The time has finally arrived. FINRA’s new suitability and know-your-customer rules take effect today.
Rule 2111 expands broker-dealer suitability obligations in three important ways. First, the revised rule covers investment strategies and explicit recommendations to hold securities, adding to the old Rule 2310’s requirement for suitability analysis relating to recommendations of a purchase, sale or exchange.
Second, Rule 2111 adds to the necessary customer profile information that a broker-dealer is required to obtain.
Third, the rule enumerates three specific suitability evaluations as follows:
1. Investment Strategies and Hold Recommendations.
While FINRA Rule 2310 requires a suitability analysis in connection with a recommendation of a purchase, sale or exchange, Rule 2111 broadens this obligation. It requires an associated person or member firm to undertake a suitability analysis in connection with a recommendation of a “transaction or investment strategy involving a security or securities.” Supplementary material to the rule define “investment strategy involving a security or securities” as including “an explicit recommendation to hold a security or securities.” As are result, the new Rule 2111 extends the suitability obligation to cover an explicit recommendation to hold, or not to sell, a security.
FINRA defines an investment strategy to be “‘a call to action’ and has specifically noted that a hold recommendation is an investment strategy in the sense of a suggestion that a customer stay the course with the investment,” offering the example of a quarterly or annual investment review during which the associated person plainly advises the customer not to make any changes to the client’s portfolio allocation. Thus, a broker-dealer may not recommend that a customer hold a security (or maintain an allocation) unless the broker-dealer has analyzed the suitability, or appropriateness, of the recommendation for the customer’s financial situation and investment objectives, and the BD has a reasonable basis to believe that the recommendation is appropriate.
This new obligation stands in contrast to the U.S. Supreme Court’s decisions in several cases which held that there is no right of action for “holder” claims. Extension of the suitability obligations under Rule 2111 is not limited to recommendations to hold. The “investment strategies” covered by the rule include recommendations that amounts to “calls to action” irrespective of whether they result in a transaction or reference particular securities.
For example, recommendations that a client use margin, liquefy home equity or engage in day-trading would be covered by the rule, even though no specific security is referenced.
The supplementary materials make clear, however, that not all of a broker-dealer’s communications with its customers will be considered “investment strategies” subject to the suitability obligation.
The rule creates specific exemptions from the definition of investment strategy for the following customer communications: providing general financial and investment information; discussing basic investment concepts; offering information about historical asset class returns; affording estimates of future income needs; providing descriptive information about an employer-sponsored retirement plan, and furnishing a customer with asset allocation models based upon “generally accepted investment theory.”
Accordingly, a broker-dealer should be able to provide such information to its customers without triggering suitability obligations, so long as an explicit recommendation is not made to the customer.
Regulatory Notice 11-02 provides some guidance in determining whether a communication rises to the level of a recommendation, which may be helpful in assessing when a suitability review is triggered. The determination of whether a recommendation is made follows an objective, not a subjective, standard. Factors to be considered include the communication’s “content, context, and presentation.” The primary consideration is whether a particular communication to a customer would reasonably be viewed as a suggestion that the customer take action or refrain from taking action regarding a security or investment strategy.
For example, a series of actions or communications that may not constitute recommendations when viewed individually may be considered to constitute a recommendation when viewed in the aggregate. Generally, the more individually tailored the communication is to a particular customer, the more likely the communication is to be viewed as a recommendation.
While Rule 2111 expands the reach of the suitability obligation to cover a broader category of investment strategies, it does not change the temporal limitations on a registered representative’s suitability duty. Suitability will still be assessed at the time of the recommendation of the investment strategy, without respect to whether the strategy was ultimately successful. Significantly, Rule
2111 does not create any new ongoing duties to monitor a customer’s investments or to make subsequent recommendations.
2. Increased Need for Additional Customer Information
In addition to expanding the circumstances requiring the suitability assessment, Rule 2111 increases the information needed to conduct a suitability analysis. While NASD Rule 2310(b) required BDs to use “reasonable efforts” to obtain information concerning a customer’s financial status, tax status, investment objectives and any such information “considered to be reasonable” in making a recommendation, Rule 2111 enlarges the required customer profile data to include the following:
- the customer’s age;
- other investments held by the customer;
- the customer’s financial status and needs;
- tax status;
- investment objectives;
- investment experience;
- investment time horizon, or the expected number of months, years or decades that a customer plans to invest to achieve a particular financial goal;
- liquidity needs, as to the extent to which the customer desires the ability to quickly and easily convert to cash all or a portion of the investment without a loss in value (for lack of a ready market) or a penalty;
- risk tolerance, defined as a customer’s ability and willingness to lose some or all of the customer’s original investment in exchange for higher potential returns; and
- any other information the customer may disclose to the member or associated person in connection with such recommendation.
Rule 2111(a) only requires that a broker-dealer seek to obtain and consider the information in the profile factors; it does not contain any explicit documentation requirements.
According to Regulatory Notice 11-25, the essential requirement of Rule 2111(a) is that the registered representative “exercise reasonable diligence to ascertain the customer’s investment profile,” and “in most instances, asking a customer for the information would constitute reasonable diligence.” A firm may not necessarily violate the suitability rule if it makes recommendations without knowing every one of the customer’s investment profile factors, but if the firm is not able to obtain all factors for the customer, FINRA cautions that it should “carefully consider whether it has a sufficient understanding of the customer to properly evaluate the suitability of the recommendation.”
A broker-dealer may not be required to obtain and analyze all of the factors if it “has 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 facts and circumstances of the case.”
Therefore, the customer-specific suitability obligation requires that firms obtain enough information about the customer to have a reasonable basis for the recommendation.
Customers with multiple accounts at the broker-dealer may have varying investment profiles or investment profile factors for different accounts. FINRA cautions that the firm should document the customer’s intent for specific accounts to avoid confusion.
Further, for each account, the account profile and all profile factors should be independently completed. FINRA cautions that the firm also may not “borrow” profile factors from one of the customer’s accounts to justify a recommendation that was made in a different account; the investor profile to be considered in the suitability determination is the profile for the account in which the investment was made.
3. Different Suitability Assessments
Rule 2111 also defines three separate suitability assessments that BDs are required to undertake.
First, BDs are required to assess reasonable-basis suitability. This obligation requires the broker-dealer or associated person to “have a reasonable basis to believe, based upon reasonable diligence, that the recommendation is suitable for at least some investors.” The reasonable basis suitability assessment, similar to guidance provided by NTM 04-30 and similar notices, imposes two requirements on a broker-dealer.
First, the broker-dealer must perform reasonable due diligence to understand the risks and rewards of a particular investment or investment strategy. The amount of due diligence required for a product will vary with the complexity of the product and the BD’s familiarity with the security or investment strategy.
Second, the broker-dealer must educate its associated persons on the potential risks of the investment strategy before it permits them to recommend that investment strategy to anyone. In addition to the firm’s obligations, the associated person has an individual, reasonable-basis suitability obligation to understand the potential risks and rewards associated with the recommendation.
A key to the reasonable-basis suitability obligation is training of representatives to ensure they understand the products. The second required assessment is customer-specific suitability. In language similar to Rule 2310(a), the supplementary material to Rule 2111 requires “that a member or associated person have a reasonable basis to believe that the recommendation is suitable for a particular customer based on that customer’s investment profile, as delineated in Rule 2111(a).”
Therefore, the broker-dealer or associated person should be familiar with the customer’s investment profile and attempt to ensure that the recommended investment strategy or product is suitable for the customer in light of the customer’s investment profile factors for that account.
While the customer-specific suitability analysis is required for recommendations in individual accounts,
Rule 2111(b) exempts recommendations to institutional investors under certain circumstances. NASD Rule 3110(c)(4) defines “institutional account” to include the accounts of banks, savings and loan associations, insurance companies, registered investment companies, registered investment advisers, and any other entities with total assets of at least $50 million.
Recommendations to these customers are exempt from the customer-specific suitability analysis where:
1) the registered representative has a reasonable basis to believe that the institutional customer is capable of evaluating investment risks independently, both generally and with respect to the particular transaction or strategy at issue; and
2) the institutional customer affirmatively indicates that it is exercising independent judgment to evaluate the member’s recommendation. An institutional customer may indicate that it is exercising independent judgment for specific recommended transactions or make this indication once for all recommendations made in the account. An agent of the institutional customer may make the investment decisions on behalf of the institution.
The third requirement is an assessment of quantitative suitability, an entirely new suitability obligation. The requirement of “quantitative suitability” essentially reflects and codifies existing case law relating to churning or excessive trading.
Quantitative suitability requires that the broker-dealer have a reasonable basis to believe that the number of recommended transactions in a customer’s account within a certain period is not excessive (i.e., that the investor’s account is not being churned).
A quantitative suitability assessment is required where a registered representative or firm has either actual or so-called “de facto” control over the account. “De facto” control in an ostensibly non-discretionary account only exists under certain rare circumstances. Courts have found “de facto” control where “special circumstances…render the client dependent—a client who has impaired faculties, or one who has a closer than arms-length relationship with the registered representative, or one who is so lacking in sophistication that de facto control of the account is deemed to rest in the broker.”
“De facto” control only exists where there is “a high degree of dominance” by the registered representative and reliance by the customer. Factors such as turnover rate, cost-equity ratio, and use of in-and-out trading are the types of factors that may provide a basis for finding that the activity is excessive. The supplementary material requires an associated person who has “de facto” or actual control over a customer account to have “a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together in light of the customer’s investment profile.”
(Tomorrow: The “Know Your Customer” Rule 2090 and more on the practical considerations of suitability)
(*These pieces are excerpted from an article published in Thomson Reuters’s Wall Street Lawyer and authored by Clifford Kirsch, a partner and member of the financial services practice group in the New York office of the law firm Sutherland Asbill & Brennan; S. Lawrence Polk, a partner and member of Sutherland’s litigation practice group in the firm’s Atlanta office; Brian Rubin, a partner and member of the litigation practice group in the firm’s Washington, D.C. office; and Avital Stadler, a counsel and member of the firm’s litigation practice group in Atlanta).