FINRA Adopts Amendments to Reduce Conflict and Confusion with SEC’s Reg BI
Dallas, Texas (July 7, 2020) - As we discussed in a previous client alert, in June 2019, the Securities and Exchange Commission (SEC) adopted Regulation Best Interest (Reg BI) as the new standard of care among brokers and dealers to become effective June 30, 2020. As set forth in the announcement, the obligations imposed by Reg BI apply when a broker-dealer makes a recommendation to a “Retail Customer.” The regulation defines that term to mean a “natural person acting for his or her own account (but not for the account of a business for which the person works), including an individual plan participant, where the recommendation is to be used for personal, family or household purposes.” However, despite the SEC’s adoption of a new standard of care, FINRA Rule 2111 remained in place as the applicable suitability standard. To address potential conflicts and to remove inconsistencies with Reg BI, the Financial Industry Regulatory Authority (FINRA) proposed amendments to the suitability rule to be effective June 30, 2020 to coincide with the implementation date of Reg BI. Specifically, pursuant to Regulatory Notice 20-18 issued on June 19, 2020, FINRA amended its suitability rule (FINRA Rule 2111) to state that it will not apply to recommendations subject to Reg BI. Similarly, FINRA made amendments to the quantitative suitability obligation removing the control element to make it consistent with Reg BI. Third, FINRA conformed the Capital Acquisition Broker (CAB) suitability rule, Rule 211 to the amendments to FINRA Rule 2111, to be consistent with Reg BI. Finally, FINRA also adopted amendments to rules governing non-cash compensation to be consistent with Reg BI’s conflicts of interest rules addressing broker-dealer and issuer-sponsored sales contests based on reaching sales targets within limited periods of time. An overview of the amendments follows.
FINRA’s Suitability Rules and the SEC’s Reg BI
In Regulatory Notice, 20-18, FINRA provided the following statement in an attempt to provide clarity for the amendments:
“Reg BI’s Care Obligation addresses the same conduct with respect to retail customers that is addressed by Rule 2111, but employs a best interest, rather than a suitability standard, in addition to other key enhancements. Absent action by FINRA, a broker-dealer would be required to comply with both Reg BI and Rule 2111 regarding recommendations to retail customers. In such circumstances, compliance with Reg BI would result in compliance with Rule 2111 because a broker-dealer that meets the best interest standard would necessarily meet the suitability standard.”
Both Reg BI and FINRA’s suitability rules apply to standards of conduct but contain key definitional differences. To avoid ambiguity and conflict, FINRA limited its suitability rule to situations in which Reg BI does not apply. As set forth in Reg BI, compliance is met when a broker satisfies four obligations: a Disclosure obligation, a Care obligation, a Conflict obligation, and a Compliance obligation. However, as set forth in Reg BI’s explanation, to satisfy the Care obligation, the broker-dealer will have to satisfy, at a minimum, all of the elements of FINRA’s existing suitability rule (FINRA Rule 2111), plus some additional elements. To the extent Reg BI applies to individual retail customers trading for their own accounts for “personal family or household purposes,” Reg BI is now the applicable standard and Rule 2111 would not apply to retail customers trading for their own accounts. To fulfill a broker-dealers’ customer-specific obligation to institutional investors, pension funds, charitable foundations, and accounts defined by Rule 4512(c), Rule 2111(b) suitability is still the standard. In addition, for other FINRA rules that have suitability components such as FINRA Rule 2330 (Members Responsibilities regarding Deferred Variable Annuities) and FINRA Rule 2360 (Options), the suitability standard remains intact. Those types of accounts would continue to be governed by Rule 2111 (a) and (b).
Additionally, the Supplementary Material to former Rule 2111 (.05) (a)-(c) identify three obligations of suitability - reasonable basis, customer-specific, and quantitative suitability obligations. The prior version of the quantitative suitability obligation, which deals with over-trading and excessive trading, limited the quantitative suitability requirement to members or associated persons who had “actual or de facto control over a customer account.” That limitation has now been eliminated from Rule 2111.05(c) to be consistent with Reg BI.
Finally, FINRA has amended Rule 2310 (c)(2) (Direct Participation Programs), Rule 2320 (Variable Contracts of an Insurance Company), Rule 2341(Investment Company Securities), Rule 5110 (Corporate Financing Rule-Underwriting Terms and Arrangements), and Rule 211 (Capital Acquisition Broker Rules) to clarify that any such non-cash arrangements, awards, contests, prizes, compensation, or payments in all instances must be consistent with the applicable requirements of SEA 151-1(Reg BI). Specifically, the Conflict obligation of Reg BI addresses conflicts of interests as “an interest that might incline a person…consciously or unconsciously . . . to make a recommendation that is not disinterested.” This obligation encourages broker-dealers to address potential conflicts such as financial incentives for sales persons, and eliminates sales contests based on sales of specific securities within a limited time period requiring disclosure of “material facts.” The changes to the above rules regarding non-cash compensation are consistent with the goals of Reg BI to eliminate conflicts between broker-dealers and their retail customers and to promote full disclosure if they cannot be eliminated.
The releases by both the SEC and FINRA apply to broker and dealer conduct after June 30, 2020. There will be a number of cases and situations involving broker conduct that occurred before June 30, 2020 in which FINRA arbitration cases will lead to differing views about what standard of conduct applies to the accounts in question and the scope of the broker-dealer’s supervisory obligations. FINRA’s amendments to Rule 2111 and the non-cash compensation rule amendments aim to create more clarity going forward. However, the SEC’s statement regarding Reg BI still leaves open the issue of “what is in the best interest of a retail customer depends on the facts and circumstances of a recommendation at the time it is made, including matching the recommended security or investment strategy to the retail customer's investment profile at the time of the recommendation.”
For more information on this announcement, contact the authors of this alert. Visit our Securities Litigation & FINRA Practice page for more alerts in this area.
Clint A. Corrie, Partner
Michael Gonzales, Associate