New FINRA rules covering know-your-customer and suitability obligations will become effective in FINRA's consolidated rulebook on 10/7/11 - FINRA Rule 2090, Know Your Customer, and FINRA Rule 2111, Suitability.  The new rules retain the core features of these important obligations and at the same time strengthen, stream-line and clarify them - as discussed below. 

[C-I Note:  Firms - consider implementing the new reqs now, before they "become law."  Be ahead of the Regulators.  Be Prepared.]

FINRA Contacts.   James S. Wrona, Office of General Counsel, at (202) 728-8270.  For a complete read, click onto:   [FINRA RegNote 11-2, January].

    Know Your Customer, Rule 2090.   In general, the rule's modeled after former NYSE Rule 405(1) and requires firms to use “reasonable diligence," in regard to the opening and maintenance of every account, to know the “essential facts” concerning every customer. "Essential facts" are "those required to:  (a) effectively service customer’s account;  (b) act in accordance with any special handling instructions for account;  (c) understand the authority of each person acting on behalf of customer;  (d) comply with applicable laws, regulations, and rules."

The KYC obligation arises at the beginning of the customer-broker relationship and doesn't depend on whether the broker has made a recommendation.  Unlike former NYSE Rule 405, the new rule does not specifically address orders, supervision or account opening - areas that are explicitly covered by other rules. 

Suitability, Rule 2111.   In general, the rule's modeled after former NASD Rule 2310, Suitability, and requires that a firm or associated person ("AP") "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 AP to ascertain the customer’s investment profile."  The rule ID's various factors to be considered - e.g., age, tax status, investment time horizon. 

An RR's "recommendation" continues to serve as the triggering event for application of the rule and continues to apply a flexible “facts and circumstances” approach to determining what communications constitute such a recommendation.  The new rule also applies to recommended investment strategies, clarifies the types of information that brokers must attempt to obtain and analyze, and discusses the 3 main suitability obligations. Finally, the new rule modifies the institutional-investor exemption in a number of important ways.

Recommendations.   FINRA reiterates that several guiding principles are relevant to determining whether a particular communication could be viewed as a recommendation for purposes of the suitability rule - e.g., a communication’s content, context and presentation. 

The determination, moreover, is an objective rather than subjective inquiry.  An important factor is whether - given its content, context and manner of presentation - a particular communication from a firm or AP to a customer reasonably would be viewed as a suggestion that the customer take action or refrain from taking action re: a security or investment strategy. 

The more individually tailored the communication is to particular customer(s) or about a specific security or investment strategy, the more likely the communication will be viewed as a recommendation.  A series of actions that may not constitute recommendations when viewed individually, however, may amount to a recommendation when considered in the aggregate. More considerations in the RegNote. 

Strategies.   The new rule explicitly applies to recommended investment strategies involving a security or securities, and it emphasizes that the term “strategy” should be interpreted broadly.  The rule's triggered when a firm or AP recommends a security or strategy regardless of whether the recommendation results in a transaction.

Among other things, the term “strategy” would capture a broker’s explicit recommendation to hold a security or securities. The rule recognizes that customers may rely on firms’ and APs’ investment expertise and knowledge, and it's thus appropriate to hold firms and AP responsible for the recommendations that they make to customers, regardless of whether those recommendations result in transactions or generate transaction-based compensation.

FINRA, however, exempted from the new rule’s coverage certain categories of educational material - which the strategy language otherwise would cover - as long as such material doesn't include (standing alone or in combination with other communications) a recommendation of a particular security or securities.  FINRA believes it's important to encourage firms and APs to freely provide educational material and services to customers.

Customer’s Investment Profile.   There's an expanded list of explicit types of information that firms and APs must attempt to gather and analyze as part of a suitability analysis.  The new rule essentially adds age, investment experience, time horizon, liquidity needs and risk tolerance to the existing list (other holdings, financial situation and needs, tax status and investment objectives). 

Recognizing that not every factor regarding a “customer’s investment profile” will be relevant to every recommendation, the rule provides flexibility concerning the type of information that firms must seek to obtain and analyze.  However, because the listed factors generally are relevant (and often crucial) to a suitability analysis, the rule requires firms and APs to document with specificity their reasonable basis for believing that a factor is not relevant in order to be  relieved of the obligation to seek to obtain information about that factor.

Main Suitability Obligations.  The new suitability rule lists in one place the 3 main suitability obligations:  (i) reasonable basis;  (ii) customer-specific;  and, (iii) quantitative suitability.

Reasonable-basis suitability requires an RR to have a reasonable basis to 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 firm’s or AP's familiarity with the security or investment strategy.  A firm’s or AP's reasonable diligence must provide the firm or associated person with an understanding of the potential risks and rewards associated with the recommended security or strategy.

Customer-specific suitability requires that an RR have a reasonable basis to believe that the recommendation is suitable for a particular customer based on that customer’s investment profile.

Quantitative suitability requires an RR 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, are not excessive and unsuitable for the customer when taken together in light of the customer’s investment profile.  Factors to consider:  turnover rate;  cost-equity ratio;  use of in-and-out trading in a customer’s account may provide a basis for finding that the activity at issue was excessive.

Institutional-Investor Exemption.  Rule 2111(b) provides an exemption to customer-specific suitability for recommendations to institutional customers under certain circumstances. The new exemption harmonizes the definition of institutional customer in the suitability rule with the more common definition of “institutional account” in NASD Rule 3110(c)(4).23. 

Beyond the definitional requirements, the exemption’s main focus is whether the broker
has a reasonable basis to believe the customer is capable of evaluating investment risks
independently, both in general and with regard to particular transactions and investment
strategies,24 and whether the institutional customer affirmatively acknowledges that it is
exercising independent judgment.

In regard to an institutional investor, a firm that satisfies the conditions of the exemption fulfils its customer-specific obligation, but not its reasonable-basis and quantitative obligations under the suitability rule.  FINRA believes that, even when institutional customers are involved, it is crucial that brokers understand the securities they recommend and that those securities are appropriate for at least some investors. FINRA also believes that it is important that a firm not recommend an unsuitable number of  transactions in those circumstances where it has control over the account. FINRA emphasizes, however, that quantitative suitability generally would apply only with regard to that portion of an institutional customer’s portfolio that the firm controls and only with regard to the firm’s recommended transactions.