Alert August 24, 2010

FINRA Proposes Amendments to Suitability and Know Your Customer Rules

The SEC published a proposal by FINRA to adopt FINRA Rule 2111 (Suitability) and FINRA Rule 2090 (Know Your Customer) as part of the Consolidated FINRA Rulebook.  The proposed rules are part of FINRA’s continuing process of replacing the NASD and Incorporated NYSE Rules that continue to apply to member firms with FINRA Rules that are part of the Consolidated FINRA Rulebook.  In this instance, as part of the consolidation, FINRA has proposed substantive changes to both rules.  The text of the proposed rules is available on the FINRA website.

Suitability Rule

The essence of FINRA’s suitability requirements is that a member firm may not make a recommendation to a customer unless the firm has a reasonable basis for concluding that what is being recommended is suitable for the customer.  Current NASD Rule 2310 and its interpretive materials (i) distinguish between suitability obligations for retail accounts and those for institutional accounts, (ii) specify information to be obtained from retail and institutional accounts, and (iii) identify the elements of the suitability determination.  Proposed FINRA Rule 2111 retains the general structure of NASD Rule 2310, but makes several key changes, including the following:

  • The suitability obligation would apply to recommendations of investment strategies as well as recommendations of securities;
  • The Rule would specifically list three components of the suitability determination: “reasonable basis” suitability, “customer specific” suitability and “quantitative” suitability; and
  • The list of items to be considered in a retail customer’s investment profile would be expanded.
  • The Rule would clarify the means for satisfying the customer-specific suitability obligation for recommendations to an institutional account.

Investment Strategy Recommendations

The text of FINRA Rule 2111 would refer specifically to a “recommended transaction or investment strategy involving a security or securities.”  FINRA believes that the suitability obligation already applies to recommendations of investment strategies, and notes that the term is currently used in NASD IM-2310-3, which addresses suitability obligations to institutional investors.  The proposed rule would, however, exclude some categories of investment strategies, including general financial and investment information, such as basic investment concepts, information about an employer-sponsored retirement or benefit plan, and asset allocation models that are, among other things, based on generally accepted investment theory.  In the regulatory notice originally proposing FINRA Rules 2111 and 2090, FINRA requested comment on whether the suitability rule should also apply to recommendations of non-securities products.  FINRA has determined, for now at least, to apply Rule 2111 only to recommended transactions and investment strategies involving securities.

Components of Suitability Determination

In interpretive guidance, FINRA (and previously, the NASD) identified three components of suitability determinations.  The reasonable basis obligation requires the person making a recommendation to have a reasonable basis to believe, based on adequate due diligence, that the recommendation is suitable for at least some investors.  This obligation requires, among other things, that the person making the recommendation understand the product.  The customer-specific obligation requires that the person making the recommendation have reasonable grounds to believe that the recommendation is suitable for a particular customer, based on the customer’s investment profile.  The quantitative suitability obligation requires that a member or associated person who has actual or de facto control over a customer account have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable when taken together.  These components are proposed to be codified in Supplementary Material .03 of FINRA Rule 2111.

Retail Customer Investment Profile Considerations

The principal distinction between retail and institutional accounts for purposes of the proposed rule is found in the means used to fulfill the customer-specific obligation.  Pursuant to proposed FINRA Rule 2111(a), a customer-specific suitability determination for a retail customer must be based on information including, but not limited to, the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and other information disclosed by the customer.  This is an expansion of the list found in NASD Rule 2310, which specifically includes only financial status, tax status and investment objectives. 

Customer-Specific Suitability for Institutional Accounts

Proposed FINRA Rule 2111(b) would provide that a member or associated person would be deemed to have fulfilled the customer-specific suitability obligation for an institutional account (as defined in NASD Rule 3110(c)(4)) if (1) the member or associated person has a reasonable basis to believe that the institutional customer is capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies involving securities and (2) the customer affirmatively indicates that it is exercising independent judgment in evaluating the recommendation.  If the institutional account has delegated decision-making to an agent, such as an investment adviser, the analysis would be applied to the agent. 

Know Your Customer Rule

Currently, FINRA member broker-dealers have two know-your-customer obligations with different objectives.  The first arises out of a broker’s suitability obligations.  A broker must know its customer sufficiently well to make the required suitability determination.  This obligation is implicit in NASD Rule 2310, the current suitability rule, covered to some extent in NASD Rule 3110(c) (account opening information) and explicitly stated in NYSE Rule 405(1).  The second know-your-customer obligation for broker-dealers arises out of the anti-money laundering (“AML”) laws and regulations.  The AML laws and regulations require brokers to be able to positively identify their customers, ascertain the sources of funds, and make observations about possible illicit uses of funds.  The AML know-your-customer obligation is addressed indirectly by FINRA Rule 3310, which requires member firms to have an effective AML compliance program.  Proposed FINRA Rule 2090 would require every member to “use due diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer and concerning the authority of each person acting on behalf of such customer.”  Proposed Supplementary Material .01 would specify that “essential facts” include not only those necessary to effectively service the customer’s account but those necessary to comply with applicable laws, regulations and rules.

In conjunction with adopting FINRA Rule 2090, FINRA proposes to eliminate many of the elements of NYSE Rule 405 as redundant or unnecessary.  Of particular significance would be the elimination of the requirement of NYSE Rule 405(1) that a broker learn the essential facts relative to “every order.”  FINRA believes this obligation is adequately addressed by specific order-handling rules of the SEC (e.g., Regulation NMS) and FINRA (e.g., NASD Rule 2320 on best execution) and by the reasonable-basis obligation of proposed FINRA Rule 2111.

Public Comment and SEC Action

Comments on the proposed rule changes may be submitted on or before September 9, 2010.  The SEC must act on the proposed rule changes by September 27, 2010 (subject to extension).