In November of 2010, the SEC approved a new suitability rule developed by FINRA as part of the ongoing comprehensive reform of the financial regulatory system. FINRA, the New York based self-regulatory organization (“SRO”), issued guidance on the new rule in May 2012, and the rule went into effect on July 9, 2012.
In general, the rule requires brokers to perform reasonable diligence on products, understand those investments and have a reasonable basis to believe that a security or investment strategy is suitable for the customer based on the customer’s profile. In addition, the rule adds age, investment experience, time horizon, liquidity needs and risk tolerance to the list of factors that affect a suitability determination.
When the rule hit the financial industry, it sent some broker-dealers all a’ twitter, literally. The suitability rule is the closest that FINRA has come to codifying a fiduciary duty of broker-dealers to oversee the accounts of their customers. This came as a surprise to the financial industry given that, presently, the SEC is developing a fiduciary standard under the Dodd-Frank Act. In addition to concerns about new duties, broker-dealers were concerned about the suitability obligations that the rule imposes on investment strategies.
In response to the implementation of the suitability rule, some reputable financial firms in the financial industry expressed frustration with FINRA’s broad interpretation of particular terms within the rule. They argued that broadly defined terms such as “customer,” “potential investor” and “investment strategy” would cause confusion in broker-dealer training. Further, broker-dealers complained that without an objective standard, unlike the rather subjective “best interests” standard of care for customers provided in FINRA’s guidance, it would be nearly impossible to measure compliance internally.
In response to the rising tide of complaints from the financial industry, FINRA issued Notice 12-55, a clarification of the suitability rule, in December 2012. In the clarification, FINRA defined “customer” as excluding broker-dealers and registered representatives. Moreover, the definition of customer was given as a person who opens a brokerage account at a broker-dealer or purchases a security for which the broker-dealer receives or will receive compensation.
This particular clarification allays the “cocktail rule” concern in which a company’s compliance system would need to account for recommendations made to an attendee at a cocktail party. FINRA elucidated that in the case of the “potential investor” the rule would apply to a broker-dealer or registered representative only if the potential investor becomes a customer of the broker-dealer who made the recommendation and the broker-dealer is compensated for the transaction.
In Notice 12-55, FINRA addressed the question of what constitutes an “investment strategy” under the suitability rule. (The suitability rule provides that, when making a recommendation, a broker-dealer must have a reasonable basis to believe that a security or investment strategy was suitable for the customer at the time that it was recommended.) The new guidance provides that a general recommendation to a customer to invest in either equity or fixed income does not constitute an investment strategy.
FINRA refined the definition for the purpose of the suitability rule to encompass recommendations to customers to invest in more specific types of securities, such as high dividend companies, regardless of whether the recommendations identify particular securities. Moreover, it refers to recommendations “to use a bond ladder, day trading, ‘liquefied home equity,’ or margin strategy involving securities, irrespective of whether the recommendations mention particular securities.”
Under the new rule, the term would capture an explicit recommendation to hold a security or to continue to use an investment strategy involving a security or non-security. However, there is a carve-out in the investment strategy language: if the broker-dealer or registered representative recommends investment in only non-security products, then the suitability rule does not apply. But if the broker-dealer recommends to the customer to liquidate securities in order to purchase non-securities, then the suitability rule would apply only to the broker-dealer’s recommendation to sell the securities.
Lastly, in regard to the supervisory role, a broker-dealer must play over its registered representatives. Aside from establishing a standard of “reasonableness” FINRA declined to outline a specific diligence and compliance system. Rather, FINRA placed the obligation of knowing the products, knowing the customers, and spotting red flags, as well as the burden of designing a system, squarely on the shoulders of the broker-dealers. In addition, FINRA highlighted the fact that under the current the regulatory scheme, broker-dealers have obligations to investigate unusual activity.
Overall, with the suitability rule FINRA appears to have achieved the ability to regulate broker-dealers more broadly and to provide transparency, albeit limited, on non-security transactions. The clarifications of the suitability rule are likely a welcome sigh of relief for many broker-dealers and a small concession from regulators.