Document ID: SEC-2010-1785-0001
Agency: sec
Document Type: Notice
Title: Self-Regulatory Organizations; Proposed Rule Changes: Financial Industry Regulatory Authority, Inc.
Posted Date: 2010-11-23T05:00Z

[Federal Register Volume 75, Number 225 (Tuesday, November 23, 2010)]
[Notices]
[Pages 71479-71485]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2010-29447]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-63325; File No. SR-FINRA-2010-039]

Self-Regulatory Organizations; Financial Industry Regulatory 
Authority, Inc.; Notice of Filing of Amendment No. 1 to a Proposed Rule 
Change and Order Granting Accelerated Approval of a Proposed Rule 
Change, as Modified by Amendment No. 1, To Adopt FINRA Rules 2090 (Know 
Your Customer) and 2111 (Suitability) in the Consolidated FINRA 
Rulebook

November 17, 2010.

I. Introduction

    On July 30, 2010, the 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''), pursuant to Section 19(b)(1) of the Securities 
Exchange Act of 1934 (the ``Exchange Act'') \1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change to adopt FINRA Rule 2090 (Know 
Your Customer) and FINRA Rule 2111 (Suitability) in the consolidated 
FINRA rulebook (``Consolidated FINRA Rulebook'').\3\ The Commission 
published the proposed rule change in the Federal Register.\4\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ 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.
    \4\ See Exchange Act Release No. 62718 (August 13, 2010), 75 FR 
51310 (August 19, 2010). This release was later amended to correct 
footnote cross-references. Exchange Act Release No. 62718A (August 
20, 2010), 75 FR 52562 (August 26, 2010). The Commission also 
published the corrected notice on its Web site.
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    The Commission received 22 comments in response to the proposed 
rule change.\5\ On September 21, 2010, FINRA responded to the comments 
\6\ and filed Amendment No. 1 to the proposed rule change.\7\ The 
Commission is publishing this notice and order to solicit comments on 
Amendment No. 1 and to approve the proposed rule change, as amended, on 
an accelerated basis.
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    \5\ See Letters from Steven B. Caruso, Maddox Hargett & Caruso, 
P.C. (Sept. 8, 2010) (``Caruso Letter''); Barry D. Estell, Attorney 
(Sept. 9, 2010) (``Estell Letter''); Barbara Black, Charles Hartsock 
Professor of Law and Director, Corporate Law Center, University of 
Cincinnati College of Law, and Jill I. Gross, Professor of Law and 
Director of Legal Skills and Director, Pace Investor Rights Clinic, 
Pace University School of Law (Sept. 9, 2010) (``Black-Gross 
Letter''); David P Neuman, Stoltmann Law Offices, PC (Sept. 9, 2010) 
(``Neuman Letter''); Richard M. Layne (Sept. 9, 2010) (``Layne 
Letter''); William A. Jacobson, Associate Clinical Professor of Law, 
Cornell Law School, and Director, Cornell Securities Law Clinic 
(Sept. 9, 2010) (``Jacobson Letter''); Scott R. Shewan, President, 
Public Investors Arbitration Bar Association (Sept. 9, 2010) 
(``PIABA Letter''); Pamela Lewis Marlborough, Associate General 
Counsel, Advocacy & Oversight, TIAA-CREF (Sept. 9, 2010) (``TIAA-
CREF Letter''); Gary A. Sanders, Vice President, Securities and 
State Government Relations, National Association of Insurance and 
Financial Advisors (Sept. 9, 2010) (``NAIFA Letter''); Stephen 
Krosschell, Goodman Nekvasil, P.A. (Sept. 9, 2010) (``Krosschell 
Letter''); Sutherland Asbill & Brennan LLP, on behalf of the 
Committee of Annuity Insurers (Sept. 9, 2010) (``CAI Letter''); Lisa 
Catalano, Director, St. John's University School of Law Securities 
Arbitration Clinic, (Sept. 9, 2010) (``Catalano Letter''); G. Mark 
Brewer, Esquire (Sept. 9, 2010) (``Brewer Letter''); Bari Havlik, 
SVP and Chief Compliance Officer, Charles Schwab & Co. Inc. (Sept. 
9, 2010) (``Schwab Letter''); Peter J. Mougey, Levin, Papantonio, 
Thomas, Mitchell, Echsner, Rafferty, Proctor, P.A. (Sept. 9, 2010) 
(``Mougey Letter''); Al Van Kampen, Esquire (Sept. 10, 2010) (``Van 
Kampen Letter''); James T. McHale, Managing Director and Associate 
General Counsel, SIFMA (Sept. 14, 2010) (``SIFMA Letter''); John S. 
Markle, Deputy General Counsel, TD Ameritrade (Sept. 15, 2010) (``TD 
Ameritrade Letter''); Scott C. Ilgenfritz, Johnson, Pope, Bokor, 
Ruppel & Burns, LLP (Sept. 24, 2010) (``Ilgenfritz Letter''); Dale 
E. Brown, President and CEO, Financial Services Institute, Inc. 
(Sept. 27, 2010) (``FSI Letter''); Timothy R. Wing, President and 
CEO, CME Stock/Option Consulting Services, Inc. (Sept. 28, 2010) 
(``CME/OCS Letter'').
    \6\ See Letter from James Wrona, Associate Vice President and 
Associate General Counsel, FINRA to Elizabeth M. Murphy, Secretary, 
Commission, dated October 21, 2010 (``FINRA Response'').
    \7\ See Amendment No. 1 to FINRA-2010-039, dated October 21, 
2010 (``Amendment No. 1''). The text of Amendment No. 1 is available 
on FINRA's Web site at http://www.finra.org/web/groups/industry/@ip/@reg/@rulfil/documents/rulefilings/p122318.pdf, at the principal 
office of FINRA, and on the Commission's Internet Web site (http://www.sec.gov/rules/sro/finra.shtml).
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II. Description of the Proposed Rule Change

    As part of the process of developing the Consolidated FINRA 
Rulebook, FINRA proposed FINRA Rule 2090 (Know Your Customer) and FINRA 
Rule 2111 (Suitability). The ``know your customer'' and suitability 
obligations are critical to ensuring investor protection and fair 
dealing with customers. FINRA's proposed rule change was designed to 
retain the core features of these obligations (set forth in NYSE Rule 
405(1) and NASD Rule 2310), while modifying both rules to strengthen 
and clarify them.
    The proposed rule change built on a similar proposed rule change on 
which

[[Page 71480]]

FINRA requested comment in FINRA Regulatory Notice 09-25 (May 2009). 
The proposed rule change FINRA filed with the Commission included both 
a comprehensive response to the comments FINRA received in response to 
Regulatory Notice 09-25 and modifications to address those comments.

A. Proposed FINRA Rule 2090

    The proposed ``Know Your Customer'' obligation in FINRA Rule 2090 
encompasses the main ethical standard of NYSE Rule 405(1). As proposed, 
the rule would require broker-dealers to use ``reasonable diligence,'' 
with regard to the opening and maintenance of every account, in order 
to know and retain the essential facts concerning every customer.\8\ 
The obligation would arise at the beginning of the customer/broker 
relationship, independent of whether the broker has made a 
recommendation, and continue throughout the term of that relationship. 
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.'' \9\
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    \8\ See Proposed FINRA Rule 2090.
    \9\ See Proposed FINRA Rule 2090.01. FINRA proposed to change 
the explanation of ``essential facts'' in response to comments.
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    The proposal would not incorporate the requirement in NYSE Rule 
405(1) to learn the essential facts relative to ``every order.'' FINRA 
proposed to exclude the ``every order'' language because of the 
application of existing order-handling rules.\10\ In addition, the 
reasonable-basis obligation under FINRA's suitability rule requires 
broker-dealers and their associated persons to use reasonable diligence 
to understand the securities and strategies they recommend.
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    \10\ 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); NASD 
Rule 2400 Series (Commissions, Mark-Ups and Charges); NASD IM-2110-2 
(Trading Ahead of Customer Limit Order); and IM-2110-3 (Front 
Running Policy). See also, FINRA Regulatory Notice 08-80 (December 
2008) (proposed FINRA Rule 5310); FINRA Regulatory Notice 08-83 
(December 2008) (proposed FINRA Rule 5270); and Exchange Act Release 
No. 61168 (December 15, 2009) (proposed FINRA Rule 5320).
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    FINRA also proposed 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.\11\
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    \11\ FINRA is proposing to adopt NASD Rule 3010 as FINRA Rule 
3110, subject to certain amendments. See FINRA Regulatory Notice 08-
24 (May 2008).
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    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 prior to approving the 
opening of the account. However, FINRA believes that a number of other 
FINRA rules do, and proposed FINRA rules would, create substantially 
similar obligations. For example, proposed FINRA Rule 2090 would 
require members to know the essential facts as to each customer, and 
NASD Rule 3110(c)(1)(C) requires the signature of the member, partner, 
officer or manager who accepts the account.\12\
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    \12\ FINRA is proposing to adopt NASD Rule 3110(c)(1)(C) as 
FINRA Rule 4512(a)(1)(D), subject to certain amendments. See 
Exchange Act Release No. 63181 (October 26, 2010), 75 FR 67155 
(November 1, 2010). Proposed FINRA Rule 4512(a)(1)(D) 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.
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    FINRA Rule 3310, which requires a firm to have procedures 
reasonably designed to achieve compliance with the Bank Secrecy Act 
(``BSA'') and the implementing regulations, also affect a firm's 
account-opening obligations. One BSA regulation requires a firm to 
verify the identity of a customer opening a new account.\13\ Another 
BSA regulation requires a firm to engage in due diligence sufficient to 
enable the firm to evaluate the risk of each customer and to determine 
if transactions by the customer could be suspicious such that the firm 
would need to file a suspicious activity report.\14\
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    \13\ See 31 CFR 103.122.
    \14\ See 31 CFR 103.19.
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    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.\15\
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    \15\ See, e.g., Exchange Act 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).
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    FINRA also believes that NYSE Supplementary Material 405.10 is 
redundant of other FINRA proposed and existing requirements, and that 
the cross references provided in NYSE Supplementary Material 405.20 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. As discussed above, proposed FINRA 
Rule 2090 and proposed FINRA Supplementary Material 2090.01 would 
require firms to know the essential facts concerning every customer. 
Moreover, NASD Rule 3110(c) (Customer Account Information), requires 
firms to maintain a record identifying the person(s) authorized to 
transact business on behalf of a customer that is a legal entity.\16\ 
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.
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    \16\ FINRA is proposing to adopt NASD Rule 3110(c) as FINRA Rule 
4512 (Customer Account Information), subject to certain amendments. 
See Exchange Act Release No. 63181 (October 26, 2010), 75 FR 67155 
(November 1, 2010).
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    FINRA believes that the associated 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 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) provides 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 would similarly require 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, existing FINRA rules address currently these activities. FINRA 
Rule 5210 (Publication

[[Page 71481]]

of Transactions and Quotations) prohibits members from publishing or 
circulating or causing to publish or circulate, any notice, 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 the member believes that the 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 the member is prepared to purchase or sell at that 
price and under the conditions stated at the time of the offer to buy 
or sell. Moreover, the use of fictitious transactions by a member or 
associated person to manipulate the market would also violate FINRA's 
rules regarding just and equitable principles of trade (FINRA Rule 
2010) and fraud (FINRA Rule 2020).\17\
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    \17\ See, e.g., Terrance Yoshikawa, Exchange Act Release No. 
53731 (April 26, 2006), 87 SEC Docket 2924, 2006 SEC LEXIS 948 
(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).
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    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. Section 11(a) of the Exchange Act and the rules 
thereunder also 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 proposed rule change.

B. Proposed FINRA Rule 2111

    The proposed suitability obligation in 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 * * 
*.'' \18\ This assessment would need to be ``based on the information 
obtained through the reasonable diligence of the member or associated 
person to ascertain the customer's investment profile[,]'' which 
``includes, but is 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.'' \19\
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    \18\ See Proposed FINRA Rule 2111(a).
    \19\ See Proposed FINRA Rule 2111(a). FINRA modified various 
aspects of the proposed information-gathering requirements in 
response to comments.
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    The proposed rule would explicitly cover a recommended investment 
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) estimates of 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 Interpretative Material 
(``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; \20\ and
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    \20\ FINRA is proposing to adopt NASD IM-2210-6 as FINRA Rule 
2214 without material change. See Regulatory Notice 09-55 (September 
2009).
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     Interactive investment materials that incorporate the 
above.\21\
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    \21\ See Proposed FINRA Rule 2111.03. FINRA included this 
exception in response to comments.
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    The proposal also would codify interpretations of the three main 
suitability obligations, listed below:
     Reasonable basis (members must have reasonable grounds to 
believe, based on reasonable 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 transactions recommended to a customer within a 
certain period is not excessive).\22\
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    \22\ See Proposed FINRA Rule 2111.03.
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    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,\23\ and is exercising 
independent judgment in evaluating recommendations.\24\ The proposal 
would require institutional customers to affirmatively indicate that 
they are exercising independent judgment,\25\ and would harmonize the 
definition of institutional customer in the suitability rule with the 
definition of ``institutional account'' in NASD Rule 3110(c)(4).\26\
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    \23\ 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 NASD 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.''
    \24\ See Proposed FINRA Rule 2111(b).
    \25\ Id. FINRA noted 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.
    \26\ 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 Exchange Act Release No. 63181 (October 26, 2010), 75 FR 
67155 (November 1, 2010).

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[[Page 71482]]

    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 these IMs would be unnecessary in 
light of the proposed changes to the scope of the suitability rule 
(e.g., the proposed rule text would capture ``strategies'' currently 
referenced in IM-2310-3),\27\ and others would be 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 Commission's penny stock rules,\28\ while fraudulent conduct 
identified in IM-2310-2 is covered by Exchange Act and FINRA anti-fraud 
provisions \29\).
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    \27\ See Proposed Rule 2111(a).
    \28\ See Exchange Act Rule 15g-1 through 15g-9.
    \29\ See Section 10(b) of the Act; FINRA Rule 2020.
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    Other IM provisions would be incorporated in some form into the 
proposed rule or the supplementary material to the proposed rule. For 
example, the exemption in IM-2310-3 dealing with institutional 
customers has been modified and would be included in the text of 
proposed FINRA Rule 2111.\30\ In addition, the explication of the three 
main suitability obligations in IM-2310-2 and IM-2310-3 has been 
consolidated into a single discussion in the proposed rule's 
supplementary material.\31\ Similarly, the proposed rule's 
supplementary material would include a modified form of the current 
requirement in IM-2310-2 that a member refrain from recommending 
purchases beyond a customer's capability.\32\ The supplementary 
material also would incorporate the discussions in IM-2310-2 and IM-
2310-3 regarding the significance of the suitability rule in promoting 
fair dealing with customers and ethical sales practices.\33\
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    \30\ See Proposed Rule 2111(a).
    \31\ See Proposed Rule 2111.05.
    \32\ See Proposed Rule 2111.06.
    \33\ See Proposed Rule 2111.01.
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    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).\34\ Consequently, the 
elimination of the discussion of unauthorized trading in the IMs 
following the suitability rule does not alter the longstanding view 
that unauthorized trading is serious misconduct and clearly violates 
FINRA's rules.
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    \34\ 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).
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    FINRA will announce the implementation date of the proposed rule 
change in a Regulatory Notice to be published no later than 60 days 
following Commission approval. The implementation date will be no later 
than 270 days following publication of the Regulatory Notice announcing 
Commission approval.

III. Summary of Comments and FINRA's Response

    As stated previously, the Commission received 22 comments in 
response to the proposed rule change,\35\ and FINRA responded to the 
comments both by letter \36\ and by filing an amendment to the proposed 
rule change to address certain comments.\37\ Although commenters raised 
numerous suitability-related issues that FINRA previously addressed in 
its original rule filing with the Commission, a few commenters 
identified new suitability-related concerns regarding the proposed rule 
change, and some persuaded FINRA to amend the proposal. A discussion of 
those comments and FINRA's response follows.
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    \35\ See supra, note 5.
    \36\ See supra, note 6.
    \37\ See supra, note 7.
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Request for Indeterminate Delay of the Proposal

     Comments
    Six commenters argued that FINRA's proposed rule changes should not 
be acted on until after policymakers (e.g., Congress, the Commission, 
and/or FINRA) determine whether broker-dealers must comply with 
fiduciary obligations.\38\ In particular, these commenters cited the 
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 
(``Dodd-Frank''), which, among other things, requires the SEC to study 
the standards of care broker-dealers and investment advisers must 
adhere to when dealing with clients (including a fiduciary duty). These 
commenters advocated postponing FINRA's proposed rule changes until the 
parameters of any SEC rulemaking resulting from the study are clear. 
Other commenters strongly opposed any delay, citing the importance of 
FINRA's proposal to investor protection.\39\
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    \38\ See TIAA-CREF Letter, CAI Letter, Schwab Letter, SIFMA 
Letter, TD Ameritrade Letter, and FSI Letter.
    \39\ See Black-Gross Letter.
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     FINRA's Response
    FINRA stated that its proposal generally maintains the core 
features of its current ``know your customer'' and suitability rules. 
FINRA also indicated that the proposed changes to those rules would 
provide greater protection to investors and greater certainty to 
broker-dealers by streamlining various provisions to focus on critical 
obligations that are not covered by other rules and by codifying in one 
place significant interpretations of key requirements.
    FINRA also expressed the view that nothing in Dodd-Frank argues for 
the discontinuance of these important sales-practice obligations or the 
weakening of investor protection generally. FINRA stated that the 
suitability obligations in proposed Rule 2111 would not be inconsistent 
with a fiduciary duty if broker-dealers become subject to that duty at 
some future date.\40\ In addition, FINRA noted that the suitability and 
``know your customer'' standards are a material part of a fiduciary 
duty in the context of advice or recommendations.
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    \40\ 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.
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    In response to similar comments made with respect to FINRA's NTM 
09-25, FINRA quoted a Commission release that noted ``investment 
advisers under the Advisers Act'' that 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.'' \41\ FINRA also cited another Commission 
release that

[[Page 71483]]

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.'' \42\
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    \41\ 75 FR 51310, at 51314 (Aug. 19, 2010) and 75 FR 52562, 
52567 (Aug. 26, 2010) citing SEC 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).
    \42\ 75 FR 51310, at 51314 (Aug. 19, 2010) and 75 FR 52562, 
52567 (Aug. 26, 2010) citing Investment Advisers Act Release No. 
1406, 1994 SEC LEXIS 797, at *4 (Mar. 16, 1994) (Suitability of 
Investment Advice Provided by Investment Advisers).
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    As to timing, FINRA maintained that improvements to investor 
protection and clarification of broker-dealer obligations should not be 
postponed indefinitely simply because there could potentially be a rule 
that may address similar issues at a future time. FINRA indicated that 
delay also would be problematic because it would amount to an open-
ended postponement of the important benefits to customers and broker-
dealers noted above. As some commenters noted, Dodd-Frank does not 
require that the Commission engage in rulemaking at the end of its 
study and, even if the Commission proposes a rule, there is no 
timetable for doing so.\43\
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    \43\ See Black-Gross Letter.
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Proposed FINRA Rule 2090

     Comments
    One commenter expressed concern regarding FINRA's proposed 
elimination of Supplementary Material .20 to NYSE Rule 405, which 
references the applicability of NYSE Rule 382 (Carrying Agreements) and 
the allocation of responsibility between introducing and carrying 
firms.\44\
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    \44\ See SIFMA Letter.
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     FINRA's Response
    FINRA stated that because NASD Rule 3230 (Clearing Agreements), 
which generally would be applicable, similarly covers allocation issues 
between introducing and carrying firms, reference to NYSE Rule 382 is 
both outdated and unnecessary.

Proposed FINRA Rule 2111--Consistent Terminology and Expanded 
Explanation of Key Terms

     Comments
    One commenter suggested that FINRA should maintain a standard 
approach to the terminology used in the rule.\45\ The commenter gave as 
an example the use of ``reasonable basis'' in one section and 
``reasonable grounds'' in another. The commenter also noted that the 
rule uses both ``reasonable diligence'' and ``adequate due diligence.'' 
Another commenter asked FINRA to provide greater clarity in 
Supplementary Material regarding the terms ``investment profile'' and 
``reasonable diligence.'' \46\
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    \45\ See SIFMA Letter.
    \46\ Id.
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     FINRA's Response
    In response to this and other comments, FINRA filed Amendment No. 
1, which amended the proposal to use more consistent terminology, where 
possible, and to provide more detailed explanations regarding key terms 
or responsibilities. As amended, the rule would consistently use the 
term ``reasonable basis'' rather than also using ``reasonable grounds'' 
and ``reasonable expectations,'' and the term ``reasonable diligence'' 
instead of also using ``due diligence'' and ``adequate diligence.'' 
\47\ In addition, Amendment No. 1 amends the proposal to add expanded 
discussions regarding a ``customer's investment profile'' (see 
discussion below of new Supplementary Material .04--Customer's 
Investment Profile) and the ``reasonable diligence'' standards in the 
context of a customer's investment profile (see below) and reasonable-
basis suitability.\48\
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    \47\ See, e.g., Proposed Rule 2090 (replacing the term ``due 
diligence'' with ``reasonable diligence''); Supplementary Material 
.04 (Customer's Investment Profile) to Proposed Rule 2111 (using the 
terms ``reasonable basis'' and ``reasonable diligence''); 
Supplementary Material .05 (Components of Suitability Obligations) 
to Proposed Rule 2111 (replacing the term ``adequate due diligence'' 
with the term ``reasonable diligence'' and replacing the term 
``reasonable grounds'' with the term ``reasonable basis''); 
Supplementary Material .06 (Customer's Financial Ability) to 
Proposed Rule 2111 (replacing the term ``reasonable expectation'' 
with the term ``reasonable basis'').
    \48\ The Supplementary Material regarding reasonable-basis 
suitability now contains the following expanded discussion of the 
term ``reasonable diligence'': ``A member's or associated person's 
reasonable diligence must provide the member or associated person 
with an understanding of the potential risks and rewards associated 
with the recommended security or strategy. The lack of such an 
understanding when recommending a security or strategy violates the 
suitability rule.''
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Proposed FINRA Rule 2111--Information Gathering

     Comments
    Some commenters took issue with various aspects of the proposal's 
information-gathering requirements. Several commenters stated that 
obtaining each specified category of information is not warranted on 
every occasion.\49\ Some asked that FINRA build flexibility into the 
rule so that a firm would not have to collect information if it was 
irrelevant based on the particular facts and circumstances.\50\ 
Alternatively, these commenters requested that FINRA establish an 
effective date for the new rule that recognizes the difficulty 
associated with developing, modifying, and implementing forms and 
systems to request and capture the proposed new categories of 
information.\51\
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    \49\ See Schwab Letter, CAI Letter, SIFMA Letter, TD Ameritrade 
Letter, and TIAA-CREF Letter.
    \50\ See CAI Letter, TD Ameritrade Letter, and TIAA-CREF Letter.
    \51\ See Schwab Letter, CAI Letter, SIFMA Letter, TD Ameritrade 
Letter, and TIAA-CREF Letter.
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    One commenter maintained that factors such as a customer's 
investment experience, time horizon, and risk tolerance should be 
considered when reviewing a customer's portfolio as a whole, and not 
individual trades.\52\ In this commenter's view, requiring 
consideration of such factors on a trade-by-trade basis would prevent 
customers from creating a diverse portfolio made up of securities with 
different levels of liquidity, risk, and time horizons.
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    \52\ See FSI Letter.
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     FINRA's Response
    FINRA noted that the factors it added to the rule are subsets of 
broader categories of information identified in the current suitability 
rule, and that case law and regulatory notices have long stressed the 
significance of these factors to a suitability analysis. In response to 
those comments requesting flexibility regarding the type of information 
that firms must seek to obtain and comments requesting more guidance on 
what is required, FINRA proposed in Amendment No. 1 to add 
Supplementary Material .04 to FINRA Rule 2111.\53\ FINRA believes 
proposed Supplementary Material .04 would provide flexibility regarding 
the type of information that firms must seek to obtain and analyze in 
connection with a recommendation under the proposed rule. However, 
because FINRA believes the factors discussed in Rule 2111(a) generally 
are relevant (and often crucial) to a suitability analysis, the 
proposed rule would require firms to document with specificity their 
reasonable basis for believing that a factor is not relevant in order 
to be relieved of the obligation

[[Page 71484]]

to seek to obtain information about that factor.\54\
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    \53\ Supplementary Material .04 to Proposed FINRA Rule 2111 
would provide, ``.04 Customer's Investment Profile. A member or 
associated person shall make a recommendation covered by this Rule 
only if, among other things, the member or associated person has 
sufficient information about the customer to have a reasonable basis 
to believe that the recommendation is suitable for that customer. 
The factors delineated in Rule 2111(a) regarding a customer's 
investment profile generally are relevant to a determination 
regarding whether a recommendation is suitable for a particular 
customer, although the level of importance of each factor may vary 
depending on the facts and circumstances of the particular case. A 
member or associated person shall use reasonable diligence to obtain 
and analyze all of the factors delineated in Rule 2111(a) unless the 
member or associated person has a reasonable basis to believe, 
documented with specificity, that one or more of the factors are not 
relevant components of a customer's investment profile in light of 
the facts and circumstances of the particular case.''
    \54\ FINRA noted that the efforts of a firm that seeks but does 
not obtain information about a particular factor (as opposed to a 
situation where the firm does not attempt to obtain the information 
about a particular factor) would be judged by the ``reasonable 
diligence'' standard. FINRA also noted that, when customer 
information is unavailable despite a firm's reasonable diligence in 
seeking to obtain the information, the firm must carefully consider 
whether it has sufficient customer information to properly evaluate 
the suitability of a recommendation to the customer. However, FINRA 
noted further that if the firm used reasonable diligence, the 
absence of some customer information that is not critical to the 
analysis based on the facts and circumstances of the particular 
situation generally would not preclude a recommendation from being 
viewed as suitable as long as the broker had obtained and analyzed 
other customer information that provided the broker with a 
reasonable basis to believe that the recommendation was suitable for 
that customer. FINRA Response, note 19.
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    FINRA stated that proposed Supplementary Material .04 also led to 
the addition of new Supplementary Material .02 to proposed Rule 2111 
that reiterates FINRA's longstanding position that firms and their 
associated persons cannot disclaim any obligations under the 
suitability rule.\55\ Among other things, Supplementary Material .02 
would clarify that firms and their associated persons cannot disclaim 
their obligation to use reasonable diligence to obtain and analyze 
relevant customer information.
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    \55\ See e.g., Notice to Members 01-23 (Apr., 2001) (``[A] 
broker-dealer cannot disclaim away its suitability obligations * * 
*.'') Supplementary Material .02 to Proposed FINRA Rule 2111 reads 
``.02 Disclaimers. A member or associated person cannot disclaim any 
responsibilities under the suitability rule.''
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    Finally, FINRA indicated that it disagrees with the premise that a 
recommendation-by-recommendation analysis precludes consideration of a 
customer's investment portfolio. FINRA contended that although its 
suitability rule requires a recommendation-by-recommendation analysis, 
the current and proposed suitability rules explicitly permit the 
suitability analysis of a particular transaction to be performed within 
the context of the investor's other security holdings or investments. 
In fact, they requires that firms make reasonable efforts to gather and 
analyze information regarding a customer's other securities holdings as 
part of its suitability review.\56\
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    \56\ This statement was confirmed in a telephone conversation 
between James Wrona, Associate Vice President and Associate General 
Counsel, FINRA, and Bonnie Gauch, Special Counsel, Division of 
Trading and Markets, Commission, on November 15, 2010.
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Proposed Rule 2111--Recommendations To Hold Securities

     Comments
    Several commenters urged FINRA to clarify in the rule that the rule 
covers explicit recommendations to hold a security or securities.\57\
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    \57\ See Brewer Letter, Catalano Letter, Estell Letter, 
Ilgenfritz Letter, Jacobson Letter, Krosschell Letter, Layne Letter, 
Mougey Letter, Neuman Letter, PIABA Letter, and Van Kampen Letter.
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     FINRA's Response
    FINRA indicated that it previously had stated that eliminating in 
the proposed rule the reference to ``purchase, sale or exchange'' used 
in the current rule and adding in the proposed rule the term 
``strategy'' meant that the proposed rule would cover explicit 
recommendations to hold a security or securities.\58\ FINRA explained 
that 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, regardless of whether 
those recommendations result in transactions or generate transaction-
based compensation.\59\
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    \58\ Exchange Act Release No. 62718 (Aug. 13, 2010), 75 FR 
51310, at 51316 (Aug. 19, 2010) and Exchange Act Release No. 62718A 
(Aug. 20, 2010), 75 FR 52562, at 52568 (Aug. 26, 2010) (``The term 
``strategy,'' moreover, would cover explicit recommendations to hold 
a security or securities.'') FINRA further stated that the rule 
would not cover implicit recommendations to hold a security or 
securities.
    \59\ Id.
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    For purposes of clarity, Amendment No. 1 would amend Supplementary 
Material .03 to state that investment strategies would include, among 
other things, an explicit recommendation to hold a security or 
securities.

Proposed Rule 2111--Institutional Customers

     Comments
    One commenter requested that FINRA exempt from the ``affirmative 
indication'' requirement of proposed Rule 2111(b) those institutional 
investors that qualify as qualified institutional buyers (``QIBs'') for 
purposes of Rule 144A under the Securities Act of 1933 (the 
``Securities Act'').\60\ That commenter argued that ``[QIBs] are among 
the most sophisticated counterparties in the institutional marketplace, 
and member firms already have well established suitability procedures 
for these customers that reflect their level of sophistication.''
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    \60\ See SIFMA Letter. Rule 144A deals with the application of 
Section 5 of the Securities Act to private resales of securities to 
institutions. It does not limit the application of the antifraud or 
other provisions of the federal securities laws.
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    The same commenter also suggested that FINRA expand the coverage of 
proposed Rule 2111(b) so that, in addition to meeting its customer-
specific suitability obligation, a member firm also meets its 
quantitative suitability obligation if the conditions in Rule 
2111(b)(1) and (2) are satisfied.\61\ That commenter stated that 
imposing a quantitative suitability obligation in the institutional 
delivery-versus-payment/receipt-versus-payment context makes little 
sense. The commenter also stated that, because business institutions 
typically have their own internal portfolio managers, handle custody 
away from the broker-dealer and execute trades with multiple firms, no 
single broker-dealer would see all of an institution's trades or its 
entire investment portfolio, and thus no single broker-dealer would be 
in a position to determine whether the institution's transactions are 
so excessive or frequent as to constitute churning.
---------------------------------------------------------------------------

    \61\ See SIFMA Letter.
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    In addition, this commenter requested that FINRA modify the 
sentence in proposed Supplementary Material .05 providing that ``[w]ith 
respect to having to indicate affirmatively that it is exercising 
independent judgment in evaluating the member's or associated person's 
recommendations, an institutional customer may indicate that it is 
exercising independent judgment on a trade-by-trade basis, on an asset-
class-by-asset-class basis, or in terms of all potential transactions 
for its account.'' \62\ The commenter believed this sentence was 
confusing and subject to varying interpretations. The commenter stated 
that it believed that ``the intent of Supplementary Material .05 is to 
clarify that proposed Rule 2111(b)(2) allows member firms to establish 
and document a clear understanding of the institutional customer's 
independence at the outset of the relationship--that is, at the time of 
account opening,'' and that if the intent were not as it believed, the 
sentence would ``fundamentally alter the operation of the institutional 
markets and could have a negative impact on execution quality.''
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    \62\ Id.
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     FINRA's Response
    FINRA stated, with respect to the comment that FINRA should exempt 
firms from the requirement to obtain an ``affirmative indication'' from 
QIBs, that it does not believe that a monetary threshold, whatever the 
amount or context, is an adequate substitute for the proposed 
requirement that the institutional customer affirmatively acknowledge 
that it is exercising independent judgment as part of the determination 
that an exemption from customer-specific suitability applies.

[[Page 71485]]

    With respect to the comment that FINRA should expand proposed Rule 
2111(b) to provide that a member firm meets both its customer specific 
obligation and its quantitative suitability obligation if it satisfies 
the conditions in Rule 2111(b)(1) and (2), FINRA stated that it is 
important that a firm not recommend an unsuitable number of 
transactions in those circumstances where it has control over an 
account. FINRA emphasized, however, that quantitative suitability 
generally would apply only with regard to that portion of an 
institutional customer's portfolio that the firm controls and only with 
regard to the firm's recommended transactions.
    Finally, with respect to the request for clarification of the 
sentence in Supplementary Material .05, FINRA stated that its intent 
was to allow an institutional investor to indicate that it is 
``exercising independent judgment on a trade-by-trade basis, on an 
asset-class-by-asset-class basis, or in terms of all potential 
transactions for its account,'' and that it believes the language of 
the Supplementary Material is clear. Further, FINRA indicated that if a 
broker-dealer believes that such action on a trade-by-trade basis would 
fundamentally change its operations, it can decide as a business matter 
to service only those institutional investors that are willing to make 
the affirmative indication in terms of all potential transactions for 
its account.

IV. Discussion and Commission Findings

    After careful review of the proposed rule change, the comments 
received, and FINRA's response to the comments, the Commission finds 
that the proposed rule change is consistent with the requirements of 
the Act, and the rules and regulations thereunder that are applicable 
to a national securities association.\63\ The Commission believes that 
the proposed rule change is consistent with the provisions of Section 
15A(b)(6) of the Act \64\ in that it is designed to prevent fraudulent 
or manipulative acts and practices, promote just and equitable 
principles of trade, and, in general, to protect investors and the 
public interest.
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    \63\ In approving this proposal, the Commission has considered 
the proposed rules' impact on efficiency, competition, and capital 
formation. See 15 U.S.C. 17c(f).
    \64\ 15 U.S.C. 78o-3(b)(6).
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    Specifically, the Commission believes the proposed rule change is 
consistent with FINRA's obligations under the Exchange Act to prevent 
fraudulent or manipulative acts and practices, and to promote just and 
equitable principles of trade, because the proposed rule would 
incorporate the NASD suitability rule and the NYSE ``know your 
customer'' rule into the FINRA consolidated rulebook. The suitability 
and ``know your customer'' obligations are critical to ensuring 
investor protection and fair dealing with customers. The proposed rule 
changes also would modify those rules to strengthen and clarify them, 
and incorporate into the rules certain settled interpretive guidance 
and case law.
    Additionally, the Commission believes that FINRA has adequately 
responded to commenters' concerns both by its letter of October 21, 
2010 and its filing of Amendment No. 1. Amendment No. 1 would 
standardize the terminology used in the proposed rule change, provide 
additional clarification with respect to certain aspects of the 
proposed rule change, and provide broker-dealers with appropriate 
flexibility without impairing the rules' investor protection goals.

V. Accelerated Approval

    The Commission finds good cause, pursuant to Section 19(b)(2) of 
the Exchange Act,\65\ for approving the proposed rule change, as 
modified by Amendment No. 1, prior to the 30th day after publication of 
Amendment No. 1 in the Federal Register. The changes proposed in 
Amendment No. 1 respond to specific concerns raised by commenters and 
do not raise any additional issues. In particular, Amendment No. 1 
would standardize the terminology used in the proposed rule change, 
provide additional clarification with respect to certain aspects of the 
proposed rule change, and provide broker-dealers with appropriate 
flexibility without impairing the rule's investor protection goals.
---------------------------------------------------------------------------

    \65\ 15 U.S.C. 78s(b)(2).
---------------------------------------------------------------------------

    Accordingly, the Commission finds that good cause exists to approve 
the proposal, as modified by Amendment No.1, on an accelerated basis.

VI. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Comments may be submitted by any of 
the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
     Send an e-mail to rule-comments@sec.gov. Please include 
File Number SR-FINRA-2010-039 on the subject line.

Paper Comments

     Send paper comments in triplicate to Elizabeth M. Murphy, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-1090.

All submissions should refer to File Number SR-FINRA-2010-039. This 
file number should be included on the subject line if e-mail is used. 
To help the Commission process and review your comments more 
efficiently, please use only one method. The Commission will post all 
comments on the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). Copies of the submission, all subsequent amendments, 
all written statements with respect to the proposed rule change that 
are filed with the Commission, and all written communications relating 
to the proposed rule change between the Commission and any person, 
other than those that may be withheld from the public in accordance 
with the provisions of 5 U.S.C. 552, will be available for Web site 
viewing and printing in the Commission's Public Reference Room, 100 F 
Street, NE., Washington, DC 20549, on official business days between 
the hours of 10 a.m. and 3 p.m. Copies of such filing also will be 
available for inspection and copying at the principal office of FINRA. 
All comments received will be posted without change; the Commission 
does not edit personal identifying information from submissions. You 
should submit only information that you wish to make available 
publicly. All submissions should refer to File Number SR-FINRA-2010-039 
and should be submitted on or before December 14, 2010.

VII. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\66\ that the proposed rule change (SR-FINRA-2008-039), as modified 
by Amendment No. 1, be, and hereby is, approved on an accelerated 
basis.
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    \66\ Id.

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\67\
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    \67\ 17 CFR 200.30-3(a)(12).
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Florence E. Harmon,
Deputy Secretary.
[FR Doc. 2010-29447 Filed 11-22-10; 8:45 am]
BILLING CODE 8011-01-P