The Financial Services Regulatory Revolution: Navigating the New World of Broker-Dealer and Investment Adviser Regulation

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1 81 ALI-ABA Course of Study The Financial Services Regulatory Revolution: Navigating the New World of Broker-Dealer and Investment Adviser Regulation October 8-9, 2009 New York, New York Suitability-Recent Developments: Reviewing and Assessing Your Firm s Progress By Clifford E. Kirsch Sutherland Asbill & Brennan LLP New York, New York

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3 83 Suitability-Recent Developments: Reviewing and Assessing your Firm s Program by Clifford E. Kirsch 1 Sutherland 1114 Avenue of the Americas- 40 th Floor New York, NY clifford.kirsch@sutherland.com I. Introduction During the past year, there have been significant developments regarding FINRA s suitability requirements. As part of it s Rulebook Consolidation process, FINRA has proposed a new suitability rule and a new know-your-customer rule. FINRA has also finalized its new variable annuity suitability rule and has also issue guidance with respect to specific products such as leveraged ETFs. In this outline, we review these developments, but first outline the current regulatory framework. II. The Current Regulatory Framework A. The SEC s Shingle Theory A broker-dealer, by hanging out its shingle and conducting a public securities business, impliedly represents that it will deal fairly with customers.1 In 1994, the Securities and Exchange Commission ( SEC ) stated that suitability should be considered as a facet of the shingle theory and is part of the obligation every broker-dealer owes to every customer.2 As part of this obligation of fair dealing, broker-dealers must have a reasonable basis for believing that their securities recommendations are suitable for the customer in light of the customer s financial needs, objectives and circumstances. In addition, broker-dealers must have a reasonable basis for believing that the particular security being recommended is appropriate. 1 See 1963 Special Study of the Securities Markets, H.R. Doc. 95, 88 th Cong., 1 st Sess. (12963) at 238; see also Richard N. CAE, 44 S.E.C. 8, 18 (1969), and Mac Robbins & Co., 41 S.E.C. 116 (1962). 2 Investment Advisers Act Release No (March 16, 1994), 59 Fed. Reg n. 6 (March 22, 1994).

4 84 B. FINRA Suitability Requirements Under NASD Conduct Rule 2310, FINRA s suitability rule, a broker-dealer must meet the requirement of customer-specific suitability.3 Customer-specific suitability refers to a broker-dealer s obligation to tailor a recommendation to a customer s financial profile and investment objectives. Thus, a broker-dealer may not recommend a security unless it believes that the security is appropriate for the customer based upon the information that the broker-dealer has obtained from the customer. Rule 2310(b) also provides that, prior to the execution of a transaction recommended to a retail customer, a member must make reasonable efforts to obtain information concerning: The customer s financial status; The customer s tax status; The customer s investment objectives; and Such other information used or considered to be reasonable by such member or registered representative in making recommendations to the customer.4 This section, in effect, creates a duty of inquiry for FINRA member firms before they may recommend securities to their retail customers.5 In addition, NASD Rule 2110 requires members in the conduct of their business to observe high standards of commercial honor and just and equitable principles of trade. 6 This rule is not a suitability rule per se, nor has its application been confined to cases involving unsuitable securities recommendations. However, FINRA has frequently cited Rule 2110 in enforcement cases involving unsuitable recommendations. Moreover, the FINRA Board of Governors has stated that suitability obligations emanate from members fundamental responsibility for fair dealing with their customers, a responsibility that is reflected in Rule The rule also includes the concept of reasonable basis suitability, that is, the broker-dealer s obligation to have an adequate and reasonable basis for a recommendation, regardless of the customer to whom the recommendation is made. 4 NASD Conduct Rule 2310(b). 5 FINRA also imposes suitability obligations on its members with regard to recommendations made to institutional customers. See NASD Interpretive Material NASD Conduct Rule See NASD Interpretive Material (a)(1). 2

5 85 III. Proposed Rule 2111 Suitability In Regulatory Notice 09-25, Proposed Consolidated FINRA Rules Governing Suitability and Know-Your-Customer Obligations (the Notice ), FINRA proposes to use NASD Conduct Rule 2310 as the model for FINRA Rule 2111 ( Rule 2111 ), addressing the suitability obligations of member firms. In addition, the Notice indicates that FINRA proposes FINRA Rule 2090 ( Rule 2090 ) based on a modified version of NYSE Rule 405(1) that addresses know-your-customer ( KYC ) obligations. Each of the proposed FINRA Rules makes modifications to the existing rules upon which they are based. As described in the Notice, Rule 2111 includes a number of changes to existing NASD Conduct Rule 2310, and also requests comments on certain specific aspects of the proposed FINRA Rule. The changes include: the proposed applicability of suitability obligations to investment strategies as well as securities; the proposed expansion of a member firm s duty to asses any recommendation in light of any information known by the member or associated person; the request for comment on expanding the suitability obligation to apply to any recommendation of the member firm, regardless of whether such recommendation is related to a security; and revisions to the rule s institutional customer exception. A. Applicability of Rule 2111 to Recommendations of Investment Strategies. Rule 2111 proposes to apply the suitability obligations to recommendations of investment strategies involving securities. The Notice indicates that this change would codify longstanding SEC and FINRA decisions and other interpretations stating that NASD Conduct Rule 2310 covers both recommended securities and investment strategies. While the Notice does not provide any citations to either SEC or FINRA decisions or interpretations, it does reference language that is present in the current Interpretive Material ( IM ) covering institutional investors. Commenters have raised several concerns related to the proposed expansion of the suitability obligation to investment strategies involving securities. The comments have raised fundamental concerns about the applicability by FINRA of a suitability obligation to anything other than a securities transaction. The suitability requirement historically has been rooted in a broker-dealer s recommendation of a securities transaction, a discrete activity with clear boundaries. In contrast, FINRA s use of the term investment strategies does not have clearly articulated boundaries. 3

ALI-ABA Conference on Life Insurance Company Products November 3-4, 2011 Washington, D.C.

775 ALI-ABA Conference on Life Insurance Company Products November 3-4, 2011 Washington, D.C. Redefining the Retail Relationship: The Emerging Regulatory Framework Governing Suitability, the Standard of