New rules from FINRA on suitability and “knowing your customer” take effect today, expanding the definition of a customer’s investment profile and clarifying that a broker's recommendations must be "consistent with" a customer's "best interests."

The new Suitability rule (Rule 2111) replaces NASD Rule 2310, while the Know Your Customer rule (Rule 2090) is similar to a New York Stock Exchange rule on the matter. Both were approved by the Securities and Exchange Commission in November 2010.

Many features of the new rules are similar to the old FINRA and relevant NYSE rules, but they codify interpretations previously discussed in case law, the regulator said.

Rule 2111

New FINRA rule 2111 requires that broker-dealers 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 information obtained through the reasonable diligence of the [firm] or associated person to ascertain the customer’s investment profile.”

Obligations include:

·        Reasonable basis suitability. A broker must perform “reasonable diligence” to understand the recommended investment or investment strategy, including the potential risks and rewards, “and determine whether the recommendation is suitable for at least some investors based on that understanding.”

·        Customer specific suitability. A broker must have a “reasonable basis” for thinking that an investment is suitable for the particular customer it is being recommended to, based on that customer’s investment profile.

·        Quantitative suitability. A broker with control over a customer’s account must have a “reasonable basis” for believing that, in total, a series of recommended transactions is not excessive.

The rule expands the explicit list of customer details a firm must take into account when recommending products to cover a customer’s age, investment experience, time horizon, liquidity needs and risk tolerance. Moreover, it reinterprets the term “investment strategy” to cover hold recommendations, as well as buy and sell. However, this hold recommendation must be explicit (i.e. remaining silent on a security does not trigger an implicit recommendation).

Importantly, FINRA states in its note that, in interpreting its suitability standard, “numerous cases explicitly state that a broker’s recommendations must be consistent with his customers’ best interests.” This means a broker cannot place his or her interests above a customer’s while complying with the rule, it said.

Regarding the Jumpstart Our Business Startups (JOBS) Act, which directs the SEC to amend a rule under the Securities Act, effectively making all purchasers accredited investors, FINRA says: “When a broker-dealer ‘recommends’ a private placement…the suitability rule applies.”

However, the Act removes certain marketing impediments to private placements, the note says. Particularly, “general solicitation” of a private placement through marketing or offering materials would not “by itself” constitute a recommendation.

Rule 2090

The new “Know Your Customer” rule requires firms to “use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer,” according to a FINRA note.

The essential facts are those required to “effectively service the customer’s account,” to “act in accordance with any special handling instructions for the account,” to “understand the authority of each person acting on behalf of the customer,” and to “comply with applicable laws, regulations and rules.”