Prior to executing a transaction with a retail customer, the RR must make reasonable efforts to obtain the following information:
- Customer’s financial status
- Customer’s tax status
- Customer’s investment objectives
- Any other pertinent facts the member knows about the customer
Recommended Strategy
Includes an investment strategy involving a security or securities with an “explicit” recommendation to hold a security. However, excluded from this rule, as long as they do not include a “recommendation” of a particular security or securities would be:
- General financial and investment information
- Descriptive information about an employer-sponsored retirement or benefit plan
- Asset allocation models that are based on generally accepted investment theory
- Interactive investment materials that incorporate 1, 2, or 3
Components of suitability obligations
- The reasonable-basis obligation
- The customer-specific obligation
- Quantitative suitability
The Reasonable-Basis Obligation
Requires a member or associated person to have a “reasonable basis” to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors. In order to satisfy reasonable diligence the member or associated person must have an understanding of the potential risks and rewards associated with the recommended security or strategy. The lack of such an understanding when recommending a security or strategy violates the suitability rule.
The Customer-Specific Obligation
Requires that a member or associated person have a reasonable basis to believe that the recommendation is suitable for “a particular customer” based on that customer’s investment profile.
Quantitative Suitability
Requires a member or associated person who has actual or de facto control over a customer account to have a reasonable basis for believing that a series of recommended transactions, even if suitable, when viewed in isolation, are not excessive and unsuitable for the customer when taken together in light of the customer’s investment profile.
Considerations for excessive activity include:
- The turnover rate
- The cost-equity ratio
- Use of in and out trading
Suitability Notes
- Suitability is always the primary factor, not divididends or appreciation
- Obtaining the above information is NOT necessary if the recommendation is for money market funds
- B/D’s can never guarantee a customer against loss or offer to buy shares back from a customer at no loss to the customer. Such activity is considered to be fraudulent and manipulative
- FINRA suitability requirements apply to all debt and equity securities with one exception which is municipal securities
- Social media - if a firm recommends a security through a social media site, that triggers the “suitability” rules and requires a B/D to determine that the recommendation is suitable for every investor to whom it is made.
Guidelines for making recommendations to customers:
- Older investors would be primarily invested in fixed income securities and some cash
- Younger investors would be primarily invested in equities and some cash
- Middle-aged investors would be invested in a combination of equities, fixed income, and some cash
Suitability obligations to institutional customers
An “institutional account” means a bank, savings and loan association, insurance company, registered investment company, registered investment adviser or any other person with total assets of at least $50 million. FINRA institutional customer guidelines state that the 2 most important considerations in determining a member’s suitability obligations to institutional customers are:
- The institutional customer’s capability to evaluate investment risk independently
- The extent to which the institutional customer is exercising independent judgment in evaluating a member’s recommendation
**An institutional investor may exercise independent judgment on a trade by trade basis, or an asset-class by asset-class basis, or in terms of all potential transactions for its account
Review Requirements for recommendations to Customers in OTC Equity securities
A member who recommends that a customer purchase or sell short any OTC equity security must first review the current financial condition of the issuer:
- For domestic issuers: Financial statements including a balance sheet no older than 15 months and a profit and loss statement(income statement) no older than 12 months preceding the date of the balance sheet
- For foreign private issuers: Financial statements including a balance sheet no older than 18 months and a profit and loss statement(income statement) no older than 12 months preceding the date of the balance sheet
- Delinquent Filers: If the issuer has not made the required public filings the reviewer must inquire as to the circumstances concerning the failure to make the required filings. This determination must be documented
Compliance requirement for recommendations to customers in OTC Equity securities
- A registered person(Series 9/10 or 24) must conduct the review requirement stated above. This can be delegated to a person who is not registered as a principal, provided that person has the requisite skills, background, and knowledge to perform the review and that the person is supervised by a Principal
- Recordkeeping: The member must document the review to include what was reviewed, the person who reviewed it, and the date of the review
OTC Equity Security
Means any non-exchange listed security and certain exchange-listed securities that do not otherwise qualify for real-time trade reporting.
Exemptions to OTC equity securities
- Regulation D transactions
- Transactions with institutional customers, “qualified institutional buyers”, and “qualified purchasers”
- A security that has a published bid price of at least $50
Penny Stocks or Designated Securities
Penny stocks are OTC securities with a market value of less than $5.00/share. Due to the risk involved in trading low priced securities, b/d’s must adhere to certain requirements.
Penny stock rules for new customers
- Document the basis for determining suitability of the penny stock recommendation for this customer
- Deliver to the customer the written suitability determination
- Receive from the customer a written agreement for the recommended transaction prior to executing the trade
Penny stock rules for established customers
An established customer can purchase a penny stock without the suitability determination requirement if the RR did not make the recommendation
Definition of an established customer
- A customer who has maintained an account at the member firm for at least one year; OR
- has made 3 penny stock purchases effected on separate days and for different issuers
What needs to happen before any investor buys a penny stock?
- The RR must disclose the bid and offer price and the compensation to be paid to both the RR and the firm for the trade
- The brokerage firm must send a monthly account statement that gives an estimate of the value of each penny stock in the account.
Non-managed fee based account programs
Arrangements in which no investment advisory services are provided by the member firm and in which customers are charged a fixed fee and/or percentage of the account’s value rather than transaction based commissions. These programs benefit customers who trade frequently. All fees and costs associated with the account must be disclosed before the account is established. Customers must receive a full description of the services they provide and a list of eligible assets available to the account. The firm must have procedures in place which monitor these accounts for possible “excessive” trading.
Recommendations to customers for option transactions
The RR must have reason to believe the customer has the knowledge and expertise to evaluate the risks of such transactions
