FINRA's Expanded Obligations For Broker-Dealers

Size: px

Start display at page:

Download "FINRA's Expanded Obligations For Broker-Dealers"

Jasmine Murphy
6 years ago
Views:

Portfolio Media. Inc. 860 Broadway, 6th Floor New York, NY 10003 www.law360.com Phone: +1 646 783 7100 Fax: +1 646 783 7161 customerservice@law360.

1 Portfolio Media. Inc. 860 Broadway, 6th Floor New York, NY Phone: Fax: FINRA's Expanded Obligations For Broker-Dealers Law360, New York (February 18, 2011) -- On Oct. 7, 2011, two new Financial Industry Regulatory Authority rules will become effective: Rule 2090 (Know Your Customer) and Rule 2111 (Suitability). The rules amend and replace New York Stock Exchange Rule 405 and National Association of Securities Dealers Rule Rule 2090 requires members to gather essential facts concerning each customer at the time the account is opened and at regular intervals over the length of the customer relationship. Rule 2111 expands previous suitability requirements for broker-dealers. Rule 2111 extends the broker s suitability obligations to cover recommendations of investment strategy, including an explicit recommendation to hold a security or securities. FINRA Conduct Rule The rule also sets out three components of broker-dealers suitability obligations: a) reasonable-basis suitability; b) customer-specific suitability and; c) quantitative suitability. Know Your Customer (Rule 2090) Rule 2090 encompasses many of the provisions contained in former NYSE Rule 405. The new rule requires member firms to use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) essential facts concerning every customer and concerning the authority of each person acting on behalf of such customer. Essential facts are defined as the facts required to effectively service the customer s account, act in accordance with any special handling instructions for the account, understand the authority of each person acting on behalf of the customer, and comply with applicable laws, regulations and rules. FINRA Conduct Rule These facts include the customer s financial profile and investment objectives. The obligation to obtain essential facts about the customer arises immediately upon the opening of an account, regardless of whether the broker has made a recommendation to the customer.

2 The new rule eliminates the requirement in NYSE Rule 405(1) that the firm/associated person learn the essential facts relative to every order, deferring instead to the requirements of specific order handling rules (such as FINRA Rule 5310 and NASD Rules 2320, 2400). However, the rule does require the brokerdealer to obtain customer information at reasonable intervals after the account is opened. Although the rule does not specify how often broker-dealers are required to update this information, FINRA suggests that customer information should be obtained at intervals reasonably calculated to prevent and detect any mishandling of a customer s account that might result from the customer s change in circumstances. *1+ The reasonableness of a broker s information-gathering is judged under the circumstances. Broker-dealers are currently required to update account information for those accounts where suitability determinations have been made every 36 months under SEA Rule 17a-3, and NYSE Rule 405(03) has required gathering essential customer information upon opening an account. Therefore, Rule 2090 is unlikely to change most broker-dealers current information-gathering practices. Suitability (Rule 2111) The new suitability rule will have a greater impact. FINRA Rule 2111 includes three important changes to a broker-dealer s suitability requirements: 1) the revised rule covers investment strategies and explicit recommendations to hold securities; 2) it expands the necessary factors for making a suitability determination; and 3) it includes definitions for three specific suitability evaluations that the brokerdealer must undertake. Suitability Review Expanded to Strategies, Including Explicit Recommendations to Hold The current suitability rule, NASD Rule 2310, states, In recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs. FINRA s new suitability rule will expand this obligation beyond assessment of a purchase, sale or exchange. Rule 2111(a) requires an associated person/member firm to have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer. Supplementary material to the rule notes that investment strategy is to be interpreted broadly and would include, among other things, an explicit recommendation to hold a security or securities. FINRA Conduct Rule Only explicit recommendations to hold, not implicit recommendations, will trigger the suitability obligations. FINRA suggests that a customer s reliance on a broker s knowledge where the broker makes a recommendation to hold a security is of the same nature as reliance on the recommendation to purchase a security; thus, the same suitability determination should be required.[2]

3 In contrast, the U.S. Supreme Court has held, in Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975) and Merrill Lynch Pierce Fenner & Smith Inc. v. Dabit, 547 U.S. 71 (2006) that there is no right of action for holder claims. The rule s supplementary material, however, attempts to clarify that although investment strategy is to be broadly construed, not all communications between a member and a customer will be considered recommendations of investment strategy. Specifically, a broker may provide the following information to a customer without triggering a suitability assessment obligation (so long as the information does not include a recommendation of a particular security): 1) General financial and investment information, such as information discussing basic investment concepts, assessment of the customer s investment profile (including estimates of future or retirement income needs), materials on the effects of inflation, and materials on average historical returns of various asset classes. 2) Asset allocation models based upon generally accepted investment theory. 3) Descriptive information about an employer-sponsored retirement plan, including investment options under the plan. FINRA Conduct Rule Expansion of Suitability Factors: Investor Profile The new suitability rule describes specific facts about a customer that an associated person must ascertain and consider prior to making a recommendation. NASD s Rule 2310(b) requires the broker to use reasonable efforts to obtain information concerning a customer s financial status, tax status, investment objectives and any other information considered to be reasonable in making a recommendation. Rule 2111 will expand these requirements, mandating that the member/associated person must have a reasonable basis to believe that a recommended transaction or investment strategy is suitable based on the customer s investment profile. The member/associated person and must use reasonable diligence to ascertain the investment profile, which includes the following: 1) The customer s age; 2) other investments; 3) financial status and needs; 4) tax status; 5) investment objectives; 6) investment experience; 7) investment time horizon; 8) liquidity needs; 9) risk tolerance; and 10) any other information the customer may disclose to the member or associated person in connection with such recommendation. FINRA Conduct Rule 2111(a).

4 If the firm or associated person does not believe that all of the listed factors are relevant to the suitability analysis in a particular circumstance, the firm must specifically document the reasons that a particular factor is not relevant in order to be relieved of the obligation to obtain information on that factor. What constitutes reasonable diligence in obtaining investor profile information is a fact-specific assessment depending on the circumstances of a particular case. In addition to assessing suitability according to the customer s investment profile, a firm or associated person must also have a reasonable basis to believe that the customer has the financial ability to meet the financial commitment required by the recommended security or investment strategy. FINRA Conduct Rule Rule 2111(b), which addresses the obligations for an institutional account, provides an important qualification of the investment profile requirement. Where an institutional account is at issue, the associated person will not be required to assess the investor profile or obtain information on each of these factors if there is a reasonable basis to believe that the institutional customer is capable of independently evaluating the investment risks of the strategy or security and the customer affirmatively indicates that it is independently evaluating the recommendations. This exception also applies in cases where an institutional customer delegates authority to an investment adviser or other agent. FINRA Conduct Rule 2111(b). The institutional customer may affirmatively indicate its intent to exercise independent judgment for all transactions in its account, for certain asset classes, or on a trade-by-trade basis. FINRA Conduct Rule Many broker-dealers already obtain most, if not all, of the customer information required by the investment profile before recommending a security. The major difference will be that broker-dealers will now be required to check the box for each of the 10 factors provided by Rule 2111(a) by providing either the information itself or a reason why the factor is irrelevant before making a recommendation. Broker-dealers may want to assess whether their current customer information-gathering and documentation procedures reflect that all of a customer s investment profile factors are considered before any recommendation is made to purchase or hold securities. Three Specific Suitability Obligations Finally, Rule 2111 expands a broker-dealer suitability obligations by defining three separate suitability assessments that the broker-dealer/associated person is required to undertake. These three components of the overall suitability analysis require the broker-dealer or associated person to have an understanding of the recommendation, of the customer s investment profile, and of the customer s overall portfolio and transaction history before any recommendation is made. 1) Reasonable-Basis Suitability: This component of the suitability assessment relates to knowledge about the proposed security or investment strategy. The member/associated person must have a reasonable basis to believe, based upon reasonable diligence, that the recommendation is suitable for at least some investors.

5 The amount of due diligence required to form a reasonable basis will vary depending on the circumstances of each case, including the complexity of the product at issue and the associated person s familiarity with the security or investment strategy. Reasonable due diligence requires that a member or associated person must at least understand the potential risks and rewards before making any recommendations about a particular security or strategy. FINRA Conduct Rule (a). 2) Customer-Specific Suitability: This component refers to the traditional analysis of customer-specific suitability, as provided by NASD Rule 2310 and expanded by Rule 2111(a). Before making a recommendation, the member 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, as delineated in Rule 2111(a). FINRA Conduct Rule (b). 3) Quantitative Suitability: This suitability obligation is entirely new, but it essentially reflects existing case law relating to churning or excessive trading. See, e.g., O'Connor v. R.F. Lafferty & Co., 965 F.2d 893, 898 (10th Cir. 1992) (setting forth elements of churning claim). This obligation requires an associated person who has de facto or actual control over a customer account to have a reasonable basis for believing that a series of recommended 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. FINRA Conduct Rule (c). Thus, in addition to considering information about the nature of the recommendation and the customer s profile, the broker should consider whether the recommendation is suitable in light of the customer s overall investment history at the firm. Conclusion The new rules further define and expand a broker s suitability obligations, including additional information-gathering requirements and additional factors that must be considered before a recommendation may be deemed suitable. Prior to the effective date of Oct. 7, 2011, firms may want to review their account information-gathering procedures to ensure that they meet the requirements of the rules. Firms may also want to consider whether to develop additional procedures to gather information on all of the customer investment profile factors and whether to memorialize that information in written form. Moreover, firms may want to consider whether and how to document conversations in which representatives discuss holding securities, because FINRA is now taking the position that explicit hold recommendations will implicate the suitability rule. --By S. Lawrence Polk and Sarah E. Scott, Sutherland Asbill & Brennan LLP Larry Polk (larry.polk@sutherland.com) is a partner in Sutherland's litigation practice group in the firm's Atlanta office. Sarah Scott (sarah.scott@sutherland.com) is an associate in the firm's litigation practice group in the Atlanta office focusing on securities regulatory and enforcement matters.

6 The opinions expressed are those of the authors and do not necessarily reflect the views of the firm, its clients, or Portfolio Media, publisher of Law360. This article is for general information purposes and is not intended to be and should not be taken as legal advice. [1] Securities and Exchange Commission Release No A, SR-FINRA (Aug. 20, 2010) at 18. [2] Securities and Exchange Commission Release No A, SR-FINRA (Aug. 20, 2010) at 18. All Content , Portfolio Media, Inc.

COMPLIANCE BULLETIN. Customer Identification & Verification

COMPLIANCE BULLETIN. Customer Identification & Verification COMPLIANCE BULLETIN Customer Identification & Verification 2017 Customer Identification & Verification Proper identification of customers has two major benefits: appropriate customer suitability analysis,