FINRA Issues Guidance on Suitability Rule Concerning Definition of "Customer" and "Investment Strategy"

Thursday, December 27, 2012

By way of background, FINRA Rule 2111 requires that a broker-dealer or registered representative “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 customer’s investment profile.”

Recently-issued FINRA Regulatory Notice 12-55 provides additional guidance related to FINRA Rule 2111. Specifically, Notice 12-55 addresses the scope of the terms  “customer” and “investment strategy.”

According to Notice 12-55, “the term customer includes a person who is not a broker or dealer who either opens a brokerage account at a broker-dealer or purchases a security for which the broker-dealer receives or will receive, directly or indirectly, compensation even though the security is held at an issuer, the issuer’s affiliate or a custodial agent . . . or using another similar arrangement” (i.e. even though the security is not held by the broker-dealer).

Notice 12-55 also addresses the application of the suitability rule in the context of a recommendation made by a broker-dealer or registered representative to a potential investor. In such a case, suitability obligations do not apply unless the potential investor executes the transaction through the broker-dealer or if the broker-dealer receives compensation. If and when a transaction occurs, suitability obligations immediately commence. However, the suitability of the recommendation is evaluated based on circumstances at the time of the recommendation.

Notice 12-55 also addresses the term “investment strategy.” Under 12-55, the term “investment strategy” is to be broadly construed, focusing on whether the recommendation was suitable when made. The “investment strategy” language would  “apply to recommendations to customers to invest in more specific types of securities, such as high dividend companies or the ‘Dogs of the Dow,’ or in a market sector, regardless of whether the recommendations identify particular securities.” This language would also apply to general recommendations to customers to use a bond ladder, day trading, “liquefied home equity,” or margin strategy involving securities even if the recommendations do not reference particular securities. In addition, “the term would capture an explicit recommendation to hold a security or securities or to continue to use an investment strategy involving a security or securities.”

It is worth emphasizing that, under Notice 12-55, the suitability rule encompasses a broker-dealers’ recommendation of an investment strategy involving both security and non-security components.

Although Notice 12-55 appears to offer some helpful clarifications, it is interesting to note the inconsistent treatment between customers and potential customers. Moreover, despite various illustrations, the limit of Notice 12-55’s broad reach with regard to investment strategy is far from clear. Outside of the specific illustrations in Notice 12-55, it seems that it would be safe to assume that most investment advice would constitute “investment strategy,” particularly given that this term is to be broadly construed. Time will tell how Notice 12-55 will play out in practice.

Regulatory Notice 12-55, Guidance on FINRA's Suitability Rule

Davis Polk. Guidance on FINRA's Suitability Rule