1. Suitability

2. 2 Suitability Defined It is the “appropriateness” of a recommended transaction when considering the risks associated with the transaction, the customer’s other securities holdings, his financial situation (income and net worth), financial needs and investment objectives..

3. 3 Rule Requirements  FINRA Rule 2010 A member in the conduct of his business, shall observe high standards of commercial honor and just and equitable principles of trade.

4. 4 Rule Requirements  NASD Conduct Rule 2310 It is a prohibited business practice to recommend to a customer the purchase, sale or exchange of any security without reasonable grounds to believe that the recommendation is suitable for the customer on the basis of information furnished by the customer after reasonable inquiry concerning the customer's investment objectives, financial situation and needs, and any other information known by the dealer;

5. 5 Rule Requirements  Options – FINRA Conduct Rule 2360(19) No member or person associated with a member shall recommend to a customer an opening transaction in any option contract unless the person making the recommendation has a reasonable basis for believing, at the time of making the recommendation, that the customer has such knowledge and experience in financial matters that he may reasonably be expected to be capable of evaluating the risks of the recommended transaction, and is financially able to bear the risks of the recommended position in the option contract.

6. 6 Important Case Principles  The suitability doctrine entails the matching of two elements: the investment objectives and specific needs of the customer with the investment objectives and specific needs of the customer with the characteristics of the the security which is being recommended while taking into account the other investments held by the customer at this or any other firm. the characteristics of the the security which is being recommended while taking into account the other investments held by the customer at this or any other firm.  The suitability rules generally apply only when an agent makes a recommendation.

7. 7 When is a transaction considered recommended by the broker?  Generally speaking, a transaction will be considered to be recommended when the firm or agent brings the specific security to the attention of the customer through any means including direct telephone communication, the delivery of promotional material, or the transmission of electronic messages.

8. 8 What’s not a recommendation?  Exchange Act Release 27,160 states: The FINRA suitability rules would not apply to situations in which a dealer functioned solely as an order taker and executed transactions for persons who, on their own initiative, decide to purchase a security without a recommendation from the broker.

9. 9 Customer Account Information  Although there is no regulatory requirement to place the information in one place or on a form, most if not all firms will place the information on a document, the customer (new) account card.

10. 10 Customer Account Information  The customer account card will generally have information including but not limited to: name and address of account holder(s), age(s), employment or employment status, income, net worth, tax status, investment objective(s)/risk tolerance and prior investment experience.

11. 11 Customer Account Information  The account card must be dated and signed by the agent opening the account and approved for trading by supervisor/principal designated by the dealer. SEC Rule 17a-3 requires that the firm send a copy of the new account (card) information to the customer within 30 days of opening the account, when updates are made or on a rolling 36 month basis. Any account which is actively traded (one per year) and has not been updated in the last three years, must be updated at the time of the transaction.

12. 12 Customer Account Information  Should information on the customer account card become inaccurate (e.g., account holder becomes retired, increase/decrease in net worth or income, marital status) the agent must update the information.

13. 13 Customer Account Information  It is incumbent upon the examiner to not only review the account card for completeness, but also to review the document to ensure its accuracy. For example, is it plausible for a 30-year old investor to have 15 years of investment experience?

14. 14 A Few Words About Fee Based Accounts  NASD Notice to Members 03-68  Tully Report (1995)  Fee-based programs typically charge a customer a fixed fee or percentage of assets under management in lieu of transaction- based commissions. While FINRA recognizes the benefits these programs offer for many customers, they are not appropriate in all circumstances.

15. 15 A Few Words About Fee Based Accounts-cont. Therefore members must have reasonable grounds for believing that a fee-based program is appropriate for a particular customer, taking into account the services provided, cost, and customer preferences and number of transactions.

16. 16 A Few Words About Fee Based Accounts–cont.  The 1995 Report of the Committee on Compensation Practices (the”Tully Report”) labeled fee-based programs a “best practice” because they more closely align the interests of the broker dealer and customer and reduce the likelihood of abusive sales practices such as churning, high-pressure sales tactics, and recommending unsuitable transactions.

17. 17 A Few Words About Fee Based Accounts–cont.  The Tully Report noted that fee-based programs are particularly appropriate for investors who prefer consistent and explicit monthly or annual charges and those that engage in at least a moderate level of trading activity. The report also acknowledged that fee-based programs may not fit the needs of certain investors.

18. 18 A Few Words About Fee Based Accounts–cont.  The report noted that accounts with low trading activity may be better off with a commission-based program. These accounts might include those comprised mainly of bonds or mutual funds, where the customer has a stated buy-and-hold strategy.

19. 19 A Few Words About Fee Based Accounts–cont.  Both the firm and agent have a responsibility to ensure that not only upon the opening but on an ongoing basis the fee based feature and the amount of the fee for the account is and continues to be appropriate for the client.

20. 20 Examination Steps to Detect Unsuitable Recommendations  Select a Sampling of Customer Accounts  Focus your review on the accounts of conservative, retired, and/or low net worth persons. These types of accounts are generally more susceptible to unsuitable trading  Review the sales of high-risk investments. High risk investments should generally be placed only in accounts with objectives of aggressive growth and/or speculation.

21. 21 Examination Steps to Detect Unsuitable Recommendations  Review accounts that utilize margin borrowing  Margin borrowing increases the customer’s “buying power” but also increases the risk of loss should the price of the stock decrease in value  A review of customer complaints will provide you with information as to those customers complaining about unsuitable trades.

22. 22 Examination Steps to Detect Unsuitable Recommendations  Review exception reports or “happiness” letters.  Exception reports are generated by the dealer, or in the case of an introducing dealer, by the clearing dealer, to aid in supervision. An exception report will be generated if certain trading parameters established by the dealer have been broken.

23. 23 Examination Steps to Detect Unsuitable Recommendations For example, if an account has been approved for “Safety of Principal” and speculative trades have been executed in the account, a report should be generated for the account in question. It will then be the responsibility of the manager to determine the reason for the exception, and if necessary take action to resolve the concern. For example, if an account has been approved for “Safety of Principal” and speculative trades have been executed in the account, a report should be generated for the account in question. It will then be the responsibility of the manager to determine the reason for the exception, and if necessary take action to resolve the concern.

24. 24 Examination Steps to Detect Unsuitable Recommendations  A “happiness letter” is used by a dealer to contact the customer for the purpose of having the customer confirm his knowledge of and approval of certain trading patterns present in their account which may not mirror the account’s investment objectives

25. 25 Proof Checklist  Element of the Violation  Transaction was recommended by the agent.  Proof  The order ticket(s) will indicate the trade was placed and whether the trade was solicited (recommended) by the agent.  Confirmation(s) will indicate the terms by which the trade was executed.  Customer’s account statement(s) showing disputed transaction and absence of similar transactions  The customer account statements will indicate transactions in the account on a monthly or quarterly basis.  Customer complaint allegations

26. 26 Proof Checklist  Customer’s testimony The customer’s testimony will prove critical to your case in determining the accuracy of the account card information and their conversations with the agent relating to the trades in question.The customer’s testimony will prove critical to your case in determining the accuracy of the account card information and their conversations with the agent relating to the trades in question.  Agent’s testimony Like the customer’s testimony, the agent’s testimony is critical in determining the accuracy of the account information and his conversations with the customer relating to the transactions in question.Like the customer’s testimony, the agent’s testimony is critical in determining the accuracy of the account information and his conversations with the customer relating to the transactions in question.

27. 27 Proof Checklist  Firm’s research report or sales literature During the course of obtaining information from the agent, it is important to obtain and verify the accuracy of any internal research reports or sales literature assembled by the dealer or agent, and utilized in connection with a sale.During the course of obtaining information from the agent, it is important to obtain and verify the accuracy of any internal research reports or sales literature assembled by the dealer or agent, and utilized in connection with a sale.  Reports, press releases or other material issued by the issuer and used by the agent. Like the research reports and sales literature, the examiner should obtain copies of materials and verify accuracy.Like the research reports and sales literature, the examiner should obtain copies of materials and verify accuracy.

28. 28 Proof Checklist  Other customers that purchased the stock at the same time The examiner should obtain customer account information and trading activity in these accounts. After analysis it may be necessary to interview these additional investors to determine the extent of suitability concerns for this agent or the dealer.The examiner should obtain customer account information and trading activity in these accounts. After analysis it may be necessary to interview these additional investors to determine the extent of suitability concerns for this agent or the dealer.

29. 29 Proof Checklist  Element of the Violation  Recommended transaction did not match customer’s risk profile, investment objectives or financial needs.  Proof  Prospectus, sales literature, 10-K report describing the risks of the investment If offering documents were utilized were they accurate? Additionally, if a reporting company with the SEC, do reports filed provide information to the examiner to document suitability concerns?If offering documents were utilized were they accurate? Additionally, if a reporting company with the SEC, do reports filed provide information to the examiner to document suitability concerns?  Does an analysis of the investment indicate the risk factors were consistent with the customer’s investment objective(s)?

30. 30 Proof Checklist  Customer’s personal financial statement It may be useful to obtain a personal financial statement or tax return from the investor. Is the financial information on these forms similar to the information on the account card?It may be useful to obtain a personal financial statement or tax return from the investor. Is the financial information on these forms similar to the information on the account card?  Examiner’s analysis of investment concentration Does the account contain an inordinate amount (%) of a particular sector of securities, such as start-up technology companies with little or no operating history, in an account with safety of principal or conservative objectives?Does the account contain an inordinate amount (%) of a particular sector of securities, such as start-up technology companies with little or no operating history, in an account with safety of principal or conservative objectives?

31. 31 Proof Checklist  Was the new account information accurate for the investor?  Agent and customer interviews (See proof checklist for recommended transactions)  History at prior firms All too often examiners fail to obtain and review investments held at prior dealers. It is imperative to obtain and review trading at each firm in an effort to document the validity of investment experience indicated on the account card.All too often examiners fail to obtain and review investments held at prior dealers. It is imperative to obtain and review trading at each firm in an effort to document the validity of investment experience indicated on the account card.

32. 32 Proof Checklist  Element of the Violation  Customer facts were disclosed by the customer to agent prior to recommendation. Level of sophistication and experienceLevel of sophistication and experience Financial situation and needsFinancial situation and needs Customer’s ability to bear the loss of the investmentCustomer’s ability to bear the loss of the investment Investment objectivesInvestment objectives  Proof  Customer’s testimony detailing pertinent disclosure  Agent’s testimony admitting pertinent customer disclosure  New account information showing investment objectives  Prior account statements showing limited investment history  Customer letters, memos or e-mails to or from agent concerning disclosure and desires