Does the suitability rule apply when a broker-dealer or registered representative makes a recommendation to a potential investor? FINRA cautioned, however, that a firm should evidence a customer's intent to use different investment profiles or factors for the different accounts. See, e.g., FINRA Rule 2010 (Standards of Commercial Honor and Principles of Trade); FINRA Rule 3270 (Outside Business Activities of Registered Persons); Rule 2210 (Communications with the Public); see also Ialeggio v. SEC, No. See, e.g., NASD Rules 1014, 1021 and 1031, and FINRA Rule 1240. 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. Reg. [Notice 12-55 (FAQ 10(b)]. The rule thus explicitly permits a suitability analysis to be performed within the context of a customer's other investments. No. [Notice 11-25 (FAQ 5)]. A3.9. 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. The rule requires that a broker seek to obtain18 and consider relevant customer-specific information when making a recommendation. Firms should use a similar approach to analyzing whether particular recommendations are eligible for the Rule 2111.03 safe-harbor provision. Although such holdings continue to act as precedent regarding those issues, the new rule does not broaden the scope of implicit recommendations. 73 Robin B. McNabb, 54 S.E.C. [Notice 12-25 (FAQ 25)]. [Notice 12-25 (FAQ 22)], A5.1. A3.4. 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. See also [Regulatory Notice 11-25, at 9 n.6]. 69 Raghavan Sathianathan, Exchange Act Rel. 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 broker poses questions that are confusing or misleading to a degree that the information-gathering process is tainted, the customer exhibits clear signs of diminished capacity, or. 68 See Regulatory Notice 11-02, at 7 n.11; SEC Staff Study on Investment Advisers and Broker-Dealers as Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, at 59 (Jan. 2011) (IA/BD Study). Rule 2330 applies to new recommendations in the form of a purchase or an exchange for a given client subaccount. 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. 20100224056, 2012 FINRA Discip. C07960035, 1997 NASD Discip. What is the nature of the obligation under the suitability rule created by a hold recommendation? [Notice 11-25 (FAQ 4)]. Firms seeking to rely on the provision should take a conservative approach to determining whether a particular communication is eligible for such treatment. While the rule lists some of the aspects of a typical investment profile, not every factor may be relevant to all situations. As described in greater detail in FAQ [4.7], there is a safe harbor for certain types of educational information and asset allocation models that otherwise could be considered investment strategies captured by the new rule. As discussed [below] in the answer to [FAQ 9.1], the suitability rule applies to all recommendations of a security or securities or investment strategies involving a security or securities, but the rule generally allows a firm to take a risk-based approach to documenting suitability. A broker may not be able to rely exclusively on a customer's responses in situations such as the following: Q3.6. This document consolidates the questions and answers in Regulatory Notices 12-55, 12-25 and 11-25, organized by topic. 2111. Can a broker who does not understand the risks associated with a recommendation violate the reasonable-basis obligation even if the recommendation is suitable for some investors? [Notice 12-25 (FAQ 18)]. A broker-dealer may use a risk-based approach to supervising its registered representatives' recommendations of investment strategies with both a security and non-security component. In regard to the type or form of documentation that may be needed, the facts and circumstances must inform that decision. As noted above in the answer to [FAQ 8.1], FINRA has not endorsed or promoted any certificate. In general, an associated person may rely on a firm's fair and balanced explanation of the potential risks and rewards of a product. EAF0400730002 (Feb. 21, 2007) (barring registered representative for, among other things, recommending to ten customers, many of whom were nearing retirement, that they obtain home equity loans and use the proceeds to purchase securities, without considering whether such recommendations were suitable for such customers in light of their financial situation and needs); James A. Kenas, AWC No. [Notice 11-25 (FAQ 11)], A5.2. 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. FINRA Rule 2111 requires, in part, that a broker-dealer or associated person "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 the reasonable diligence of the [firm] or associated person to ascertain the customer's investment profile." 1990). File a complaint about fraud or unfair practices. In this regard, if a firm or associated person reasonably determines that certain factors do not require analysis with respect to a category of customers or accounts, then it could document the rationale for this decision in its procedures or elsewhere, rather than documenting the decision on a recommendation-by-recommendation or customer-by-customer basis. "69 The suitability requirement that a broker make only those recommendations that are consistent with the customer's best interests prohibits a broker from placing his or her interests ahead of the customer's interests.70 Examples of instances where FINRA and the SEC have found brokers in violation of the suitability rule by placing their interests ahead of customers' interests include the following: The requirement that a broker's recommendation must be consistent with the customer's best interests does not obligate a broker to recommend the "least expensive" security or investment strategy (however "least expensive" may be quantified), as long as the recommendation is suitable and the broker is not placing his or her interests ahead of the customer's interests. 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. What could be considered a "safe-harbor" provision in Supplementary Material .03 is limited in scope. 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]."). The new rule explains that, "[i]n general, what constitutes reasonable diligence will vary depending on, among other things, the complexity of and risks associated with the security or investment strategy and the [broker-dealer's] familiarity with the security or investment strategy. [FAQ 5.2]. Suitability The Rule Notices 2110. The quantitative suitability obligation under the new rule simply codifies excessive trading cases. LEXIS 20, at *63 (NAC July 7, 1999) (stating that, under the facts of the case, the mere distribution of offering material, without more, did not constitute a recommendation triggering application of the suitability rule), aff'd, 55 S.E.C. 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. That will not always be the case, however. Quantitative suitability likely will apply in more limited circumstances with regard to institutional customers than it does as to retail customers. In the context of a recommended investment strategy involving a security and an outside business activity, the broker-dealer's general understanding of the outside business activity would be based on the information and considerations required by FINRA Rule 3270.96. 82 FINRA Rule 2111(b). It is important to note, however, that the suitability rule would not apply to a firm's explanation of a strategy falling outside the safe-harbor provision if a reasonable person would not view the communication as a recommendation. LEXIS 8, at *19 (NAC May 10, 2010) (same), aff'd, Exchange Act Rel. What is the scope of the safe-harbor provision in Rule 2111.03 regarding a firm's use of an asset allocation model? 59 FINRA[, in FAQ 5.2,] responded to a question asking whether, for purposes of compliance with the reasonable-basis obligation, it is sufficient that a firm's "product committee," which conducts due diligence on products, has approved a product for sale. 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. [Notice 12-55 (FAQ 7)]. The new rule does not change the longstanding application of the suitability rule on a recommendation-by-recommendation basis. See Richard G. Cody, Exchange Act Rel. 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. In the case of a trust held in a brokerage account, for instance, the firm should consider the trustee's investment experience with, and knowledge of, various investments and investment strategies. 4 See, e.g., Rafael Pinchas, 54 S.E.C. 61 See, e.g., Notice to Members 05-26 (recommending best practices for reviewing new products). A3.8. 52 Nonetheless, FINRA has stated that the safe-harbor provision would be strictly construed. 2 See, e.g., SEC Adoption of Rules Under Section 15(b)(10) of the Exchange Act, 32 Fed. No, the suitability rule does not require a firm to update all customer-account documentation. 33 For certain requirements related to margin, see FINRA Rule 2264. 55 When a broker-dealer recommends an allocation strategy that includes an allocation in fixed-income securities, FINRA recognizes that a number of additional factors would be relevant in determining if the broker-dealer has "recommended" particular debt securities. 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]. 112-106, 126 Stat. 58 That is true under case law addressing the predecessor suitability rule as well. 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 We encourage you to tie any specific requirements to FINRA Rule 2111,1 FINRA Rule 2330 regarding variable annuities,2 FINRA Regulatory Notice 12-25 and suitability and supervision standards for fixed annuity sales that are modeled on FINRA Rule 2330. As FINRA has stated previously, "FINRA appreciates that no two [broker-dealers] are exactly alike. No. 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? FINRA IS A REGISTERED TRADEMARK OF THE FINANCIAL INDUSTRY REGULATORY AUTHORITY, INC. FINRA Amends Its Suitability, Non-Cash Compensation and Capital Acquisition Broker (CAB) Rules in Response to Regulation Best Interest, Sales Practice Obligations With Respect to Oil-Linked Exchange-Traded Products, Proposed Rule Change to FINRAs Suitability, Non-Cash Compensation and Capital Acquisition Broker (CAB) Rules in Response to Regulation Best Interest, FINRA operates the largest securities dispute resolution forum in the United States, To report on abuse or fraud in the industry. See Peter C. Bucchieri, 52 S.E.C. Yes. The suitability rule would not apply, for instance, if a registered representative recommends a non-security investment as part of an outside business activity and the customer separately decides on his or her own to liquidate securities positions and apply the proceeds toward the recommended non-security investment.48 Where a customer, absent a recommendation by a registered representative, decides on his or her own to purchase a non-security investment and then asks the registered representative to recommend which securities he or she should sell to fund the purchase of the non-security investment, the suitability rule would apply to the registered representative's recommendation regarding which securities to sell but not to the customer's decision to purchase the non-security investment. How should a firm document "hold" recommendations? [Notice 12-25 (FAQ 13)], A9.2. Where a customer discloses information to a broker in connection with the recommendation, the broker must consider that information as part of the suitability analysis. Reg. Id. 64565, 2011 SEC LEXIS 1862, at *30-32 (May 27, 2011) (stating that a broker can violate reasonable-basis suitability by failing to perform a reasonable investigation of the recommended product and to understand its risks even though the recommendation is otherwise suitable) [aff'd, 693 F. 3d 251 (1st Cir. [Notice 12-25 (FAQ 24)]. Vincent Apicella, Stock Focus: "Dogs of the Dow" Companies, Forbes.com (May 29, 2001). 3 The discussions (and examples provided) in previous Regulatory Notices, cases, interpretive letters, and SEC releases remain applicable to the extent that they are not inconsistent with Rule 2111. What constitutes a "customer" for purposes of the suitability rule? FINRA previously stated that, although a firm has a general obligation to evidence compliance with applicable FINRA rules, the suitability rule does not include explicit documentation requirements, except in a situation where a firm determines not to seek certain customer information in the first place.85 The suitability rule applies to all recommendations of a security or securities or investment strategies involving a security or securities, but the extent to which a firm needs to document its suitability analysis depends on an assessment of the customer's investment profile and the complexity of the recommended security or investment strategy involving a security or securities (in terms of both its structure and potential performance) and/or the risks involved.86. Any significant variation from the list in the safe-harbor provision would be subject to regulatory scrutiny. Customers sometimes ask broker-dealer call centers whether they may continue to maintain their investments at the firm if, for instance, they want to move from an employer-sponsored retirement account held at the firm to an individual retirement account held at the firm. If a firm's call center informs customers that they are permitted to continue to maintain their investments at the firm under such circumstances, would FINRA consider those communications to be "hold" recommendations triggering application of the new suitability rule? Pinchas, 54 S.E.C. The factors that must exist for an institutional customer to qualify for the exemption may, depending on the facts, negate some of the elements relevant to a showing of a broker's "control" over the account. The hold recommendation must be explicit.5, Q1.3. other "red flags" exist indicating that the customer information may be inaccurate. 2010), cert. 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. ), cert. 562, 565, 1995 LEXIS 3452, at *9 (1995) (remarking that securities of companies "with a limited history of operations and no profitability" are speculative); David J. Dambro, 51 S.E.C. See also Donna M. Vogt, AWC No. C05020055, 2007 NASD Discip. [Notice 12-25 (FAQ 4)]. denied, 130 S.Ct. Arbitration and mediation case participants and FINRA neutrals can view case information and submit documents through this Dispute Resolution Portal. 1996) (same); Robert L. Wallace, 53 S.E.C. Rule 2330 requires firms to have written policies and procedures in place for surveillance of brokers recommending, purchasing or exchanging of deferred variable annuities. 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. 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]."). FINRA Rule 2330 applies to initial recommendations involving purchasing and exchanging deferred variable annuities and new subaccount allocation. A8.3. at 504-05, 2003 SEC LEXIS 1154, at *14. Does a broker-dealer have to seek to obtain all of the customer-specific factors listed in the new rule by the rule's implementation date? To meet its suitability obligations, a firm must obtain and analyze enough customer information to have a reasonable basis to believe the recommendation is suitable. 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." 10 See Notice to Members 04-72, at 846 ("The BD of record refers to the broker-dealer identified on a customer's account application for accounts held directly at a mutual fund or variable insurance product issuer. What is the difference between Rule 2111 and Rule 2330? 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. In all cases, the suitability rule applies to recommendations, but the extent to which a firm needs to evidence suitability generally depends on the complexity of the security or strategy in structure and performance and/or the risks involved. As a general matter, these terms are to be understood commensurate with their meaning in financial analysis. Rule 2111 would cover a recommendation to purchase securities using margin or liquefied home equity or to engage in day trading, irrespective of whether the 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. A3.6. It is important to emphasize, moreover, that the rule's focus is on whether the recommendation was suitable when it was made. "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." at 339-40 n.14, 1999 SEC LEXIS 1754, at *17 n.14. 52562, 52567 (Aug. 26, 2010)]. 46 FINRA made similar points regarding recommended investment strategies on several occasions under the predecessor suitability rule. 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.49, Q4.5. See SEA Rules 17a-3(a)(6) and 17a-4(b)(1) and (b)(4). 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. [Notice 11-25 (FAQ 3)]. Q3.12. Q8.2. Consistent with the discussions above, however, the complexity of and risks associated with a particular security or strategy likely will impact the level of documented analysis that is appropriate. For example, the recommendation of a large-cap, value-oriented equity security generally would not require written documentation as to the recommendation. [Notice 12-55 (FAQ 6(b))], A2.2. 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 emphasizes, however, that a high level of liquidity does not, in and of itself, mean that the recommended product is suitable for all customers. Under these circumstances, the suitability of a broker's recommendation may be analyzed on the basis of whether the customer's overall portfolio, considering any changes to the portfolio that flow from the broker's recommendation, aligns with the customer's investment profile.29. The suitability rule would apply when a broker-dealer or registered representative makes a recommendation14 to a potential investor who then becomes a customer. To the extent that a customer account at a broker-dealer can be discretionary under applicable federal securities laws, the suitability rule generally would not apply where a firm refrains from selling a security. 3333 (2010). "); F.J. Kaufman and Co., 50 S.E.C. A risk-based approach also may lead a firm to pay particular attention to hold recommendations where, at the time the recommendation is made, a customer's account has a heavy concentration in a particular security or industry sector or the security or securities in question are inconsistent with the customer's investment profile.90 The same approach applies to other recommended strategies. Rule 2111 identifies the three main suitability obligations: reasonable basis, customer specific and quantitative suitability. [Notice 12-25 (FAQ 3)], A1.2. See SEC Division of Corporation Finance: Standard Industrial Classification. A3.12. Some third-party vendors have created and aggressively marketed proprietary "Institutional Suitability Certificates" to facilitate compliance with the new institutional-customer exemption. FINRA has extensively addressed those guiding principles in past Regulatory Notices, and cases have applied them to specific facts.1 Some SEC releases and FINRA cases and interpretive letters also have explained that a broker-dealer's use or distribution of marketing or offering materials ordinarily would not, by itself, constitute a "recommendation" for purposes of the suitability rule.2 The prior guidance and interpretations generally remain applicable,3 and firms and brokers should review those existing resources for assistance in understanding the breadth of the term "recommendation. Id. Reg. As to an institutional customer's affirmative indication that it intends to exercise independent judgment (a new requirement), Rule 2111.07 states that "an institutional customer may indicate that it is exercising independent judgment on a trade-by-trade basis, on an asset-class-by-asset-class basis, or in terms of all potential transactions for its account." 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? 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. How much of a duty does a firm have to pursue "any other information the customer may disclose" to see if it has suitability implications? Each firm has a general obligation to evidence compliance with applicable FINRA rules. Can you provide some examples of what would and would not be considered an "investment strategy" under the rule? Does a firm have to use the exact rule terminology when seeking to obtain customer-specific information? at 295. Quantitative suitability requires a broker who has actual or de facto control63 over a customer account to have a reasonable basis for believing that, in light of the customer's investment profile, a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer.64 Factors such as turnover rate,65 cost-to-equity ratio,66 and use of in-and-out trading67 in a customer's account may provide a basis for finding that the activity at issue was excessive.

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