FINRA’s Regulatory Notice 13–31 — issued on September 25, 2013 — is the fourth in a series of notices FINRA has published on its new suitability rule.1 In this Notice, FINRA provides guidance on three main topics: it details specific suitability issues FINRA covers in routine examinations; it identifies, with approval, specific supervisory and compliance practices firms have adopted to comply with FINRA’s suitability rule, and, while it purports not to alter existing guidance,2 a close reading provides insight into certain areas where FINRA may be pushing firms to further tighten supervision and compliance practices.
FINRA Rule 2111, which became effective on July 9, 2012, requires a firm and its associated persons 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.” The Rule defines three suitability obligations:
Rule 2111 also requires firms to perform a suitability analysis for recommended investment strategies involving a security, including explicit recommendations to hold a security, and provides a safe harbor for customer-specific suitability obligations for institutional accounts in certain circumstances.
II. Guidance on Examinations
Notice 13–31 provides guidance on approaches FINRA takes in its examinations to assessing suitability supervision and compliance.3 For example:
• FINRA examiners test suitability supervisory and compliance systems, with the “depth and breadth of . . . testing . . . generally determined by the supervisory systems and controls the firm developed, the products and strategy the firm recommends, the firm’s business activities, the firm’s customer base, and other relevant information considered by FINRA staff during the examination planning and execution process.”4
• FINRA typically asks firms to respond to various questions and information requests and to provide supporting documents. Notice 13–31 lists several specific types of exam questions, concerning: (1) employee training, (2) supervision of investment strategy and hold recommendations, (3) supervisory and compliance procedures for reasonable-basis, customer-specific and quantitative suitability, (4) procedures for implementing the institutional investor exemption, and (5) the firm’s use of portfolio analytic tools and models.5
• Examiners review transactions and related suitability documentation that raise red flags about potential unsuitable recommendations, such as:
• those that appear to deviate from the firm’s internal suitability guidelines for a particular security;
• a long-term investment for an investor with a short-term horizon;
• a speculative investment or strategy held in the account of an investor with a conservative investment objective; and
• the same security held in the account or strategy implemented for multiple investors of a particular representative despite customer profiles that differ.6
• Examiners review documents used by firms to supervise suitability decisions and rule requirements, including the information obtained by the firm or associated person regarding a particular recommended security or investment strategy to ascertain its suitability, the source materials used to assess potential risks and rewards associated with a recommended security or strategy, and the records used to determine reasonable-basis suitability. In the Notice, “FINRA reminds firms” that, “[w]hile examiners review documents used by firms to supervise suitability decisions and rule requirements, . . . Rule 2111 generally does not impose explicit documentation requirements.”7 In other words, as FINRA noted in its prior guidance, while documentation is not required, good documentation will smooth the discussions with FINRA, particularly where the investment is complex or its suitability open to question.
The cited examples of red flags examiners look for, and the examples of documents examiners may review, can be used by firms to assess the robustness of their suitability programs and to make improvements as appropriate.
FINRA reports in the Notice that it has referred only a few of the deficiencies it identified in examinations to its Enforcement Department, and those “involv[ed] suitability violations that were actionable under the predecessor suitability rule.”8 FINRA states it disposed of most deficiencies through a Cautionary Action, emphasizing its preference at this point to encourage firms to adopt robust policies rather than penalizing them for falling short of the mark this early in the game.9
III. Guidance on Suitability Compliance and Supervision
Notice 13–31 identifies specific policies, procedures and systems firms have adopted to meet their suitability obligations.10 The Notice provides examples relative to reasonable-basis suitability, customer-specific suitability, quantitative suitability, the institutional-customer exemption, hold or other investment strategy recommendations, and supervision.11 Some of the examples are:
Reasonable Basis Suitability: FINRA notes some common practices including establishing a process for the firm to vet new products, posting diligence on products to internal websites to assist registered representatives in their suitability analysis, and requiring training before representatives may sell certain products.
Customer-Specific Suitability: FINRA observes that firms went to varying lengths to capture updated customer suitability information, including updating forms and systems, incentivizing representatives to meet with customers to gather updated information, implementing systems that flag accounts when a transaction is recommended if the account does not have a complete customer profile, adding policies that prohibit recommendations when customer-suitability information is incomplete, and adding policies and exception systems that flag vulnerable investors — typically those who are unable to sustain more than limited losses — for enhanced customer-specific suitability review.
Hold and Strategy Recommendations: According to the Notice, in the examinations FINRA has conducted since new Rule 2111 went into effect, examiners have identified deficiencies in only a small percentage of firms, with “inadequate procedures for hold recommendations (e.g., how the firm supervises and, when necessary, documents such recommendations)” being the most frequent deficiency. FINRA notes with approval that firms have adopted procedures including hold tickets or hold blotters, notes of discussions with customers, branch inspections focusing on documentation of hold and other strategy discussions, and account forms that note specific strategies that might be recommended, with requirements that these forms be updated and signed when a strategy is recommended.
Quantitative Suitability: FINRA reports in the Notice that most firms have in place and continue to rely successfully on policies, procedures and systems that predated the new Rule.
Institutional Customer Exemption: FINRA notes a variety of practices to gather the information required by the exemption, including updated account forms, separate certifications, and using third parties to verify institutional status. Some firms adopted a system to ensure compliance where the exemption does not cover all trading in the account, including systems to flag particular trades. In some instances, firms decided only to service institutional customers if they agreed to exercise independent judgment for all trades in the account, or entirely prohibited recommendations to institutional customers if they did not.
While the discussion includes a caveat noting that adopting the practices discussed in the Notice “will not ensure rule compliance or result in a safe harbor,” FINRA’s approval of the examples it provides is also clear.12 Firms should refer to the Notice and consider whether any of the policies, procedures and systems it details warrant integration into their own suitability programs.
IV. FINRA’s (Not So Gentle) Nudges
A. Compensation Arrangements As Possible Incentives For Unsuitable Recommendations
Although FINRA found nothing specific to complain about (or report on) regarding systems to supervise quantitative suitability, it appears FINRA thinks firms can and should be doing more in this area. In particular, FINRA encourages firms to evaluate whether their compensation arrangements could create incentives for associated persons to make unsuitable recommendations or to engage in excessive, unsuitable trading.13 Of the several policies, procedures and systems FINRA details in the Notice, this stands out as the only one that comes as a suggestion originating from FINRA rather than as a favorable report on what examined firms are doing. Given that many firms have long monitored for churning and other quantitative suitability red flags, FINRA may be signaling its hope that firms revisit their underlying compensation arrangements as opposed to their quantitative suitability supervisory systems.
B. Investment Strategies Involving Both Security And Non-Security Components
Firms should also consider the extent to which additional, supervisory procedures may be warranted for investment strategies involving a representative’s outside business activity. In Notice 13–31, FINRA reiterates its position on investment strategies involving a security and non-security component:
For an investment strategy that involves both a security and non-security component, a firm’s suitability obligations apply to the security component but its suitability analysis must be informed by a general understanding of the non-security part of the strategy. A firm’s general understanding of the non-security product would depend on the facts and circumstances; but ordinarily a firm would need to have only basic knowledge of the non-security product. In the case of a recommended investment strategy involving a security and an outside business activity, a firm’s general understanding of the non-security component will be informed by the information and considerations required as part of a notice of an outside business activity pursuant to FINRA Rule 3270 (Outside Business Activities of Registered Persons).14
One effect of this call to review such hybrid strategy recommendations through the lens of Rule 3270 could be to blur the line between securities-related activities subject to FINRA’s jurisdiction and non-securities activity not subject to FINRA’s jurisdiction. Indeed, FINRA’s call on firms to have a general understanding of the outside business activity aspect of a hybrid strategy might, in practice, require some level of supervision of that outside business activity as it pertains to a firm customer and is arguably contrary to both Rule 2111 (which does not directly apply to the non-securities transaction aspect of a hybrid strategy) and Rule 3270 (which does not require members to supervise outside business activities).15
Although FINRA’s rules may not require firms to supervise outside business activities, doing so may be preferable to the alternative: FINRA notes with approval a firm policy it observed that prohibits an associated person from engaging firm clients in the associated person’s outside business activities.16 This unqualified suggestion is troubling, in that it does not recognize or distinguish activities that might be problematic and warrant a prohibition from more common situations, such as registered representatives who are licensed to sell insurance, which may not.
If FINRA intends to prod firms into taking a new stance on outside business activities, it should provide further guidance as to when firms should not approve outside business activities, as well as whether and how firms might implement supervisory procedures for assessing the suitability of recommendations of investment strategies involving representatives’ outside business activities.
C. Accounts Where Relevant Customer-Specific Suitability Information Has Not Been Obtained
Notice 13–31 reflects an apparent expectation by FINRA that firms will not permit recommendations where a customer has refused to provide relevant profile information. Included in FINRA’s list of demonstrative questions used by examiners is:
Describe . . .
the manner in which the firm reasonably detects and prevents transactions in accounts for which customer investment profile information is unavailable or incomplete. To the extent that customer investment profile factors are not incorporated into account documentation, FINRA examiners may ask the firm to explain its efforts to obtain the profile information before making new recommendations to customers and, if any of the information is unavailable, how the firm determines whether there is a reasonable basis to believe that a recommendation is suitable.17
Thus, FINRA is looking for firms to prohibit recommendations when profile information is incomplete, unless the firm has documented with specificity (per Rule 2111.04) its basis for concluding that the missing information is not relevant.18
While FINRA seems to recognize that complying with some aspects of the suitability rule remains a work in progress, it is clear that examiners have taken and will continue to take a close look at firms’ practices and overall compliance with the Rule. Notice 13–31 provides firms with concrete, practical advice on its approach to examinations, and lists specific, recommended policies, procedures and controls that can be used to achieve compliance with suitability obligations. It also gives insight into some of FINRA’s more nuanced (and potentially unsupportable) interpretations of Rule 2111, and on its own preferences for how firms can best meet their suitability obligations.33 Depending on their risk profiles, firms should heed as much of the advice (express and implicit) as is applicable and possible.
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1 Suitability: FINRA Highlights Examination Approaches, Common Findings and Effective Practices for Complying With Its Suitability Rule, Regulatory Notice 13-31 (Sept. 25, 2013), available at http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p351220.pdf. This is the latest in a series of FINRA notices concerning suitability. Helpfully, previous notices and other pertinent documents are collected on FINRA’s website at http://www.finra.org/Industry/Issues/Suitability/. Included on this page is a document consolidating the questions and answers in Regulatory Notices 12-55, 12-25 and 11-25, arranged by topic (“recommendation," “customer,” customer’s investment profile — information gathering requirements, investment strategies, reasonable basis suitability, quantitative suitability, acting in a customer’s best interests, institutional-customer exemption, documentation and supervision regarding suitability obligations). This is a useful document, but note the disclaimer at the end: “With this guidance, FINRA attempts to present information in a format that is easily understandable. However, please be aware that, in case of any misunderstanding, the rule language prevails.”
2 Regulatory Notice 13–31, supra note 1, at 1.
3 Id. at 3-5.
4 Id. at 3.
5 Id. at 3-5. Regarding the set of questions concerning portfolio analytic tools or models and whether any of those offered by a firm to its customers qualify for the Rule 2111.03(c) safe harbor for “asset allocation models,” see NASD IM-2210–6.
6 Regulatory Notice 13-31, supra note 1, at 5.
7 Id. at 5. Rule 2111 does impose one explicit documentation requirement, and previous guidance, like Regulatory Notice 13-31, also places some emphasis on documentation. See Rule 2111.04 (“A member or associated person shall use reasonable diligence to obtain and analyze all of the factors delineated in Rule 2111(a) unless the member or associated person 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 particular case.” (emphasis added); Suitability: Additional Guidance on FINRA’s New Suitability Rule, Regulatory Notice 12-25 at 9 (May 18, 2012), available at http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p126431.pdf (“the extent to which a firm needs to document its suitability analysis depends on an assessment of the customer’s investment profile and the complexity of the recommended security or investment strategy . . . and/or the risks involved”; “the recommendation of a complex and/or potentially risky security or investment strategy involving a security or securities usually would require documentation”).
8 Regulatory Notice 13-31, supra note 1, at 5–6.
9 Id. at 6.
10 Id. at 6–11.
11 The Notice also includes examples of practices small firms have adopted. Id. at 6 (“even smaller firms established investment committees to vet complex or risky products to determine whether the product met the reasonable-basis suitability standard for retail customers, and if so, the type of customer profile for which the product would be suitable if recommended”); at 7 (“Some small firms have policies that, although not required by Rule 2111, prohibit recommended transactions unless the customer fully completes or updates account information with all of the factors listed in the amended rule.”); at 8 (“Some small firms reported conducting targeted educational discussions with vulnerable customers regarding products, markets and risks, as well as more frequent portfolio assessments.”); at 10 (“Some small firms use clearing firm platforms to capture explicit hold recommendations or other strategies. The practice is for small firm representatives to rely on client notes capabilities offered by clearing firms. Notes capabilities permit registered representatives of small firms to capture the substance of conversations with clients at a granular level (e.g., substance and time of conversation, name of security or type of strategy) and thereby provide an audit trail. Moreover, some small firms counsel their registered representatives to use the notes functionality to capture whether recommendations were made relative to the transfer of positions from another broker-dealer. In particular, some small firms memorialize disclosures to customers that transferred securities – that the firm does not follow – will not be the subject of hold or sell recommendations.”); at 10–11 (“To detect potential red flags based on securities positions, some small firms look beyond an individual customer’s account. Firms look for concentrated positions of a security in the accounts serviced by specific registered representatives, or look across customer accounts or branch offices for an accumulation of a security that is not readily explained (e.g., a security not followed by the firm).”).
12 Id. at 1 (“we believe [the examples of suitability practices provided] are positive steps in building a strong compliance environment”).
13 Id. at 8.
14 Id. at 2. The history of Rule 2111 demonstrates an evolution in FINRA’s thinking relative to what a firm’s obligations should be for investment strategies involving a non-security component, outside business activity. As detailed in our previous alerts, in the notice seeking comment on FINRA’s original proposal, FINRA solicited comments on whether to expand the reach of proposed Rule 2111 to non-securities products. 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), at 4, available at http://www.bingham.com/SearchResults?au=davilas. This issue generated the greatest number of comments, the majority of which were opposed to such a change. Ultimately, FINRA refrained from explicitly adding non-securities products to the rule. After the Securities and Exchange Commission approved new Rule 2111 and shortly before the rule was to take effect, FINRA issued new guidance (Regulatory Notice 12–25), stating in relevant part that, pursuant to the new rule (and by virtue of the statement in the Supplementary Material that “[t]he phrase ‘investment strategy involving a security or securities’ . . . is to be interpreted broadly”), FINRA has jurisdiction over investment strategies with security and non-security components. See Supplementary Material 2111.04; Regulatory Notice 12–25 at 11 (Question 17) and 13 (Question 21), available at http://finra.complinet.com/net_file_store/new_rulebooks/f/i/FINRANotice12_25.pdf. This broad pronouncement contradicted the understanding many firms had of the final proposal that went to the SEC for approval, and was contrary to the established principle that FINRA lacks jurisdiction over non-securities. Although subsequent guidance (Regulatory Notice 12–55) tempered this pronouncement in certain respects, it also stated that the “suitability analysis . . . must be informed by a general understanding of the non-security component of the recommended investment strategy,” and introduced for the first time the concept of looking to Rule 3270 for purposes of assessing investment strategies involving a security component and an outside business activity, non-security component. See FINRA Issues Guidance Narrowing the Scope of its New Suitability Rule, at 2–3 (Dec. 17, 2012), available at http://www.bingham.com/SearchResults?au=davilas; Suitability: Guidance on FINRA’s Suitability Rule, Regulatory Notice 12–55 at Q.10(b) and A.10(b), available at http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p197435.pdf. This approach to assessing such hybrid investment strategies persists in Notice 13–31.
15 See FINRA Responds to Comments, supra note 14, at 2.
16 Regulatory Notice 13–31, supra note 1, at 9.
17 Id. at 4.
18 In a recent interpretive letter, FINRA addressed another nuanced although discrete issue: the application of suitability obligations to a member’s recommendation of a security or investment strategy involving a security to foreign nationals in connection with the EB–5 Immigration Investor Program. FINRA concluded that the suitability rule would apply to such a recommendation. See Interpretive Letter to Trustmont Financial Group, Inc. (Aug. 26, 2013), available at http://www.finra.org/industry/regulation/guidance/interpretiveletters/p332008.
This article was originally published by Bingham McCutchen LLP.