Alert June 05, 2012

FINRA Issues Further Guidance on Suitability Rule

FINRA has published Regulatory Notice 12-25 providing additional guidance (the “Guidance”) on FINRA’s customer suitability rule (FINRA Rule 2111 (the “Rule”).  The implementation date for Rule 2111 is July 9, 2012.  The Rule requires broker-dealers and their associated persons to “have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through reasonable diligence of the firm or associated person to ascertain the customer’s investment profile.”  The Guidance is in response to industry questions and provides further clarification of Regulatory Notice 11-02.  This article summarizes the Guidance, whose component questions and answers are referred to as Q1 - Q26.

General Solicitation under the JOBS Act

Section 201(a) of the Jumpstart Our Business Startups Act (JOBS Act) requires the SEC to amend Rule 506 of Regulation D to eliminate the prohibition on general solicitations.  However, according to the Guidance, the JOBS Act does not remove broker-dealer obligations under the Rule for private placements.  FINRA explains that 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 Rule.  When a broker-dealer does make a “recommendation” within the meaning of existing guidance, however, the Rule will apply.  (Q5)

Institutional Customers and Suitability Certificates

The Guidance states that FINRA has not approved or endorsed so-called “Institutional Suitability Certificates” created by third-party vendors to facilitate compliance with the new institutional-customer exemption under Rule 2111(b).  Use of the “Institutional Suitability Certificates” does not constitute a safe harbor from the Rule.  In adopting the Rule, FINRA modified the institutional-customer exemption by replacing the previous definition of “institutional customer” with the definition of “institutional account” used in FINRA’s “books and records” rule under Rule 4512(c).  “Institutional account” is defined as the account of a “bank, savings and loan association, insurance company, registered investment company, registered investment adviser or any other person (whether natural person, corporation, partnership, trust or otherwise) with total assets of at least $50 million.”  However, the institutional customer exemption, as distinct from the definition, contains two additional 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 Rule’s predecessor) and (2) whether “the institutional customer affirmatively indicates that it is exercising independent judgment” (a new requirement).  A broker-dealer fulfills its customer-specific suitability obligation only if all of these conditions are satisfied.  Institutional Suitability Certificates may not contain all of the information a broker needs to make a suitability determination with respect to the purchase of a particular security or class of securities, so brokers must make their own independent judgments based on information they deem relevant to the determination.  (Q24 and Q25) 

The Guidance advises that firms may use a risk-based approach to documenting suitability determinations for institutional customers.  While the requirement to obtain an affirmative indication that an institutional customer intends to exercise independent judgment by definition cannot be satisfied with a non-response to a negative consent letter, the affirmative indication does not necessarily need to be in writing.  Such an affirmative consent could, therefore, be given orally to the broker and memorialized by the broker in a written record.  (Q26)

Definition of Customer.  The Rule only applies to a broker’s recommendation to a “customer.” “Customer” is defined broadly as anyone who is not a “broker or dealer” and includes an individual or entity with whom a broker-dealer has a business relationship related to brokerage services.  Even an informal business relationship with an individual or entity would constitute a broker-customer relationship.  For example, recommendations to a potential investor, even if the investor does not have an account with the firm, will fall under the broker-customer relationship.   (Q6)

Definition of Recommendation.  The Rule does not define “recommendation”; however, FINRA directs member firms to the basic principles outlined in previous FINRA guidance and SEC cases and states that the prior guidance generally remains applicable.  (Q2)

While the Rule now applies to hold recommendations, it does not apply to implicit hold recommendations.  In order to trigger obligations under the Rule, the hold recommendation must be explicit; a broker’s silence regarding security positions in an account does not implicate the Rule.  (Q3)  Advice from a firm’s call center personnel to customers who want to know whether they may continue to maintain their investments at the firm if, for instance, they move positions from an employer-sponsored retirement account to an individual retirement account held at the firm would not constitute a hold recommendation if it relates only to account requirements and not to specific securities.  (Q4)

If a customer transfers a security whose purchase the broker did not recommend into the broker’s account, the broker would not be deemed to make a hold recommendation unless the broker made an explicit recommendation.  In the event the broker does make a hold recommendation regarding such a transferred security, the level of documentation required to support the hold recommendation may be determined using a risk-based approach.  Documentation of a hold recommendation for a portfolio of blue-chip stocks may require less documentation than for complex or alternative investments, or where the customer has a highly concentrated position.  (Q11)

Investment Strategy 

Definition of “Investment Strategy”.  Under the Rule, “investment strategy” is intended to be interpreted broadly and covers such things as: (1) a recommended investment strategy regardless of whether the recommendation results in a securities transaction or mentions a specific security; (2) recommendations to invest in specific types of securities (e.g., Dogs of the Dow) or in a particular market sector; (3) recommendations to use a bond ladder or margin strategy involving securities regardless of whether the recommendation mentions a particular security; and (4) an explicit recommendation to hold a security or continue to use an investment strategy.  Ultimately the Rule focuses on whether the recommendation was suitable when it was made.  (Q7)

Safe Harbor.  The Rule provides a safe harbor for the use of asset allocation models that are: (1) based on a generally accepted investment theory; (2) accompanied by disclosures of all material facts and assumptions that may affect a reasonable investor’s assessment of the asset allocation model (or any reports); and (3) in compliance with the Requirements for the Use of Investment Analysis Tools, NASD IM-2210-6 (which will become new FINRA Rule 2214 when effective), if the asset allocation model is an investment analysis tool within the meaning of IM-2210-6.  However, the narrower or more specific a recommendation becomes, the more it is likely to become a recommendation of a particular security and, thus, trigger obligations under the Rule.  (Q8)  Finally, the safe harbor provision under the Rule would apply to recommendations of a generic asset mix based on an asset allocation model.  (Q9)

Security and Non-Security Investments.  The Rule continues to cover a broker’s recommendation of an investment strategy involving both securities and non-securities.  Further, firms must establish a supervisory system which is reasonably designed to achieve compliance with applicable securities laws, regulations and FINRA rules as applied to investment strategies involving securities and non-securities.   This may be done by setting up a system which identifies relevant red flags.  For example, a broker’s recommendation that a customer with limited means purchase a large position in a security should raise questions about the source of funds for the purchase.  If the broker recommended that the customer raise money by putting a new mortgage on his or her primary residence (a non-security investment strategy), this would require a suitability analysis covering more than the securities purchase.  (Q10)

Risk-Based Approach to Documenting Compliance

In General.  There are no explicit documentation requirements under the Rule.  The extent to which a firm needs to document its suitability analysis will depend on an assessment of the customer’s investment profile and the complexity of the recommended security or investment strategy involving securities and the risks involved.  For example, recommendation of a large-cap, value-oriented equity security would generally not require documentation.  The Guidance advises firms to consult previous Regulatory Notices and cases discussing various types of complex or potentially risky securities and investment strategies for further guidance concerning recommendations requiring documentation.   (Q12) 

Documenting “Hold” Recommendations.  Firms should pay particular attention to documenting hold recommendations of securities that by their nature or due to a particular circumstance could be viewed as having a shorter-term investment component.  For example, leveraged ETFs, REITs, overly concentrated security positions, or securities that are inconsistent with the customer’s investment profile.  (Q13)  The Guidance further provides that although the Rule does not prescribe the manner in which a firm must document “hold” recommendations, examples include hold tickets or other reasonable methods.  Ultimately, firms may use a risk-based approach to documenting and supervising “hold” recommendations.  (Q14)

Information-Gathering about Customer Suitability.  The Rule requires broker-dealers to obtain and analyze customer-specific factors listed in the Rule when making a recommendation to the customer.  A broker-dealer is not required to obtain all the customer-specific factors by the Rule’s implementation date, but rather, a firm may obtain the factors when it makes new recommendations to customers (old and new).  (Q15)

The Guidance provides that absent red flags indicating the information is inaccurate, a broker may exercise reasonable diligence and thus rely on a customer’s responses to the factors listed in the Rule.  However, there are situations in which a broker may not rely exclusively on a customer’s responses including when a customer exhibits clear signs of diminished capacity.  (Q16)  Further, reasonable diligence does not include making assumptions about customer-specific factors when the customer declines to provide the information.  Moreover, a firm must still consider whether it has sufficient understanding of the customer to properly evaluate the suitability of a recommendation when a customer refuses to provide customer-specific information.  (Q17)

Although there is no affirmative obligation to ask customers for additional information beyond what is listed as the customer-specific factors under the Rule, the best practice, according to the Guidance, is to obtain as much relevant information as possible about the customer prior to making a recommendation.  (Q18)  Additionally, if a customer chooses inconsistent investment objectives, the firm must make meaningful suitability determinations under an appropriate level of supervision.  This may include clarifying the customer’s intent and reconciling how it will handle the inconsistent investment objectives.  (Q19)

Finally, when a third-party (i.e., trustee, custodian, or guardian) is managing an account, the investment experience of the third party should be considered.  The firm must consider other factors such as the trust’s investment objectives, time horizon, and risk tolerance in the suitability analysis.  Importantly, when an institutional customer delegates decision-making authority to an agent (e.g., investment adviser, bank trust), the factors governing the institutional-customer exemption will apply to the agent.  (Q20)

Reasonable Basis and Quantitative Suitability

Customer’s Best Interests.  Generally, a broker’s recommendations must be consistent with the customer’s “best interests.”  A broker may violate the Rule by placing his or her interests ahead of a customer’s interests.  For example, it has previously been held that a broker who recommended a product because of the potential for larger commissions violated the Rule.  Likewise, a broker who recommended the purchase of promissory notes to use in his business violated the Rule.  Despite these examples, the obligation to make recommendations consistent with a customer’s best interests does not equate to recommending the least expensive security or investment strategy, as long as the recommendation is suitable and the broker does not place his or her interests above the customer’s interest.  Cost associated with a recommendation is only one of many important factors in the suitability analysis.  (Q1)

Reasonable-Basis Suitability.  The reasonable-basis obligation requires the broker to (1) perform reasonable diligence to understand the nature of the recommended security or investment strategy, the potential risks, and potential rewards; and (2) determine whether the recommendation is suitable for at least some investors based on the broker’s understanding of the product.  A broker will not meet his or her reasonable-basis obligation (or the customer-specific obligations) if the broker does not understand the securities and investment strategies being recommended.  (Q22)

Portfolio Approach.  Brokers may make recommendations based on a customer’s overall portfolio -- that is, portfolios held with other financial institutions -- so long as the customer is in agreement with that approach.  In fact, the Rule explicitly requires a broker to seek to obtain and analyze a customer’s other investments.  However, a broker may not use a portfolio approach in making a suitability analysis when (1) the customer wants individual recommendations to be consistent with the customer’s investment profile or particular factors in that profile; (2) the broker is unaware of the customer’s overall portfolio; or (3) red flags exist which indicate that the broker may have inaccurate information about the customer’s other holdings.  (Q21)

Quantitative Suitability.  Quantitative suitability requires brokers who have actual or de facto control over a customer’s account to have a reasonable basis for believing, in light of the customer’s investment profile, that a series of recommended transactions is not excessive and unsuitable for the customer, even if suitable when viewed in isolation.  The quantitative suitability obligation under the Rule essentially codifies the excessive trading line of cases under the previous rule and the general obligation of fair dealing.  (Q23)