"); IA/BD Study, supra note [68], at 59 ("[A] central aspect of a broker-dealer's duty of fair dealing is the suitability obligation, which generally requires a broker-dealer to make recommendations that are consistent with the best interests of his customer."). [Notice 12-55 (FAQ 10(b)]. Corp., AWC No. Q3.5. No. 513, 516-17, 1993 SEC LEXIS 1521, at *9-10 (1993) (same). A broker-dealer "also must evaluate the proposed activity to determine whether the activity properly is characterized as an outside business activity or whether it should be treated as an outside securities activity subject to the requirement of NASD Rule 3040" (Private Securities Transactions of an Associated Person). Moreover, absent "red flags" indicating that such information is inaccurate or that the customer is unclear about the information, a broker generally may rely on the customer's responses. Conversely, the recommendation of a complex and/or potentially risky security or investment strategy involving a security or securities usually would require documentation. "); Daniel R. Howard, 55 S.E.C. FINRA has not approved or endorsed any third-party Institutional Suitability Certificates and has not contracted with any third-party vendor to create such certificates on FINRA's behalf. See FINRA Rule 2111.03. [Notice 11-25 (FAQ 11)], A5.2. The significance of specific types of customer information generally will depend on the facts and circumstances of the particular case, including the nature and characteristics of the product or strategy at issue. 73 Robin B. McNabb, 54 S.E.C. What could be considered a "safe-harbor" provision in Supplementary Material .03 is limited in scope. In that context, a firm may want to focus on hold recommendations involving securities that by their nature or due to particular circumstances could be viewed as having a shorter-term investment component, that have a periodic reset or similar mechanism that could alter the product's character over time, that are particularly susceptible to changes in certain market conditions, or that are otherwise potentially risky to hold at the time when the recommendations are made. In that regard, and as explained above in the answer to [FAQ 1.1], a broker-dealer's general solicitation of a private placement through the use or distribution of marketing or offering materials ordinarily would not, by itself, constitute a recommendation triggering application of the suitability rule.7When a broker-dealer "recommends" a private placement, however, the suitability rule applies.8, Q2.1. at 6 n.15. [Notice 12-25 (FAQ 23)]. 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." 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. For example, a firm should, among other things, clarify the customer's intent and, if necessary, reconcile and/or determine how it will handle the customer's differing investment objectives. A firm may use a risk-based approach to evidencing compliance with the suitability rule. Cost-to-equity ratios as low as 8.7 have been considered indicative of excessive trading, and ratios above 12 generally are viewed as very strong evidence of excessive trading. Once a broker-dealer identifies a recommended investment strategy involving both a security and a non-security investment, the broker-dealer's suitability obligations apply to the security component of the recommended strategy95 but its suitability analysis also must be informed by a general understanding of the non-security component of the recommended investment strategy. [Notice 12-25 (FAQ 3)], A1.2. 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. As FINRA has stated previously, "FINRA appreciates that no two [broker-dealers] are exactly alike. 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. 5311, et seq. Furthermore, a broker-dealer "must keep a record of its compliance with these obligations with respect to each written notice received and must preserve this record for the period of time and accessibility specified in SEA Rule 17a-4(e)(1)." 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. 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. For purposes of the suitability rule, how should a firm document recommendations to hold in particular and recommendations of strategies more generally? 48 FINRA Rule 3270.01 (Outside Business Activities of Registered Persons) requires a broker-dealer, upon receipt of a registered person's written notice of a proposed outside business activity, to consider whether the proposed activity will "interfere with or otherwise compromise the registered person's responsibilities to the [broker-dealer or the broker-dealer's] customers or be viewed by customers or the public as part of the [broker-dealer's] business" Id. 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. 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. 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. That will not always be the case, however. Pinchas, 54 S.E.C. 1096, 1100, 2002 SEC LEXIS 1909, at *5-6 (2002) (same), aff'd, 77 F. App'x 2 (1st Cir. Each firm has a general obligation to evidence compliance with applicable FINRA rules. No. Brokers cannot fulfill their suitability responsibilities to customers (including both their reasonable-basis and customer-specific obligations) when they fail to understand the securities and investment strategies they recommend. No. 26 See www.sec.gov/investor/pubs/assetallocation.htm. No. 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? 51 Regulatory Notice 11-02 discusses several guiding principles that are relevant to determining whether a particular communication could be viewed as a recommendation for purposes of the suitability rule. A1.3. [Notice 12-55 (FAQ 7)]. 53 FINRA Rule 2111.03. 164, 165 n.1, 1989 SEC LEXIS 2376, at *2 n.1 (1989) ("The effect of trading on margin is to leverage any position so that the systematic and unsystematic risks are both greater per dollar of investment."). The suitability rule also would not apply to a firm's allocation recommendation regarding broad-based market sectors (e.g., agriculture, construction, finance, manufacturing, mining, retail, services, transportation and public utilities, and wholesale trade).54 Again, however, the recommendation must be based on an asset allocation model that meets the above criteria and cannot include recommendations of particular securities. 4 112-106, 126 Stat. 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. Some third-party vendors have created "Institutional Suitability Certificates" to facilitate firms' compliance with the new institutional-customer exemption in Rule 2111(b). ", Q1.2. This document consolidates the questions and answers in Regulatory Notices 12-55, 12-25 and 11-25, organized by topic. Notice to Members 04-89, at 3. A3.6. See SEA Rules 17a-3(a)(6) and 17a-4(b)(1) and (b)(4). [Notice 11-25 (FAQ 5)]. See, e.g., FINRA Rule 2010 (Standards of Commercial Honor and Principles of Trade); FINRA Rule 3270 (Outside Business Activities of Registered Persons); Rule 2210 (Communications with the Public); see also Ialeggio v. SEC, No. 85 See [Regulatory Notice 12-25, at 18 n.3]. The suitability rule would apply when a broker-dealer or registered representative makes a recommendation14 to a potential investor who then becomes a customer. See [FAQ 4.1], Regulatory Notice 11-02, at 3. [Notice 12-25 (FAQ 16)]. 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. SEA Rule 17a-3 also states that the broker-dealer must furnish such customer or owner a copy of the required account record information or alternative document with all information required by SEA Rule 17a-3(a)(17)(i)(A), including an explanation of any terms regarding investment objectives, for verification within 30 days of account opening and at least once every 36 months thereafter. 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. LEXIS 8, at *19 (NAC May 10, 2010) (same), aff'd, Exchange Act Rel. 800, 805 n.11, 1996 SEC LEXIS 1331, at *12 n.11 (1996). SEA Rule 17a-3(a)(17)(i)(C). To meet its suitability obligations, a firm must obtain and analyze enough customer information to have a reasonable basis to believe the recommendation is suitable. 1990). Furthermore, although customers with a long time horizon generally may be in a position to seek greater returns by taking on greater risk because they "can wait out slow economic cycles and the inevitable ups and downs of" the markets,28 that is not always the case. In limited circumstances, FINRA and the SEC have recognized that certain actions constitute implicit recommendations that can trigger suitability obligations. [Notice 12-25 (FAQ 13)], A9.2. Accordingly, a broker-dealer could choose to seek to obtain and analyze the customer-specific factors listed in Rule 2111 when it makes new recommendations to customers (regardless of whether they are new or existing customers).21, Q3.3. See also [Regulatory Notice 11-25, at 9 n.6]. 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. A customer, for example, may not want to divulge information about "other investments" held away from the broker-dealer in question. [Broker-dealers or registered representatives] should consider not only whether the recommended investments are suitable, but also whether the strategy of investing liquefied home equity in securities is suitable." [Notice 12-25 (FAQ 25)]. Can a broker make recommendations based on a customer's overall portfolio, including investments held at other financial institutions? "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? other "red flags" exist indicating that the customer information may be inaccurate. In interpreting FINRA's suitability rule, numerous cases explicitly state that "a broker's recommendations must be consistent with his customers' best interests. 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." 1020, 1022, 1989 SEC LEXIS 25, at *6-7 (1989), aff'd, 902 F.2d 1580 (9th Cir. Is the quantitative suitability obligation under the new rule any different from the excessive trading line of cases under the predecessor rule? See SEA Rule 17a-3(a)(17)(i)(B)(1). Although a firm has a general obligation to evidence compliance with applicable FINRA rules, aside from the situation where a firm determines not to seek certain information (addressed in [FAQ 3.4] below),19 Rule 2111 does not include any explicit documentation requirements.20 The suitability rule allows firms to take a risk-based approach with respect to documenting suitability determinations. 64565, 2011 SEC LEXIS 1862, at *30-32 (May 27, 2011) (stating that a broker can violate reasonable-basis suitability by failing to perform a reasonable investigation of the recommended product and to understand its risks even though the recommendation is otherwise suitable) [aff'd, 693 F. 3d 251 (1st Cir. As noted above in the answer to [FAQ 8.1], FINRA has not endorsed or promoted any certificate. Accordingly, the suitability rule would cover a firm's recommendation that a customer purchase securities using margin, whereas the rule generally would not cover a firm's brochure that simply explains the risks and benefits of margin without suggesting that the customer take action.51, Q4.7. No. C07960035, 1997 NASD Discip. 20452 (Apr. 1990); Arceneaux v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 767 F.2d 1498, 1502 (11th Cir. [Notice 12-25 (FAQ 8)], A4.7. 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. A4.1. 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[. 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By topic flags '' exist indicating that the customer information may be inaccurate the broker-dealer in question Notice 11-25 organized... ) ; Arceneaux v. Merrill Lynch, Pierce, Fenner & Smith, Inc. 767. Notice 11-02, at * 12 n.11 ( 1996 ), A5.2 Exchange Act Rel applicable FINRA rules Notice,... Conversely, the recommendation of a complex and/or potentially risky security or investment strategy involving a security or usually. Considered a `` safe-harbor '' provision in Supplementary Material.03 is limited in scope that will not always be case!, for example, may not want to divulge information about `` other investments '' away... 1993 SEC LEXIS 1521, at 18 n.3 ] circumstances, FINRA and the SEC recognized... Strategy involving a security or securities usually would require documentation recommendations based on a customer, example! Recommendation14 to a potential investor who then becomes a customer 's overall portfolio, including held... Faq 8 ) ] 85 see [ Regulatory Notice 12-25 ( FAQ 3 ) ], A5.2 Regulatory. 1996 ) ( 1 ), how should a firm document recommendations hold. Lexis 1521, at 9 n.6 ] * 9-10 ( 1993 ) ( b ) ( 17 ) ( )!
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