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. [Notice 12-55 (FAQ 10(a))], A4.3 The new suitability rule would continue to cover a broker-dealer's or registered representative's recommendation of an "investment strategy" involving both a security and a non-security investment.45 Suitability obligations apply, for example, to a broker-dealer's or registered representative's recommendation of an investment strategy to use home equity to purchase securities46 or to liquidate securities to purchase an investment-related product that is not a security.47. 26 See www.sec.gov/investor/pubs/assetallocation.htm. Recently FINRA Rule 2111 went into effect regarding Suitability. A broker who sought to increase his commissions by recommending that customers use margin so that they could purchase larger numbers of securities. 54 The examples of market sectors discussed in [Regulatory Notice 12-25] are from the Standard Industrial Classification Code. 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." 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. File a complaint about fraud or unfair practices. Does the suitability rule apply when a broker-dealer or registered representative makes a recommendation to a potential investor? 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. [Notice 12-25 (FAQ 3)], A1.2. Under this provision, the suitability rule would not apply, for example, to a general recommendation that a customer's portfolio have certain percentages of investments in equity securities, fixed-income securities and cash equivalents, if the recommendation is based on an asset allocation model that meets the above criteria and the firm does not recommend a particular security or securities in connection with the allocation. 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. 108, 117, 2003 SEC LEXIS 338, at *15 (2003) (focusing, in part, on risks of using margin); James B. 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. See Pryor, McClendon, Counts & Co., Exchange Act Rel. A3.6. 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." The quantitative suitability obligation under the new rule simply codifies excessive trading cases. 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). [Notice 12-55 (FAQ 10(b)]. L. No. For instance, some relatively liquid products can be complex and/or risky and therefore unsuitable for some customers. 333 (2010). A3.1. A4.1. What constitutes a "customer" for purposes of the suitability rule? 82 FINRA Rule 2111(b). What are the conditions under which an implicit recommendation can trigger the suitability rule? 30, 32 n.11 (1992) (stating that transactions a broker effects for a discretionary account are implicitly recommended). Thus, the new rule's "hold" language would not apply when a broker remains silent regarding security positions in an account. See SEA Rule 17a-3(a)(17)(i). at 295. In many circumstances, the answer is yes. For example, the recommendation of a large-cap, value-oriented equity security generally would not require written documentation as to the recommendation. 57 FINRA Rule 2111.05(a). [Broker-dealers] have different business models; offer divergent services, products and investment strategies; and employ distinct approaches to complying with applicable regulatory requirements. 40 See id. 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. What is the difference between Rule 2111 and Rule 2330? Does the new rule cover a "hold" recommendation regarding securities that the broker did not originally recommend? Firms should understand that the use of any such Institutional Suitability Certificate in no way constitutes a safe harbor from the rule. See FINRA Rule 2111.03. 1996) (same); Robert L. Wallace, 53 S.E.C. 112-106, 126 Stat. FINRA has stated that the new suitability rule does not broaden the scope of implicit recommendations applicable to the predecessor rule. Q4.1. 2003); Powell & McGowan, Inc., 41 S.E.C. Can a customer with multiple accounts at a single firm have different investment profiles or investment-profile factors (e.g., objectives, time horizons, risk tolerance) for those different accounts? That will not always be the case, however. 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. 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. Some customers, moreover, desire portfolios made up of securities with different levels of liquidity, risk and time horizons. 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? A firm could comply with this requirement, for example, by having an institutional customer indicate in a signed customer agreement or other document that the institutional customer will be exercising independent judgment in evaluating recommendations or a firm could call its institutional customer, have that discussion, and (if it chooses or circumstances require) document the conversation to evidence the institutional customer's affirmative indication. FINRA expects a firm to be capable of explaining how an asset allocation model that it uses is consistent with generally accepted investment theory. Thus, identifying a more limited universe of debt issuers may not constitute a recommendation if such issuers have many debt securities outstanding, of many maturities, and having distinct structures or features. 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 cautioned, however, that a firm should evidence a customer's intent to use different investment profiles or factors for the different accounts. Would a firm violate the suitability rule if it makes recommendations to customers for whom it has not obtained all of the customer-specific information listed in FINRA Rule 2111(a)? No. See Richard G. Cody, Exchange Act Rel. 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. 41 The "Dogs of the Dow" strategy is premised on investing "equal dollar amounts in the ten constituents of the Dow Jones industrial average with the highest dividend yields, hold[ing] them for twelve months and then switch[ing] to a new group of dogs." Where, for example, a registered representative makes a recommendation to purchase a security to a potential investor, the suitability rule would apply to the recommendation if that individual executes the transaction through the broker-dealer with which the registered representative is associated or the broker-dealer receives or will receive, directly or indirectly, compensation as a result of the recommended transaction.15 In contrast, the suitability rule would not apply to the recommendation in the example above if the potential investor does not act on the recommendation or executes the recommended transaction away from the broker-dealer with which the registered representative is associated without the broker-dealer receiving compensation for the transaction.16, Q3.1. The firm, however, also must consider factors such as the trust's investment objectives, time horizon and risk tolerance to complete the suitability analysis. Id. 6 Pub. Suitability The Rule Notices 2110. 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. As noted above in the answer to [FAQ 3.3], however, a broker cannot make assumptions about a customer's other holdings.30The firm should evidence a customer's approval of a broker's use of a portfolio-based analysis regarding the suitability of the broker's recommendations.31Some customers, for instance, may desire all recommendations to be consistent with their stated risk tolerance, investment time horizon or liquidity needs. FINRA stated that, "[t]o 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." In its response to comments during the rulemaking process, however, FINRA noted that a broker-dealer "is free to decide as a business matter to service only those institutional investors that are willing to make the affirmative indication in terms of all potential transactions for its account. See SEA Rule 17a-3(a)(17)(i)(A). 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. Rule 2330 applies to new recommendations in the form of a purchase or an exchange for a given client subaccount. The suitability rule applies on a recommendation-by-recommendation basis. "); Paul C. Kettler, 51 S.E.C. 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. Nothing in this guidance, however, relieves a firm from having to ensure that the investment profiles or factors accurately reflect the customer's decisions. "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. Note: With this guidance, FINRA attempts to present information in a format that is easily understandable. denied, 130 S.Ct. 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. The rule also explicitly covers recommended investment strategies involving securities, including recommendations to "hold" securities. [Notice 12-25 (FAQ 2)], A1.1. A firm's analysis of whether the identification of a more limited universe of fixed-income securities constitutes a recommendation of particular securities may, depending on the facts and circumstances, differ from its assessment regarding equity securities. The institutional-customer exemption does not apply to reasonable-basis and quantitative suitability. 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. '")[, aff'd, 416 F. App'x 142 (3d Cir. 1304, 1311, 1997 SEC LEXIS 762, at *19 (1997). 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. 4, 2012). FINRA's definition of a customer in FINRA Rule 0160 excludes a "broker or dealer. 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. 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. 513, 516-17, 1993 SEC LEXIS 1521, at *9-10 (1993) (same). If a customer is either generally not capable of evaluating investment risk or lacks sufficient capability to evaluate the particular product or investment strategy that is the subject of a recommendation, the scope of a broker's customer-specific obligations under the suitability rule would not be diminished by the fact that the broker was dealing with an institutional customer. 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. 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. 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. 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. 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]."). A6.1. The rule states that it applies to explicit recommendations to hold. A9.3. Rule 2111 would cover a recommendation to recommendations. See SEC Division of Corporation Finance: Standard Industrial Classification. Similarly, a registered representative's recommendation that a "buy and hold" customer with an investment objective of income liquidate large positions in blue chip stocks paying regular dividends might raise a "red flag" regarding whether that recommendation is part of a broader investment strategy. 95 For example, in supervising an identified recommended investment strategy involving a security and a non-security component, a broker-dealer may need to consider, in addition to the customer's investment profile, whether a recommended securities liquidation causes an overconcentration in particular securities or types of securities remaining in the account, changes the composition of the customer's remaining securities investments to an extent that the customer's portfolio no longer matches his or her investment profile, subjects the customer to early withdrawal fees or penalties, exposes the customer to losses because of the lack of a ready market for the securities at the time of the liquidation, or results in potential adverse tax treatment. 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." [Notice 12-25 (FAQ 12)], A9.1. "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." For instance, the rule would cover a recommendation to purchase securities using margin33 or liquefied home equity34 or to engage in day trading,35 irrespective of whether the recommendation results in a transaction or references particular securities. FINRA and the SEC have recognized that certain actions constitute implicit recommendations that can trigger suitability obligations. 80 Compare FINRA Rules 2111(b) and 4512(c) with NASD IM-2310-3. In general, however, when there is an indication that the institutional customer is not capable of analyzing, or does not intend to exercise independent judgment regarding, all of a broker-dealer's recommendations, the broker-dealer necessarily will have to be more specific in its approach to ensuring that it complies with the exemption. 77 It is important to keep in mind that, in addition to the suitability rule, FINRA has numerous other investor-protection rules. 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. Q3.11. 331, 341 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 the NASD rules. [Notice 11-25 (FAQ 11)], A5.2. the customer wants each individual recommendation to be consistent with his or her investment profile or particular factors within that profile; the broker is unaware of the customer's overall portfolio; or. Reg. 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. ) ; Powell & McGowan, Inc., 41 S.E.C the examples market! Be the case, however, the recommendation case, however hold '' language would not apply when a or. 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