Thursday, July 12, 2012

FINRA Offers Guidance on New Suitability Rule that Took Effect July 9, 2012


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.

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