Rule 2111 would cover a recommendation to recommendations. Does a firm have to use the exact rule terminology when seeking to obtain customer-specific information? Once a broker-dealer identifies a recommended investment strategy involving both a security and a non-security investment, the broker-dealer's suitability obligations apply to the security component of the recommended strategy95 but its suitability analysis also must be informed by a general understanding of the non-security component of the recommended investment strategy. See Peter C. Bucchieri, 52 S.E.C. See SEA Rules 17a-3(a)(6) and 17a-4(b)(1) and (b)(4). Q1.1. FINRA has stated that the new suitability rule does not broaden the scope of implicit recommendations applicable to the predecessor rule. The customer's investment profile, for example, is critical to the assessment, as are a host of product- or strategy-related factors in addition to cost, such as the product's or strategy's investment objectives, characteristics (including any special or unusual features), liquidity, risks and potential benefits, volatility and likely performance in a variety of market and economic conditions. 9 See FINRA Rule 0160(b)(4) (Definition of Customer). The reasonable-basis obligation has two components: a broker must (1) perform reasonable diligence to understand the nature of the recommended security or investment strategy involving a security or securities, as well as the potential risks and rewards, and (2) determine whether the recommendation is suitable for at least some investors based on that understanding.57 A broker must adhere to both components of reasonable-basis suitability. The significance of specific types of customer information will depend on the facts and circumstances of the particular case.24, Q3.4. A broker's use of in-and-out trading ordinarily is a strong indicator of excessive trading. In addition to the definitional change, the new institutional-customer exemption focuses on two factors: (1) whether a broker "has a reasonable basis to believe the institutional customer is capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies involving a security or securities" (a factor used in the predecessor rule), and (2) whether "the institutional customer affirmatively indicates that it is exercising independent judgment" (a new requirement).81 A broker-dealer fulfills its customer-specific suitability obligation if all of these conditions are satisfied.82. 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? However, where a broker-dealer's or registered representative's recommendation does not refer to a security or securities, the suitability rule is not applicable. Reasonable Basis Obligation This means the However, when a broker-dealer or registered representative makes a recommendation to a customer (as opposed to a potential investor), suitability obligations attach at the time the recommendation is made, irrespective of whether a transaction occurs. Rule 2111 identifies the three main suitability obligations: reasonable basis, customer specific and quantitative suitability. Firms do not have to document or individually approve every "hold" recommendation.91 As with recommendations of other types of investment strategies or of purchases, sales or exchanges of securities, firms may use a risk-based approach to documenting and supervising "hold" recommendations. 1996) (same); Robert L. Wallace, 53 S.E.C. 1304, 1311, 1997 SEC LEXIS 762, at *19 (1997). 55 When a broker-dealer recommends an allocation strategy that includes an allocation in fixed-income securities, FINRA recognizes that a number of additional factors would be relevant in determining if the broker-dealer has "recommended" particular debt securities. Q9.2. 496, 503, 2003 SEC LEXIS 1154, at *10-11 (2003) ("As we have frequently pointed out, a broker's recommendations must be consistent with his customer's best interests. Any significant variation from the list in the safe-harbor provision would be subject to regulatory scrutiny. For example, the recommendation of a large-cap, value-oriented equity security generally would not require written documentation as to the recommendation. However, as explained in FAQ [1.2], the rule would not cover an implicit recommendation to hold. 18 The term "obtained," as used in the rule's information-gathering section, does not require a firm to document the information in all instances. In general, FINRA would not view those communications as "hold" recommendations for purposes of the rule because the firm's call center is not responding to the question of whether the customer should hold the securities, but rather whether the customer can continue to maintain them at the firm. 30, 32 n.11 (1992) (stating that transactions a broker effects for a discretionary account are implicitly recommended). 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. Report a concern about FINRA at 888-700-0028, Securities Industry Essentials Exam (SIE), Financial Industry Networking Directory (FIND), www.sec.gov/investor/pubs/assetallocation.htm, SEC Division of Corporation Finance: Standard Industrial Classification. 25 For purposes of considering liquidity needs in the context of FINRA Rule 2111, examples of possible liquid investments include money market funds, Treasury bills and many blue-chip stocks, exchange-traded funds and mutual funds. These are all important considerations in analyzing the suitability of a particular recommendation, which is why the suitability rule and the concept that a broker's recommendation must be consistent with the customer's best interests are inextricably intertwined.77, Q8.1. In relation to a customer affirmatively indicating the intention to exercise independent judgment, negative consent will not suffice, but the affirmative indication does not necessarily have to be in writing. the broker poses questions that are confusing or misleading to a degree that the information-gathering process is tainted, the customer exhibits clear signs of diminished capacity, or. at 6 n.15. As FINRA has stated previously, "FINRA appreciates that no two [broker-dealers] are exactly alike. Finally, the rule provides a modified institutional-customer exemption. [Notice 12-25 (FAQ 2)], A1.1. Although due diligence reviews by such committees can be extremely beneficial,61 a firm's approval of a product for sale does not necessarily mean that an associated person has complied with the reasonable-basis obligation. LEXIS 15, at *9 (NBCC Mar. FINRA also emphasizes that broker-dealers are not required to use such certificates to comply with the new institutional-customer exemption. 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). ), cert. C07000003, 2001 NASD Discip. By way of background, the new suitability rule modifies the institutional-customer exemption that existed under the predecessor rule (NASD IM-2310-3). Does a broker-dealer have to seek to obtain all of the customer-specific factors listed in the new rule by the rule's implementation date? at 339-40 n.14, 1999 SEC LEXIS 1754, at *17 n.14. The average monthly investment is the cumulative total of the net investment in the account at the end of each month, exclusive of loans, divided by the number of months under consideration." See also [Regulatory Notice 11-25, at 9 n.6]. Thus, the new rule's "hold" language would not apply when a broker remains silent regarding security positions in an account. Although such holdings continue to act as precedent regarding those issues, the new rule does not broaden the scope of implicit recommendations. 2008015651901 (Dec. 15, 2011) (stating that "[r]everse convertibles are complex structured products that combine a debt instrument and put option into one product," the repayment of principal is linked to the performance of an underlying asset, such as a stock, a basket of stocks or an index, which is generally unrelated to the issuer of the note, and at maturity, if the value of the underlying asset has fallen below a certain level, the investor may receive less than a full return of principal); Chase Invs. 4 See, e.g., Rafael Pinchas, 54 S.E.C. Servs. [Notice 12-55 (FAQ 6(b))], A2.2. 52 Nonetheless, FINRA has stated that the safe-harbor provision would be strictly construed. Id. Notices, Proposed Rules, Rules, and Presidential Documents published in the Notice to Members 04-89, at 3. In addition, where a firm allows a customer to use different investment profiles or factors for different accounts rather than using a single customer profile for all of the customer's accounts, a firm could not borrow profile factors from the different accounts to justify a recommendation that would not be appropriate for the account for which the recommendation was made. 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. "69 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.70 Examples of instances where FINRA and the SEC have found brokers in violation of the suitability rule by placing their interests ahead of customers' interests include the following: 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 (however "least expensive" may be quantified), as long as the recommendation is suitable and the broker is not placing his or her interests ahead of the customer's interests. If a customer is either generally not capable of evaluating investment risk or lacks sufficient capability to evaluate the particular product or investment strategy that is the subject of a recommendation, the scope of a broker's customer-specific obligations under the suitability rule would not be diminished by the fact that the broker was dealing with an institutional customer. FINRA cautioned, however, that, "if the associated person remains uncertain about the potential risks and rewards of a product, or has reason to believe that the firm failed to address a particular issue or has done so in an incomplete or inaccurate manner, then the associated person would need to engage in further inquiry before recommending the product." 54722, 2006 SEC LEXIS 2572, at *21 (Nov. 8, 2006) [, aff'd, 304 F. App'x 883 (D.C. Cir. A hold recommendation involving shares of a blue chip stock ordinarily would not present the type of risk, absent unusual facts, that would require a detailed analysis or documentation. The absence of some customer information that is not material under the circumstances generally should not affect a firm's ability to make a recommendation. The rule would apply, for example, when an associated person meets with a customer during a quarterly or annual investment review and explicitly advises the customer not to sell any securities in or make any changes to the account or portfolio. For purposes of the suitability rule, how should a firm document recommendations to hold in particular and recommendations of strategies more generally? Vincent Apicella, Stock Focus: "Dogs of the Dow" Companies, Forbes.com (May 29, 2001). 82 FINRA Rule 2111(b). Id. Is the quantitative suitability obligation under the new rule any different from the excessive trading line of cases under the predecessor rule? 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