FINRA’s new suitability rule
took effect on July 9, 2012 and requires that a
broker have a reasonable basis to believe that a recommended transaction or
investment strategy involving securities is suitable for the customer, based on
the information obtained through the reasonable diligence to ascertain the
customer’s investment profile. Generally, FINRA’s new suitability rule retains
the core features of the previous NASD suitability rule. In addition, FINRA Rule
2111 codifies several important interpretations of the predecessor rule and
imposes a few new or modified obligations. The new rule, for instance, codifies
and clarifies the three main suitability obligations that previously had been
discussed largely in case law.
First,
there is reasonable-basis suitability under which a broker must perform
reasonable diligence to understand the nature of the recommended security or
investment strategy involving securities, as well as the potential risks and
rewards, and determine whether the recommendation is suitable for at least some
of the investors
based on that understanding. Second, there is customer-specific suitability under
which a broker must have a reasonable basis to believe that a recommendation of
a security or investment strategy involving securities is suitable for the
particular customer based on the customer’s investment profile. The third prong
is quantitative suitability under which a broker who has control over a customer
account must have a reasonable basis to believe that a series of recommended
securities transactions are not excessive.
In
guidance, FINRA clarified that the elimination of the ban on general
solicitation in Rule 506 of Regulation D effected by the JOBS Act does not mean
that brokers no longer have suitability obligations regarding private
placements. The JOBS Act removes certain marketing impediments but not a
broker-dealer’s suitability obligations. In that regard, a broker-dealer’s
general solicitation of a private placement through the use or distribution of
marketing or offering materials ordinarily would not, by itself, constitute a
recommendation triggering application of the suitability rule.
When a broker-dealer recommends a private placement, however,
the suitability rule applies.
The
new suitability rule also broadens the explicit list of customer-specific
factors that brokerage firms must attempt to obtain and analyze when making
recommendations to customers by adding a customer’s age, investment experience,
time horizon, liquidity needs, and risk tolerance to
the explicit list of customer-specific factors from the predecessor rule, such
as other investments, financial situation and, tax status. In addition, the new
rule imposes broader obligations on firms regarding recommendations of
investment strategies involving securities. Not only does the new rule now
explicitly cover recommended investment strategies involving securities, said
FINRA, but it also states that the term investment strategy is to be
interpreted broadly and includes recommendations to hold a security.
Also,
the new rule modifies the institutional-customer exemption by changing the
definition of institutional customer and requiring an affirmative indication
from the institutional customer of its intention to independently analyze the
broker-dealer’s recommendations. FINRA stated that firms generally may use a
risk-based approach to documenting compliance with the rule.
Since
many of the obligations under the new rule are the same as those under the
predecessor rule and related case law, existing guidance and interpretations
regarding suitability obligations continue to apply to the extent that they are
not inconsistent with the new rule. Furthermore, FINRA appreciates that no two
firms are exactly alike. Firms have different business models; offer divergent
services, products and investment strategies and employ distinct approaches to
complying with applicable regulatory requirements. FINRA’s guidance is not
intended to influence any firm’s choice of a particular business model or
reasonable approach to ensuring compliance with suitability requirements.
In
interpreting FINRA’s suitability rule, numerous cases explicitly state that a broker’s
recommendations must be consistent with his customers’ best interests. FINRA
explained that 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.
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, said FINRA, as long as the recommendation
is suitable and the broker is not placing his or her interests ahead of the
customer’s interests.
Although
FINRA does not define the term “recommendation,” it has offered several guiding
principles that firms and brokers should consider when determining whether
particular communications could be viewed as recommendations. FINRA has
extensively addressed those guiding principles in past Regulatory Notices,
and cases have applied them to specific facts. Some SEC releases and FINRA
cases and interpretive letters also have explained that a broker-dealer’s use
or distribution of marketing or offering materials ordinarily would not, by
itself, constitute a recommendation for purposes of the suitability rule.
FINRA
and the SEC have recognized that certain actions constitute implied recommendations
that can trigger suitability obligations. FINRA and the SEC have held, for
example, that brokers who effect transactions on a customer’s behalf without
informing the customer have implicitly recommended those transactions, thereby
triggering application of the suitability rule. Although such holdings continue
to act as precedent regarding those issues, the new rule does not broaden
the
scope of implied recommendations. The new rule, for example, does not apply to implicit recommendations
to hold a
security. Thus, the new rule’s “hold” language would not apply when a broker
remains silent regarding security positions in an account. The hold
recommendation must be explicit.
The
suitability rule only applies to a broker’s recommendation to a “customer.”
FINRA defines “customer” broadly as including anyone who is not a broker or
dealer. Although in certain circumstances the term may include some additional
parameters, 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. A broker-customer relationship would arise
and the suitability rule would apply, for example, when a broker recommends a
security to a potential
investor, even one who does not have an account at the
firm.
Rule
2111 states that the term “investment strategy” is to be interpreted broadly. The
new rule would cover a recommended investment strategy involving a security
regardless of whether the recommendation results in a securities transaction or
even mentions a specific security. 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 eligible
for the safe-harbor provision in Rule 2111.03
Specifically,
the rule provides a safe harbor for firms’ use of asset allocation models that
are based on generally accepted investment theory, accompanied by disclosures
of all material
facts
and assumptions that may affect a reasonable investor’s assessment of the asset
allocation model or any report generated by such model, and in compliance with NASD IM-2210-6
(Requirements for the Use of Investment Analysis Tools) (soon to be renumbered
as FINRA Rule 2214), if the asset allocation model is an investment analysis
tool covered by the interpretative material.