Suitability. 2 Suitability Defined It is the “appropriateness” of a recommended transaction when considering the risks associated with the transaction,

SuitabilitySuitability

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Suitability DefinedSuitability Defined

It is the “appropriateness” of a It is the “appropriateness” of a recommended transaction when recommended transaction when considering the risks associated with the considering the risks associated with the transaction, the customer’s other securities transaction, the customer’s other securities holdings, his financial situation (income and holdings, his financial situation (income and net worth), financial needs and investment net worth), financial needs and investment objectives.objectives.

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Rule RequirementsRule Requirements

FINRA Rule 2010FINRA Rule 2010

A member in the conduct of his business, shall A member in the conduct of his business, shall observe high standards of commercial honor observe high standards of commercial honor and just and equitable principles of trade.and just and equitable principles of trade.

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Rule RequirementsRule Requirements NASDNASD Conduct Rule 2310Conduct Rule 2310

It is a prohibited business practice to It is a prohibited business practice to recommendrecommend to a customer the purchase, sale to a customer the purchase, sale or exchange of any security without reasonable or exchange of any security without reasonable grounds to believe that the recommendation is grounds to believe that the recommendation is suitable for the customer on the basis of suitable for the customer on the basis of information information furnished by the customerfurnished by the customer after after reasonable inquiryreasonable inquiry concerning the customer's concerning the customer's investment objectives, financial situation and investment objectives, financial situation and needs, and any other information known by the needs, and any other information known by the dealer;dealer;

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Rule RequirementsRule Requirements

Options – FINRA Conduct Rule 2360(19)Options – FINRA Conduct Rule 2360(19)No member or person associated with a member shall No member or person associated with a member shall recommend to a customer an opening transaction in any recommend to a customer an opening transaction in any option contract unless the person making the option contract unless the person making the recommendation has a reasonable basis for believing, at recommendation has a reasonable basis for believing, at the time of making the recommendation, that the customer the time of making the recommendation, that the customer has such knowledge and experience in financial matters has such knowledge and experience in financial matters that he that he may reasonably be expected to be capable of may reasonably be expected to be capable of evaluating the risks of the recommended transaction, and evaluating the risks of the recommended transaction, and is financially able to bear the risks of the recommended is financially able to bear the risks of the recommended position in the option contract.position in the option contract.

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Important Case PrinciplesImportant Case Principles

The suitability doctrine entails the The suitability doctrine entails the matchingmatching of two elements: of two elements: the investment objectives and specific the investment objectives and specific

needs of the customer with needs of the customer with the characteristics of the the security which the characteristics of the the security which

is being recommended while taking into is being recommended while taking into account the other investments held by the account the other investments held by the customer at this or any other firm.customer at this or any other firm.

The suitability rules generally apply only The suitability rules generally apply only when an agent makes a when an agent makes a recommendation.recommendation.

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When When isis a transaction a transaction considered recommended by considered recommended by

the broker?the broker?

Generally speaking, a transaction will be Generally speaking, a transaction will be considered to be recommended when the firm or considered to be recommended when the firm or agent brings the agent brings the specificspecific security to the attention security to the attention of the customer through any means including of the customer through any means including direct telephone communication, the delivery of direct telephone communication, the delivery of promotional material, or the transmission of promotional material, or the transmission of electronic messages.electronic messages.

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What’s What’s notnot a recommendation? a recommendation?

Exchange Act Release 27,160 states:Exchange Act Release 27,160 states:

The FINRA suitability rules would not apply to The FINRA suitability rules would not apply to situations in which a dealer functioned solely as situations in which a dealer functioned solely as an order taker and executed transactions for an order taker and executed transactions for persons who, on their own initiative, decide to persons who, on their own initiative, decide to purchase a security without a recommendation purchase a security without a recommendation from the broker.from the broker.

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Customer Account InformationCustomer Account Information

Although there is no regulatory Although there is no regulatory requirement to place the information in requirement to place the information in one place or on a form, most if not all firms one place or on a form, most if not all firms will place the information on a document, will place the information on a document, the customer (new) account card.the customer (new) account card.

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The customer account card will generally The customer account card will generally have information including but not limited have information including but not limited to: name and address of account to: name and address of account holder(s), age(s), employment or holder(s), age(s), employment or employment status, income, net worth, tax employment status, income, net worth, tax status, investment objective(s)/risk status, investment objective(s)/risk tolerance and prior investment experience.tolerance and prior investment experience.

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The account card must be dated and signed by The account card must be dated and signed by the agent opening the account and approved for the agent opening the account and approved for trading by supervisor/principal designated by the trading by supervisor/principal designated by the dealer. SEC Rule 17a-3 requires that the firm dealer. SEC Rule 17a-3 requires that the firm send a copy of the new account (card) send a copy of the new account (card) information to the customer within 30 days of information to the customer within 30 days of opening the account, when updates are made or opening the account, when updates are made or on a rolling 36 month basis. Any account which on a rolling 36 month basis. Any account which is actively traded (one per year) and has not is actively traded (one per year) and has not been updated in the last three years, must be been updated in the last three years, must be updated at the time of the transaction. updated at the time of the transaction.

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Should information on the customer Should information on the customer account card become inaccurate (e.g., account card become inaccurate (e.g., account holder becomes retired, account holder becomes retired, increase/decrease in net worth or income, increase/decrease in net worth or income, marital status) the agent must update the marital status) the agent must update the information.information.

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It is incumbent upon the examiner to not It is incumbent upon the examiner to not only review the account card for only review the account card for completeness, but also to review the completeness, but also to review the document to ensure its accuracy. For document to ensure its accuracy. For example, is it plausible for a 30-year old example, is it plausible for a 30-year old investor to have 15 years of investment investor to have 15 years of investment experience?experience?

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A Few Words About Fee A Few Words About Fee Based AccountsBased Accounts

NASD Notice to Members 03-68NASD Notice to Members 03-68 Tully Report (1995)Tully Report (1995) Fee-based programs typically charge a Fee-based programs typically charge a

customer a fixed fee or percentage of assets customer a fixed fee or percentage of assets under management in lieu of transaction-under management in lieu of transaction-based commissions. While FINRA based commissions. While FINRA recognizes the benefits these programs offer recognizes the benefits these programs offer for many customers, they are not appropriate for many customers, they are not appropriate in all circumstances.in all circumstances.

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A Few Words About Fee A Few Words About Fee Based Accounts-cont.Based Accounts-cont.

Therefore members must have reasonable Therefore members must have reasonable grounds for believing that a fee-based grounds for believing that a fee-based program is appropriate for a particular program is appropriate for a particular customer, taking into account the services customer, taking into account the services provided, cost, and customer preferences provided, cost, and customer preferences and number of transactions.and number of transactions.

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A Few Words About Fee A Few Words About Fee Based Accounts–cont.Based Accounts–cont.

The 1995 Report of the Committee on The 1995 Report of the Committee on Compensation Practices (the”Tully Compensation Practices (the”Tully Report”) labeled fee-based programs a Report”) labeled fee-based programs a “best practice” because they more closely “best practice” because they more closely align the interests of the broker dealer and align the interests of the broker dealer and customer and reduce the likelihood of customer and reduce the likelihood of abusive sales practices such as churning, abusive sales practices such as churning, high-pressure sales tactics, and high-pressure sales tactics, and recommending unsuitable transactionsrecommending unsuitable transactions..

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The Tully Report noted that fee-based The Tully Report noted that fee-based programs are particularly appropriate for programs are particularly appropriate for investors who prefer consistent and investors who prefer consistent and explicit monthly or annual charges and explicit monthly or annual charges and those that engage in at least a moderate those that engage in at least a moderate level of trading activity. The report also level of trading activity. The report also acknowledged that fee-based programs acknowledged that fee-based programs may not fit the needs of certain investors.may not fit the needs of certain investors.

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The report noted that accounts with low The report noted that accounts with low trading activity may be better off with a trading activity may be better off with a commission-based program. These commission-based program. These accounts might include those comprised accounts might include those comprised mainly of bonds or mutual funds, where mainly of bonds or mutual funds, where the customer has a stated buy-and-hold the customer has a stated buy-and-hold strategy.strategy.

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Both the firm and agent have a Both the firm and agent have a responsibility to ensure that not only upon responsibility to ensure that not only upon the opening but on an ongoing basis the the opening but on an ongoing basis the fee based feature and the amount of the fee based feature and the amount of the fee for the account is and continues to be fee for the account is and continues to be appropriate for the client.appropriate for the client.

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Examination Steps to Detect Examination Steps to Detect Unsuitable RecommendationsUnsuitable Recommendations

Select a Sampling of Customer AccountsSelect a Sampling of Customer Accounts Focus your review on the accounts of Focus your review on the accounts of

conservative, retired, and/or low net worth conservative, retired, and/or low net worth persons. These types of accounts are generally persons. These types of accounts are generally more susceptible to unsuitable tradingmore susceptible to unsuitable trading

Review the sales of high-risk investments. Review the sales of high-risk investments. High risk investments should High risk investments should generallygenerally be be placed only in accounts with objectives of placed only in accounts with objectives of aggressive growth and/or speculation.aggressive growth and/or speculation.

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Review accounts that utilize margin borrowingReview accounts that utilize margin borrowing Margin borrowing increases the customer’s Margin borrowing increases the customer’s

“buying power” but also increases the risk of loss “buying power” but also increases the risk of loss should the price of the stock decrease in valueshould the price of the stock decrease in value

A review of customer complaints will provide you A review of customer complaints will provide you with information as to those customers with information as to those customers complaining about unsuitable trades.complaining about unsuitable trades.

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Review exception reports or “happiness” Review exception reports or “happiness”

letters.letters. Exception reports are generated by the Exception reports are generated by the

dealer, or in the case of an introducing dealer, dealer, or in the case of an introducing dealer, by the clearing dealer, to aid in supervision. by the clearing dealer, to aid in supervision. An exception report will be generated if An exception report will be generated if certain trading parameters established by the certain trading parameters established by the dealer have been broken. dealer have been broken.

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For example, if an account has been For example, if an account has been approved for “Safety of Principal” and approved for “Safety of Principal” and speculative trades have been executed in speculative trades have been executed in the account, a report should be generated the account, a report should be generated for the account in question. It will then be for the account in question. It will then be the responsibility of the manager to the responsibility of the manager to determine the reason for the exception, determine the reason for the exception, and if necessary take action to resolve the and if necessary take action to resolve the concern.concern.

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A “happiness letter” is used by a dealer to A “happiness letter” is used by a dealer to contact the customer for the purpose of contact the customer for the purpose of having the customer confirm his knowledge of having the customer confirm his knowledge of and approval of certain trading patterns and approval of certain trading patterns present in their account which may not mirror present in their account which may not mirror the account’s investment objectivesthe account’s investment objectives

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Proof ChecklistProof Checklist Element of the ViolationElement of the Violation

Transaction was recommended by the agent.Transaction was recommended by the agent. ProofProof

The order ticket(s) will indicate the trade was placed and The order ticket(s) will indicate the trade was placed and whether the trade was solicited (recommended) by the whether the trade was solicited (recommended) by the agent.agent.

Confirmation(s) will indicate the terms by which the trade Confirmation(s) will indicate the terms by which the trade was executed.was executed.

Customer’s account statement(s) showing disputed Customer’s account statement(s) showing disputed transaction and absence of similar transactionstransaction and absence of similar transactions

The customer account statements will indicate The customer account statements will indicate transactions in the account on a monthly or quarterly transactions in the account on a monthly or quarterly basis.basis.

Customer complaint allegationsCustomer complaint allegations

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Proof ChecklistProof Checklist

Customer’s testimonyCustomer’s testimony• The customer’s testimony will prove critical to your The customer’s testimony will prove critical to your

case in determining the accuracy of the account case in determining the accuracy of the account card information and their conversations with the card information and their conversations with the agent relating to the trades in question.agent relating to the trades in question.

Agent’s testimonyAgent’s testimony• Like the customer’s testimony, the agent’s Like the customer’s testimony, the agent’s

testimony is critical in determining the accuracy of testimony is critical in determining the accuracy of the account information and his conversations with the account information and his conversations with the customer relating to the transactions in the customer relating to the transactions in question.question.

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Firm’s research report or sales literatureFirm’s research report or sales literature• During the course of obtaining information from the During the course of obtaining information from the

agent, it is important to obtain and agent, it is important to obtain and verifyverify the the accuracy of any internal research reports or sales accuracy of any internal research reports or sales literature assembled by the dealer or agent, and literature assembled by the dealer or agent, and utilized in connection with a sale.utilized in connection with a sale.

Reports, press releases or other material Reports, press releases or other material issued by the issuer and issued by the issuer and usedused by the agent. by the agent.• Like the research reports and sales literature, the Like the research reports and sales literature, the

examiner should obtain copies of materials and examiner should obtain copies of materials and verify accuracy. verify accuracy.

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Other customers that purchased the stock at Other customers that purchased the stock at the same timethe same time• The examiner should obtain customer account The examiner should obtain customer account

information and trading activity in these accounts. information and trading activity in these accounts. After analysis it may be necessary to interview After analysis it may be necessary to interview these additional investors to determine the extent these additional investors to determine the extent of suitability concerns for this agent or the dealer.of suitability concerns for this agent or the dealer.

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Element of the ViolationElement of the Violation Recommended transaction did not match customer’s Recommended transaction did not match customer’s

risk profile, investment objectives or financial needs.risk profile, investment objectives or financial needs.

ProofProof Prospectus, sales literature, 10-K report describing the Prospectus, sales literature, 10-K report describing the

risks of the investmentrisks of the investment• If offering documents were utilized were they accurate? If offering documents were utilized were they accurate?

Additionally, if a reporting company with the SEC, do reports Additionally, if a reporting company with the SEC, do reports filed provide information to the examiner to document filed provide information to the examiner to document suitability concerns?suitability concerns?

Does an analysis of the investment indicate the risk Does an analysis of the investment indicate the risk factors were consistent with the customer’s investment factors were consistent with the customer’s investment objective(s)?objective(s)?

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Customer’s personal financial statement Customer’s personal financial statement • It may be useful to obtain a personal financial statement or It may be useful to obtain a personal financial statement or

tax return from the investor. Is the financial information on tax return from the investor. Is the financial information on these forms similar to the information on the account card?these forms similar to the information on the account card?

Examiner’s analysis of investment concentrationExaminer’s analysis of investment concentration• Does the account contain an inordinate amount (%) of a Does the account contain an inordinate amount (%) of a

particular sector of securities, such as start-up technology particular sector of securities, such as start-up technology companies with little or no operating history, in an account companies with little or no operating history, in an account with safety of principal or conservative objectives?with safety of principal or conservative objectives?

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Was the new account information accurate Was the new account information accurate for the investor?for the investor?

Agent and customer interviews (See proof Agent and customer interviews (See proof checklist for recommended transactions)checklist for recommended transactions)

History at prior firms History at prior firms • All too often examiners fail to obtain and review All too often examiners fail to obtain and review

investments held at prior dealers. It is investments held at prior dealers. It is imperative to obtain and review trading at imperative to obtain and review trading at each each firmfirm in an effort to document the validity of in an effort to document the validity of investment experience indicated on the investment experience indicated on the account card.account card.

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Proof ChecklistProof Checklist Element of the ViolationElement of the Violation

Customer facts were Customer facts were disclosed disclosed by the customer to agent by the customer to agent prior to recommendation.prior to recommendation.

• Level of sophistication and experienceLevel of sophistication and experience• Financial situation and needsFinancial situation and needs• Customer’s ability to bear the loss of the investmentCustomer’s ability to bear the loss of the investment• Investment objectivesInvestment objectives

ProofProof Customer’s testimony detailing pertinent disclosureCustomer’s testimony detailing pertinent disclosure Agent’s testimony admitting pertinent customer disclosureAgent’s testimony admitting pertinent customer disclosure New account information showing investment objectivesNew account information showing investment objectives Prior account statements showing limited investment Prior account statements showing limited investment

historyhistory Customer letters, memos or e-mails to or from agent Customer letters, memos or e-mails to or from agent

concerning disclosure and desiresconcerning disclosure and desires

Documents

Suitability. 2 Suitability Defined It is the “appropriateness” of a recommended transaction when considering the risks associated with the transaction,