On May 18, 2011, FINRA issued Regulatory Notice 11-25, which provides further guidance on new consolidated consolidated FINRA rules governing Know Your Customer (Rule 2090) and Suitability (Rule 2111) and extending the implementation date to July 9, 2012 (previously, October 7, 2011).
FINRA Rule 2090 (Know Your Customer) requires firms to “use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer….” The rule explains that essential facts are “those required to (a) effectively service the customer’s account, (b) act in accordance with any special handling instructions for the account, (c) understand the authority of each person acting on behalf of the customer, and (d) comply with applicable laws, regulations, and rules.”
FINRA Rule 2111 (Suitability) requires that a firm or associated person “have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile.
Discussion and Guidance
FINRA provided guidance on the following:
Know Your Customer
Authority of Person Acting on Behalf of the Customer – firms need to know: (1) names of persons authorized to act and (2) any limits on their authority. (FINRA notes that firms may decide to limit business to persons without limited scope of authority).
Customer’s Investment Profile
Updating Documentation – firms are not required to update all customer account documentation, and does not contain any explicit documentation requirements, but allows firms to take a risk-based approach with respect to documenting suitability determinations.” The suitability rule applies to recommendations, but the extent to which a firm needs to evidence suitability generally depends on the complexity of the security or strategy in structure and performance and/or the risks involved. However, firms must keep in mind that when suitability is not evident from the recommendation itself, lack of documentation may create examination and enforcement issues.
As a reminder, Rule 2111 adds additional, specific factors to consider in making suitability determinations prior to any recommendation, including 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 customer may disclose to the member or associated person in connection with such recommendation ((old rule only included financial status, tax status, and investment objectives).
Lack of Certain Customer-Specific Information – absence of some customer information that is not material under the circumstances generally should not affect a firm’s ability to make a recommendation. To meet its suitability obligations, a firm must obtain and analyze enough customer information to have a reasonable basis to believe the recommendation is suitable. The significance of specific types of customer information generally will depend on the facts and circumstances of the particular case, including the nature and characteristics of the product or strategy at issue. Firms should document the rationale for factors not requiring analysis.
Guidance on Terms:
- Liquidity Needs: extent of customer’s desired ability or financial obligations that dictate the need to quickly and easily convert to cash all or a portion of an investment or investments without experiencing significant loss in value
- Time Horizon: expected number of months, years, or decades of planned customer investment to achieve a particular financial goal
- Risk Tolerance: ability and willingness to lose some or all of the original investment in exchange for greater potential returns.
Different Investment Profiles on Separate Accounts – possible, but firm should evidence customer’s intent and must not allow factors from other accounts to justify recommendations
Terminology – specific terminology is not required when seeking relevant information
Scope of Term “Strategy” – interpreted broadly, including recommendations that: (i) do not result in a securities transaction, (ii) do not reference a specific security, (iii) explicit recommendation to hold a security regardless of involvement in original purchase (but not an implicit one)
Firm Approval Does Not Mean Suitable for Particular Customer – Even if a firm’s product committee has approved a product for sale, an individual broker’s lack of understanding of a recommended product or strategy could violate the obligation. Reasonable-basis suitability has two main components: a broker must (1) perform reasonable diligence to understand the potential risks and rewards associated with a recommended security or strategy and (2) determine whether the recommendation is suitable for at least some investors based on that understanding. A broker can violate reasonable-basis suitability under either prong of the test. Firms should educate its associated persons on the potential risks and rewards of the products that the firm permits them to recommend.
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