It’s finally here. After over a year of discussion and a postponement, Financial Industry Regulatory Authority (FINRA) Rule 2111 on suitability requirements governing the sale of securities is set for implementation July 9. Also scheduled to go into effect on the same date is its companion regulation, FINRA Rule 2090, or Know Your Customer.
The new rules essentially combine, with two significant changes, previous regulations from the National Association of Securities Dealers (NASD) and the New York Stock Exchange (NYSE) covering suitability standards when securities such as equities, fixed income products, mutual funds, derivatives and variable annuities are being sold by broker-dealers.
In a regulatory notice issued in May 2011, FINRA wrote that a suitability investigation “requires that a firm or associated person have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile.”
Two main changes
Added to the list of factors that must be obtained and considered by a broker-dealer or advisor before recommending a security purchase to a client are: age, investment experience, time horizon, liquidity needs and risk tolerance.
The new rule further expands the suitability review to include discussions of investment strategies, not just recommendations for the purchase of a particular security.
However, FINRA does not specify what those investment strategies could be except to say that the “term strategy should be interpreted broadly.” The only strategy FINRA specifically mentions in the May 2011 notice is that an “explicit” hold recommendation would be considered an investment strategy.
Therein lies some of the trepidation broker-dealers and other FINRA-supervised advisors have with the new rule.
Gary Sanders, vice president, securities and state government affairs for the National Association of Insurance and Financial Advisors (NAIFA) in Falls Church, Va., said in an interview that including discussions about investment strategies under the suitability umbrella could have a “chilling effect” on interactions between advisors and their clients.
“[Advisors] would think that every time they talked and contacted their clients they would have to go through a full suitability analysis when they talk about investment strategies as opposed to just having a conversation about the topic,” Sanders said. “It could have the opposite effect of what people want in the sense it could result in preventing a client from getting a real diverse portfolio.”
Sanders further pointed out that a singular security purchase may be deemed unsuitable when looked at in the context of just that one-off sale. However, when reviewed from the perspective of a person’s entire portfolio, the sale may be suitable in terms of diversification, he said.
The latest rule, said Sanders “doesn’t go into that much detail. And the concern of some advisors and broker-dealers is that it’s almost going to stop the interaction between advisors and their clients rather than expanding it.”
Yet NAIFA was pleased that the new rule excludes non-securities, Sanders noted. When the revamped regulation was first being discussed, FINRA had sought to include non-securities, but later left such products out of the rule.
Sanders said NAIFA members have not expressed great concern over the updated regulation at this time.
“The bigger concern may be on the part of the broker-dealers who actually have to collect, monitor and analyze all this additional data that is going to be collected from millions of customers,” he said. “That is one of the things that led to the delay on the effective date.” Originally, the Rule 2111 was scheduled to go into effect in 2011.
“Confounding” to the industry
David Thetford, securities compliance principal analyst with Wolters Kluwer Financial Services in Riverswood, Ill., agreed the investment strategy recommendation is so broad as to be “confounding” to the industry.
“The confounding part is, one, what actually is and is not a strategy,” he said in an interview, “because the only definition in the rule is that it will be broadly interpreted. So for an individual broker, what do I have to document as a strategy and how do I document it? If I document something, it has to be done to the satisfaction of the regulators. So what is to the satisfaction of the regulators? It’s a tough thing.”
FINRA has issued several subsequent notices that provide more detailed guidance on investment strategies, noted Thetford, mostly dealing with documentation.
“Documentation is the basis of everything,” he said. “If it’s not written down somewhere it never happened.”
Despite the changes, Thetford said he did not believe the new regulation will have a significant impact on the selling of annuities since the broader suitability requirements from NASD and NYSE remain intact.
As far as collecting more client information, Thetford said he didn’t see that as much of an issue as well. “That makes it a little more difficult but in my opinion, not a lot more difficult,” he said. “It’s a couple more minutes during a discussion with your customers.”
Wait till the dust settles
As with any new rule, there may be some angst in the beginning as the industry becomes accustomed to the new guidelines.
“With any type of regulation like this, you have to wait for the dust to settle and see how it works out in reality rather than just in theory,” Sanders said.
Thetford concurred. “A lot of questions will work themselves out over time but until that time, it’s like a knot in their stomachs.”
Tomorrow, a broker-dealer discusses how the firm prepared for the new rule.