31 Firms should note, however, that SEA Rule 17a-3 requires that, for each account with a natural person as a customer or owner, a broker-dealer generally must create a record that includes, among other things, the account's investment objectives. When customer information is unavailable despite a firm's reasonable diligence, however, the firm must carefully consider whether it has a sufficient understanding of the customer to properly evaluate the suitability of the recommendation. The rule expands the definition of what is a recommendation to include investment strategies and also expands the amount of information to be collected for each recommendation. The essential requirement of this provision is that the member firm or associated person exercise "reasonable diligence" to ascertain the customer's investment profile. The new rule, for example, does not apply to implicit recommendations to hold a security or securities. Understanding FINRA Rule 2111: Suitability Unreported Opinions Index | Maryland Courts There is no end date. The suitability rule would not apply, for instance, if a registered representative recommends a non-security investment as part of an outside business activity and the customer separately decides on his or her own to liquidate securities positions and apply the proceeds toward the recommended non-security investment.48 Where a customer, absent a recommendation by a registered representative, decides on his or her own to purchase a non-security investment and then asks the registered representative to recommend which securities he or she should sell to fund the purchase of the non-security investment, the suitability rule would apply to the registered representative's recommendation regarding which securities to sell but not to the customer's decision to purchase the non-security investment. FINRA and the SEC have recognized that certain actions constitute implicit recommendations that can trigger suitability obligations. Pinchas, 54 S.E.C. "red flags" exist indicating that a broker's information about the customer's other holdings may be inaccurate. C3B040001 (Jan. 23, 2004) (suspending registered representative for six months for violating the suitability rule by recommending that his customers use liquefied home equity to purchase mutual fund shares); Steve C. Morgan, AWC No. 91 Firms are reminded, however, that copies of all communications relating to their business as such and memoranda of brokerage orders are required to be preserved for three years. Brokers cannot fulfill their suitability responsibilities to customers (including both their reasonable-basis and customer-specific obligations) when they fail to understand the securities and investment strategies they recommend. [Notice 12-25 (FAQ 24)]. ), cert. This rule does not apply to: Transfers and A4.8. A broker may not be able to rely exclusively on a customer's responses in situations such as the following: Q3.6. [Notice 12-25 (FAQ 4)]. [Notice 11-25 (FAQ 11)], A5.2. at 6 n.15. Should the investment experience of a guardian, custodian, trustee or similarly situated third party managing an account be taken into consideration when making account recommendations? LEXIS 8, at *19 (NAC May 10, 2010) (same), aff'd, Exchange Act Rel. 2 See, e.g., SEC Adoption of Rules Under Section 15(b)(10) of the Exchange Act, 32 Fed. 61 See, e.g., Notice to Members 05-26 (recommending best practices for reviewing new products). That includes requiring a reasonable belief that the customer has A3.6. What is the scope of the provision in Supplementary Material .03 that excludes from the rule's coverage certain types of strategy-related communications that are educational in nature?50 [Notice 11-25 (FAQ 9)], A4.6. No. Q4.1. FINRA has stated that the new suitability rule does not broaden the scope of implicit recommendations applicable to the predecessor rule. Harry Gliksman, 54 S.E.C. No. 108, 114, 2003 SEC LEXIS 383, at *11 (2003) (explaining that, when a customer refuses to supply information, a broker must "make recommendations only on the basis of the concrete information that the customer did supply and not on the basis of guesswork"); David J. Dambro, 51 S.E.C. The term also would capture an explicit recommendation to hold a security or securities.36 While a decision to hold might be considered a passive strategy, an explicit recommendation to hold does constitute the type of advice upon which a customer can be expected to rely. Id. It is important to note, however, that the suitability rule would not apply to a firm's explanation of a strategy falling outside the safe-harbor provision if a reasonable person would not view the communication as a recommendation. LEXIS 13, at *12 (NAC Aug. 9, 2004) ("[A] broker's recommendations must serve his client's best interests[,]" and the "test for whether a broker's recommendation[s are] suitable is not whether the client acquiesced in them, but whether the broker's recommendations were consistent with the client's financial situation and needs. A8.3. The rule states that certain communications "are excluded from the coverage of Rule 2111 as long as they do not include (standing alone or in combination with other communications) a recommendation of a particular security or securities[.]" 933, 935, 1964 SEC LEXIS 497, at *3-4 (1964) (same); Dep't of Enforcement v. Evans, No. In its response to comments during the rulemaking process, however, FINRA noted that a broker-dealer "is free to decide as a business matter to service only those institutional investors that are willing to make the affirmative indication in terms of all potential transactions for its account. The safe-harbor provision in Rule 2111.03 would apply to a recommendation to maintain a generic asset mix based on an asset allocation model that meets the criteria described in the rule if the firm does not explicitly recommend that the customer "hold" the specific securities that make up the allocation. Note: With this guidance, FINRA attempts to present information in a format that is easily understandable. Nothing in this guidance, however, relieves a firm from having to ensure that the investment profiles or factors accurately reflect the customer's decisions. The rule also explicitly covers recommended investment strategies involving securities, including recommendations to "hold" securities. See, e.g., FAQ [1.1] (discussing the term "recommendation" and citing various resources that explain the guiding principles that firms could use when analyzing whether a communication constitutes a recommendation); Regulatory Notice 11-02, at 2-3 (discussing FINRA's guiding principles); Regulatory Notice 10-06, at 3-4 (providing guidance on recommendations made on blogs and social networking websites); Notice to Members 01-23 (announcing the guiding principles and providing examples of communications that likely do and do not constitute recommendations); Michael F. Siegel, Exchange Act Rel. A9.3. 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.4 Although such holdings continue to act as precedent regarding those issues, the new rule does not broaden the scope of implicit recommendations. The significance of specific types of customer information generally will depend on the facts and circumstances of the particular case, including the nature and characteristics of the product or strategy at issue. Is the quantitative suitability obligation under the new rule any different from the excessive trading line of cases under the predecessor rule? 40 See id. This document consolidates the questions and answers in Regulatory Notices 12-55, 12-25 and 11-25, organized by topic. See SEA Rule 17a-3(a)(17)(i)(B)(1). How should a firm document "hold" recommendations? A3.4. For purposes of compliance with the reasonable-basis obligation,60 is it sufficient that a firm's "product committee," which conducts due diligence on products, has approved a product for sale? Yes. As to an institutional customer's affirmative indication that it intends to exercise independent judgment (a new requirement), Rule 2111.07 states that "an institutional customer may indicate that it is exercising independent judgment on a trade-by-trade basis, on an asset-class-by-asset-class basis, or in terms of all potential transactions for its account." Q3.12. That is, even if a firm's product committee has approved a product for sale, an individual broker's lack of understanding of a recommended product or strategy could violate the obligation, notwithstanding that the recommendation is suitable for some investors.62. Firm compliance professionals can access filings and requests, run reports and submit support tickets. Would a broker, for example, be responsible for a hold recommendation involving blue chip stocks that a customer transferred into an account at the broker-dealer? Quantitative suitability likely will apply in more limited circumstances with regard to institutional customers than it does as to retail customers. The new rule does not change the longstanding application of the suitability rule on a recommendation-by-recommendation basis. C07960035, 1997 NASD Discip. at 504-05, 2003 SEC LEXIS 1154, at *14. Where the hold recommendation involves an overly concentrated position in a security, however, documentation usually would be necessary, even if the broker did not originally recommend the purchase of the security. [Notice 12-55 (FAQ 6(b))], A2.2. A8.2. Rule 2111(b) replaces the previous rule's definition of "institutional customer" with the more common definition of "institutional account" in FINRA's "books and records" rule, Rule 4512(c).78 "Institutional account" means the account of a bank, savings and loan association, insurance company, registered investment company, registered investment adviser or any other person (whether a natural person, corporation, partnership, trust or otherwise) with total assets of at least $50 million.79 In regard to the "other person" category, the monetary threshold generally changed from at least $10 million invested in securities and/or under management used in the predecessor rule to at least $50 million in assets in the new rule.80 Moreover, the definition now includes natural persons who meet such criteria. Rule 2111 states that the term "investment strategy" is to be interpreted "broadly. See also Donna M. Vogt, AWC No. This standard recognizes that a supervisory system cannot guarantee firm-wide compliance with all laws and regulations. What is the difference between Rule 2111 and Rule 2330? Yes. 73 Robin B. McNabb, 54 S.E.C. 52 Specifically, the rule In general, an associated person may rely on a firm's fair and balanced explanation of the potential risks and rewards of a product." 37 See FINRA Rule 2111.03. See also [Regulatory Notice 12-25, at 18 n.3]. Firms may continue to use such approaches. 331, 341 n.22, 1999 SEC LEXIS 1754, at *20 n.22 (1999) ("Transactions that were not specifically authorized by a client but were executed on the client's behalf are considered to have been implicitly recommended within the meaning of [FINRA's suitability rule]. In the context of a recommended investment strategy involving a security and an outside business activity, the broker-dealer's general understanding of the outside business activity would be based on the information and considerations required by FINRA Rule 3270.96. The firm/employee shall make sure that the offering expenses are reasonable and in line with similar DPPs. denied, 130 S.Ct. A firm should educate its associated persons on the potential risks and rewards of the products that the firm permits them to recommend. Id. A broker-dealer would have de facto control over an account if the customer routinely follows the broker-dealer's advice "because the customer is unable to evaluate the broker's recommendations and [to] exercise independent judgment." [Notice 11-25 (FAQ 8)], A4.4. When a broker is aware of a customer's overall portfolio (including investments held at other financial institutions), the broker is permitted to make recommendations based on the customer's overall portfolio as long as the customer is in agreement with such an approach. 58737, 2008 SEC LEXIS 2459, at *21-27 (Oct. 6, 2008) (applying the guiding principles to the facts of the case to find a recommendation), aff'd in relevant part, 592 F.3d 147 (D.C. No. 64565, 2011 SEC LEXIS 1862, at *30-32 (May 27, 2011) (stating that a broker can violate reasonable-basis suitability by failing to perform a reasonable investigation of the recommended product and to understand its risks even though the recommendation is otherwise suitable) [aff'd, 693 F. 3d 251 (1st Cir. [FINRA Rule 2214 replaced NASD IM-2210-6 (Requirements for the Use of Investment Analysis Tools)]. 34 See Notice to Members 04-89 (reminding firms that "recommending liquefying home equity to purchase securities may not be suitable for all investors and that [firms] should perform a careful analysis to determine whether liquefying home equity is a suitable strategy for an investor"). 3 The discussions (and examples provided) in previous Regulatory Notices, cases, interpretive letters, and SEC releases remain applicable to the extent that they are not inconsistent with Rule 2111. Customers sometimes ask broker-dealer call centers whether they may continue to maintain their investments at the firm if, for instance, they want to move from an employer-sponsored retirement account held at the firm to an individual retirement account held at the firm. The firm, however, also must consider factors such as the trust's investment objectives, time horizon and risk tolerance to complete the suitability analysis. FINRA previously has provided guiding principles that firms and registered representatives could consider when determining whether a particular communication could be viewed as a recommendation for purposes of the suitability rule. 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.49, Q4.5. In Dep't of Enforcement v. Siegel, for instance, FINRA's National Adjudicatory Council explained that a "recommendation may lack 'reasonable-basis' suitability if the broker: (1) fails to understand the transaction, which can result from, among other things, a failure to conduct a reasonable investigation concerning the security; or (2) recommends a security that is not suitable for any investors." 2010), cert. How does FINRA define the terms "liquidity needs," "time horizon" and "risk tolerance" for purposes of the suitability rule? Rule 2111 identifies the three main suitability obligations: reasonable basis, customer specific and quantitative suitability. An explicit recommendation to hold is tantamount to a "call to action" in the sense of a suggestion that the customer stay the course with the investment. The suitability rule applies only to recommended securities and investment strategies involving securities, but FINRA does not define the term "recommendation" other than to say that it is a facts and circumstances inquiry. at 339-40 n.14, 1999 SEC LEXIS 1754, at *17 n.14. Arbitration and mediation case participants and FINRA neutrals can view case information and submit documents through this Dispute Resolution Portal. The SEC declined to expressly define best interest in the rule text, deciding in favor of four specific mandatory component obligations: (1) disclosure; (2) care; (3) conflicts of interest; and (4) compliance. 1990). FINRA has extensively addressed those guiding principles in past Regulatory Notices, and cases have applied them to specific facts.1 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.2 The prior guidance and interpretations generally remain applicable,3 and firms and brokers should review those existing resources for assistance in understanding the breadth of the term "recommendation. See, e.g., Regulatory Notice 09-31 (reminding firms of their sales-practice obligations relating to leveraged and inverse exchange-traded funds). A8.1. A4.1. As discussed above in the answer to [FAQ 4.7], Rule 2111.03 provides a safe harbor for firms' use of asset allocation models that are, among other things, based on "generally accepted investment theory." Does the firm have a duty, for example, to ask its customers if there is anything else it should know about them when collecting information for suitability purposes? Members' Responsibilities Regarding Deferred Variable Annuities Selected Notices: 07 "68 What does it mean to act in a customer's best interests? In many circumstances, the answer is yes. See, e.g., Rafael Pinchas, 54 S.E.C. 6693, 6696 (Feb. 14, 1989) (stating that proposed SEA Rule 15c2-6, which would have required documented suitability determinations for speculative securities, "would not apply to general advertisements not involving a direct recommendation to the individual"); DBCC v. Kunz, No. Moreover, absent "red flags" indicating that such information is inaccurate or that the customer is unclear about the information, a broker generally may rely on the customer's responses. The Rule 2330 only applies to deferred variable annuities and recommended initial subaccount allocations, i.e., to purchases and exchanges of deferred variable . In this regard, firms should note that, as an allocation recommendation becomes narrower or more specific, the recommendation gets closer to becoming a recommendation of particular securities and, thus, subject to the suitability rule, depending on a variety of factors (including the number of issuers that fall within the broker-dealer's allocation recommendation).55 Accordingly, broker-dealers should assess whether allocation recommendations involving certain types of sub-categories of broader market sectors or even more limited groupings are so specific or narrow that they constitute recommendations of particular securities.56, Q4.8. In general, however, when there is an indication that the institutional customer is not capable of analyzing, or does not intend to exercise independent judgment regarding, all of a broker-dealer's recommendations, the broker-dealer necessarily will have to be more specific in its approach to ensuring that it complies with the exemption. Each firm has a general obligation to evidence compliance with applicable FINRA rules. FINRA is aware that some firms currently ask customers for relevant information without using the exact rule terminology or separately designating factors (e.g., investment objectives that include a risk-tolerance component that is not separately labeled as such). Id. A broker who recommended new issues being pushed by his firm so that he could keep his job. [Notice 12-55 (FAQ 10(b)]. A broker whose mutual fund recommendations were "designed 'to maximize his commissions rather than to establish an appropriate portfolio' for his customers. These models often take into account the historic returns of different asset classes over defined periods of time. Where a customer discloses information to a broker in connection with the recommendation, the broker must consider that information as part of the suitability analysis. Unless the facts indicate that an associated person's failure to sell securities in a discretionary account was intended as or tantamount to an explicit recommendation to hold, FINRA would not view the associated person's inaction or silence in such circumstances as a recommendation to hold the securities for purposes of the suitability rule. 64565, 2011 SEC LEXIS 1862 (May 27, 2011); Dep't of Enforcement v. Bendetsen, No. [Broker-dealers or registered representatives] should consider not only whether the recommended investments are suitable, but also whether the strategy of investing liquefied home equity in securities is suitable." 96 See also supra note [48] and discussion therein. denied, 130 S.Ct. To meet its suitability obligations, a firm must obtain and analyze enough customer information to have a reasonable basis to believe the recommendation is suitable. LEXIS 22 (Mar. 917, 928, 2000 SEC LEXIS 2120, at *24 (2000), aff'd, 298 F.3d 1126 (9th Cir. "); see also Jack H. Stein, 56 S.E.C. 2008015078603 (Nov. 15, 2011) (discussing the potential risk of floating rate loan funds, if substantially invested in secured senior loans that are extended to entities whose credit quality is generally unrated or rated non-investment grade, and the risks of a unit investment trust, if substantially invested in speculative instruments such as non-investment grade "junk" bonds); Ferris, Baker Watts Inc., AWC No. No. Other firms may require emails or memoranda to supervisors or emails or letters to customers copying supervisors. Similarly, a registered representative's recommendation that a "buy and hold" customer with an investment objective of income liquidate large positions in blue chip stocks paying regular dividends might raise a "red flag" regarding whether that recommendation is part of a broader investment strategy. The suitability rule also would not apply to a firm's allocation recommendation regarding broad-based market sectors (e.g., agriculture, construction, finance, manufacturing, mining, retail, services, transportation and public utilities, and wholesale trade).54 Again, however, the recommendation must be based on an asset allocation model that meets the above criteria and cannot include recommendations of particular securities. If a firm's call center informs customers that they are permitted to continue to maintain their investments at the firm under such circumstances, would FINRA consider those communications to be "hold" recommendations triggering application of the new suitability rule? Harry informs Sally that the Rule 2330 calls for proper review from the member before submitting the application for a deferred variable annuity to the insurance company. Id. Does a firm have to use the exact rule terminology when seeking to obtain customer-specific information? Q9.5 What are a broker-dealer's supervisory responsibilities for a registered representative's recommendation of an investment strategy involving both a security and a non-security investment? 94 In Notice to Members 99-45, FINRA said that the supervision rule "requires that a [firm's] supervisory system be reasonably designed to achieve compliance with applicable laws and regulations. [Notice 12-25 (FAQ 16)]. What could be considered a "safe-harbor" provision in Supplementary Material .03 is limited in scope. The quantitative suitability obligation under the new rule simply codifies excessive trading cases. A1.3. 2003); Powell & McGowan, Inc., 41 S.E.C. [Notice 11-25 (FAQ 4)]. [Notice 12-25 (FAQ 2)], A1.1. Some customers with long time horizons may not desire to take on such risk and others, because of considerations outside their time horizons, are unable to do so. (Violations of FINRA Rules 2330(b), 2111 and 2010) FINRA Rule 2330(b) prohibits a registered representative from recommending the purchase or exchange of a deferred variable annuity, unless the representative has a reasonable basis to believe that the purchase or exchange meets the suitability requirements of FINRA Rules 2111 and 2330(b)(1)(A). The rule states that it applies to explicit recommendations to hold. 88 See, e.g., Cody, 2011 SEC LEXIS 1862, at *36-40 (discussing non-investment grade securities); Wells Fargo Invs., LLC, AWC No. However, the fact that a customer initially needed help understanding a potential investment or investment strategy need not necessarily imply that the customer did not ultimately develop an understanding. 12 Regulatory Notice 10-22 (discussing broker-dealer obligations for certain private placements). No. A broker-dealer may use a risk-based approach to supervising its registered representatives' recommendations of investment strategies with both a security and non-security component. "84, Q8.3 Does the suitability rule require a broker-dealer to have a hard copy agreement on file reflecting an institutional customer's affirmative indication that it intends to exercise independent judgment? [Notice 11-25 (FAQ 10)]. For example, a firm should, among other things, clarify the customer's intent and, if necessary, reconcile and/or determine how it will handle the customer's differing investment objectives. Quantitative suitability requires a broker who has actual or de facto control63 over a customer account to have a reasonable basis for believing that, in light of the customer's investment profile, a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer.64 Factors such as turnover rate,65 cost-to-equity ratio,66 and use of in-and-out trading67 in a customer's account may provide a basis for finding that the activity at issue was excessive. Recently FINRA Rule 2111 went into effect regarding Suitability. 112-106, 126 Stat. Where a broker did not recommend the original purchase of a security but explicitly recommends that the customer subsequently hold that security, the new suitability rule would apply. Id. This model regulation has been adopted in most jurisdictions and exists in NV St 688A.450. A recommendation to hold securities, maintain an investment strategy involving securities or use another investment strategy involving securitiesas with a recommendation to purchase, sell or exchange securitiesnormally would not create an ongoing duty to monitor and make subsequent recommendations. [Notice 12-25 (FAQ 13)], A9.2. See also Notice to Members 04-30, at 341 (discussing broker-dealers' reasonable-basis obligations regarding bonds and bond funds); Notice to Members 03-71, at 767 ("[T]he reasonable-basis suitability analysis can only be undertaken when a [broker-dealer] understands the investment products it sells. For instance, as long as the supervisory system is reasonably designed to achieve compliance with applicable securities laws, regulations and FINRA rules, a firm could focus on the detection, investigation and follow-up of "red flags" indicating that a registered representative may have recommended an unsuitable investment strategy with both a security and non-security component.94 A registered representative's recommendation that a customer with limited means purchase a large position in a security might raise a "red flag" regarding the source of funds for such a purchase. Rule 2111 would cover a recommendation to recommendations. 292, 293-94, 1993 SEC LEXIS 3645, at *3-5 (1993) (discussing risky nature of investing in a company when that company "was losing money, had never paid a dividend, and its prospects were totally speculative"); Patrick G. Keel, 51 S.E.C. Where, for example, a registered representative makes a recommendation to purchase a security to a potential investor, the suitability rule would apply to the recommendation if that individual executes the transaction through the broker-dealer with which the registered representative is associated or the broker-dealer receives or will receive, directly or indirectly, compensation as a result of the recommended transaction.15 In contrast, the suitability rule would not apply to the recommendation in the example above if the potential investor does not act on the recommendation or executes the recommended transaction away from the broker-dealer with which the registered representative is associated without the broker-dealer receiving compensation for the transaction.16, Q3.1. See also [infra note 86; Regulatory Notice 12-25, at 19 n.12]. Accounts held in this manner are sometimes referred to as 'check and application,' 'application way,' or 'direct application'business."). 1985). The new suitability rule (as with the predecessor rule) requires a broker to seek to obtain and analyze a customer's other investments. Q4.4. "); F.J. Kaufman and Co., 50 S.E.C. See [FAQ 4.1], Regulatory Notice 11-02, at 3. No. 59 FINRA[, in FAQ 5.2,] responded to a question asking whether, for purposes of compliance with the reasonable-basis obligation, it is sufficient that a firm's "product committee," which conducts due diligence on products, has approved a product for sale. A4.5. 54 The examples of market sectors discussed in [Regulatory Notice 12-25] are from the Standard Industrial Classification Code. 471, 475, 1999 SEC LEXIS 2685, at *7 (1999). Some of the "Institutional Suitability Certificates" that are being marketed do not identify an institutional customer's experience with particular asset classes or types of securities or investment strategies involving a security or securities.

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