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FINRA CLARIFIES TERMS “INVESTMENT STRATEGY” AND “CUSTOMER” UNDER SUITABILITY RULE 2111

Last July 9th, FINRA’s updated suitability rule became effective. That rule, FINRA Rule 2111, had a number of terms that were far from clear. To assist them, FINRA issued Notice to Members (“NTM”) 12-25 in May 2012. Securities Law and Compliance covered this in depth in prior posts on June 24, 2012 (Eight Things You Need to Know about FINRA’s New Suitability Rule – 2111) and November 27, 2012 (Suitability Requirements Concerning Leveraged and Inverse Exchange-Traded Funds). Now, FINRA has issued NTM 12-55 in November 2012 to clear up additional terms defined in FINRA Rule 2111.

Who is a “Customer” Under FINRA Rule 2111?

The suitability rules only apply to customers. However, if a broker-dealer or registered representative makes a recommendation to a potential customer who later, in fact, becomes a customer then the suitability rule does apply. The suitability rule does not apply if the potential customer does not become a customer of the firm or representative. Indeed, even if the potential customer acts on the advice given, but not through the broker-dealer or registered representative and neither receives any compensation, then the suitability rule also does not apply.

What is an “Investment Strategy” under FINRA Rule 2111?

The more specific the recommendation as to securities or sectors, the more likely it is to be an “investment strategy.”While the term investment strategy is to be considered broadly under FINRA Rule 2111.03, it does not apply to recommendations in “equity” or “fixed income” securities or asset allocation plans based upon generally accepted investment theory. However, the following strategies are “investment strategies” subject to the rule:

1) “Dogs of the Dow”;
2) high dividend paying stocks; or
3) a particular market sector, i.e., health care, regardless of whether a particular security is mentioned.

Despite not Referring to a Particular Security, the Following Strategies are “Investment Strategies” under FINRA Rule 2111:

i) day trading;
ii) utilizing margin;
iii) constructing a bond ladder; and
iv) investing home equity in the securities markets.

The Elusive “Hold” Recommendation.

An explicit recommendation to hold a security or securities or to continue to utilize an investment strategy of the same is subject to the suitability rule, FINRA Rule 2111. Therefore, an implicit hold recommendation does not trigger FINRA Rule 2111. Perhaps FINRA will issue additional guidance on this seemingly vague and easy to argue distinction.

However, FINRA continued to explain that FINRA Rule 2111 is not meant to change the existing law that any recommendation of a security or maintaining an investment strategy does not normally create an ongoing duty to monitor that position, and that the suitability of a “hold” recommendation or investment strategy for that matter is judged when it is made.

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Eight Things You Need to Know about FINRA’s New Suitability Rule – 2111

 Securities Law and Compliance Blog

Upcoming Effective Date of FINRA’s Amended Suitability Rule

Back in 2011, FINRA announced its new Suitability Rule.  The effective date is approximately fifteen (15) days away on July 9, 2012.  Some highlights of the new rule are provided below:

Suitability under amended FINRA Rule 2111: 

1)      Like its predecessor, the suitability rule is applicable only to those transactions which are “recommended” by the broker-dealer (BD) or registered representative (“RR”);

2)      The representative and/or broker-dealer 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 to ascertain the customer’s investment profile;

3)      The new rule explicitly applies to investment strategies and hold recommendations involving a security or securities. FINRA defines “strategy” broadly.

4)      Expressly, the new rule delineates the following to information to be used in determining suitability: (i) age, (ii) investment experience, (iii) risk tolerance, (iv) liquidity needs, (v) investment time horizon, (vi) tax status; and (vii) investment objectives.

5)      The rule defines three types of suitability which must be understood and abided by:  (i) Reasonable product; (ii) Customer specific; and (iii) Numerical or quantitative suitability, i.e., that the number of recommended transactions is not excessive;

6)      Broker-dealers and registered representatives are allowed an exemption to its “Reasonable-basis” suitability obligation for the purposes of an institutional customer (defined under NASD Rule 3110 (c)(4)) when the BD or RR has basis to believe the customer is capable of evaluating investment risks independently, and when the institutional customer “affirmatively acknowledges that it is exercising independent judgment.”  Such an acknowledgment will not, however, release the firm from its other suitability obligations;

7)      Customer-specific and Quantitative-suitability are always applicable whether the client be to institutional or retail; and

8)      In determining whether a communication is a “recommendation” for purposes of the rule, FINRA considers the content, the context and presentation; the more tailored to a particular customer or customers, the more likely it is to be considered a recommendation by the broker-dealer or representative; A series of actions which may not be considered a recommendation individually may still amount to a recommendation when taken in the aggregate.

May Law, PC is a securities and commodities boutique firm that has a an extensive knowledge of FINRA related rules and assists registered broker-dealers (BDs) and associated persons (APs) in responding to FINRA investigations, disciplinary matters and routine “on the record” interviews (OTRs).  The firm also assists broker-dealers draft and revise compliance, supervisory manuals and written supervisory procedures. The firm’s website is located at www.maylawpc.net, and the main number is 847-675-1052. Andrew May has been practicing law for 16 years and can be contacted at amay@maylawpc.net.

© 2012 May Law, PC

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