On July 9, 2012 new FINRA Rule 2090 and FINRA Rule 2111 will take effect. The goal of FINRA (the Financial Industry Regulatory Authority) is to “strengthen, streamline and clarify” those very
important investor protection rules. Indeed, that goal is apparent in reviewing FINRA Regulatory Notices 11-25 and 12-25, which elaborate on those new rules. Let’s highlight the key features of the new rules.
First, Regulatory Notice 12-25 contains an informative answer to the question of what constitutes “reasonable diligence” in attempting to obtain the customer-specific information required
by new Rule 2090, the “Know Your Customer” rule. The rule requires financial services firms
(and their advisers) to “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.” And an important aspect of new Rule 2090 is its emphasis on requiring Know Your Customer information not just at the time that the account was opened, but also throughout the life of the account relationship with the customer, so that the account may be effectively serviced and supervised.
But what is reasonable due diligence? FINRA answers that what is reasonable depends upon the facts and circumstances, and that absent any “red flags” indicating that the customer information is inaccurate or that the customer is unclear about the information, an adviser generally will be able to rely on that information, for example, in making investment recommendations. However, FINRA states that an adviser “may not be able to rely exclusively on a customer’s responses” in situations such as the following:
- Theadviser “poses questions that are confusing or misleading to a degree that theinformation-gathering process is tainted”;
- Thecustomer “exhibits clear signs of diminished capacity”; or
- Other “red flags” exist indicating that the customer information may be inaccurate.
The significance of securing and updating accurate customer profile information cannot be understated. For example, in Regulatory Notice11-25, FINRA discusses a customer’s liquidity needs, time horizon and risk tolerance for investments as being important considerations for the suitability requirements contained in new Rule 2111, the “Suitability” rule.
Second, both Regulatory Notices 11-25 and 12-25 contain a host of helpful guidance with respect to new Rule 2111. One thought-provoking commentary in Regulatory Notice 11-25 relates to the juxtaposition of risk tolerance, on the one hand, with time horizon, on the other hand. For example, while one may assume that an investor with a long term time horizon is suitable for riskier investments, FINRA states that such an assumption may be wrong. As FINRA states, “Some customers with long time horizons may not desire to take on such risk and others, because of
considerations outside their time horizons, are unable to do so.”
Another important aspect relates to the fact that the new suitability rule explicitly applies to recommended investment strategies involving a security or securities. FINRA states in Regulatory Notice 11-02 that the term “strategy” is to be interpreted broadly, and that the rule is triggered when a firm or adviser recommends a security or a strategy regardless of whether the recommendation
results in a transaction. Most critical, FINRA states that “the term ‘strategy’ would capture a broker’s explicit recommendation to hold a security or securities.” FINRA explains that it is reasonable to hold
firms and their advisers responsible for “hold recommendations” because customers may rely on them for their expertise. Such hold recommendations, of course, frequently were made preceding and
during the market downturn in 2008, causing investors to lose substantial sums, for which securities arbitration may be an option for recovery.
As part of its commentary as to what constitutes an “investment strategy”, FINRA states in Regulatory Notice 12-25 that a mere recommendation broadly to invest in equities, or in fixed income
securities, would not qualify. On the other hand, the new suitability rule would apply to investment strategies such as:
- Investing in dividend paying equities;
- Investing in particular market sectors;
- Day trading;
- Using home equity to purchase investments; and
- Using margin loans to purchase investments.
Indeed, those latter two investment strategies should be weighed against FINRA’s new section to the suitability rule entitled Customer’s Financial Ability. The rule reads: “Rule 2111 prohibits a member or associated person from recommending a transaction or investment strategy involving a security or
securities or the continuing purchase of a security or securities or use of an investment strategy involving a security or securities unless the member or associated person has a reasonable basis to believe that the customer has the financial ability to meet such a commitment” (emphasis added).
The new rule thus envisions situations in which an investment recommendation is unsuitable for an investor because he or she cannot afford to lose his or her principal. Thus, the use of home equity, as well as margin, may be a “red flag” that the customer does not have the financial ability to engage in a particular investment transactionor investment strategy.