Newly Released Regulatory Notice 12-55 Provides Additional Clarity on Suitability Obligations
December 17, 2012
On December 10, 2012, FINRA issued Regulatory Notice 12-55, which provides updated guidance on FINRA’s recently revised Suitability Rule, FINRA Rule 2111. The Notice addresses issues discussed in a previous FINRA notice, Regulatory Notice 12-25, that remained ambiguous, notably, the scope of the terms “customer” and “investment strategy”. The notice further describes the suitability obligations for hold recommendations, non-security investments, and broker-dealers’ supervisory responsibilities. FSI has been urging FINRA to provide additional clarity on these areas since the rule was originally proposed, and applaud FINRA for releasing further guidance.
The following bullet points summarize the new FINRA guidance:
Scope of the Term "Customer"
- Customer Defined - A “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 at an issuer, the issuer’s affiliate or a custodial agent (e.g., “direct application business, “investment program” securities, or private placement), or using another similar arrangement.
- Application of Rule - The suitability rule would apply when a broker-dealer or registered representative makes a recommendation to a potential investor who then later becomes a customer.
- Transactions Executed Away from the B/D - If a potential investor does not act on a recommendation or if the potential investor executes the recommended transaction away from the broker-dealer with which the registered representative is associated (without the broker-dealer receiving compensation for the transaction), the suitability rule would not apply.
Scope of the Term "Investment Strategy"
- General Recommendations Not Covered - Recommendations by a registered representative that a customer generally invest in equity or fixed income securities would not be covered by the Suitability Rule. The recommendation would only be covered if it is part of an asset allocation plan not eligible for the safe-harbor included within the suitability rule.
- Recommendations of Specific Securities - The suitability rule covers more specific recommendations, particularly those related to specific types of securities (e.g. “Dogs of the Dow,” high dividend companies, or companies in a particular market sectors), even if the recommendation does not identify specific securities.
- Other Investment Strategy Recommendations - “Investment strategy” would also encompass general recommendations for customers to use a bond ladder, day trading, liquefied home equity, or margin strategy involving securities, regardless of whether the recommendations mention specific securities.
- Explicit Hold Recommendations - “Investment strategies” capture only explicit recommendations to hold a security or securities. When a registered representative meets or otherwise communicates with a customer during a quarterly or annual investment review and explicitly advises the customer not to sell any securities or make any changes to the account or portfolio or to continue to use an investment strategy, the rule would apply.
- Implicit Hold Recommendations - The rule does not cover an implicit recommendation by a registered representative to hold a security.
- Suitable When Made - FINRA’s focus is on whether the recommendation was suitable when it was made.
- No Ongoing Duty to Monitor - Hold recommendations or recommendations to maintain an investment strategy normally would not create an ongoing duty to monitor and make subsequent recommendations.
Suitability Obligations for Non-Security Investments:
- Suitability Obligation Extends to Securities Transactions - Suitability obligations apply to a broker-dealer or registered representative’s recommendation of an investment strategy to use home equity to purchase securities or to liquidate securities to purchase an investment-related product that is not a security.
- Rule Does Not Apply to Non-Securities Investments - The suitability rule does not apply where a broker-dealer or registered representative’s recommendation does not refer to a security or securities. For example, if a registered representative recomends 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, the rule does not apply.
- Liquidating Transactions to Fund Non-Securities Investments - Where a customer 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-securities investment, the suitability rule would apply only to the registered representative’s recommendation regarding which securities to sell, not to the customer’s decision to purchase the non-security investment.
Supervisory Responsibilities of a Broker-Dealer:
- Supervision Responsibility - A broker-dealer’s supervisory system must be reasonably designed to achieve compliance with applicable securities laws, regulations, and FINRA rules.
- Variety of Approaches are Acceptable - A variety of approaches to identifying and supervising registered representatives’ recommendations of investment strategies involving securities and non-securities can be considered and employed by the broker-dealer. For example, a supervisory system may be reasonably designed to achieve compliance if the firm focused on the detection, investigation, and review of “red flags” indicating the registered representative may have recommended an unsuitable investment strategy.
- Red Flags - If a registered person makes a recommendation that a customer with limited means purchase a large position in a specific security, this may raise such a “red flag.” Similarly, a red flag may be raised by a recommendation that a “buy and hold” customer with an investment objective listed as “income” on their account liquidate large positions in blue chip stocks paying regular dividends.
- General Understanding of Non-Security Component of Strategy - Suitability analysis must be informed by a general understanding of the non-security component of the recommended investment strategy once a broker-dealer identifies a recommended investment strategy involving both a security and non-security investment.
- Outside Business Activities - When a recommended investment strategy involves 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.
Although we would have preferred FINRA providing clarity on these points at the time the final rule was adopted, we appreciate FINRA’s effort to respond to our concerns by offering this guidance. However, if you have remaining concerns or other feedback you wish to share, please contact FSI’s Advocacy Team or read the full Regulatory Notice.