[Federal Register: August 26, 2010 (Volume 75, Number 165)]
[Notices]
[Page 52562-52574]
[DOCID:fr26au10-100]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-62718A; 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; Correction

August 20, 2010.

Need for Correction

    On August 13, 2010, the Commission published (and sent to the
Federal Register for publication) Release No. 34-62718--a Notice that
the Financial Industry Regulatory Authority, Inc. (``FINRA'') had
proposed rule changes to adopt FINRA Rules 2090 and 2111 (the ``August
13 Notice''). On August 18, 2010, Commission staff discovered that
several footnote cross-references in the August 13 Notice were
inaccurate. The staff believes this was the result of its
reorganization of the discussion of the rules to parallel the numerical
order of those rules.
    This correction does not substantively amend the August 13 Notice.
The sole purpose of this correction is to rectify the footnote errors
and alleviate any resulting confusion. As the number of footnotes
affected is significant, the entire August 13 Notice is being
republished with corrected footnotes.

Correction of Publication

    Accordingly, the August 13 Notice is republished in whole to
correct certain footnotes and footnote cross-references as follows:

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 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 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\ 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., William A. Jacobson and Sang Joon Kim, Cornell
Securities Law Clinic, June 27, 2009 (``Cornell Letter'').
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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 Bari Havlik, SVP and Chief Compliance Officer for
Charles Schwab & Co., June 29, 2009 (``Charles Schwab Letter'');
Matthew Farley, Drinker, Biddle & Reath LLP, June 29, 2009
(``Drinker Biddle Letter''); Mike Hogan, President and CEO of
FOLIOfn Investments, Inc., June 29, 2009 (``FOLIOfn Letter''); Lisa
Roth, National Ass'n of Independent Broker-Dealers, Inc., June 29,
2009 (``NAIBD Letter''); Joan Hinchman, Executive Director,
President, and CEO of the National Society of Compliance
Professionals Inc., June 29, 2009 (``NSCP Letter''); Amal Aly,
Managing Director and Associate General Counsel, Securities Industry
and Financial Markets Association, June 29, 2000 (``SIFMA Letter'');
John S. Markle, Deputy General Counsel for TD Ameritrade, June 29,
2009 (``TD Ameritrade Letter''); Sarah McCafferty, Vice President
and Chief compliance Officer at T.RowePrice, June 29, 2009
(``T.RowePrice Letter''); Ronald C. Long, Director of Regulatory
Affairs for Wells Fargo Advisors, LLC, June 29, 2009 (``Wells Fargo
Letter'').
    \36\ See T.RowePrice Letter, supra note 35.
    \37\ See Charles Schwab Letter, supra note 35; Drinker Biddle
Letter, supra note 35; FOLIOfn Letter, supra note 35; SIFMA Letter,
supra note 35; TD Ameritrade Letter, supra note 35; Wells Fargo
Letter, supra note 35. 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 35.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \38\ See SIFMA Letter, supra note 35; Wells Fargo Letter, supra
note 35.
    \39\ See SIFMA Letter, supra note 35; TD Ameritrade Letter,
supra note 35; Wells Fargo Letter, supra note 35.
    \40\ See FOLIOfn Letter, supra note 35.
---------------------------------------------------------------------------

    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 34.
    \42\ See Cornell Letter, supra note 34.
    \43\ See Clifford Kirsch and Eric Arnold, Sutherland Asbill &
Brennan LLP for the Committee of Annuity Insurers, June 29, 2009
(``Committee of Annuity Insurers Letter'').
---------------------------------------------------------------------------

     FINRA's Response:
    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 43;
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'').
    \45\ See Committee of Annuity Insurers Letter, supra note 43;
Hancock, MetLife and Prudential Letter, supra note 44.
---------------------------------------------------------------------------

     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 34; Rex A. Staples, General
Counsel for the North American Securities Administrators
Association, July 13, 2009 (``NASAA Letter'').
    \48\ See Cornell Letter, supra note 34; NASAA Letter, supra note
47.
    \49\ See NASAA Letter, supra note 47.
---------------------------------------------------------------------------

     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 8.

---------------------------------------------------------------------------

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\ NASAA Letter, supra note 47.
    \52\ See NSCP Letter, supra note 35; Committee of Annuity
Insurers Letter, supra note 43. In addition, 491 individuals and
entities made this point, among others, using one form letter
(``Form Letter Type A'') and 1,203 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
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
email 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 Letter''),
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''); Cornell Letter, supra note
34; T.RowePrice Letter, supra note 35; 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 34; Mougey and Kraszewski
Letter, supra note 61; St. John's Letter, supra note 61.
    \63\ See Mougey and Kraszewski Letter, supra note 61; St. John's
Letter, supra note 61.
---------------------------------------------------------------------------

    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 Charles Schwab Letter, supra note 35.
    \65\ See SIFMA Letter, supra note 35; 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 43; James Livingston, President and CEO of
National Planning Holdings, Inc., June 29, 2009 (``National Planning
Holdings Letter''); 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 66; Committee of Annuity
Insurers Letter, supra note 43; Hancock, MetLife and Prudential
Letter, supra note 44; National Planning Holdings Letter, supra note
66.
    \69\ See Hancock, MetLife and Prudential Letter, supra note 44
(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 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 44
(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 61; Taurus
Letter, supra note 61.
    \74\ See Mougey and Kraszewski Letter, supra note 61.
    \75\ See Taurus Letter, supra note 61.
    \76\ See Corporate Law Center & Investor Rights Clinic Letter,
supra note 61.
    \77\ See Corporate Law Center & Investor Rights Clinic Letter,
supra note 61.
    \78\ See Corporate Law Center & Investor Rights Clinic Letter,
supra note 61.
    \79\ See Corporate Law Center & Investor Rights Clinic Letter,
supra note 61.
---------------------------------------------------------------------------

    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 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 35; Committee
of Annuity Insurers Letter, supra note 43; John M. Damgard,
President of the Futures Industry Association, June 29, 2009 (``FIA
Letter''); Form Letter Type A, supra note 52; Form Letter Type B,
supra note 52; Hancock, MetLife and Prudential Letter, supra note
44; James L. Harding, James L. Harding & Associates, Inc., July 1,
2009 (``Harding Letter''); FOLIOfn Letter, supra note 35; Wells
Fargo Letter, supra note 35; LPL Letter, supra note 66; TD
Ameritrade Letter, supra note 35; NSCP Letter, supra note 35; NAIBD
Letter, supra note 35; Thomas W. Sexton, Senior Vice President &
General Counsel for the National Futures Association, June 29, 2009
(``NFA Letter''), SIFMA Letter, supra note 35; T.RowePrice Letter,
supra note 35; 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
43; FOLIOfn Letter, supra note 35; Form Letter Type A, supra note
52; Form Letter Type B, supra note 52; Hancock, MetLife and
Prudential Letter, supra note 44; LPL Letter, supra note 66; NSCP
Letter, supra note 35; T.RowePrice Letter, supra note 35.
    \82\ See, e.g., AALU Letter, supra note 80; AELIC Letter, supra
note 80; Cyr & Cyr Insurance Services Letter, supra note 80;
Principal Life Insurance Co. Letter, supra note 80.
    \83\ See, e.g., AELIC Letter, supra note 80; Committee of
Annuity Insurers Letter, supra note 43; FIA Letter, supra note 80;
Form Letter Type A, supra note 52; Form Letter Type B, supra note
52; Hancock, MetLife and Prudential Letter, supra note 44; Michael
T. McRaith, Illinois Department of Insurance Letter, June 29, 2009;
NAIBD Letter, supra note 35; NFA Letter, supra note 80; NSCP Letter,
supra note 35; SIFMA Letter, supra note 35.
    \84\ See, e.g., AALU Letter, supra note 80; Committee of Annuity
Insurers Letter, supra note 43; Wells Fargo Letter, supra note 35.
    \85\ See, e.g., AELIC Letter, supra note 80.
---------------------------------------------------------------------------

     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 35; Mougey and
Kraszewski Letter, supra note 61.
    \87\ See FOLIOfn Letter, supra note 35.
    \88\ See FOLIOfn Letter, supra note 35.
    \89\ See FOLIOfn Letter, supra note 35.
    \90\ TD Ameritrade Letter, supra note 35.
    \91\ See Estell Letter, supra note 86; Mougey and Kraszewski
Letter, supra note 61.
---------------------------------------------------------------------------

     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 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 Letter,
supra note 61; St. John's Letter, supra note 61; Taurus Letter,
supra note 61.
    \97\ See Charles Schwab Letter, supra note 35; Committee of
Annuity Insurers Letter, supra note 43; FOLIOfn Letter, supra note
35; LPL Letter, supra note 66; NSCP Letter, supra note 35; SIFMA
Letter, supra note 35; TD Ameritrade Letter, supra note 35.
    \98\ See Charles Schwab Letter, supra note 35; FOLIOfn Letter,
supra note 35; NSCP Letter, supra note 35; SIFMA Letter, supra note
35; TD Ameritrade Letter, supra note 35.
    \99\ See Charles Schwab Letter, supra note 35; SIFMA Letter,
supra note 35.
---------------------------------------------------------------------------

    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 43;
National Planning Holdings Letter, supra note 66.
    \101\ See Committee of Annuity Insurers Letter, supra note 43;
National Planning Holdings Letter, supra note 66.
    \102\ See LPL Letter, supra note 66; SIFMA Letter, supra note
35.
---------------------------------------------------------------------------

     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 Letter,
supra note 61; Mougey and Kraszewski Letter, supra note 61; St.
John's Letter, supra note 61; T.RowePrice Letter, supra note 35.
    \104\ See St. John's Letter, supra note 61; Mougey and
Kraszewski Letter, supra note 61.
---------------------------------------------------------------------------

    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 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 35; SIFMA Letter,
supra note 35; TD Ameritrade Letter, supra note 35; Wells Fargo
Letter, supra note 35.
    \106\ See Charles Schwab Letter, supra note 35; SIFMA Letter,
supra note 35; TD Ameritrade Letter, supra note 35; Wells Fargo
Letter, supra note 35.
    \107\ See Charles Schwab Letter, supra note 35; SIFMA Letter,
supra note 35; TD Ameritrade Letter, supra note 35; Wells Fargo
Letter, supra note 35.
    \108\ See Charles Schwab Letter, supra note 35; LPL Letter,
supra note 66; SIFMA Letter, supra note 35; Wells Fargo Letter,
supra note 35.
---------------------------------------------------------------------------

    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 35.
    \110\ See LPL Letter, supra note 66.
    \111\ See LPL Letter, supra note 66.
    \112\ See LPL Letter, supra note 66.
    \113\ See FOLIOfn Letter, supra note 35.
    \114\ See FOLIOfn Letter, supra note 35.
    \115\ See FOLIOfn Letter, supra note 35.
    \116\ See FOLIOfn Letter, supra note 35.
---------------------------------------------------------------------------

    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 Letter, supra note 66.
    \118\ See National Planning Holdings Letter, supra note 66.
    \119\ See National Planning Holdings Letter, supra note 66.
---------------------------------------------------------------------------

    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 120.
---------------------------------------------------------------------------

     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 forgo the protection
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 44;
NAIBD Letter, supra note 35; NSCP Letter, supra note 35; SIFMA
Letter, supra note 35; Wells Fargo Letter, supra note 35.
    \125\ See NAIBD Letter, supra note 35; SIFMA Letter, supra note
35; Wells Fargo Letter, supra note 35.
    \126\ See Hancock, MetLife and Prudential Letter, supra note 44;
NAIBD Letter, supra note 35; NSCP Letter, supra note 35; SIFMA
Letter, supra note 35; Wells Fargo Letter, supra note 35.
---------------------------------------------------------------------------

     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 35; Wells Fargo Letter, supra
note 35.
    \128\ See SIFMA Letter, supra note 35.
    \129\ See Hancock, MetLife and Prudential Letter, supra note 44;
NAIBD Letter, supra note 35; NSCP Letter, supra note 35.
    \130\ See NAIBD Letter, supra note 35.
---------------------------------------------------------------------------

    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 44.
    \132\ See Hancock, MetLife and Prudential Letter, supra note 44.
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 35. 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 61.
    \134\ See Mougey and Kraszewski Letter, supra note 61.
---------------------------------------------------------------------------

     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 47.
---------------------------------------------------------------------------

     FINRA's Response:
    The proposed institutional investor discussion, while shorter than
the 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 Letter,
supra note 61; Taurus Letter, supra note 61; T.RowePrice Letter,
supra note 35.
    \137\ See NASAA Letter, supra note 47.
    \138\ See NASAA Letter, supra note 47.
    \139\ See NASAA Letter, supra note 47.
---------------------------------------------------------------------------

    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 34; Estell Letter, supra
note 86.
    \141\ See FOLIOfn Letter, supra note 35.
---------------------------------------------------------------------------

     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).
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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\
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    \145\ See Cornell Letter, supra note 34; Corporate Law Center &
Investor Rights Clinic Letter, supra note 61; NASAA Letter, supra
note 47.
    \146\ See Cornell Letter, supra note 34; Corporate Law Center &
Investor Rights Clinic Letter, supra note 61; NASAA Letter, supra
note 47.
    \147\ See Corporate Law Center & Investor Rights Clinic Letter,
supra note 61.
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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) 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<EMAIL_ADDRESS>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. 2010-21228 Filed 8-25-10; 8:45 am]
BILLING CODE 8010-01-P