On April 20, 2018, FINRA issued proposed amendments to Rule 2111’s “quantitative suitability” provisions. According to FINRA, the proposal is designed to more effectively counter the problem of “churning,” or excessive trading in customer accounts.
As discussed below, the proposal arrives shortly after the SEC’s proposal of “Regulation BI” and illustrates how these two regulators will need to coordinate in order to ensure that broker-dealers are not subject to inconsistent sets of rules.
The proposal, issued in Regulatory Notice 18-13, may be found here. We have previously discussed the three main obligations imposed by Rule 2111 (reasonable-basis suitability, customer-specific suitability and quantitative suitability) in Frequently Asked Questions which may be accessed here.)
Summary of the Change
FINRA’s new proposal addresses Rule 2111’s quantitative suitability requirements.
The quantitative suitability obligation currently requires a FINRA member (or associated person) who has “actual or de facto control” over a customer account to have a reasonable basis to believe that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together in light of the customer’s investment profile. Excessive trading or “churning” of a customer’s account will typically violate this rule.
The proposed rule amendments would remove the concept of “control” that is currently needed to demonstrate a violation. Under the existing rule, if a broker does not control a customer’s account, the quantitative suitability obligation does not apply when the broker recommends a series of transactions, even if that series of transactions is excessive and unsuitable. Under the proposed amendments, a broker’s conduct would violate the rule even if the broker only recommended the relevant transactions, if the level of trading was excessive and unsuitable for the customer.
In connection with the proposals, FINRA noted that it has reconsidered the appropriateness of the “control” requirement due to its experience with the rule, the other requirements of the rule and, in light of current events, the SEC’s proposed Regulation BI (we discuss the newly-proposed Regulation BI in this blog entry). FINRA notes that Regulation BI, while incorporating a prohibition on excessive trading, does not have a “control” requirement like the one found in current Rule 2111.
FINRA noted that it is not always clear when there is “actual” or “de facto” control over an account. To the extent that de facto control may depend upon whether the customer follows the broker’s advice routines, because it cannot independently evaluate the recommendation, the customer must admit that it lacks sophistication in order to make a claim under the existing provision. This can be the case even where it is otherwise clear that the broker recommended the relevant transactions and that they were excessive. In effect, the control element appears to create an unwarranted defense for otherwise unscrupulous brokers.
FINRA is optimistic that the proposal would impose only modest compliance burdens on members. This is because FINRA believes that most firms already routinely perform compliance reviews for excessive trading activity, whether or not a broker “controls” the relevant account. However, if the proposal is enacted, some member firms may need to update their written supervisory procedures to reflect the change.
Request for Comments
The comment period for this proposal will extend until June 19, 2018. FINRA has set forth a variety of specific and general questions relating to the proposal, including the potential economic impact. FINRA is also seeking confirmation that members do in fact review accounts for excessive trading, whether or not the broker “controls” the account.
We think that it is likely that the SEC and FINRA will coordinate to some extent their rulemaking activities in the next several months, especially while market participants comment on proposed SEC Regulation BI. A degree of harmonization will be needed to ensure that broker-dealers will be subject to SEC rules and FINRA rules that work together effectively and render their compliance obligations clear.