The Securities Litigation Expert Blog

IPO Churning - It Ain't What it Used to Be (And it Never Was)

Posted by Jack Duval

Jul 18, 2019 7:38:28 AM

I'm pleased to announce a new white paper entitled IPO Churning - It Ain't What it Used to Be (And it Never Was).

Over the years, I have participated in many IPO churning cases and have heard defense counsel argue that the client doesn't pay the commission and therefore there can be no churning.

This argument is just plain wrong.

Confusion about this issue arises from counsel not understanding the different types of IPOs commonly used today.  This white paper unpacks the different types of IPOs and shows how in almost all cases, the client pays the markup (commission) to the underwriters, not the issuing firms.

The paper also discusses:

  • How IPO churning has changed since the technology bubble and why clients are unlikely to make money in such a "strategy";
  • How prospectuses are used to solicit investors into IPOs;
  • The different types of prospectuses used;
  • Suitability, and;
  • Supervision.

To learn more about fiduciary expert Jack Duval, click here.

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Topics: supervision, IPO, Investment Suitability, FINRA Suitability Rule 2111, Suitability Expert, Churning, Section 2(a)(10), Section 15(c)(2)

SEC Regulation Best Interest - The Final Rule

Posted by Jack Duval

Jun 13, 2019 8:03:07 AM

Accelerant SEC Regulation Best Interest - Logo 

This blog post continues my series on SEC Regulation Best Interest ("RBI") and the DOL Rule.

After having disappeared for about a year, SEC Regulation Best Interest (“RBI”) is back, in finalized form.  The new rule will have an effective date 60 days after it appears in the Federal Register and a compliance date of June 30, 2020.[1]  The compliance date is when RBI goes live for all customers at all broker-dealers (“BDs”).

Like the '33 Act, the '34 Act, and both of the '40 Acts, as well as FINRA itself, the raison d'etre of RBI is to protect investors.  The SEC writes: [2]

We are adopting a new rule 15l-1 under the Exchange Act ("Regulation Best Interest") that will improve investor protection by: (1) enhancing the obligations that apply when a broker-dealer makes a recommendation to a retail customer and natural persons who are associated persons of a broker-dealer… and (2) reducing the potential harm to retail customers from conflicts of interest that may affect the recommendation.  (Emphasis added)

As a quick refresher, most of the language in the Proposed Release has been accepted, including that:

  • The RBI “standard of conduct draws from key principles underlying fiduciary obligations”;[3]
  • RBI is designed to “enhance the BD standard of conduct beyond existing suitability obligations”;[4]
  • RBI is still recommendation-based (like FINRA's Suitability Rule 2111). In particular, “regardless of whether a retail investor chooses a broker-dealer (“BD”) or an investment adviser (or both), the retail investor will be entitled to a recommendation (from a BD) or advice (from an investment adviser) that is in the best interest of the retail investor and that does not place the interest of the firm or the financial professional ahead of the interest of the retail investor”;[5]
  • The obligations of RBI exist at the time of the recommendation. (This is a key distinction from the continuous fiduciary obligations owed by investment advisors to their clients);[6]
  • The RBI standards cannot be satisfied through disclosure alone;[7]
  • To the chagrin of many, the final version of RBI still does not define “best interest” but does give significant discussion to the four elements that must be satisfied to meet the best interest standard.

There have been a number of significant modifications to the Proposed Rule.  I have summarized them below.[8]

Modifications of the Proposed Regulation Best Interest

Definition of a “Retail Customer”

A “retail customer” is now defined as:

any natural person who receives a recommendation from the BD for the natural person's own account (but not an account for a business that he or she works for), including individual plan participants… The plan representative will be a retail customer to the extent that the sole proprietor or self-employed individual receives recommendations directly from a BD primarily for personal, family or household purposes. [9]

Implicit Hold Recommendations

While BDs will not be required to monitor accounts, in instances where a BD agrees to provide the retail customer with specified account monitoring services, it is our view that such an agreement will result in buy, sell or hold recommendations subject to RBI, even when the recommendation to hold is implicit.[10]

Recommendations as to Account Types and Rollovers

RBI expressly applies to account recommendations including, among others, recommendations to roll over or transfer assets in a workplace retirement plan account to an IRA, recommendations to open a particular securities account (such as brokerage or advisory), and recommendations to take a plan distribution for the purpose of opening a securities account.[11]

Dually Registered Firms

RBI does not apply to advice provided by a BD that is dually registered as an investment adviser (dual-registrant") when acting in the capacity of an investment advisor.[12]

“Best Interest” Determination is Fact Specific

Whether a BD has acted in the retail customer's best interest in compliance with RBI will turn on an objective assessment of the facts and circumstances of how the specific components of RBI - including its Disclosure, Care, Conflict of Interest, and Compliance Obligations - are satisfied at the time that the recommendation is made (and not in hindsight).[13]

Definition of “Conflict of Interest”

RBI now defines a conflict of interest as, "an interest that might incline a BD - consciously or unconsciously - to make a recommendation that is not disinterested”.[14]

Disclosure of Material Facts

The final version of RBI revised the Disclosure Obligation to require disclosure of "material facts" regarding conflicts of interest associated with the recommendation.  This explicitly requires BDs to provide "full and fair" disclosure of material facts, rather than requiring BDs to "reasonably disclose" such information.

We are also clarifying that at a minimum, a BD needs to disclose whether or not account monitoring services will be provided (and if so, the scope and frequency of those services), account minimums, and any material limitations on the securities or investment strategies involving securities that may be recommended to the retail customer.

Also, we conclude that the basis for a BDs recommendations as a general matter (i.e., what might commonly be described as the firm's investment approach, philosophy, or strategy) and the risks associated with a BDs recommendations in standardized (as opposed to individualized) terms are material facts relating to the scope and terms of the relationship that should be disclosed.[15]  (Emphasis added)

The Care Obligation

The final version of RBI added explicit focus on the costs of a recommendation and reiterated that meeting the standard will be judged by how the BD established a reasonable basis to believe the recommendation was in the client’s best interest.

We are expressly requiring that a BD understand and consider the potential costs associated with its recommendation, and have a reasonable basis to believe that the recommendation does not place the financial or other interest of the broker-dealer ahead of the interest of the retail customer.  Nevertheless, we emphasize that while cost must be considered, it should never be the only consideration.  Cost is only one of many important factors to be considered regarding the recommendation and that the standard does not necessarily require the "lowest cost option".

... determining whether a BDs recommendation satisfied the Care Obligation will be an objective evaluation turning on the facts and circumstances of the particular recommendation and the particular retail customer.  We recognize that a facts and circumstances evaluation of a recommendation makes it difficult to draw bright lines around whether a particular recommendation will meet the Care Obligation.  Accordingly, we focus on how a BD could establish a reasonable basis to believe that a recommendation is in the best interest of its retail customer and does not place the BDs interest ahead of the retail customer's interest, and the circumstances under which a BD could not establish such a reasonable belief.[16]

We are clarifying that an evaluation of reasonably available alternatives does not require an evaluation of every possible alternative (including those offered outside the firm) nor require BDs to recommend one "best" product, and what this evaluation will require in certain contexts (such as a firm with open architecture).[17]

We further clarify that, when a BD materially limits its product offering ... it must still comply with the Care Obligation... and thus could not use its limited menu to justify recommending a product that does not satisfy the obligation to act in a retail customer's best interest.[18]  (Emphasis added)

Conflicts of Interest

Eliminate the distinction between financial incentives and all other conflicts of interest; and focus on mitigating conflicts of interest associated with recommendations that create an incentive for the associated person of the BD to place the interest of the firm or the associated person ahead of the interest of the retail customer.[19]

Elimination of Sales Contests

We are requiring BDs to establish written policies and procedures reasonably designed to identify and eliminate any sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sale of specific securities or the sale of specific types of securities within a limited period of time.[20]

General Compliance Obligation

Establishing a new general "Compliance Obligation" to require BDs to establish policies and procedures to achieve compliance with RBI in its entirety.[21]

Federal Securities Laws, Scienter, and State Laws

Compliance with RBI will not alter a BDs obligations under the general antifraud provisions of the federal securities laws.  RBI applies in addition to any obligations under the Exchange Act, along with any rules the Commission may adopt thereunder, and any other applicable provisions of the federal securities laws and related rules and regulations.[22]

Scienter will not be required to establish a violation of RBI.

We note that the preemptive effect of RBI on any state law governing the relationship between regulated entities and their customers would be determined in future judicial proceedings based on the specific language and effect of that state law.[23]

No Waiver of Compliance or Protections

In addition, under Section 29(a) of the Exchange Act, a BD will not be able to waive compliance with RBI, nor can a retail customer agree to waive her protections under RBI. Furthermore, we do not believe RBI creates any new private right of action or right of rescission, nor do we intend such a result.[24]

“Federalizing” the Suitability Rule

FINRA CEO Jay Cook recently commented that FINRA is:

… thinking more generally about are there aspects of our rules that might need to be adjusted/aligned with where the SEC lands.  It’s not surprising because most of the sales practice requirements historically have come from the FINRA rulebook.  Reg BI is sort of federalizing sales practice issues… There’s a suitability element to Reg BI, and that’s when we’re talking about looking at alignment with our rulebook; if they (the SEC) have covered 100 percent of our suitability rule, then we might look at whether we need our suitability rule or do we need it in all circumstances?[25]

My guess is that FINRA Suitability Rule 2111 will be modified, possibly to focus on institutional investors.

In subsequent posts I will unpack the implications of the finalized RBI in more detail.

__________

Notes:

[1]      Regulation Best Interest: The Broker-Dealer Standard of Conduct; 17 CFR Part 240; Release No. 34-86031; File No. S7-07-18; 2 and 371. Available at https://www.sec.gov/rules/final/2019/34-86031.pdf; Accessed June 9, 2019.

[2]      Id. at 5.

[3]      Id. at 1.

[4]      Id.

[5]      Id. at 2.

[6]      Id. at 1.  As discussed below, this is true unless there is an explicit representation by a Registered Representative that positions will be monitored, which must be disclosed by the BD.

[7]      Id.

[8]      There were also a number of less significant modifications which I have left out of this summary.

[9]      Id. at 33 and Footnote 62.  A “retail customer” also includes a nonprofessional trustee who represents the assets of a natural person.

[10]    Id. at 34.

[11]    Id.

[12]    Id. at 35.

[13]    Id.

[14]    Id.

[15]    Id. at 37.

[16]    Id. at 38.

[17]    Id. at 39.

[18]    Id.

[19]    Id. at 40.

[20]    Id. at 41.

[21]    Id. at 42.

[22]    Id. at 43.

[23]    Id.

[24]    Id. at 44.

[25]    Melanie Waddell; ThinkAdvisor; “FINRA’s Cook: SEC Reg BI Compliance to Be a Heavy Lift”; May 8, 2019.  Available at: https://www.thinkadvisor.com/2019/05/08/finras-cook-two-issues-top-of-mind-regarding-sec-reg-bi-compliance/; Accessed July 12, 2019.

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Topics: supervision, Investment Suitability, FINRA Suitability Rule 2111, Suitability Expert, Securities Exchange Commission, Regulation Best Interest

SEC Regulation Best Interest - State Fiduciary Laws

Posted by Jack Duval

Oct 26, 2018 7:52:58 AM

Accelerant SEC Regulation Best Interest - Logo 

This blog post continues my series on SEC Regulation Best Interest ("RBI") and the DOL Rule.

There has been some hand-wringing over the past year about the potential of a fractured fiduciary duty landscape for Broker-Dealers ("BDs") and their Registered Representatives.  The concern is that individual states will impose a fiduciary standard on Registered Representatives while the FINRA suitability standard, and ultimately SEC Regulation Best Interest ("RBI"), cover the rest.

Allow me to allay these concerns:  the fractured fiduciary landscape already exists, and has for decades.

Nevada's Fiduciary Statues

The event that started the concern was Nevada passing legislation that imposed a fiduciary duty on anyone giving financial advice.  In short, the Nevada law:  "imposes a statutory fiduciary duty as set for in Chapter 628A of the Nevada Revised Statutes on Broker-Dealers and Investment Advisers."[1]

However, four other states have common law fiduciary duties for registered representatives and 31 additional states have quasi-fiduciary duties required under common law.[2]  I'm defining "quasi-fiduciary" obligations as Finke and Langdon do: those that exceed the FINRA suitability rules but do not expressly classify BDs as fiduciaries.[3]

Table 1: Fiduciary Status of Registered Representatives by State[4]

 Accelerant LLC Jack Duval - table of fiduciary status of registered representatives by state

Thus, 36 states already have some form of fiduciary duty required of registered representatives.

Voluntary Fiduciary Status for Broker-Dealers?

The existing uneven fiduciary duty landscape has not hampered BDs business efforts and I wouldn't expect it to in the future.[5]  Furthermore, if BDs were to find complying with the varying standards too taxing, they could just implement a fiduciary standard nation-wide.

Given SIFMA’s[6] long-standing resistance to a fiduciary standard, voluntary adherence to one is highly unlikely.   However, this might be more economical in the long-run, especially if more states pass their own fiduciary statutes.

As I have discussed in this blog posts series, I believe the pseudo-fiduciary standard under RBI will be difficult and expensive to implement.  BDs and their clients would be better off under a fiduciary standard.  Further, from a purely business perspective, adopting a fiduciary standard would help BDs compete with registered investment advisory firms which have been winning the battle for clients and assets.

Given the disappointment in many states with the defeat of the DOL Fiduciary Rule and RBI, it would not be surprising to see more states adopt fiduciary statutes.  Fiduciary expert James Watkins opines that “So long as states enact fiduciary laws that don’t impact a pension plan like a 401(k), they have every right to act,”.[7]

__________

Notes:

 

[1]       Nevada Secretary of State; Website; Available at: https://www.nvsos.gov/sos/licensing/securities/new-fiduciary-duty; Accessed October 25, 2018.

[2]       Michael Finke and Thomas Langdon; The Impact of the Broker-Dealer Fiduciary Standard on Financial Advice; March 9, 2012; Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2019090; Accessed October 26, 2018; 13.

[3]       Id. at 14.

[4]       Id.

[5]       See supra Note 2.

[6]       Securities Industry and Financial Markets Association; https://www.sifma.org/about/.

[7]       Mark Miller; U.S. states eye protections for investors if federal regulation falters; Reuters; April 12, 2018; Available at: https://www.reuters.com/article/us-column-miller-fiduciary/u-s-states-eye-protections-for-investors-if-federal-regulation-falters-idUSKBN1HJ1NT?feedType=RSS&feedName=PersonalFinance; Accessed October 25, 2018.

 

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Topics: supervision, Investment Suitability, FINRA Suitability Rule 2111, Suitability Expert, Securities Exchange Commission, Regulation Best Interest

Understanding FINRA Suitability Rule 2111 - Prospectus Delivery and Suitability

Posted by Jack Duval

Dec 19, 2013 10:27:00 AM

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.

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Topics: FINRA Suitability Rule 2111, Suitability Expert, Customer-specific Suitability, Prospectus Delivery, Reasonable

Understanding FINRA Suitability Rule 2111 - Leveraged and Inverse ETF Suitability

Posted by Jack Duval

Dec 17, 2013 6:56:00 AM

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 particular, customer-specific and reasonable-basis suitability will be examined.

ETF Specific Suitability

Leveraged and inverse ETFs are not suitable for most investors because they are (respectively) speculative and aggressive investments.  In order to understand why these investments are speculative and aggressive it is helpful to define those terms.

Speculation

Speculation is a term of art within the investment world and it has a very specific meaning, in particular, it indicates the high probability of the complete, or near complete, loss of the entire investment.  A classic example of a speculative investment is purchasing an out-of-the-money (“OTM”) call option on a stock.

When you purchase an OTM call option, it has a fixed amount of time before it expires worthless.  If the underlying stock does not rise above the strike price before the expiration date, the call option will become worthless and the investor will have lost the entire premium she paid for it.

Aggressive

Aggressive investments are also a term of art within the investment world.  An aggressive investment is one in which there can be expected large and violent price movements, but which do not have a high likelihood of a total loss. A good example of an aggressive investment is an investment in a stock market index such as the S&P 500 or the NASDAQ index.

As recent investors in the above indicies can attest, both have experienced extreme volatility over the past 14 years. Indeed, the S&P 500 declined approximately 45 percent twice and the NASDAQ declined approximately 70 percent and 50 percent over the same time period.  While these investments are extremely volatile, they carry a much smaller risk of complete loss than a stock option, and thus are in a different category.

Investment Math

Additionally, the more speculative or aggressive an investment is, the more closely it must be watched and the more active management it requires.  This is due to what is commonly referred to as “investment math”. If an investor holds an investment that declines by 50 percent and then rises by 50 percent, they are still down 25 percent on a dollar basis.  The reason for this is that the positive 50 percent return came after the investment had already declined by 50 percent, so it was a 50 percent return on a “50 percent investment”.  Thus that return was only 25 percent of the original investment.

A simple example is instructive. If an investor invests $100,000 and it declines to $50,000, a 50 percent return on the $50,000 only gets her back to $75,000.  She is still down $25,000 on her original investment.  What is needed is a 100 percent return after the original decline (because a 100 percent return on $50,000 is $50,000 and this would get her back to her original investment value).

This investment math is why investors who have been invested in the broad stock market since 2000 have the same portfolio value 13 years later.  They suffered through two declines of around 50 percent and subsequent recoveries of around 100 percent but their portfolios are at the same approximate value as when they started.

Using broad asset allocation rebalancing on a quarterly or annual basis is a way to more actively manage aggressive positions. However, more frequent management may be warranted given an investment’s specific traits. In particular, leveraged and inverse ETFs require constant vigilance and frequent (even daily) rebalancing by the advisor if they are held longer than one day.

As discussed in other posts, leveraged ETFs are speculative because the use of leverage magnifies the deleterious effects of internal rebalancing to maintain constant leverage. Simply put, the more leverage used, the faster the ETF declines towards zero.

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.  

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

 

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Topics: Investment Suitability, FINRA Suitability Rule 2111, Suitability Expert, Leveraged and Inverse ETF, Speculative and Aggressive Investments

Understanding FINRA Suitability Rule 2111

Posted by Jack Duval

Dec 13, 2013 9:25:00 AM

This blog post is the first in 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.

Suitability

The concept of suitability can be succinctly stated as appropriately matching investments to the investor. In order to accomplish a suitability determination, a broker must know and understand both the investments and the investor.  Given that the FINRA suitability rule has recently been updated to explicitly include both elements, both will be examined.

FINRA Rule 2010 (Standards of Commercial Honor and Principals of Trade)

Before addressing suitability it is worth noting that FIRNA Rule 2010 sets forth the standard for member conduct. This Rule states simply:

 A member, in the conduct of its business, shall observe high standards of commercial honor and just and equitable principles of trade.[1]              

While not a fiduciary standard, FINRA is clearly setting the bar beyond mere arms length transactions and caveat emptor. This standard should be kept in mind by member firms and their associated persons in all their dealings with customers and other member firms.

FINRA Rule 2310 (Recommendations to Customers)

During the initial popularity of leveraged and inverse ETFs in 2006-2007, Registered Representatives (hereafter “brokers”) working for FINRA member firms, were required under Rule 2310 to insure each recommendation made to a client was “suitable”.  FINRA Suitability Rule 2310 stated (in part):

(a)   In recommending to a customer the purchase, sale or exchange of any security, a member shall 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.
(b)   Prior to the execution of a transaction recommended to a non-institutional customer, other than transactions with customers where investments are limited to money market mutual funds, a member shall make reasonable efforts to obtain information concerning:
(1) the customer's financial status;
(2) the customer's tax status;
(3) the customer's investment objectives; and
(4) such other information used or considered to be reasonable by such member or registered representative in making recommendations to the customer. [2]

In order to comply with FINRA Rule 2310, the broker must know her client.  In order to know her client, a broker must conduct the necessary due diligence by gathering all the pertinent facts, goals, objectives, and circumstances of the client. In the industry, this process is known as “profiling”.

Similarly, in order to know an investment, a broker must conduct the necessary due diligence by reading the prospectus, prospectus supplements, statements of additional information, and other documents, depending on the type of investment being recommended.

Once the broker knows her client and many different investments, she can go about selecting investments that are within the client’s risk tolerance and investment objectives and will help achieve her client’s goals and objectives.

Importantly, if either side of the suitability due diligence equation is not completed, the recommendation cannot be said to be suitable.  More specifically, if the broker does not know the client or the investment, or both, then she cannot have “reasonable grounds” for believing the recommendation is suitable.

FINRA Rule 2111 (Suitability)

On July 9th, 2012, FINRA updated Rule 2310 with a new suitability rule, 2111.  FINRA Rule 2111 states, in part:

(a)   A member or an associated person must 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. 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.[3]

A few aspects of this are worth highlighting:  the explicit inclusion of investment strategies; the explicit description of the three components of the suitability obligation; and the treatment of a recommendation to hold as a recommendation.

As will be discussed, all three of these aspects existed before the new suitability rule, with Rule 2111, FINRA has merely brought them together in one place.[4] This has greatly simplified the rule for brokers and broker-dealer firms and should lead to better supervisory practices and customer outcomes.

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]                 FINRA Rule 2010 (Standards of Commercial Honor and Principles of Trade); available at http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=6905&element_id=5504&highlight=2010#r6905; accessed June 20, 2013.

[2]                 FINRA Rule 2310 (Recommendations to Customers), FINRA Manual; available at http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=4315&element_id=3638&highlight=2310#r4315; accessed June 16, 2013.

[3]                 FINRA Rule 2111, FINRA Manual; available at http://finra.complinet.com/en/display/display.html?rbid=2403&element_id=9859; accessed June 16, 2013.

[4]                 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.

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Topics: Investment Suitability, FINRA Suitability Rule 2111, Suitability Expert

Understanding FINRA Suitability Rule 2111 - Recommendations to Hold

Posted by Jack Duval

Dec 13, 2013 8:46:00 AM

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.

 

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Topics: hold recommendations, Investment Suitability, FINRA Suitability Rule 2111, Suitability Expert, Customer-specific Suitability

Understanding FINRA Suitability Rule 2111 - The Three Components of Suitability

Posted by Jack Duval

Dec 12, 2013 8:03:00 AM

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.

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Topics: reasonable basis suitability, Investment Suitability, FINRA Suitability Rule 2111, Suitability Expert, Quantitative Suitability, Customer-specific Suitability

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