As part of the process of developing a consolidated Rulebook, the Financial Industry Regulatory Authority (FINRA), in Regulatory Notice 11-02, advises broker-dealers the SEC has approved two new FINRA Rules concerning the obligation to “know your customer” and provide suitable investment recommendations. The Rules codify existing interpretations of NYSE Rule 405(1) and NASD Rule 2310, and will be effective October 7, 2011. The full notice is available here. The SEC’s approval order, detailing specific changes, is available here.
Know-your-customer obligations will be enforced through new FINRA Rule 2090, which is modeled after, but strengthens and clarifies, former NYSE Rule 405(1). Rule 2090 requires members to use “reasonable diligence” to learn the “essential facts” concerning every customer. “Essential facts” are defined as those required to (a) effectively service the account; (b) act in accordance with special handling instructions; (c) understand the authority of each person acting on behalf of the customer; and (d) comply with applicable laws, regulations and rules.
This obligation is ongoing, arising at the beginning of the broker-dealer’s relationship with the customer, and ending when the relationship ends. Recognizing the fluidity of the member-customer relationship, FINRA does not prescribe a specific time period for updating information, but reminds members that Securities Exchange Act Rule 17a-3 requires members to attempt to update account information every 36 months.
Suitability obligations will be enforced through new FINRA Rule 2111, which is modeled after, but strengthens and clarifies, former NASD Rule 2310. Rule 2111 requires FINRA members to “have a reasonable basis to believe that a recommended transaction or investment strategy . . . is suitable for the customer.” Members must determine suitability through “reasonable diligence” efforts to ascertain a customer’s investment profile. The “customer’s investment profile” includes, but is not limited to, the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, and risk tolerance.
Suitability obligations are triggered by a member’s “recommendation” of an investment. What constitutes a “recommendation” remains a question of the facts and circumstances of each particular case. FINRA provides some guidance, however, for determining whether a communication could be construed as a “recommendation.” First, a communication suggesting a customer take action or refrain from action regarding an investment could be considered a “recommendation.” Second, a communication individually tailored to particular customers about a specific investment could be considered a “recommendation.” Members will be held accountable for their “recommendations” regardless of whether a transaction occurs. FINRA expressly exempts educational materials, asset allocation models, and information regarding employer-sponsored retirement or benefit plans.
Rule 2111 also modifies the institutional-investor exemption by focusing on whether members have a reasonable basis to believe the institutional customer is capable of evaluating investment risks independently, and requiring the institutional investor to affirmatively indicate it is evaluating investment risks independently.