More On Legal & Compliancefrom The Advisor's Professional Library
- Risk-Based Oversight of Investment Advisors Even if the SEC had a larger budget and more resources, it is doubtful that the Commission would have the resources to regularly examine all RIAs. Therefore, the SEC is likely to continue relying on risk-based oversight to fulfill its mission of protecting investors.
- Client Commission Practices and Soft Dollars RIAs should always evaluate whether the products and services they receive from broker-dealers are appropriate. The SEC suggested that an RIAs failure to stay within the scope of the Section 28(e) safe harbor may violate the advisors fiduciary duty to clients, so RIAs must evaluate their soft dollar relationships on a regular basis to ensure they are disclosed properly and that they do not negatively impact the best execution of clients transactions.
FINRA on Tuesday clarified what the terms “customer” and “investment strategy” mean in its suitability rule, which became effective on July 9.
The clarifications are updates to FINRA's Regulatory Notice 12-25, which was issued in May and provides guidance on the rule in a “frequently asked questions” format.
FINRA has also created a web page specifically for its suitability rule, Rule 2111.
The updated Notice 12-55 says that the suitability rule does apply when a broker-dealer or registered rep makes a recommendation to a “potential investor who then becomes a customer.”
For instance, FINRA states that when a registered rep “makes a recommendation to purchase a security to a potential investor, the suitability rule would apply to the recommendation if that individual executes the transaction through the broker-dealer with which the registered rep is associated or the broker-dealer receives or will receive, directly or indirectly, compensation as a result of the recommended transaction.”
However, the suitability rule would not apply to the recommendation in the example above “if the potential investor does not act on the recommendation or executes the recommended transaction away from the broker-dealer with which the registered rep is associated without the broker-dealer receiving compensation for the transaction.”
As to the updated response to frequently asked question 7, FINRA said that while Rule 2111 states that the term “investment strategy” is to be interpreted “broadly,” FINRA would not consider a broker-dealer’s or registered rep’s recommendation that a customer generally invest in “equity” or “fixed income” securities to be an investment strategy covered by the rule, unless such a recommendation was part of an asset allocation plan not eligible for the safe-harbor provision in Rule 2111.
The “investment strategy” language would, FINRA says, “apply to recommendations to customers to invest in more specific types of securities, such as high dividend companies or the ‘Dogs of the Dow,’ or in a market sector, regardless of whether the recommendations identify particular securities.”
It also would apply to recommendations to customers generally to use a bond ladder, day trading, “liquefied home equity,” or margin strategy involving securities, irrespective of whether the recommendations mention particular securities, the agency states. In addition, “the term would capture an explicit recommendation to hold a security or securities or to continue to use an investment strategy involving a security or securities.”
The rule would apply, for example, “when a registered rep (or otherwise communicates) with a customer during a quarterly or annual investment review and explicitly advises the customer not to sell any securities in or make any changes to the account or portfolio or to continue to use an investment strategy,” FINRA said
However, as explained in frequently asked question 3, the rule “would not cover an implicit recommendation to hold,” FINRA states. “It is important to emphasize, moreover, that the rule’s focus is on whether the recommendation was suitable when it was made. A recommendation to hold securities, maintain an investment strategy involving securities or use another investment strategy involving securities—as with a recommendation to purchase, sell or exchange securities—normally would not create an ongoing duty to monitor and make subsequent recommendations.”