RIA Compliance Blog
The Financial Industry Regulatory Authority (FINRA) released a Regulatory Notice in May clarifying its new suitability rule, Rule 2111. The rule, which was approved by the Securities and Exchange Commission (SEC) in November 2010, will be implemented on July 9, 2012. The Notice is intended to answer industry questions and provide guidance on the new rule.
According to FINRA, the new rule imposes the same obligations as the predecessor rule and related case law. It is intended to clarify and codify three main suitability obligations.
The first obligation is reasonable-basis suitability, which has two components: a broker must (1) perform reasonable diligence to understand the nature of the recommended security or investment strategy involving a security or securities, as well as the potential risks and rewards, and (2) determine whether the recommendation is suitable for at least some investors based on that understanding.
The second obligation is customer-specific suitability, in which the broker must have a reasonable basis to believe that a recommendation of a security or investment strategy is suitable for the particular customer based on the customer’s investment profile.
The third obligation is quantitative suitability, in which the broker who has control over a customer account must have a reasonable basis to believe that a series of recommended securities transactions are not excessive.
The language of the new rule requires, “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.” The Notice includes questions and answers in specific areas to clarify areas of ambiguity.
The rule requires that the broker act in the customer’s best interest. FINRA specifies that the phrase “acting in the customer’s best interest” is intended to prohibit brokers from placing their interests ahead of a customer’s interest. The majority of examples listed describe situations in which brokers act so as to increase their commissions. FINRA states that “the customer’s best interests does not obligate a broker to recommend the ‘least expensive’ security or investment strategy as long as the recommendation is suitable and the broker is not placing his or her interests ahead of the customer’s interests.”
The next area discussed in the notice relates to what constitutes a “recommendation.” Because a broker’s recommendation triggers the suitability rule, when asked what factors are used to determine whether a recommendation has been made, FINRA answers that “the prior guidance and interpretations generally remain applicable, and firms and brokers should review those existing resources for assistance in understanding the breadth of the term recommendation.” FINRA provides as examples some of the factors in a Regulatory Notice that it issued in January 2011. The 2011 Notice stated that the determination of what is a recommendation has always been based on the facts of each case. Some factors that FINRA will take into consideration include the communication’s content, context and presentation. FINRA stated that “the more individually tailored the communication is to a particular customer or customers about a specific security or investment strategy, the more likely the communication will be viewed as a recommendation.”
The Notice also addresses who should be considered to be a “customer.” A customer “clearly would include an individual or entity with whom a broker-dealer has even an informal business relationship related to brokerage services, as long as that individual or entity is not a broker or dealer,” according to the Notice. Brokers should note that a “potential” investor can also be considered a customer if the broker recommends a security to him or her.
The new rule imposes broader obligations on brokers in connection with recommending “investment strategies.” FINRA explains that the term “investment strategy” is to be interpreted broadly, and applies to investment strategy recommendations “regardless of whether the recommendation results in a securities transaction or even mentions a specific security or securities.” This would also include explicit recommendations to hold a security or securities. The rule includes a safe harbor provision which excludes communications that are educational in nature even though they could be considered investment strategies. There are certain situations, however, where the safe harbor provision would not apply. The notice describes in detail these situations.
The new rule also broadens the express list of customer-specific facts that firms and associated persons generally must attempt to obtain. The new factors include the customer’s age, investment experience, time horizon, liquidity needs, and risk tolerance. The rule will require the broker to obtain this information using “reasonable diligence.” Relying on the customer’s exclusive answer, however, will not be sufficient in the follow circumstances:
- Broker asks questions that are confusing and misleading which resulted in the information-gathering process being tainted;
- The customer exhibits clear signs of diminished capacity; or
- Other “red flags” exist indicating that the customer information may be inaccurate.
Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds and issuers of securities, among others. Our regulatory practice group assists financial service providers with the complex issues that arise in the course of their businesses, including compliance with federal and state laws and rules.