The Securities Litigation Expert Blog

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.

 

 

Finra has released NTM 12-55 to further clarify the recently updated suitability Rule 2111.  (Finra)  Some key takeaways:

1. The term "customers" does not include other broker-dealers;


2. The suitability rule applies to recommendations made to potential clients who become clients and execute the recommended trade or strategy at the recommending firm;


3. The suitability rule applies to recommended strategies, such as the general use of margin, even if there is no specific investment recommendation made;


4. The suitability rule applies to explicit recommendations to hold securities or to continue with an investment strategy (Finra uses an example of a quarterly review meeting with a client where the Registered Representative explicitly advises the client not to sell any securities or to continue their existing investment strategy.);


5. The suitability rule applies to recommendations to sell securities in order to raise funds to purchase non-securities.

See our previous coverage of suitability Rule 2111 here.

Compliance departments need to update their policies and procedures to reflect these clarifications and to monitor RR activity regarding: investment strategies, hold recommendations, and sell recommendations to purchase non-securities.

This blog post continues our expert analysis of complex investments and their regulation.

Speaking at a PLI Seminar on Broker-Dealer Regulation and Enforcement on October 24, 2012, Finra EVP Susan F. Axelrod had some interesting comments on Complex Investments, the new Suitability Rule 2111, and Know Your Customer Rule 2090.  (Axelrod)  You can also see our previous coverage on Complex Products here.  Below are some extracts.

Finra has noticed the hunt for yield that we have been observing in junk bonds here and MLPs here:

Let me now turn to complex products. This is an area that warrants our attention because of the continuous and rapid evolution of these types of products, and more importantly, because these products are now more frequently being offered to retail investors. There is no doubt that customers are seeking higher returns. The industry has responded by creating products that offer the potential for greater yields. But the greater yields provided through complex products can expose customers to increased risk. Firms and registered representatives must ensure that these products are only sold after a careful evaluation, through which all parties fully understand the intricacies of each product. Effective product vetting is critical if your firm is going to sell complex products.

The reasonable basis suitability requirement gets a lot of attention as well, including comprehensive due diligence, written supervisory procedures, and training:

FINRA examiners have been focused on several product types, including principal-protected notes, non-traded REITs, reverse-convertible notes, structured notes, and leveraged and inverse ETFs. FINRA recently issued Regulatory Notice 12-03 highlighting our concerns about complex products and offering guidance to firms on developing adequate supervisory systems for these products. In that guidance, FINRA notes that complex products often necessitate more scrutiny and supervision by a firm. More specifically, the guidance calls for a comprehensive process that includes due diligence prior to approval of the product for sale to clients. Also, this due diligence process must inform the firm's written supervisory procedures and training programs. Brokers should be trained on the features of the product as well as the firm's own suitability guidelines for that product. And these guidelines should be specific enough to identify those to whom the product should and should not be offered. The decision to offer complex products to retail investors is one that should be carefully considered and made only after a thorough assessment of a product's features, a comprehensive training effort and a full evaluation of firm supervisory systems related to that product.

The recent AWC and fine of David Lerner Associates was cited as an example of improper due diligence:

Earlier this week, FINRA announced a significant action involving David Lerner Associates wherein the firm agreed to pay approximately $11.7 million in restitution to customers who purchased Apple REIT Ten, a publicly registered, non-traded REIT. The sanctions, which also include a suspension of the firm's President, David Lerner, as well as a $250,000 fine, stem from the firm's recommendations and sales of Apple REIT Ten without performing adequate due diligence in violation of its suitability obligations. Also, the firm marketed the product using misleading marketing materials, including the presentation of performance results for closed Apple REIT issues, which did not disclose that income from those REITs was insufficient to support the distributions. David Lerner consented to findings that he made false, exaggerated and misleading claims regarding the investment returns, market values, prospects and performance of the closed Apple REIT issues through investment seminars and in letters to customers. As FINRA has repeatedly stated, inadequate due diligence in the complex product space is a recipe for significant problems. FINRA will take appropriate action when it finds that a firm has failed to take reasonable steps in this area.

Finally, Axelrod highlighted how some firms are now documenting hold recommendations:

In addition to understanding the products they sell, every firm must take steps to ensure that the products they sell are suitable for the specific customer. FINRA Rule 2111 (the Suitability Rule) and FINRA Rule 2090 (Know Your Customer Rule) became effective in July. The results of the examinations of this area, while preliminary at this stage, are very encouraging. With very few exceptions, FINRA examiners have observed that firms are demonstrating awareness of the requirements of the rules and have updated their supervisory procedures accordingly. Firms have updated their new account forms to include questions about the information that is required in the new know your customer rule. Although not a specific requirement of the rule, some firms have implemented a process whereby they create a "hold" ticket when brokers make an explicit hold recommendation. Others prefer to document the recommendation in customer relationship management systems. As we have said previously, not a one-size-fits-all approach to compliance with these rule changes.