FINRA recently issued Regulatory Notice 12-55 (“RN 12-55”), expressing new views on discrete but significant aspects of the suitability rule, FINRA Rule 2111, that went into effect in July 2012.1
The guidance provides revised and supplemental answers to three of the questions posed in Regulatory Notice 12-25 (May 2012) (“May Guidance”) and adds two new questions and answers.2 In so doing, the guidance refines the previous guidance on who is a “customer” for purposes of the rule, and on suitability obligations when an investment strategy involves both a security and a non-security investment. Generally, the new answers provide welcome clarification.
This Alert explains how the new guidance limits the scope of the rule as compared to the guidance that preceded it.
1. Definition of “Customer”
The suitability obligations in Rule 2111 apply only to a “customer,” which FINRA’s rules generally define as anyone who is not a broker or dealer.3 In its May Guidance, FINRA advised that this definition covered “informal business relationships,” including those involving a “potential investor” who “does not have an account at the firm.”4 The May Guidance also stated that suitability duties cover “a recommended investment strategy involving a security or securities regardless of whether the recommendation results in a securities transaction . . .”5 The guidance was a vast expansion of a member firm’s suitability obligations, potentially including informal comments made at pitches or in social situations to investors who then act on the advice on their own, away from the firm, or not at all.
RN 12-55 (by updating the answers to questions 6 and 7) reverts to the traditional interpretation of “customer,” stating that, for purposes of the suitability rule, “the term customer includes a person who is not a broker or dealer who opens a brokerage account at a broker-dealer or purchases a security for which the broker-dealer receives or will receive, directly or indirectly, compensation even though the security is held” outside the firm.6
Additionally, RN 12-55 adds a new question 6(b), addressing when suitability requirements apply to recommendations to potential investors. The guidance explains that the suitability rule applies to a “potential investor” only to the extent the “potential investor” “then becomes a customer.”7 For a potential investor who becomes a customer after receiving the advice, “suitability obligations attach when the transaction occurs, but the suitability of the recommendation is evaluated based on the circumstances that existed at the time the recommendation was made.”8 In effect, this new “look-back” provision requires broker-dealers to give suitable advice at a time when the suitability obligation does not technically exist, and poses supervisory challenges.9
For an investor who is already a customer, “suitability obligations attach at the time the recommendation is made, irrespective of whether a transaction occurs.”10 This extension of the rule to recommendations not resulting in a transaction also poses supervisory challenges for firms.
2. Definition of “Investment Strategy Involving Both a Security and Non-Security Investment”
Prior to its recent amendment, the suitability rule generally was not interpreted to cover investment strategies.11 FINRA Rule 2111 changed this standard, making investment strategies explicitly subject to suitability duties and stating that “‘investment strategy involving a security or securities’ . . . is to be interpreted broadly.”12 In the May Guidance, FINRA elaborated, stating that an investment strategy involving both a security and a non-security component is subject to Rule 2111, implying that the suitability requirements applied to both the securities and non-securities recommendations, notwithstanding FINRA’s lack of jurisdiction over non-securities transactions.13
The new guidance (updating the answer to question 10) clarifies the instances in which suitability duties attach to hybrid recommendations. While a recommendation need not mention “particular securities” to be subject to the rule,14 the new guidance explains that, if a “recommendation does not refer to a security or securities,” then “the suitability rule is not applicable.”15 RN 12-55 then provides new examples of investment strategies outside the scope of the rule: “Where a customer, absent a recommendation by a registered representative, decides on his or her own to purchase a non-security investment and then asks the registered representative to recommend which securities he or she should sell to fund the purchase of the non-security investment, the suitability rule would apply to the registered representative’s recommendation regarding which securities to sell but not to the customer’s decision to purchase the non-security investment.”16 Additionally, “[t]he suitability rule would not apply . . . if a registered representative recommends a non-security investment as part of an outside business activity and the customer separately decides on his or her own to liquidate securities positions and apply the proceeds toward the recommended non-security investment.”17
Notwithstanding FINRA’s acknowledgement that its suitability rule does not extend to non-securities, RN 12-55 sends a fairly mixed message regarding a firm’s suitability obligations. While FINRA instructs that the suitability obligation applies only to the security component of a hybrid strategy,18 FINRA then states that the “suitability analysis also must be informed by a general understanding of the non-security component of the recommended investment strategy.”19 In short, even if Rule 2111 does not directly apply to the non-securities transaction, the firm must “generally” understand the impact that transaction had on the securities transaction.
3. Supervising Recommendations of Investment Strategies Involving Both a Security and Non-Security Investment
The May Guidance advised firms that it was permissible to use a “risk-based approach” to supervising recommendations of investment strategies involving both a security and a non-security-component, explaining that such an approach could “focus on the detection, investigation and follow-up of ‘red flags’ indicating that a broker may have recommended an unsuitable investment strategy. . . .”20 It gave two examples of such red flags: “A broker’s recommendation that a customer with limited means purchase a large position in a security might raise a ‘red flag’ regarding the source of funds for such a purchase. Similarly, a broker’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.”21
In the May Guidance FINRA also reminded firms that their “supervisory system[s] must be reasonably designed to achieve compliance with applicable securities laws, regulations and FINRA rules,” and “that a supervisory system cannot guarantee firm-wide compliance with all laws and regulations.”22 Nonetheless, the possibility that firms would be responsible for non-securities transactions involving outside business activities created a substantial additional burden. RN 12-55 adds some measured reassurance to firms that FINRA approves of a risk-based approach: The guidance acknowledges “that no two [broker-dealers] are exactly alike,” and that a broker-dealer “can consider a variety of approaches to identifying and supervising its registered representatives’ recommendations of investment strategies involving both a security and a non-security component.”23
Even as narrowed by the recent guidance, FINRA Rule 2111 imposes sweeping suitability obligations, both by its terms and when interpreted in light of Regulatory Notice 12-25, which remains the single most comprehensive reference point on FINRA’s views on the scope of the new rule. Firms should continue raising the nuances of the rule with FINRA, both to obtain clarity and to provoke further parsing and rethinking.
FINRA recently created on its website a compilation of information and resources regarding FINRA’s suitability requirements, including Regulatory Notices 12-25 and 12-55. That compilation is available at www.finra.org/Industry/Issues/Suitability/.
The following Alerts track the history of the new rule and may also be helpful:
FINRA Issues Additional Guidance on its Soon to be Implemented New Suitability Rule (May 31, 2012), available at: http://www.bingham.com/Alerts/2012/05/finra-issues-additional-guidance-suitability-rule
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 (Sept. 9, 2010), available at: http://www.bingham.com/Alerts/2010/09/FINRA-Responds-to-Comments--SEC-Approves-FINRA-Rule-Change-Relating-to-Outside-Business-Activities-and-Considers-FINRA-Proposal
FINRA Proposes Consolidated Rules Governing Suitability and Know-Your-Customer Obligations (May 20, 2009), available at: http://www.bingham.com/Alerts/2009/05/FINRA-Proposes-Consolidated-Rules-Governing-Suitability-and-Know-Your-Customer-Obligations
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:Boch-David
1 Suitability, Regulatory Notice 12-55 (Dec. 10, 2012), available at http://www.finra.org/Industry/Regulation/Notices/2012/P197436
2 Suitability, Regulatory Notice 12-25 (May 18, 2012), available at http://www.finra.org/Industry/Regulation/Notices/2012/P126432
3 FINRA Rule 0160.
4 Regulatory Notice 12-25 at 6, Q&A 6.
5 Id. at 6, Q&A 7.
6 Regulatory Notice 12-55 at 2, Q&A 6(a).
7 Id. at 2, Q&A 6(b).
8 Id. at 6, n. 10.
9 FINRA also reminds firms that other rules, including FINRA Rule 2010 (Standards of Commercial Honor and Principles of Trade), FINRA Rule 2020 (Use of Manipulative, Deceptive or Other Fraudulent Devices), Rule 2210 (Communications with the Public), and NASD Rule 3040 (Private Securities Transactions of an Associated Person) may apply to investment advice. Id. at 7, n. 11.
10 Id. at 6, n. 10 (noting prior guidance to the same effect in Regulatory Notice 11-15 at 6 and Regulatory Notice 11-02 at 3).
11 There were, however, a couple of exceptions, including the use of margin, and the use of liquefied home equity to purchase securities.
12 FINRA Rule 2111.03.
13 Regulatory Notice 12-25 at 6, Q&A 7 and 8, Q&A 10.
14 Id. at 3, Q&A 7 (emphasis omitted).
15 Id. at 4, Q&A 10(a).
17 Id. However, FINRA noted, in such cases, other rules, including Rule 3270.01 (Outside Business Activities of Registered Persons), and NASD Rule 3040 (Private Securities Transactions of an Associated Person) could govern. Id. at 8, n. 21.
18 In this regard FINRA notes that “a broker-dealer may need to consider, in addition to the customer’s investment profile, whether a recommended securities liquidation causes an overconcentration in particular securities or types of securities remaining in the account, changes the composition of the customer’s remaining securities investments to an extent that the customer’s portfolio no longer matches his or her investment profile, subjects the customer to early withdrawal fees or penalties, exposes the customer to losses because of the lack of a ready market for the securities at the time of liquidation, or results in potential adverse tax treatment.” Regulatory Notice 12-55 at 9, n. 25.
19 Id. at 5, Q&A 10(b). FINRA further states that, “[i]n the context of a recommended investment strategy involving a security and an outside business activity, the broker-dealer’s general understanding of the outside business activity would be based on the information and considerations required by FINRA Rule 3270 [Outside Business Activities].” Id.
20 Regulatory Notice 12-25 at 8, Q&A 10.
23 Regulatory Notice 12-55 at 4, Q&A 10(b).
This article was originally published by Bingham McCutchen LLP.