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[. 70 See Epstein, 2009 SEC LEXIS 217, at *42 (stating that the broker's "mutual fund switch recommendations served his own interest by generating substantial production credits, but did not serve the interests of his customers" and emphasizing that the broker violated the suitability rule "when he put his own self-interest ahead of the interests of his customers"). LEXIS 10362, *4-5 (9th Cir. In general, an associated person may rely on a firm's fair and balanced explanation of the potential risks and rewards of a product." 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. What constitutes "reasonable diligence" in attempting to obtain the customer-specific information? Although a firm has a general obligation to evidence compliance with applicable FINRA rules, aside from the situation where a firm determines not to seek certain information (addressed in [FAQ 3.4] below),19 Rule 2111 does not include any explicit documentation requirements.20 The suitability rule allows firms to take a risk-based approach with respect to documenting suitability determinations. Firms should use a similar approach to analyzing whether particular recommendations are eligible for the Rule 2111.03 safe-harbor provision. A broker's use of in-and-out trading ordinarily is a strong indicator of excessive trading. 1020, 1022, 1989 SEC LEXIS 25, at *6-7 (1989), aff'd, 902 F.2d 1580 (9th Cir. Q9.1. Rule 2330 requires firms to have written policies and procedures in place for surveillance of brokers recommending, purchasing or exchanging of deferred variable annuities. How should a firm document "hold" recommendations? [Notice 12-25 (FAQ 4)]. The following frequently asked questions (FAQs) provide guidance on FINRA Rule 2111 (Suitability). 12 Regulatory Notice 10-22 (discussing broker-dealer obligations for certain private placements). Id. As noted above in the answer to [FAQ 3.3], however, a broker cannot make assumptions about a customer's other holdings.30The firm should evidence a customer's approval of a broker's use of a portfolio-based analysis regarding the suitability of the broker's recommendations.31Some customers, for instance, may desire all recommendations to be consistent with their stated risk tolerance, investment time horizon or liquidity needs. The rule generally requires a broker-dealer to seek to obtain and analyze the customer-specific factors listed in the rule when making a recommendation to a customer. 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. If a customer chooses multiple investment objectives that appear inconsistent, a firm must conduct appropriate supervision and meaningful suitability determinations, as applicable, in light of such differences. The new rule, for example, does not apply to implicit recommendations to hold a security or securities. 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? 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. Rule 2111 would cover a recommendation to recommendations. [Notice 12-25 (FAQ 17)], A3.3. 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. 52 Specifically, the rule The suitability rule generally requires broker-dealers to use reasonable diligence to seek to obtain and analyze the customer-specific factors listed in the rule. 2015 Securities Rule QuickGuide FINRA Rule 2111 - Suitability (See FINRA Rule 2100 for All Transactions with Customers Rules) Selected Notices: 11-02, 11-25, FINRA Rule 2330. LEXIS 15, at *9 (NBCC Mar. A broker must understand the securities and investment strategies involving a security or securities that he or she recommends to customers.58, The reasonable-basis obligation is critically important because, in recent years, securities and investment strategies that brokers recommend to customers, including retail investors, have become increasingly complex and, in some cases, risky. 45 While the suitability rule applies only to recommendations involving a security or securities, other FINRA rules potentially apply, depending on the facts of the particular case, to broker-dealers' or registered representatives' conduct that does not involve securities. See [FAQ 3.10]. A8.1. [Notice 12-55 (FAQ 7)]. 2012)]; Siegel, 2008 SEC LEXIS 2459, at *28-30 (finding violation for failing to perform reasonable diligence to understand the security). FINRA's supervision rules do not dictate the exact manner in which a broker-dealer must supervise its registered representatives' recommendations of investment strategies involving a security and a non-security investment. 1985). Moreover, the relative importance of the issuers to other factors in making fixed-income investment decisions varies depending on the total mix of the relevant facts and circumstances. Although such holdings continue to act as precedent regarding those issues, the new rule does not broaden the scope of implicit recommendations. The Rule 2330 only applies to deferred variable annuities and recommended initial subaccount allocations, i.e., to purchases and exchanges of deferred variable . The suitability rule applies on a recommendation-by-recommendation basis. 551, 2002 SEC LEXIS 104 (2002); FINRA Interpretive Letter, Mar. 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? [Notice 11-25 (FAQ 11)], A5.2. 22 See DBCC v. Hurni, No. 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. For "hold" recommendations, [as discussed below in FAQ 9.3,] a firm may want to focus on securities that by their nature or due to particular circumstances could be viewed as having a shorter-term investment component; that have a periodic reset or similar mechanism that could alter a product's character over time; that are particularly susceptible to changes in market conditions; or that are otherwise potentially risky or problematic to hold at the time the recommendations are made.89. [Notice 12-25 (FAQ 19)]. The new suitability rule (as with the predecessor rule) requires a broker to seek to obtain and analyze a customer's other investments. Reg. A6.1. Costello v. Oppenheimer & Co., 711 F.2d 1361, 1369 n.9 (7th Cir. '")[, aff'd, 416 F. App'x 142 (3d Cir. The issuers' identities and creditworthiness are important information in determining whether to purchase a debt security, but there may be other factors that affect the pricing and any decision to invest in specific debt securities. 73 Robin B. McNabb, 54 S.E.C. "); Paul C. Kettler, 51 S.E.C. Some of the cases in which FINRA and the SEC have found that brokers placed their interests ahead of their customers' interests involved cost-related issues. However, a customer may have a long time horizon, but also may need or want to invest all or a portion of his or her portfolio in liquid assets to pay for unexpected expenses or take advantage of unforeseen opportunities. 306 (2012). 20006005977901, 2011 FINRA Discip. 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? Accordingly, the suitability rule would cover a firm's recommendation that a customer purchase securities using margin, whereas the rule generally would not cover a firm's brochure that simply explains the risks and benefits of margin without suggesting that the customer take action.51, Q4.7. In many ways this rule is very similar to FINRA Rule 2330 which relates to variable annuity Reasonable Basis Obligation This means the denied, 130 S.Ct. Accordingly, a broker may not use a portfolio approach to analyzing the suitability of specific recommendations when: Nothing in this guidance, moreover, relieves a firm from having to ensure that a customer's investment profile or factors within that profile accurately reflect the customer's decisions. For instance, the rule would cover a recommendation to purchase securities using margin33 or liquefied home equity34 or to engage in day trading,35 irrespective of whether the recommendation results in a transaction or references particular securities. A firm could comply with this requirement, for example, by having an institutional customer indicate in a signed customer agreement or other document that the institutional customer will be exercising independent judgment in evaluating recommendations or a firm could call its institutional customer, have that discussion, and (if it chooses or circumstances require) document the conversation to evidence the institutional customer's affirmative indication. 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 had handled the account.38, Q4.2. May 20, 1999) (holding that FINRA's requirement that registered representatives act in a manner consistent with just and equitable principles of trade applies to all unethical business conduct, regardless of whether the conduct involves securities); Vail v. SEC, 101 F.3d 37, 39 (5th Cir. 11 Regulatory Notice 08-35, at 2 (stating that direct participation programs (DPPs) and unlisted real estate investment trusts (REITs) are referred to as "investment programs"). See also [Regulatory Notice 11-25, at 9 n.6]. See [FAQ 4.1], Regulatory Notice 11-02, at 3. 917, 928, 2000 SEC LEXIS 2120, at *24 (2000), aff'd, 298 F.3d 1126 (9th Cir. In interpreting FINRA's suitability rule, numerous cases explicitly state that "a broker's recommendations must be consistent with his customers' best interests. denied, 130 S.Ct. No. 87 See, e.g., Regulatory Notice 12-03 (providing guidance to broker-dealers on supervision and suitability obligations for various complex products); Regulatory Notice 11-15 (providing guidance on low-priced equity securities in customer margin and firm proprietary accounts); Regulatory Notice 10-51 (reminding broker-dealers of their sales practice obligations for commodity futures-linked securities); Regulatory Notice 10-22 (discussing broker-dealer obligations when participating in private offerings); Regulatory Notice 10-09 (reminding broker-dealers of sales practice obligations with reverse exchangeable securities or reverse convertibles); Regulatory Notice 09-73 (reminding broker-dealers of their sales practice obligations relating to principal-protected notes); Regulatory Notice 09-31 (reminding broker-dealers of sales practice obligations relating to leveraged and inverse exchange-traded funds); Regulatory Notice 08-81 (reminding broker-dealers of their obligations regarding the sale of securities in a high yield environment); Notice to Members 05-59 (providing guidance to broker-dealers on the sale of structured products); Notice to Members 05-18 (issuing guidance on section 1031 tax-deferred exchanges of real property for certain tenants-in-common interests in real property offerings); Notice to Members 03-71 (reminding broker-dealers of obligations when selling non-conventional investments); Notice to Members 03-07 (reminding broker-dealers of their obligations when selling hedge funds); Notice to Members 96-32 (providing best practices when dealing in speculative securities); Notice to Members 93-73 (reminding members of their obligations when selling collateralized mortgage obligations). 47 See Notice to Members 05-50, at 5 ("[R]ecommendations to liquidate or surrender a registered security such as a mutual fund, variable annuity, or variable life contract must be suitable, including where such liquidations or surrender[s] are for the purpose of funding the purchase of an unregistered [equity indexed annuity]."). 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. Reasonable Basis Obligation This means the SEA Rule 17a-3 also states that the broker-dealer must furnish such customer or owner a copy of the required account record information or alternative document with all information required by SEA Rule 17a-3(a)(17)(i)(A), including an explanation of any terms regarding investment objectives, for verification within 30 days of account opening and at least once every 36 months thereafter. Does the suitability rule apply when a broker-dealer or registered representative makes a recommendation to a potential investor? See id. Q4.6. 95 For example, in supervising an identified recommended investment strategy involving a security and a non-security component, a broker-dealer may need to consider, in addition to the customer's investment profile, whether a recommended securities liquidation causes an overconcentration in particular securities or types of securities remaining in the account, changes the composition of the customer's remaining securities investments to an extent that the customer's portfolio no longer matches his or her investment profile, subjects the customer to early withdrawal fees or penalties, exposes the customer to losses because of the lack of a ready market for the securities at the time of the liquidation, or results in potential adverse tax treatment. Although the reasonableness of the effort will depend on the facts and circumstances, asking a customer for the information ordinarily will suffice. As noted above in the answer to [FAQ 8.1], FINRA has not endorsed or promoted any certificate. Q3.9. In general, the more complex and risky the strategy, the more the firm using a risk-based approach should focus on the recommendation. FINRA has not approved or endorsed any third-party Institutional Suitability Certificates and has not contracted with any third-party vendor to create such certificates on FINRA's behalf. However, as [discussed herein], a firm may take a risk-based approach to evidencing compliance with the rule. 72 Epstein, 2009 SEC LEXIS 217, at *72; see also Sathianathan, 2006 SEC LEXIS 2572, at *23. 4 What is the difference between Rule 2111 and Rule 2330? 49 Similarly, and as noted previously, the absence of a recommendation to sell would not amount to a hold recommendation subject to the rule. The new suitability rule requires that a recommended investment strategy involving a security or securities must be suitable. Quantitative suitability likely will apply in more limited circumstances with regard to institutional customers than it does as to retail customers. That includes requiring a reasonable belief that the customer has [Notice 11-25 (FAQ 5)]. These are only examples of how some firms may document "hold" recommendations if necessary. 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? In limited circumstances, FINRA and the SEC have recognized that certain actions constitute implicit 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.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 will depend on the facts and circumstances of the particular case.24, Q3.4. 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. However, please be aware that, in case of any misunderstanding, the rule language prevails. Yes. 80 Compare FINRA Rules 2111(b) and 4512(c) with NASD IM-2310-3. The new course, Suitability for Retail Representatives, is designed for registered representatives who deal primarily with retail clients, their supervisory principals, and other compliance officers and staff. at 504-05, 2003 SEC LEXIS 1154, at *14. Reg. File a complaint about fraud or unfair practices. FINRA emphasizes, however, that a high level of liquidity does not, in and of itself, mean that the recommended product is suitable for all customers. A3.6. 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. 13 Nothing in this guidance shall be construed as altering a broker-dealer's obligations under applicable federal laws, regulations and rules or other FINRA rules, including, but not limited to, Sections 9, 10(b) and 15(c) of the Securities Exchange Act of 1934, Section 17(a) of the Securities Act of 1933, the Bank Secrecy Act, 31 U.S.C. Firms should understand that the use of any such Institutional Suitability Certificate in no way constitutes a safe harbor from the rule. 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. 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. Q4.1. In addition, for other FINRA rules that have suitability components such as FINRA Rule 2330 (Members Responsibilities regarding Deferred Variable Annuities) and FINRA Rule 2360 A broker who recommended speculative securities that paid high commissions because he felt pressured by his firm to sell the securities. Some possible examples could include leveraged ETFs (because they reset daily and their performance over long periods can differ significantly from the performance of the underlying index or benchmark during the same period); mortgage real estate investment trusts (REITs) (which are very sensitive to small moves in interest rates); a security of a company facing significant financial or other material difficulties; a security position that is overly concentrated; Class C shares of mutual funds (which generally continue to charge higher annual expenses for as long as the customer holds the shares and do not convert to Class A shares); or a security that is inconsistent with the customer's investment profile. [Notice 12-25 (FAQ 15)], A3.2. 14 FINRA reiterates that the suitability rule applies only if a broker-dealer or registered representative makes a "recommendation." A customer could proceed in such a manner, but a firm should evidence the customer's intent to use different investment profiles or investment-profile factors for the different accounts. ; Regulatory Notice 11-02, at 4-5. 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. Turnover rates between three and six may trigger liability for excessive trading. 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. Suitability The Rule Notices 2110. In many circumstances, the answer is yes. See, e.g., NASD Rules 1014, 1021 and 1031, and FINRA Rule 1240. What is the scope of the term "strategy" as used in FINRA Rule 2111? 4, 1997 ("[T]he staff agrees that a reference to an investment company or an offer of investment company shares in an advertisement or piece of sales literature would not by itself constitute a 'recommendation' for purposes of [the suitability rule]."). [Notice 12-25 (FAQ 22)], A5.1. For instance, does each individual recommendation have to be consistent with the customer's investment profile or can the suitability of a broker's recommendation be judged in light of its consistency with the customer's overall portfolio? [Notice 12-25 (FAQ 16)]. Does the elimination of the general solicitation prohibition mean that broker-dealers no longer have suitability obligations regarding private placements? Q6.1. C05020055, 2007 NASD Discip. Rule 2330 requires a registered principal to review and determine whether to approve a customers application for a deferred variable annuity 35415, 1995 SEC LEXIS 481, at *2-3 (Feb. 24, 1995) ("His excessive trading yielded an annualized commission to equity ratio ranging between 12.1% and 18.0%."). In addition, the term would capture an explicit recommendation to hold a security or securities or to continue to use an investment strategy involving a security or securities.44 The rule would apply, for example, when a registered representative meets (or otherwise communicates) 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 or to continue to use an investment strategy. The hold recommendation must be explicit.5, Q1.3. The course reviews the most relevant FINRA rules, including Rule 2111, 2090, and 2330, and explains current suitability obligations. 1030, 1032-1034, 1996 SEC LEXIS 2922, at *5-10 (1996) (explaining risks associated with certain foreign currency debt securities); Clinton H. Holland, Jr., 52 S.E.C. FINRA previously issued written guidance on a customer's capability of analyzing risks (a factor used in both the predecessor and new suitability rules).83 FINRA stated that a broker-dealer may conclude in some cases that a customer is not capable of making independent investment decisions in general. 3333 (2010). 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. Still other firms may create data fields for entering such information into automated supervisory systems. Yes. A4.2. As a general matter, these terms are to be understood commensurate with their meaning in financial analysis. Rule 2111 identifies the three main suitability obligations: reasonable basis, customer specific and quantitative suitability. See Pryor, McClendon, Counts & Co., Exchange Act Rel. For purposes of using a risk-based approach to documenting compliance with suitability obligations, what types of recommendations does FINRA generally consider complex or potentially risky? 75 See Curtis I. Wilson, 49 S.E.C. However, as explained in FAQ [1.2], the rule would not cover an implicit recommendation to hold. It also is important to note that, where an institutional customer has delegated decisionmaking authority to an agent, such as an investment adviser or a bank trust department, Rule 2111(b) makes clear that the factors relevant to determining whether the customer meets the criteria for the institutional-customer exemption will be applied to the agent. 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. Each firm has a general obligation to evidence compliance with applicable FINRA rules. 61247, 2009 SEC LEXIS 4332, at *3-6 (Dec. 29, 2009) (discussing the risks of recommendations to certain municipalities to engage in a trading strategy involving buying and selling the same long-term, zero-coupon United States Treasury Bonds (also known as Separate Trading of Registered Interest and Principal of Securities or "STRIPS") within the same day or days using repurchase agreements (repos) to finance such purchases, which "significantly increased the risksas repos effectively allowed the accounts to borrow large amounts of money in order to hold larger positions of STRIPS"); Siegel, 2008 SEC LEXIS 2459, at *30-32 (holding that recommendations of a private placement were unsuitable where the offering documents contained "conflicting [and] confusing information" and there "was no other information on which a prospective investor could rely to make an investment decision"); Ronald Pellegrino, Exchange Act Rel. 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