SR-FINRA-2010-039 Text of Proposed Rule Change

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Pursuant to the requirements of the Securities Exchange Act of 1934,

Section 19(b)(3)(A) * Section 19(b)(3)(B) *Initial * Amendment *

Pursuant to Rule 19b-4 under the Securities Exchange Act of 1934

Description

Proposed Rule Change to Adopt FINRA Rules 2090 (Know Your Customer) and 2111 (Suitability) in the Consolidated

FINRA Rulebook

Stephanie Dumont,

Stephanie Dumont

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1. Text of Proposed Rule Change

(a) Pursuant to the provisions of Section 19(b)(1) of the Securities Exchange Act

of 1934 (“Act” or “SEA”),

Financial Industry Regulatory Authority, Inc. (“FINRA”)

(f/k/a National Association of Securities Dealers, Inc. (“NASD”)) is filing with the

Securities and Exchange Commission (“SEC” or “Commission”) a proposed rule change

to adopt FINRA Rule 2111 (Suitability) and FINRA Rule 2090 (Know Your Customer)

as part of the Consolidated FINRA Rulebook. The proposed rules are based in large part

on NASD Rule 2310 (Recommendations to Customers (Suitability)) and its related

Interpretative Materials (“IMs”) and Incorporated NYSE Rule 405(1) (Diligence as to

Accounts), respectively. As further detailed herein, the proposed rule change would

delete those NASD and Incorporated NYSE rules and related NASD IMs and

Incorporated NYSE Rule Interpretations.

The text of the proposed rule change is attached as Exhibit 5.

(b) Upon Commission approval and implementation by FINRA of the proposed

rule change, the corresponding NASD and Incorporated NYSE rules and interpretations

will be eliminated from the current FINRA rulebook.

2. Procedures of the Self-Regulatory Organization

At its meeting on February 11, 2009, the FINRA Board of Governors authorized

the filing of the proposed rule change with the SEC. No other action by FINRA is

necessary for the filing of the proposed rule change. FINRA will announce the

implementation date of the proposed rule change in a Regulatory Notice

to be published

15 U.S.C. 78s(b)(1).

Page 4 of 776

no later than 90 days following Commission approval. The implementation date will be

no later than 240 days following Commission approval.

3. Self-Regulatory Organization’s Statement of the Purpose of, and Statutory

Basis for, the Proposed Rule Change

(a) Purpose

As part of the process of developing a new consolidated rulebook (“Consolidated

FINRA Rulebook”),

FINRA is proposing to adopt FINRA Rule 2111 (Suitability) and

FINRA Rule 2090 (Know Your Customer). The rules are based in large part on NASD

Rule 2310 (Recommendations to Customers (Suitability)) and its related IMs and NYSE

Rule 405(1) (Diligence as to Accounts), respectively.

As further discussed below, the

proposed rule change would delete NASD Rule 2310, IM-2310-1 (Possible Application

of SEC Rules 15g-1 through 15g-9), IM-2310-2 (Fair Dealing with Customers), IM-

2310-3 (Suitability Obligations to Institutional Customers), NYSE Rule 405(1) through

(3) (including NYSE Supplementary Material 405.10 through .30), and NYSE Rule

Interpretations 405/01 through /04.

The current FINRA rulebook consists of (1) FINRA Rules; (2) NASD Rules; and

(3) rules incorporated from NYSE (“Incorporated NYSE Rules”) (together, the

NASD Rules and Incorporated NYSE Rules are referred to as the “Transitional

Rulebook”). While the NASD Rules generally apply to all FINRA members, the

Incorporated NYSE Rules apply only to those members of FINRA that are also

members of the NYSE (“Dual Members”). The FINRA Rules apply to all FINRA

members, unless such rules have a more limited application by their terms. For

more information about the rulebook consolidation process, see

Information

Notice, March 12, 2008 (Rulebook Consolidation Process).

For convenience, the Incorporated NYSE Rules are referred to as the NYSE

Rules.

FINRA notes that NYSE Rule 405(4) was eliminated from the Transitional

Rulebook on June 14, 2010 pursuant to a previous rule filing. See

Securities

Exchange Act Release No. 61808 (March 31, 2010), 75 FR 17456 (April 6, 2010)

Page 5 of 776

The suitability and “know your customer” obligations are critical to ensuring

investor protection and fair dealing with customers. Under the proposal, the core features

of these obligations set forth in NASD Rule 2310 and NYSE Rule 405(1) remain intact.

FINRA, however, proposes modifications to both rules to strengthen and clarify them. In

Regulatory Notice

09-25 (May 2009), FINRA sought comment on the proposal. The

current filing includes additional proposed changes that respond to comments.

Item 5 of this filing provides a detailed discussion of the proposed modifications,

comments FINRA received, and FINRA’s responses thereto. In brief, however, the

proposed new suitability rule, designated FINRA Rule 2111, would require a broker-

dealer or associated person to have “a reasonable basis to believe that a recommended

transaction or investment strategy involving a security or securities is suitable for the

customer….”

This assessment must be “based on the information obtained through the

reasonable diligence of the member or associated person to ascertain the customer’s

investment profile, including, but not limited to, the customer’s age, other investments,

financial situation and needs, tax status, investment objectives, investment experience,

investment time horizon, liquidity needs, risk tolerance, and any other information the

customer may disclose to the member or associated person in connection with such

recommendation.”

(Order Approving File No. SR-FINRA-2010-005); see

also Regulatory Notice 10-

21 (April 2010).

See Proposed FINRA Rule 2111(a).

See Proposed FINRA Rule 2111(a). As discussed infra at Item 5 of this filing,

FINRA modified various aspects of the proposed information-gathering

requirements in response to comments.

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 The proposal would add the term “strategy” to the rule text so that the rule

explicitly covers a recommended strategy. Although FINRA generally intends the term

“strategy” to be interpreted broadly, the proposed supplementary material would exclude

the following communications from the coverage of Rule 2111 as long as they do not

include (standing alone or in combination with other communications) a recommendation

of a particular security or securities:

 General financial and investment information, including (i) basic investment

concepts, such as risk and return, diversification, dollar cost averaging,

compounded return, and tax deferred investment, (ii) historic differences in

the return of asset classes (e.g., equities, bonds, or cash) based on standard

market indices, (iii) effects of inflation, (iv) estimating future retirement

income needs, and (v) assessment of a customer’s investment profile;

 Descriptive information about an employer-sponsored retirement or benefit

plan, participation in the plan, the benefits of plan participation, and the

investment options available under the plan;

 Asset allocation models that are (i) based on generally accepted investment

theory, (ii) accompanied by disclosures of all material facts and assumptions

that may affect a reasonable investor’s assessment of the asset allocation

model or any report generated by such model, and (iii) in compliance with

NASD IM-2210-6 (Requirements for the Use of Investment Analysis Tools) if

the asset allocation model is an “investment analysis tool” covered by NASD

IM-2210-6;

and

 Interactive investment materials that incorporate the above.

The proposal also would codify interpretations of the three main suitability

obligations, listed below:

FINRA is proposing to adopt NASD IM-2210-6 as FINRA Rule 2214, without

material change. See Regulatory Notice 09-55 (September 2009).

See Proposed FINRA Rule 2111.02. As discussed infra at Item 5 of this filing,

FINRA included this exception to the rule’s coverage in response to comments.

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 Reasonable basis (members must have a reasonable basis to believe, based on

adequate due diligence, that a recommendation is suitable for at least some

investors);

 Customer specific (members must have reasonable grounds to believe a

recommendation is suitable for the particular investor at issue); and

 Quantitative (members must have a reasonable basis to believe the number of

recommended transactions within a certain period is not excessive).

In addition, the proposal would modify the institutional-customer exemption by

focusing on whether there is a reasonable basis to believe that the institutional customer

is capable of evaluating investment risks independently, both in general and with regard

to particular transactions and investment strategies,

and is exercising independent

judgment in evaluating recommendations.

The proposal, moreover, would require

institutional customers to affirmatively indicate that they are exercising independent

See Proposed FINRA Rule 2111.03.

See Proposed FINRA Rule 2111(b). The requirement in Proposed FINRA Rule

2111(b) that the firm or associated person have a reasonable basis to believe that

“the institutional customer is capable of evaluating investment risks

independently, both in general and with regard to particular transactions and

investment strategies” comes from current IM-2310-3. As FINRA explained in

that IM, “[i]n some cases, the member may conclude that the customer is not

capable of making independent investment decisions in general. In other cases,

the institutional customer may have general capability, but may not be able to

understand a particular type of instrument or its risk.” FINRA further stated that,

“[i]f a customer is either generally not capable of evaluating investment risk or

lacks sufficient capability to evaluate the particular product, the scope of a

member’s customer-specific obligations under the suitability rule would not be

diminished by the fact that the member was dealing with an institutional

customer.” FINRA also stated that “the fact that a customer initially needed help

understanding a potential investment need not necessarily imply that the customer

did not ultimately develop an understanding and make an independent decision.”

See Proposed FINRA Rule 2111(b).

Page 8 of 776

judgment.

The proposal also would harmonize the definition of institutional customer

in the suitability rule with the more common definition of “institutional account” in

NASD Rule 3110(c)(4).

Finally, the suitability proposal would eliminate or modify a number of the IMs

associated with the existing suitability rule

because they are no longer necessary. Some

of the discussions are not needed because of the changes to the scope of the suitability

rule proposed herein (e.g.

, the proposed rule text would capture “strategies” currently

referenced in IM-2310-3).

Others are redundant because they identify conduct

explicitly covered by other rules (e.g., inappropriate sale of penny stocks referenced in

IM-2310-1 is covered by the SEC’s penny stock rules,

fraudulent conduct identified in

IM-2310-2 is covered by the FINRA and SEC anti-fraud provisions

Still other IM discussions have been incorporated in some form into the proposed

rule or its supplementary material. For example, the exemption in IM-2310-3 dealing

with institutional customers is modified and moved to the text of proposed FINRA Rule

See Proposed FINRA Rule 2111(b). As discussed infra at Item 5 of this filing,

FINRA substituted this requirement for another in response to comments. FINRA

emphasizes that the institutional-customer exemption applies only if both parts of

the two-part test are met: (1) there is a reasonable basis to believe that the

institutional customer is capable of evaluating investment risks independently, in

general and with regard to particular transactions and investment strategies, and

(2) the institutional customer affirmatively indicates that it is exercising

independent judgment in evaluating recommendations.

See Proposed FINRA Rule 2111(b). FINRA is proposing to adopt NASD Rule

3110(c)(4) as FINRA Rule 4512(c), without material change. See Regulatory

Notice 08-25 (May 2008).

See Proposed Rule 2111(a).

See SEA Rule 15g-1 through 15g-9.

See Section 10(b) of the Act; FINRA Rule 2020.

Page 9 of 776

2111.

In addition, the explication of the three main suitability obligations, currently

located in IM-2310-2 and IM-2310-3, are consolidated into a single discussion in the

proposed rule’s supplementary material.

Similarly, the proposed rule’s supplementary

material includes a modified form of the current requirement in IM-2310-2 that a member

refrain from recommending purchases beyond a customer’s capability.

The

supplementary material also retains the discussion in IM-2310-2 and IM-2310-3

regarding the suitability rule’s significance in promoting fair dealing with customers and

ethical sales practices.

The only type of misconduct identified in the IMs that is neither explicitly

covered by other rules nor incorporated in some form into the proposed new suitability

rule is unauthorized trading, currently discussed in IM-2310-2. However, it is well-

settled that unauthorized trading violates just and equitable principles of trade under

FINRA Rule 2010 (previously NASD Rule 2110).

Consequently, the elimination of the

discussion of unauthorized trading in the IMs following the suitability rule in no way

See Proposed Rule 2111(a).

See Proposed Rule 2111.03.

See Proposed Rule 2111.04.

See Proposed Rule 2111.01.

See, e.g., Robert L. Gardner, 52 S.E.C. 343, 344 n.1 (1995), aff’d, 89 F.3d 845

(9th Cir. 1996) (table format); Keith L. DeSanto

, 52 S.E.C. 316, 317 n.1 (1995),

aff’d, 101 F.3d 108 (2d Cir. 1996) (table format); Jonathan G. Ornstein, 51 S.E.C.

135, 137 (1992); Dep’t of Enforcement v. Griffith

, No. C01040025, 2006 NASD

Discip. LEXIS 30, at *11-12 (NAC Dec. 29, 2006); Dep’t of Enforcement v.

Puma, No. C10000122, 2003 NASD Discip. LEXIS 22, at *12 n.6 (NAC Aug. 11,

2003).

Page 10 of 776

alters the longstanding view that unauthorized trading is serious misconduct and clearly

violates FINRA’s rules.

The proposed FINRA “Know Your Customer” obligation, designated FINRA

Rule 2090, captures the main ethical standard of NYSE Rule 405(1). As proposed,

broker-dealers would be required to use “due diligence,” in regard to the opening and

maintenance of every account, in order to know the essential facts concerning every

customer.

The obligation would arise at the beginning of the customer/broker

relationship, independent of whether the broker has made a recommendation. The

proposed supplementary material would define “essential facts” as those “required to (a)

effectively service the customer’s account, (b) act in accordance with any special

handling instructions for the account, (c) understand the authority of each person acting

on behalf of the customer, and (d) comply with applicable laws, regulations, and rules.”

The proposal would eliminate the requirement in NYSE Rule 405(1) to learn the

essential facts relative to “every order.” FINRA proposes eliminating the “every order”

language because of the application of numerous, specific order-handling rules.

addition, the reasonable-basis obligation under the suitability rule requires broker-dealers

See Proposed FINRA Rule 2090.

See Proposed FINRA Rule 2090.01. As discussed infra at Item 5 of this filing,

FINRA changed the explanation of “essential facts” in response to comments.

See, e.g., SEC Regulation NMS (National Market System), 17 CFR 242.600-

242.612; FINRA Rule 7400 Series (Order Audit Trail System); NASD Rule 2320

(Best Execution and Interpositioning) [proposed FINRA Rule 5310; see

Regulatory Notice 08-80 (December 2008)]; NASD Rule 2400 Series

(Commissions, Mark-Ups and Charges); NASD IM-2110-2 (Trading Ahead of

Customer Limit Order) [proposed FINRA Rule 5320; see

SR-FINRA-2009-090];

and IM-2110-3 (Front Running Policy) [proposed FINRA Rule 5270; see

Regulatory Notice

08-83 (December 2008)].

Page 11 of 776

and associated persons to perform adequate due diligence so that they “know” the

securities and strategies they recommend.

FINRA also is proposing to delete NYSE Rule 405(2) through (3), NYSE

Supplementary Material 405.10 through .30, and NYSE Rule Interpretation 405/01

through /04 because they generally are duplicative of other rules, regulations, or laws.

For instance, NYSE Rule 405(2) requires firms to supervise all accounts handled by

registered representatives. That provision is redundant because NASD Rule 3010

requires firms to supervise their registered representatives.

NYSE Rule 405(3) generally requires persons designated by the member to be

informed of the essential facts relative to the customer and to the nature of the proposed

account and to then approve the opening of the account. A number of other existing and

proposed FINRA rules do or will create substantially similar obligations. Proposed

FINRA Rule 2090, discussed herein, would require members to know the essential facts

as to each customer. NASD Rule 3110(c)(1)(C) requires the signature of the member,

partner, officer or manager who accepts the account.

A firm’s account-opening obligations also are impacted by FINRA Rule 3310,

which requires a firm to have procedures reasonably designed to achieve compliance with

the Bank Secrecy Act and the implementing regulations. One of those regulations

FINRA is proposing to adopt NASD Rule 3010 as FINRA Rule 3110, subject to

certain amendments. See Regulatory Notice 08-24 (May 2008).

FINRA is proposing to adopt NASD Rule 3110(c)(1)(C) as FINRA Rule

4512(a)(1)(C), subject to certain amendments. See Regulatory Notice 08-25

(May 2008). Proposed FINRA Rule 4512(a)(1)(C) would clarify that members

maintain the signature of the partner, officer or manager denoting that the account

has been accepted in accordance with the member’s policies and procedures for

acceptance of accounts.

Page 12 of 776

requires the firm to verify the identity of a customer opening a new account.

Another

requires due diligence that would enable the firm to evaluate the risk of each customer

and to determine if transactions by the customer could be suspicious and need to be

reported.

Moreover, before certain customers can purchase certain types of investment

products (such as options, futures or penny stocks) or engage in certain strategies (such as

day trading), the firm must explicitly approve their accounts for such activity.

NYSE Supplementary Material 405.10 is redundant of other FINRA proposed and

existing requirements, and the cross references provided in .20 and .30 are no longer

necessary. NYSE Supplementary Material 405.10 generally discusses the requirements

that firms know their customers and understand the authority of third-parties to act on

behalf of customers that are legal entities. Proposed FINRA Rule 2090 and proposed

FINRA Supplementary Material 2090.01, discussed herein, would require firms to know

the essential facts as to each customer. NYSE Supplementary Material 405.10 also

discusses certain documentation obligations regarding persons authorized to act on behalf

of various types of customers that are legal entities. NASD Rule 3110(c) (Customer

Account Information), however, similarly requires firms to maintain a record identifying

the person(s) authorized to transact business on behalf of a customer that is a legal

See 31 CFR 103.122.

See 31 CFR 103.19.

See, e.g., SEA Rule 15g-1 through 15g-9 (Penny Stock Rules); FINRA Rule 2360

(Options); FINRA Rule 2370 (Security Futures); FINRA Rule 2130 (Approval

Procedures for Day-Trading Accounts).

Page 13 of 776

entity.

NYSE Supplementary Material 405.20 and .30 provide cross references to

NYSE Rule 382 (Carrying Agreements) and NYSE Rule 414 (Index and Currency

Warrants), respectively, which are no longer necessary or appropriate for inclusion in

proposed FINRA Rule 2090.

The NYSE Rule Interpretations also are redundant. NYSE Rule Interpretations

405/01 (Credit Reference—Business Background) and /02 (Approval of New

Accounts/Branch Offices) recommend that the credit references and business

backgrounds of a new account be cleared by a person other than the registered

representative opening the account and require a designated person to ultimately approve

a new account. These obligations are substantially similar to the requirements in NASD

Rule 3110(c)(1)(C) and FINRA Rule 3310, discussed above.

NYSE Rule Interpretation 405/03 (Fictitious Orders) states that firm “personnel

opening accounts and/or accepting orders for new or existing accounts should make every

effort to verify the legitimacy of the account and the validity of every order.” The

interpretation contemplates knowing the customer behind the order as part of the process

of ensuring that the order is bona fide. Proposed FINRA Rule 2090 and FINRA Rule

3310 together place similar requirements on firms to know their customers.

To the extent NYSE Rule Interpretation 405/03 seeks to guard against the use of

fictitious trades as a means of manipulating markets, various FINRA rules cover such

activities. FINRA Rule 5210 (Publication of Transactions and Quotations) prohibits

members from publishing or circulating or causing to publish or circulate, any notice,

As noted previously, FINRA is proposing to adopt NASD Rule 3110(c) as

FINRA Rule 4512 (Customer Account Information), subject to certain

amendments. See Regulatory Notice 08-25 (May 2008).

Page 14 of 776

circular, advertisement, newspaper article, investment service, or communication of any

kind which purports to report any transaction as a purchase or sale of, or purports to

quote the bid or asked price for, any security unless such member believes that such

transaction or quotation was bona fide. FINRA Rule 5220 (Offers at Stated Prices)

prohibits members from making an offer to buy from or sell to any person any security at

a stated price unless such member is prepared to purchase or sell at such price and under

such conditions as are stated at the time of such offer to buy or sell. Moreover, the use of

fictitious transactions by a member or associated person to manipulate the market would

violate FINRA’s just and equitable principles of trade (FINRA Rule 2010) and anti-fraud

provision (FINRA Rule 2020).

NYSE Rule Interpretation 405/04 (Accounts in which Member Organizations

have an Interest) discusses requirements regarding transactions initiated “on the Floor”

for an account in which a member organization has an interest. The interpretation is

directed to the NYSE marketplace. Moreover, Section 11(a) of the Act and the rules

thereunder address trading by members of exchanges, brokers and dealers. For the

reasons discussed above, FINRA believes NYSE Rule 405(1) through (3), NYSE

Supplementary Material 405.10 through .30, and NYSE Rule Interpretations 405/01

through /04 are no longer necessary. They will be eliminated from the current FINRA

rulebook upon Commission approval and implementation by FINRA of this current

proposed rule change.

See, e.g., Terrance Yoshikawa, Securities Exchange Act Release No. 53731, 2006

SEC LEXIS 948 (April 26, 2006) (upholding finding that president of broker-

dealer violated just and equitable principles of trade and anti-fraud provisions by

fraudulently entering orders designed to manipulate the price of securities).

Page 15 of 776

As noted in Item 2 of this filing, FINRA will announce the implementation date

of the proposed rule change in a Regulatory Notice to be published no later than 90 days

following Commission approval. The implementation date will be no later than 240 days

following Commission approval.

(b) Statutory Basis

The proposed rule change is consistent with the provisions of Section 15A(b)(6)

of the Act,

which requires, among other things, that FINRA’s rules must be designed to

prevent fraudulent and manipulative acts and practices, to promote just and equitable

principles of trade, and, in general, to protect investors and the public interest. The

proposed rule change furthers these purposes because it requires firms and associated

persons to know, deal fairly with, and make only suitable recommendations to customers.

4. Self-Regulatory Organization’s Statement on Burden on Competition

FINRA does not believe that the proposed rule change will result in any burden

on competition that is not necessary or appropriate in furtherance of the purposes of the

Act.

5. Self-Regulatory Organization’s Statement on Comments on the Proposed

Rule Change Received from Members, Participants, or Others

As noted above, the proposed rule change was published for comment in

Regulatory Notice

09-25 (May 2009). A copy of the Notice is attached as Exhibit 2a.

FINRA received 2,083 comment letters, 389 of which were individualized letters and

1,694 of which were form letters. A copy of the index to comment letters received in

response to the Notice

is attached as Exhibit 2b, and copies of the comment letters

received in response to the Notice

are attached as Exhibit 2c.

15 U.S.C. 78o-3(b)(6).

Page 16 of 776

Comments came from broker-dealers, insurers, investment advisers, academics,

industry associations, investor-protection groups, lawyers in private practice, and a state

government agency. Commenters had myriad different views regarding nearly every

aspect of the proposal. A discussion of those comments and FINRA’s responses thereto

follows.

SUITABILITY

(Proposed FINRA Rule 2111)

Fiduciary Standard

Although FINRA did not request comment on whether fiduciary obligations

should influence the suitability proposal, more than a thousand commenters raised issues

involving fiduciary obligations. A brief discussion of these issues is thus warranted.

 Comments

One commenter suggested that FINRA should consider a fiduciary duty standard

in addition to a suitability standard.

Numerous other commenters argued that FINRA

should not move forward with proposed changes to the suitability rule until after

policymakers (e.g., Congress, the SEC, and/or FINRA) determine whether broker-dealers

must comply with fiduciary obligations.

One commenter further posited that it would

Rex A. Staples, General Counsel for the North American Securities

Administrators Association, July 13, 2009 (“NASAA Letter”).

See Joan Hinchman, Executive Director, President, and CEO of the National

Society of Compliance Professionals Inc., June 29, 2009 (“NSCP Letter”);

Clifford Kirsch and Eric Arnold, Sutherland Asbill & Brennan LLP for the

Committee of Annuity Insurers, June 29, 2009 (“Committee of Annuity Insurers

Letter”). In addition, 435 individuals and entities made this point, among others,

using one form letter (“Form Letter Type A”) and 1,197 individuals did so using

another form letter (“Form Letter Type B”).

Page 17 of 776

be easier for firms to implement a single, integrated change to customer care standards

adopted at one time.

 FINRA’s Response

FINRA notes that the application of a suitability standard is not inconsistent with

a fiduciary duty standard. In this regard, the SEC emphasized in one release that

"investment advisers under the Advisers Act,” who have fiduciary duties, “owe their

clients the duty to provide only suitable investment advice…. To fulfill this suitability

obligation, an investment adviser must make a reasonable determination that the

investment advice provided is suitable for the client based on the client's financial

situation and investment objectives."

In another release, the SEC similarly explained

that “[i]nvestment advisers are fiduciaries who owe their clients a series of duties, one of

which is the duty to provide only suitable investment advice.”

Suitability obligations constitute a material part of a fiduciary standard in the

context of investment advice and recommendations. It also is important to note that case

law makes clear that, under FINRA’s suitability rule, "a broker's recommendations must

be consistent with his customers' best interests."

Thus, the suitability obligations set

See NSCP Letter, supra note 34.

Release Nos. IC-22579, IA-1623, S7-24-95, 1997 SEC LEXIS 673, at *26 (Mar.

24, 1997) (Status of Investment Advisory Programs under the Investment

Company Act of 1940). See

also Shearson, Hammill & Co., 42 S.E.C. 811 (1965)

(finding willful violations of Section 206 of the Advisers Act when investment

adviser made unsuitable recommendations).

Investment Advisers Act Release No. 1406, 1994 SEC LEXIS 797, at *4 (Mar.

16, 1994) (Suitability of Investment Advice Provided by Investment Advisers).

Raghavan Sathianathan, Securities Exchange Act Release No. 54722, 2006 SEC

LEXIS 2572, at *21 (Nov. 8, 2006), aff’d

, 304 F. App’x 883 (D.C. Cir. 2008); see

also

Dane S. Faber, Securities Exchange Act Release No. 49216, 2004 SEC

Page 18 of 776

forth in proposed Rule 2111 would not be inconsistent with the addition of a fiduciary

duty at some future date.

Scope of the Suitability Rule

FINRA sought comment on two main issues potentially impacting the scope of

the suitability rule: whether to add the term “strategy” to the rule language and whether

to broaden the rule so that it reaches non-securities products. The second issue was not

highlighted in the rule text. Rather, it was raised in a discussion in the Notice seeking

comment.

 Strategies

The issue of whether the suitability rule applies to recommended strategies has

been addressed previously. SEC and FINRA discussions in IMs, releases, and notices, as

well as in some decisions, indicate that the current suitability rule applies to certain types

of recommended strategies.

NASD IM-2310-3 (Suitability Obligations to Institutional Customers) provides in

its “Preliminary Statement” that broker-dealers’ “responsibilities include having a

reasonable basis for recommending a particular security or strategy

, as well as having

LEXIS 277, at *23-24 (Feb. 10, 2004) (explaining that a broker’s

recommendations “must be consistent with his customer’s best interests”); Daniel

R. Howard, 55 S.E.C. 1096, 1099-1100 (2002) (same), aff’d, 77 F. App’x 2 (1st

Cir. 2003).

FINRA notes as well that the suitability rule is only one of many FINRA

business-conduct rules with which broker-dealers and their associated persons

must comply. Many FINRA rules prohibit, limit, or require disclosure of

conflicts of interest. Broker-dealers and their associated persons, for instance,

must comply with just and equitable principles of trade, standards for

communications with the public, order-handling requirements, fair-pricing

standards, and various disclosure obligations regarding research, trading,

compensation, margin, and certain sales and distribution activity, among others, in

addition to suitability obligations.

Page 19 of 776

reasonable grounds for believing the recommendation is suitable for the customer to

whom it is made.” Similarly, Notices to Members have stated that broker-dealers'

responsibilities under Rule 2310 “include having a reasonable basis for recommending a

particular security or strategy.”

Moreover, when the SEC published FINRA’s Online

Suitability Policy Statement, Notice to Members

01-23 (Apr. 2001) (“NTM 01-23”), in

the Federal Register

, the Commission included the following statement in the release:

“The Commission notes that although [NTM] 01-23 does not expressly discuss electronic

communications that recommend investment strategies, the NASD suitability rule

continues to apply to the recommendation of investment strategies, whether that

recommendation is made via electronic communication or otherwise.”

A number of SEC decisions also support application of the suitability rule to

recommended strategies. The case often cited as standing for such a proposition is F.J.

Kaufman & Co., 50 S.E.C. 164 (1989), in which the SEC found that the respondent

violated NASD Rule 2310 by recommending an unsuitable strategy to customers. A

number of Commission decisions issued after Kaufman also lend support for applying the

suitability rule to recommended strategies in certain situations. Many of these cases

See Notice to Members 96-32, 1996 NASD LEXIS 51, at *2 (May 1996); see also

Notice to Members 05-68, 2005 NASD LEXIS 44, at *11 (Oct. 2005) (stating that

members and their associated persons “should perform a careful analysis to

determine whether liquefying home equity is a suitable strategy for an investor”);

Notice to Members 04-89, 2004 NASD LEXIS 76, at *7 (Dec. 2004) (same).

See Securities Exchange Act Release No. 44178, 2001 SEC LEXIS 731, at *28-

29 (April 12, 2001), 66 FR 20697, 20702 (April 24, 2001) (Notice of Filing and

Immediate Effectiveness of FINRA’s Online Suitability Policy Statement).

Page 20 of 776

involved recommendations to purchase securities on margin (which can be viewed as a

strategy).

The proposed suitability rule explicitly covers recommended strategies. The

commenters’ views on the inclusion of the term were varied.

o Comments

A number of commenters supported the addition of the term to the rule text.

Some commenters requested that FINRA make clear in the supplementary material that

the term “strategy” should be interpreted broadly and include recommendations to hold

an investment.

Some of these commenters also believed that firms should have an

affirmative duty to review portfolios that are transferred into a firm and that the lack of a

See, e.g., Jack H. Stein, Securities Exchange Act Release No. 47335, 2003 SEC

LEXIS 338, at *15 (Feb. 10, 2003); Justine S. Fischer, 53 S.E.C. 734 (1998);

Stephen T. Rangen, 52 S.E.C. 1304, 1307-1308 (1997); Arthur J. Lewis, 50

S.E.C. 747, 748-50 (1991).

See Barbara Black, Director of the Corporate Law Center of the University of

Cincinnati College of Law, and Jill I. Gross, Director of the Investor Rights Clinic

of the Pace University School of Law (“Corporate Law Center & Investor Rights

Clinic”), June 29, 2009; Peter J. Harrington, Christine Lazaro & Lisa A. Catalano,

Securities Arbitration Clinic at St. John’s University, June 25, 2009 (“St. John’s

Letter”); William A. Jacobson and Sang Joon Kim, Cornell Securities Law Clinic,

June 27, 2009 (“Cornell Letter”); Sarah McCafferty, Vice President and Chief

compliance Officer at T.RowePrice, June 29, 2009 (“T.RowePrice Letter”); Peter

J. Mougey and Kristian P. Kraszewski, Levin, Papantonio, Thomas, Mitchell,

Echsner & Proctor P.A., June 29, 2009 (“Mougey and Kraszewski Letter”);

Daniel C. Rome, General Counsel of Taurus Compliance Consulting LLC, June

29, 2009 (“Taurus Letter”).

See Cornell Letter, supra note 43; Mougey and Kraszewski Letter, supra note 43;

St. John’s Letter, supra

note 43.

Page 21 of 776

recommendation to make any changes to the portfolio effectively constitutes an implicit

recommendation to retain what is in the account.

Other commenters supported the inclusion of the term strategy but asked FINRA

to clarify that the suitability rule would apply only to recommended “strategies resulting

in the purchase, sale or exchange of a security or securities”

or where there is a

“reasonable nexus between the recommended investment strategy and a securities

transaction in furtherance of the recommended strategy.”

Other commenters stated that

FINRA should define or clarify the term “strategy.”

One of these commenters believed

that, without a definition, there would be confusion among firms and FINRA examiners

regarding whether all asset allocation programs and “buy and hold” recommendations

should be viewed as strategies.

See Mougey and Kraszewski Letter, supra note 43; St. John’s Letter, supra note

43.

See Bari Havlik, SVP and Chief Compliance Officer for Charles Schwab & Co.,

June 29, 2009 (“Charles Schwab Letter”).

See Amal Aly, Managing Director and Associate General Counsel, Securities

Industry and Financial Markets Association, June 29, 2000 (“SIFMA Letter”);

NSCP Letter, supra

note 34.

See NSCP Letter, supra note 34. A number of commenters stated that FINRA

should eliminate the term strategy from the rule but argued that, if FINRA

continues to use it, FINRA needed to clarify what the term means. See

Committee of Annuity Insurers Letter, supra note 34; James Livingston, President

and CEO of National Planning Holdings, Inc., June 29, 2009 (“National Planning

Holdings”); Stephanie L. Brown, Managing Director and General Counsel for

LPL Financial Corporation, June 29, 2009 (“LPL Letter”).

See NSCP Letter, supra note 34.

Page 22 of 776

A number of commenters opposed the inclusion of the term “strategy.”

However, one of these commenters stated that, if FINRA includes the term in the final

proposal, FINRA should except from the rule’s coverage any information determined to

be “investment education” under the Employee Retirement Income Security Act

(“ERISA”).

o FINRA’s Response

FINRA agrees that the term “strategy” should be included in the rule language

and that, in general, it should be interpreted broadly. For instance, FINRA rejects the

contention that the rule should only cover a recommended strategy if it results in a

transaction. As with the current suitability rule, application of the proposed rule would

be triggered when the broker-dealer or associated person recommends the security or

strategy regardless of whether the recommendation results in a transaction.

The term

“strategy,” moreover, would cover explicit recommendations to hold a security or

securities. The rule recognizes that customers may rely on members’ and associated

persons’ investment expertise and knowledge, and it is thus appropriate to hold members

and associated persons responsible for the recommendations that they make to customers,

See LPL Letter, supra note 48; Committee of Annuity Insurers Letter, supra note

34; Clifford E. Kirsch, Sutherland Asbill & Brennan LLP on behalf of John

Hancock Life Insurance Co., MetLife Inc., and the Prudential Insurance Co. of

America, June 29, 2009 (“Hancock, MetLife and Prudential Letter”); National

Planning Holdings, supra

note 48.

See Hancock, MetLife and Prudential Letter, supra note 50 (citing 29 CFR

2509.96-1(d)).

See, e.g., Dist. Bus. Conduct Comm. v. Nickles, Complaint No. C8A910051,

1992 NASD Discip. LEXIS 28, at *18 (NBCC Oct. 19, 1992) (holding that

suitability rule "applies not only to transactions that registered persons effect for

their clients, but also to any recommendations that a registered person makes to

his or her client").

Page 23 of 776

regardless of whether those recommendations result in transactions or generate

transaction-based compensation.

In regard to the comment concerning implicit recommendations on portfolios

transferred to a firm, FINRA notes that nothing in the current rule proposal is intended to

change the longstanding application of the suitability rule on a recommendation-by-

recommendation basis. In limited circumstances, FINRA and the SEC have recognized

that implicit recommendations can trigger suitability obligations. For example, FINRA

and the SEC have held that associated persons who effect transactions on a customer’s

behalf without informing the customer have implicitly recommended those transactions,

thereby triggering application of the suitability rule.

The rule proposal is not intended

to broaden the scope of implicit recommendations.

As discussed in Item 3 of this rule filing, FINRA also proposes to explicitly

exempt from the rule’s coverage certain categories of educational material as long as they

do not include (standing alone or in combination with other communications) a

recommendation of a particular security or securities. FINRA believes that it is important

to encourage broker-dealers and associated persons to freely provide educational material

and services to customers. As one commenter explained, the U.S. Department of Labor

provided a similar exemption from some requirements under ERISA.

See, e.g., Rafael Pinchas, 54 S.E.C. 331, 341 n.22 (1999) (“Transactions that were

not specifically authorized by a client but were executed on the client’s behalf are

considered to have been implicitly recommended within the meaning of the

NASD rules.”); Paul C. Kettler

, 51 S.E.C. 30, 32 n.11 (1992) (stating that

transactions broker effects for a discretionary account are implicitly

recommended).

See Hancock, MetLife and Prudential Letter, supra note 50 (citing 29 CFR

2509.96-1(d)).

Page 24 of 776

 Non-Securities Products

The current suitability rule and the proposed new suitability rule cover

recommendations involving securities. In the Notice seeking comment, however, FINRA

asked whether the suitability rule should cover recommendations of non-securities

products made in connection with the firm’s business. This issue generated the greatest

number of comments, most of which were against extending the rule’s reach.

o Comments

Some commenters favored broadening the suitability rule so that it covers non-

securities products.

One commenter stated that the expansion was needed because

broker-dealers market more than just securities and oftentimes customers do not

understand that they may be afforded less protection when purchasing non-securities

products.

Another commenter stated that it would be unreasonable for a firm to allow a

non-securities recommendation that was inconsistent with a customer’s suitability

profile.

Yet another commenter believed that broker-dealers implicitly already have

similar obligations but favored explicitly applying the suitability rule to non-securities

products.

According to this commenter, broker-dealers fail to observe the high

standards of commercial honor and just and equitable principles of trade required by

FINRA Rule 2010 if they recommend any unsuitable financial product, service, or

See Mougey and Kraszewski Letter, supra note 43; Taurus Letter, supra note 43.

See Mougey and Kraszewski Letter, supra note 43.

See Taurus Letter, supra note 43.

See Corporate Law Center & Investor Rights Clinic, supra note 43.

Page 25 of 776

strategy to their customers.

This commenter argued that the proposal was not an

expansion of broker-dealer obligations; rather the proposal would make explicit what

FINRA’s rules have consistently required from broker-dealers and associated persons.

The commenter supported a revision of proposed Rule 2111 to incorporate an explicit

suitability obligation that is not limited to securities.

The vast majority of commenters, however, were against applying the suitability

rule to non-securities products.

Some argued that FINRA did not have jurisdiction over

See Corporate Law Center & Investor Rights Clinic, supra note 43.

See, e.g., Michael Berenson, Morgan, Lewis & Bockius LLP on behalf of

American Equity Life Insurance Company, June 23, 2009 (“AELIC Letter”);

Charles Schwab Letter, supra note 46; Committee of Annuity Insurers Letter,

supra note 34; John M. Damgard, President of the Futures Industry Association,

June 29, 2009 (“FIA Letter”); Form Letter Type A, supra note 34; Form Letter

Type B, supra note 34; Hancock, MetLife and Prudential Letter, supra note 50;

James L. Harding, James L. Harding & Associates, Inc., July 1, 2009 (“Harding

Letter”); Mike Hogan, President and CEO of FOLIOfn Investments, Inc., June 29,

2009 (“FOLIOfn Letter”); Ronald C. Long, Director of Regulatory Affairs for

Wells Fargo Advisors, LLC, June 29, 2009 (“Wells Fargo Letter”); LPL Letter,

supra

note 50; John S. Markle, Deputy General Counsel for TD Ameritrade, June

29, 2009 (“TD Ameritrade Letter”); NSCP Letter, supra note 34; Lisa Roth,

National Ass’n of Independent Broker-Dealers, Inc., June 29, 2009 (“NAIBD

Letter”); Thomas W. Sexton, Senior Vice President & General Counsel for the

National Futures Association, June 29, 2009 (“NFA Letter”), SIFMA Letter,

supra

note 47; T.RowePrice Letter, supra note 43; Robert R Carter and David A

Stertzer, Association for Advanced Life Underwriting, June 29, 2009 (“AALU

Letter”); Alan J Cyr, Cyr & Cyr Insurance Services, June 26, 2009 (“Cyr & Cyr

Insurance Services Letter”); F. John Millette, IMG Financial Group, June 23,

2009 (“IMG Financial Group Letter”); Neal Nakagiri, NPB Financial Group,

LLC, June 2, 2009 (“NPB Financial Group Letter”); Richard C. Orvis, Principal

Life Insurance Co., June 23, 2009 (“Principal Life Insurance Co. Letter”).

Page 26 of 776

non-securities products.

Some argued against the expansion because they claimed there

is no evidence of abuse resulting from recommendations involving non-securities

products.

Some commenters stated that such action is unnecessary because the states

and federal regulators, and in some instances other self-regulatory organizations, already

regulate many non-securities products and services (e.g.

, insurance, real estate,

investment advisers, futures products, etc.).

Others claimed that FINRA was ill-suited

to regulate non-securities products because it has no expertise outside securities issues.

A few argued that adoption of an enhanced suitability rule would create confusion

regarding whether a recommendation is made “in connection with a firm’s business.”

o FINRA’s Response

With the possible exception of potentially duplicative regulation, which FINRA

believes could be addressed in any further expansion of the reach of the rule, FINRA

does not agree with the commenters’ reasoning against extending the scope of the

See, e.g., Committee of Annuity Insurers Letter, supra note 34; FOLIOfn Letter,

supra note 62; Form Letter Type A, supra note 34; Form Letter Type B, supra

note 34; Hancock, MetLife and Prudential Letter, supra note 50; LPL Letter,

supra note 48; NSCP Letter, supra note 34; T.RowePrice Letter, supra note 43.

See, e.g., AALU Letter, supra note 62; AELIC Letter, supra note 62; Cyr & Cyr

Insurance Services Letter, supra note 59; Principal Life Insurance Co. Letter,

supra note 59.

See, e.g., AELIC Letter, supra note 62; Committee of Annuity Insurers Letter,

supra note 34; FIA Letter, supra note 62; Form Letter Type A, supra note 34;

Form Letter Type B, supra note 34; Hancock, MetLife and Prudential Letter,

supra

note 50; Michael T. McRaith, Illinois Department of Insurance Letter, June

29, 2009; NAIBD Letter, supra note 62; NFA Letter, supra note 62; NSCP Letter,

supra

note 34; SIFMA Letter, supra note 47.

See, e.g., AALU Letter, supra note 62; Committee of Annuity Insurers Letter,

supra

note 34; Wells Fargo Letter, supra note 62.

See, e.g., AELIC Letter, supra note 62.

Page 27 of 776

suitability rule. FINRA acknowledges, however, that future developments in regulatory

restructuring could impact any such proposal. FINRA emphasizes, moreover, that the

proposed new suitability rule (including the explicit coverage of recommended strategies

and expanded list of the types of information that members must seek to gather and

analyze) and the proposed “Know Your Customer” rule together provide enhanced

protection to investors. Consequently, FINRA will not include explicit references to non-

securities products in the rule at this time.

 Clarification of the Term “Recommendation”

Consistent with the current suitability rule, the proposed new rule does not define

the term “recommendation.” FINRA received a number of comments regarding the term.

o Comments

Some commenters asked FINRA to define the term “recommendation.”

One

commenter believed that FINRA’s failure to define “recommended transaction” will

make it difficult for firms to distinguish recommended transactions from “discussed”

and/or “reviewed” transactions.

This commenter stated that the “current compliance

rule of thumb matches customer action within a measured period of time after

information is provided to a customer as a test of whether any resulting transaction was

‘recommended.’”

The commenter believes that “the discussion in NTM 01-23 provides

a good foundation upon which FINRA can base the definition.”

Another commenter

See Barry D. Estell, Attorney at Law, June 24, 2009 (“Estell Letter”); FOLIOfn

Letter, supra note 62; Mougey and Kraszewski Letter, supra note 43.

See FOLIOfn Letter, supra note 62.

Page 28 of 776

asked that FINRA reaffirm the principles discussed in NTM 01-23 regarding the term

“recommendation.”

Other commenters argued that the term should be defined to

include recommendations to hold securities.

o FINRA’s Response

The determination of the existence of a recommendation has always been based

on the facts and circumstances of the particular case and, therefore, the fact of such action

having taken place is not susceptible to a bright line definition.

As two commenters

noted, however, FINRA announced several guiding principles in NTM 01-23 regarding

whether a communication constitutes a recommendation. In general, those guiding

principles remain relevant.

For instance, FINRA stated that a communication’s content, context, and

presentation are important aspects of the inquiry. In addition, the more individually

tailored the communication is to a particular customer or customers about a specific

security or strategy, the more likely the communication will be viewed as a

recommendation. FINRA also explained that a series of actions that may not constitute

recommendations when viewed individually may amount to a recommendation when

considered in the aggregate. FINRA stated, moreover, that it makes no difference

whether the communication was initiated by a person or a computer software program.

TD Ameritrade Letter, supra note 62.

See Estell Letter, supra note 68; Mougey and Kraszewski Letter, supra note 43.

FINRA has stated that "defining the term 'recommendation' is unnecessary and

would raise many complex issues in the absence of specific facts of a particular

case." Securities Exchange Act Release No. 37588, 1996 SEC LEXIS 2285, at

*29 (Aug. 20, 1996), 61 FR. 44100, 44107 (Aug. 27, 1996) (Notice of Filing and

Order Granting Accelerated Approval of NASD’s Interpretation of its Suitability

Rule).

Page 29 of 776

Finally, FINRA noted the relevance of determining whether a reasonable person would

view the communication as a recommendation. Thus, for example, FINRA explained

that a broker could not avoid suitability obligations through a disclaimer where—given

its content, context, and presentation—the particular communication reasonably would be

viewed as a recommendation.

These guiding principles, together with numerous litigated decisions and the facts

and circumstances of any particular case, inform the determination of whether the

communication is a recommendation for purposes of FINRA’s suitability rule.

FINRA

believes that this guidance and these precedents allow broker-dealers to fundamentally

understand what communications likely do or do not constitute recommendations.

In the same vein, it is important to note that a customer’s acquiescence or desire

to engage in a transaction does not relieve a broker-dealer or associated person of

the responsibility to make only suitable recommendations. See, e.g., Clinton H.

Holland, Jr., 52 S.E.C. 562, 566 (1995) (“Even if we conclude that Bradley

understood Holland’s recommendations and decided to follow them, that does not

relieve Holland of his obligation to make reasonable recommendations.”), aff’d,

105 F.3d 665 (9th Cir. 1997) (table format); John M. Reynolds, 50 S.E.C. 805,

809 (1991) (regardless of whether customer wanted to engage in aggressive and

speculative trading, representative was obligated to abstain from making

recommendations that were inconsistent with the customer’s financial condition);

Eugene J. Erdos, 47 S.E.C. 985, 989 (1983) (“[W]hether [the customer]

considered the transactions … suitable is not the test for determining the propriety

of [the registered representative’s] conduct.”), aff’d

, 742 F.2d 507 (9th

Cir. 1984);

Dep’t of Enforcement v. Bendetsen, No. C01020025, 2004 NASD Discip. LEXIS

13, at *12 (NAC Aug. 9, 2004) (“[A] broker’s recommendations must serve his

client’s best interests and that the test for whether a broker’s recommendation is

suitable is not whether the client acquiesced in them, but whether the broker’s

recommendations were consistent with the client’s financial situation and

needs.”).

To the extent that past Notices to Members, Regulatory Notices, case law, etc., do

not conflict with proposed new rule requirements or interpretations thereof, they

remain potentially applicable, depending on the facts and circumstances of the

particular case.

Page 30 of 776

It also is important to emphasize that both the current and proposed suitability

rules require that a recommendation be suitable when made. Firms may have different

methods of tracking recommendations for a variety of reasons, but the main suitability

obligation is not dependent on whether and, if so, where and how, a transaction occurs.

Finally, as noted above, the proposed rule would capture explicit

recommendations to hold securities as a result of FINRA’s elimination of the “purchase,

sale or exchange” language and the addition of the term “strategy.” Accordingly, there is

no reason to define “recommendation” to include recommendations to hold securities.

Information Gathering

The proposal discussed in the Notice seeking comment made two changes to the

type of information that firms and associated persons had to attempt to gather and analyze

as part of their suitability obligation. First, the proposal would have required the firm and

associated person to consider information known by the firm or associated person.

Second, the proposal included an expanded list of information that members and

associated persons would have to attempt to gather and analyze when making

recommendations.

 Information Known By the Firm

The proposal discussed in the Notice

would have required members and

associated persons to consider all information about the customer that was “known by the

member or associated person.”

See Nickles, 1992 NASD Discip. LEXIS 28, at *18.

Page 31 of 776

o Comments

Some commenters supported requiring firms and brokers to analyze information

known by the firm regardless of how the firm learned of the information.

However,

other commenters were opposed to this requirement.

Some were opposed because of

the difficulty they believed it would cause for firms with multiple business lines.

According to these commenters, customers may provide information for a variety of

different purposes (e.g.

, banking, insurance, or securities transactions) to different

employees working in different departments and recording the information on separate

systems, and a single broker may not have access to all of that information.

Other commenters opposed the language on the basis that it might require

associated persons to capture and consider personal information that may not be relevant

to investment decisions and that clients may not want captured in a system or shared with

a broader audience (especially when the associated person has intimate knowledge of a

client through a family relationship or friendship).

According to the commenters,

examples may include a diagnosed illness, pending divorce or separation, pending legal

See Corporate Law Center & Investor Rights Clinic, supra note 43; St. John’s

Letter, supra note 43; Taurus Letter, supra note 43.

See Charles Schwab Letter, supra note 46; Committee of Annuity Insurers Letter,

supra

note 34; FOLIOfn Letter, supra note 62; LPL Letter, supra note 48; NSCP

Letter, supra note 35; SIFMA Letter, supra note 47; TD Ameritrade Letter, supra

note 62.

See Charles Schwab Letter, supra note 46; FOLIOfn Letter, supra note 62; NSCP

Letter, supra note 34; SIFMA Letter, supra note 47; TD Ameritrade Letter, supra

note 62.

See Charles Schwab Letter, supra note 46; SIFMA Letter, supra note 47.

See Committee of Annuity Insurers Letter, supra note 34; National Planning

Holdings, supra

note 48.

Page 32 of 776

action, or other personal problems.

Finally, some commenters believed that such a

requirement could be unfair to associated persons in situations where firms are aware of

information about customers but do not pass it along to the associated persons.

o FINRA’s Response

FINRA has modified the proposal and no longer refers to facts “known by the

member or associated person.” The current proposal requires the member or associated

person to have reasonable grounds to believe the recommendation is suitable based on

“information obtained through the reasonable diligence of the member or associated

person to ascertain the customer’s investment profile, including, but not limited to, the

customer’s age, other investments, financial situation and needs, tax status, investment

objectives, investment experience, investment time horizon, liquidity needs, risk

tolerance, and any other information the customer may disclose to the member or

associated person in connection with such recommendation.”

“Reasonable diligence” is that level of effort that, based on the facts and

circumstances of the particular case, provides the member or associated person with

sufficient information about the customer to have reasonable grounds to believe that the

recommended security or strategy is suitable. The level of importance of each category

of customer information may vary depending on the facts and circumstances of the

particular case. However, members and associated persons must use reasonable diligence

to gather and analyze the customer information and may only make a recommendation if

they have reasonable grounds to believe the recommendation is suitable. In this regard,

See Committee of Annuity Insurers Letter, supra note 34; National Planning

Holdings, supra

note 48.

See LPL Letter, supra note 48; SIFMA Letter, supra note 47.

Page 33 of 776

failing to use reasonable diligence to gather the information or basing a recommendation

on inadequate information would violate customer-specific suitability, which requires a

broker-dealer to have a reasonable basis to believe a recommendation is suitable for the

particular investor at issue.

Apart from the new “reasonable diligence” language, the modified proposal also

alters the wording at the end of paragraph (a) of the proposed rule. Instead of requiring

members and associated persons to consider “any other information the member or

associated person considers to be reasonable,” the modified proposal requires them to

consider “any other information the customer may disclose to the member or associated

person in connection with” the recommendation. In light of some of the comments noted

above, FINRA believes it is important to tie this customer information to possible

investment decisions.

 Additional Information

The proposal expands the explicit list of types of information that broker-dealers

and associated persons have to attempt to gather and analyze. At present, the suitability

rule requires that broker-dealers and associated persons attempt to gather information

about and analyze the customer’s other security holdings, financial situation and needs,

financial status, tax status, investment objectives, and such other information used or

considered to be reasonable by such member or associated person in making

recommendations to the customer. FINRA expanded that list to include the customer's

age, investment experience, investment time horizon, liquidity needs, and risk tolerance.

Page 34 of 776

o Comments

Some commenters applauded FINRA for placing a clear affirmative duty on firms

to make reasonable efforts to gather a more comprehensive and specific list of facts about

the customer prior to making a recommendation.

These commenters believed that the

investing public will benefit because broker-dealers will consider a larger number of

consistent criteria.

A few other commenters, while agreeing that such information is relevant in some

situations, stated that obtaining each specified category of information may not be

warranted on every occasion.

These commenters requested that FINRA build flexibility

into the rule and not mandate that the member seek to obtain these new categories of

information for every recommended transaction.

According to these commenters,

broker-dealers should have discretion to determine what customer information is relevant

to the suitability determination associated with each recommended transaction.

FINRA does require firms to obtain and capture this information, these commenters also

asked FINRA to establish an effective date for the new rule that recognizes the difficulty

See Corporate Law Center & Investor Rights Clinic, supra note 43; Mougey and

Kraszewski Letter, supra note 43; St. John’s Letter, supra note 43; T.RowePrice

Letter, supra note 43.

See St. John’s Letter, supra note 43; Mougey and Kraszewski Letter, supra note

43.

See Charles Schwab Letter, supra note 46; SIFMA Letter, supra note 47; TD

Ameritrade Letter, supra note 62; Wells Fargo Letter, supra note 62.

See Charles Schwab Letter, supra note 46; SIFMA Letter, supra note 47; TD

Ameritrade Letter, supra note 62; Wells Fargo Letter, supra note 62.

See Charles Schwab Letter, supra note 46; SIFMA Letter, supra note 47; TD

Ameritrade Letter, supra

note 62; Wells Fargo Letter, supra note 62.

Page 35 of 776

associated with developing, modifying, and implementing forms and systems to request

and capture the proposed new categories of information.

Other commenters more strongly objected to the proposed expansion of the list of

items that broker-dealers must attempt to gather and analyze.

One commenter argued

that factors such as a customer’s investment experience, time horizon, and risk tolerance

are ones to be considered when reviewing a customer’s portfolio as a whole, not

individual trades.

According to this commenter, requiring consideration of such factors

on a trade-by-trade basis will prevent customers from creating a diverse portfolio made

up of securities with different levels of liquidity, risk, and time horizons.

This

commenter also stated that requiring firms to attempt to gather information about a

customer’s “other investments” would be difficult because it would require an associated

person to have a complete view of a customer’s entire portfolio.

Another commenter

went further and stated that the current list of items in Rule 2310 should be abolished.

The commenter stated that “FINRA should adopt a rule that states that broker dealers

should collect sufficient data and perform the analysis that it, in its professional

judgment, deems reasonably necessary to provide the services it offers and advertises to

See Charles Schwab Letter, supra note 46; LPL Letter, supra note 48; SIFMA

Letter, supra note 47; Wells Fargo Letter, supra note 62.

See FOLIOfn Letter, supra note 62.

See LPL Letter, supra note 48.

See FOLIOfn Letter, supra note 62.

Page 36 of 776

consumers.”

If that cannot be achieved, the commenter recommends limiting the

information to that discussed in SEA Rule 17a-3.

This commenter also argued that

FINRA should detail exactly how firms are required to use each piece of information that

FINRA requires firms to gather.

Another commenter stated that FINRA should maintain a standard approach to

the terminology used in relation to this aspect of the rule.

As an example, the

commenter noted that the rule proposal uses the term “other investments,” while FINRA

Rule 2330 covering deferred variable annuities uses “existing assets (including

investment and life insurance holdings).”

100

The commenter believed that “other

investments” is overly broad and that FINRA should use the term currently used in Rule

2330.

101

Finally, one commenter argued that money market mutual funds be exempted

from all or some of the requirements to gather information when making

recommendations.

102

According to the commenter, a current exemption from some

See FOLIOfn Letter, supra note 62.

See National Planning Holdings, supra note 48.

100

See National Planning Holdings, supra note 48.

101

See National Planning Holdings, supra note 48.

102

See Tamara K. Salmon, Senior Associate Counsel for the Investment Company

Institute, June 29, 2009 (“ICI Letter”).

Page 37 of 776

information gathering for transactions in money market mutual funds should continue or

be expanded in the proposed rule.

103

o FINRA’s Response

Under the current suitability rule, broker-dealers must attempt to gather

information on and analyze the customer’s other holdings, financial situation and needs,

financial status, tax status, investment objectives, and such other information used or

considered to be reasonable by the firm or associated person in making recommendations

to the customer. The expanded information in the proposed rule includes the customer’s

age, investment experience, investment time horizon, liquidity needs, and risk tolerance.

FINRA cannot dictate exactly how firms should use each piece of information. As

discussed above, the level of importance of each category of customer information (not

only those in the expanded list) may vary depending on the facts and circumstances of the

particular case. However, failing to use reasonable diligence to gather the information or

basing a recommendation on inadequate information would violate customer-specific

suitability.

FINRA declines one commenter’s request to exempt money market mutual funds

from all or some of the requirements to gather information when making

recommendations. By way of background, the original suitability rule (currently

paragraph (a) of NASD Rule 2310) required firms and brokers to have reasonable

grounds to believe that the recommendation to purchase, sell, or exchange any security is

suitable based upon the facts, if any, disclosed by the customer as to “his other security

holdings and as to his financial situation and needs.” In 1990, the SEC approved

103

See ICI Letter, supra note 102.

Page 38 of 776

amendments that created a second information-gathering requirement (currently

paragraph (b) of NASD Rule 2310).

104

The new paragraph added in 1990 required firms

to make reasonable efforts to also obtain the customer’s financial status, tax status,

investment objectives, and such other information used or considered to be reasonable by

such member or associated person in making recommendations to the customer.

Transactions involving money market mutual funds were exempted from the requirement

under the new paragraph. However, transactions involving money market mutual funds

were not exempted from the original suitability requirements under paragraph (a).

FINRA believes that recommended money market mutual funds should be subject to the

same information-gathering requirements as other recommended securities. That is

especially true in light of the problems experienced by the Reserve Primary Fund in late

2008.

105

Institutional Customer

At present, IM-2310-3 provides a limited exemption from the customer-specific

obligation when dealing with institutional customers in certain situations. The proposal

continues to provide an exemption, but it adds a requirement that institutional customers

provide affirmative acknowledgement of certain aspects of their relationship with the

broker-dealer and modifies the definition of institutional customer.

104

See Securities Exchange Act Release No. 27982, 1990 SEC LEXIS 795 (May 2,

1990) (Order Approving Rule Change to Obtain Information Pertinent to

Customer Account).

105

As the SEC explained, “On Sept. 15, 2008, the Reserve Primary Fund, which held

$785 million in Lehman-issued securities, became illiquid when the fund was

unable to meet investor requests for redemptions. The following day, the Reserve

Fund declared it had ‘broken the buck’ because its net asset value had fallen

below $1 per share.” http://www.sec.gov/news/press/2010/2010-16.htm

Page 39 of 776

 Affirmative Acknowledgement Regarding Surrendering Rights

As with the current suitability rule, the proposal provides an exemption from

customer-specific suitability regarding institutional customers if the broker-dealer or

associated person has a reasonable basis to believe that the institutional customer is

capable of evaluating investment risks independently and is exercising independent

judgment in evaluating the member’s or associated person’s recommendations.

However, the proposal discussed in the Notice seeking comment added as a third

requirement that the institutional customer must affirmatively indicate that it is willing to

forego the protection of the customer-specific obligation of the suitability rule.

o Comments

A number of commenters stated that requiring institutional customers to

affirmatively acknowledge that they are giving up rights is impractical and will render the

institutional exemption ineffective.

106

According to these commenters, this requirement

is unnecessary in light of the other two conditions (that the customer be capable of

evaluating risks and is exercising independent judgment).

107

The commenters also stated

that, because institutional clients are highly unlikely to affirmatively forego suitability

protections for commercial reasons, this new requirement will have the practical effect of

negating the exemption.

108

106

See Hancock, MetLife and Prudential Letter, supra note 50; NAIBD Letter, supra

note 62; NSCP Letter, supra

note 34; SIFMA Letter, supra note 47; Wells Fargo

Letter, supra note 62.

107

See NAIBD Letter, supra note 62; SIFMA Letter, supra note 47; Wells Fargo

Letter, supra note 62.

108

See Hancock, MetLife and Prudential Letter, supra note 50; NAIBD Letter, supra

note 62; NSCP Letter, supra

note 34; SIFMA Letter, supra note 47; Wells Fargo

Letter, supra

note 62.

Page 40 of 776

o FINRA’s Response

FINRA has modified the proposed exemption in a way that should alleviate

commenters’ concerns while providing the necessary protection to institutional

customers. The revised exemption eliminates the requirement that institutional customers

affirmatively indicate that they are giving up suitability protections and focuses on the

two main conditions discussed in the current exemption. The revised exemption,

however, does require institutional customers to affirmatively indicate that they are

exercising independent judgment.

 Change in Definition

The proposal harmonizes the definition of “institutional customer” in the

suitability rule with the more common definition of “institutional account” in NASD Rule

3110(c)(4) [proposed FINRA Rule 4512(c)]. As a result, the monetary threshold for an

institutional customer would increase from the current $10 million invested in securities

and/or under management to $50 million in assets. In addition, unlike the current

exemption, a natural person could qualify as an institutional customer under the proposal.

o Comments

Some commenters supported the change in definition.

109

One commenter stated

further that consistent standards produce more efficient, effective, and clear regulation

that is beneficial to investors, regulators, and market participants alike.

110

Other

commenters, however, disagreed, arguing that the definition of $10 million invested in

securities and/or under management in current IM-2310-3 is a more appropriate standard

109

See SIFMA Letter, supra note 47; Wells Fargo Letter, supra note 62.

110

See SIFMA Letter, supra note 47.

Page 41 of 776

for purposes of the institutional account suitability exemption and should be retained in

the new rule rather than referencing the Rule 3110(c)(4) standard of at least $50 million

in total assets.

111

According to one commenter, many highly sophisticated institutional

brokerage customers would not satisfy the $50 million dollar asset threshold but would

not need the protection of the suitability rule.

112

Another commenter who favored keeping the current standard stated that, if

FINRA believes a different standard should be used for uniformity, FINRA should use

the definition in NASD Rule 2211(a)(3) (Communications with the Public) rather than

the one in NASD Rule 3110(c)(4).

113

Under NASD Rule 2211, institutional sales

material may be distributed only to “institutional investors,” defined to include several

categories of persons, including those identified in NASD Rule 3110(c)(4). It also adds

the following entities: employee benefit plans meeting the requirements of Section

403(b) or Section 457 of the Internal Revenue Code with at least 100 participants,

qualified plans with at least 100 participants, and governmental entities or subdivisions

thereof. This commenter also suggested that FINRA should make the standard a

rebuttable presumption against determining that an entity that is outside the list of plans

identified above is an institutional customer.

114

111

See Hancock, MetLife and Prudential Letter, supra note 50; NAIBD Letter, supra

note 62; NSCP Letter, supra note 34.

112

See NAIBD Letter, supra note 62.

113

See Hancock, MetLife and Prudential Letter, supra note 50.

114

See Hancock, MetLife and Prudential Letter, supra note 50. In addition, one

commenter stated that the exemption should apply to all suitability obligations

and should not, as previously had been the case, be limited to customer-specific

suitability. See SIFMA Letter, supra note 47. FINRA believes that the exemption

should remain focused on customer-specific suitability. For instance, it remains

Page 42 of 776

Finally, one commenter argued that there should not be any exemption for

institutional customers.

115

According to this commenter, many institutional customers,

even those with $50 million in assets, are not particularly sophisticated about complex

securities and need the protections of the suitability rule.

116

o FINRA’s Response

While any standard is imperfect, FINRA believes that it is important to use the

definition in Rule 3110(c)(4) for consistency and because of its higher monetary

threshold. FINRA does not believe that it is appropriate to use the much broader

definition in NASD Rule 2211(a)(3), which defines “institutional investor” for purposes

of the rules governing communications with the public. Communications that are

distributed or made available only to institutional investors qualify as institutional sales

material, which is not subject to the same content, principal approval and filing

requirements as communications that are distributed or made available to retail investors.

The communication rules’ requirements, while important, serve a different purpose than

the sales-practice protections that the suitability rule provides when a broker-dealer

recommends a security to a customer.

FINRA understands the concern that even some institutional customers with $50

million in assets might be unsophisticated about complex securities and need the

protections of the suitability rule. However, the exemption would not apply in that

circumstance. Again, the broker-dealer or associated person must have a reasonable basis

important that brokers understand the securities they recommend and that those

securities are appropriate for at least some investors.

115

See Mougey and Kraszewski Letter, supra note 43.

116

See Mougey and Kraszewski Letter, supra note 43.

Page 43 of 776

to believe that the institutional customer is capable of evaluating investment risks

independently and, under the modified proposal, the customer must affirmatively state

that it is exercising independent judgment in evaluating the recommendations.

 Eliminating Detailed Discussion from IM-2310-3

Although the focus is the same, the proposed institutional exemption is

considerably shorter in length than the current one. Its brevity generated one comment.

o Comments

One commenter viewed the new, abbreviated institutional investor discussion in

the proposal as a “box check” waiver that provides less protection than the detailed

discussion in IM-2310-3 of considerations for determining whether the exemption should

apply.

117

o FINRA’s Response

The proposed institutional investor discussion, while shorter than the current

version in IM-2310-3, contains certain stricter standards. In addition to the two main

considerations used in both versions, the proposal includes an increased monetary

threshold that certain institutions must meet to qualify for the exemption and, even more

important, a requirement that the institution affirmatively indicate that it is independently

evaluating the firm’s recommendations.

Supplementary Material

The Consolidated FINRA Rulebook uses supplementary material to discuss

certain aspects of a rule’s requirements in greater detail. However, a number of

commenters raised issues regarding the supplementary material.

117

See NASAA Letter, supra note 33.

Page 44 of 776

 Comments

A number of commenters supported codifying various interpretations of the

suitability rule.

118

Some commenters, however, believed that FINRA should modify

some of those interpretations. For instance, one commenter questioned the “three-

pronged approach” to suitability discussed in Supplementary Material .02, which codifies

discussions in IMs and case law about reasonable-basis suitability, customer-specific

suitability, and quantitative suitability. This commenter suggested that the approach

created new standards that provide less protection to customers.

119

This commenter took

particular issue with reasonable-basis suitability, which requires a broker-dealer to have a

reasonable basis to believe, based on adequate due diligence, that the recommendation is

suitable for at least some investors.

120

The commenter believed that a member’s

familiarity with a product should be presumed.

121

Two other comments focused on quantitative suitability, which requires a broker-

dealer that has actual or de facto control over an 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. These commenters believed that FINRA should

eliminate the requirement under quantitative suitability that a broker-dealer have

118

See Corporate Law Center & Investor Rights Clinic, supra note 43; Taurus Letter,

supra

note 43; T.RowePrice Letter, supra note 43.

119

See NASAA Letter, supra note 33.

120

See NASAA Letter, supra note 33.

121

See NASAA Letter, supra note 33.

Page 45 of 776

“control” over an account before the obligation applies.

122

Yet another commenter stated

that FINRA should eliminate supplementary material from all rules and limit rulemaking

to rule text.

123

 FINRA’s Response

FINRA believes that supplementary material is an important means of providing

greater specificity to a rule’s overarching requirements. FINRA notes that supplementary

material will be filed with the SEC and is enforceable to the same extent as the main rule

text.

With regard to the codification of the main suitability obligations, FINRA

disagrees with the contention that the discussion creates new standards that provide less

protection to customers. The discussion at issue codifies existing interpretations of

suitability obligations, often directly from IMs following NASD Rule 2310

124

and case

law.

125

The commenter argued that presuming that firms and associated persons are

122

See Cornell Letter, supra note 43; Estell Letter, supra note 68.

123

See FOLIOfn Letter, supra note 62.

124

See, e.g., IM-2310-2(b)(2) (discussing quantitative suitability, also called

excessive trading); IM-2310-3 (discussing reasonable-basis and customer-specific

suitability).

125

See, e.g., James B. Chase, Securities Exchange Act Release No. 47476, 2003 SEC

LEXIS 566, at *17 (Mar. 10, 2003) (involving customer-specific suitability);

Harry Gliksman, 54 S.E.C. 471, 474-75 (1999) (discussing excessive trading);

Rafael Pinchas

, 54 S.E.C. 331 (1999) (discussing excessive trading and customer-

specific suitability); F.J. Kaufman & Co., 50 S.E.C. 164, 168-69 (1989)

(discussing both reasonable-basis and customer-specific suitability); Patrick G.

Keel, 51 S.E.C. 282, 284-87 (1993) (upholding violation of customer-specific

suitability); Dep’t of Enforcement v. Medeck, No. E9B2003033701, 2009 FINRA

Discip. LEXIS 7, at *31 (NAC July 30, 2009) (discussing excessive trading);

Dep’t of Enforcement v. Siegel

, No. C05020055, 2007 NASD Discip. LEXIS 20,

at *36-40 (NAC May 11, 2007) (discussing reasonable-basis suitability and due-

diligence requirement thereunder), aff’d, Securities Exchange Act Release No.

Page 46 of 776

familiar with the products they recommend would provide greater protection to

customers. FINRA believes the opposite is true, and FINRA’s examination and

enforcement experience belies the notion that firms and associated persons are always

familiar with every recommended product or strategy. The existing duty to perform

adequate due diligence to understand the products and strategies that firms and associated

persons recommend is of critical importance to the protection of investors.

126

This is

especially true in light of the increasing complexity of certain products and strategies.

Elimination of Interpretive Material Following NASD Rule 2310

In connection with the new suitability rule, FINRA proposes eliminating many

and modifying some of the IMs that follow NASD Rule 2310. This aspect of the

proposal also generated several comments.

58737, 2008 SEC LEXIS 2459 (Oct. 6, 2008), aff’d in relevant part, 592 F.3d 147

(D.C. Cir. Jan. 12, 2010), cert. denied

, 2010 U.S. LEXIS 4340 (May 24, 2010);

see also Regulatory Notice 10-22, 2010 FINRA LEXIS 43, at *10-20 (April 2010)

(discussing due diligence required for reasonable-basis suitability in context of

recommended private offerings); Notice to Members 03-71, 2003 NASD LEXIS

81, *5-6 (Nov. 11, 2003) (discussing due diligence requirement for reasonable-

basis suitability in context of recommendations of non-conventional investments).

126

See F.J. Kaufman & Co., 50 S.E.C. at 168-69 (discussing both reasonable-basis

and customer-specific suitability); Siegel, 2007 NASD Discip. LEXIS 20, at *36-

40 (discussing reasonable-basis suitability and due-diligence requirement

thereunder); see

also Regulatory Notice 10-22, 2010 FINRA LEXIS 43, at *10-20

(April 2010) (discussing due diligence required for reasonable-basis suitability in

context of recommended private offerings); Notice to Members

03-71, 2003

NASD LEXIS 81, *5-6 (Nov. 11, 2003) (discussing due diligence requirement for

reasonable-basis suitability in context of recommendations of non-conventional

investments).

Page 47 of 776

 Comments

A few commenters were concerned that the proposal did not include some of the

current IMs, especially IM-2310-2.

127

These commenters believe that it is important to

maintain the statement in IM-2310-2 that brokers can be disciplined for excessive

trading, unauthorized trading, and fraud.

128

One commenter noted in particular that this

IM was the only place in the entire NASD conduct rules explicitly prohibiting

unauthorized trading.

129

 FINRA’s Response

FINRA continues to believe that most of the current IMs following NASD Rule

2310 should be eliminated or modified because they are no longer necessary. As

discussed in detail in Item 3 of this filing, some are duplicative of other rules and others

would be rendered unnecessary by changes proposed in the new suitability rule. For

example, as noted in Item 3, it is well-settled that unauthorized trading violates just and

equitable principles of trade under FINRA Rule 2010. Consequently, the elimination of

the discussion of unauthorized trading in the IMs following the suitability rule in no way

alters the longstanding view that unauthorized trading clearly violates FINRA’s rules.

KNOW YOUR CUSTOMER

(Proposed FINRA Rule 2090)

The proposal would require broker-dealers to use “due diligence, in regard to the

opening and maintenance of every account, to know (and retain) the essential facts

127

See Cornell Letter, supra note 43; Corporate Law Center & Investor Rights

Clinic, supra

note 43; NASAA Letter, supra note 33.

128

See Cornell Letter, supra note 43; Corporate Law Center & Investor Rights

Clinic, supra

note 43; NASAA Letter, supra note 33.

129

See Corporate Law Center & Investor Rights Clinic, supra note 43.

Page 48 of 776

concerning every customer and concerning the authority of each person acting on behalf

of such customer.” Although there were some comments generally in favor of the

proposal,

130

most comments addressed specific language, as discussed below.

Essential Facts

The proposal states that broker-dealers must attempt to learn the “essential facts”

concerning every customer. Supplementary Material .01 that was discussed in the Notice

seeking comment clarified that “facts ‘essential’ to ‘knowing the customer’ included the

customer’s financial profile and investment objectives or policy.” That language

generated a fairly large number of comments.

 Comments

A number of commenters argued that the collection of financial profile and

investment objective information under the proposed “know your customer” rule is a new

requirement and unnecessarily confuses “know your customer” obligations with

suitability obligations.

131

One commenter believed it would mislead customers into

incorrectly thinking that a firm would only permit a customer to execute a self-directed

transaction if it has determined that the transaction is appropriate for that customer.

132

Along those same lines, other commenters believed the requirement would be particularly

problematic where a customer’s trading activity is self-directed or directed by an

130

See, e.g., Cornell Letter, supra note 43.

131

See Charles Schwab Letter, supra note 46; Matthew Farley, Drinker, Biddle &

Reath LLP, June 29, 2009 (“Drinker Biddle Letter”); FOLIOfn Letter, supra note

62; NAIBD Letter, supra

note 62; NSCP Letter, supra note 34; SIFMA Letter,

supra note 47; TD Ameritrade Letter, supra note 62; T.RowePrice Letter, supra

note 43; Wells Fargo Letter, supra

note 62.

132

See T.RowePrice Letter, supra note 43.

Page 49 of 776

independent investment adviser because regulators or private litigants could seek to hold

firms accountable for permitting unsolicited customer trading activity that is inconsistent

with the “know your customer” information that is on record at the firm.

133

Some of these commenters supported “know your customer” obligations, but

believed they should be limited in scope to essential facts necessary to open the account –

i.e., the identity and address of each account owner, the legal authorization of each person

having investment authority with respect to the account, the source of funding for the

account, and the credit status of the account owners.

134

Some commenters suggested

removing proposed Supplementary Material .01 to Rule 2090 in its entirety and instead

permitting each firm to interpret and apply the “essential facts” standard to their

particular business model, recognizing that it is the nature of the relationship between the

firm and customer that dictates those facts.

135

Another commenter similarly stated that

the information should be limited to an investor’s name, address, and tax identification

number, which the commenter asserted was all the information that is needed to know the

customer’s identity and to make a credit determination.

136

133

See Charles Schwab Letter, supra note 46; Drinker Biddle Letter, supra note 131;

FOLIOfn Letter, supra note 62; SIFMA Letter, supra note 47; TD Ameritrade

Letter, supra note 62; Wells Fargo Letter, supra note 62. One commenter made

the same claim in the context of clearing firms and also stated that requiring a

clearing firm to maintain this information as well as the introducing firm—which

has the primary if not exclusive contact with the customer—would create a

needless redundancy of effort, expense and information storage. See Drinker

Biddle Letter, supra note 131.

134

See SIFMA Letter, supra note 47; Wells Fargo Letter, supra note 62.

135

See SIFMA Letter, supra note 47; TD Ameritrade Letter, supra note 62; Wells

Fargo Letter, supra

note 62.

136

See FOLIOfn Letter, supra note 62.

Page 50 of 776

One commenter, however, believed that firms should have to make reasonable

efforts to collect the types of information delineated in paragraph (a) of proposed Rule

2111.

137

This commenter indicated that each of those factors is essential to knowing the

customer.

138

Others suggested that the term should be clarified.

139

 FINRA’s Response

After analyzing the comments, FINRA agrees with those commenters who stated

that the “know your customer” obligation should remain flexible and that the extent of

the obligation generally should depend on a particular firm’s business model, its

customers, and applicable regulations. As a result, FINRA has modified proposed

Supplementary Material .01 to FINRA Rule 2090 so that it is less prescriptive. That

provision now states: “For purposes of this Rule, facts ‘essential’ to ‘knowing the

customer’ are those required to (a) effectively service the customer’s account, (b) act in

accordance with any special handling instructions for the account, (c) understand the

authority of each person acting on behalf of the customer, and (d) comply with applicable

laws, regulations, and rules.”

Maintenance of Every Account

A few commenters focused on the “maintenance” aspect of the “know your

customer” requirement.

137

See Cornell Letter, supra note 43.

138

See Cornell Letter, supra note 43.

139

See Committee of Annuity Insurers Letter, supra note 34.

Page 51 of 776

 Comments

Two commenters stated that the “maintenance” language was both new and vague

and would lead to practical implementation issues, particularly in the retirement plan

marketplace.

140

The commenters stated that FINRA should provide more guidance on

what it means by “maintenance” and an opportunity to comment if it keeps the term.

141

 FINRA’s Response

FINRA believes that it is self-evident that a broker-dealer must know its

customers not only at account opening but also throughout the life of its relationship with

customers in order to, among other things, effectively service and supervise the customer

accounts. Since a broker-dealer’s relationship with its customers is dynamic, FINRA

does not believe that it can prescribe a period within which broker-dealers must attempt

to update this information. Firms should verify the essential facts about customers at

intervals reasonably calculated to prevent and detect any mishandling of customer

accounts that might result from changes to the “essential facts” about the customers.

142

The reasonableness of a broker-dealer’s efforts in this regard will depend on the facts and

circumstances of the particular case.

140

See Committee of Annuity Insurers Letter, supra note 34; Hancock, MetLife and

Prudential Letter, supra note 50.

141

See Committee of Annuity Insurers Letter, supra note 34; Hancock, MetLife and

Prudential Letter, supra note 50.

142

Broker-Dealers should note, however, that, under SEA Rule 17a-3, they must,

among other things, attempt to update certain account information every 36

months regarding accounts for which the broker-dealers were required to make

suitability determinations.

Page 52 of 776

Not Applicable to Every Order

At present, NYSE Rule 405(1) applies to “every order.” The proposal eliminates

this language.

 Comments

Two commenters argued that the proposed “know your customer” rule should, as

is true currently under NYSE Rule 405(1), require due diligence as to “every order” and

not simply as to every account.

143

These commenters stated that it was a mistake to focus

on knowing the customer rather than knowing both the customer and the product.

144

One

of these commenters did not believe that reasonable-basis suitability provides enough

protection in that respect in part because the suitability rule applies only when a

recommendation is made.

145

 FINRA’s Response

FINRA is not proposing to adopt the NYSE requirement to learn the essential

facts relative to every order in NYSE Rule 405(1), given the application of specific order-

handling rules.

146

In addition, as noted by a commenter, the reasonable-basis obligation

under the suitability rule requires broker-dealers and associated persons to know the

securities and strategies they recommend through performing adequate due diligence.

6. Extension of Time Period for Commission Action

Not applicable.

143

See Cornell Letter, supra note 43; NASAA, supra note 33.

144

See Cornell Letter, supra note 43; NASAA, supra note 33.

145

See NASAA, supra note 33.

146

See supra note 24.

Page 53 of 776

7. Basis for Summary Effectiveness Pursuant to Section 19(b)(3) or for

Accelerated Effectiveness Pursuant to Section 19(b)(2)

Not applicable.

8. Proposed Rule Change Based on Rules of Another Self-Regulatory

Organization or of the Commission

Not applicable.

9. Exhibits

Exhibit 1. Completed notice of proposed rule change for publication in the

Federal Register.

Exhibit 2a. FINRA Regulatory Notice 09-25 (May 2009).

Exhibit 2b. Index to comments received in response to FINRA Regulatory Notice

09-25 (May 2009).

Exhibit 2c. Comments received in response to FINRA Regulatory Notice 09-25

(May 2009).

Exhibit 5. Text of the proposed rule change.

Page 54 of 776

EXHIBIT 1

SECURITIES AND EXCHANGE COMMISSION

(Release No. 34- ; File No. SR-FINRA-2010-039)

Self-Regulatory Organizations; Financial Industry Regulatory Authority, Inc.; Notice of

Filing of Proposed Rule Change to Adopt FINRA Rules 2090 (Know Your Customer)

and 2111 (Suitability) in the Consolidated FINRA Rulebook

Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Act”)

and

Rule 19b-4 thereunder,

notice is hereby given that on ,

Financial Industry Regulatory Authority, Inc. (“FINRA”) (f/k/a National Association of

Securities Dealers, Inc. (“NASD”)) filed with the Securities and Exchange Commission

(“SEC” or “Commission”) the proposed rule change as described in Items I, II, and III

below, which Items have been prepared by FINRA. The Commission is publishing this

notice to solicit comments on the proposed rule change from interested persons.

I. Self-Regulatory Organization’s Statement of the Terms of Substance of the

Proposed Rule Change

FINRA is proposing to adopt FINRA Rule 2111 (Suitability) and FINRA Rule

2090 (Know Your Customer) as part of the Consolidated FINRA Rulebook. The

proposed rules are based in large part on NASD Rule 2310 (Recommendations to

Customers (Suitability)) and its related Interpretative Materials (“IMs”) and Incorporated

NYSE Rule 405(1) (Diligence as to Accounts), respectively. As further detailed herein,

the proposed rule change would delete those NASD and Incorporated NYSE rules and

related NASD IMs and Incorporated NYSE Rule Interpretations.

15 U.S.C. 78s(b)(1).

17 CFR 240.19b-4.

Page 55 of 776

The text of the proposed rule change is available on FINRA’s Web site at

http://www.finra.org, at the principal office of FINRA and at the Commission’s Public

Reference Room.

II. Self-Regulatory Organization’s Statement of the Purpose of, and Statutory Basis

for, the Proposed Rule Change

In its filing with the Commission, FINRA included statements concerning the

purpose of and basis for the proposed rule change and discussed any comments it

received on the proposed rule change. The text of these statements may be examined at

the places specified in Item IV below. FINRA has prepared summaries, set forth in

sections A, B, and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization’s Statement of the Purpose of, and Statutory

Basis for, the Proposed Rule Change

1. Purpose