Defining the Scope of Terms, "Customer" and "Investment Strategy."

[ by Howard Haykin ]

FINRA Rule 2111, Suitability, was approved 2 years ago and it became effective this past summer (7/9/12).  Before it went effective in July 2012, FINRA issued a Q&A guidance in May 2012. [ Regulatory Notice 12-25 ], two issues remain troublesome for some broker-dealers - the scope of the terms “customer” and “investment strategy.” 

On Monday, 12/10, FINRA addressed those issues in newly released FINRA RegNote 12-55.   The RegNote also mentions that FINRA made available a new resource page for its members:  The Suitability Webpage on the FINRA Website.  FINRA will maintain on this one page, among other things, any and all questions and answers it issues re: FINRA Rule 2111.

[C-I Note:  It is our recommendation that C-I Members read the Endnotes while reading the main text of newly published RegNote 12-55. That is because there are 4 pages of Endnotes - which likely indicates the notes contain substantive information.  C-I did not refer to those footnotes upon our first reading, but will do so when we re-review the Notice.] 

FINRA Staff Contacts.   Direct questions to:  James Wrona, VP & Assoc. General Counsel - Office of General Counsel (OGC) - (202) 728-8270; or   Matthew Vitek, Ass't General Counsel - OGC - (202) 728-8156.

Discussion.   FINRA Rule 2111 requires, in part, that a broker-dealer ("BD") or registered representative ("RR") “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 customer’s investment profile.  In Regulatory Notice 12-25, FINRA addressed the scope of the terms “customer” and “investment strategy” in FAQ 6, 7 and 10. The answers to those questions are superseded by the answers provided below in this Notice.

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INVESTMENT STRATEGY.

Question 7 from Regulatory Notice 12-25 with a new answer

Q7. The new suitability rule requires that a recommended investment strategy involving a security or securities must be suitable. Can you provide some examples of what would and would not be considered an “investment strategy” under the rule?

A7. Rule 2111 states that the term “investment strategy” is to be interpreted “broadly.”  However, FINRA would not consider a BD'S or RR's recommendation that a customer generally invest in “equity” or “fixed income” securities to be an investment strategy covered by the rule, unless such a recommendation was part of an asset allocation plan not eligible for the safe-harbor provision in Rule 2111.03 (discussed in FAQ 8). The “investment strategy” language would apply to recommendations to customers to invest in more specific types of securities, such as high dividend companies or the “Dogs of the Dow,” or in a market sector, regardless of whether the recommendations identify particular securities. It also would apply to recommendations to customers generally to use a bond ladder, day trading, “liquefied home equity,”  or margin strategy involving securities, irrespective of whether the recommendations mention particular securities.

In addition, the term would capture an explicit recommendation to hold a security or securities or to continue to use an investment strategy involving a security or securities. The rule would apply, for example, when an RR meets (or otherwise communicates) with a customer during a quarterly or annual investment review and explicitly advises the customer not to sell any securities in or make any changes to the account or portfolio or to continue to use an investment strategy. However, as explained in FAQ 3, the rule would not cover an implicit recommendation to hold. 

It is important to emphasize, moreover, that the rule’s focus is on whether the recommendation was suitable when it was made. A recommendation to hold securities, maintain an investment strategy involving securities or use another investment strategy involving securities - as with a recommendation to purchase, sell or exchange securities - normally would not create an ongoing duty to monitor and make subsequent recommendations.

Question 10 from Regulatory Notice 12-25 is now 10(a) with a new answer.

Q10(a). Does the new rule’s “investment strategy” language cover an RR's recommendation involving both a security and a non-security investment?

A10(a). The new suitability rule would continue to cover a BD's or RR's recommendation of an “investment strategy” involving both a security and a non-security investment.  Suitability obligations apply, for example, to a BD's or RR'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. 

However, where a BD's or RR's recommendation does not refer to a security or securities, the suitability rule is not applicable.  The suitability rule would not apply, for instance, if an RR recommends 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.

Where a customer, absent a recommendation by an RR, decides on his or her own to purchase a non-security investment and then asks the RR to recommend which securities he or she should sell to fund the purchase of the non-security investment, the suitability rule would apply to the RR's recommendation regarding which securities to sell but not to the customer’s decision to purchase the non-security investment.

New question and answer 10(b)

Q10(b). What are a BD's supervisory responsibilities for an RR's recommendation of an investment strategy involving both a security and a non-security investment?

A10(b). FINRA’s supervision rules do not dictate the exact manner in which a BD must supervise its RRs' recommendations of investment strategies involving a security and a non-security investment. A BD's supervisory system must be reasonably designed to achieve compliance with applicable securities laws, regulations and FINRA rules.  The reasonableness of a supervisory system will depend on the facts and circumstances.  As FINRA has stated previously, “FINRA appreciates that no two [BD's] are exactly alike. [BD's] have different business models; offer divergent services, products and investment strategies; and employ distinct approaches to complying with applicable regulatory requirements.” A BD can consider a variety of approaches to identifying and supervising its RRs' recommendations of investment strategies involving both a security and a nonsecurity component.

A BD may use a risk-based approach to supervising its RRs' recommendations of investment strategies with both a security and non-security component. For instance, as long as the supervisory system is reasonably designed to achieve compliance with applicable securities laws, regulations and FINRA rules, a firm could focus on the detection, investigation and follow-up of “red flags” indicating that an RR may have recommended an unsuitable investment strategy with both a security and non-security component.  An RR's recommendation that a customer with limited means purchase a large position in a security might raise a “red flag” regarding the source of funds for such a purchase. Similarly, an RR's recommendation that a “buy and hold” customer with an investment objective of income liquidate large positions in blue chip stocks paying regular dividends might raise a “red flag” regarding whether that recommendation is part of a broader investment strategy.  Once a BD identifies a recommended investment strategy involving both a security and a non-security investment, the BD's suitability obligations apply to the security component of the recommended strategy but its suitability analysis also must be informed by a general understanding of the non-security component of the recommended investment strategy. In the context of a recommended investment strategy involving a security  and an outside business activity, the BD's general understanding of the outside business activity would be based on the information and considerations required by FINRA Rule 3270.26.

Finally, BDs must keep in mind that, in addition to suitability and supervisory responsibilities, firms have other regulatory obligations to investigate unusual activity.

For further details, go to:   [FINRA RegNote 12-55, December 2012], [FINRA RegNote 12-25, May 2012 ]   and    [ FINRA Suitability Page].