On Nov. 23, 2010, as part of FINRA's ongoing rule consolidation effort, the SEC approved two new rule changes: FINRA Rule 2090 (Know Your Customer) and FINRA Rule 2111 (Suitability).1 As announced in the just-released FINRA Regulatory Notice 11-02, the new rules take effect on Oct. 7, 2011. Like the old bridal custom, these new rules are a bit of the old, the new and the borrowed . . . and of course, if the changes are not well-heeded, perhaps the “blue,” as well.
The new rules retain much of what firms and practitioners will recognize as the core features of the suitability obligations in old NASD Rule 2310, and they borrow liberally from the “know your customer” obligations set forth in former NYSE Rule 405(1). But they also expand on those obligations in some new and important ways. In addition to revamping the old NYSE and NASD rules, FINRA took this opportunity to propose several new provisions with which member firms and registered representatives should become familiar. Perhaps the most significant of the changes, which could have an enormous impact on customer claims, is the expansion of members’ suitability obligations to “investment strategies,” which expressly includes recommendations to “hold” securities.
This alert introduces firms and practitioners to the key features of new FINRA rules 2090 and 2111, and also includes several practice tips for navigating the new rules.
FINRA Rule 2090 – Know Your Customer
The “know your customer” obligation in new FINRA Rule 2090 is based on the ethical standard contained in NYSE Rule 405(1).2 The FINRA rule expressly requires broker-dealers, with regard to the opening and maintenance of every account, to use “reasonable diligence” to know and retain the essential facts concerning every customer and concerning the authority of each person acting on behalf of such customer. The obligation arises at the beginning of the customer relationship – regardless of whether a recommendation has been made – and continues throughout the term of that relationship. Firms should be mindful of the new requirement to “retain” the “essential facts” concerning every customer.
In response to several comments concerning the meaning of the phrase “essential facts,” FINRA provided “Supplementary Material” to Rule 2090, which defines “essential facts” as those required to:
- effectively service the customer’s account;
- act in accordance with any special handling instructions for the account;
- understand the authority of each person acting on behalf of the customer; and
- comply with applicable laws, regulations and rules.
This explanation does not appear in the NYSE rule or the Rule Interpretations.
FINRA Rule 2090 does not incorporate the requirement from NYSE Rule 405(1) to learn the essential facts relative to every order; rather, the FINRA rule is limited to essential facts concerning every customer. FINRA excluded this “every order” language because of existing order-handling rules. Nevertheless, the reasonable-basis obligation under FINRA’s new suitability rule (discussed below) still requires broker-dealers and their associated persons to use reasonable diligence to understand the securities and strategies they recommend. Lack of such an understanding will violate the FINRA suitability rule. Thus, the “know your customer” obligation, in effect, still requires familiarity with both the customers and the recommended transactions and investment strategies in their accounts.
In light of the mandatory language in this new FINRA rule, firms and registered representatives may question what should be done with a prospective or current customer who declines to give information that is considered an “essential fact” – either at the beginning of the relationship or while the relationship is ongoing. Must the customer be turned away or “fired”? Can the firm proceed with the relationship so long as a “reasonable” effort has been made to obtain the “essential facts” concerning the customer?
Notably, the 2010 NAIC Suitability in Annuity Transactions Model Regulation (the Model Regulation) relating to annuities expressly limits an insurance producer’s obligations to the consumer if the consumer refuses to provide complete or accurate suitability information.3 Unfortunately, no such clarifying provision appears in new Rule 2090 or the commentary to it. As discussed below, if a firm or registered representative chooses to continue the relationship with a customer who declines to turn over pertinent information, great care should be taken to document the efforts to obtain the “essential facts” and to explain why certain information which the customer refused to provide may not be relevant to the suitability analysis for the recommended investment transaction or strategy.
FINRA Rule 2111 – Suitability
The suitability obligation in FINRA Rule 2111 is based on prior NASD Rule 2310. Similar to the NASD rule, the new FINRA rule would require a broker-dealer or associated person to have “a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer …”
However, unlike the NASD rule, which was limited to recommendations for the purchase, sale or exchange of any security, FINRA Rule 2111 expands the suitability obligation beyond investment transactions to “investment strategies.” Thus, brokers must now think more broadly about what “strategy” has been recommended to the customer and whether it is suitable, and they must understand that their suitability obligations may not begin and end with a specific order. The expanded suitability obligation for “strategies” also raises the question of whether brokers now must consider and recommend an overarching “strategy” for each of their customers, as opposed to simply providing advice on an order-by-order basis.
Rule 2111, with its Supplementary Material, is intended to codify three main suitability obligations:
- reasonable basis suitability (where the recommendation meets a threshold suitability for at least some investors);
- customer specific suitability (where the recommendation is suitable for a particular customer based on that customer’s unique investment profile); and
- quantitative suitability (which is relevant in churning cases and exists where a member or associated person with de facto control over a customer account believes that a series of recommended transactions are not excessive and unsuitable when taken together).
Each requires the broker to exercise “reasonable diligence” in analyzing the suitability of the recommendation.
The FINRA suitability rule, like its NASD predecessor, still hinges on the existence of a recommendation. The determination of the existence of a recommendation is based on the facts and circumstances of a particular case and is made on an objective, rather than subjective, basis. The context, content and presentation of the communication are all relevant to the analysis. In Regulatory Notice 11-02, FINRA has reiterated several guiding principles for evaluating whether a communication constitutes a recommendation. For instance, members should consider whether a particular communication to a customer could reasonably be viewed as a suggestion that the customer take action, or refrain from taking action, regarding an investment transaction or strategy. In addition, communications that are more tailored to the particular customer are more likely to be deemed “recommendations.” Further, a series of communications when viewed in the aggregate may constitute recommendations, even though they would not be viewed as such individually. Finally, it makes no difference to FINRA whether the communication was initiated by a person or by a computer software program; either method of communication could result in a “recommendation,” depending on the particular facts and circumstances.4
Types of Information To Be Obtained
Rule 2111 requires that the suitability assessment be “based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile,” such as “the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation.” [emphasis added]
By way of contrast, the prior NASD rule had identified only three types of specific information to be obtained by the member:
- the customer’s financial status;
- the customer’s tax status; and
- the customer’s investment objectives.
Thus, the FINRA rule clearly expands the factors to be considered in assessing suitability (borne perhaps from recent investment experiences like auction rate securities) and raises the bar for members to show that a particular recommendation or strategy is suitable. As a practical matter, however, most, if not all, of these factors are widely understood to be pertinent in determining suitability. Interestingly, the factors specified in Rule 2111 largely mirror those stated in the 2010 NAIC Model Regulation for suitability of annuity transactions.
Section 2111.04 of the Supplementary Material explains that a recommendation should be made only if the firm or associated person has sufficient information about the customer, based on the factors delineated in Rule 2111(a), to make the suitability assessment. The level of importance of each factor may vary, depending on the facts and circumstances of the particular case. This flexibility, however, is tempered by the presumption that all of the listed factors generally are relevant (and often crucial) to a suitability analysis.
Members, therefore, must use “reasonable diligence” to obtain information regarding all of these factors, unless they have a reasonable basis to believe, documented with specificity, that one or more of the factors are not relevant components of a customer’s investment profile in light of the particular facts and circumstances. Even if certain of the factors do not appear to be critical to the overall suitability analysis in a particular case, the firm and broker must still use reasonable diligence to obtain all the information and must have obtained enough other information about the customer to support the suitability determination.
The new rule and its Supplementary Material still do not address a member’s potential liability where a customer declines to provide information that would be relevant to a suitability determination. In response to comments to the proposed rule changes, FINRA stated only that the efforts of a firm that seeks, but does not obtain, information will be judged under the “reasonable diligence” standard. Unfortunately, this response leaves a firm’s liability open to interpretation. Efforts that may seem “reasonable” by the firm’s standards may not satisfy a regulator who likely is reviewing the situation after the fact and with the benefit of hindsight.
Members should be diligent in documenting in detail:
- their attempts to obtain the essential factors about the customer contemplated in both Rule 2090 and Rule 2111 (such as requiring the information to be included in new account forms signed by the customer and a supervisor);and
- if certain information is not provided by the customer, the reasons why such information is not relevant to the ultimate suitability determination for a particular recommended transaction or strategy.
This latter step may require detailed written correspondence between a supervisor and the client, preferably with the client acknowledging the situation in writing. The more that information is lacking or documentation is not sufficient, the more likely it is that a member may later be judged not to have satisfied its reasonable diligence obligation and the more likely that the recommendation may be deemed not suitable. Firms should determine whether their policies and procedures address this documentation process and the requirement to retain such documentation of their due diligence and suitability analysis.
"Investment Strategies" and Recommendations to Hold Securities
Pursuant to Section 2111.03 of the Supplementary Material, FINRA interprets the term “strategy” broadly, to include, among other things, an explicit recommendation to “hold” a security. Thus, even advice to “stay the course” in the face of market declines must pass muster under the FINRA suitability rule.
FINRA justifies its interpretation by arguing that customers rely on their brokers’ expertise and knowledge in deciding whether or not to sell a particular security. Thus, FINRA believes it is appropriate to hold brokers responsible for recommendations made to customers, regardless of whether those recommendations result in transactions or generate transaction-based compensation. Practitioners should be aware that FINRA’s position in this respect directly conflicts with federal securities law as well as state law in many jurisdictions, including Pennsylvania. Courts routinely hold that there can be no viable cause of action relating to the decision to hold a security.5
The Supplementary Material to Rule 2111 also sets forth several types of communications that are excepted from the suitability requirement, provided that they do not include a recommendation. Those exceptions are:
- general financial and investment information (such as the explanation of basic investment concepts or the general assessment of a customer’s investment profile);
- descriptive information about an employer-sponsored retirement or benefit plan;
- asset allocation models; and
- interactive investment materials that incorporate the above.
Practitioners should consider whether the above exception for asset allocation models provides a basis from which to argue – both in the discovery phase and in addressing the merits in a hearing or trial – that a firm’s asset allocation modeling is not relevant to a suitability-based customer claim. In other words, this exception appears to recognize that a firm’s general asset allocation models should not be a factor in determining whether the actual strategy and transactions implemented for the particular customer was suitable for that customer.
Rule 2111 provides an institutional customer exemption by focusing on whether there is a reasonable basis to believe that the institutional customer is capable of evaluating investment risks independently and is exercising independent judgment in evaluating recommendations. The rule requires institutional customers to affirmatively indicate they are exercising independent judgment. This rule also expressly harmonizes the definition of “institutional customer” in the suitability rule with the definition of “institutional account” in NASD Rule 3110(c)(4) – i.e., any entity (whether a natural person, corporation, partnership, trust or otherwise) with total assets of at least $50 million.
Finally, firms and associated persons should be aware that they cannot disclaim any responsibilities under the suitability rule. This is contained in the Supplementary Material and is not based on the old NYSE or NASD rules.
As discussed throughout this alert, these new rule consolidations do not simply recast existing NASD and NYSE rules. They contain many new features, of which members need to be mindful, and for which firms and their associated persons may need to design new compliance measures. For instance, firms should take care in documenting customer information and efforts to obtain such information. Firms may also need to develop new policies and procedures and provide training to their retail and supervisory staff concerning the expanded list of the types of customer information that brokers must obtain and analyze, the reasonable diligence aspects of knowing both the customer and the recommended security or strategy, and the application of the suitability rule to “investment strategies,” including recommendations to “hold.” Firms should not simply assume that their existing procedures address the suitability and know-your-customer obligations set forth in the new rules. Instead, firms should closely review the FINRA rules and consider how the changes could impact their procedures.
1 A complete copy of the rules can be viewed at http://finra.complinet.com/en/display/display.html?rbid=2403&element_id=9858 and http://finra.complinet.com/en/display/display.html?rbid=2403&element_id=9859.
2 FINRA did not propose to incorporate subsections (2) or (3) of NYSE Rule 405 because they are generally duplicative of other rules, regulations or laws, including NASD Rule 3010 (Supervision), and NASD rules 3110(c)(1)(C)(Customer Account Information) and 3011 (Anti-Money Laundering Compliance Program).
3 See Model Reg. at Section 6D.
4 See FINRA Notice 11-02 (January 2011).
5 As the United States Supreme Court has held, only purchasers or sellers of securities are entitled to sue under Section 10(b) of the Securities Exchange Act of 1934. Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 749, 95 S.Ct. 1917 (1975). See WM High Yield Fund v. O’Hanlon, No. 04-3423, 2005 WL 1017811, *12 (E.D. Pa. Apr. 29, 2005) (stating that Pennsylvania has never recognized a cause of action for “holders” of securities); see also Holmes v. Grubman, 568 F.3d 329, 337 (2d Cir. 2009) (collecting cases and listing at least seven other states – including Pennsylvania – that do not recognize “holder claims”).
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