New Implementation Date for and Additional Guidance on the Consolidated FINRA Rules Governing Know-Your-Customer and Suitability Obligations
Know Your Customer and Suitability
Consolidated FINRA Rulebook
Know Your Customer
|Referenced Rules & Notices
Bank Secrecy Act
FINRA Rule 2090
FINRA Rule 2111
FINRA Rule 2130
FINRA Rule 2264
FINRA Rule 2270
Regulatory Notice 09-31
Regulatory Notice 11-02
SEA Rule 17a-3
On November 17, 2010, the Securities and Exchange Commission (SEC) approved FINRA's proposal to adopt rules governing know-your-customer and suitability obligations1 for the consolidated FINRA rulebook.2 On January 10, 2011, FINRA issued Regulatory Notice 11-02, which provided guidance regarding the new rules and announced an implementation date. This Notice announces a new implementation date of July 9, 2012, and provides additional guidance in response to some recent industry questions and concerns.
Questions regarding this Notice should be directed to James S. Wrona, Vice President and Associate General Counsel, Office of General Counsel, at (202) 728-8270.
New 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."3
New 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."4
In general, the new FINRA rules retain the core features of the previous NASD and NYSE rules covering the same subject areas and codify well-settled interpretations of those rules. A few aspects of the FINRA rules, however, have created new or modified obligations. Numerous firms asked that FINRA delay the implementation date to allow more time to prepare new or update current procedures, modify automated systems, and educate their associated persons regarding compliance with the new or modified requirements. Given these concerns and the significance of the rules to both the industry and the public, FINRA believes it is appropriate to provide firms with a reasonable extension of the implementation date to comply with the new or modified requirements. Accordingly, FINRA filed with the SEC a rule change effective immediately to delay the rules' implementation date until July 9, 2012.5
A number of firms have asked FINRA to provide additional guidance to assist them in preparing to comply with the new rules. The most frequently asked questions and FINRA's answers are discussed below.6 FINRA reiterates, however, that many of the obligations under the new rules are the same as those under the predecessor rules and interpretations of those rules. FINRA emphasizes that existing guidance and interpretations regarding know-your-customer and suitability obligations continue to apply to the extent that they are not inconsistent with the new rules.
Know Your Customer
Firms' questions regarding the new suitability rule have focused on information-gathering requirements in relation to a customer's investment profile, the scope of the term "strategy," and reasonable-basis obligations.
Customer's Investment Profile
The 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.
The term also would capture an explicit recommendation to hold a security or securities.19 While a decision to hold might be considered a passive strategy, an explicit recommendation to hold does constitute the type of advice upon which a customer can be expected to rely. An explicit recommendation to hold is tantamount to a "call to action" in the sense of a suggestion that the customer stay the course with the investment. The rule would apply, for example, when an associated person meets with a customer during a quarterly or annual investment review and explicitly advises the customer not to sell any securities in or make any changes to the account or portfolio. The rule, however, would not cover an implicit recommendation to hold.20 The rule, for instance, would not apply where an associated person remains silent regarding, or refrains from recommending the sale of, securities held in an account. That is true regardless of whether the associated person previously recommended the purchase of the securities, the customer purchased them without a recommendation, or the customer transferred them into the account from another firm where the same or a different associated person had handled the account.21
In regard to the type or form of documentation that may be needed, the facts and circumstances must inform that decision. Consistent with the discussions above, however, the complexity of and risks associated with a particular security or strategy likely will impact the level of documented analysis that is appropriate.
A firm should educate its associated persons on the potential risks and rewards of the products that the firm permits them to recommend. In general, an associated person may rely on a firm's fair and balanced explanation of the potential risks and rewards of a product. However, if the associated person remains uncertain about the potential risks and rewards of a product or has reason to believe that the firm failed to address a particular issue or has done so in an incomplete or inaccurate manner, then the associated person would need to engage in further inquiry before recommending the product.
1See 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 also are 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, March 12, 2008 (Rulebook Consolidation Process).
3 FINRA Rule 2090.01.
4 FINRA Rule 2111(a).
5See Securities Exchange Act Release No. 64260 (April 8, 2011), 76 FR 20759 (April 13, 2011) (Notice of Filing and Immediate Effectiveness of Proposed Rule Change to Delay the Implementation Date of FINRA Rule 2090 Know Your Customer) and FINRA Rule 2111 (Suitability); File No. SR-FINRA-2011-016).
6 Nothing in this guidance shall be construed as altering in any manner a member firm's obligations under other applicable federal securities laws or FINRA rules, including SEA Rule 17a-3 and the Bank Secrecy Act, 31 U.S.C.§§ 5311, et seq.
7See FINRA Rule 2111(a).
8 The term "obtained," as used in the rule's information-gathering section, does not require a firm to document the information in all instances.
9See FINRA Rule 2111.04 (explaining that a firm that decides not to seek to obtain and analyze information about a customer-specific factor must document its reasonable basis for believing that the factor is not a relevant consideration).
10FINRA notes that there are SEC and other FINRA rules that explicitly require specific types of documentation.See, e.g., SEA Rule 17a-3(a)(17)(i)(A) (discussing "books and records" requirements for certain account information, including, among other things, date of birth, employment status, annual income, net worth and investment objectives, regarding an account with a natural person as a customer).See also supra note 6.
11For purposes of considering liquidity needs in the context of FINRA Rule 2111, examples of possible liquid investments include money market funds, Treasury bills and many blue chip stocks, exchange-traded funds and mutual funds. FINRA emphasizes, however, that a high level of liquidity does not, in and of itself, mean that the recommended product is suitable for all customers. For instance, some relatively liquid products can be complex and/or risky and therefore unsuitable for some customers. See, e.g., Regulatory Notice 09-31(June 2009) (reminding firms of their sales-practice obligations relating to leveraged and inverse exchange-traded funds).
15See FINRA Rule 2111.03.
16 For certain requirements related to margin, see FINRA Rule 2264.
17See Notice to Members (NTM) 04-89 (December 2004) (reminding firms that "recommending liquefying home equity to purchase securities may not be suitable for all investors and that [firms] should perform a careful analysis to determine whether liquefying home equity is a suitable strategy for an investor").
19See FINRA Rule 2111.03.
20See FINRA Rule 2111.03. In limited circumstances, FINRA and the SEC have recognized that certain actions constitute implicit recommendations that 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 implicitly recommended). Although such holdings continue to act as precedent regarding those issues, the new rule does not broaden the scope of implicit recommendations. The new rule does not apply to implicit recommendations to hold.
21 Firms also have asked whether the absence of a sell order in a discretionary account amounts to an implicit hold recommendation covered by the rule.To the extent that a customer account at a broker-dealer can be discretionary under applicable federal securities laws,the suitability rule generally would not apply where a firm refrains from selling a security. The rule states that it applies to explicit recommendations to hold.See FINRA Rule 2111.03. Unless the facts indicate that an associated person's failure to sell securities in a discretionary account was intended as or tantamount to an explicit recommendation to hold, FINRA would not view the associated person's inaction or silence in such circumstances as a recommendation to hold the securities for purposes of the suitability rule.
22 Similarly, and as noted previously, the absence of a recommendation to sell would not amount to a hold recommendation subject to the rule.
23See FINRA Rule 2111.03.
24Regulatory Notice 11-02 (January 2011) discusses several guiding principles that are relevant to determining whether a particular communication could be viewed as a recommendation for purposes of the suitability rule
25 As discussed in Question 8 above, absent an agreement, course of conduct or unusual fact pattern that might alter the normal broker-customer relationship, a hold recommendation would not create an ongoing duty to monitor and make subsequent recommendations.
26See FINRA Rule 2111.05(a).
27See, e.g., NTM 05-26 (April 2005) (recommending best practices for reviewing new products).
28See FINRA Rule 2111.05(a). This position is consistent with requirements under the previous suitability rule. In Dep't of Enforcement v. Siegel, for instance, FINRA's National Adjudicatory Council explained that a "recommendation may lack 'reasonable-basis' suitability if the broker: (1) fails to understand the transaction, which can result from, among other things, a failure to conduct a reasonable investigation concerning the security; or (2) recommends a security that is not suitable for any investors." Dep't of Enforcement v. Siegel, No. C05020055, 2007 NASD Discip. LEXIS 20, at *38 (NAC May 11, 2007), aff'd, Exchange Act Release No. 58737, 2008 SEC LEXIS 2459 (Oct. 6, 2008), aff'd in relevant part, 592 F.3d 147 (D.C. Cir. 2010),cert. denied, 2010 U.S. LEXIS 4340 (May 24, 2010).