In January 2011, FINRA announced that the SEC had approved FINRA’s proposed updated rules relating to suitability and brokers’ “know your customer” obligations. We previously described these provisions in Volume 1, Issue 13 of Structured Thoughts: http://www.mofo.com/files/Uploads/Images/101004-Structured-Thoughts-Issue-13.pdf.
Now that the SEC has approved them, these rules will become effective on October 7, 2011. FINRA’s summary of the new rules, together with their provisions, may be found at: http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p122778.pdf.
The final suitability rules, now set forth at Rule 2111, will implement a number of changes. Suitability determinations would apply to recommended investment strategies, and not only to recommendations relating to specific securities. There are three elements or components of suitability identified by the rule: reasonable basis suitability,1 customer specific suitability2 and quantitative suitability.3
Each of these suitability tests is likely to be relevant to a particular offering of structured products. For example, in considering quantitative suitability, the broker-dealer should make a determination that a series of transactions, when viewed together, would be suitable for the client. Recommendations as to offerings of structured notes could violate the quantitative suitability test if, for example, they caused an investor’s portfolio to be over-concentrated in a particular issuer’s common stock, or over-concentrated in the credit of a particular structured note issuer.
The list of items included as part of a retail investor’s profile would be expanded as part of new Rule 2111. These items will include age, other investments, financial situation and needs, tax status, investment objectives, investment experience and time horizon, liquidity needs and risk tolerance. The prior rule that Rule 2111 replaces listed a much smaller number of items.
The rule clarifies the means by which the customer suitability obligation may be discharged in respect of recommendations made to institutional accounts. This duty would be discharged if the broker-dealer has a reasonable basis to believe that the institutional customer is capable of evaluating investment risks independently (both in general and with respect to particular transactions and investment strategies) and the customer affirmatively indicates that it is exercising independent judgment in evaluating the recommendation. An “institutional account” would include an institutional investor with $50 million in assets under management.
We note that suitability and related concepts will be revisited following the completion of the SEC’s study on standards of care, which was mandated by the Dodd-Frank Act.