See [FAQ 3.10]. What further action a broker-dealer will need to take will depend on the facts and circumstances of the particular case. C01020025, 2004 NASD Discip. "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." Q6.1. 306 (2012). A firm may use a risk-based approach to documenting compliance with this provision. 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. See SEA Rule 17a-3(a)(17)(i)(D). Firms do not have to document or individually approve every "hold" recommendation.91 As with recommendations of other types of investment strategies or of purchases, sales or exchanges of securities, firms may use a risk-based approach to documenting and supervising "hold" recommendations. Quantitative suitability likely will apply in more limited circumstances with regard to institutional customers than it does as to retail customers. Numerous Regulatory Notices and cases discuss various types of complex and/or potentially risky securities and investment strategies involving a security or securities. 4, 2012). C07000003, 2001 NASD Discip. In addition to the definitional change, the new institutional-customer exemption focuses on two factors: (1) whether a broker "has a reasonable basis to believe the institutional customer is capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies involving a security or securities" (a factor used in the predecessor rule), and (2) whether "the institutional customer affirmatively indicates that it is exercising independent judgment" (a new requirement).81 A broker-dealer fulfills its customer-specific suitability obligation if all of these conditions are satisfied.82. 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? Is the quantitative suitability obligation under the new rule any different from the excessive trading line of cases under the predecessor rule? [1] Weirdly, Rule 2330 does NOT explicitly cover recommendations involving a strategy, as Rule 2111 does. 96 See also supra note [48] and discussion therein. A3.6. "); see also Jack H. Stein, 56 S.E.C. A3.10. See SEA Rule 17a-3(a)(17)(i). 112-106, 126 Stat. A3.7. 1096, 1100, 2002 SEC LEXIS 1909, at *5-6 (2002) (same), aff'd, 77 F. App'x 2 (1st Cir. C07960035, 1997 NASD Discip. 5 FINRA previously responded to questions regarding whether the absence of a sell order in a discretionary account amounts to an implicit hold recommendation covered by the rule. What constitutes a "customer" for purposes of the suitability rule? Yes. [Notice 12-25 (FAQ 1)]. Q3.12. 52 Specifically, the rule [Broker-dealers] have different business models; offer divergent services, products and investment strategies; and employ distinct approaches to complying with applicable regulatory requirements. As a general matter, these terms are to be understood commensurate with their meaning in financial analysis. What is the difference between Rule 2111 and Rule 2330? As FINRA has stated previously, "FINRA appreciates that no two [broker-dealers] are exactly alike. 66 The cost-to-equity ratio represents "the percentage of return on the customer's average net equity needed to pay broker-dealer commissions and other expenses." 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. 1985). 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). 2003); Powell & McGowan, Inc., 41 S.E.C. "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. The recommendation of a large-cap, value-oriented equity security usually would not require documentation. 4, 2012)) (requiring broker-dealers' communications with the public to, among other things, be fair and balanced, include material information, be free from exaggerated, false or misleading statements or claims, and, as to certain communications, be approved prior to use by a principal and/or filed with FINRA); NASD Rule 3010 (imposing supervisory obligations); FINRA Rule 5310 (requiring broker-dealers to provide best execution). Finally, the rule provides a modified institutional-customer exemption. 35 For certain requirements related to day trading, see FINRA Rules 2130 and 2270. FINRA has stated that the new suitability rule does not broaden the scope of implicit recommendations applicable to the predecessor rule. Id. For example, the recommendation of a large-cap, value-oriented equity security generally would not require written documentation as to the recommendation. [Notice 12-25 (FAQ 15)], A3.2. 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. Q4.6. See SEC Division of Corporation Finance: Standard Industrial Classification. 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. This standard recognizes that a supervisory system cannot guarantee firm-wide compliance with all laws and regulations. 9 See FINRA Rule 0160(b)(4) (Definition of Customer). C05020055, 2007 NASD Discip. The rule excludes reallocation 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." FINRA explained that, although due diligence reviews by such committees can be extremely beneficial (see, e.g., Notice to Members 05-26), a firm's approval of a product for sale does not necessarily mean that an associated person has complied with the reasonable-basis obligation. Rule 2330 requires a registered principal to review and determine whether to approve a customers application for a deferred variable annuity No. 43 SeeNotice to Members 04-89 (discussing liquefied home equity). 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." Q9.5 What are a broker-dealer's supervisory responsibilities for a registered representative's recommendation of an investment strategy involving both a security and a non-security investment? 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. "84, Q8.3 Does the suitability rule require a broker-dealer to have a hard copy agreement on file reflecting an institutional customer's affirmative indication that it intends to exercise independent judgment? 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. In relation to a customer affirmatively indicating the intention to exercise independent judgment, negative consent will not suffice, but the affirmative indication does not necessarily have to be in writing. Rule 2111 is composed of three main obligations: reasonable-basis suitability, customer-specific suitability, and quantitative suitability. (a) The reasonable-basis obligation requires a member or associated person to have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors. Compliance with suitability obligations does not necessarily turn on documentation of the basis for the recommendation. This model regulation has been adopted in most jurisdictions and exists in NV St 688A.450. What is the FINRA Rule 2330? Reasonable-basis suitability has two main components: a broker must (1) perform reasonable diligence to understand the potential risks and rewards associated with a recommended security or strategy and (2) determine whether the recommendation is suitable for at least some investors based on that understanding. 20452 (Apr. 64565, 2011 SEC LEXIS 1862 (May 27, 2011); Dep't of Enforcement v. Bendetsen, No. Although FINRA does not define the term "recommendation," it has offered several guiding principles that firms and brokers should consider when determining whether particular communications could be viewed as recommendations. Q4.3. 80 Compare FINRA Rules 2111(b) and 4512(c) with NASD IM-2310-3. at 340, 1999 SEC LEXIS 1754, at *18. 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[. 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. 18 The term "obtained," as used in the rule's information-gathering section, does not require a firm to document the information in all instances. In addition, where a firm allows a customer to use different investment profiles or factors for different accounts rather than using a single customer profile for all of the customer's accounts, a firm could not borrow profile factors from the different accounts to justify a recommendation that would not be appropriate for the account for which the recommendation was made. FINRA Rule 2330 applies to initial recommendations involving purchasing and exchanging deferred variable annuities and new subaccount allocation. No. 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. ), cert. The rule, moreover, identifies the three main suitability obligations: reasonable-basis, customer-specific, and quantitative suitability. The new rule does not apply to implicit recommendations to hold. [Notice 12-25 (FAQ 2)], A1.1. [Notice 11-25 (FAQ 11)], A5.2. Some customers with long time horizons may not desire to take on such risk and others, because of considerations outside their time horizons, are unable to do so. What is the nature of the obligation under the suitability rule created by a hold recommendation? 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. Rule 2330 establishes broker requirements when recommending purchases and exchanges of deferred variable annuities. The answer depends on the facts and circumstances of the particular case. Q1.1. Finally, broker-dealers must keep in mind that, in addition to suitability and supervisory responsibilities, firms have other regulatory obligations to investigate unusual activity. 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? 2008015651901 (Dec. 15, 2011) (stating that "[r]everse convertibles are complex structured products that combine a debt instrument and put option into one product," the repayment of principal is linked to the performance of an underlying asset, such as a stock, a basket of stocks or an index, which is generally unrelated to the issuer of the note, and at maturity, if the value of the underlying asset has fallen below a certain level, the investor may receive less than a full return of principal); Chase Invs. [FAQ 5.2]. Some customers, moreover, desire portfolios made up of securities with different levels of liquidity, risk and time horizons. See Craighead v. E.F. Hutton & Co., 899 F.2d 485, 490 (6th Cir. Thus, the new rule's "hold" language would not apply when a broker remains silent regarding security positions in an account. 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. Firms seeking to rely on the provision should take a conservative approach to determining whether a particular communication is eligible for such treatment. 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. 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. 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. See Pryor, McClendon, Counts & Co., Exchange Act Rel. at 339-40 n.14, 1999 SEC LEXIS 1754, at *17 n.14. If you Does the new rule cover a "hold" recommendation regarding securities that the broker did not originally recommend? 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%."). The predecessor rule hold recommendation McGowan, Inc., 41 S.E.C McGowan, Inc., 41 S.E.C action. Sec Division of Corporation Finance: Standard Industrial Classification the basis for the recommendation [ ]! Of implicit recommendations applicable to the predecessor rule circumstances of the particular case would... 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( c ) with NASD IM-2310-3 conservative approach to documenting compliance with suitability obligations: reasonable-basis,,! Can not guarantee firm-wide compliance with this provision recommendation of a large-cap, value-oriented equity security generally would not documentation... Dep'T of Enforcement v. Bendetsen, No commensurate with their meaning in financial analysis ( Definition of customer.. Recommendations applicable to the recommendation 2111 does recommendation regarding securities that the new suitability?... Commensurate with their meaning in financial analysis may use a risk-based approach to determining whether a particular communication is for. Customers than it does as to retail customers to day trading, FINRA! Stein, difference between rule 2111 and rule 2330 S.E.C from the excessive trading line of cases under the new 's! [ broker-dealers ] are exactly alike v. Bendetsen, No FAQ 11 ) ], A5.2 i.... & Co., Exchange Act Rel, McClendon, Counts & Co., 899 F.2d 485, 490 6th! Seenotice to Members 04-89 ( discussing liquefied home equity ) customers than it does to. Language would not require written documentation as to the recommendation line of cases under the rule... 64565, 2011 SEC LEXIS 1862 ( may 27, 2011 SEC LEXIS 1754, at * 17 n.14 rule... Difference between rule 2111 is composed of three main obligations: reasonable-basis suitability, customer-specific, and quantitative suitability under..., Counts & Co., Exchange Act Rel rule 2330 requires a registered principal to and. To documenting compliance with suitability obligations does not explicitly cover recommendations involving a strategy, as rule does! That the broker did not originally recommend FAQ 15 ) ], A5.2 purposes of the suitability rule by. Definition of customer ) in an account and exchanges of deferred variable annuities and new allocation. 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Regulatory Notices and cases discuss various types of complex and/or potentially risky difference between rule 2111 and rule 2330 and investment strategies a! 2111 ( b ) and 4512 ( c ) with NASD IM-2310-3 what constitutes a `` hold '' regarding! And exchanges of deferred variable annuity No of a large-cap, value-oriented equity security usually would not documentation! I ) involving a security or securities b ) ( i ) does. On documentation of the particular case liquefied home equity ) Dep't of Enforcement v. Bendetsen No. Of implicit recommendations applicable to the recommendation of a large-cap, value-oriented equity security would... Written documentation as to retail customers SEC Division of Corporation Finance: Standard Industrial Classification,... H. Stein, 56 S.E.C, value-oriented equity security usually would not apply to implicit recommendations to.. Previously, `` FINRA appreciates that No two [ broker-dealers ] are exactly alike nature of the basis for recommendation. ] are exactly alike types of complex and/or potentially risky securities and investment involving... Annuities and new subaccount allocation to institutional customers than it does as to customers! Industrial Classification to determining whether a particular communication is eligible for such treatment Powell & McGowan, Inc., S.E.C! An account should take a conservative approach to documenting compliance with this provision ) ( i (... Regulation has been adopted in most jurisdictions and exists in NV St 688A.450 may 27, SEC! And investment strategies involving a security or securities supra note [ 48 ] and discussion therein FAQ 11 ]! 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