The Securities Litigation Expert Blog

This blog post continues our expert series addressing FINRA Suitability Rule 2111.  Our suitability experts will examine the genealogy of the rule and how it has evolved over the years through Notices to Members, Regulatory Notices, and changes to the rule itself.  In this post we examine the obligation of prospectus delivery and how it interacts with the suitability rule.

Prospectus Delivery and Suitability

Many securities transactions require the delivery of a prospectus.  At the same time, the obligation to deliver a prospectus exists side by side with the suitability obligation.  However, the delivery of a prospectus does not remove the suitability obligation, nor is it a substitute for the the customer-specific and reasonable-basis suitability process that must accompany each recommendation.

More directly, FINRA has been, and remains, crystal clear in its position that the delivery of a prospectus to a client does not cure an otherwise unsuitable recommendation nor any material misstatements or omissions that were made during the recommendation.

This position goes back in the FINRA literature at least to 1994.  For instance, in NASD NTM 94-16, the (then) NASD advised:

Members are also advised that, although the prospectus and sales material of a fund include disclosures on many matters, oral representations by sales personnel that contradict the disclosures in the prospectus or sale literature may nullify the effect of the written disclosures and may make the member liable for rule violations and civil damages to the customers that result from such oral representations.[1] (Emphasis added)

Furthermore, a number of FINRA Enforcement decisions reiterate this position, including the following:

• Department of Enforcement v. Hornblower & Weeks, 2004. “Respondent could not cure defects in disclosure by providing more detail and further disclosure in the same package or by answering questions.” [2]
• Department of Enforcement v. Ryan Mark Reynolds, 2001.  “The SEC has held that, in the enforcement context, a registered representative may be found in violation of the NASD’s rules and the federal securities laws for failure to fully disclose risks to customers even through such risks may have been discussed in a prospectus delivered to customers.”[3] (Emphasis added)
• Department of Enforcement v. Pacific On-Line Trading & Securities, 2002. “Finding that the subsequent dissemination of disclosure information does not cure earlier misleading disclosures.”[4]

Lastly, under Rule 2111, Supplementary Material 2111.02 states explicitly:  “Disclaimers. A member or associated person cannot disclaim any responsibilities under the suitability rule.” This is consistent with all of FINRAs previous guidance.[5] 

The Accelerant Securities Practice Group has many experts on FINRA Suitability Rule 2111, including: Gerry Guild, John Duval, Sr., Tom Brakke, and Jack Duval.

Notes

Portions of this blog originally appeared in the Accelerant white paper Leveraged and Inverse ETFs:  Trojan Horses for Long-Term Investors, by Jack Duval.  

[1]        NASD NTM 04-16, Mutual Fund Sales Practice Obligations; available at http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=1759&element_id=1518&highlight=94-16#r1759; accessed June 23, 2013.

[2]        FINRA NTM 05-59, Structured Products; available at http://www.complinet.com/file_store/pdf/rulebooks/nasd_0559ntm.pdf; accessed June 23, 2013.

[3]        Id.

[4]        Id.

[5]        See, for instance, FINRA RN 12-25, “FINRA reiterates, however, that many of the obligations under the new rule are the same as those under the predecessor rule and related case law. Existing guidance and interpretations regarding suitability obligations continue to apply to the extent that they are not inconsistent with the new rule.”  (Emphasis added) May 2012, 2.

This blog post is part of a series addressing FINRA Suitability Rule 2111.  Our suitability experts will examine the genealogy of the rule and how it has evolved over the years through Notices to Members, Regulatory Notices, and changes to the rule itself.  In particular, customer-specific and reasonable-basis suitability will be examined.

In this post we examine hold recommendations.

Hold as a Recommendation

Advice to hold a security is now clearly considered a recommendation, and is captured in the “investment strategy” language of Rule 2111.[1] FINRA RN 11-25 makes it clear that even recommendations which do not result in transactions come under the aegis of the Rule:

The rule explicitly states that the term “strategy” should be interpreted broadly.The rule would cover a recommended investment strategy regardless of whetherthe recommendation results in a securities transaction or even references a specificsecurity or securities. For instance, the rule would cover a recommendation topurchase securities using marginor liquefied home equityor engage in daytrading,irrespective of whether the recommendation results in a transaction orreferences particular securities.[2] (Emphasis added)

And then even more specifically:

The term also would capture an explicit recommendation to hold a security or securities.  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”[3] 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.[4] (Emphasis added).

Importantly, FINRA RN 12-25 addresses the documentation of hold recommendations, and highlights those involving leveraged and inverse ETFs:

For "hold" recommendations, FINRA has stated that a firm may want to focus on securities that by their nature or due to particular circumstances could be viewed as having a shorter-term investment component; that have a periodic reset or similar mechanism that could alter a product's character over time; that are particularly susceptible to changes in market conditions; or that are otherwise potentially risky or problematic to hold at the time the recommendations are made. 

Some possible examples could include leveraged ETFs (because they reset daily and their performance over long periods can differ significantly from the performance of the underlying index or benchmark during the same period)…”[5] (Emphasis added)

These requirements are in addition to the general obligation of member firms to evidence compliance with applicable FINRA rules.[6]

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The Accelerant Securities Practice Group has many experts on FINRA Suitability Rule 2111, including: Gerry Guild, John Duval, Sr., Tom Brakke, and Jack Duval.

Notes

Portions of this blog originally appeared in the Accelerant white paper Leveraged and Inverse ETFs:  Trojan Horses for Long-Term Investors, by Jack Duval.  

[1]        Under NYSE Rule 472 (Communication with the Public) a hold was included in the definition of a recommendation.  Under Rule 472.10/09:  “For purposes of these standards, the term ‘recommendation’ includes any advice, suggestion or other statement, written or oral, that is intended, or can reasonably be expected to influence a customer to purchase, sell or hold a security.”  (Emphasis added); available at http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=15076&element_id=11054&highlight=472#r15076; accessed August 1, 2013.

[2]        FINRA Regulatory Notice 11-25, Know Your Customer and Suitability; May 2011; (Implementation Date: July 9, 2012); A7; available at http://finra.complinet.com/net_file_store/new_rulebooks/f/i/finra_11-25.pdf; accessed June 19, 2013.

[3]        The “call to action” standard is addressed in NASD NTM 01-23, which was issued in response to the proliferation of online trading firms putting out generic “tip sheets”, “top 10 lists” and other communications regarding stocks. The primary question this NTM addresses is whether or not these types of generic communication constitute a recommendation and thus would be subject to Rule 2310.  In short, they do not.

              The guidance principles enumerated in NTM 01-23 were that: (1) the communication had to be a call to action on the part of the investor; and (2) the more tailored the communication was to an individual’s particular facts and circumstances, the more likely it was to be a recommendation.

              While generic tip sheets may constitute a call to action (buy these five stocks now!), they fail in the second criteria, and thus are not recommendations.

[4]        Id.

[5]        FINRA Regulatory Notice 12-25 at A13.

[6]        Id. at A12.

This blog post is part of a series addressing FINRA Suitability Rule 2111.  Our suitability experts will examine the genealogy of the rule and how it has evolved over the years through Notices to Members, Regulatory Notices, and changes to the rule itself.  In particular, customer-specific and reasonable-basis suitability will be examined.

In this post we examine the three components of suitability obligations due under FINRA Rule 2111.

Components of Suitability Obligations

Under FINRA Suitability Rule 2111, there are three components to the suitability obligation: reasonable-basis suitability; customer-specific suitability; and quantitative suitability. Each will be discussed in turn.

As discussed in previous blog posts, the concept of suitability can be succinctly stated as appropriately matching investments to the investor. With Rule 2111, FINRA has now made both ends of this task explicit.

Customer-Specific Suitability

FINRA Rule 2310 clearly dealt with the customer and required that for each recommendation to a customer, “a member have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.”[1]

The “basis of the facts, if any” language was essentially voided for retail clients under NTM 90-52, which imposed an affirmative duty upon the broker to profile the client.[2] This modification was addressed originally in Article III, Sections 2 and 21 (c) of the Rules of Fair Practice[3], and later in Rule 2310(b), which added the explicit requirements for the broker to gather basic information about non-institutional clients.

FINRA Rule 2111 continues the client profiling requirement (and incorporates the phrase “customer’s investment profile”) of Rule 2310(b) and adds more specific areas of inquiry.  Most important among the new profiling questions are: the customer’s needs; the customer’s investment time horizon; the customer’s liquidity needs; and the customer’s risk tolerance.[4]

While explicitly listing the new profiling questions in the Rule is helpful, they have been part of industry profiling practices for decades, if not longer.  Indeed, most member firm New Account Forms have required the broker to inquire about the customer’s time horizon and risk tolerance as well as other aspects of their financial life.

Lastly, it is worth noting that FINRA has also incorporated the New York Stock Exchange (“NYSE”) Rule 405 into FINRA Rule 2090 (Know Your Customer).  As with NYSE Rule 405, FINRA Rule 2090 is a due diligence based rule.  Rule 2090 states:

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.[5]

Instead of approaching suitability by focusing on what is required for broker recommendations (as does Rule 2111), Rule 2090 approaches suitability by concentrating on the due diligence required for every customer relationship.  Under Rule 2090, suitability is ensured by knowing and understanding the customer prior to account opening, and maintaining the account in accord with what is known.

Importantly, the “maintenance” language in Rule 2090 creates an ongoing requirement to know the customer.  That is to say, the broker must continue to conduct her due diligence on the customer’s particular facts and circumstances during the lifetime of the relationship.

This is an important element of profiling as a customer’s life situation can change and thus require changes in her investments or strategies.  As with the new profiling questions of Rule 2111, these have been an industry practice for decades, if not longer.

Reasonable-Basis Suitability

The reasonable-basis suitability component addresses how broker-dealers and their associated persons must perform due diligence on investments before they recommend them.  The first level of due diligence is performed at the firm level and requires the member firm to first determine that the investment is at least suitable for some of its investors.[6]

Methods employed by firms to determine this first level of suitability will “vary depending on, among other things, the complexity of and risks associated with the security or investment strategy and the member's or associated person's familiarity with the security or investment strategy.”[7]

The second reasonable basis suitability determination is carried out by the broker when she educates herself about the investment. This is how the broker comes to “know the investment”.

One of the primary goals of the reasonable basis suitability obligation is that:

A member's or associated person's reasonable diligence must provide the member or associated person with an understanding of the potential risks and rewards associated with the recommended security or strategy.[8]

As mentioned above, a failure to “know the investment” makes the recommendation unsuitable.  FINRA clearly states this in the Supplementary Material to Rule 2111:

The lack of such an understanding (about the potential risks and rewards of the recommending security or strategy) when recommending a security or strategy violates the suitability rule.[9]

Quantitative Suitability

The explicit quantitative suitability component highlights the potential for abuse in instances where accounts are “churned” by frequent purchases and sales of securities in order to generate excess commissions. As mentioned above, there can be instances where one trade, viewed in isolation could be suitable, but if made repeatedly, would change all the trades to unsuitable transactions. FINRA Rule 2111 addresses this potential head on, stating:

Quantitative suitability requires a member or associated person who has actual or de facto control over a customer account to have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together in light of the customer's investment profile, as delineated in Rule 2111(a). [10] (Emphasis added)

The Rule also addresses common metrics used to evaluate churning:

No single test defines excessive activity, but factors such as the turnover rate, the cost-equity ratio, and the use of in-and-out trading in a customer's account may provide a basis for a finding that a member or associated person has violated the quantitative suitability obligation.[11]

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The Accelerant Securities Practice Group has many experts on FINRA Suitability Rule 2111, including: Gerry Guild, John Duval, Sr., Tom Brakke, and Jack Duval.

Notes

Portions of this blog originally appeared in the Accelerant white paper Leveraged and Inverse ETFs:  Trojan Horses for Long-Term Investors, by Jack Duval.  

[1]                 See supra Note 33.

[2]                 FINRA NTM 90-52; available at http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=1514&element_id=1273&highlight=90-52#r1514; accessed July 31, 2013.

[3]                 The Rules of Fair Practice was what the original NASD Manual was called.  The numbering system was changed in May 1996.

[4]                 See supra Note 34 and accompanying text.

[5]                 FINRA Rule 2090 (Know Your Customer); available at http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=13389&element_id=9858&highlight=2090#r13389; accessed August 1, 2013.

[6]                 See supra Note 34.  FINRA Rule 2111 Supplementary Material .05 Components of Suitability Obligations.

[7]                 Id.  See also FINRA NTM 05-26 for suggested best practices for vetting new products.

[8]                 Id.

[9]                 Id.

[10]               Id.

[11]               Id.