FINRA yesterday released Regulatory Notice 12-55 to provide guidance to broker-dealers on the implementation of FINRA Rule 2111 (Suitability). Rule 2111 became effective on July 9, 2012. In Regulatory Notice 12-25, released in May 2012, FINRA addressed the scope of the terms “customer” and “investment strategy” as used in Rule 2111. Regulatory Notice 12-55 supersedes the guidance of Regulatory Notice 12-25 on the scope of those terms.
Among the most salient points raised by Regulatory Notice 12-55:
- Regulatory Notice 12-55 suggests that a broker-dealer may not be liable for violations of the suitability rule by one of its brokers who is “selling away.”
- FINRA affirmatively states that a broker-dealer or broker generally does not have an ongoing duty to monitor after making a recommendation to hold securities, to maintain an investment strategy, or to implement a new investment strategy in place of another.
Rule 2111(a) provides:
A member or an associated person must 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. A customer’s investment profile includes, but is not limited to, the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation. (Emphasis added.)
In Regulatory Notice 12-55, FINRA defines a “customer” for purposes of Rule 2111 as “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 … .” Notably, under this definition, the term “customer” would not appear to include a person who purchases a security recommended by a broker when the broker’s employer does not receive compensation in connection with the transaction. In other words, broker-dealers may not be liable for unsuitable recommendations made by its broker when the broker is “selling away” (i.e., when the broker recommends an investment that is not offered through the broker-dealer), even when the individual broker receives compensation.
Another significant piece of guidance provided in Regulatory Notice 12-55 deals with whether a broker has an ongoing duty to monitor after making a recommendation to hold a security or to maintain an investment strategy. In this regard, Regulatory Notice 12-55 provides:
It is important to emphasize, moreover, that the [suitability] rule’s focus is on whether the recommendation was suitable when it was made. (Emphasis added.)
Thus, a recommendation to hold a security, to maintain an investment strategy, or to implement an investment strategy – as with a recommendation to buy or sell securities – “normally would not create an ongoing duty to monitor and make subsequent recommendations.” The modifier “normally” arguably leaves room for application of the ongoing duty to monitor in certain circumstances, such as in fee-based accounts (i.e., where the broker receives a quarterly or annual fee for managing an account, instead of receiving commissions for each transaction) or where the broker affirmatively undertakes the duty to monitor a customer’s account. However, FINRA’s guidance unequivocally establishes that, under normal circumstances, a broker has no obligation to monitor the suitability of a security or an investment strategy after the purchase is made or the investment strategy is implemented, regardless of changes in the market or economic environment.
With respect to the term “investment strategy,” FINRA states that a recommendation to invest generally in “equity” or “fixed income” would not constitute an investment strategy, while a recommendation to invest in specific types of securities or a market sector would constitute an investment strategy, thus triggering the suitability obligation. Recommendations to customers to use a bond ladder, day trading, or margin trading also constitute the recommendation of an investment strategy.
When an investment strategy involves both a security and non-security investment (e.g., using a home equity loan to purchase securities), suitability obligations apply to a broker-dealer’s or broker’s recommendation. The trickier question is whether suitability obligations apply when the customer, independent of any broker or broker-dealer recommendation, decides either side of the security and non-security “investment strategy.” FINRA states that the suitability obligations do not not apply where, for example, a broker recommends a non-security investment (e.g., real estate) and the customer separately decides to liquidate securities to fund the purchase of non-security investment. Conversely, where the customer independently decides to purchase a non-security investment and then asks the broker what securities to sell to fund the non-security investment, the suitability rule would apply to the broker’s recommendation as to which securities to sell but would not apply to the decision to purchase the non-security investment.
In terms of supervision, when a broker recommends an investment strategy involving both a security and a non-security, the broker-dealer’s suitability obligations apply to the security component of the recommended investment strategy, but its suitability analysis also “must be informed by a general understanding of the business activity based on the information and considerations required by FINRA Rule 3270 [(Outside Business Activities of Registered Persons)].”