From the Desk of Jim Eccleston at Eccleston Law:
FINRA (the Financial Industry Regulatory Authority) has had an opportunity to examine how financial services firms are complying with FINRA Rule 2111, effective July, 2012. The new rule made several important changes, especially related to recommendations of investment strategies and recommendations to hold securities positions. Based upon examinations of firms conducted during the last year, FINRA has issued Regulatory Notice 13-31. Let’s highlight the key provisions.
As background, Rule 2111 relates to recommendations made by a financial adviser and his or her firm. Historically, the application of the rule was limited to recommendations to buy or sell securities. In the new rule, FINRA added recommended investment strategies involving a security or securities, including the explicit recommendation to “hold” a security or securities.
Also, in making a recommendation, Rule 2111 continues with the requirement that the financial adviser and his or her firm have a “reasonable basis” to believe that the recommendation is “suitable.” However, the new rule added several requirements. First, FINRA expanded the list of information required to ascertain the customer’s suitability profile. The list includes the customer’s age, investment experience, time horizon, liquidity needs and risk tolerance as information items that advisers and their firms must attempt to obtain and analyze.
Second, the new rule recited the “three main suitability obligations” according to Regulatory Notice 13-31. They are “reasonable-basis”, “customer-specific” and “quantitative” suitability obligations. In short, reasonable basis means that a recommended security or investment recommendation is suitable for at least some investors; customer-specific means that the recommendation is suitable for a particular customer; and quantitative means that “a series of recommended transactions, even if suitable when viewed in isolation, are not excessive.”
In light of the new requirements of the suitability rule, FINRA examiners have analyzed the firms’ “controls”, including testing the firms’ supervisory and compliance systems. FINRA examiners also have reviewed for “Red Flags” of possible deficiencies. Those Red Flags include: a long term investment for an investor with a short term time horizon; or a speculative investment or strategy held in the account of a conservative investor. FINRA concludes in its regulatory notice that the most common deficiency among firms was having inadequate procedures for “hold” recommendations.
Based upon those examinations, Regulatory Notice 13-31 discusses numerous “observations of effective practices” to provide guidance to firms and their advisers. For example, in the guidance regarding reasonable-basis suitability, FINRA commented on an effective way some firms use to ensure that their financial advisers understand the (sometimes complex) products that they are recommending. Those firms “post due diligence on products (and accompanying documents) to an internal website that [advisers] can access when recommending a product.” The information “includes audited financial statements, notes of interviews with key individuals of the product sponsor or issuer, and other information relevant to understanding the product and its features.”
Likewise, in the guidance related to customer-specific suitability, FINRA comments that some firms bolstered compliance by requiring specific customer suitability information such as high risk tolerance, low liquidity needs, substantial investment experience, and an indication that the recommended transaction represents a small percentage of a balanced portfolio.
Finally, the guidance regarding investment strategies and hold recommendations is notable. FINRA notes that effective compliance and supervisory systems included the following:
• A “hold ticket” or “hold blotter” that captures hold and, in certain instances, other types of strategy recommendations;
• Notes of discussions with clients regarding explicit hold or other strategy recommendations by associated persons maintained in customer files;
• Firm branch office inspections focused on the documentation of hold and other strategy conversations with clients;
• Modified new account forms to include specific investment strategies (determined by the firm) which could be identified if an adviser recommends them at the time of the account opening;
• New or amended account opening forms that must be signed by the customer when advisers recommend changes to a previously recommended account investment strategy; and
• A prohibition on advisers’ engaging firm clients in any business activity that an adviser conducts outside of his or her firm.
Although FINRA states that Rule 2111 generally does not impose explicit documentation requirements, some documentation likely is necessary for adequate supervision. The regulatory notice states, “The type or form of documentation that may be needed is dependent on the facts and circumstances of the investment strategy or hold recommendation, including the complexity and risks associated with the security or investment strategy at the time of the recommendation.” Firms must find a way “to capture hold and other strategy recommendations.”
As one can see, Regulatory Notice 13-31 contains a great deal of helpful guidance for firms to implement to ensure that recommendations are suitable.
The attorneys of Eccleston Law represent investors and advisers nationwide in securities and employment matters. Our attorneys draw on a combined experience of nearly 50 years in delivering the highest quality legal services.
