On December 10, 2012, FINRA issued Regulatory Notice 12-55, in which FINRA expanded on its earlier suitability guidance, in Regulatory Notice 12-25, of the terms “customer” and “investment strategy”, as used in FINRA Rule 2111. FINRA also provided a link to its new “suitability Web page”, containing questions and answers about FINRA Rule 2111.
Regulatory Notice 12-55 can be found at:
The suitability web page can be found at:
The updated guidance is relevant to sales practices in the structured products industry.5
Definition of “Customer” as it Relates to Potential Investors
FINRA clarified that the suitability rule applies to a potential investor who then becomes a customer, and the point at which suitability obligations attach. The rule applies where a registered representative makes a recommendation to purchase a security to a potential investor if that individual executes the transaction through the broker-dealer with which the representative is associated or the broker-dealer will receive, directly or indirectly, compensation as a result of the recommended transaction. The suitability obligation would not apply, however, if the potential investor does not act on the recommendation or executes the recommended transaction away from the broker-dealer with which the registered representative is associated without the broker-dealer receiving compensation for the transaction.
FINRA noted that, with respect to a recommendation made to a potential investor, suitability obligations attach when the transaction occurs, but the suitability of the recommendation is evaluated based on circumstances that existed at the time that the recommendation was made. When a broker-dealer or registered representative makes a recommendation to a customer (as opposed to a potential investor), suitability obligations attach at the time that the recommendation is made, irrespective of whether a transaction occurs.
FINRA expanded on its examples of what would or would not be considered an “investment strategy”. Recommended investment strategies must be suitable. Recommendations of some specific types of securities, such as high dividend companies or types of securities in a particular market sector would constitute an investment strategy, regardless of whether the recommendation identified particular securities. The notice does not indicate whether recommending “structured notes” generally is sufficiently specific to constitute an investment strategy.6
Recommendations that do not refer to a security or securities do not fall under the suitability rule. For example, the rule would not apply to a registered representative’s recommendation of a non-security investment as part of a customer’s outside business activity, where that customer separately decides on its own to liquidate securities positions and apply the proceeds toward the recommended non-security investment. In contrast, if a customer, absent a recommendation by a registered representative, decides on its own to purchase a non-security investment and then asks the registered representative to recommend which securities the customer should sell to fund the purchase of the non-security investment, the suitability rule would apply to the recommendation regarding which securities to sell, but not to the customer’s decision to purchase the non-security investment.
The notice raises the question about a broker-dealer’s supervisory responsibilities for a registered representative’s recommendation of an investment strategy involving a security and a non-security investment. While stating that its supervisory rules do not provide an exact method, the notice indicated that a broker-dealer could use a risk-based approach. A firm could focus on the detection, investigation and follow-up of “red flags” indicating that a recommendation may have been made for an unsuitable investment strategy with both a security and a non-security component. The suitability obligations would apply to the security component of the recommended investment strategy, but the suitability analysis must also be informed by a general understanding of the non-security component of the recommended investment strategy. These concerns would apply to an investment strategy that involves structured certificates of deposits, even though they are typically not “securities”, and other structured products. FINRA reminded broker-dealers of their other regulatory obligations to investigate unusual activity.