New Effective Date: July 9, 2012
On May 18, 2011, FINRA announced in Regulatory Notice 11-25 that it is extending the implementation date for compliance with FINRA Rule 2090 (Know Your Customer) and FINRA Rule 2111 (Suitability). The new effective date is July 9, 2012. The notice may be found at: http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p123701.pdf.
This new date gives firms a nine-month extension to modify their procedures, implement policy changes, and educate associated persons to comply with the new rules. The original effective date was October 7, 2011. The provisions of FINRA Rule 2090 and Rule 2111 may be found at: Regulatory Notice 11-02, http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p122778.pdf.
New FINRA Guidance for Rule 2090 and Rule 2111
In addition to announcing a new effective date, Regulatory Notice 11-25 provides guidance to frequently asked questions about the new rules. However, note that existing guidance and interpretations of Rule 2090 and Rule 2111 continue to apply to the extent that they are not inconsistent with the new rules.
We previously described the provisions of FINRA Rule 2090 and Rule 2111 in Volume 1, Issue 13 of Structured Thoughts (available at: http://www.mofo.com/files/Uploads/Images/101004-Structured-Thoughts-Issue-13.pdf), as well as FINRA’s announcement of the original effective date of the rules in Volume 2, Issue 1 of Structured Thoughts (available at: http://www.mofo.com/files/Uploads/Images/110120-Structured-Thoughts.pdf). However, we repeat here some of the key provisions, in order to indicate how some of the new guidance applies.
Rule 2090 (Know Your Customer)
Rule 2090 requires firms to “use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer…”8 Essential facts are “those required to (a) effectively service the customer’s account, (b) act in accordance with any special handling instructions for the account, (c) understand the authority of each person acting on behalf of the customer, and (d) comply with applicable laws, regulations, and rules.”9
Regulatory Notice 11-25 clarifies that the obligation under subsection (c) to “understand the authority of each person acting on behalf of the customer” requires the firm to know both (a) the names of any authorized persons and (b) any limits on their authority that the customer establishes and communicates to the firm.10
Rule 2111 (Suitability)
Rule 2111 requires that a firm 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 member or associated person to ascertain the customer’s investment profile.”11
This profile includes, but is not limited to, “the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information that the customer may disclose to the member or associated person in connection with such recommendation.”12
The Customer’s Investment Profile
A firm must attempt to obtain and analyze relevant customer-specific information, but may use its own appropriate method or process to obtain it. Rule 2111 does not include explicit documentation requirements. In order to fulfill the general obligation to evidence compliance with FINRA rules, the firm may document suitability depending on the complexity, strategy, performance, and/or risks involved.13
- If a firm has not obtained all of the customer-specific information listed in Rule 2111 (age, investments, financial situation, tax status, investment objectives, investment experience, time horizon, liquidity needs, and risk tolerance, etc.), it must carefully consider whether it has sufficient understanding of the customer to properly evaluate suitability.14
- If a firm allows a customer to use different investment profiles or factors for different accounts, it cannot use factors from different accounts to justify a recommendation that is not appropriate for the account for which the recommendation is made.15
The term “strategy” is interpreted broadly. Rule 2111 would cover a recommended investment strategy regardless of whether the recommendation results in a securities transaction. The more complex and risky the strategy is, the more the firm using a risk-based approach should focus on the recommendation.16
Rule 2111 would also capture an explicit recommendation to hold a security or securities. However, a hold recommendation would not create an ongoing duty to monitor and make subsequent recommendations absent an agreement that might alter the normal broker-customer relationship.17
“Safe-Harbor” Provision in Supplementary Material
Rule 2111 exempts certain educational material as long as the material does not include a recommendation of a particular security or securities.18 However, the provision is limited in scope.
FINRA recommends that firms take a conservative approach when seeking to rely on Rule 2111 for strategy-related communications that are educational in nature, because any significant variation from the list in the provision (such as general and interactive financial and investment information, descriptive information about an employersponsored retirement or benefit plan, asset allocation models) is subject to regulatory scrutiny. However, it is important to note that the rule does not apply if a reasonable person would not view the communication as a recommendation. This means that the suitability rule covers the firm’s recommendation to a customer, but generally not a firm’s marketing brochure that explains risks and benefits without suggesting that the reader customer take action.
This safe harbor is likely to be relevant to offerings of structured products. For example, issuers and underwriters often distribute free writing prospectuses that describe products or strategies to customers. Given that the safe harbor is limited, issuers and underwriters should continue to review free writing prospectuses to ensure that they are not appearing to make a recommendation.
The reasonable-basis obligation provision has two main components. A broker must 1) perform reasonable diligence to understand the risks and rewards associated with the strategy and 2) determine whether the recommendation is suitable for at least some investors based on that understanding.19 A broker can violate reasonable-basis suitability if either of the two elements is missing. Therefore, even if a firm’s “product committee” has approved a product for sale after performing due diligence, an individual broker’s lack of understanding could still violate the reasonable-basis obligation.20