Document ID: SEC-2010-1279-0001
Agency: sec
Document Type: Notice
Title: Self-Regulatory Organizations; Proposed Rule Changes: Financial Industry Regulatory Authority, Inc.
Posted Date: 2010-08-19T04:00Z

[Federal Register: August 19, 2010 (Volume 75, Number 160)]
[Notices]               
[Page 51310-51322]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr19au10-91]                         

[[Page 51310]]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-62718; 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

August 13, 2010.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on July 30, 2010, 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 and 
II below, which Items substantially have been prepared by FINRA. The 
Commission is publishing this notice to solicit comments on the 
proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    FINRA is proposing to adopt FINRA Rule 2090 (Know Your Customer) 
and FINRA Rule 2111 (Suitability) as part of the Consolidated FINRA 
Rulebook. The proposed rules are based in large part on Incorporated 
NYSE Rule 405(1) (Diligence as to Accounts) and, NASD Rule 2310 
(Recommendations to Customers (Suitability)) and its related 
Interpretative Materials (``IMs'') 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 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. In addition, the text of the 
proposed rule change is included as Exhibit 5 on the Commission's Web 
site at: http://www.sec.gov/rules/sro/finra.shtml, under the heading 
SR-FINRA-2010-039.

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
    As part of the process of developing a new consolidated rulebook 
(``Consolidated FINRA Rulebook''),\3\ FINRA is proposing to adopt FINRA 
Rule 2090 (Know Your Customer) and FINRA Rule 2111 (Suitability). The 
rules are based in large part on NYSE Rule 405(1) (Diligence as to 
Accounts) and NASD Rule 2310 (Recommendations to Customers 
(Suitability)) and its related IMs, respectively.\4\ 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.\5\
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    \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).
    \4\ For convenience, the Incorporated NYSE Rules are referred to 
as the NYSE Rules.
    \5\ 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) (Order Approving File No. SR-
FINRA-2010-005); see also Regulatory Notice 10-21 (April 2010).
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    The ``know your customer'' and suitability obligations are critical 
to ensuring investor protection and fair dealing with customers. Under 
the proposal, the core features of these obligations set forth in NYSE 
Rule 405(1) and NASD Rule 2310 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 II.C. of this filing provides a detailed discussion of the 
proposed modifications, comments FINRA received, and FINRA's responses 
thereto. In brief, however, 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.\6\ 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.'' \7\
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    \6\ See Proposed FINRA Rule 2090.
    \7\ See Proposed FINRA Rule 2090.01. As discussed infra at Item 
II.C. of this filing, FINRA changed the explanation of ``essential 
facts'' in response to comments.
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    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.\8\ In addition, the 
reasonable-basis obligation under the suitability rule requires broker-
dealers and associated persons to perform adequate due diligence so 
that they ``know'' the securities and strategies they recommend.
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    \8\ 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)].
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    FINRA also is proposing to delete NYSE Rule 405(2) through (3), 
NYSE

[[Page 51311]]

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.\9\
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    \9\ FINRA is proposing to adopt NASD Rule 3010 as FINRA Rule 
3110, subject to certain amendments. See 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 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.\10\
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    \10\ 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.
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    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 requires the firm to verify the 
identity of a customer opening a new account.\11\ 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.\12\ 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.\13\
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    \11\ See 31 CFR 103.122.
    \12\ See 31 CFR 103.19.
    \13\ 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).
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    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 entity.\14\ 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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    \14\ 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).
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    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, 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).\15\
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    \15\ 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).
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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. 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.
    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 * * *.'' \16\ 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

[[Page 51312]]

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.'' \17\
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    \16\ See Proposed FINRA Rule 2111(a).
    \17\ See Proposed FINRA Rule 2111(a). As discussed infra at Item 
II.C. 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; \18\ and
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    \18\ 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.\19\
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    \19\ See Proposed FINRA Rule 2111.02. As discussed infra at Item 
II.C. of this filing, FINRA included this exception to the rule's 
coverage 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 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).\20\
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    \20\ 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,\21\ and is exercising 
independent judgment in evaluating recommendations.\22\ The proposal, 
moreover, would require institutional customers to affirmatively 
indicate that they are exercising independent judgment.\23\ 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).\24\
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    \21\ 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.''
    \22\ See Proposed FINRA Rule 2111(b).
    \23\ See Proposed FINRA Rule 2111(b). As discussed infra at Item 
II.C. 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.
    \24\ 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).
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    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).\25\ 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,\26\ fraudulent conduct identified in 
IM-2310-2 is covered by the FINRA and SEC anti-fraud provisions \27\).
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    \25\ See Proposed Rule 2111(a).
    \26\ See SEA Rule 15g-1 through 15g-9.
    \27\ See Section 10(b) of the Act; FINRA Rule 2020.
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    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 2111.\28\ 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.\29\ 
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.\30\ 
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.\31\
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    \28\ See Proposed Rule 2111(a).
    \29\ See Proposed Rule 2111.03.
    \30\ See Proposed Rule 2111.04.
    \31\ 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).\32\

[[Page 51313]]

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 is serious misconduct and 
clearly violates FINRA's rules.
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    \32\ 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 90 days 
following Commission approval. The implementation date will be no later 
than 240 days following Commission approval.
2. Statutory Basis
    The proposed rule change is consistent with the provisions of 
Section 15A(b)(6) of the Act,\33\ 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.
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    \33\ 15 U.S.C. 78o-3(b)(6).
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B. 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.

C. 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 can be 
viewed at http://www.finra.org/web/groups/industry/@ip/@reg/@notice/
documents/notices/p118709.pdf. FINRA received 2,083 comment letters, 
389 of which were individualized letters and 1,694 of which were form 
letters. An index to the comment letters received in response to the 
Notice can be viewed at http://www.finra.org/Industry/Regulation/
Notices/2009/P118711, and copies of the comment letters received in 
response to the Notice can also be accessed through that Web site. In 
addition, these documents, submitted with FINRA's filing as Exhibits 
2a, 2b, and 2c, respectively, can be viewed at the Commission's Web 
site at: http://www.sec.gov/rules/sro/finra.shtml, under the heading 
SR-FINRA-2010-039.
    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.
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 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,\34\ most comments addressed specific language, as discussed 
below.
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    \34\ See, e.g., Cornell Letter, supra note 44.
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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.\35\ 
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.\36\ 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 
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.\37\
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    \35\ See Charles Schwab Letter, supra note 47; Matthew Farley, 
Drinker, Biddle & Reath LLP, June 29, 2009 (``Drinker Biddle 
Letter''); FOLIOfn Letter, supra note 63; NAIBD Letter, supra note 
63; NSCP Letter, supra note 35; SIFMA Letter, supra note 48; TD 
Ameritrade Letter, supra note 63; T. Rowe Price Letter, supra note 
44; Wells Fargo Letter, supra note 63.
    \36\ See T. Rowe Price Letter, supra note 44.
    \37\ See Charles Schwab Letter, supra note 47; Drinker Biddle 
Letter, supra note 132; FOLIOfn Letter, supra note 63; SIFMA Letter, 
supra note 48; TD Ameritrade Letter, supra note 63; Wells Fargo 
Letter, supra note 63. 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 132.
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    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.\38\ 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.\39\ 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.\40\
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    \38\ See SIFMA Letter, supra note 48; Wells Fargo Letter, supra 
note 63.
    \39\ See SIFMA Letter, supra note 48; TD Ameritrade Letter, 
supra note 63; Wells Fargo Letter, supra note 63.
    \40\ See FOLIOfn Letter, supra note 63.
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    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.\41\ This commenter indicated that 
each of those factors is essential to knowing the customer.\42\ Others 
suggested that the term should be clarified.\43\
---------------------------------------------------------------------------

    \41\ See Cornell Letter, supra note 44.
    \42\ See Cornell Letter, supra note 44.
    \43\ See Committee of Annuity Insurers Letter, supra note 35.
---------------------------------------------------------------------------

     FINRA's Response

[[Page 51314]]

    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.
     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.\44\ 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.\45\
---------------------------------------------------------------------------

    \44\ See Committee of Annuity Insurers Letter, supra note 35; 
Hancock, MetLife and Prudential Letter, supra note 51.
    \45\ See Committee of Annuity Insurers Letter, supra note 35; 
Hancock, MetLife and Prudential Letter, supra note 51.
---------------------------------------------------------------------------

     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.\46\ 
The reasonableness of a broker-dealer's efforts in this regard will 
depend on the facts and circumstances of the particular case.
---------------------------------------------------------------------------

    \46\ 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.
---------------------------------------------------------------------------

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.\47\ 
These commenters stated that it was a mistake to focus on knowing the 
customer rather than knowing both the customer and the product.\48\ 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.\49\
---------------------------------------------------------------------------

    \47\ See Cornell Letter, supra note 44; NASAA, supra note 34.
    \48\ See Cornell Letter, supra note 44; NASAA, supra note 34.
    \49\ See NASAA, supra note 34.
---------------------------------------------------------------------------

     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.\50\ 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.
---------------------------------------------------------------------------

    \50\ See supra note 25.
---------------------------------------------------------------------------

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.\51\ 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.\52\ One commenter further posited 
that it would be easier for firms to implement a single, integrated 
change to customer care standards adopted at one time.\53\
---------------------------------------------------------------------------

    \51\ Rex A. Staples, General Counsel for the North American 
Securities Administrators Association, July 13, 2009 (``NASAA 
Letter'').
    \52\ 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'').
    \53\ See NSCP Letter, supra note 35.
---------------------------------------------------------------------------

     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.'' \54\ 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.'' \55\
---------------------------------------------------------------------------

    \54\ 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).
    \55\ Investment Advisers Act Release No. 1406, 1994 SEC LEXIS 
797, at *4 (Mar. 16, 1994) (Suitability of Investment Advice 
Provided by Investment Advisers).
---------------------------------------------------------------------------

    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.'' \56\ Thus, the suitability obligations 
set forth in proposed Rule 2111 would not be inconsistent with the

[[Page 51315]]

addition of a fiduciary duty at some future date.\57\
---------------------------------------------------------------------------

    \56\ 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 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).
    \57\ 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.
---------------------------------------------------------------------------

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.
Scope of the Suitability Rule/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 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.'' \58\ 
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.'' \59\
---------------------------------------------------------------------------

    \58\ 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 [to facilitate the purchase of securities] is a suitable 
strategy for an investor''); Notice to Members 04-89, 2004 NASD 
LEXIS 76, at *7 (Dec. 2004) (same). (Change to footnote made per e-
mail from James Wrona, Associate Vice President and Associate 
General Counsel, FINRA, to Bonnie Gauch, Special Counsel, Division 
of Trading and Markets, Commission, dated August 12, 2010.)
    \59\ 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).
---------------------------------------------------------------------------

    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 involved recommendations to purchase 
securities on margin (which can be viewed as a strategy).\60\
---------------------------------------------------------------------------

    \60\ 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).
---------------------------------------------------------------------------

    The proposed suitability rule explicitly covers recommended 
strategies. The commenters' views on the inclusion of the term were 
varied.
     Comments
    A number of commenters supported the addition of the term to the 
rule text.\61\ 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.\62\ 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 recommendation to make any changes to the portfolio 
effectively constitutes an implicit recommendation to retain what is in 
the account.\63\
---------------------------------------------------------------------------

    \61\ 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'').
    \62\ See Cornell Letter, supra note 44; Mougey and Kraszewski 
Letter, supra note 44; St. John's Letter, supra note 44.
    \63\ See Mougey and Kraszewski Letter, supra note 43; St. John's 
Letter, supra note 44.
---------------------------------------------------------------------------

    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'' \64\ or where there is a ``reasonable nexus 
between the recommended investment strategy and a securities 
transaction in furtherance of the recommended strategy.'' \65\ Other 
commenters stated that FINRA should define or clarify the term 
``strategy.'' \66\ 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.\67\
---------------------------------------------------------------------------

    \64\ See Bari Havlik, SVP and Chief Compliance Officer for 
Charles Schwab & Co., June 29, 2009 (``Charles Schwab Letter'').
    \65\ See Amal Aly, Managing Director and Associate General 
Counsel, Securities Industry and Financial Markets Association, June 
29, 2000 (``SIFMA Letter''); NSCP Letter, supra note 35.
    \66\ See NSCP Letter, supra note 35. 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 35; 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'').
    \67\ See NSCP Letter, supra note 35.
---------------------------------------------------------------------------

    A number of commenters opposed the inclusion of the term 
``strategy.'' \68\ 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'').\69\
---------------------------------------------------------------------------

    \68\ 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 49.
    \69\ See Hancock, MetLife and Prudential Letter, supra note 51 
(citing 29 CFR 2509.96-1(d)).
---------------------------------------------------------------------------

     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

[[Page 51316]]

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.\70\ 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, regardless of whether those recommendations result in 
transactions or generate transaction-based compensation.
---------------------------------------------------------------------------

    \70\ 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'').
---------------------------------------------------------------------------

    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.\71\ The rule 
proposal is not intended to broaden the scope of implicit 
recommendations.
---------------------------------------------------------------------------

    \71\ 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).
---------------------------------------------------------------------------

    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.\72\
---------------------------------------------------------------------------

    \72\ See Hancock, MetLife and Prudential Letter, supra note 51 
(citing 29 CFR 2509.96-1(d)).
---------------------------------------------------------------------------

Scope of the Suitability Rule/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.
     Comments
    Some commenters favored broadening the suitability rule so that it 
covers non-securities products.\73\ 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.\74\ 
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.\75\ Yet another commenter believed that 
broker-dealers implicitly already have similar obligations but favored 
explicitly applying the suitability rule to non-securities 
products.\76\ 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 strategy to their 
customers.\77\ 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.\78\ The commenter supported a revision 
of proposed Rule 2111 to incorporate an explicit suitability obligation 
that is not limited to securities.\79\
---------------------------------------------------------------------------

    \73\ See Mougey and Kraszewski Letter, supra note 44; Taurus 
Letter, supra note 44.
    \74\ See Mougey and Kraszewski Letter, supra note 44.
    \75\ See Taurus Letter, supra note 44.
    \76\ See Corporate Law Center & Investor Rights Clinic, supra 
note 44.
    \77\ See Corporate Law Center & Investor Rights Clinic, supra 
note 44.
    \78\ See Corporate Law Center & Investor Rights Clinic, supra 
note 44.
    \79\ See Corporate Law Center & Investor Rights Clinic, supra 
note 44.
---------------------------------------------------------------------------

    The vast majority of commenters, however, were against applying the 
suitability rule to non-securities products.\80\ Some argued that FINRA 
did not have jurisdiction over non-securities products.\81\ Some argued 
against the expansion because they claimed there is no evidence of 
abuse resulting from recommendations involving non-securities 
products.\82\ 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.).\83\ Others claimed that FINRA was 
ill-suited to regulate non-securities products because it has no 
expertise

[[Page 51317]]

outside securities issues.\84\ 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.'' \85\
---------------------------------------------------------------------------

    \80\ 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 47; Committee 
of Annuity Insurers Letter, supra note 35; John M. Damgard, 
President of the Futures Industry Association, June 29, 2009 (``FIA 
Letter''); Form Letter Type A, supra note 35; Form Letter Type B, 
supra note 35; Hancock, MetLife and Prudential Letter, supra note 
51; 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 51; 
John S. Markle, Deputy General Counsel for TD Ameritrade, June 29, 
2009 (``TD Ameritrade Letter''); NSCP Letter, supra note 35; 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 48; T.RowePrice Letter, 
supra note 44; 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'').
    \81\ See, e.g., Committee of Annuity Insurers Letter, supra note 
35; FOLIOfn Letter, supra note 63; Form Letter Type A, supra note 
35; Form Letter Type B, supra note 35; Hancock, MetLife and 
Prudential Letter, supra note 51; LPL Letter, supra note 49; NSCP 
Letter, supra note 35; T.RowePrice Letter, supra note 44.
    \82\ See, e.g., AALU Letter, supra note 63; AELIC Letter, supra 
note 63; Cyr & Cyr Insurance Services Letter, supra note 60; 
Principal Life Insurance Co. Letter, supra note 60.
    \83\ See, e.g., AELIC Letter, supra note 63; Committee of 
Annuity Insurers Letter, supra note 35; FIA Letter, supra note 63; 
Form Letter Type A, supra note 35; Form Letter Type B, supra note 
35; Hancock, MetLife and Prudential Letter, supra note 51; Michael 
T. McRaith, Illinois Department of Insurance Letter, June 29, 2009; 
NAIBD Letter, supra note 63; NFA Letter, supra note 63; NSCP Letter, 
supra note 35; SIFMA Letter, supra note 48.
    \84\ See, e.g., AALU Letter, supra note 63; Committee of Annuity 
Insurers Letter, supra note 35; Wells Fargo Letter, supra note 63.
    \85\ See, e.g., AELIC Letter, supra note 63.
---------------------------------------------------------------------------

     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 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.
Scope of the Suitability Rule/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.
     Comments
    Some commenters asked FINRA to define the term ``recommendation.'' 
\86\ 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.\87\ 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.' '' \88\ The 
commenter believes that ``the discussion in NTM 01-23 provides a good 
foundation upon which FINRA can base the definition.'' \89\ Another 
commenter asked that FINRA reaffirm the principles discussed in NTM 01-
23 regarding the term ``recommendation.'' \90\ Other commenters argued 
that the term should be defined to include recommendations to hold 
securities.\91\
---------------------------------------------------------------------------

    \86\ See Barry D. Estell, Attorney at Law, June 24, 2009 
(``Estell Letter''); FOLIOfn Letter, supra note 63; Mougey and 
Kraszewski Letter, supra note 44.
    \87\ See FOLIOfn Letter, supra note 63.
    \88\ See FOLIOfn Letter, supra note 63.
    \89\ See FOLIOfn Letter, supra note 63.
    \90\ TD Ameritrade Letter, supra note 63.
    \91\ See Estell Letter, supra note 69; Mougey and Kraszewski 
Letter, supra note 44.
---------------------------------------------------------------------------

     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.\92\ 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.
---------------------------------------------------------------------------

    \92\ 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).
---------------------------------------------------------------------------

    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. 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.\93\
---------------------------------------------------------------------------

    \93\ 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.'').
---------------------------------------------------------------------------

    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.\94\ FINRA 
believes that this guidance and these precedents allow broker-dealers 
to fundamentally understand what communications likely do or do not 
constitute recommendations.
---------------------------------------------------------------------------

    \94\ 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.
---------------------------------------------------------------------------

    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.\95\
---------------------------------------------------------------------------

    \95\ See Nickles, 1992 NASD Discip. LEXIS 28, at *18.
---------------------------------------------------------------------------

    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

[[Page 51318]]

attempt to gather and analyze when making recommendations.
Information Gathering/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.''
     Comments
    Some commenters supported requiring firms and brokers to analyze 
information known by the firm regardless of how the firm learned of the 
information.\96\ However, other commenters were opposed to this 
requirement.\97\ Some were opposed because of the difficulty they 
believed it would cause for firms with multiple business lines.\98\ 
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.\99\
---------------------------------------------------------------------------

    \96\ See Corporate Law Center & Investor Rights Clinic, supra 
note 44; St. John's Letter, supra note 44; Taurus Letter, supra note 
44.
    \97\ See Charles Schwab Letter, supra note 47; Committee of 
Annuity Insurers Letter, supra note 35; FOLIOfn Letter, supra note 
63; LPL Letter, supra note 49; NSCP Letter, supra note 35; SIFMA 
Letter, supra note 47; TD Ameritrade Letter, supra note 63.
    \98\ See Charles Schwab Letter, supra note 47; FOLIOfn Letter, 
supra note 63; NSCP Letter, supra note 35; SIFMA Letter, supra note 
48; TD Ameritrade Letter, supra note 63.
    \99\ See Charles Schwab Letter, supra note 47; SIFMA Letter, 
supra note 48.
---------------------------------------------------------------------------

    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).\100\ According to 
the commenters, examples may include a diagnosed illness, pending 
divorce or separation, pending legal action, or other personal 
problems.\101\ 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.\102\
---------------------------------------------------------------------------

    \100\ See Committee of Annuity Insurers Letter, supra note 35; 
National Planning Holdings, supra note 49.
    \101\ See Committee of Annuity Insurers Letter, supra note 35; 
National Planning Holdings, supra note 49.
    \102\ See LPL Letter, supra note 49; SIFMA Letter, supra note 
48.
---------------------------------------------------------------------------

     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, 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.
Information Gathering/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.
     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.\103\ These commenters believed that the investing 
public will benefit because broker-dealers will consider a larger 
number of consistent criteria.\104\
---------------------------------------------------------------------------

    \103\ See Corporate Law Center & Investor Rights Clinic, supra 
note 44; Mougey and Kraszewski Letter, supra note 44; St. John's 
Letter, supra note 44; T.RowePrice Letter, supra note 44.
    \104\ See St. John's Letter, supra note 44; Mougey and 
Kraszewski Letter, supra note 44.
---------------------------------------------------------------------------

    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.\105\ 
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.\106\ 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.\107\ If 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

[[Page 51319]]

difficulty associated with developing, modifying, and implementing 
forms and systems to request and capture the proposed new categories of 
information.\108\
---------------------------------------------------------------------------

    \105\ See Charles Schwab Letter, supra note 47; SIFMA Letter, 
supra note 48; TD Ameritrade Letter, supra note 63; Wells Fargo 
Letter, supra note 63.
    \106\ See Charles Schwab Letter, supra note 47; SIFMA Letter, 
supra note 48; TD Ameritrade Letter, supra note 63; Wells Fargo 
Letter, supra note 63.
    \107\ See Charles Schwab Letter, supra note 47; SIFMA Letter, 
supra note 48; TD Ameritrade Letter, supra note 63; Wells Fargo 
Letter, supra note 63.
    \108\ See Charles Schwab Letter, supra note 47; LPL Letter, 
supra note 49; SIFMA Letter, supra note 48; Wells Fargo Letter, 
supra note 63.
---------------------------------------------------------------------------

    Other commenters more strongly objected to the proposed expansion 
of the list of items that broker-dealers must attempt to gather and 
analyze.\109\ 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.\110\ 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.\111\ 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.\112\ Another commenter went further 
and stated that the current list of items in Rule 2310 should be 
abolished.\113\ 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 consumers.'' \114\ If that cannot be achieved, the commenter 
recommends limiting the information to that discussed in SEA Rule 17a-
3.\115\ 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.\116\
---------------------------------------------------------------------------

    \109\ See FOLIOfn Letter, supra note 63.
    \110\ See LPL Letter, supra note 49.
    \111\ See LPL Letter, supra note 49.
    \112\ See LPL Letter, supra note 49.
    \113\ See FOLIOfn Letter, supra note 63.
    \114\ See FOLIOfn Letter, supra note 63.
    \115\ See FOLIOfn Letter, supra note 63.
    \116\ See FOLIOfn Letter, supra note 63.
---------------------------------------------------------------------------

    Another commenter stated that FINRA should maintain a standard 
approach to the terminology used in relation to this aspect of the 
rule.\117\ 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).'' \118\ The commenter believed 
that ``other investments'' is overly broad and that FINRA should use 
the term currently used in Rule 2330.\119\
---------------------------------------------------------------------------

    \117\ See National Planning Holdings, supra note 49.
    \118\ See National Planning Holdings, supra note 49.
    \119\ See National Planning Holdings, supra note 49.
---------------------------------------------------------------------------

    Finally, one commenter argued that money market mutual funds be 
exempted from all or some of the requirements to gather information 
when making recommendations.\120\ According to the commenter, a current 
exemption from some information gathering for transactions in money 
market mutual funds should continue or be expanded in the proposed 
rule.\121\
---------------------------------------------------------------------------

    \120\ See Tamara K. Salmon, Senior Associate Counsel for the 
Investment Company Institute, June 29, 2009 (``ICI Letter'').
    \121\ See ICI Letter, supra note 103.
---------------------------------------------------------------------------

     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 amendments that created a second information-
gathering requirement (currently paragraph (b) of NASD Rule 2310).\122\ 
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.\123\
---------------------------------------------------------------------------

    \122\ 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).
    \123\ 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.
---------------------------------------------------------------------------

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.
Institutional Customer/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

[[Page 51320]]

of the customer-specific obligation of the suitability rule.
     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.\124\ 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).\125\ 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.\126\
---------------------------------------------------------------------------

    \124\ See Hancock, MetLife and Prudential Letter, supra note 51; 
NAIBD Letter, supra note 63; NSCP Letter, supra note 35; SIFMA 
Letter, supra note 48; Wells Fargo Letter, supra note 63.
    \125\ See NAIBD Letter, supra note 63; SIFMA Letter, supra note 
48; Wells Fargo Letter, supra note 63.
    \126\ See Hancock, MetLife and Prudential Letter, supra note 51; 
NAIBD Letter, supra note 63; NSCP Letter, supra note 35; SIFMA 
Letter, supra note 48; Wells Fargo Letter, supra note 63.
---------------------------------------------------------------------------

     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.
Institutional Customer/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.
     Comments
    Some commenters supported the change in definition.\127\ One 
commenter stated further that consistent standards produce more 
efficient, effective, and clear regulation that is beneficial to 
investors, regulators, and market participants alike.\128\ 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 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.\129\ 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.\130\
---------------------------------------------------------------------------

    \127\ See SIFMA Letter, supra note 48; Wells Fargo Letter, supra 
note 63.
    \128\ See SIFMA Letter, supra note 48.
    \129\ See Hancock, MetLife and Prudential Letter, supra note 51; 
NAIBD Letter, supra note 63; NSCP Letter, supra note 35.
    \130\ See NAIBD Letter, supra note 63.
---------------------------------------------------------------------------

    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).\131\ 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.\132\
---------------------------------------------------------------------------

    \131\ See Hancock, MetLife and Prudential Letter, supra note 51.
    \132\ See Hancock, MetLife and Prudential Letter, supra note 51. 
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 48. FINRA believes that the exemption should 
remain focused on customer-specific suitability. For instance, it 
remains important that brokers understand the securities they 
recommend and that those securities are appropriate for at least 
some investors.
---------------------------------------------------------------------------

    Finally, one commenter argued that there should not be any 
exemption for institutional customers.\133\ 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.\134\
---------------------------------------------------------------------------

    \133\ See Mougey and Kraszewski Letter, supra note 44.
    \134\ See Mougey and Kraszewski Letter, supra note 44.
---------------------------------------------------------------------------

     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 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.
Institutional Customer/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.
     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.\135\
---------------------------------------------------------------------------

    \135\ See NASAA Letter, supra note 34.
---------------------------------------------------------------------------

     FINRA's Response
    The proposed institutional investor discussion, while shorter than 
the

[[Page 51321]]

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.
     Comments
    A number of commenters supported codifying various interpretations 
of the suitability rule.\136\ 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.\137\ 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.\138\ The 
commenter believed that a member's familiarity with a product should be 
presumed.\139\
---------------------------------------------------------------------------

    \136\ See Corporate Law Center & Investor Rights Clinic, supra 
note 44; Taurus Letter, supra note 44; T.RowePrice Letter, supra 
note 44.
    \137\ See NASAA Letter, supra note 34.
    \138\ See NASAA Letter, supra note 34.
    \139\ See NASAA Letter, supra note 34.
---------------------------------------------------------------------------

    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 ``control'' over an account 
before the obligation applies.\140\ Yet another commenter stated that 
FINRA should eliminate supplementary material from all rules and limit 
rulemaking to rule text.\141\
---------------------------------------------------------------------------

    \140\ See Cornell Letter, supra note 44; Estell Letter, supra 
note 69.
    \141\ See FOLIOfn Letter, supra note 63.
---------------------------------------------------------------------------

     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 \142\ and 
case law.\143\ The commenter argued that presuming that firms and 
associated persons are 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.\144\ This is especially true in light of the 
increasing complexity of certain products and strategies.
---------------------------------------------------------------------------

    \142\ 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).
    \143\ 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. 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).
    \144\ 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).
---------------------------------------------------------------------------

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.
     Comments
    A few commenters were concerned that the proposal did not include 
some of the current IMs, especially IM-2310-2.\145\ 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.\146\ One commenter noted in particular that this IM 
was the only place in the entire NASD conduct rules explicitly 
prohibiting unauthorized trading.\147\
---------------------------------------------------------------------------

    \145\ See Cornell Letter, supra note 44; Corporate Law Center & 
Investor Rights Clinic, supra note 44; NASAA Letter, supra note 34.
    \146\ See Cornell Letter, supra note 44; Corporate Law Center & 
Investor Rights Clinic, supra note 44; NASAA Letter, supra note 34.
    \147\ See Corporate Law Center & Investor Rights Clinic, supra 
note 44.
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     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 II.A. 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 II.A., 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.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 45 days of the date of publication of this notice in the 
Federal Register or within such longer period (i)

[[Page 51322]]

as the Commission may designate up to 90 days of such date if it finds 
such longer period to be appropriate and publishes its reasons for so 
finding or (ii) as to which the self-regulatory organization consents, 
the Commission will:
    (A) by order approve or disapprove such proposed rule change, or
    (B) institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. 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 September 9, 2010.

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\148\
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    \148\ 17 CFR 200.30-3(a)(12).
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Florence E. Harmon,
Deputy Secretary.
[FR Doc. 2010-20537 Filed 8-18-10; 8:45 am]
BILLING CODE 8010-01-P