Dec 13, 2019

Navigating the Co-Existence of Regulation Best Interest and FINRA Rule 2111

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Introduction

On June 5, 2019, the U.S. Securities and Exchange Commission (SEC) adopted Regulation Best Interest (“Regulation BI”).[1] The goal of Regulation BI is to improve investor protection by: (1) enhancing the obligations that apply when a broker-dealer makes a recommendation to a retail customer[2]; and (2) reducing the potential harm to retail customers from conflicts of interest that may affect such recommendations.

Among other obligations, Regulation BI requires that broker-dealers act in the best interest of the retail customer at the time a recommendation is made, without placing the financial or other interest of the broker-dealer ahead of the interests of the retail customer. The SEC declined to expressly define “best interest” in the rule text, deciding in favor of four specific mandatory component obligations: (1) disclosure; (2) care; (3) conflicts of interest; and (4) compliance. Of these components, the care obligation contains requirements similar to that of FINRA Rule 2111 (Suitability) (“Rule 2111”), which sets forth certain suitability standards applicable to customer recommendations.

While Regulation BI applies only to retail customers, Rule 2111 applies to all customers of a broker-dealer, albeit with an exemption available for institutional accounts, as defined in FINRA Rule 4512(c).[3] This creates both overlap between these two frameworks and instances where only Rule 2111 applies. One question that we continue to hear is “how might regulation BI and Rule 2111 co-exist?” Since the adoption of Regulation BI, FINRA has not published guidance regarding either the specific impact of Regulation BI on Rule 2111 or any proposed amendment to Rule 2111 in the face of the adoption of Regulation BI.[4]

This note examines the co-existence of Regulation BI and Rule 2111. Part II outlines key differences between these two frameworks. Part III considers when Regulation BI or Rule 2111 (or both) may apply to customer recommendations. Part IV provides certain challenges that may arise from the co-existence of these two frameworks.

Regulation BI and FINRA Rule 2111—Key Substantive Differences

Currently, there are a number of key substantive differences between the two frameworks. The table set forth below highlights certain of these differences.

REGULATION BI AND FINRA RULE 2111 – KEY SUBSTANTIVE DIFFERENCES

 

REGULATION BI

FINRA RULE 2111

Broker-Dealer Obligations

Four distinct obligations under the general obligation of Regulation BI:

  • Disclosure;
  • Care (Suitability);
  • Conflicts of Interest; and
  • Compliance
  • Suitability requirements
  • Detailed guidance regarding recordkeeping

Customer Applicability

All “retail customers” (as defined in Regulation BI)

All customers, although there is an exemption available for “institutional accounts” (including natural persons with total assets of at least $50 million)

Quantitative Suitability

Applies regardless of whether broker-dealer has actual or de facto control over the customer’s account[5]

Only applies when the broker-dealer has actual or de facto control over the customer’s account[6]

Types of Recommendations

  • “Standard” recommendations;
  • Explicit recommendations to hold a security;
  • Recommendations with respect to account types and rollovers; and
  • Implicit hold recommendations resulting from agreed-upon account monitoring
  • “Standard” recommendations; and
  • Explicit recommendations to hold a security
 

Regulation BI and FINRA Rule 2111—Applicability Differences

Given the substantive differences between the Regulation BI and Rule 2111 frameworks, a question arises with respect to what framework applies for any given recommendation made by a broker-dealer. The table set forth below captures when Regulation BI or Rule 2111 (or both) may apply.

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DOES REGULATION BI OR FINRA RULE 2111 APPLY?

 

REGULATION BI

FINRA RULE 2111

Natural persons, or the legal representative of such natural person, using recommendation primarily for personal, family or household purposes[7]

Yes

Yes (less than $50 million in total assets)
Exemption Available ($50 million or more in total assets)

Natural persons, or the legal representative of such natural person, using recommendation primarily for commercial or business purposes[8]

No

Yes (less than $50 million in total assets)
Exemption Available ($50 million or more in total assets)

Entities

No

Yes (non-institutional accounts)
Exemption Available (institutional accounts)

Compliance and Applicability Questions

The co-existence of Regulation BI and Rule 2111 may lead to fact patterns that raise questions regarding compliance with, and the applicability of, these two frameworks, including:

  • Has a broker-dealer provided a recommendation when a natural person customer with total assets of at least $50 million is advised with respect to the opening of a specific type of account? Is the answer different if the person is seeking the recommendation for business purposes?
  • What quantitative suitability standard applies for natural person customers with less than $50 million in total assets? (Note: we assume that the more inclusive standard under Regulation BI would apply)
  • Does the implicit hold recommendation language of Regulation BI apply to a natural person customer who has arranged for periodic monitoring across all accounts (business and personal)?
  • Is there any substantive difference between personal, family or household purposes and commercial or business purposes for certain customers (e.g., ultra-high-net-worth clients and family offices)?

Conclusion

Currently, Regulation BI and Rule 2111 present similar, but substantively different, frameworks regarding recommendations to customers, with which broker-dealers will need to ensure compliance. Because instances remain where Rule 2111 would apply and Regulation BI would not, FINRA will likely need to amend Rule 2111 (including its applicability and current exemption language) in order to harmonize Rule 2111 with the Regulation BI framework. FINRA does, however, have time to consider appropriate changes; broker-dealers will have until June 30, 2020 to comply with the requirements of Regulation BI. Regardless, broker-dealers will need to consider the impact that the continued existence of these two frameworks will have on existing policies, procedures and practice with respect to customer recommendations.

Footnotes

[1]  Regulation Best Interest: The Broker-Dealer Standard of Conduct, 84 Fed. Reg. 33,318 (July 12, 2019) (the “Regulation BI Adopting Release”) (codified at 17 C.F.R. 240.15l–1). For a comprehensive summary of Regulation BI, you may wish to refer to our client publications: “Raising the Bar? SEC Proposes Broker-Dealer Standard of Care and Guidance on Investment Advisers’ Fiduciary Standard” and “Raising the Bar: SEC Adopts Broker-Dealer Standard of Care and Guidance on Investment Advisers’ Fiduciary Duty”.

[2]  Regulation BI defines “retail customer” to mean “a natural person, or the legal representative of such natural person, who: (A) receives a recommendation of any securities transaction or investment strategy involving securities from a broker, dealer, or a natural person who is an associated person of a broker or dealer; and (B) uses the recommendation primarily for personal, family, or household purposes.”

[3]  FINRA Rule 4512(c) defines “institutional account” as:

(1) a bank, savings and loan association, insurance company or registered investment company;

(2) an investment adviser registered either with the SEC under Section 203 of the Investment Advisers Act of 1940 or with a state securities commission (or any agency or office performing like functions); or

(3) any other person (whether a natural person, corporation, partnership, trust or otherwise) with total assets of at least $50 million.

[4]  Shortly after Regulation BI was proposed in April of 2018, FINRA requested comments with respect to a proposed amendment to Rule 2111 that would harmonize the quantitative suitability provisions of Rule 2111 with those of Regulation BI. See Quantitative Suitability, FINRA Regulatory Notice 18-13 (Apr. 2018) https://www.finra.org/sites/default/files/notice_doc_file_ref/Regulatory-Notice-18-13.pdf. To this point, however, FINRA has not taken action to adopt this proposal.

[5]  See Regulation BI Adopting Release at 33,444-33,445 (noting that “[i]n contrast [to FINRA Rule 2111], the Care Obligation requires that a broker-dealer or its associated person has a reasonable basis to believe that a series of recommended transactions is not excessive and is in that retail customer’s best interest. This is the case at all times—when the broker-dealer or associated person has actual or de facto control over a customer’s account as well as when no control exists (whether actual or de facto).”).

[6]  See FINRA Rule 2111.05(c).

[7]  Under Regulation BI, the SEC interprets “personal, family or household purposes” to mean any recommendation to a natural person for his or her account, other than recommendations to natural persons seeking investment services for commercial or business purposes. See Regulation BI Adopting Release at 33,343.

[8]  Neither Regulation BI, nor its adopting release provides a definitive definition for “commercial or business purposes,” but the adopting release does provide certain examples of what activities may fall within this category (e.g., “an employee seeking services for an employer or an individual who is seeking services for a small business or on behalf of another non-natural person entity such as a charitable trust”). See Regulation BI Adopting Release at 33,343.

 

Autoren und Mitwirkende

Russell Sacks

Partner

Financial Institutions Advisory & Financial Regulatory

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+1 212 848 7585

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Jennifer D. Morton

Partner

Financial Institutions Advisory & Financial Regulatory

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Steven Blau

Associate

Financial Institutions Advisory & Financial Regulatory

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+1 212 848 8534

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Jenny Ding Jordan

Associate

Financial Institutions Advisory & Financial Regulatory

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+1 212 848 5095

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P. Sean Kelly

Associate

Financial Institutions Advisory & Financial Regulatory

+1 212 848 7312

+1 212 848 7312

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Taylor Pugliese

Associate

Financial Institutions Advisory & Financial Regulatory

+1 212 848 7294

+1 212 848 7294

New York