[ by Howard Haykin ] In November 2010, FINRA's new suitability rule, FINRA 2111, was approved by the SEC, and scheduled to become effective in October 2011.  FINRA published Regulatory Notice 11-02 to introduce the new rule and explain its requirements.  FINRA also issued Regulatory Notice 11-25 to provide further guidance and to announce 7/9/12 as the new implementation date. On Friday, FINRA published Regulatory Notice 12-25 to provide, yet, additional guidance and to announce that the rule is still set to become effective on 7/9/12. FINRA Discussion of Specific Factors. New FINRA Rule 2111 requires, in part, that a broker-dealer or associated person “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 [firm] or associated person to ascertain the customer’s investment profile.” In general, FINRA’s new suitability rule retains the core features of the previous NASD suitability rule, NASD Rule 2310.  In addition, new Rule 2111 codifies several important interpretations of the predecessor rule and imposes a few new or modified obligations - e.g., the new codifies and clarifies the 3 main suitability obligations that previously had been discussed largely in case law:

• reasonable-basis suitability - a broker must perform reasonable diligence to understand the nature of the recommended security or investment strategy involving a security or securities, as well as the potential risks and rewards, and determine whether the recommendation is suitable for at least some investors based on that understanding);

• customer-specific suitability - a broker must have a reasonable basis to believe that a recommendation of a security or investment strategy involving a security or securities is suitable for the particular customer based on the  customer’s investment profile); and,

• quantitative suitability - a broker who has control over a customer account must have a reasonable basis to believe that a series of recommended securities transactions are not excessive.

The new rule also broadens the explicit list of customer-specific factors that firms and associated persons generally must attempt to obtain and analyze when making recommendations to customers.  The new rule adds to the explicit list of customer-specific factors from the predecessor rule: (i) customer’s age; (ii) investment experience; (iii) time horizon; (iv) liquidity needs; and, (v) risk tolerance. The list in the predecessor rule included, the following: (i) other investments; (ii) financial situation and needs; (iii) tax status; and, (iv) investment objectives.  These factors generally make up a customer’s investment profile. The new rule, moreover, imposes broader obligations ... on firms and associated persons re: recommendations of investment strategies involving a security or securities.  Not only does it now explicitly cover recommended investment strategies involving a security or securities, but it also states that the term "investment strategy" is to be interpreted "broadly" and includes recommendations to "hold" a security or securities. In addition, the new rule modifies the institutional-customer exemption by changing the definition of institutional customer and requiring an affirmative indication from the institutional customer of its intention to independently analyze the broker-dealer’s recommendations.  Finally, FINRA stated that firms generally may use a risk-based approach to documenting compliance with the rule. New Rules Retains Many Obligations From Predecessor Rule. FINRA notes that many of the obligations under the new rule are the same as those under the predecessor rule and related case law.  Existing guidance and interpretations re: suitability obligations continue to apply to the extent that they are not inconsistent with the new rule. In providing this new guidance, which uses questions and answers, FINRA appreciates that now 2 firms are exactly alike - having different business models; offering divergent services, products and investment strategies; and employing distinct approaches to complying with applicable regulatory requirements.  As a result, FINRA’s guidance is not intended to influence any firm’s choice of a particular business model or reasonable approach to ensuring compliance with suitability or other regulatory requirements. Suitability Questions and Answers. Firms’ recent questions re: Rule 2111 have focused on the following topics:  (i) obligation to act in a customer’s best interests; (ii) scope of the terms "recommendation," "customer" and "investment strategy"; (iii) use of a risk-based approach to documenting suitability; (iv) information-gathering requirements;  (v) reasonable-basis and quantitative suitability; and, (vi) the institutional-customer exemption. The questions addressed below are representative of the issues firms are attempting to resolve as they finalize their compliance strategies. FINRA emphasizes, however, that it previously addressed numerous issues during the rulemaking process and immediately after the SEC approved the rule.  Accordingly, FINRA encourages firms to review its responses to comments and RegNotes 11-02 and 11-25, which provide additional information regarding the rule’s requirements.

FINRA provides answers to 26 questions - C-I basically highlights the topics and their respective first question.  Use the links to RegNote 12-25 - provided above and below - to access the complete pronouncement.

Topic 1: Acting in a Customer’s Best Interests. Q1. Regulatory Notice 11-02 and a recent SEC staff study on investment adviser and broker-dealer sales-practice obligations cite cases holding that brokers’ recommendations must be consistent with their customers’ “best interests.”14 What does it mean to act in a customer’s best interests? Topic 2: Recommendation. Q2. The suitability rule applies only to recommended securities and investment strategies involving securities, but FINRA does not define the term “recommendation” other than to say that it is a facts and circumstances inquiry. What factors determine whether a recommendation has been made for purposes of the suitability rule? Topic 3: Customer. Q6. What constitutes a “customer” for purposes of the suitability rule? Topic 4: Investment Strategy. Q7. The new suitability rule requires that a recommended investment strategy involving a security or securities must be suitable. What is an “investment strategy” under the rule? Topic 5: Risk-Based Approach to Documenting Compliance With Suitability Obligations. Q12. For purposes of using a risk-based approach to documenting compliance with suitability obligations, what types of recommendations does FINRA generally consider complex or potentially risky? Topic 6: Information-Gathering Requirements. Q15. Does a broker-dealer have to seek to obtain all of the customer-specific factors listed in the new rule by the rule’s implementation date? Topic 7: Reasonable-Basis Suitability. Q22. Can a broker who does not understand the risks associated with a recommendation violate the reasonable-basis obligation even if the recommendation is suitable for some investors? Topic 8: Quantitative Suitability. Q23. Is the quantitative suitability obligation under the new rule any different from the excessive trading line of cases under the predecessor rule? Topic 9: Institutional-Customer Exemption. Q24. Some third-party vendors have created “Institutional Suitability Certificates” to facilitate firms’ compliance with the new institutional-customer exemption in Rule 2111(b). Has FINRA endorsed or approved any of these certificates? The final question is #26. FINRA Staff Contact. Direct your questions to James Wrona, VP and Assoc. General Counsel, at (202) 728-8270. For further details, and all the Q's & A's, go to:  [FINRA RegNote 12-25, May 2012].