FINRA’s new suitability rule looms, with expanded customer-information requirements

June 27, 2012

By Nick Paraskeva

NEW YORK, June 27 (Thomson Reuters Accelus) – FINRA’s new suitability rule expanding customer information requirements and applying them to more transactions the is set to go into effect July 9, after delays requested by firms to get more time to adapt.

The rules will require a broker dealer or their associated persons to have a “reasonable basis” to believe a recommended transaction is suitable for the customer, based on information obtained through “reasonable diligence” to understand a customer’s investment profile.”FINRA and representative broker dealers discussed the new rule in a New York panel last week at the Securities Industry and Financial Market Assosciation, that followed issuance in May of further FINRA guidance on how the rule should be applied, in response to member questions.

The panel consisted of James Wrona, FINRA’s vice president and associate general counsel, Morgan Stanley executive director Belinda Blaine, Linda Schaffer-Guttman, Managing Director, Citigroup Global Markets, Inc. and Paul Merolla, Partner, Murphy & McGonigle, P.C. It was moderated by Gerald Baker of SIFMA, and took place at a meeting of SIFMA’s Compliance and Legal Society in New York on June 19th.


FINRA has recently received further questions on the interaction between the suitability rule and the variable annuity rule, Wrona said. An enhanced suitability review for deferred variable annuities applies to purchases and exchanges of variable annuities contracts, and to the initial subaccount allocations. It does not apply to a reallocation of sub-accounts or to the subsequent deposits of funds after an initial purchase or exchange.

Citigroup’s Schaffer-Guttman said monitoring resources will develop as understanding increases and more FINRA guidance is issued. This will be a continuing process, and is seen as an active area over the next six months. Citi had the benefit of an earlier internal initiative to revise their KYC and suitability standards, so had less adjustment than other firms. Considerable effort was used to understand what it means to the firm, to be followed by training on new technology, policies and procedure, and supervisory procedures.

Citi only needed to add one new data field to its customer system for “other investments,” and also issued guidance to representatives on the need to take notes on the recommendations they make to customers. Definitions and training were recalibrated, with the new training manual for representatives incorporating FINRA’s latest regulatory notice that was issued in May, and for questions received from the branches.

Monitoring will initially be done by including the rule in regular internal supervision, with supervisors also looking at a broker’s recommendation notes and their suitability assessments as a part of the review. The second stage will be a more targeted focus to look specifically at the quality of the notes. Representatives have been asked to document their rationale for client recommendations, by using existing firm systems.


The rule now contains narrower exemptions for recommendations to “institutional customers.” Institutional accounts are limited to banks, insurers, investment companies, registered investment advisers, or other persons with total assets of over $50 million. The broker dealer is required to believe that an institutional customer is capable of evaluating the investment risks independently. Such customers are also required to affirmatively acknowledge to the broker that they are indeed exercising such independent judgment.

The rule is a game-changer, said Morgan Stanley’s Blaine, given that the firm mainly deals with institutional investors. The institutional threshold was raised to $50 million of assets from $10 million, with additional documentation requirements. The cash-against-delivery business has not historically required substantial documentation, except for the OTC derivatives business, which relies on standardized agreements of the International Swaps and Derivatives Association.

Institutional customers are skeptical of giving the required affirmative confirmation, said Blaine. Given that it is impractical for the firm to call all 10,000 clients individually to explain the rule and negotiate wording, an industry-wide approach is preferable. Industry came up with standard certifications, to be distributed by vendors. However, FINRA has not approved third-party institutional suitability certificates, there is no requirement to use them, and the use of such certificates does not constitute a safe harbor from the rule.

Most institutional clients believe they are exercising independent judgment, said Blaine. For the few that will not sign an affirmation, the firm is looking at introducing new account forms that ask customers about their liquidity needs and their time horizons. The firm can verbally ask a client officer if they are making an independent investment decision, and where that is in a phone call, there is no need to obtain a certificate.

Affirmative determinations are needed, but a risk-based approach means a firm can determine that certain factors do not apply to institutional customers, Wrona said. If the firm asks and a customer does not answer, they may have made reasonable efforts and a basis to believe a recommendation is suitable.

Information-gathering requirements

The rule imposes suitability obligations based on three tests. The first is “reasonable-basis suitability,” the basis to believe a recommendation is suitable for at least some investors. Customer-specific suitability is where the firm believes it is suitable for a particular customer, based on their investment profile. The third is quantitative suitability where they believe that a series of recommended transactions are not excessive.

The rule adds new factors that a firm should consider when determining suitability, based on information it obtains to assess the customer’s investment profile. The profile will be based on, and require information relating to, the customer’s age, other investments, financial needs, tax status, and investment objectives. It also includes a customer’s investment experience, time horizon, liquidity needs and risk tolerance level.

A firm that asks its customer to provide specific information to assess suitability would usually qualify as having performed reasonable diligence to obtain it. Absent any red flag that the information is inaccurate, the firm may rely on responses provided by the customer. The rule does not prohibit a recommendation, even if certain customer information is unavailable, as long as the firm has enough information on the customer for it to reach a reasonable basis of suitability.

The rule will give a new weapon to clients who want to pursue firms or bring a suit for an unsuitable recommendation, said Paul Merolla of Murphy and McGonigle. The rule uses a risk-based approach, so firms get to decide which recommendations to document, and how they will document them. Such documentation is important in a dispute setting, and the content of what a firm’s documents contain will be a key factor.

Firms will have to determine how they interpret the term “strategy,” and what a “hold recommendation” is. They will have to interpret what it means to make a recommendation to a “prospective customer” that has no account with the firm. This may apply in social situations where a broker talks to a person who then subsequently becomes a client, said Merolla. FINRA’s Wrona said the key is whether the firm is making recommendations or not. Sending general materials would not normally be viewed as recommendations.

A broker must have a good understanding of both customer needs and any product that they recommend. A failure to understand the recommended product can itself violate the suitability rule. In recent guidance, FINRA highlighted the importance of representatives understanding the products they sell, given that in recent years, some brokers have recommended strategies that are increasingly complex or risky.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. <a href=” ions/regulatory-intelligence/compliance- complete/” target=_new”>Compliance Complete</a> provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges.)

(Nick Paraskeva is principal of Reg-Room LLC (, which provides regulatory information and consultancy. He covers various facets of the banking and securities industry and delivers exclusive analysis through Thomson Reuters. He can be contacted at (212) 217-0403 and Follow Nick on Twitter@regroom. )


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