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Univ. of Toledo College of Law

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Saturday, July 7, 2012

FINRA's New Suitability Rule Goes into Effect July 9

FINRA's new Know-Your-Customer (Rule 2090) and Suitability (Rule 2111) Rules go into effect on July 9.  The SEC approved the rules in November 2010.  The rules are essentially a reworking of the prior NYSE and NASD rules, but they have engendered some anxiety in the industry.  FINRA delayed the original effective date of Oct. 7, 2011 because members expressed the need for more time to update procedures, modify automated systems and educate associated persons.  FINRA has also issued three Notices providing guidance on the rules' requirements (NTM 11-02, 11-25, 12-25).

So what do the rules require?

New FINRA Rule 2090 (Know Your Customer), based on the prior NYSE Rule, requires firms to “use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer….” For purposes of the rule, essential facts are “those required to (a) effectively service the customer’s account, (b) act in accordance with any special handling
instructions for the account, (c) understand the authority of each person acting on behalf of the customer, and (d) comply with applicable laws, regulations, and rules.”

New FINRA Rule 2111 (Suitability), based on the prior NASD rule, requires that a firm 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 member or associated person to ascertain the customer’s investment profile.”  Paragraph (b) of the Rule provides an exemption for institutional accounts.

In the supplementary material to Rule 2111, FINRA explains that "investment strategy" is to be interpreted broadly.  However, certain communications are excluded so long as they do not include a recommendation of any particular security: general financial and investment information, descriptive information about an employee-sponsored retirement or benefit plan, asset allocation models that meet certain requirements, and interactive investment materials that incorporate the above.

The supplementary material also sets forth what FINRA has previously described as the components of the suitability obligation:

    Reasonable-Basis Suitability.  The firm must have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors.  Importantly, "[a] member's or associated person's reasonable diligence must provide the member or associated person with an understanding of the potential risks and rewards associated with the recommended security or strategy.  The lack of such an understanding when recommending a security or strategy violates the suitability rule."

    Customer-Specific Obligation.  The firm or associated person must have a reasonable basis to believe that the recommendation is suitable for a particular customer based on that customer's investment profile.

    Quantitative Suitability addresses excessive trading in a customer's account and requires a firm or associated person who has actual or de facto control over the account to have a reasonable basis for believing that a series of 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.

Why have these rules created anxiety among broker-dealers?  In NTM 11-25, FINRA stated that questions from broker-dealers focused on information-gathering requirements in relation to a customer’s investment profile, the scope of the term “strategy,” and reasonable-basis obligations.  In NTM 12-25, FINRA identified further concerns: the
obligation to act in a customer’s best interests; the scope of the terms “recommendation,” “customer” and “investment strategy”; the use of a risk-based approach to documenting suitability; information gathering requirements; reasonable-basis and quantitative suitability; and the institutional-customer exemption.

FINRA has tried to provide reassurance to members.  In NTM 12-25, for example:

FINRA reiterates, however, that many of the obligations under the new rule are the same as those under the predecessor rule and related case law. Existing guidance and interpretations regarding suitability obligations continue to apply to the extent that they are not inconsistent with the new rule. Furthermore, FINRA appreciates that no two firms are exactly alike. Firms have different business models; offer divergent services, products and investment strategies; and employ distinct approaches to complying with applicable regulatory requirements. FINRA’s guidance is not intended to influence any firm’s choice of a particular business model or reasonable approach to ensuring compliance with suitability or other regulatory requirements.

According to Investment News, the industry is upset because it thinks the suitability standard comes "awfully close" to a fiduciary standard.  InvNews, New Finra suitability rules worry industry 

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