Alert December 26, 2012

FINRA Provides Additional Guidance on New Suitability Rule

FINRA has provided additional Guidance on Rule 2111, the Suitability Rule, in FRN 12-55.  The new guidance amends frequently asked questions (FAQs) first published in FRN 12-25 in May, 2012, and addresses in particular the scope of the terms “customer” and “investment strategy.”  FINRA Rule 2111 became effective on July 9, 2012.  For a discussion of the original FAQs, see the article “FINRA Issues Further Guidance on Suitability Rule” in the June 5, 2012 Financial Services Alert.

Customers and Potential Investors

Question 6 of the original FAQs asked, “what constitutes a ‘customer’ for purposes of the suitability rule?”  That has become question 6(a), and FINRA has added language to clarify that the term customer includes not only a person who opens a brokerage account at a broker-dealer but also a person who does not open an account but who “purchases a security for which the broker-dealer receives or will receive, directly or indirectly, compensation even though the security is held at an issuer, the issuer’s affiliate or a custodial agent… or using another similar arrangement.”  Firms that act as placement agents but do not open customer accounts are, therefore, still responsible for determining the suitability of recommendations to investors who purchase securities for which the firm receives placement agent fees.

In newly-created question 6(b), FINRA explains that if a broker-dealer makes a recommendation to a potential investor (one who is not yet a customer), the suitability rule applies only if the potential investor subsequently purchases the security through that broker-dealer.  Thus, a broker-dealer will not be liable for making an unsuitable recommendation to a potential investor if the broker-dealer learns that the transaction is not suitable and declines to enter into the transaction with the potential investor, even if the potential investor finds another broker-dealer to execute the transaction.

Investment Strategy Recommendations

FAQ 7, addressing the meaning of “investment strategy,” was amended in part to delete the following sentence:  “The new rule would cover a recommended investment strategy involving a security or securities regardless of whether the recommendation results in a securities transaction or even mentions a specific security or securities.”  While FINRA has not explained its reasoning for this change, it is consistent with the definition of customers in new FAQ 6(b) to exclude potential investors who do not enter into a transaction with the broker-dealer.

FAQ 10, addressing investment strategies involving both a security and a non-security investment, has been split into two parts.  In FAQ 10(a), FINRA clarifies that where a recommendation does not refer to a security or securities, the suitability rule is not applicable.  This would be true, for example, where a broker recommends a non-security investment and the customer independently decides to liquidate securities positions and apply the proceeds to the non-security investment.  Finally, in new FAQ 10(b), FINRA discusses the responsibility of a broker-dealer with respect to the non-security component of a recommendation of an investment strategy with both a security and non-security component.  The broker-dealer’s suitability analysis of such a mixed investment strategy “must be informed by a general understanding of the non-security component of the recommended investment strategy.”  FINRA further states that where the non-security component involves an outside business activity of the broker-dealer (for example, an insurance business), the broker-dealer’s general understanding of the outside business activity would be based on the information and considerations required by FINRA Rule 3270 (Outside Business Activities of Registered Persons).