By John Moses and Michael Brady 

Now that FINRA has delayed the implementation date of the changes to the know-your-customer (Rule 2090) and suitability (Rule 2111) rules until July 9, 2012, it is an opportune time for securities firms to re-visit the changes, solidify their understanding of the new rules, and make plans for implementation.  In Regulatory Notice 11-25, FINRA provides additional guidance to firms regarding the rule changes based upon industry questions and concerns that FINRA has received.  Several significant topics addressed by Regulatory Notice 11-25 include:

Authority of Person Acting on Behalf of Customer.  As part of the new Rule 2090, the “facts ‘essential’ to ‘knowing the customer’” specifically include an understanding of “the authority of each person acting on behalf of the customer . . . .”  FINRA states that this element is satisfied by the firm:  (1) knowing the names of any persons authorized to act on behalf of the customer; and (2) understanding the specific limits on that person’s authority. One can easily see how even good-faith mistakes in this regard could lead to significant issues if an authorized person is mistakenly allowed to engage in investment transactions that exceed the scope of their authority.  FINRA notes that some firms may make the decision not to do business with customers that seek to qualify the scope of authority of persons acting on their behalf.

Updates to Account Information.  As part of the new Rule 2111, FINRA has added additional, express factors for members to consider in making suitability determinations.  The old suitability rule only specifically mentions financial status, tax status, and investment objectives.  The new rule reiterates those factors and adds age, other investments, experience, time horizon, liquidity needs, and risk tolerance.  Firms expressed concern that FINRA would require them to update all account documents to include these new factors.  In Regulatory Notice 11-25, FINRA responded that Rule 2111 does not require firms to update all customer account documentation, and in fact does not contain any explicit documentation requirements.  Instead, the suitability rule allows firms to take a “risk-based approach” to the documentation of suitability determinations.  In providing examples, FINRA makes it clear that the extent to which a firm needs to “evidence” suitability determinations generally depends on the complexity of the security or strategy involved and/or the risks involved.  FINRA further drives the point home by stating that while compliance with suitability obligations “does not necessarily turn on documentation,” if the suitability basis is not self-evident, “FINRA examination and enforcement concerns will rise with the lack of documentary evidence for the recommendation.”  Thus, while wholesale re-papering of accounts may not be required, Regulatory Notice 11-25 makes it clear that the more documentation in a customer file exhibiting a consideration of the suitability factors – particularly with complex or risky products and strategies – the better position the firm will be in upon a subsequent examination.  The same holds true if a firm is later faced with defending a customer-initiated suitability claim.

Definitions of “liquidity needs,” “time horizon” and “risk tolerance”.  As stated above, new factors for consideration in the suitability rule include an investor’s “liquidity needs,” “time horizon” and “risk tolerance.”  These terms are not defined in Rule 2111, but FINRA did provide some guidance in response to firms’ requests.  FINRA noted that the terms are to be “understood commensurate with their meaning in financial analysis,” and offered the following “guidelines”:

Liquidity Needs:  “The extent to which a customer desires the ability or has financial obligations that dictate the need to quickly and easily convert to cash all or a portion of an investment or investments without experiencing significant loss in value from, for example, the lack of a ready market, or incurring significant costs or penalties.”

Time Horizon:  “The expected number of months, years, or decades [a customer plans to invest] to achieve a particular financial goal.”

Risk Tolerance:  “A customer’s ability and willingness to lose some or all of [the] original investment in exchange for greater potential returns.”

Different Accounts, Different Profiles.  Many firms were interested in whether the same person or entity with multiple accounts at a given firm could have different investment profile factors for different accounts.  FINRA answers in the affirmative, but recommends that the firm expressly document the diverse intentions of the customer among the accounts.  Going further, FINRA states that “a firm could not borrow profile factors from the different accounts to justify a recommendation that would not be appropriate for the account for which the recommendation was made.”  In other words, if a customer has a conservatively-profiled account and an aggressive-risk account, the firm cannot borrow the profile from the aggressive-risk account in order to justify risky transactions in the conservative account.  Neither the new Rule 2111 nor Regulatory Notice 11-25 addresses the fact that an asset allocation strategy may involve holding a basket of conservative and more risky investments in a single account.  Here again, appropriate documentation of the strategy being employed will be helpful if suitability questions later arise.

Nature of a “hold” recommendation.  The new suitability rule applies to recommended investment strategies and emphasizes that the term “strategy” is defined broadly and includes, for example, an “explicit recommendation” to hold a security or to continue with a strategy.  In response to inquiry as to the ongoing nature of a firm’s obligations in the event of a hold recommendation, FINRA notes that the new rule doesn’t change the long-standing application of the suitability rule “on a recommendation-by-recommendation basis” and that the focus remains on the suitability of a recommendation at the time it was made.  FINRA also reiterates that absent an agreement, course of conduct or a unique situation, a “hold recommendation would not create an ongoing duty to monitor and make subsequent recommendations.”

The complete text of Regulatory Notice 11-25 can be found at: http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p123701.pdf.

(John Moses is an attorney at Bass, Berry & Sims PLC, focusing his practice on securities litigation and arbitration, contract disputes, and general business litigation.  Michael Brady is a Member in Bass, Berry & Sims' Broker-Dealer and Financial Products Litigation Group where he concentrates his practice in the securities litigation, arbitration and compliance areas).