On December 10, 2012, FINRA issued Regulatory Notice 12-55 further addressing the scope of the terms “customer” and “investment strategy” used in its new suitability rule, Rule 2111 (effective July 9, 2012). RN 12-55 is presented in a FAQ format and supersedes the answers FINRA previously provided in RN 12-25 on these topics.

FINRA’s answer to RN 12-25 Question 6 left some ambiguity as to the suitability rule’s application to recommendations to potential investors. The new guidance clarifies that a customer is limited to a person who opens an account at a broker-dealer or purchases a security for which the broker-dealer will receive compensation, even if the security is held at the issuer or elsewhere. The suitability rule only applies to recommendations to potential investors when the broker-dealer makes a recommendation to a potential investor who then becomes a customer—either by executing a transaction through the broker-dealer or by receiving compensation as a result of the recommendation.

In the new guidance, FINRA also makes clear that in situations where a broker makes an investment strategy recommendation involving both a security and a non-security, the new suitability rule applies to both the security and non-security aspects of the recommendation. For example, where a broker recommends the use of home equity to purchase securities, the suitability rule applies to the recommendation in its entirety because the investment strategy recommendation involved a security (and a non-security). Conversely, the rule does not apply where the recommendation actually made does not involve a security. For instance, the rule would not apply where a broker recommends a non-security investment as part of an outside business activity, and the customer independently decides to liquidate certain securities to fund the non-security investment. In the case where a customer independently decides to purchase a non-security investment, and then asks the broker which securities to sell to fund the purchase, the rule would only apply to the broker’s recommendation regarding which securities to sell, and not the decision to purchase the non-security, as it was not a part of the broker’s recommendation.

RN 12-55 also clarifies, in FINRA’s response to Question 7, that a broker’s recommendation to purchase, sell or hold securities or a strategy involving securities “normally does not create an ongoing duty to monitor and make subsequent recommendations.” This is because, as FINRA emphasizes, “the rule’s focus is on whether the recommendation was suitable when it was made.” Thus the suitability of a recommendation involving a security is not to be evaluated by events occurring after the recommendation and the fact of the recommendation does not create “an ongoing duty to monitor.” If, however, the broker is also an IAR in connection with the customer’s account or the particular recommendation, the duties of an investment advisor may independently create the duty to monitor.

Lastly, FINRA rules do not dictate how a broker-dealer must supervise recommendations of investment strategies involving both securities and non-securities. RN 12-55 emphasizes the supervision must be reasonably designed to achieve compliance with securities laws and states a broker-dealer may use a risk-based system that focuses on the detection, investigation and follow-up of red flags. While a broker-dealer’s suitability obligations apply only to the security component of a recommended investment strategy involving both a security and a non-security, its suitability analysis but must be informed by a general understanding of the non-security component. Where applicable, this general understanding should include outside business information the broker-dealer is required to maintain.