20100224056, 2012 FINRA Discip. 800, 805 n.11, 1996 SEC LEXIS 1331, at *12 n.11 (1996). A broker must understand the securities and investment strategies involving a security or securities that he or she recommends to customers.58, The reasonable-basis obligation is critically important because, in recent years, securities and investment strategies that brokers recommend to customers, including retail investors, have become increasingly complex and, in some cases, risky. As FINRA has stated previously, "FINRA appreciates that no two [broker-dealers] are exactly alike. Nothing in this guidance, however, relieves a firm from having to ensure that the investment profiles or factors accurately reflect the customer's decisions. See Cody, 2011 SEC LEXIS 1862, at *49 & *55 (finding cost-to-equity ratio of 8.7 percent excessive); Thomas F. Bandyk, Exchange Act Rel. Q3.8. 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. See [FAQ 4.6]. This rule does not apply to: Transfers and What customer-specific information a firm should seek to obtain from a customer in addition to the factors that the rule specifically lists will depend on the facts and circumstances of the particular case. 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. "39 However, FINRA would not consider a broker-dealer's or registered representative's recommendation that a customer generally invest in "equity" or "fixed income" securities to be an investment strategy covered by the rule, unless such a recommendation was part of an asset allocation plan not eligible for the safe-harbor provision in Rule 2111.03 (discussed [below in FAQ 4.7]).40 The "investment strategy" language would apply to recommendations to customers to invest in more specific types of securities, such as high dividend companies or the "Dogs of the Dow,"41 or in a market sector, regardless of whether the recommendations identify particular securities.42 It also would apply to recommendations to customers generally to use a bond ladder, day trading, "liquefied home equity,"43 or margin strategy involving securities, irrespective of whether the recommendations mention particular securities. 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. Moreover, absent "red flags" indicating that such information is inaccurate or that the customer is unclear about the information, a broker generally may rely on the customer's responses. Yes. What is the nature of the obligation under the suitability rule created by a hold recommendation? 4, 2012). 7, 1997) ("A broker has a duty to make recommendations based upon the information he has about his customer, rather than based on speculation. LEXIS 8, at *19 (NAC May 10, 2010) (same), aff'd, Exchange Act Rel. Is the quantitative suitability obligation under the new rule any different from the excessive trading line of cases under the predecessor rule? 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. 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. [Notice 11-25 (FAQ 4)]. In most instances, asking a customer for the information would constitute reasonable diligence. What could be considered a "safe-harbor" provision in Supplementary Material .03 is limited in scope. [Notice 12-25 (FAQ 26)]. 933, 935, 1964 SEC LEXIS 497, at *3-4 (1964) (same); Dep't of Enforcement v. Evans, No. Would a recommendation to maintain an asset mix that was based on an asset allocation model that meets the criteria described in the rule fall within the safe-harbor provision in Rule 2111.03? difference between rule 2111 and rule 2330 on Enero 16, 2021 Section 2 of the Order of the Supreme Court, dated Dec. 4, 1967, provided: "That the foregoing rules shall take effect on Accordingly, a [firm] must perform appropriate due diligence to ensure that it understands the nature of the product, as well as the potential risks and rewards associated with the product."). 20006005977901, 2011 FINRA Discip. In many circumstances, the answer is yes. Q4.1. LEXIS 10362, *4-5 (9th Cir. A firm may use a risk-based approach to documenting compliance with this provision. Reasonable Basis Obligation This means the "93 A broker-dealer can consider a variety of approaches to identifying and supervising its registered representatives' recommendations of investment strategies involving both a security and a non-security component. These (and many other) FINRA rules provide broad and significant protections to investors. The suitability rule applies only to recommended securities and investment strategies involving securities, but FINRA does not define the term "recommendation" other than to say that it is a facts and circumstances inquiry. 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. Finally, the rule provides a modified institutional-customer exemption. Moreover, the relative importance of the issuers to other factors in making fixed-income investment decisions varies depending on the total mix of the relevant facts and circumstances. 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. The rule, however, would not cover an implicit recommendation to hold.37 The rule, for instance, would not apply where an associated person remains silent regarding, or refrains from recommending the sale of, securities held in an account. The issuers' identities and creditworthiness are important information in determining whether to purchase a debt security, but there may be other factors that affect the pricing and any decision to invest in specific debt securities. Firms seeking to rely on the provision should take a conservative approach to determining whether a particular communication is eligible for such treatment. For instance, some relatively liquid products can be complex and/or risky and therefore unsuitable for some customers. 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." 67 In-and-out trading refers to the "sale of all or part of a customer's portfolio, with the money reinvested in other securities, followed by the sale of the newly acquired securities." FINRA previously has provided guiding principles that firms and registered representatives could consider when determining whether a particular communication could be viewed as a recommendation for purposes of the suitability rule. FINRA BrokerCheck, moreover, allows investors to review the professional and disciplinary backgrounds of firms and brokers online. The rule thus explicitly permits a suitability analysis to be performed within the context of a customer's other investments. 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 The rule states that it applies to explicit recommendations to hold. What is the scope of the provision in Supplementary Material .03 that excludes from the rule's coverage certain types of strategy-related communications that are educational in nature?50 [Notice 11-25 (FAQ 9)], A4.6. See SEA Rule 17a-3(a)(17)(i)(D). Firm compliance professionals can access filings and requests, run reports and submit support tickets. The suitability rule does not prescribe the manner in which a firm must document "hold" recommendations when documentation may be necessary. Accordingly, a broker-dealer could choose to seek to obtain and analyze the customer-specific factors listed in Rule 2111 when it makes new recommendations to customers (regardless of whether they are new or existing customers).21, Q3.3. In this regard, firms should note that, as an allocation recommendation becomes narrower or more specific, the recommendation gets closer to becoming a recommendation of particular securities and, thus, subject to the suitability rule, depending on a variety of factors (including the number of issuers that fall within the broker-dealer's allocation recommendation).55 Accordingly, broker-dealers should assess whether allocation recommendations involving certain types of sub-categories of broader market sectors or even more limited groupings are so specific or narrow that they constitute recommendations of particular securities.56, Q4.8. Furthermore, a broker-dealer "must keep a record of its compliance with these obligations with respect to each written notice received and must preserve this record for the period of time and accessibility specified in SEA Rule 17a-4(e)(1)." 2003); Powell & McGowan, Inc., 41 S.E.C. 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. Firms' supervisory policies and procedures must be reasonably designed to ensure that their brokers comply with this important requirement.59, Q5.2. In general, the more complex and risky the strategy, the more the firm using a risk-based approach should focus on the recommendation. 513, 515, 1993 SEC LEXIS 1521, at *5 (1993) (discussing risky nature of investing in a company that had a history of operating losses and concentrated its assets in illiquid holdings in other unproven start-up companies in the same industry); Gordon S. Venters, 51 S.E.C. LEXIS 22 (Mar. 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. The cost associated with a recommendation, however, ordinarily is only one of many important factors to consider when determining whether the subject security or investment strategy involving a security or securities is suitable. [Notice 12-25 (FAQ 14)]. C3A040016 (Mar. [FINRA Rule 2214 replaced NASD IM-2210-6 (Requirements for the Use of Investment Analysis Tools)]. No. Cir. 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. Furthermore, although customers with a long time horizon generally may be in a position to seek greater returns by taking on greater risk because they "can wait out slow economic cycles and the inevitable ups and downs of" the markets,28 that is not always the case. Q4.3. 33 For certain requirements related to margin, see FINRA Rule 2264. LEXIS 20, at *38 (NAC May 11, 2007), aff'd, Exchange Act Rel. C01020025, 2004 NASD Discip. The rule explicitly states that the term "strategy" should be interpreted broadly.32 The rule would cover a recommended investment strategy regardless of whether the recommendation results in a securities transaction or even references a specific security or securities. [Notice 11-25 (FAQ 11)], A5.2. In general, a customer's investment profile would include the customer's age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs and risk tolerance. Can you provide some examples of what would and would not be considered an "investment strategy" under the rule? A3.4. 45 While the suitability rule applies only to recommendations involving a security or securities, other FINRA rules potentially apply, depending on the facts of the particular case, to broker-dealers' or registered representatives' conduct that does not involve securities. 58737, 2008 SEC LEXIS 2459, at *21-27 (Oct. 6, 2008) (applying the guiding principles to the facts of the case to find a recommendation), aff'd in relevant part, 592 F.3d 147 (D.C. The institutional-customer exemption does not apply to reasonable-basis and quantitative suitability. 42 The rule would apply, for instance, to a registered representative's recommendation to a customer to purchase shares of high dividend companies even though the registered representative does not mention a particular high dividend company. That will not always be the case, however. 2111. 98-70854, 1999 U.S. App. It also is important to note that, where an institutional customer has delegated decisionmaking authority to an agent, such as an investment adviser or a bank trust department, Rule 2111(b) makes clear that the factors relevant to determining whether the customer meets the criteria for the institutional-customer exemption will be applied to the agent. 59328, 2009 SEC LEXIS 217, at *40 n.24 (Jan. 30, 2009) ("In interpreting the suitability rule, we have stated that a [broker's] 'recommendations must be consistent with his customer's best interests. "That is, even if a firm's product committee has approved a product for sale, an individual broker's lack of understanding of a recommended product or strategy could violate the obligation, notwithstanding that the recommendation is suitable for some investors." [Notice 12-25 (FAQ 20)]. 55988, 2007 SEC LEXIS 1407, at *21-23 (June 29, 2007) (describing the speculative nature of three low-priced securities at issue); Faber, 2004 SEC LEXIS 277, at *25 (discussing speculative nature of the security of a company that "had no revenues and had never showed any profits"); Jack H. Stein, 56 S.E.C. Only investors who understand those risks, and who are able to sustain the costs and financial losses that may be associated with options trading should participate in the listed options markets. See also [Regulatory Notice 11-25, at 9 n.6]. However, if the associated person remains uncertain about the potential risks and rewards of a product or has reason to believe that the firm failed to address a particular issue or has done so in an incomplete or inaccurate manner, then the associated person would need to engage in further inquiry before recommending the product. See also [Regulatory Notice 12-25, at 18 n.3]. 1 See, e.g., Regulatory Notice 11-02, at 2-3 (discussing FINRA's guiding principles that firms and brokers should consider when determining whether a particular communication could be considered a "recommendation" for purposes of the suitability rule); 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. See 77 Fed. [Notice 11-25 (FAQ 6)]. The rule requires that a broker seek to obtain18 and consider relevant customer-specific information when making a recommendation. 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. 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)]. In Dep't of Enforcement v. Siegel, for instance, FINRA's National Adjudicatory Council explained that a "recommendation may lack 'reasonable-basis' suitability if the broker: (1) fails to understand the transaction, which can result from, among other things, a failure to conduct a reasonable investigation concerning the security; or (2) recommends a security that is not suitable for any investors." Recently FINRA Rule 2111 went into effect regarding Suitability. Rule 2111 would cover a recommendation to recommendations. 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. Q3.11. [Notice 12-25 (FAQ 11)]. For purposes of the suitability rule, how should a firm document recommendations to hold in particular and recommendations of strategies more generally? Q4.4. "68 What does it mean to act in a customer's best interests? 13 Nothing in this guidance shall be construed as altering a broker-dealer's obligations under applicable federal laws, regulations and rules or other FINRA rules, including, but not limited to, Sections 9, 10(b) and 15(c) of the Securities Exchange Act of 1934, Section 17(a) of the Securities Act of 1933, the Bank Secrecy Act, 31 U.S.C. [Notice 12-25 (FAQ 23)]. Id. LEXIS 36, at *22 (NAC Oct. 3, 2011) (same); Dep't of Enforcement v. Cody, No. 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? "); Daniel R. Howard, 55 S.E.C. A broker who sought to increase his commissions by recommending that customers use margin so that they could purchase larger numbers of securities. 20452 (Apr. 6 Pub. 35415, 1995 SEC LEXIS 481, at *2-3 (Feb. 24, 1995) ("His excessive trading yielded an annualized commission to equity ratio ranging between 12.1% and 18.0%."). [Notice 12-25 (FAQ 4)]. 1996) (same); Robert L. Wallace, 53 S.E.C. 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? 4 See, e.g., Rafael Pinchas, 54 S.E.C. If you [Notice 12-25 (FAQ 9)]. 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." 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. For example, FINRA and the SEC have held that associated persons who effect transactions on a customer's behalf without informing the customer have implicitly recommended those transactions, thereby triggering application of the suitability rule. 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