FINRA has proposed and encouraged comment on consolidated rules governing suitability and know-your-customer obligations. Proposed FINRA Rule 2111 is designed to replace current NASD Rule 2310 (suitability) and proposed FINRA Rule 2090 is designed to replace NYSE Rule 405 (knowyour- customer). See FINRA Notice 09-25 (May 15, 2009).
The proposed rules represent FINRA's latest efforts to create a Consolidated FINRA Rulebook. The comment period ends on June 29, 2009.
Proposed Rule 2111 would codify interpretations regarding the scope of the NASD suitability rule, clarifies the information to be gathered and used as part of a suitability analysis, and creates an exemption, subject to certain conditions, for recommended transactions involving institutional customers. Proposed Rule 2111 does not seek to consolidate or replace NASD Rule 2821, which governs recommendations of deferred variable annuities.
General Suitability Standard
Similar to NASD Rule 2310, Proposed Rule 2111 would apply only if the firm or associated person makes a recommendation of a transaction or investment strategy involving a security or securities. Also, Proposed Rule 2111 would codify in a single section the three main suitability obligations as expressed in Interpretive Memoranda following NASD Rule 2310: reasonable basis suitability, customer specific suitability and quantitative suitability.
Recommendations of Non-Securities Products
In what will likely invite further claims of unauthorized expansion of FINRA jurisdiction over sales of non-securities products, FINRA requested comment on application of Proposed Rule 2111 to all types of recommendations by FINRA member firms and their associated persons, regardless of whether the recommendations involve a security. FINRA stated as follows:
In light of the more expansive application of some FINRA rules, such as those addressing just and equitable principles of trade and communications with the public, and given the seamless nature of a broker-dealer's business in providing financial services, FINRA also seeks comment on whether it should propose expanding suitability obligations to all recommendations of investment products, services and strategies made in connection with a firm's business, regardless of whether the recommendations involve securities.
Proposed Rule 2111, as currently drafted in Notice 09-25, does not cover recommendations of non-securities products. This concept follows the debate associated with NASD Notice to Members 05-50 (Aug. 2005) about FINRA's jurisdiction to regulate recommendations by FINRA member firms and their associated persons of non-security insurance products (i.e., fixed indexed annuities). Since then, the SEC proposed and adopted Rule 151A under the Securities Act of 1933, which denies indexed annuities the statutory insurance exemption and requires indexed annuities to be registered as securities. Rule 151A is currently under challenge in the U.S. Court of Appeals for the D.C. Circuit.
FINRA's regulation of recommendations of non-security investment products could include various types of insurance products, for example, long-term care insurance, term insurance and fixed annuity contracts. It also could include banking products, charitable giving, and college savings programs to name a few others. How FINRA would regulate recommendations of non-securities products and to what end are open questions.
Information to be Obtained
Proposed Rule 2111 would require members or their associated persons to make reasonable efforts to obtain more information than currently enumerated in Rule 2310. In particular, Rule 2111(a) would call for consideration of:
a 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 the member or associated persons considers reasonable in making recommendations.
With regard to institutional customers, Proposed Rule 2111(b) would shorten the current suitability standards to three factors that, if present, would allow an associated person to satisfy his or her customer-specific suitability obligation to institutional customers. The factors ask whether:
- the institutional customer affirmatively indicates that it is willing to forego
- the protection of the customer-specific obligation of the suitability rule;
- the firm or associated person has a reasonable basis to believe that the institutional customer is capable of analyzing the risks of investments independently both in general and with regard to particular transactions and investment strategies involving a security or securities; and the firm or associated person has a reasonable basis to believe that the institutional customer is exercising independent judgment in evaluating the recommendations.
Notice 09-25 also proposes FINRA Rule 2090 (know-your-customer) to capture the "main ethical standard of NYSE Rule 405(1)." Proposed Rule 2090 would require every member to "use due diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer and concerning the authority of each person acting on behalf of such customer." The know-your-customer obligation would arise at the beginning of the relationship and would not depend on whether a recommendation is made.
FINRA Notice 09-25 is attached here.