On February 13, 2007, NASD published a Notice to Members outlining special considerations for supervision of registered representatives who change firms. See “Supervision of Recommendations After a Registered Representative Changes Firms,” NTM 07-06 (Feb. 13, 2007).1 NASD recognized that registered persons who change firms may attempt to retain as much of their customer base and assets as possible. In certain instances, however, the new firm may lack a dealer or servicing agreement with the product provider. Thus, the representative may not be able to transfer certain investments for existing customers to the new firm. NASD posits that in those instances, the representative may be financially tempted to liquidate existing investments and replace them with similar investments that are available at his or her new firm. In this Notice to Members, NASD: (1) reaffirmed that such replacements may be made only after a full assessment of the suitability of the transaction; and (2) mandated that firms establish additional procedures to monitor investment recommendations relating to mutual funds and variable products that are made by newly associated representatives.

Suitability Review. NASD makes clear that all recommendations to replace existing mutual funds or variable products with similar investments must be suitable. A recommendation must be based solely on the customer’s investment needs and objectives. Recommendations may not be made simply for the purpose of obtaining compensation. When evaluating the suitability of a new representative’s recommendation to surrender or liquidate an existing mutual fund or variable product, the firm should consider several factors, including:

  • whether the customer’s current mutual fund or variable product is subject to a contingent deferred sales charge, surrender period or other features that materially affect its value or liquidity;
  • the fees, expenses and the new holding period associated with the new product; and
  • whether the firm lacks a dealer or servicing agreement with the product sponsor so that the registered representative will not be able to service the product at the new firm.

Supervisory Procedures. NASD mandated that firms institute additional supervisory procedures that specifically review and evaluate investment recommendations, such as liquidations, replacements and surrenders of mutual funds and variable products, that newly associated representatives make to their existing clients. NASD suggests that, at a minimum, the procedures should include the following:

  • specifically inquiring about the nature of a prospective representative’s business, i.e., whether the representative offers at his or her current firm investment products that the new firm would need a dealer or servicing agreement to offer;
  • determining whether the hiring firm will seek such agreements;
  • advising new customers of: (1) the firm’s unwillingness or inability (if any) to service existing products; and (2) the customers’ options for holding such investments at the previous firm. This advice must be given prior to any recommendation to liquidate such investments; and
  • reviewing recommended replacements for a reasonable period following the association of a new representative to ensure both that proper disclosures precede all liquidations and surrenders and that the replacements are suitable. NASD also noted that special supervisory considerations should be given to replacement annuity products that offer premium credits, or “bonuses,” toward the value of the variable annuity contract. NASD reaffirmed that firms should ensure that all fees, expenses and surrender charges of replacement products are disclosed to the clients. NASD also noted that “bonuses” may not be viewed or considered as an “offset” against other applicable fees or expenses.

NASD’s “special considerations” relating to supervision of recommendations when registered representatives change firms are basically a reaffirmation of the conventional principles of suitability. It is possible, however, that implementing these considerations in this context will require firms to create additional exception reports and documentation specific to the recommendations of new representatives. Furthermore, the requirement that firms inquire into the nature of a potential registered representative’s business may create certain difficulties, particularly in light of Regulation S-P’s restrictions on disclosure of non-public customer information to third parties.