The Financial Industry Regulatory Authority (FINRA) implemented a new suitability rule on July 9 that broadens the list of factors firms and brokers need to analyze before recommending securities or investment strategies.
The SEC Approves New FINRA Rule
The Securities and Exchange Commission (SEC) approved the new FINRA Rule 2111 in November 2010. Since then, FINRA has issued three regulatory notices discussing the new rule’s requirements. The latest notice was released in May in response to questions from the industry, FINRA said.
Regulatory Notice 12-25 states that new FINRA Rule 2111(a) requires broker-dealer firms and the brokers associated with these firms to have a reasonable basis to believe that the securities transaction or investment strategy they are recommending is suitable for the customer. This also applies to recommendations on whether to hold a particular security, which is now considered part of an investment strategy.
The reasonable belief of the firms and brokers must be based on information obtained through “reasonable diligence” exercised by them to learn the customer’s investment profile.
The new suitability rule also codifies case law holding that, for a broker’s recommendations to be suitable, they must be consistent with a customer’s best interests. The regulatory notice stated that this essentially means brokers cannot place their interests ahead of the interests of their customers, say by recommending one product over another in order to receive larger commissions.
While the new rule mostly retains the central features of its predecessor – National Association of Securities Dealers (NASD) Rule 2310 – it also codifies interpretations of the old rule and includes a few new or modified obligations, the regulatory notice said.
For example, new FINRA Rule 2111(a) codifies and clarifies the three main obligations regarding suitability developed mostly through case law:
Reasonable-basis suitability refers to brokers’ duty to perform reasonable diligence to make sure they understand the product or investment strategy they are recommending. They must also be aware of the potential risks and possible upside, and determine whether the security or strategy is suitable for some investors in general based on their understanding.
Customer-specific suitability refers to the reasonable basis brokers’ must have to believe the product or investment strategy is suitable for the specific customer to whom they are recommending it based on that customer’s investment profile.
Quantitative suitability concerns brokers who have control over customer accounts and the reasonable basis they must have to believe that the number or series of securities transactions they are recommending is not excessive.
In addition, the new rule broadens the list of customer-specific factors that must be apprehended and analyzed when making recommendations, the regulatory notice said. FINRA Rule 2111 adds a customer’s age, investment experience, and time horizon, which represents the span of time within which a customer expects to achieve his or her financial goals. The new rule also adds liquidity needs and risk tolerance to the explicit list.
These new factors join the factors already listed in NASD Rule 2310, which are: other investments, overall financial situation and need, tax status, and investment objectives. All these factors – in both new rule and old – generally make up a customer’s investment profile, the regulatory notice said.
The explicit factors added to the new rule grew out of case law that directed brokers to consider customer-specific factors that NASD Rule 2310 did not expressly reference. However, FINRA Rule 2111.04 states that firms and brokers do not have to apprehend and analyze all of the factors if they have a reasonable basis to believe that one or more of them are irrelevant to the customer’s investment profile in light of that customer’s particular circumstances.
If a firm or broker makes the determination that certain factors don’t require analysis, they need to document the rationale for this decision, according to the regulatory notice FINRA issued on the new rule in 2011.
The regulatory notice issued in May also explained that new FINRA Rule 2111 imposes broader obligations on firms and brokers regarding the recommendation of investment strategies involving securities.
Now the rule expressly covers investment strategies and also states that the term “investment strategy” is interpreted broadly to include recommendations to hold securities, the regulatory notice said.
The new rule also changed the definition of institutional customer, thus modifying the institutional-customer exemption by requiring an affirmative indication from such customers of their intention to independently analyze the firm’s or broker’s recommendations, the regulatory notice said.
Finally, FINRA said in the regulatory notice that firms may use a risk-based approach to documenting compliance with the rule.
Firms Question Concerns With New Rule
Soon after the SEC approved the new rule, firms began to question what effect it would have on their supervisory procedures, and whether they needed to modify their automated systems and train their brokers in compliance.
According to a report by Investment News, broker-dealers expressed the most concern over the suitability obligations imposed on investment strategies, now defined as they are to include buy, sell or hold recommendations.
Another point of concern for the industry is the “best interests” standard of care for customers they perceive was described in the May regulatory notice. This standard caught some off guard, the report said, because the SEC is working on developing a fiduciary standard for brokers under the Dodd-Frank Act.
Brian Rubin, a partner at Sutherland Asbill & Brennan LLP, told Investment News that usually, “best interests” are the words you use when setting a fiduciary standard.
W. Hardy Callcott, a partner at Bingham McCutchen LLP, told Investment News he think FINRA is trying bolster its case for getting oversight of advisers with this “best interests” language.
However, FINRA said most of the changes in the new suitability rule simply codify case law and past interpretations.
FINRA Issues Notices To Address Concerns
FINRA issued the regulatory notices to address industry concerns. In the latest May notice, FINRA reiterated that many of the obligations are the same under both the new and old suitability rules and applicable case law. Previous guidance and interpretations regarding suitability continue to apply unless they are inconsistent with the new rule, the regulatory notice said.
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