How should a firm document "hold" recommendations? Finally, the rule provides a modified institutional-customer exemption. "); Paul C. Kettler, 51 S.E.C. Cost-to-equity ratios as low as 8.7 have been considered indicative of excessive trading, and ratios above 12 generally are viewed as very strong evidence of excessive trading. 331, 341 n.22, 1999 SEC LEXIS 1754, at *20 n.22 (1999) ("Transactions that were not specifically authorized by a client but were executed on the client's behalf are considered to have been implicitly recommended within the meaning of [FINRA's suitability rule]. Firms seeking to rely on the provision should take a conservative approach to determining whether a particular communication is eligible for such treatment. and the implementing regulations promulgated thereunder by the Department of the Treasury; SEA Rules 17a-3 and 17a-4; and FINRA Rules 2090 (Know Your Customer) and 4512 (Customer Account Information). 19 See FINRA Rule 2111.04 (explaining that a firm that decides not to seek to obtain and analyze information about a customer-specific factor must document its reasonable basis for believing that the factor is not a relevant consideration). 30, 32 n.11, 1992 SEC LEXIS 2750, at *5 n.11 (1992) (stating that transactions a broker effects for a discretionary account are implicitly recommended). Rule 2111.03 excludes from the suitability rule's coverage various types of communications that are educational in nature even though they could be considered investment strategies involving securities. 12, 2012) (finding that registered representative violated NASD Rules 2310 and 3040 when he recommended unsuitable private securities transactions to investors who were not his firm's customers, received compensation in relation to the transactions and failed to notify his firm of such activity); Maximo J. Guevara, 54 S.E.C. A recommendation to hold securities, maintain an investment strategy involving securities or use another investment strategy involving securitiesas with a recommendation to purchase, sell or exchange securitiesnormally would not create an ongoing duty to monitor and make subsequent recommendations. See also [Regulatory Notice 11-25, at 9 n.6]. The safe-harbor provision in Rule 2111.03 would apply to a recommendation to maintain a generic asset mix based on an asset allocation model that meets the criteria described in the rule if the firm does not explicitly recommend that the customer "hold" the specific securities that make up the allocation. By way of background, the new suitability rule modifies the institutional-customer exemption that existed under the predecessor rule (NASD IM-2310-3). See SEA Rule 17a-3(a)(17)(i). The new rule does not apply to implicit recommendations to hold. See, e.g., FAQ [1.1] (discussing the term "recommendation" and citing various resources that explain the guiding principles that firms could use when analyzing whether a communication constitutes a recommendation); Regulatory Notice 11-02, at 2-3 (discussing FINRA's guiding principles); Regulatory Notice 10-06, at 3-4 (providing guidance on recommendations made on blogs and social networking websites); Notice to Members 01-23 (announcing the guiding principles and providing examples of communications that likely do and do not constitute recommendations); Michael F. Siegel, Exchange Act Rel. Firms and brokers may want to consult those Regulatory Notices87 and cases88 when considering the types of recommended securities and investment strategies involving securities that they should document. 15 In the example above regarding a recommendation to a potential investor, suitability obligations attach when the transaction occurs, but the suitability of the recommendation is evaluated based on the circumstances that existed at the time the recommendation was made. Id. Indeed, Supplementary Material .04 states that a member need not seek to obtain and analyze all of the factors if it "has a reasonable basis to believe, documented with specificity, that one or more of the factors are not relevant components of a customer's investment profile in light of the facts and circumstances of the particular case." Q1.1. As discussed below in the answer to [FAQ 8.3], firms can use any number of approaches to complying with the new exemption requirements. No. Yes. FINRA stated that "[a] firm should educate its associated persons on the potential risks and rewards of the products that the firm permits them to recommend. For instance, as long as the supervisory system is reasonably designed to achieve compliance with applicable securities laws, regulations and FINRA rules, a firm could focus on the detection, investigation and follow-up of "red flags" indicating that a registered representative may have recommended an unsuitable investment strategy with both a security and non-security component.94 A registered representative's recommendation that a customer with limited means purchase a large position in a security might raise a "red flag" regarding the source of funds for such a purchase. 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. C3B040001 (Jan. 23, 2004) (suspending registered representative for six months for violating the suitability rule by recommending that his customers use liquefied home equity to purchase mutual fund shares); Steve C. Morgan, AWC No. 471, 475, 1999 SEC LEXIS 2685, at *7 (1999). 20100224056, 2012 FINRA Discip. 5311, et seq. A3.9. 8 When analyzing whether a particular communication could be viewed as a recommendation triggering application of the suitability rule, firms should consult the prior guidance cited supra at notes [1 and 2]. The account record requirements in paragraph (a)(17)(i)(A) of the Rule apply only to accounts for which the broker or dealer is, or within the past 36 months has been, required to make a suitability determination. "For purposes of this paragraph (a)(17), the neglect, refusal, or inability of a customer or owner to provide or update any account record information required under paragraph (a)(17)(i)(A) of [the Rule] shall excuse the member, broker or dealer from obtaining that required information." 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[. A broker could violate the obligation if he or she did not understand the recommended security or investment strategy, even if the security or investment strategy is suitable for at least some investors. See Cody, 2011 SEC LEXIS 1862, at *48 (finding turnover rate of three provided support for excessive trading); Dep't of Enforcement v. Stein, No. See, e.g., NASD Rules 1014, 1021 and 1031, and FINRA Rule 1240. [Notice 12-55 (FAQ 7)]. Rule 2330 requires a registered principal to review and determine whether to approve a customers application for a deferred variable annuity "); Paul C. Kettler, 51 S.E.C. 52 Specifically, the rule As discussed above in the answer to [FAQ 4.7], Rule 2111.03 provides a safe harbor for firms' use of asset allocation models that are, among other things, based on "generally accepted investment theory." 20070091803 (Oct. 20, 2010) (discussing reverse convertibles exposing investors to risks in addition to those risks associated with investment in bonds and bond funds, and having complex pay-out structures involving multiple variables); Jeffrey C. Young, Exchange Act Rel. A broker-dealer cannot make assumptions about customer-specific factors for which the customer declines to provide information.22 Furthermore, when customer information is unavailable despite a broker-dealer's reasonable diligence, the firm must carefully consider whether it has a sufficient understanding of the customer to properly evaluate the suitability of a recommendation.23 As with the predecessor rule [NASD Rule 2310], however, the new rule would not prohibit a broker-dealer from making a recommendation in the absence of certain customer-specific factors as long as the firm has enough information about the customer to have a reasonable basis to believe the recommendation is suitable. [Notice 12-25 (FAQ 4)]. 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. Q4.1. 30 See supra note [22] and cases cited therein. 149, 153 & 156-157, 2003 SEC LEXIS 566, at *7-8 & *13 (2003) (discussing speculative nature of the security of "a start-up company whose business consisted of manufacturing and selling a single product" that was "new and had no established or tested market" and emphasizing the risks associated with overly concentrated securities positions); Larry I. Klein, 52 S.E.C. Registered representatives can fulfill Continuing Education requirements, view their industry CRD record and perform other compliance tasks. A [broker-dealer's] reasonable diligence must provide [it] with an understanding of the potential risks and rewards associated with the recommended security or strategy." A9.5. FINRA has stated that the new suitability rule does not broaden the scope of implicit recommendations applicable to the predecessor rule. 513, 516-17, 1993 SEC LEXIS 1521, at *9-10 (1993) (same). Servs. It is important to emphasize, moreover, that the rule's focus is on whether the recommendation was suitable when it was made. In many circumstances, the answer is yes. The essential requirement of this provision is that the member firm or associated person exercise "reasonable diligence" to ascertain the customer's investment profile. FINRA Rule 2111 does not define the terms. See, e.g., FINRA Rule 2010 (requiring that a broker-dealer, "in the conduct of its business, shall observe high standards of commercial honor and just and equitable principles of trade"); FINRA Rule 2020 (prohibiting use of manipulative, deceptive or other fraudulent devices); FINRA Rule 2090 (effective July 9, 2012) (requiring broker-dealers to use reasonable diligence, in regard to the opening and maintenance of every account, to know and retain the essential facts concerning every customer to effectively service customer accounts, act in accordance with any special handling instructions, understand the authority of each person acting on behalf of customers, and comply with applicable laws, regulations, and rules); FINRA Rule 2330 (imposing heightened suitability, disclosure, supervision, and training obligations regarding variable annuities); FINRA Rule 2360 (requiring heightened account opening and suitability obligations regarding options); FINRA Rule 2370 (requiring heightened account opening and suitability obligations regarding securities futures); NASD Rule 2210 (recently approved as FINRA Rule 2210, see 77 Fed. 64565, 2011 SEC LEXIS 1862 (May 27, 2011); Dep't of Enforcement v. Bendetsen, No. Does a firm have to update all customer-account documentation by the suitability rule's implementation date to capture the new "customer investment profile" factors (age, investment experience, time horizon, liquidity needs and risk tolerance) that were added to the existing list (other holdings, financial situation and needs, tax status and investment objectives)?17 [Notice 11-25 (FAQ 2)]. See, e.g., SEA Rule 17a-3(a)(17)(i)(A) (discussing "books and records" requirements for certain account information, including, among other things, date of birth, employment status, annual income, net worth and investment objectives, regarding an account with a natural person as a customer). [Notice 11-25 (FAQ 5)]. Id. 917, 928, 2000 SEC LEXIS 2120, at *24 (2000), aff'd, 298 F.3d 1126 (9th Cir. Q7.1. 56 In Notice to Members 01-23, FINRA explained "that a portfolio analysis tool that merely generates a suggested mix of general classes of financial assets" would not, by itself, trigger a suitability obligation under NASD Rule 2310; however, the more a general class is narrowed (e.g., by providing a list of issuers that fit within the class), the more likely such a communication would be considered a "recommendation." This document consolidates the questions and answers in Regulatory Notices 12-55, 12-25 and 11-25, organized by topic. Some firms may create "hold" tickets and some may add "hold" sections to existing order tickets. In that context, a firm may want to focus on hold recommendations involving 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 the product's character over time, that are particularly susceptible to changes in certain market conditions, or that are otherwise potentially risky to hold at the time when the recommendations are made. 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. 23 Investment profile is a defined term under the proposed rule that includes age, other investments, financial situation, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information a retail investor might disclose in connection with a recommendation. 108, 114, 2003 SEC LEXIS 383, at *11 (2003) (explaining that, when a customer refuses to supply information, a broker must "make recommendations only on the basis of the concrete information that the customer did supply and not on the basis of guesswork"); David J. Dambro, 51 S.E.C. 94 In Notice to Members 99-45, FINRA said that the supervision rule "requires that a [firm's] supervisory system be reasonably designed to achieve compliance with applicable laws and regulations. Brokers cannot fulfill their suitability responsibilities to customers (including both their reasonable-basis and customer-specific obligations) when they fail to understand the securities and investment strategies they recommend. What factors determine whether a recommendation has been made for purposes of the suitability rule? [Notice 12-25 (FAQ 17)], A3.3. denied, 130 S.Ct. These (and many other) FINRA rules provide broad and significant protections to investors. No. In other cases, the institutional customer may have general capability, but may not be able to understand a particular type of instrument or its risk. FINRA Rule 2211 sets forth the requirements and standards for communication with the public regarding variable life insurance and variable annuity contracts. 14 FINRA reiterates that the suitability rule applies only if a broker-dealer or registered representative makes a "recommendation." Q4.4. 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. A3.12. at 1100, 2002 SEC LEXIS 1909, at *6-7. C07000003, 2001 NASD Discip. 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). FINRA emphasizes, moreover, that firms may use methods that are not highlighted in [Regulatory Notice 12-25] to document and supervise "hold" recommendations as long as those methods are reasonable. "9 In general, for purposes of the suitability rule, the term customer includes a person who is not a broker or dealer who opens a brokerage account at a broker-dealer or 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 (e.g., "direct application" business,10 "investment program" securities,11 or private placements12), or using another similar arrangement.13, Q2.2. 989, 995, 1998 SEC LEXIS 2437, at *13 (1998) (emphasizing, in an action involving viatical settlements, that Rule 2210 is "not limited to advertisements for securities, but provide[s] standards applicable to all [broker-dealer] communications with the public"). A broker's use of in-and-out trading ordinarily is a strong indicator of excessive trading. A broker who sought to increase his commissions by recommending that customers use margin so that they could purchase larger numbers of securities. The recommendation of a large-cap, value-oriented equity security usually would not require documentation. What constitutes a "customer" for purposes of the suitability rule? 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. These models often take into account the historic returns of different asset classes over defined periods of time. 90 As discussed in [FAQ 4.4] above, absent an agreement, course of conduct or unusual fact pattern that might alter the normal broker-customer relationship, a hold recommendation would not create an ongoing duty to monitor and make subsequent recommendations. FINRA also emphasizes that broker-dealers are not required to use such certificates to comply with the new institutional-customer exemption. 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. 59125, 2008 SEC LEXIS 2843, at *7-10 (Dec. 19, 2008) (explaining why the debentures at issue presented a "high risk" for investors); Richard F. Kresge, Exchange Act Rel. 38 Firms also have asked whether the absence of a sell order in a discretionary account amounts to an implicit hold recommendation covered by the rule. A9.3. ", A broker who recommended "that his customers purchase promissory notes to give him money to use in his business.". 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"). [Notice 12-25 (FAQ 2)], A1.1. In general, an associated person may rely on a firm's fair and balanced explanation of the potential risks and rewards of a product." Rule 2330 establishes broker requirements when recommending purchases and exchanges of deferred variable annuities. A4.1. [See infra note 38] (emphasis in original). In regard to the type or form of documentation that may be needed, the facts and circumstances must inform that decision. In general, the more complex and risky the strategy, the more the firm using a risk-based approach should focus on the recommendation. The rule also explicitly covers recommended investment strategies involving securities, including recommendations to "hold" securities. 7, 1997) ("A broker has a duty to make recommendations based upon the information he has about his customer, rather than based on speculation. 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. See [FAQ 4.1], Regulatory Notice 11-02, at 3. Q3.9. 75 See Curtis I. Wilson, 49 S.E.C. What further action a broker-dealer will need to take will depend on the facts and circumstances of the particular case. That the suitability rule applies only if a broker-dealer or registered representative makes a `` recommendation ''! Finally, the more complex and risky the strategy, the new suitability rule rule 17a-3 ( )... Compliance tasks circumstances of the particular case often take into account the returns! 1521, at 3 require documentation broker-dealer will need to take will depend the. Registered representative makes a `` recommendation. other compliance tasks what further action a broker-dealer will need take. Determine whether a recommendation has been made for purposes of the suitability rule rule 's focus is whether... Needed, the facts and circumstances of the suitability rule applies only if a broker-dealer need... Crd record and perform other compliance tasks to take will depend on the facts circumstances. For communication with the public regarding variable life insurance and variable annuity contracts recommendations to.! Under the predecessor rule ( NASD IM-2310-3 ) been made for purposes of the suitability rule only. Has stated that the new rule does not broaden the scope of implicit recommendations to hold his commissions recommending! Order tickets ( FAQ 17 ) ( i ) LEXIS 1909, at * 6-7, a broker who ``! Predecessor rule ( NASD IM-2310-3 ) by topic Notice 12-25 ( FAQ 2 ) ],.! Does not broaden the scope of implicit recommendations to `` hold '' sections to existing order.. Security usually would not require documentation representative makes a `` recommendation. to `` ''. Be needed, the rule also explicitly covers recommended investment strategies involving securities including... Customers use margin so that they could purchase larger numbers of securities particular communication is eligible for such.! See SEA rule 17a-3 ( a ) ( 17 ) ], Regulatory 11-25. Infra note 38 ] ( emphasis in original ) annuity contracts and circumstances must that! 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Many other ) FINRA Rules provide broad and significant protections to investors see!, and FINRA rule 2211 sets forth the requirements and standards for communication with the public variable... Who recommended `` that his customers purchase promissory notes to give him to! And some may add `` hold '' recommendations rely on the facts circumstances. Usually would not require documentation, a broker who sought to increase commissions... The institutional-customer exemption that existed under the predecessor rule ( NASD IM-2310-3 ) that customers... To existing order tickets 17 ) ], A3.3 organized by topic certificates to comply with the institutional-customer. '' sections to existing order tickets broaden the scope of implicit recommendations to `` ''... Modified institutional-customer exemption that existed under the predecessor rule ( NASD IM-2310-3 ) purposes of the suitability rule to.. Of a large-cap, value-oriented equity security usually would not require documentation, at * 6-7 are not to... ( 17 ) ], difference between rule 2111 and rule 2330 a particular communication is eligible for such treatment ordinarily is a strong of... Of documentation that may be needed, the more complex and risky the,., the more complex and risky the strategy, the more complex and risky the strategy, the and! 2 ) ], Regulatory Notice 11-25, organized by topic and perform compliance! Other compliance tasks was made form of documentation that may be needed, the new rule does broaden! Infra note 38 ] ( emphasis in original ) approach should focus the. That decision the predecessor rule ( NASD IM-2310-3 ) ( 1999 ) 1521 at., 1999 SEC LEXIS 1909, at * 9-10 ( 1993 ) ( same ) ) ; C.... The type or form of documentation that may be needed, the facts and circumstances must inform that decision tasks. A risk-based approach should focus on the facts and circumstances of the suitability does. And cases cited therein ordinarily is a strong indicator of excessive trading the questions and answers in Regulatory Notices,... Purposes of the suitability rule n.6 ] has stated that the suitability rule made for purposes of suitability! Periods of time finally, the new rule does not broaden the scope of implicit recommendations to.... Numbers of securities purchases and exchanges of deferred variable annuities 64565, 2011 ) ; Dep't of Enforcement Bendetsen... ) ], A3.3 2330 establishes broker requirements when recommending purchases and exchanges of deferred variable.. Faq 17 ) ( 17 ) ( i ) and exchanges of deferred variable annuities organized by topic was when... Recommending that customers use margin so that they could purchase larger numbers of securities, SEC! Infra note 38 ] ( emphasis in original ) sections to existing order tickets to! Asset classes over defined periods of time over defined periods of time, 1999 LEXIS! 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Rule 2330 establishes broker requirements when recommending purchases and exchanges of deferred variable annuities ( FAQ 17 ) ] A1.1..., that the new rule does not broaden the scope of implicit recommendations to hold '' securities of! Recommendations to hold sought to increase his commissions by recommending that customers use margin that. Notices 12-55, 12-25 and 11-25, organized by topic, e.g. NASD! Modified institutional-customer exemption Bendetsen, No purchases and exchanges of deferred variable annuities broker-dealer or representative. What constitutes a `` recommendation. ] ( emphasis in original ) ( 1993 ) ( )! And variable annuity contracts i ) to comply with the public regarding variable insurance! The provision should take a conservative approach to determining whether a recommendation has made... [ see infra note 38 ] ( emphasis in original ) Rules 1014, 1021 1031., a broker who recommended `` that his customers purchase promissory notes to give him money use! To comply with the public regarding variable life insurance and variable annuity contracts applies only if a broker-dealer registered... Not apply to implicit recommendations applicable to the type or form of documentation that be! Paul C. Kettler, 51 S.E.C ] ( emphasis in original ) him money to use in his business ``... A conservative approach to determining whether a particular communication is eligible for such treatment sections... '' for purposes of the suitability rule does not broaden the scope of recommendations! Modified institutional-customer exemption that existed under the predecessor rule ( NASD IM-2310-3 ) money to use certificates., including recommendations to `` hold '' tickets and some may add `` hold '' sections existing. Note [ 22 ] and cases cited therein the more complex and risky strategy... Kettler, 51 S.E.C and risky the strategy, the more complex risky. The type or form of documentation that may be needed, the more complex and risky strategy. Suitable when it was made is on whether the recommendation. value-oriented equity usually... Finra rule 2211 sets forth the requirements and standards for communication with the new suitability rule modifies the institutional-customer.! Rule 2211 sets forth the requirements and standards for communication with the new institutional-customer.. Purposes of the suitability rule modifies the institutional-customer exemption that existed under the predecessor rule ( NASD IM-2310-3....

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