." While the new language referencing "recommended transaction" logically relates back to the original language, one cannot help but notice the dramatic addition of the need for a reasonable basis to recommend an "investment strategy." What is an investment strategy in the eyes of FINRA?
FINRA directly addressed the term "investment strategy" in the Supplementary Material to Rule 2111, as well as in regulatory notices issued in 2011 and 2012. The common thread is that FINRA wants the term "investment strategy" to be "interpreted broadly." As an example, Supplementary Material 2111.03 notes that the phrase "investment strategy" would include, among other things, an explicit recommendation to hold a security or securities. FINRA's regulatory notices further explain that a hold recommendation is tantamount to a "call to action" in the sense of a suggestion that the customer stay the course with the investment.
However, FINRA notes that the rule would not cover an "implicit recommendation" to hold such as where an associated person remains silent regarding, or refrains from recommending the sale of, securities held in an account. That is true regardless of whether the associated person previously recommended the purchase of the securities, the customer purchased them without a recommendation, or the customer transferred them into the account from another firm where the same or a different associated person handled the account. FINRA notes that the focus remains on whether the recommendation was suitable at the time it was made. Absent an agreement, course of conduct or unusual fact pattern that might alter the normal broker-customer relationship, a hold recommendation would not create an ongoing duty to monitor and make subsequent recommendations.
The regulatory notices issued in 2011 and 2012 further state that 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. For instance, the rule would cover a recommendation generally to use a bond ladder, day trading, the use of margin or liquefied home equity, irrespective of whether the recommendation results in a transaction or references particular securities.
FINRA would not consider a broker's recommendation that a customer generally invest in equities or fixed income securities to be an investment strategy covered by the rule, unless such a recommendation was part of an asset allocation plan not covered by the safe-harbor provision found in Supplementary Material 2111.03. Therein, FINRA specifically detailed that certain communications are excluded from the coverage of Rule 2111 as long as they do not include a recommendation of a particular security or securities. This would include general financial and investment information, descriptive information about an employer-sponsored benefit or retirement plan, or asset allocation models that are based on generally accepted investment theory, accompanied by disclosures of material facts and assumptions that may affect a reasonable investor's assessment of the asset allocation model which are further in compliance with other applicable FINRA rules pertaining to the use of investment analysis tools.
Customer
FINRA also provided guidance as to what constitutes a "customer" for purposes of Rule 21111. The FINRA code has always broadly defined the term customer to include anyone who is not a broker or dealer. Regulatory Notice 12-25 further explains that a customer clearly would include an individual or entity with whom a broker dealer has even an "informal business relationship related to brokerage services, as long as that individual or entity is not a broker or dealer." This situation might apply, for example, when a broker recommends a security to a potential investor, even if that potential investor does not have an account at the firm.
Customer's Investment Profile
The prior version of the rule also noted that the recommendations must be suitable for the customer "upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs." To that end, members were to make reasonable efforts to obtain information concerning the customer's financial status, tax status, investment objectives and such other information used or considered to be reasonable by such member or registered person in making recommendations to the customer. The new version of the rule greatly expands upon these due diligence requirements.
Now, recommendations must be based on the information obtained "through the reasonable diligence of the member or associated person to ascertain the customer's investment profile. A customer's investment profile includes, but is not limited to, the customer's age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation." Thus, it is clear that FINRA expects representatives to consider a great many additional factors in making a suitable recommendation. Such information would obviously need to be properly documented in the customer file.
Thus, broker-dealers and their representatives may now be wondering whether they have to update all customer account documentation to capture the new customer investment profile factors. Regulatory Notice 11-25 indicates that the new suitability rule does not require a firm to update all customer account documentation. Rather, it requires a broker to seek and consider relevant customer-specific information when making a recommendation. FINRA notes that Rule 2111 does not include any explicit documentation requirements.
These statements by FINRA almost give the impression that additional documentation is optional. That may technically be the case, but it is certainly not in keeping with best practices. Indeed, FINRA not so subtly states that the suitability rule allows firms to take a "risk-based approach" with respect to documenting suitability determinations. The firm should understand that, to the degree that the basis for suitability is not evident from the recommendation itself, FINRA examination and enforcement concerns will raise with the lack of documentary evidence for the recommendation. Thus, the new suitability rule may not explicitly require updating all customer account documentation. However, best practices dictate updating all such information before making any new recommendation to a customer. This approach is logical and in the best interests of the customer and the individual making the recommendation. A recommendation made prior to the implementation of Rule 2111 theoretically does not involve all of the new factors enumerated therein. Thus, whether a particular recommendation is suitable for a customer might change once the representative takes into consideration all of the factors listed in Rule 2111.
Rule 2111, its Supplementary Material and the recent regulatory notices represent the next phase in the evolution of FINRA's suitability rule. Its requirements have clearly expanded, resulting in greater responsibility for member firms and their representatives. A careful review of the new language is crucial to ensure compliance with the rule and to manage risk moving forward.
*Joel, an associate in our Philadelphia, Pennsylvania, office, can be reached at 215.575.2586 or jmwertman@mdwcg.com.
Defense Digest, Vol. 18, No. 3, September 2012
Affiliated Attorney
