[Federal Register Volume 59, Number 18 (Thursday, January 27, 1994)] [Unknown Section] [Page 0] From the Federal Register Online via the Government Publishing Office [www.gpo.gov] [FR Doc No: 94-1716] [[Page Unknown]] [Federal Register: January 27, 1994] ----------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION [Release No. 34-33498; File No. SR-MSRB-94-01] Self-Regulatory Organizations; Proposed Rule Change by the Municipal Securities Rulemaking Board Relating to Suitability of Recommendations January 21, 1994. Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (``Act''), 15 U.S.C. 78s(b)(1), notice is hereby given that on January 7, 1994, the Municipal Securities Rulemaking Board (``Board'' or ``MSRB'') filed with the Securities and Exchange Commission (``Commission'') a proposed rule change as described in Items I, II, and III below, which Items have been prepared by the self-regulatory organization. The purpose of the proposed rule change is to strengthen the MRSB's rules governing customer suitability. The Commission is publishing this notice to solicit comments on the proposed rule change from interested persons. I. Self-Regulatory Organization's Statement of the Terms of Substance of the Proposed Rule Change The Board is filing amendments to rule G-19, concerning suitability of recommendations and rule G-8 concerning recordkeeping. The proposed rule change: (1) Clarifies and strengthens the existing language of rule G-19 that requires suitability determinations to be made when recommending transactions to customers; (2) clarifies the obligation of dealers to make reasonable efforts to obtain specific types of customer suitability information for all accounts that are not ``institutional accounts'' (i.e., retail accounts); and (3) clarifies the definition of ``institutional account.'' II. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change In its filing with the Commission, the Board 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 and is set forth in sections (A), (B), and (C) below. A. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change The proposed rule change is designed to strengthen the Board's customer suitability rule. In a letter dated May 8, 1992, the Commission's Division of Market Regulation asked the Board to review the requirements of rule G-19 on suitability of recommendations.\1\ In September 1992, the Board published a Request for Comments on a number of customer protection issues, including the application of rule G-19 to customer transactions. After reviewing these matters, the Board decided that rule G-19 embodies the appropriate general standard for dealers in making recommendations to customers. Nevertheless, the Board recognized there was a perception that certain provisions of the rule could be viewed as permitting recommendations to go forward without proper regard to the nature of the security being recommended and the customer to whom it is recommended. Accordingly, at the May 1993 Board meeting, the Board approved a Request for Comments on draft amendments to clarify and strengthen the suitability requirements of rule G-19. The draft amendments were approved at the November 1993 Board meeting and form the basis of the proposed rule change. --------------------------------------------------------------------------- \1\Letter from William H. Heyman, Director, Division, Commission, to Christopher A. Taylor, Executive Director, MSRB (May 8, 1992). --------------------------------------------------------------------------- Rule G-19 generally requires that, before making any recommendation to a customer, a dealer must first determine that the proposed transaction is suitable for the customer. To strengthen rule G-19, the proposed rule change eliminates two provisions from the rule which, in effect, are exceptions to this general requirement. The first such provision permits a dealer to make a recommendation when a customer refuses to provide sufficient information about himself for the dealer to determine that the recommendation is suitable for the customer. The provision states that a recommendation can go forward in this case as long as the dealer has no reasonable grounds to believe and does not believe that the recommendation is unsuitable (the ``not unsuitable'' provision). Although the Board did not conclude that this provision was the cause of customer protection problems (i.e., there was no evidence that dealers relied on this provision to make unsuitable recommendations), the Board believed that the provision should be deleted to avoid any ambiguities regarding a dealer's obligation to make a suitability determination. Eliminating the provision also will prevent any future use of the provision as an excuse for unsuitable recommendations. The second provision of rule G-19 that is removed by the proposed rule change provides that a dealer, notwithstanding its determination that a transaction is not suitable for a customer, may, after so informing the customer of this, nevertheless respond to the customer's requests for investment advice and execute transactions at the direction of the customer. This ``notwithstanding'' provision allows dealers to recommend specific municipal securities to investors who want to invest in municipal securities even after being informed by the dealer that, based on their financial circumstances, investments in municipal securities would not be suitable. While there have been no reported problems associated with this provision, the Board, nevertheless, believed that this exemptive provision also should be deleted to strengthen the suitability rule. The Board also reviewed and clarified the customer data inquiries that are necessary for non-institutional and institutional accounts. For non-institutional (i.e., retail) accounts, the proposed rule change clarifies that dealers must make reasonable efforts to obtain the following information: the customer's financial status, tax status, investment objectives and such other information used or considered to be reasonable and necessary by the dealer in making recommendations to the customer. For some institutional customers, however, these specific information requests may not be appropriate. For example, the ``tax status'' of a tax-exempt bond fund generally is not relevant to a suitability determination. Therefore, the proposed rule change does not provide a specific list of items that must be requested from all institutional accounts, but does state that dealers must obtain appropriate and sufficient data from each institutional customer to make a suitability determination for each transaction that is recommended (as also is required for non-institutional accounts). Finally, the proposed rule change revises the definition of ``institutional account'' contained in rule G-8. This definition is used in rule G-19, by cross-reference. This amendment would make the Board's definition of institutional account the same as the National Association of Securities Dealers' (``NASD'') definition for purposes of suitability determinations. Accounts that do not qualify as ``institutional accounts'' (i.e., retail accounts) would be subject to the specific information inquiries described above. The Board believes the proposed rule change is consistent with Section 15B(b)(2)(C) of the Act which provides that the Board's rules: be designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade * * * to remove impediments and to perfect the mechanism of a free and open market in municipal securities, and, in general, to protect investors and the public interest. The Board believes that the proposed rule change will protect investors and the public interest because it is designed to ensure that dealers, before making a recommendation to a customer, make a determination that the municipal securities transaction is suitable. B. Self-Regulatory Organization's Statement on Burden on Competition Because the proposed rule change will have an equal impact on all dealers, the Board believes that the proposed rule change will not have any impact on competition. C. Self-Regulatory Organization's Statement on Comments on the Proposed Rule Change Received From Members, Participants, or Others September 1992 Request for Comments In September 1992, as part of the Board's general review of customer protection measures, the Board requested comment on potential problem areas in the municipal securities market and suggestions for how customer protection could be improved. Specific questions were asked about the effectiveness of rule G-19 and the Board obtained various comments on the ``not unsuitable'' provision of rule G-19 from Merrill Lynch, North American Securities Administrators Association, Barre & Co., Griffen, Kubik, Stephens & Thompson, and the Public Securities Association. While some of these commentators at that time believed that the ``not unsuitable'' provision should be deleted, other commentators believed it should be retained because some customers do not wish to provide certain information about themselves. Specifically, two commentators believed that removing the provision would not be a problem and would make the Board's rule consistent with normal practice in other securities markets. Three commentators noted that some customers do not want to provide their financial information to a dealer. One of those commentators indicated, however, that ``in the vast majority of cases, dealers do routinely obtain information for each customer account reflecting net worth, income level and investment objectives.'' August 1993 Request for Comments In August 1993, the Board published for comment the proposed rule change. Comment letters were received from Fidelity Investments, First Interstate Bank of Oregon, Heitner Corporation, Lehman Brothers, Liberty Bank and Trust Company of Tulsa, Merrill Lynch, and the Securities Department of Arkansas. Comments on the General Approach of the Proposed Rule Change In general, the commentators' reaction to the approach taken by the proposed rule change was favorable. One commentator agreed with the Board's approach by stating that the proposed rule change would address a ``difficult problem'' by deleting the ``not unsuitable'' and ``notwithstanding'' provisions from the current suitability rule. Another commentator noted that rule G-19 ``as reformulated by the Board sets forth an appropriate affirmative standard.'' Two other commentators also expressed general support for the approach taken by the proposed rule change. Two commentators expressed reservations over removal of the ``not unsuitable'' and the ``notwithstanding'' provisions. One commentator opposed both changes because of its belief that the majority of its customers are not willing ``to divulge their financial strength.'' Another commentator, while indicating that it does not make recommendations in municipal securities to customers, also believes that the ``notwithstanding'' provision should be retained because a customer may disagree with a dealer's opinion of unsuitability. That commentator indicated that dealers should be permitted to make recommendations to a customer who has already decided to purchase a municipal security and who asks for assistance in choosing an issue, even if the transaction would be unsuitable for the customer. While the ``not unsuitable'' and the ``notwithstanding'' provisions were initially adopted by the Board in the late 1970s for reasons similar to those cited by the commentators, the Board notes that there have been significant changes in the municipal securities market since that time. The number of retail investors has increased and the introduction of increasing numbers of complex, and in some cases, speculative municipal securities has become a characteristic of today's market. In such an environment, the Board believes that it is critical that dealers have clear policies to ensure that sales personnel do not recommend securities to customers without first establishing the suitability of the transaction. Therefore, the Board believes that the proposed rule change deleting these provisions is necessary. Comments on Specific Provisions of the Proposed Rule Change Commentators offered several specific suggestions and sought guidance from the Board in a number of areas of the proposed rule change. Customer Account Data and Suitability Determinations The proposed rule change includes an amendment to rule G-19(b) which states that, for retail customers, prior to making a recommendation a dealer must ``make reasonable effort to obtain information concerning: (i) The customer's financial status; (ii) the customer's tax status; (iii) the customer's investment objectives; and (iv) such other information used or considered to be reasonable and necessary by such broker, dealer or municipal securities dealer in making recommendations to the customer.'' Two commentators were concerned as to what would happen if all such information could not be obtained. As indicated in the Request for Comments, the language of the proposed rule change does not necessarily preclude a dealer from making a recommendation if all items of information enumerated in the proposed amendment to rule G-19(b) cannot be obtained. Given the nature of the transaction (e.g., the nature of the security and the known items of information about the customer), the dealer may have enough customer data to make a specific, affirmative suitability determination for the recommendation, even if the customer refuses to provide some of the requested information. However, reasonable efforts must be made to obtain all customer information listed in the proposed amendment to rule G-19(b), in any event. As noted above, the amount of customer information that is required to make a suitability determination depends in part upon the nature of the transaction recommended. With respect to some types of transactions--for example, those in more speculative securities--the amount of information needed to make a suitability determination will be greater than if a more conservative recommendation is being made. One commentator requested that the Board provide guidance on this subject by specifying ``core'' suitability information that must be obtained from a customer even when making a ``conservative'' recommendation. That commentator also requested that the Board provide specific guidance on what would be considered ``more speculative'' securities for which more detailed customer account data would be needed. The proposed rule change to rule G-19(b) states that dealers must make reasonable efforts to obtain certain ``core'' customer suitability data for recommendations to non-institutional customers including: (i) The customer's financial status; (ii) the customer's tax status; (iii) the customer's investment objectives; and (iv) such other information used or considered to be reasonable and necessary by such broker, dealer or municipal securities dealer in making recommendations to the customer. The Board notes that if, after reasonable efforts, a dealer cannot obtain all such information regarding a customer, but nevertheless desires to proceed with a ``conservative'' transaction, the dealer must exercise its judgment, based on known information about the customer and the security, as to whether a suitability determination can be made. Furthermore, all information about the customer that is used in making this determination must be recorded in the customer account record under rule G-8(a)(xi)(F). The Board also believes it to be inadvisable to attempt to provide detailed guidance on whether a particular security or proposed transaction is more ``conservative'' or more ``speculative.'' The Board notes that dealers will have to make such decisions based on their knowledge of the security and the risks involved in the transaction. Attempts to state a universally applicable formula for such considerations could encourage the substitution of simplistic guidelines for the broader judgment that is sometimes required to determine whether a proposed municipal securities transaction includes a relatively low or high degree of risk. Unsolicited Transactions Several commentators requested that the Board provide guidance on how to identify and document ``unsolicited'' transactions, i.e., transactions that are not recommended. Neither the current version of rule G-19 nor the proposed rule change precludes dealers from executing specific transactions at the request of customers, where no recommendation is made. Thus, the suitability requirements of the proposed rule change would not apply to such ``unsolicited'' transactions. The Board notes, however, that most municipal securities transactions are made in connection with recommendations. Because of its concern with customer protection and in recognition of the special characteristics of the municipal securities market, the Board views the term ``recommendation'' (and the application of the Board's suitability requirement) broadly. For example, with respect to transactions occurring after investment seminars and in response to a dealer's advertisements, the Board has indicated that the suitability requirements of G-19 apply ``in the same way they apply to all other recommendations made to customers.'' Thus, although transactions may, in some instances, be ``unsolicited'' if a customer places an order for a specific security, transactions cannot be considered unsolicited if the order occurs after a dealer has mentioned a specific security to a customer (e.g., in a listing of offerings, an advertisement or in any other communication by the dealer to the customer). One commentator asked how ``unsolicited'' orders should be specified in a dealer's records, and whether such orders should always be handled by the dealer ``as agent.'' Board rules do not require dealers to handle specific types of orders as either principal or agent. Rule G-8(a)(vi), however, specifies the recordkeeping requirements for the terms and conditions of an agency order, including the fact that it is an agency order. Similarly, rule G-15(a)(vii) requires the confirmation to state the agency role of a dealer in a transaction. Neither rule G-8 nor rule G-15 has provisions for documenting orders as ``unsolicited.'' As previously noted, the Board believes that relatively few transactions in municipal securities actually are ``unsolicited.'' While documenting these relatively rare transactions as such on the confirmation and in the dealer's records may be prudent for the dealer's own protection, the Board is concerned that incorporating a requirement in the Board's rules might have the unintended and undesired effect of encouraging the classification of transactions as ``unsolicited,'' even when they are not ``unsolicited'' under Board rules. Institutional Accounts The Board received several comments concerning the proposed definition for institutional account contained in the proposed rule change and the more generally stated suitability standard for institutional accounts. No commentator argued that it was inappropriate to distinguish between institutional and non-institutional investors when obtaining customer account data and making suitability determinations. One commentator believed the proposed standard for institutional investors was appropriate and noted that the information relevant to a suitability determination for a specific institutional account is necessarily a matter of judgment for the dealer. One commentator, however, suggested the establishment of specific minimum requirements for institutional accounts and specifically suggested that dealers should document the customer's investment objectives (including credit quality and maturity standards) and ``other information'' used or considered reasonable or necessary by the dealer. Another commentator suggested including corporate resolutions, trading authorization, and yearly audited financial statements as required information for institutional customers. As indicated by several commentators, it is often necessary or advisable to obtain specific kinds of information from an institutional investor. Rule G-8(a)(xi)(F) currently requires that the customer suitability information used to make a suitability determination be recorded in the customer account record. The proposed rule change to rule G-8 also makes this requirement clear. In addition, rule G- 8(a)(xi) also requires other customer account information including, among other things, the customer's name and address, tax identification or social security number and with respect to discretionary accounts, the customer's written authorization. For various types of institutional accounts, it may be advisable for dealers to obtain certain additional data and documentation. Often this additional documentation may be necessary for the dealer's own protection (e.g., trading authorizations). Similarly, for certain institutional accounts, dealers may wish to obtain yearly audited financial statements where assurance is desired that the account is and remains an institutional account for the purpose of rule G-19. Because of the wide variety in the types of institutional accounts and the documentation that might be necessary to establish suitability or otherwise considered to be necessary and prudent by the dealer, the Board believes that dealers ultimately will have to employ a certain degree of judgment in determining what information and documentation should be obtained and recorded for specific institutional customers beyond that now required by rule G-8(a)(xi). One commentator noted that, in many instances, a suitability determination should be made on the basis of the investment objectives articulated by an institution for a specific transaction or a specific component of a large investment portfolio. In these cases, the overall investment objectives of the institution or portfolio may not be the deciding factor in determining suitability. The Board notes that this view is consistent with the current language of rule G-19 and the proposed rule change, which requires that a dealer have reasonable grounds for recommending a transaction ``based on the facts disclosed by such customer or otherwise known about such customer.'' Clearly, if specific portfolio or transaction objectives are given, the proposed rule change and current Board rules require that such information be used to make a suitability determination and be recorded pursuant to rule G-8(a)(xi)(F). One commentator preferred the Commission's definition of ``accredited investor'' to the definition of ``institutional account'' in the proposed rule change. The Commission's accredited investor definition includes a wide range of investors, such as any private business development company or individuals making in excess of $200,000 per year for three years. The term ``accredited investor'' is used as part of an exemptive provision from certain registration requirements under the Securities Act of 1933. Having a customer classified as an ``accredited investor,'' however, does not excuse dealers from obtaining specific customer account data when making recommendations in equity transactions. Moreover, because ``institutional account''--rather than ``accredited investor''--is used by the NASD to define a dealer's customer account requirements, the Board believes that the use of a different test for municipal securities transactions would complicate the internal recordkeeping requirements of most securities firms. Transactions With Investment Advisors Two commentators requested clarification of the suitability requirements that exist when a dealer executes a transaction for an investment advisor. The Board notes that this question is answered by determining who the dealer's customer is--the investment advisor or the investment advisor's client. The Board believes that, in general, the investment advisor will be the dealer's customer. However, it is not possible to state this as an ironclad rule. The requirement for establishing suitability may depend on whether the beneficial owner is looking to the dealer or exclusively to the investment advisor for recommendations on investments. The dealer, of course, should obtain the necessary customer account data from whomever is the customer. If the investment advisor is the customer, then the dealer would proceed as with other institutional accounts. However, if a dealer has a dealer-customer relationship with the beneficial owner and treats that entity as its own customer, then the dealer must obtain the information necessary to make a suitability determination prior to making a recommendation. In this case, the investment advisor is treated as an interested party to the transaction. III. Date of Effectiveness of the Proposed Rule Change and Timing for Commission Action Within 35 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 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. Persons making written submissions should file six copies thereof with the Secretary, Securities and Exchange Commission, 450 Fifth Street NW., Washington, DC 20549. 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 inspection and copying in the Commission's Public Reference Room. Copies of the filing will also be available for inspection and copying at the principal office of the MSRB. All submissions should refer to the file number in the caption above and should be submitted on February 17, 1994. For the Commission by the Division of Market Regulation, pursuant to delegated authority, 17 CFR 200-30-3(a)(12). Margaret H. McFarland, Deputy Secretary. [FR Doc. 94-1716 Filed 1-26-94; 8:45 am] BILLING CODE 8010-01-M