March 2011 | Legislative Intelligence Update

March 2011—Legislative Intelligence Update | The Impact of the Know-Your-Customer and
Suitability Rule Changes on Investment Management Consultants

Welcome to this edition of IMCA's Legislative Intelligence update. This month's update discusses FINRA's new know-your-customer and suitabilty rules, effective October 7, 2011, which will expand the obligations broker–dealers must follow when opening accounts and recommending transactions.

The purpose of this update, prepared by Morgan Lewis, is to give members legislative and public affairs intelligence and analysis and is strictly informational and educational. IMCA, as an education and credentialing organization, does not lobby legislators or regulators nor advocate for any particular legislative or regulatory position either on its own or through its relationship with Morgan Lewis.

If, after reading this update, you have additional questions please contact IMCA using the "Questions? E-mail IMCA" button at the bottom of this e-mail. We will either respond personally to your inquiry or include a response in an upcoming issue.
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Overview

Starting October 7, 2011, broker–dealers will be subject to expanded obligations for opening accounts and recommending transactions under the Financial Industry Regulatory Authority’s (FINRA) new know-your-customer and suitability rules.¹ IMCA members who work at broker–dealers likely will see changes to their firm’s procedures that will require them to gather more information about customers and more thoroughly document that recommended trades and strategies were appropriate. Specifically, these new responsibilities will involve the following:

Gathering more categories of information about customers;
Following the suitability rules when recommending strategies that involve holding securities;
Considering the overall rate of activity in a customer’s account when making recommendations; and
Complying with the suitability rules for a larger number of institutional customers and gathering an “affirmative acknowledgment” from exempt institutional customers that they are exercising their own independent judgment.

Although the rule changes will not take effect until October, given the scope of the changes to procedures and systems that broker–dealers will be required to make to comply with the new requirements, IMCA members may see the procedural changes taking effect in stages over the next several months as firms rush to come into compliance.

New Requirements to Gather Information about Customers

In addition to the information already required to be collected in connection with the recommendation of any transaction or new investment strategy, the new rules will require broker–dealers to collect information on a customer’s age, investment experience, time horizon, liquidity needs, and risk tolerance. This information will be required to be updated throughout the life of the account. Although FINRA did not state how frequently this information needs to be updated, it did note an existing 36-month requirement to update suitability information.

To meet this new requirement, broker–dealers likely will revise their account opening documentation to collect this additional information. Broker–dealers also may implement stricter guidelines for gathering customer information, including a more rigorous follow-up with customers who do not initially provide required account information. In addition to the stricter guidelines, IMCA members also may find that their compliance departments will be conducting more frequent suitability reviews and will be covering these additional categories of information in those reviews.

Expanding the Scope of the Suitability Rules to Cover Explicit “Hold” Recommendations

The new FINRA rules also will expand a broker–dealer’s suitability obligations to cover strategies that may not involve a specific transaction. The new FINRA rules not only require that a recommendation that a customer engage in a transaction—a purchase or sale of a security—be suitable, but also that recommendations as to investment strategy, including explicit recommendations to “hold” a security, be suitable. Given these new requirements, broker–dealers can be expected to formalize their requirements over “hold” recommendations and to require that “hold” recommendations be supported and documented in a manner comparable to explicit buy or sell recommendations.

Quantitative Suitability: Monitoring for Overall Account Activity

Broker–dealers also will have to consider whether recommended transactions and strategies are consistent with a new type of suitability. Currently, before recommending a transaction, broker–dealers are required to determine whether the security is suitable for any customer (this is called “reasonable basis” suitability) and that the security is appropriate for the particular customer based on the customer’s investment profile (this is called “customer specific suitability”). Under the new rules, unless a customer is capable of and is in fact exercising independent judgment, the broker–dealer also will be required to monitor for “quantitative suitability.” Monitoring for quantitative suitability entails determining whether a series of transactions, even if they would be suitable for the customer if considered individually, are appropriate for the particular customer taking into account factors such as the turnover rate and cost involved.

IMCA members working for broker–dealers may see additional monitoring of turnover in their customer’s accounts, especially if high turnover is inconsistent with the customer’s investment profile. In preparing for this new requirement, when recommending a strategy to customers that may involve high turnover, broker–dealers and their personnel should consider documenting the reasons why a strategy with high turnover is appropriate for the customer.

Limiting the Institutional Investor Exception

The new FINRA rules also will expand suitability obligations by limiting the exception to the suitability rules for institutional customers. Under current rules, a broker–dealer is not required to gather suitability information regarding institutional entities that are banks, savings and loans, registered investment companies, registered investment advisors, or any entity with at least $50 million in total assets (“exempt institutional entities”). In addition, broker–dealers are not required to make suitability determinations when they have reasonable grounds to believe that an institutional customer (including institutional customers that did not meet the requirements for an exempt institutional entity) is capable of and actually did exercise independent judgment in deciding whether to engage in a transaction. The new FINRA rule limits the institutional customer exception to situations where the customer is an exempt institutional entity. Further, in addition to current requirements for the institutional customer exception that the broker–dealer have a reasonable basis to believe that the institutional customer is capable of and is in fact exercising independent judgment, the new FINRA rule requires the institutional customer to affirmatively indicate that it is exercising independent judgment in evaluating the broker–dealer’s investment decisions.

In preparing for this change in the exception for institutional customers, broker–dealers will need to review which of their institutional customers may meet the requirements for the more limited exception and to develop a process for obtaining affirmative indications, as will be required in October.

Conclusion

The new suitability rules will require significant changes in the way broker–dealers deal with their customers. Some of these changes will require broker–dealers and representatives to alter their practices for dealing with customers. Therefore, it is important for IMCA members to begin preparing for the application of these new rules.

Endnote

¹ FINRA NTM 11-02. The new rules, FINRA Rules 2090 and 2111, were approved by the Securities and Exchange Commission (SEC) in November 2010. SEC Exchange Act Rel. No. 63325 (Nov. 17, 2010).