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FINRA Responds to Comments – SEC Approves FINRA Rule Change Relating to Outside Business Activities and Considers FINRA Proposal for New ‘Know Your Customer’ and Suitability Rules

September 09, 2010

Those who question the benefit of commenting on proposed rule changes should take note of two recent developments where FINRA has made substantial changes to proposed rules based on comments received about the proposed rules.

On August 23‚ 2010, the SEC announced its accelerated approval of FINRA Rule 3270 (Outside Business Activities of Registered Persons) as part of the consolidated FINRA rulebook. The Rule clarifies the obligations of a member firm when an associated person notifies it of an outside business activity. Significantly, the Rule does not require member firms to supervise outside business activities in the same way as activities actually conducted at the member firm, as an earlier FINRA proposal would have effectively required. After FINRA received negative comments, FINRA eliminated that proposed requirement. The effective date of the new rule is not yet known.

The SEC is currently considering a separate FINRA proposal to adopt FINRA Rules 2090 (Know Your Customer) and 2111 (Suitability) in its consolidated rulebook. This proposal underwent a similar process of revision following the receipt of comments, resulting in the current proposal being far less expansive than its previous iteration. The original suitability proposal would have required a member firm making a suitability assessment to consider all information known to the member firm, may have expanded a member firm’s suitability obligation to non-securities products and would have required institutional investors to affirmatively acknowledge their relinquishment of suitability protections. The original ‘know your customer’ proposal would have required that member firms know the customer’s financial profile and investment objectives or policy. Based on comments received, FINRA eliminated these aspects of the original proposal and replaced them with more workable standards. On August 20, 2010, the SEC published the final proposal for comment, with comments due within 45 days.

The revisions that FINRA made in response to comments are summarized below, as are other key elements of the new outside business activity rule and proposed suitability and ‘know your customer’ rules. The full text of the new outside business activity rule is available at FINRA’s website (http://www.finra.org/industry/regulation/rulefilings/2007/p037160), as is the full text of the proposed suitability and ‘know your customer’ rules (http://www.finra.org/Industry/Regulation/RuleFilings/2010/P121836).

I. The New Outside Business Activities Rule

 

Background

FINRA Rule 3270 adopts NASD Rule 3030 (Outside Business Activities of an Associated Person) with revisions and incorporates certain aspects of NYSE Rule 346 (Limitations — Employment and Association with Members and Member Organizations).

NYSE Rule 346(b) requires an associated person to obtain “prior written consent” from the member firm with which it is associated before engaging in outside business activities, although it does not specify the criteria a member firm should consider in granting or denying such consent. NASD Rule 3030 only requires that an associated person provide “prompt written notice” to the member firm of outside business activities, also without specifying what a member firm’s obligations are upon receiving such notice.

Changes Based on Comments Received by FINRA

Unlike the predecessor rules, the new formulation details a member firm’s obligations upon learning of a proposed outside business activity.

Under Supplementary Material .01 (Obligations of Member Receiving Notice) to the new rule, a member receiving written notice of a proposed outside business activity must consider whether the proposed activity will: (1) interfere with or otherwise compromise the registered person’s responsibilities to the member and/or the member’s customers or (2) be viewed by customers or the public as part of the member’s business based upon, among other factors, the nature of the proposed activity and the manner in which it will be offered. Based upon this review, the member must evaluate the advisability of imposing specific conditions or limitations on a registered person’s outside business activity, including, where warranted, prohibiting the activity. A member also must evaluate the proposed activity to determine whether it is properly characterized as an outside business activity or whether it should be treated as an outside securities activity, governed by NASD Rule 3040. The member must also keep a record of its compliance with these obligations.

The original FINRA proposal, which was published for comment on July 8, 2009, set forth more expansive obligations for member firms. In one relevant part, the original proposed Supplementary Material .01 would have required that a member make a determination as to whether the proposed activity raises investor protection concerns.

FINRA received six comment letters in response to its proposal. Although the comment letters addressed different aspects of the proposal, all six addressed Supplementary Material .01. Most commenters expressed the view that the proposal exceeded FINRA’s jurisdiction by requiring members to supervise outside business activities. In response, on July 30, 2010, FINRA filed an amendment to the proposed rule change, scaling back its proposal and setting forth the standard set forth above.

The revision marks a positive change in that it eliminates the focus on customers of the outside business activities (who may not also be customers of the member firm) and instead expressly empowers member firms to limit or prohibit an associated person’s outside business activities when the member believes those activities pose a risk to the member. Although that right may have been implicit in the NYSE’s prior written consent standard, it was less apparent under the FINRA standard.
 
Other Aspects of the New Rule

The final rule adopts the NASD written notice standard rather than the NYSE written consent standard, while incorporating the NYSE principle that the interaction between an associated person and the member must occur “prior” to the associated person engaging in the outside business activity (rather than the “prompt” notice requirement under the old NASD rule).

The new rule also reconciles the partly overlapping standards under NASD Rule 3270 and NYSE Rule 346 for what constitutes an outside business activity. Specifically, under the new rule, a registered person is required to comply with the prior written notice requirement whenever he or she will be an employee, independent contractor, sole proprietor, officer, director or partner of another person, or will be compensated, or have a reasonable expectation of compensation, from any other person as a result of any outside business activity. The “reasonable expectation of compensation” element expands existing standards (although NYSE Rule 346 encompassed the similar concept of indirect financial interests, which was excluded from the new rule).

II. The Proposed ‘Know Your Customer’ and Suitability Rules

Background

In May 2009, FINRA sought comments on proposed FINRA Rules 2111 (Suitability) and 2090 (Know Your Customer). On July 30, 2010, after revising its proposal based on the comments it received, FINRA filed its proposed rule change with the SEC.

Proposed FINRA Rule 2111 is based on NASD Rule 2310 (Recommendations to Customers (Suitability)), while proposed FINRA Rule 2090 is based on NYSE Rule 405(1) (Diligence as to Accounts). These rules, and much of their associated interpretive materials, would be deleted or modified if the SEC approves the new rules.

FINRA received 2,083 comment letters and made substantial changes to its final proposal as a result. Notably, 1,694 of the comment letters were one of two form letters, both of which argued that FINRA should table its proposed changes to the suitability rule until after policymakers determine whether broker-dealers have fiduciary duties. FINRA rejected this request. At the time, legislators were considering implementing a uniform fiduciary duty standard as part of the financial reform legislation. The Dodd-Frank Wall Street Reform and Consumer Protection Act, which Congress passed on July 15, 2010, ultimately did not impose a fiduciary standard on broker-dealers, although it empowered the SEC to do so.

A. The Proposed New Suitability Rule

Changes Based on Comments Received by FINRA

FINRA’s original proposal would have required a member or associated person making a suitability assessment to consider, among other things, all information about the customer “known by the member or associated person.” Because the original proposal did not make any distinctions concerning how the member or associated person learned of the information about the customer, it stood to significantly expand member firms’ obligations. For instance, as some commenters noted, the original proposal would have caused issues for firms with multiple business lines. The original proposal also would have required a member or associated person to consider “any other information the member or associated person considers to be reasonable” (a variation of the catch-all requirement in the current rule, which requires consideration of “such other information used or considered to be reasonable by such member or registered representative in making recommendations to the customer”).

In response to comments, FINRA revised its proposal so that it would instead 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, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile. . . .” Additionally, the modified proposal replaces the original, proposed catch-all requirement with a requirement that a member or associated person consider “any other information the customer may disclose to the member or associated person in connection with such recommendation.”

In the Notice seeking comment, FINRA also solicited comments on whether to expand the reach of the proposed rule to non-securities products. This issue generated the greatest number of comments, the majority of which were opposed to such a change. FINRA largely disagreed with the commenters’ reasoning (“[w]ith the possible exception of potentially duplicative regulation, which FINRA believes could be addressed in any further expansion of the reach of the rule”). Nonetheless, it refrained from adding non-securities products to the proposed rule for the time being, on the bases that future developments in regulatory restructuring could impact any such proposal and because the proposed new suitability and ‘know your customer’ rules would provide enhanced protection to investors.

FINRA’s original proposal also would have required institutional customers (who are subject to an exemption to the suitability rule under IM-2310-3) to indicate affirmatively they are relinquishing suitability protections. Commenters critiqued that proposal on the basis that institutional investors would be unlikely to make such an affirmation, thereby negating the exemption. In response, FINRA revised the proposal to instead require that institutional customers affirmatively acknowledge that they are “exercising independent judgment.”

In response to comments, FINRA also revised the proposed supplementary material to add an exclusion for certain categories of educational material (including general financial and investment information, descriptive information about an employer-sponsored retirement or benefit plan, asset allocation models meeting certain specified criteria, and interactive investment materials). As long as these materials do not include (standing alone or in combination with other communications) a recommendation of a particular security or securities, they do not trigger any suitability obligation. Aside from providing this exemption, the rule, like the current framework, does not define what constitutes or does not constitute a recommendation.

Other Aspects of the Proposed Rule

The proposed rule also defines the “the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile” to include, without limitation, “the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, [and] risk tolerance. . . .” In contrast, the current rule lists only three specific factors: the customer’s financial status, tax status and investment objectives. Thus, the proposal expands the current standard for assessing suitability, although it is substantively consistent with commonly understood interpretations of the factors relevant to assessing suitability.

The proposed rule also would impose an obligation to ensure the suitability of recommended strategies (and not merely recommended securities transactions). In doing so, the rule would codify an existing interpretive principle, based in SEC and FINRA guidance, as well as a number of SEC decisions, which supports the application of the suitability obligation to recommended strategies in certain situations (including, commonly, recommendations to purchase securities on margin). Notably, FINRA rejected requests that it revise the rule to apply only to recommended strategies resulting in a transaction. Thus, as with the current rule, the proposed rule would apply to all recommendations regardless of whether they result in a transaction.

The proposal also would modify the definition of institutional investor to be consistent with the definition of “institutional account” in NASD Rule 3110(c)(4) by increasing the monetary threshold from $10 million invested in securities and/or under management to $50 million in assets. In this respect, the proposed rule potentially stands to expand a broker-dealer’s suitability obligations to sophisticated institutional investors who do not meet the higher threshold. In another respect, the proposed rule potentially stands to reduce a broker-dealer’s existing suitability obligations since, unlike the current exemption, it allows a natural person to qualify as an institutional customer.

The proposal also would codify existing interpretations that the suitability assessment is composed of three components: reasonable-basis suitability (which exists when there is a reasonable basis to believe, based on adequate due diligence, that a recommendation is suitable for at least some investors); customer-specific suitability (which exists when there are reasonable grounds to believe a recommendation is suitable for the particular investor at issue); and quantitative suitability (which exists when there is a reasonable basis to believe the number of recommended transactions within a certain period is not excessive).

B.  The Proposed New ‘Know Your Customer’ Rule

Changes Based on Comments Received by FINRA

FINRA’s original proposed ‘know your customer’ rule provided in the Supplementary Material .01 that the “facts ‘essential’ to ‘knowing the customer’ included the customer’s financial profile and investment objectives or policy.” That aspect of the proposal generated a fairly large number of comments; among other things, some commenters suggested that each member should be permitted to interpret and apply the “essential facts” standard to their particular business model, since it is the nature of the relationship between the member and the customer that dictates the essential facts.

In response to these comments, FINRA revised proposed Supplementary Material .01 so that it now defines “essential facts” as 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.” Thus, the current proposal, if adopted, would add clarity to existing standards, but would not impose a substantive change to what member firms are likely doing already.

Other Aspects of the Proposed Rule

Proposed FINRA Rule 2090 also would eliminate the requirement in NYSE Rule 405(1) to learn the essential facts relative to “every order” and would replace it with a requirement that they know the essential facts concerning every customer.

III. Conclusion

FINRA’s original rule proposals governing outside business activities and ‘know your customer’ and suitability obligations stood to disrupt certain fundamental principles under the current regulatory framework. The revisions that FINRA made in response to comments it received are welcome from the perspective of broker-dealers since the new rule and the proposed rules, if adopted, should not significantly expand their present responsibilities.

Even in the absence of express regulatory requirements, member firms may want to review their policies and systems and consider making changes in three areas. First, because outside business activities can be a source of significant harm to customers of a member firm, members should consider surveilling for potentially undisclosed outside business activities, to reduce their potential exposure.

Second, firms should establish a procedure to gather affirmations from institutional investors (as defined in the proposed rule) that they are in fact exercising independent judgment in making investment decisions.

Third, based on FINRA’s rationale for refraining from applying the suitability rule to non-securities products, it is apparent that FINRA may revisit that proposal if it is not addressed in other legislative or regulatory initiatives, such as the SEC study of a potential fiduciary duty for broker-dealers mandated by section 913 of Dodd-Frank Act. Member firms can anticipate further regulation in this area, and may want to review the unique challenges their respective business models may pose to ensuring compliance with such further regulation.

 

Please direct questions to any of the listed lawyers or to any other Bingham lawyer with whom you ordinarily work on related matters:

David C. Boch, Partner, Broker-Dealer
david.boch@bingham.com, 617.951.8485

Amy Kroll, Partner, Broker-Dealer Group
amy.kroll@bingham.com, 202.373.6118

Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Financial Services Area
roger.joseph@bingham.com, 617.951.8247

Edwin E. Smith, Partner, Financial Restructuring; Co-chair, Financial Services Area
edwin.smith@bingham.com, 617.951.8615

Tim Burke, Practice Group Leader, Broker-Dealer Group; Co-chair, Financial Services Area
timothy.burke@bingham.com, 617.951.8620

This article was originally published by Bingham McCutchen LLP.