Business Compliance Partners Highlights New FINRA Know Your Customer and Suitability Rules

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New FINRA rules are now in effect that set out additional requirements for obtaining customer information and making suitability determinations. FINRA also appears to have introduced a fiduciary standard for the first time.

New FINRA Rules 2090 and 2111 covering suitability and “know your customer” obligations are now in effect. The rules are a consolidation of former NASD and NYSE rules but they contain some new requirements that were not addressed in the previous rules.

FINRA Rule 2090-Know Your Customer

Broker-Dealers (“BDs”) must know essential facts about each customer including information about every person who has trading authority over customer accounts. Every BD should know at least the name of each person authorized to act on behalf of a customer and any limits on authority that the customer establishes and communicates to the firm. BDs should also obtain information about and consider the investing experience of each of these persons for purposes of determining whether or not to make investment recommendations.

FINRA Rule 2111-Suitability

BDs are required to make determinations about the suitability of investments or investment strategies based on each customer’s profile. The profile includes information required to be obtained from each customer under Rule 2090 and SEC Rule 17a-3(a)(17)(i)(A). Rule 2111 includes a new requirement that BDs make a reasonable effort to obtain the following additional information:

  •          Customer age
  •     Current investment information
  •     Financial status and needs
  •     Tax status
  •     Investment objectives
  •     Investment experience
  •     Investment time horizon
  •     Liquidity needs
  •     Risk tolerance
  •     Any other information the customer may disclose in connection with such recommendations

BDs do not have to obtain every item of information but will have to decide whether to make a recommendation in light of any missing information. A BD must carefully consider whether it has a sufficient understanding of its customers to properly evaluate the suitability of a recommendation.

Determination of Suitability

BDs must make a determination of suitability each time a recommendation is made to purchase or sell a specific security, to utilize a particular investment strategy (e.g. purchasing securities using margin or liquidated home equity, engaging in day trading or even to “hold” securities) or to purchase or sell non-security investments (e.g. insurance policies, real estate, long-term-care, etc.).

BDs should apply a “facts and circumstances” test when determining what constitutes a recommendation. Typically, any advice would constitute a recommendation whenever it is viewed as a suggestion that the customer take action (or refrain from taking action) regarding a security or investment strategy.

There is no requirement to continuously monitor recommendations. A suitability determination is only required at the time of making a recommendation. Therefore, there is no need to monitor a “hold” recommendation unless a registered representative renews the recommendation by giving the same advice, in which case, another suitability determination is required.

Types of Required Suitability Determinations

BDs may be required to make any or all three types of suitability determinations whenever recommending any type of investment or investment strategy including:

Reasonable Basis Suitability-A BD must exercise due diligence to determine that each securities product is suitable for investment for at least some customers.

Customer Specific Suitability-BDs must make a determination that an investment is suitable for a particular customer based on that customer’s investment profile.

Quantitative Suitability-BDs that have actual or de facto control over a customer account must have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable when taken together in light of the customer’s investment profile. This requirement is new.

Institutional Investors

BDs will be deemed to have fulfilled their Customer Specific Suitability determination requirement if a customer is an institutional investor and the BD has a reasonable basis to believe that the customer is capable of evaluating investment risks independently (both in general and with regard to particular transactions and investment strategies) and the customer affirmatively acknowledges exercising independent judgment. This latter requirement is new. An acknowledgement may be made orally or in writing but BDs should attempt to obtain the acknowledgement in writing and document its basis for believing that the customer is capable of independently evaluating investment risks.

Examples of institutional investors include banks, savings and loan associations, insurance companies, registered investment companies, registered investment advisers and any other person (whether a natural person, corporation, partnership, trust, etc.) with total assets of at least $50 million.

Documentation

The reasons for suitability determinations should usually be documented in detail with copies maintained in customer files. “Plain vanilla” recommendations (e.g. investing in blue chip stocks or allocating a percentage of assets between stocks and bonds) would typically not have to be documented. In general, the more complex or risky the investment recommended, the more thoroughly the determination should be documented.

Compliance

Compliance personnel are not required to monitor each transaction for potential suitability problems but may use a risk-based approach that utilizes a “red flag” monitoring system for isolating and reviewing potentially troublesome transactions.    

Best Interest Standard for Dealing with Customers

The biggest change in these rules is the apparent adoption of a quasi fiduciary standard by FINRA that applies to BDs for the first time. In a footnote in Notice to Members 11-02, FINRA stated that registered representatives of BDs are required to put customer interests first, (regardless of their own interests), whenever making recommendations. Recommendations will not be considered suitable just because a customer acquiesces. Although FINRA implies that this has always been the case, this requirement has the potential or radically changing the way that BDs conduct business.

This article is not meant to be a complete discussion of the subject matter contained therein. For more information please refer to FINRA Notices to Members 11-02, 11-25 and 12-25.

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Paul Cox

Chris Kosifas
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