KNOW YOUR CUSTOMER INQUIRIES AND SUITABILITY

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1 Vol. 46 No. 20 November 20, 2013 KNOW YOUR CUSTOMER INQUIRIES AND SUITABILITY DETERMINATIONS UNDER THE UPDATED FINRA RULES FINRA s Know Your Customer and Suitability rules were approved by the SEC in 2010 and implemented last year. The author reviews their various provisions, including those relating to customer information, securities recommendations, and the components of the suitability obligation. By Peter W. LaVigne * FINRA Rule 2090 (Know Your Customer Rule) and 2111 (Suitability Rule) were approved by the SEC on November 17, 2010 and adopted by FINRA effective October 7, 2011, with the implementation date extended to July 9, These rules govern the conduct of brokers in connection with opening and maintaining customer accounts, and recommending securities or investment strategies to customers. This article provides an overview of certain elements of the Know Your Customer Rule and Suitability Rule and discusses new FINRA guidance, as well as the continued applicability of existing guidance. 1 FINRA Regulatory Notice (Jan. 2011) ( Regulatory Notice ); Order Approving Proposed Rule Change, Exchange Act Release No. 63,325 (Nov. 17, 2010). FINRA announced the extended implementation date in FINRA Regulatory Notice (May 2011) ( Regulatory Notice ). Predecessor Rules The updated Know Your Customer Rule is modeled substantially on NYSE Rule 405(1). However, unlike NYSE Rule 405, Rule 2090 does not specifically address orders, supervision or account opening, areas that are covered by other FINRA rules. The updated Suitability Rule, Rule 2111, is modeled after NASD Rule As discussed below, Rule 2111 adds to the types of information brokers are required to obtain from retail customers, expands the types of recommendations (e.g., hold recommendations) for which suitability determinations are required, and specifies the types of information and acknowledgements required to determine that a customer may be treated like an institutional customer. 2 When the NASD and NYSE merged their regulatory functions to create FINRA, selected NASD and NYSE rules were incorporated into the FINRA rulebook with their prior rule numbers until updated and adopted as FINRA rules. PETER W. LAVIGNE is a partner at Goodwin Procter LLP, where he represents broker-dealers, banks, and fund advisers in broker-dealer and other securities regulatory matters. His address is plavigne@goodwinprocter.com. The views stated here are those of the author and not necessarily those of Goodwin Procter or any other person. IN THIS ISSUE KNOW YOUR CUSTOMER INQUIRIES AND SUITABILITY DETERMINATIONS UNDER THE UPDATED FINRA RULES November 20, 2013 Page 253

2 RSCR Publications LLC Published 22 times a year by RSCR Publications LLC. Executive and Editorial Offices, 2628 Broadway, Suite 29A, New York, NY Subscription rates: $1,197 per year in U.S., Canada, and Mexico; $1,262 elsewhere (air mail delivered). A 15% discount is available for qualified academic libraries and full-time teachers. For subscription information and customer service call (866) or visit our Web site at General Editor: Michael O. Finkelstein; tel ; mofinkelstein@gmail.com. Associate Editor: Sarah Strauss Himmelfarb; tel ; shimmelfarb@comcast.net. To submit a manuscript for publication contact Ms. Himmelfarb. Copyright 2013 by RSCR Publications LLC. ISSN: Reproduction in whole or in part prohibited except by permission. All rights reserved. Information has been obtained by The Review of Securities & Commodities Regulation from sources believed to be reliable. However, because of the possibility of human or mechanical error by our sources, The Review of Securities & Commodities Regulation does not guarantee the accuracy, adequacy, or completeness of any information and is not responsible for any errors or omissions, or for the results obtained from the use of such information. Similarities and Differences in Rules 2090 and 2111 Rules 2090 and 2111 both require brokers to obtain information from their customers. However, there are important differences between them, including differences in the events that trigger the provisions of each rule, the nature of customers to which each rule applies, and the specific information that brokers are required to obtain under the applicable rule. The Know Your Customer Rule is triggered when a broker opens an account for a customer, although the broker thereafter needs to maintain the customer s current information. The Suitability Rule, in comparison, is triggered when the broker intends to make a recommendation to a customer regarding a security or investment strategy involving a security. FINRA s definition of customer, as further discussed below, applies in both rules. However, by its terms, Rule 2090 only applies to a customer for whom the broker opens an account. In contrast, Rule 2111 applies to a customer to whom the broker makes a recommendation, even if the broker never opens an account for the customer. In addition, while the Suitability Rule distinguishes between retail and institutional accounts, the Know Your Customer Rule does not make that distinction, although the essential facts about customers that the Know Your Customer Rule requires brokers to obtain will necessarily vary depending on the nature of the customer. Rule 2090 requires brokers to use reasonable diligence to obtain the essential facts concerning every customer and concerning the authority of each person acting on behalf of such customer. It is a general rule, in that it requires reference to other laws, regulations, and rules in order to determine what information the broker must obtain from its client. Rule 2111, on the other hand, is specific, describing the elements of the suitability determination for different types of accounts and different kinds of recommendations. With that introduction, we will discuss each rule in turn. THE KNOW YOUR CUSTOMER RULE Rule 2090 requires every broker to use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer and concerning the authority of each person acting on behalf of such customer. The facts essential to knowing the customer are 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. 3 Understanding Authority The authority of persons acting on behalf of a customer will vary depending on the nature of the customer and of the person acting with authority. Institutions can only act through authorized individuals associated with the institution and intermediaries such as investment advisers and custodian banks. Retail customers may give authority to guardians, family members, and attorneys-in-fact, as well as investment advisers and custodians. A broker must understand not only who has authority to act on behalf of a customer but also the scope of that person s authority. FINRA recognizes that some firms have elected as a matter of business practice not to open accounts for customers who wish to qualify the scope of authority of persons acting on the customers behalf. 4 Firms that permit other persons to act on behalf of an account only if they have full authority are not required to track the level of authority of such persons. Firms should, however, consider having a system in place to process notices from customers revoking or qualifying the authority of persons previously authorized to act on behalf of the customers accounts. Information Requirements of Other Rules A number of other rules of FINRA, the SEC, and the Financial Crimes Enforcement Network ( FinCEN ) 3 FINRA Rule See Regulatory Notice at Question 1. November 20, 2013 Page 254

3 require brokers to obtain information from or about their customers. As indicated, not all of the following rules require the information to be obtained at the time of account opening: Customer Identification Program in connection with anti-money laundering procedures 5 (obtained at account opening); eligible participants for portfolio margin accounts FINRA Rule 4210(g)(4) (obtained when the customer requests portfolio margining); restricted persons under FINRA Rule 5130 and covered persons under FINRA Rule 5131, who are generally not permitted to receive allocations of shares from underwriters in initial public offerings (usually obtained at account opening but may be obtained before first purchase of IPO shares by customer); opening options accounts FINRA Rule 2360(b)(16)(B) (obtained at account opening, if applicable); opening security futures accounts FINRA Rule 2370(b)(16)(B) (obtained at account opening); accredited investors as defined in Rule 501 of Regulation D, to whom sales may be made in a private offering under Rule 506 of Regulation D without regard to the number of accredited investors who purchase 6 (usually obtained at account opening but should be obtained at the latest before first purchase by the customer in a Rule 506 offering); qualified purchasers as defined in Section 2(a)(51) of the Investment Company Act of 1940, who may purchase interests in unregistered investment companies exempt under Section 3(a)(7) of that Act 7 (obtained before first purchase of fund interests); status as affiliates of an issuer of persons who hold unregistered shares of the issuer, for purposes of 5 Certain federal laws and regulations, as well as a FINRA rule, require information to be obtained in connection with antimoney laundering procedures. See, e.g., 31 U.S.C (Bank Secrecy Act); 31 C.F.R et seq.; and Anti- Money Laundering Compliance Program, FINRA Rule C.F.R (a), U.S.C. 80a-2(a)(51), -3(a)(7). Rule 144 under the Securities Act of (obtained before customer sale of unregistered shares); approval procedures for day trading accounts under FINRA Rule 2130 (obtained before commencement of day trading activities); and when a broker provides market access to a customer, information about the customer adequate for the broker to establish financial and regulatory risk management controls required by Rule 15c3-5 under the Securities Exchange Act of (obtained before providing market access). THE SUITABILITY RULE The key elements of the Suitability Rule include (i) the definition of customer, (ii) the determination of whether and when a recommendation has been made, (iii) the categories of recommendations (i.e., securities and investment strategies), (iv) qualifying institutional customers, (v) the components of the suitability obligation (i.e., reasonable-basis, customer-specific, and quantitative suitability), and (vi) the information required for the customer-specific and quantitative suitability determinations. Each of these key elements is discussed, in turn, below. Who Is a Customer? FINRA rules define customer simply by saying the term shall not include a broker or dealer. 10 There is no requirement that the person have an account with the broker. By contrast, FinCEN regulations define customer for purposes of the anti-money laundering rules applicable to brokers, in part, as (i) a person that opens a new account or (ii) an individual that opens a new account for an individual who lacks legal capacity or an entity that is not a legal person. 11 FINRA has previously provided guidance with respect to determining whether a person is a customer for purposes of the Suitability Rule in circumstances other than when a person opens an account with a broker. Arrangements Not Involving Account Opening. FINRA has stated: the term customer includes a person who is not a broker or dealer who opens a brokerage 8 17 C.F.R C.F.R c FINRA Rule 0160(b)(4) C.F.R (d). November 20, 2013 Page 255

4 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 at an issuer, the issuer s affiliate, or a custodial agent (e.g., direct application business, investment program securities, or private placements) or using another similar arrangement. 12 Thus, even where a broker merely acts as agent or finder for a private fund issuer, for example, and the issuer effects the security sale directly with the investor, that investor is deemed to be a customer of the broker if the broker is paid for the transaction. Potential Investors. The Suitability Rule applies to a recommendation to a potential investor who purchases the recommended security and thereby becomes a customer. As discussed below, the suitability obligation must be satisfied prior to making the recommendation. However, if a recommendation is made to a potential investor who does not act on the recommendation, or who executes the transaction away from the brokerdealer that made the recommendation without compensation to the recommending broker-dealer, the Suitability Rule does not apply to that recommendation. 13 Categories of Recommendations The Suitability Rule applies to a recommended transaction or investment strategy involving a security or securities. A recommendation does not have to involve a particular security if it involves an investment strategy involving securities. Recommendations not involving securities are not considered to be a recommendation for purposes of the Suitability Rule unless, as discussed below, they are part of a set of recommendations, another part of which involves the purchase or sale of securities. Investment Strategy What s Excluded. The term investment strategy involving a security or securities is to be interpreted broadly and would include an explicit recommendation to hold a security, as discussed below. 14 FINRA has stated that the following communications are excluded from the Suitability Rule, 12 FINRA Regulatory Notice at Question 6(a) ( Regulatory Notice ) (revising guidance in FINRA Regulatory Notice at Question 6 ( Regulatory Notice )) (internal citations omitted). 13 Regulatory Notice at Question 6(b). 14 See FINRA Rule so long as they do not otherwise include a recommendation of a security or securities: general financial and investment information, including basic investment concepts, historic differences in the return of asset classes, effects of inflation, estimates of future retirement income needs, and assessment of a customer s investment profile; descriptive information about an employersponsored retirement or benefit plan, participation in the plan, the benefits of plan participation, and investment options available under the plan; and asset allocation models that are based on generally accepted investment theory, accompanied by all material facts and assumptions, and in compliance with FINRA Rule 2214 relating to use of investment analysis tools, if applicable. 15 Investment Strategy What s Included. FINRA has stated that the following would be investment strategy recommendations, and thereby subject to the Suitability Rule, regardless of whether the recommendations identify particular securities: specific types of securities, such as high dividend companies or the Dogs of the Dow, investment in a particular market sector, or the use of a bond ladder, day trading, liquefied home equity, 16 or a margin strategy involving securities. 17 Hold Recommendations. A recommendation to hold a security is a recommendation of an investment strategy. The Suitability Rule applies to an explicit recommendation to hold, even if the broker did not recommend the original purchase. 18 Whether an explicit recommendation has been made involves factors discussed in the following section. However, FINRA has said that when a broker-dealer s call center answers questions about moving investments from an employersponsored retirement account at the firm to an individual retirement account at the firm, merely advising a customer that he or she is permitted to maintain particular securities in the new account is not a hold recommendation See id. 16 See Notice to Members Regulatory Notice at Question 7 (revising guidance in Regulatory Notice at Question 7). 18 Regulatory Notice at Question Id. at Question 4. November 20, 2013 Page 256

5 In September 2013, FINRA announced the results of examinations of member firms for compliance with Rule In the regulatory notice ( Examination Notice ), FINRA observed that common feedback from the examined firms was that the hold and strategy aspects of the rule create behavioral and cultural challenges since, historically, it was not customary for registered representatives to consider an explicit hold as a recommendation or to document a strategy. 21 In response, firms have provided initial training on these aspects of Rule 2111 and ongoing training, including at periodic sales meetings. FINRA identified a number of best practices that it had observed for compliance with the hold provision of the Suitability Rule, including the following systems and procedures: use of a hold ticket or hold blotter that captures hold and, in some circumstances, other types of strategy recommendations; notes of discussions with clients regarding explicit hold or other strategy recommendations by associated persons maintained in customer files; and firm branch office inspections focused on the documentation of hold and other strategy conversations with clients. 22 Communications Constituting Recommendations Rule 2111 does not alter the principles used to determine whether a communication is a recommendation. In the adopting notice for Rule 2111, FINRA stated that a communication s content, context, and presentation are important aspects of the inquiry, and that the determination of whether a recommendation has been made is an objective rather than a subjective inquiry. FINRA went on to say: An important factor in this regard is whether given its content, context, and manner of presentation a particular communication from a firm or associated person to a customer reasonably would be viewed as a suggestion that the customer take action or refrain from taking action regarding a security or investment strategy. In addition, the more individually tailored the communication is to a particular customer or 20 Regulatory Notice Id. at Id. at 9. customers about a specific security or investment strategy, the more likely the communication will be viewed as a recommendation. Furthermore, a series of actions that may not constitute recommendations when viewed individually may amount to a recommendation when considered in the aggregate. It also makes no difference whether the communication was initiated by a person or a computer software program. 23 FINRA and its predecessor, the NASD, have provided additional guidance regarding communications constituting recommendations, as described below. Online Suitability. In a notice to members, the NASD addressed the question of when electronic or online communications made to broad categories of persons are recommendations. The NASD stated that an important factor is whether the communication would reasonably be viewed as a call to action or suggestion that the customer engage in a securities transaction. 24 Under Rule 2111, that would also apply to a call to action or suggestion to use an investment strategy involving securities. The NASD stated that the more individually tailored the communication to a specific customer or a targeted group of customers about a security or group of securities, the greater likelihood that the communication may be viewed as a recommendation. 25 Conversely, the NASD noted that the fact that communications are made available to all customers or to the public at large could indicate that the communication is not a recommendation. 26 Finally, the NASD stated that, while a broker cannot disclaim away its suitability obligation, informing customers that generalized information provided is not based on the customer s particular financial situation or needs may help clarify that the information provided is not meant to be a recommendation to the customer. 27 In a January 2010 regulatory notice, FINRA stated that the principles articulated by the NASD in this regard would apply as well to communications in social media, such as Facebook Regulatory Notice at NASD Notice to Members at Id. 26 Id. at 4 & n NASD Notice to Members at n FINRA Regulatory Notice November 20, 2013 Page 257

6 Distribution of Offering Materials. In providing guidance on the updated Suitability Rule, FINRA stated that a broker s use or distribution of marketing or offering materials ordinarily would not, by itself, constitute a recommendation for purposes of the suitability rule, and that, when Rule 506 of Regulation D is amended as required by the Jumpstart Our Business Startups Act (JOBS Act) to permit general solicitation, a broker s general solicitation of a private placement through the use or distribution of marketing or offering materials ordinarily would not constitute a recommendation triggering the rule. 29 Implicit Recommendations. FINRA and the SEC have recognized that certain acts can constitute an implicit recommendation. Such is the case where a broker effects a securities transaction on a customer s behalf without informing the customer. However, a broker s silence with respect to a security owned by a customer would not constitute an implicit hold recommendation. 30 To Whom Is the Recommendation Made? Recommendations made inadvertently to persons who are not customers would not trigger the requirements of the Suitability Rule if the person does not enter into a transaction with the broker making the recommendation (see discussion of recommendations to potential investors above). However, if the person seeks to enter into a transaction, the broker should complete an appropriate suitability review. Since the suitability review is required to be completed before the recommendation is made, it would be prudent for the broker to advise the potential investor that the recommendation was not directed to the potential investor and that the broker would not be able to effect the transaction without determining that the transaction is suitable for the potential investor. The question of whether a recommendation is made to an investment adviser or to the adviser s client is discussed under the section entitled Special Situations, below. Components of Suitability Obligations FINRA has stated that the components of the suitability obligations of brokers are (i) the reasonablebasis obligation; (ii) the customer-specific obligation; and (iii) quantitative suitability. The reasonable-basis obligation requires a member or associated person to have a reasonable basis to 29 Regulatory Notice at Questions 2 and See id. at Question 3. believe, based on reasonable diligence, that the recommendation is suitable for at least some investors. In general, what constitutes reasonable diligence will vary depending on, among other things, the complexity of and risks associated with the security or investment strategy, and the member s or associated person s familiarity with the security or investment strategy. A member s or associated person s reasonable diligence must provide the member or associated person with an understanding of the potential risks and rewards associated with the recommended security or strategy. The Suitability Rule requires such an understanding when recommending a security or strategy. 31 In the Examination Notice, FINRA stated that during examinations it had noticed the following: Many firms have in place a new product vetting process that assists them in executing reasonable due diligence obligations. While many large firms have extensive frameworks for assessing products, even smaller firms established investment committees to vet complex or risk products to determine whether the product met the reasonable-basis suitability standards for retail customers, and if so, the type of customer profile for which the product would be suitable if recommended. 32 FINRA also pointed out in the Examination Notice that a firm s vetting of new products is not sufficient by itself, and that associated persons still need to understand the securities and investment strategies they recommend to their customers. 33 The customer-specific obligation requires that a member or associated person have a reasonable basis to believe that the recommendation is suitable for a particular customer based on that customer s investment profile. 34 The FINRA staff was asked whether the Suitability Rule applies to a recommendation to a customer when the customer is a foreign national seeking an investment that will allow the individual to obtain a visa under the EB-5 Program administered by the U.S. Citizenship and Immigration Services. This program provides that 31 FINRA Rule (a). 32 Regulatory Notice at Id. at FINRA Rule (b). November 20, 2013 Page 258

7 foreign nationals may qualify to obtain residency if they invest at least $1 million (or $500,000 in a Targeted Employment Area ) in a project that creates or preserves 10 jobs for U.S. workers, excluding the investor and the investor s immediate family. The requesting firm stated its view that FINRA should not exercise jurisdiction over EB-5 program investments because the purpose of the investments is first, to create jobs, second, to provide the foreign national a right of residency, and only third, to achieve investment performance. In its interpretive letter, FINRA replied that the requesting firm is required to comply with FINRA rules, including the Suitability Rule, in connection with EB-5 Program investments. However, in addition to the standard elements of the customer s investment profile, the firm may consider, in making its suitability determination, other information provided by the customer, including, in this case, the customer s goal of obtaining U.S. residency through purchasing an investment that is consistent with the requirements of the EB-5 program. 35 Quantitative suitability requires a member or associated person who has actual or de facto 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, is not excessive and unsuitable for the customer when taken together in light of the customer s investment profile. No single test defines excessive activity, but factors such as the turnover rate, the cost-equity ratio, and the use of in-and-out trading in a customer s account may provide a basis for a finding that a member or associated person has violated the quantitative suitability obligation. 36 Suitability for Institutional Customers A broker satisfies its customer-specific suitability obligation for an institutional customer if: (i) the customer qualifies as an institutional account as defined in FINRA Rule 4512(c); (ii) the broker has a reasonable basis to believe that the institutional customer is capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies involving a security or securities; and (iii) the institutional customer affirmatively indicates that it is exercising independent judgment in evaluating the member s or associated person s recommendations. Rule 2111(b) provides that where an institutional customer has delegated decision-making authority to an 35 Letter to Brian Sweeney, Trustmont Financial Group, Inc., August 26, FINRA Rule (c). agent, such as an investment adviser or a bank trust department, these factors are to be applied to the agent. Under the applicable FINRA rule, the term institutional account is defined to include the account of (1) a bank, savings and loan association, insurance company, or registered investment company; (2) an investment adviser registered either with the SEC under Section 203 of the Investment Advisers Act [of 1940] or with a state securities commission (or any agency or office performing like functions); or (3) any other person (whether a natural person, corporation, partnership, trust, or otherwise) with total assets of at least $50 million. 37 Continuing Obligation for Reasonable-Basis and Quantitative Suitability. Brokers making recommendations to institutional customers continue to have an obligation to make reasonable-basis and quantitative suitability determinations. 38 Documenting Institutional Suitability. The Suitability Rule does not require a broker to obtain an institutional customer s acknowledgement in writing. FINRA permits brokers to take a risk-based approach to documenting suitability. Thus, a broker may obtain the institutional customer s acknowledgement orally, in person, or over the telephone, and, if it chooses, memorialize it in a written record. 39 A negative consent, however, is not sufficient to satisfy the requirements of the Suitability Rule. 40 Use of Suitability Certificates. FINRA has not endorsed or condoned the use of forms of institutional suitability certificates created by the Securities Industry and Financial Markets Association (SIFMA), and others, and has stated that such a certificate in no way constitutes a safe harbor from the rule. 41 However, the certificates are widely used by brokers with institutional customers, and FINRA recognized this in the recent Examination Notice. 42 Institutional Account Opting Out of Institutional Customer Treatment. Unless an institutional account elects to be treated as an institutional customer, it must be treated as a retail customer. 37 FINRA Rule 4512(c). 38 Regulatory Notice at 5 & n Regulatory Notice at Question Id. 41 Id. at Question Regulatory Notice at 8. November 20, 2013 Page 259

8 Elements of Retail Customer Investment Profile Rule 2111(a) requires a broker to have a reasonable basis to believe that a recommended transaction or investment strategy involving securities is suitable for the customer, based on the information obtained through the reasonable diligence of the broker to ascertain the customer s investment profile. A customer s investment profile includes, but is not limited to, the following: customer age; other investments, financial situation, and needs; tax status; they have adequate information to make suitability determinations, including the following: overall, examined firms had made significant technological changes to internal systems to capture added customer profile data; some firms supplemented the technological upgrades with business processes that reassessed their entire client base and challenged its representatives to meet goals for completing customer reviews within a specified time frame, while other firms collected the enhanced customer profile information on a rolling basis as they made new recommendations; and investment objectives; investment experience; some firms implemented systems that flag customer accounts that have recommended transactions but do not have a complete customer investment profile. 45 investment time horizon; FINRA also noted: liquidity needs; risk tolerance; and any other information the customer may disclose to the broker in connection with the recommendation. Risk-Based Approach to Documenting Compliance. A broker is not required to have in its records all of the elements of a customer s investor profile in every case when recommending a security or investment strategy. FINRA permits brokers to apply a risk-based approach to documenting compliance with suitability obligations. 43 The extent to which a broker 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, in terms of both its structure and potential performance, and the risks involved. As an example, FINRA stated that the recommendation of a large-cap, value-oriented equity security usually would not require documentation. Conversely, the recommendation of a complex or potentially risky security or investment strategy usually would require documentation. 44 In the Examination Notice, FINRA discusses systems and procedures firms have put in place to ensure that 43 Regulatory Notice at Question Id. [Some firms had] bolstered compliance through heightened customer-specific suitability requirements or specific suitability profiles (e.g., customers who would qualify for complex options trading; customers who have a high-risk tolerance, low-liquidity needs, and substantial investment experience; customers where the recommended transaction represents a small percentage of a balanced portfolio). These heightened standards are designed to best ensure that a recommended security or strategy matches well with the customer s profile data. 46 Customer Refusal to Provide Information. FINRA recognizes that some customers may be reluctant to provide certain types of information required for a suitability determination (e.g., information about other investments held away from the broker making the inquiry). The broker may not make assumptions about information the customer declines to provide and must consider whether it has a sufficient understanding of the customer to properly evaluate the suitability of the recommendation. However, updated Rule 2111, like its predecessor rule, would not prohibit the broker from making a recommendation in the absence of some customer-specific factors as long as the broker has enough information about the customer to have a 45 Examination Notice at Id. at 8. November 20, 2013 Page 260

9 reasonable basis to believe the recommendation is suitable. 47 Consistent With the Best Interests of the Customer In a January 2012 regulatory notice, FINRA noted that numerous cases had stated that a broker s recommendations must be consistent with its customer s best interests. 48 FINRA interprets the best interests provision as prohibiting a broker from placing its interests ahead of the customer s interests. FINRA provided the following examples of cases where FINRA or the SEC had found brokers in violation of the suitability rule by placing their interests ahead of customers interests: a broker whose motivation for recommending one product over another was to receive larger commissions; a broker whose mutual fund recommendations were designed to maximize his commissions rather than to establish an appropriate portfolio for his customers ; a broker who recommended that his customers purchase promissory notes to give him money to use in his business ; a broker who sought to increase his commissions by recommending that customers use margin so that they could purchase larger numbers of securities; a broker who recommended new issues being pushed by his firm so that he could keep his job; and a broker who recommended speculative securities that paid high commissions because he felt pressured by his firm to sell the securities. 49 FINRA does not prohibit a broker from trying to make a profit on its business. In the January 2012 notice, FINRA added that the requirement that a broker s recommendation must be consistent with the customer s best interests does not obligate a broker to recommend the least expensive security or investment strategy, as long as the recommendation is suitable and 47 Regulatory Notice at Question Id. at Question Id. the broker is not putting its interests ahead of the customer s. 50 SPECIAL SITUATIONS Mixed Securities and Non-Securities Recommendations Brokers may make recommendations that involve a combination of an investment strategy involving securities plus an investment strategy not involving securities. This may occur, for example, in the following situations: a broker that is dual registered as a futures commission merchant advises a customer to sell a futures position and buy securities; a broker that is also an insurance broker advises a customer to sell securities and use the proceeds to purchase an insurance policy; or a broker advises a customer to refinance the mortgage on a house or sell a piece of land and use the extra proceeds to buy securities. FINRA provided guidance on mixed recommendations and the supervisory responsibilities of brokers for the mixed recommendations of their registered representatives in a May 2012 regulatory notice. 51 FINRA subsequently clarified that the Suitability Rule is not applicable to a recommendation that does not refer to securities. 52 If a registered representative recommends a non-security investment strategy (like the purchase of an insurance policy) and the customer decides independently to liquidate securities positions to pay the premium, the broker is not responsible to determine the suitability of the securities sale. 53 However, where a registered representative recommends both a security and non-security investment strategy, according to FINRA, a reasonable supervisory system would include a review of the non-security investment strategy recommendation for potential red flags. 54 For example, a recommendation that a customer place a second mortgage on a primary residence to obtain proceeds for the purchase of structured products 50 Id. 51 Id. at Question Regulatory Notice at Questions 10(a)-(b). 53 Id. at Question 10(a). 54 Id. at Question 10(b). November 20, 2013 Page 261

10 or other risky securities would raise questions about whether the securities were really suitable for the customer. Recommendations to an Agent Acting for a Client When a broker is making a recommendation to an investment adviser, the question of whether the broker must make a suitability determination with respect to the adviser or the adviser s client depends in part on whether the adviser s customer is an institutional customer or retail customer. Agent Acting for Institutional Customer. Rule 2111(b) provides that where an institutional customer has delegated decision-making authority to an agent, such as an investment adviser or a bank trust department, the factors required to establish that the customer is an institutional customer apply to the agent. Establishing that the agent is an institutional account should present little difficulty for U.S. entities, because both registered investment advisers and banks are institutional accounts, as the term institutional account is defined in Rule 4512(c). A foreign bank or investment adviser may need to qualify as an entity with total assets of at least $50 million. If the agent is qualified as an institutional account, the broker should establish a reasonable basis for believing that the agent is capable of evaluating investment risks independently, and obtain the affirmation that the agent is exercising independent judgment in evaluating the broker s recommendations. In addition, because the exception in Rule 2111(b) applies only if the agent s client is an institutional customer, the broker should obtain a representation or certification from the agent that its client is an institutional account, as such term is defined in Rule 4512(c). Agent Acting for Retail Customer. May a broker make a recommendation to an investment adviser without knowing who its clients are? FINRA has provided informal guidance suggesting that a broker may do so depending on the facts and circumstances. For example, consider the following situations: Broker sends Adviser a PPM for a private fund with a cover note saying, I know you bought interests in the prior fund in this series so I thought you might like to take a look at this. This, by itself, probably does not constitute a recommendation to anyone, based on the applicable FINRA regulatory notice. 55 Broker sends the same PPM to Adviser with a note saying, The prior fund did very well and I know you are looking for a solid real estate play for your clients. I think this is the right fund for you. That may be a recommendation to the Adviser, but not to the Adviser s clients, if Broker does not know the Adviser s clients or has recommended the fund for any specific client. Broker would need to have done a suitability determination with respect to the Adviser, but not the Adviser s clients. Adviser, after receiving and reviewing the PPM, asks Broker to meet with one of the Adviser s clients to talk about an investment in the fund. Before Broker attends the meeting, which is likely to involve communications with the client that could be considered recommendations, Broker should obtain information about the client, either from the client or Adviser, upon which Broker can make an adequate suitability determination of the kind required for retail customers, assuming the client does not qualify as an institutional account. CONCLUSION Brokers should carefully review and fully understand the elements of the rules, along with applicable supplementary and other guidance issued by FINRA. To the extent such rules include implications for the conduct of the broker in connection with the opening and maintenance of customer accounts and the recommendation of securities or investment strategies for customers, brokers should develop and maintain appropriate supervisory and compliance processes, as well as systems to ensure that subsequent guidance is incorporated into such processes. In this regard, brokers should consider the best practices highlighted by FINRA in the Examination Notice. Mr. LaVigne wishes to express his appreciation for the contributions of Karim G. Lynn, Associate General Counsel of UBS Financial Services Inc., who appeared with him on a panel discussion that formed the basis for this article. Special thanks also to Richard Kerr, counsel at Goodwin Procter, and James Catano, associate at Goodwin Procter, for their assistance in the preparation of this article. 55 Regulatory Notice at Questions 2 and 5. November 20, 2013 Page 262