With a little over one year of experience in applying its new suitability rule to broker-dealers, FINRA has declared the rule – FINRA Rule 2111 – a fairly successful work in progress. Indeed, according to its recently released Regulatory Notice,1 while FINRA’s examiners have issued Letters of Caution to certain members regarding the adequacy of their supervisory procedures with respect to suitability, examiners have not yet made any referrals to the Department of Enforcement related to the new areas covered by FINRA Rule 2111. Nevertheless, FINRA believes there is room for improvement in broker-dealers’ implementation of compliance procedures regarding the new rule, so it issued Regulatory Notice 13-31 on September 26, 2013 in an effort to provide guidance based upon some of the practices it has observed during the course of recent examinations. This FINAlert summarizes the key points for broker-dealers to consider from that Regulatory Notice.
How FINRA Rule 2111 Differs from the Prior Suitability Rule
In addition to requiring the collection of additional information during the account opening process, FINRA Rule 2111 expands the scope of the prior suitability rule by specifying three separate types of suitability obligations: (i) reasonable-basis suitability; (ii) customer-specific suitability; and (iii) quantitative suitability. Reasonable-basis suitability requires firms to perform due diligence to determine that the products they plan to sell are suitable for at least some of their customers. Customer-specific suitability requires firms to determine that the products they sell to a customer are consistent with the investment profile and objectives of that particular customer. Quantitative suitability requires brokers who make recommendations for an account, or who have discretionary authority over an account, to be able to justify the amount of trading in the account in order to guard against churning.
FINRA Rule 2111 expands the reach of the suitability requirement to cover investment strategies. Importantly, this means that hold recommendations are subject to a suitability analysis, including recommendations not to sell securities that were purchased elsewhere and then transferred into the account. FINRA also takes the view that the suitability rule extends to the non-security elements of an investment strategy, such as investing in an outside business or liquidating securities in order to make non-security investments. Thus, firms need to take a broad view of suitability in order to ensure compliance with FINRA Rule 2111.
Recognizing that certain institutional investors may be more sophisticated and savvy than retail customers with respect to making their own investment decisions and may not rely on their brokers for analysis and recommendations, FINRA Rule 2111 has an institutional customer "opt out" provision. This provision gives institutional customers the choice of confirming their own ability to exercise judgment as to the risks of a security thereby, removing that obligation from the broker-dealer. Firms must maintain documentation demonstrating an institutional customer’s decision to "opt out" of the protections of the suitability rule.
Examination Approach Regarding Suitability
The Regulatory Notice contains a thorough inventory of the types of questions asked during this year’s examination program to determine whether firms had implemented appropriate changes in their procedures, processes, exception reports, and training to adhere to the requirements of the new suitability rule. Firms that have not been examined since FINRA Rule 2111 went into effect in July 2012 should carefully review the Regulatory Notice so they can prepare for the suitability questions the examiners are likely to ask. Examples of some newer areas of inquiry are:
- The way the firm identifies and supervises accounts using strategies, or accounts with concentrations of particular types of securities, that may not align with the customer’s investment profile.
- The manner in which the firm supervises explicit hold recommendations, including the method of documenting such recommendations, as well as the information the firm considers in conducting the review.
- The tools (e.g., exception reports) firms use to identify in-and-out trading, high turnover rates and commission-equity ratios.
- How the firm determines and documents whether customers meet the definition of "institutional account" and are capable of evaluating investment risks independently.
- The protocols the firm uses to obtain an affirmative acknowledgement that an institutional customer is exercising independent judgment in evaluating the firm’s or associated person’s recommendations.2
FINRA explained in the Regulatory Notice that the firms it has examined for compliance with the new suitability rule have generally had updated policies, procedures and systems, had collected the necessary new customer information, and had trained their staffs on the new requirements. The most frequently found deficiency was inadequate procedures for supervising and documenting the hold recommendations now subject to suitability review. However, only findings that would have been violations under the prior suitability rule were referred to Enforcement.
- Practices FINRA Considers Laudable
The Regulatory Notice summarizes various practices that FINRA examiners have observed and believe broker-dealers should consider incorporating into their suitability compliance programs. As with other regulatory notices that highlight effective practices, firms generally interpret this guidance as minimum standards that FINRA will expect to see from its members.
For reasonable-basis suitability, the Regulatory Notice describes a vetting process by committee to evaluate new products, and having training programs as well as posting due diligence materials on an intranet site to further ensure that relevant personnel understand the nature of the products being sold.
For customer-specific suitability, the Regulatory Notice describes how firms have adopted new technology and forms to capture the expanded list of customer data needed to open an account, and also to update information on pre-existing customers and prohibiting trading in certain products unless customers provide the new information. The Regulatory Notice also highlights the practice of flagging "vulnerable" customers when evaluating their profile information so that these customers are noted internally as posing a serious suitability risk by not having appropriate education and disclosures.
For quantitative suitability, the Regulatory Notice describes how firms should assess their compensation arrangements to determine whether they provide inappropriate incentives for their brokers to make recommendations to customers that may result in excessive trading.
- Institutional Account Exemption
With respect to the new suitability rule’s institutional customer "opt out" provision, FINRA expects firms to have written documentation acknowledging an institutional customer’s decision to opt out, a document summarizing a conversation in which the institutional customer agreed to opt out, or a vendor form filled out by the customer (which has become a wide-spread practice in the wake of the enactment of FINRA Rule 2111). Institutional customers are not obliged to opt out of suitability coverage, and they may determine to opt out on a trade-by-trade basis rather than in an across-the-board manner. Broker-dealers, however, may have a policy that disallows institutional customer business if they choose not to opt out of the suitability requirements. Institutional investors who choose not to opt out may have to select another firm if their current firm refuses to take on the broader suitability obligations under the new rule.
- Hold Recommendations
One area singled out by FINRA as still needing enhanced compliance practices is hold recommendations. The Regulatory Notice describes how some firms use a hold ticket or generate other internal documentation so as to have a contemporaneous record of when such a recommendation was made. Firms should consider reviewing hold recommendations in their internal branch office inspections in order to evaluate compliance with the new suitability rule.
Not surprisingly, at the core of the new suitability rule is a member firm’s obligation to supervise its sales force by having the controls, procedures, training, and monitoring in place to ensure compliance with FINRA Rule 2111’s many requirements. FINRA encourages firms to look for red flags that might indicate a misalignment of recommendations and customer profiles, and to review those situations for possible unsuitable recommendations. Broker-dealers should carefully assess FINRA’s guidance in the Regulatory Notice and evaluate how their own compliance procedures and monitoring tools compare – especially with respect to the areas described above – so as to be well prepared for the suitability component of their next FINRA examination.