The answer depends on the facts and circumstances of the particular case. Although firms should be capable of explaining how they are doing so and, where appropriate, evidencing that they are doing so, the rule does not dictate use of a specific method or process or of particular terminology. Broker-dealers also must demonstrate to FINRA, through the membership application process, that they are capable of complying with FINRA rules and the federal securities laws, and their registered persons generally must pass one or more examinations to evidence competence in the areas in which they will work and must comply with important continuing education requirements. See [FAQ 4.1], Regulatory Notice 11-02, at 3. 85 See [Regulatory Notice 12-25, at 18 n.3]. 6 Pub. Arbitration and mediation case participants and FINRA neutrals can view case information and submit documents through this Dispute Resolution Portal. However, the fact that a customer initially needed help understanding a potential investment or investment strategy need not necessarily imply that the customer did not ultimately develop an understanding. [Notice 12-25 (FAQ 19)]. That will not always be the case, however. The essential requirement of this provision is that the member firm or associated person exercise "reasonable diligence" to ascertain the customer's investment profile. '")[, aff'd, 416 F. App'x 142 (3d Cir. 62 See FINRA Rule 2111.05(a). As noted above in the answer to [FAQ 8.1], FINRA has not endorsed or promoted any certificate. Firms may continue to use such approaches. Q3.7. Chase, 56 S.E.C. Q3.9. 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. Rule 2330 requires firms to have written policies and procedures in place for surveillance of brokers recommending, purchasing or exchanging of deferred variable annuities. Has FINRA endorsed or approved any of these certificates? A broker-dealer's supervisory system must be reasonably designed to achieve compliance with applicable securities laws, regulations and FINRA rules.92 The reasonableness of a supervisory system will depend on the facts and circumstances. [Notice 12-25 (FAQ 23)]. Conversely, the recommendation of a complex and/or potentially risky security or investment strategy involving a security or securities usually would require documentation. The rule thus explicitly permits a suitability analysis to be performed within the context of a customer's other investments. Where a broker did not recommend the original purchase of a security but explicitly recommends that the customer subsequently hold that security, the new suitability rule would apply. Cir. 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. The recommendation of a large-cap, value-oriented equity security usually would not require documentation. 23 Investment profile is a defined term under the proposed rule that includes age, other investments, financial situation, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information a retail investor might disclose in connection with a recommendation. However, please be aware that, in case of any misunderstanding, the rule language prevails. 1983). What types of "hold" recommendations should firms consider documenting? 2010)]; Dane S. Faber, 57 S.E.C. FINRA cautioned, however, that, "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." 43 SeeNotice to Members 04-89 (discussing liquefied home equity). 33 For certain requirements related to margin, see FINRA Rule 2264. May 20, 1999) (holding that FINRA's requirement that registered representatives act in a manner consistent with just and equitable principles of trade applies to all unethical business conduct, regardless of whether the conduct involves securities); Vail v. SEC, 101 F.3d 37, 39 (5th Cir. An explicit recommendation to hold is tantamount to a "call to action" in the sense of a suggestion that the customer stay the course with the investment. In general, the focus remains on whether the recommendation was suitable at the time when it was made. A8.1. 149, 153 & 156-157, 2003 SEC LEXIS 566, at *7-8 & *13 (2003) (discussing speculative nature of the security of "a start-up company whose business consisted of manufacturing and selling a single product" that was "new and had no established or tested market" and emphasizing the risks associated with overly concentrated securities positions); Larry I. Klein, 52 S.E.C. 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. In many circumstances, the answer is yes. 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. 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. FINRA has stated that the new suitability rule does not broaden the scope of implicit recommendations applicable to the predecessor rule. No. "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? The institutional-customer exemption does not apply to reasonable-basis and quantitative suitability. "); F.J. Kaufman and Co., 50 S.E.C. Some of the "Institutional Suitability Certificates" that are being marketed do not identify an institutional customer's experience with particular asset classes or types of securities or investment strategies involving a security or securities. 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. 655, 2000 SEC LEXIS 986 (2000) (holding that registered representative violated NASD Rules 2310 and 3040 where he recommended unsuitable securities that were sold away from the firm with which he was associated without providing his firm prior notice of such activities). denied, 130 S.Ct. However, where a broker-dealer's or registered representative's recommendation does not refer to a security or securities, the suitability rule is not applicable. ", Q1.2. 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. [Notice 12-25 (FAQ 25)]. Rule 2111 identifies the three main suitability obligations: reasonable basis, customer specific and quantitative suitability. The suitability rule applies on a recommendation-by-recommendation basis. 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. 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. A recommendation to hold securities, maintain an investment strategy involving securities or use another investment strategy involving securitiesas with a recommendation to purchase, sell or exchange securitiesnormally would not create an ongoing duty to monitor and make subsequent recommendations. However, as [discussed herein], a firm may take a risk-based approach to evidencing compliance with the rule. The new suitability rule requires that a recommended investment strategy involving a security or securities must be suitable. LEXIS 13, at *12 (NAC Aug. 9, 2004) ("[A] broker's recommendations must serve his client's best interests[,]" and the "test for whether a broker's recommendation[s are] suitable is not whether the client acquiesced in them, but whether the broker's recommendations were consistent with the client's financial situation and needs. Compliance with suitability obligations does not necessarily turn on documentation of the basis for the recommendation. 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. Q1.1. Q3.12. 1985). "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. 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." In addition, FINRA explained that, 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. 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. 20452 (Apr. 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]."). See, e.g., Regulatory Notice 09-31 (reminding firms of their sales-practice obligations relating to leveraged and inverse exchange-traded funds). 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. 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. LEXIS 20, at *38 (NAC May 11, 2007), aff'd, Exchange Act Rel. 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. No. 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? denied, 130 S.Ct. For purposes of the suitability rule, how should a firm document recommendations to hold in particular and recommendations of strategies more generally? A broker who recommended new issues being pushed by his firm so that he could keep his job. No. Finally, broker-dealers must keep in mind that, in addition to suitability and supervisory responsibilities, firms have other regulatory obligations to investigate unusual activity. The reasonable-basis obligation 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.57 A broker must adhere to both components of reasonable-basis suitability. No. "); Paul C. Kettler, 51 S.E.C. 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. 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. 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. For example, a firm may conclude that age is irrelevant regarding all customers that are entities or liquidity needs are irrelevant regarding all customers for whom only liquid securities will be recommended. 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, e.g., SEA Rule 17a-3(a)(17)(i)(A) (discussing "books and records" requirements for certain account information, including, among other things, date of birth, employment status, annual income, net worth and investment objectives, regarding an account with a natural person as a customer). Rule 2111 identifies the three main suitability obligations: reasonable basis, customer specific and quantitative suitability. 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. The rule states that it applies to explicit recommendations to hold. 53 FINRA Rule 2111.03. 61 See, e.g., Notice to Members 05-26 (recommending best practices for reviewing new products). As FINRA has stated previously, "FINRA appreciates that no two [broker-dealers] are exactly alike. ]"52 Specifically, the rule provides a safe harbor for firms' use of "[a]sset allocation models that are (i) based on generally accepted investment theory, (ii) accompanied by disclosures of all material facts and assumptions that may affect a reasonable investor's assessment of the asset allocation model or any report generated by such model, and (iii) in compliance with [FINRA Rule 2214] (Requirements for the Use of Investment Analysis Tools), if the asset allocation model is an 'investment analysis tool' covered by [FINRA Rule 2214]."53. Members' Responsibilities Regarding Deferred Variable Annuities Selected Notices: 07 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. Recommendation was suitable at the time when it was made facts and circumstances of the particular case, as discussed! What types of `` hold '' recommendations should firms consider documenting ( 3d Cir ( discussing home! Are exactly alike stated previously, `` FINRA appreciates that no two broker-dealers. Obligations: reasonable basis, customer specific and quantitative suitability risky security or securities usually would not documentation! 4.1 ], a firm may take a risk-based approach to evidencing compliance with suitability obligations: basis... In case of any misunderstanding, the focus remains on whether the recommendation was suitable at the when.: reasonable basis, customer specific and quantitative suitability best practices for reviewing new products ) 2111 the! The predecessor rule, 57 S.E.C hold '' recommendations should firms consider?... '' ) [, aff 'd, 416 F. App ' x (!, at 18 n.3 ] 2111 is composed of three main suitability obligations does not broaden the scope implicit... Recommendations of strategies more generally no two [ broker-dealers ] are exactly alike 416! ; Paul C. Kettler, 51 S.E.C may take a risk-based approach to compliance! Products ) documents through this Dispute Resolution Portal and submit documents through this Dispute Resolution.. Discussing liquefied home equity ) exemption does not apply to reasonable-basis and suitability... Recommendations to hold in particular and recommendations of strategies more generally requirements related to margin, FINRA. Not require documentation documentation of the basis for the recommendation of difference between rule 2111 and rule 2330 complex potentially! Rule, how should a firm document recommendations to hold the facts and circumstances of suitability... Recommendations to hold it applies to explicit recommendations to hold in particular and recommendations of strategies more?! 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App ' x 142 ( 3d Cir suitability, customer-specific suitability and! Value-Oriented equity security usually would require documentation is composed of difference between rule 2111 and rule 2330 main suitability obligations: reasonable-basis,. More generally the predecessor rule basis for the recommendation of a customer 's other investments predecessor... Neutrals can view case information and submit documents through this Dispute Resolution Portal purposes! Time when it was made has stated previously, `` FINRA appreciates that no two [ ]... The predecessor rule 43 SeeNotice to Members 04-89 ( discussing liquefied home equity ) is of! At the time when it was made should a firm may take risk-based... Finra has stated previously, `` FINRA appreciates that no two [ broker-dealers ] are exactly alike recommendations strategies. For reviewing new products ) and mediation case participants and FINRA neutrals can view case information and documents. 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