917, 928, 2000 SEC LEXIS 2120, at *24 (2000), aff'd, 298 F.3d 1126 (9th Cir. LEXIS 38, at *17 (NAC Dec. 3, 2001) ("Turnover rates between three and five have triggered liability for excessive trading"). "68 What does it mean to act in a customer's best interests? The rule generally requires a broker-dealer to seek to obtain and analyze the customer-specific factors listed in the rule when making a recommendation to a customer. [Notice 12-25 (FAQ 3)], A1.2. It also is important to note that, where an institutional customer has delegated decisionmaking authority to an agent, such as an investment adviser or a bank trust department, Rule 2111(b) makes clear that the factors relevant to determining whether the customer meets the criteria for the institutional-customer exemption will be applied to the agent. The rule would apply, for example, when an associated person meets with a customer during a quarterly or annual investment review and explicitly advises the customer not to sell any securities in or make any changes to the account or portfolio. The answer depends on the facts and circumstances of the particular case. 57 FINRA Rule 2111.05(a). As with many obligations under various rules, a firm will need to make some judgment calls on the types of recommendations that it should document under FINRA's suitability rule. A broker must understand the securities and investment strategies involving a security or securities that he or she recommends to customers.58, The reasonable-basis obligation is critically important because, in recent years, securities and investment strategies that brokers recommend to customers, including retail investors, have become increasingly complex and, in some cases, risky. 8 When analyzing whether a particular communication could be viewed as a recommendation triggering application of the suitability rule, firms should consult the prior guidance cited supra at notes [1 and 2]. 1985). 10 See Notice to Members 04-72, at 846 ("The BD of record refers to the broker-dealer identified on a customer's account application for accounts held directly at a mutual fund or variable insurance product issuer. As described in greater detail in FAQ [4.7], there is a safe harbor for certain types of educational information and asset allocation models that otherwise could be considered investment strategies captured by the new rule. A broker-dealer cannot make assumptions about customer-specific factors for which the customer declines to provide information.22 Furthermore, when customer information is unavailable despite a broker-dealer's reasonable diligence, the firm must carefully consider whether it has a sufficient understanding of the customer to properly evaluate the suitability of a recommendation.23 As with the predecessor rule [NASD Rule 2310], however, the new rule would not prohibit a broker-dealer from making a recommendation in the absence of certain customer-specific factors as long as the firm has enough information about the customer to have a reasonable basis to believe the recommendation is suitable. See SEA Rule 17a-3(a)(17)(i). 46 FINRA made similar points regarding recommended investment strategies on several occasions under the predecessor suitability rule. The essential requirement of this provision is that the member firm or associated person exercise "reasonable diligence" to ascertain the customer's investment profile. denied, 130 S.Ct. FINRA and the SEC have held, for example, that brokers who effect transactions on a customer's behalf without informing the customer have implicitly recommended those transactions, thereby triggering application of the suitability rule.4 Although such holdings continue to act as precedent regarding those issues, the new rule does not broaden the scope of implicit recommendations. This position is consistent with requirements under the previous suitability rule. Rule 2111 identifies the three main suitability obligations: reasonable basis, customer specific and quantitative suitability. Similarly, a registered representative's recommendation that a "buy and hold" customer with an investment objective of income liquidate large positions in blue chip stocks paying regular dividends might raise a "red flag" regarding whether that recommendation is part of a broader investment strategy. [Notice 12-25 (FAQ 14)]. 52562, 52567 (Aug. 26, 2010)]. 306 (2012). The average monthly investment is the cumulative total of the net investment in the account at the end of each month, exclusive of loans, divided by the number of months under consideration." 9 See FINRA Rule 0160(b)(4) (Definition of Customer). Rule 2330 requires a registered principal to review and determine whether to approve a customers application for a deferred variable annuity The rule states that it applies to explicit recommendations to hold. denied, 130 S.Ct. See Cody, 2011 SEC LEXIS 1862, at *48 (finding turnover rate of three provided support for excessive trading); Dep't of Enforcement v. Stein, No. ", Q1.2. Id. 333 (2010). A [broker-dealer's] reasonable diligence must provide [it] with an understanding of the potential risks and rewards associated with the recommended security or strategy." FINRA explained that, although due diligence reviews by such committees can be extremely beneficial (see, e.g., Notice to Members 05-26), a firm's approval of a product for sale does not necessarily mean that an associated person has complied with the reasonable-basis obligation. 4 See, e.g., Rafael Pinchas, 54 S.E.C. '")[, aff'd, 416 F. App'x 142 (3d Cir. A4.2. A3.5. [Notice 12-55 (FAQ 6(b))], A2.2. How much of a duty does a firm have to pursue "any other information the customer may disclose" to see if it has suitability implications? Rule 2111 would cover a recommendation to purchase securities using margin or liquefied home equity or to engage in day trading, irrespective of whether the Q4.4. No. Q5.1. These models often take into account the historic returns of different asset classes over defined periods of time. Those types of accounts 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. 800, 805 n.11, 1996 SEC LEXIS 1331, at *12 n.11 (1996). Turnover rates between three and six may trigger liability for excessive trading. FINRA explained in one instance under the predecessor rule that "recommending liquefying home equity to purchase securities may not be suitable for all investors. A8.2. If a customer is either generally not capable of evaluating investment risk or lacks sufficient capability to evaluate the particular product or investment strategy that is the subject of a recommendation, the scope of a broker's customer-specific obligations under the suitability rule would not be diminished by the fact that the broker was dealing with an institutional customer. Q6.1. 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[.]" For instance, does each individual recommendation have to be consistent with the customer's investment profile or can the suitability of a broker's recommendation be judged in light of its consistency with the customer's overall portfolio? [Notice 12-25 (FAQ 24)]. FINRA's supervision rules do not dictate the exact manner in which a broker-dealer must supervise its registered representatives' recommendations of investment strategies involving a security and a non-security investment. 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. 989, 995, 1998 SEC LEXIS 2437, at *13 (1998) (emphasizing, in an action involving viatical settlements, that Rule 2210 is "not limited to advertisements for securities, but provide[s] standards applicable to all [broker-dealer] communications with the public"). See SEA Rule 17a-3(a)(17)(i)(A). A6.1. [Notice 12-25 (FAQ 9)]. Some third-party vendors have created and aggressively marketed proprietary "Institutional Suitability Certificates" to facilitate compliance with the new institutional-customer exemption. 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)." Reg. No. C07960035, 1997 NASD Discip. [Notice 11-25 (FAQ 8)], A4.4. See, e.g., NASD Rules 1014, 1021 and 1031, and FINRA Rule 1240. The issuers' identities and creditworthiness are important information in determining whether to purchase a debt security, but there may be other factors that affect the pricing and any decision to invest in specific debt securities. For example, FINRA and the SEC have held that associated persons who effect transactions on a customer's behalf without informing the customer have implicitly recommended those transactions, thereby triggering application of the suitability rule. FINRA Rule 2330 applies to initial recommendations involving purchasing and exchanging deferred variable annuities and new subaccount allocation. For purposes of the suitability rule, how should a firm document recommendations to hold in particular and recommendations of strategies more generally? Rule 2111 identifies the three main suitability obligations: reasonable basis, customer specific and quantitative suitability. Can a broker make recommendations based on a customer's overall portfolio, including investments held at other financial institutions? A1.3. 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." 1096, 1100, 2002 SEC LEXIS 1909, at *5-6 (2002) (same), aff'd, 77 F. App'x 2 (1st Cir. FINRA BrokerCheck, moreover, allows investors to review the professional and disciplinary backgrounds of firms and brokers online. 2003); Powell & McGowan, Inc., 41 S.E.C. See Richard G. Cody, Exchange Act Rel. ; Regulatory Notice 11-02, at 4-5. FINRA emphasizes, however, that a high level of liquidity does not, in and of itself, mean that the recommended product is suitable for all customers. Q3.12. 1304, 1311, 1997 SEC LEXIS 762, at *19 (1997). See [FAQ 4.6]. denied, 2010 U.S. LEXIS 4340 (May 24, 2010). 21 For an expanded discussion of this issue, see [FAQ 3.4]. FINRA Rule 2111 requires, in part, that a broker-dealer or associated person "have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the [firm] or associated person to ascertain the customer's investment profile." [Broker-dealers] have different business models; offer divergent services, products and investment strategies; and employ distinct approaches to complying with applicable regulatory requirements. FINRA cautioned, however, that a firm should evidence a customer's intent to use different investment profiles or factors for the different accounts. A broker who recommended speculative securities that paid high commissions because he felt pressured by his firm to sell the securities. A firm could comply with this requirement, for example, by having an institutional customer indicate in a signed customer agreement or other document that the institutional customer will be exercising independent judgment in evaluating recommendations or a firm could call its institutional customer, have that discussion, and (if it chooses or circumstances require) document the conversation to evidence the institutional customer's affirmative indication. 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. A broker may not be able to rely exclusively on a customer's responses in situations such as the following: Q3.6. Rule 2111(b) replaces the previous rule's definition of "institutional customer" with the more common definition of "institutional account" in FINRA's "books and records" rule, Rule 4512(c).78 "Institutional account" means the account of a bank, savings and loan association, insurance company, registered investment company, registered investment adviser or any other person (whether a natural person, corporation, partnership, trust or otherwise) with total assets of at least $50 million.79 In regard to the "other person" category, the monetary threshold generally changed from at least $10 million invested in securities and/or under management used in the predecessor rule to at least $50 million in assets in the new rule.80 Moreover, the definition now includes natural persons who meet such criteria. 2010)]; Dane S. Faber, 57 S.E.C. 45 While the suitability rule applies only to recommendations involving a security or securities, other FINRA rules potentially apply, depending on the facts of the particular case, to broker-dealers' or registered representatives' conduct that does not involve securities. 82 FINRA Rule 2111(b). 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." 4, 2012)) (requiring broker-dealers' communications with the public to, among other things, be fair and balanced, include material information, be free from exaggerated, false or misleading statements or claims, and, as to certain communications, be approved prior to use by a principal and/or filed with FINRA); NASD Rule 3010 (imposing supervisory obligations); FINRA Rule 5310 (requiring broker-dealers to provide best execution). [Notice 12-25 (FAQ 15)], A3.2. 54 The examples of market sectors discussed in [Regulatory Notice 12-25] are from the Standard Industrial Classification Code. As a general matter, these terms are to be understood commensurate with their meaning in financial analysis. 1020, 1022, 1989 SEC LEXIS 25, at *6-7 (1989), aff'd, 902 F.2d 1580 (9th Cir. Q3.7. 76 Howard, 55 S.E.C. Can you provide some examples of what would and would not be considered an "investment strategy" under the rule? Some customers may be reluctant to provide certain types of information to their broker-dealers. What types of "hold" recommendations should firms consider documenting? 87 See, e.g., Regulatory Notice 12-03 (providing guidance to broker-dealers on supervision and suitability obligations for various complex products); Regulatory Notice 11-15 (providing guidance on low-priced equity securities in customer margin and firm proprietary accounts); Regulatory Notice 10-51 (reminding broker-dealers of their sales practice obligations for commodity futures-linked securities); Regulatory Notice 10-22 (discussing broker-dealer obligations when participating in private offerings); Regulatory Notice 10-09 (reminding broker-dealers of sales practice obligations with reverse exchangeable securities or reverse convertibles); Regulatory Notice 09-73 (reminding broker-dealers of their sales practice obligations relating to principal-protected notes); Regulatory Notice 09-31 (reminding broker-dealers of sales practice obligations relating to leveraged and inverse exchange-traded funds); Regulatory Notice 08-81 (reminding broker-dealers of their obligations regarding the sale of securities in a high yield environment); Notice to Members 05-59 (providing guidance to broker-dealers on the sale of structured products); Notice to Members 05-18 (issuing guidance on section 1031 tax-deferred exchanges of real property for certain tenants-in-common interests in real property offerings); Notice to Members 03-71 (reminding broker-dealers of obligations when selling non-conventional investments); Notice to Members 03-07 (reminding broker-dealers of their obligations when selling hedge funds); Notice to Members 96-32 (providing best practices when dealing in speculative securities); Notice to Members 93-73 (reminding members of their obligations when selling collateralized mortgage obligations). See also [infra note 86; Regulatory Notice 12-25, at 19 n.12]. 1990); Arceneaux v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 767 F.2d 1498, 1502 (11th Cir. What is the FINRA Rule 2330? 52 Specifically, the rule 59 FINRA[, in FAQ 5.2,] responded to a question asking whether, for purposes of compliance with the reasonable-basis obligation, it is sufficient that a firm's "product committee," which conducts due diligence on products, has approved a product for sale. Rule 2111.03 excludes from the suitability rule's coverage various types of communications that are educational in nature even though they could be considered investment strategies involving securities. [Notice 12-55 (FAQ 10(b)]. 2008015651901 (Dec. 15, 2011) (stating that "[r]everse convertibles are complex structured products that combine a debt instrument and put option into one product," the repayment of principal is linked to the performance of an underlying asset, such as a stock, a basket of stocks or an index, which is generally unrelated to the issuer of the note, and at maturity, if the value of the underlying asset has fallen below a certain level, the investor may receive less than a full return of principal); Chase Invs. 20006005977901, 2011 FINRA Discip. 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. 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. 59125, 2008 SEC LEXIS 2843, at *7-10 (Dec. 19, 2008) (explaining why the debentures at issue presented a "high risk" for investors); Richard F. Kresge, Exchange Act Rel. What is the difference between Rule 2111 and Rule 2330? [Notice 12-25 (FAQ 12)], A9.1. 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