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11-02 SEC Approves Consolidated FINRA Rules Governing Know-Your-Customer and Suitability Obligations; Effective Date: October 7, 2011
Know Your Customer and Suitability
Consolidated FINRA Rulebook
Referenced Rules & Notices
FINRA Rule 2090
FINRA Rule 2111
Information Notice 3/12/08
NASD Rule 2310
NASD Rule 3110
NYSE Rule 405
SEA Rule 17a-3
Know Your Customer
The SEC approved FINRA's proposal to adopt rules governing know-your-customer and suitability obligations1 for the consolidated FINRA rulebook.2 The new rules are based in part on and replace provisions in the NASD and NYSE rules.
The text of the new rules is set forth in Attachment A. The rules take effect on October 7, 2011.
Questions regarding this Notice should be directed to James S. Wrona, Associate Vice President and Associate General Counsel, Office of General Counsel, at (202) 728-8270.
The know-your-customer and suitability obligations are critical to ensuring investor protection and promoting fair dealing with customers and ethical sales practices. As part of the process of developing the consolidated FINRA rulebook, FINRA proposed and the SEC approved FINRA Rule 2090 (Know Your Customer) and FINRA Rule 2111 (Suitability). The new rules retain the core features of these important obligations and at the same time strengthen, streamline and clarify them.3 The new rules are discussed separately below.
Know Your Customer
In general, new FINRA Rule 2090 (Know Your Customer) is modeled after former NYSE Rule 405(1) and requires firms to use "reasonable diligence,"4 in regard to the opening and maintenance5 of every account, to know the "essential facts" concerning every customer.6 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."7 The know-your-customer obligation arises at the beginning of the customer-broker relationship and does not depend on whether the broker has made a recommendation. Unlike former NYSE Rule 405, the new rule does not specifically address orders, supervision or account opening—areas that are explicitly covered by other rules.
New FINRA Rule 2111 generally is modeled after former NASD Rule 2310 (Suitability) and 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."8 The rule further explains that a "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, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation."9
The new rule continues to use a broker's "recommendation" as the triggering event for application of the rule and continues to apply a flexible "facts and circumstances" approach to determining what communications constitute such a recommendation. The new rule also applies to recommended investment strategies, clarifies the types of information that brokers must attempt to obtain and analyze, and discusses the three main suitability obligations. Finally, the new rule modifies the institutional-investor exemption in a number of important ways.
The determination of the existence of a recommendation has always been based on the facts and circumstances of the particular case.10 That remains true under the new rule. FINRA reiterates, however, that several guiding principles are relevant to determining whether a particular communication could be viewed as a recommendation for purposes of the suitability rule.
For instance, a communication's content, context and presentation are important aspects of the inquiry. The determination of whether a "recommendation" has been made, moreover, is an objective rather than subjective inquiry.11 An important factor in this regard is whether-given its content, context and manner of presentation-a particular communication from a firm or associated person to a customer reasonably would be viewed as a suggestion that the customer take action or refrain from taking action regarding a security or investment strategy. In addition, the more individually tailored the communication is to a particular customer or customers about a specific security or investment strategy, the more likely the communication will be viewed as a recommendation. Furthermore, a series of actions that may not constitute recommendations when viewed individually may amount to a recommendation when considered in the aggregate. It also makes no difference whether the communication was initiated by a person or a computer software program. These guiding principles, together with numerous litigated decisions and the facts and circumstances of any particular case, inform the determination of whether the communication is a recommendation for purposes of FINRA's suitability rule.
The new rule explicitly applies to recommended investment strategies involving a security or securities.12 The rule emphasizes that the term "strategy" should be interpreted broadly.13 The rule is triggered when a firm or associated person recommends a security or strategy regardless of whether the recommendation results in a transaction. Among other things, the term "strategy" would capture a broker's explicit recommendation to hold a security or securities.14 The rule recognizes that customers may rely on firms' and associated persons' investment expertise and knowledge, and it is thus appropriate to hold firms and associated persons responsible for the recommendations that they make to customers, regardless of whether those recommendations result in transactions or generate transaction-based compensation.
FINRA, however, exempted from the new rule's coverage certain categories of educational material—which the strategy language otherwise would cover—as long as such material does not include (standing alone or in combination with other communications) a recommendation of a particular security or securities.15 FINRA believes that it is important to encourage firms and associated persons to freely provide educational material and services to customers.
Customer's Investment Profile
The new rule includes an expanded list of explicit types of information that firms and associated persons must attempt to gather and analyze as part of a suitability analysis. The new rule essentially adds age, investment experience, time horizon, liquidity needs and risk tolerance16 to the existing list (other holdings, financial situation and needs, tax status and investment objectives).17 Recognizing that not every factor regarding a "customer's investment profile" will be relevant to every recommendation, the rule provides flexibility concerning the type of information that firms must seek to obtain and analyze.18 However, because the listed factors generally are relevant (and often crucial) to a suitability analysis, the rule requires firms and associated persons to document with specificity their reasonable basis for believing that a factor is not relevant in order to be relieved of the obligation to seek to obtain information about that factor.19
Main Suitability Obligations
The new suitability rule lists in one place the three main suitability obligations: reasonable-basis, customer-specific and quantitative suitability.20
The new rule makes clear that a broker must have a firm understanding of both the product and the customer.21 It also makes clear that the lack of such an understanding itself violates the suitability rule.22
FINRA Rule 2111(b) provides an exemption to customer-specific suitability for recommendations to institutional customers under certain circumstances. The new exemption harmonizes the definition of institutional customer in the suitability rule with the more common definition of "institutional account" in NASD Rule 3110(c)(4).23 Beyond the definitional requirements, the exemption's main focus is whether the broker has a reasonable basis to believe the customer is capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies,24 and whether the institutional customer affirmatively acknowledges that it is exercising independent judgment.25
In regard to an institutional investor, a firm that satisfies the conditions of the exemption fulfils its customer-specific obligation,26 but not its reasonable-basis and quantitative obligations under the suitability rule. FINRA believes that, even when institutional customers are involved, it is crucial that brokers understand the securities they recommend and that those securities are appropriate for at least some investors. FINRA also believes that it is important that a firm not recommend an unsuitable number of transactions in those circumstances where it has control over the account. FINRA emphasizes, however, that quantitative suitability generally would apply only with regard to that portion of an institutional customer's portfolio that the firm controls and only with regard to the firm's recommended transactions.27
1 See Securities Exchange Act Release No. 63325 (November 17, 2010), 75 FR 71479 (November 23, 2010) (Order Approving Proposed Rule Change; File No. SR-FINRA-2010-039).
2 The current FINRA rulebook consists of (1) FINRA rules; (2) NASD rules; and (3) rules incorporated from NYSE (NYSE rules). While the NASD rules generally apply to all FINRA member firms, the NYSE rules apply only to those members of FINRA that are also members of the NYSE. The FINRA rules apply to all FINRA member firms, unless such rules have a more limited application by their terms. For more information about the rulebook consolidation process, see Information Notice, 3/12/08 (Rulebook Consolidation Process).
3 To the extent that past Notices to Members, Regulatory Notices, case law, etc., do not conflict with new rule requirements or interpretations thereof, they remain potentially applicable, depending on the facts and circumstances of the particular case.
4 FINRA notes that it replaced the term "due diligence" used in former NYSE Rule 405(1) with the term "reasonable diligence" in new FINRA Rule 2090 for consistency with the language used in new FINRA Rule 2111. FINRA did not intend by such action to impair or adversely affect established case law and other interpretations discussing the diligence that is required to comply with know-your-customer or suitability obligations.
5 A broker-dealer must know its customers not only at account opening but also throughout the life of its relationship with customers in order to, among other things, effectively service and supervise the customers' accounts. Since a broker-dealer's relationship with its customers is dynamic, FINRA does not believe that it can prescribe a period within which broker-dealers must attempt to update this information. As with a customer's investment profile under the suitability rule, a firm should verify the "essential facts" about a customer under the know-your-customer rule at intervals reasonably calculated to prevent and detect any mishandling of a customer's account that might result from the customer's change in circumstances. The reasonableness of a broker-dealer's efforts in this regard will depend on the facts and circumstances of the particular case. Firms should note, however, that SEA Rule 17a-3 requires broker-dealers to, among other things, attempt to update certain account information every 36 months regarding accounts for which the broker-dealers were required to make suitability determinations.
6 FINRA Rule 2090.
7 FINRA Rule 2090.01.
8 FINRA Rule 2111(a). Former NASD Rule 2310 contained interpretative material (IMs) discussing a variety of types of misconduct. Although FINRA eliminated those IMs, most of the types of misconduct that the IMs discussed were either explicitly covered by other rules or incorporated in some form into the new suitability rule. The exception was unauthorized trading, which had been discussed in IM-2310-2. However, it is well-settled that unauthorized trading violates just and equitable principles of trade under FINRA Rule 2010 (previously NASD Rule 2110). See, e.g., Robert L. Gardner, 52 S.E.C. 343, 344 n.1 (1995), aff'd, 89 F.3d 845 (9th Cir. 1996) (table format); Keith L. DeSanto, 52 S.E.C. 316, 317 n.1 (1995), aff'd, 101 F.3d 108 (2d Cir. 1996) (table format); Jonathan G. Ornstein, 51 S.E.C. 135, 137 (1992); Dep't of Enforcement v. Griffith, No. C01040025, 2006 NASD Discip. LEXIS 30, at *11–12 (NAC December 29, 2006); Dep't of Enforcement v. Puma, No. C10000122, 2003 NASD Discip. LEXIS 22, at *12 n.6 (NAC August 11, 2003). The new suitability rule does not alter that conclusion. Unauthorized trading continues to be serious misconduct that violates FINRA Rule 2010.
9 FINRA Rule 2111(a).
10 See Michael Frederick Siegel, Securities Exchange Act Release No. 58737, 2008 SEC LEXIS 2459, at *21 (October 6, 2008) (explaining that whether a communication "constitutes a recommendation is a 'facts and circumstances inquiry to be conducted on a case-by-case basis'"), aff'd in relevant part, 592 F.3d 147 (D.C. Cir. 2010), cert. denied, 2010 U.S. LEXIS 4340 (May 24, 2010). FINRA has stated that "defining the term 'recommendation' is unnecessary and would raise many complex issues in the absence of specific facts of a particular case." Securities Exchange Act Release No. 37588, 1996 SEC LEXIS 2285, at *29 (August 20, 1996), 61 FR 44100, 44107 (August 27, 1996) (Notice of Filing and Order Granting Accelerated Approval of NASD's Interpretation of Its Suitability Rule).
11 FINRA has repeatedly explained that a broker cannot avoid suitability obligations through a disclaimer where-given its content, context and presentation-the particular communication reasonably would be viewed as a recommendation. See Notice to Members 01-23 (April 2001). FINRA Rule 2111.02, moreover, explicitly states that a firm or associated person "cannot disclaim any responsibilities under the suitability rule." In the same vein, it is well-settled that a "broker's recommendations must be consistent with his customer's best interests" and are "not suitable merely because the customer acquiesces in [them]." Dane S. Faber, Securities Exchange Act Release No. 49216, 2004 SEC LEXIS 277, at *23–24 (February 10, 2004); see also Dep't of Enforcement v. Bendetsen, No. C01020025, 2004 NASD Discip. LEXIS 13, at *12 (NAC August 9, 2004) ("[A] broker's recommendations must serve his client's best interests and the test for whether a broker's recommendations are suitable is not whether the client acquiesced in them, but whether the broker's recommendations were consistent with the client's financial situation and needs").
14 Id. The new rule does not, however, broaden the scope of implicit recommendations. In limited circumstances, FINRA and the SEC have recognized that implicit recommendations can trigger suitability obligations. For example, FINRA and the SEC have held that associated persons who effect transactions on a customer's behalf without informing the customer have implicitly recommended those transactions, thereby triggering application of the suitability rule. See, e.g., Rafael Pinchas, 54 S.E.C. 331, 341 n.22 (1999) ("Transactions that were not specifically authorized by a client but were executed on the client's behalf are considered to have been implicitly recommended within the meaning of the NASD rules."); Paul C. Kettler, 51 S.E.C. 30, 32 n.11 (1992) (stating that transactions a broker effects for a discretionary account are recommended). Although such holdings continue to act as precedent regarding those issues, FINRA notes that nothing in the new rule is intended to change the longstanding application of the suitability rule on a recommendation-by-recommendation basis. The new rule would not apply, for instance, to implicit recommendations to hold securities that are transferred into an account.
15 See FINRA Rule 2111.03.
16 During the rulemaking process, some commenters argued that factors such as a customer's investment experience, time horizon and risk tolerance are ones to be considered when reviewing a customer's portfolio as a whole, not the individual trades. According to those commenters, requiring consideration of such factors on a trade-by-trade basis would prevent customers from creating a diverse portfolio made up of securities with different levels of liquidity, risk and time horizons. FINRA reiterates that a recommendation-by-recommendation analysis and consideration of a customer's investment portfolio are not mutually exclusive concepts. Although suitability is a recommendation-by-recommendation analysis, FINRA Rule 2111 explicitly permits the suitability analysis to be performed within the context of the customer's other investments. In fact, the rule requires (as did the previous suitability rule) firms and associated persons to make reasonable efforts to gather and analyze information about a customer's other investments as part of the suitability review. Moreover, the new rule explicitly covers recommended investment strategies.
17 See FINRA Rule 2111(a).
18 See FINRA Rule 2111.04.
20 See FINRA Rule 2111.05.
23 See FINRA Rule 2111(b). FINRA is proposing to adopt NASD Rule 3110(c)(4) as FINRA Rule 4512(c), without material change. See Securities Exchange Act Release No. 63181 (October 26, 2010), 75 FR 67155 (November 1, 2010) (Notice of Filing Proposed Rule Change; File No. SR-FINRA-2010-052).
24 See FINRA Rule 2111(b). FINRA reiterates that, in some cases, the broker may conclude that the customer is not capable of making independent investment decisions in general. In other cases, the institutional customer may have general capability, but may not be able to understand a particular type of instrument or its risk. If a customer is either generally not capable of evaluating investment risk or lacks sufficient capability to evaluate the particular product, the scope of a broker's customer-specific obligations under the suitability rule would not be diminished by the fact that the broker was dealing with an institutional customer. However, the fact that a customer initially needed help understanding a potential investment need not necessarily imply that the customer did not ultimately develop an understanding and make an independent decision.
25 FINRA Rule 2111(b).
26 FINRA emphasizes that the institutional-customer exemption applies only if all of the conditions in Rule 2111(b) are satisfied. It is not sufficient, for example, that an institutional customer affirmatively indicates that it is exercising independent judgment in evaluating recommendations. The institutional customer also must meet the definitional criteria and the broker must have a reasonable basis to believe that the institutional customer is capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies.
27 It is axiomatic that the suitability rule applies only to recommended transactions. See, e.g., Dep't of Enforcement v. Medeck, No. E9B2003033701, 2009 FINRA Discip. LEXIS 7, at *46 (July 30, 2009) (explaining that transactions that were not recommended could not be used to inflate the cost-to-equity ratio and the turnover rate). Case law also has long established that quantitative suitability "occurs when a registered representative has control over trading in an account and the level of activity in that account is inconsistent with the customer's objectives and financial situation." Harry Gliksman, 54 S.E.C. 471, 475 (1999), aff'd, 24 F. App'x 702 (9th Cir. 2001); see also Pinchas, 54 S.E.C. at 337 (same). In general, the control element "is satisfied if the broker has either discretionary authority or de facto control over the account. De facto control is established when the client routinely follows the broker's advice 'because the customer is unable to evaluate the broker's recommendations and to exercise independent judgment.'" Medeck, 2009 FINRA Discip. LEXIS 7, at *34 (citations omitted).
In Pryor, McClendon, Counts & Co., Securities Exchange Act Release No. 45402, 2002 SEC LEXIS 284 (February 6, 2002), the SEC analyzed allegations of churning by focusing on that portion of the city of Atlanta's portfolio that the broker-dealer respondent controlled and those transactions that the respondent recommended. Id. at *4, *15–16, *20–23. The SEC also held that, for purposes of churning, the respondent controlled the portion of Atlanta's portfolio at issue because the respondent engaged in a scheme to defraud Atlanta with the city's investment officer, who had authority to trade Atlanta's securities portfolio. Id. at *20–21 & n.10 (citing Smith v. Petrou, 705 F. Supp. 183, 187 (S.D.N.Y. 1989)).
Below is the text of the new FINRA rules.
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2000. DUTIES AND CONFLICTS
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2090. Know Your Customer
Every member shall use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer and concerning the authority of each person acting on behalf of such customer.
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2100. TRANSACTIONS WITH CUSTOMERS
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