FINRA Moves to Amend the Suitability Standard in Lockstep with the SEC’s Efforts

There is a Chinese curse which says ‘May he live in interesting times.’ Like it or not, we live in interesting times.” (Robert F. Kennedy – June 6, 1966, Speech at University of Cape Town)

May 7, 2018, has come and gone and we have not yet seen a mandate from the Fifth Circuit Court of Appeals in the Chamber of Commerce of United States of Am. v. United States Dep’t of Labor, 885 F.3d 360 (5th Cir. 2018) litigation, which is the final step necessary to effectuate that court’s order vacating the DOL Fiduciary Duty Rule.  Presumably that mandate is imminent; however, we do not know for sure. We do know, however, that the DOL will not be filing a motion for rehearing to the Fifth Circuit on its decision, as that deadline has passed. We assume there will not be a DOL writ of certiorari to the United States Supreme Court seeking to challenge the Fifth Circuit Court’s opinion, but we do not actually know that either.

What we do know is that the SEC has stepped onto the stage and issued its proposed standard of care regulation–“Regulation Best Interest” (“Reg BI”) . See comments at: Reg BI. As we have previously discussed in detail on this blog, Reg BI will apply

  • to broker-dealers and associated persons;
  • at the time a recommendation is made;
  • of any securities transaction or investment strategy involving securities;
  • to a retail customer,

and will require that the broker-dealers and associated persons act

  • in the best interest of the retail customer; and
  • without placing their own financial or other interest ahead of the interest of the customer.

Well, what does this require?  It requires that:

The broker-dealer or natural person who is an associated person of a broker or dealer, in making the recommendation, exercises reasonable diligence, care, skill, and prudence to: (1) understand the potential risks and rewards associated with the recommendation, and have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers; (2) have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks and rewards associated with the recommendation; and (3) have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer’s best interest when viewed in isolation, is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile… [Emphasis added]

If this sounds familiar, it is because Reg BI is a paraphrase of FINRA Rule 2111 (Suitability) “Supplemental Material” .05(c) of “Components of Suitability Obligation.” There is, however, a distinction between the Reg BI standard and the present FINRA rule. The SEC standard condition (3), which is taken from the “quantitative” suitability requirement for members and associated persons, removes the present qualifier that this quantitative suitability is applicable only when a member or associated person “has actual or de facto control over a customer account.” This is a significant alteration to the FINRA rule. The quantitative suitability requirement adds to the broker’s responsibility that he/she not trade excessively in his/her customer’s account. Of course, there has long been a prohibition against churning a customer’s account. However, churning requires scienter – the requisite state of mind for liability under Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. 78j, and Rule 10b-5, 17 C.F.R. § 240.10b-5. Quantitative suitability does not require scienter; it merely requires negligence. Therefore, brokers are presently prohibited from intentionally excessively trading a customer’s account for the purpose of increasing the broker’s commissions. In addition, brokers are prohibited from negligently excessively trading a customer’s account when the broker has actual or de facto control over that customer’s account. The SEC’s proposed rule would prohibit (and therefore, create liability if violated) negligently making a recommendation to a customer that would result in excessive trading given the customer’s investment profile even if the customer had control over the account and made the final decision regarding what and whether to purchase in the account.

On the heels of the SEC’s April 18, 2018, release of its proposed new conduct rules, on April 20, 2018, FINRA released Regulatory Notice 18-13 wherein FINRA states:

FINRA seeks comment on proposed rule amendments that would revise the quantitative suitability obligation under FINRA Rule 2111 (Suitability) to more effectively address instances of excessive trading in customers’ accounts. The proposed rule amendments would remove the element of control that currently must be proved to demonstrate a violation, but would not change the obligations to prove that the transactions were recommended and that the level of trading was excessive and unsuitable in light of the customer’s investment profile.

Comments on FINRA’s proposed rule must be received by June 19, 2018. Comments on Reg BI must be received by August 7, 2018. If Reg BI is enacted, then it appears likely that the FINRA rule will be enacted as well.

The devil is, of course, in the details. If the customer has control over the account, does this new requirement place an affirmative obligation on the broker to stop a customer from financial suicide? We anticipate, and perhaps we are being optimistic, that both rules will be accompanied by FAQs to clarify what the SEC and FINRA expect of broker-dealers and associated persons. Nevertheless, the foreseeable future remains murky for broker-dealers and associated persons as we await what the final rules will look like and as state standards on conduct continue to evolve. So for now, there is no question: these are indeed interesting times.

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About the Author: Sandra D. Grannum

Sandra Dawn Grannum concentrates her practice on securities, broker/dealer arbitration, litigation, mediation and regulatory defense. She is co-chair of the Commercial Litigation Team.

Sandy has tried complex multimillion-dollar arbitrations before FINRA, AAA and JAMS across the country. She has represented brokerage firms, banks, clearing firms, and associated persons in over 60 arbitrations before the NASD and FINRA which have been tried through award. In addition, she has successfully pursued cases in state and federal courts and in adversarial proceedings before bankruptcy courts.

About the Author: Jamie L. Helman

Jamie L. Helman concentrates her practice on securities, broker-dealer arbitration, litigation, mediation, employment matters, and regulatory defense. She has experience first-chairing FINRA arbitrations, defended on-the-record testimony of broker-dealer employees before FINRA, and is presently involved in the representation of broker-dealers in several pending FINRA cases as well as regulatory matters.

About the Author: Tracey Salmon-Smith

Tracey Salmon-Smith, a trusted adviser and pragmatic problem solver, assists clients with commercial and business disputes, employment litigation, securities law and internal investigations. As a former assistant United States attorney (AUSA) who also spent several years as in-house counsel for a global financial services firm, Tracey knows firsthand the pressures and challenges her clients face. Tracey is known for her composure under pressure and her commitment to achieving results.

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