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Apr 10, 2020

FINRA Proposes Amendments to Suitability and Non-Cash Compensation Rules in Response to Regulation Best Interest

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FINRA PROPOSES AMENDMENTS TO SUITABILITY AND NON-CASH COMPENSATION RULES IN RESPONSE TO REGULATION BEST INTEREST

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.

The implementation of Regulation BI resulted in certain tensions and inconsistencies between the provisions of Regulation BI and the rules promulgated by the Financial Industry Regulatory Authority, Inc. (FINRA).[3] In light of this, FINRA has proposed amendments to certain of its rules governing suitability and non-cash compensation (the “Proposal”), which were published in the Federal Register on March 25, 2020.[4] The goal of the Proposal is to provide clarity on which standard applies with respect to certain FINRA rules and to address inconsistencies with Regulation BI.

Overview of the Proposal

The proposed amendments include revisions to:

  • The suitability obligations under FINRA Rule 2111;
  • The suitability obligations for capital acquisition brokers (CABs) under FINRA Rule 211; and
  • Certain non-cash compensation provisions of FINRA Rules 2310 (Direct Participation Programs), 2320 (Variable Contracts of an Insurance Company), 2341 (Investment Company Securities) and 5110 (Corporate Financing Rule—Underwriting Terms and Arrangements).[5]

This note considers each of these provisions in turn.

Proposed Amendments to Suitability Rules

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. Of the four specific mandatory component obligations of Regulation BI, the Care obligation contains requirements similar to that of FINRA 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).[6]

The implementation of Regulation BI resulted in key substantive and applicability differences and ambiguities between Regulation BI and FINRA Rule 2111.[7] The Proposal seeks to clarify the applicability of these two suitability frameworks and harmonize certain provisions of FINRA Rule 2111 with those of Regulation BI. To that end, the Proposal:

  • Amends the “quantitative suitability” obligation under FINRA Rule 2111 Supplementary Material .05 to remove the caveat that the obligation only applies if the broker-dealer has actual or de facto control over a customer account[8]; and
  • Adds a new provision, FINRA Rule 2111 Supplementary Material .08, stating that FINRA Rule 2111 will not apply to recommendations subject to Regulation BI.

The Proposal also amends FINRA Rule 211, the suitability rule applicable to CABs, to state that it will not apply to recommendations subject to Regulation BI.

The tables set forth below provide an overview of the substantive and applicability differences between Regulation BI and current FINRA Rule 2111, and highlights how the Proposal will affect these differences.

REGULATION BI AND FINRA RULE 2111—KEY SUBSTANTIVE DIFFERENCES

 

REGULATION BI

CURRENT FINRA RULE 2111

PROPOSED AMENDMENTS TO 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

No change

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)

No change, although FINRA Rule 2111 will not apply to recommendations subject to Regulation BI

Quantitative Suitability

Applies regardless of whether broker-dealer has actual or de facto control over the customer’s account[9]

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

Will apply regardless of whether broker-dealer has actual or de facto control over the customer’s account

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

No change

 

DOES REGULATION BI OR FINRA RULE 2111 APPLY?

 

REGULATION BI

CURRENT FINRA RULE 2111

PROPOSED AMENDMENTS TO FINRA RULE 2111

Natural persons, or the legal representative of such natural person, using recommendation primarily for personal, family or household purposes[10]

Yes

Yes (less than $50 million in total assets)

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

FINRA Rule 2111 will not apply to recommendations subject to Regulation BI.

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

No

Yes (less than $50 million in total assets)

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

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)

Yes (non-institutional accounts)

Exemption Available (institutional accounts)

Proposed Amendments to Non-Cash Compensation Rules

Under the Conflicts of Interest obligation of Regulation BI, broker-dealers must establish, maintain and enforce written policies and procedures reasonably designed to identify and eliminate any sales contests, sales quotas, bonuses and non-cash compensation that are based on the sales of specific securities or specific types of securities within a limited time period.

Currently, FINRA Rules 2310 (Direct Participation Programs), 2320 (Variable Contracts of an Insurance Company), 2341 (Investment Company Securities) and 5110 (Corporate Financing Rule—Underwriting Terms and Arrangements) each contain provisions with respect to prohibited and permissible forms of non-cash compensation. Among the currently permitted forms of non-cash compensation are certain internal firm sales contests. These provisions may permit sales contests that would be prohibited under Regulation BI, such as contests based on sales of specific types of securities.

In light of this, the Proposal seeks to modify these rules to specify that any permissible form of non-cash compensation must also be consistent with the requirements set forth in Regulation BI. In addition, FINRA proposes to eliminate certain provisions in Rules 2320 and 2341 requiring broker-dealers to base internal non-cash compensation arrangements on total production and equal weighting of securities sales.

Conclusion

As set forth above, the Proposal seeks to provide clarity with respect to Regulation BI’s effect on certain FINRA rules and address inconsistencies with Regulation BI. Broker-dealers may wish to review the Proposal in anticipation of Regulation BI’s June 30, 2020 compliance date, and evaluate how these changes may affect their Regulation BI implementation plans.

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]  For additional information with respect to these differences, you may wish to refer to our client publications: “Navigating the Co-Existence of Regulation Best Interest and FINRA Rule 2111 and “SEC Publishes Frequently Asked Questions on Regulation Best Interest”.
[4]  Notice of Filing of a Proposed Rule Change to FINRA’s Suitability, Non-Cash Compensation and Capital Acquisition Broker (CAB) Rules in Response to Regulation Best Interest, 85 Fed. Reg. 16,974 (Mar. 25, 2020).
[5]  FINRA has also recently adopted and set an implementation date for other substantive changes to FINRA Rule 5110. For additional information with respect to these amendments, you may wish to refer to our client publication: “FINRA Amends Corporate Financing Rule”.
[6]  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.

[7]  For additional information with respect to these differences, you may wish to refer to our client publication: “Navigating the Co-Existence of Regulation Best Interest and FINRA Rule 2111”.
[8]  This harmonization was originally proposed by FINRA in April of 2018, shortly after Regulation BI was proposed. 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
[9]  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).”).
[10]  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.
[11]  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.

Authors and Contributors

Russell Sacks

Partner

Financial Institutions Advisory & Financial Regulatory

+1 212 848 7585

+1 212 848 7585

New York

Jennifer D. Morton

Partner

Financial Institutions Advisory & Financial Regulatory

+1 212 848 5187

+1 212 848 5187

New York

Steven Blau

Associate

Financial Institutions Advisory & Financial Regulatory

+1 212 848 8534

+1 212 848 8534

+1 416 360 2154

+1 416 360 2154

New York

Jenny Ding Jordan

Associate

Financial Institutions Advisory & Financial Regulatory

+1 212 848 5095

+1 212 848 5095

New York

P. Sean Kelly

Associate

Financial Institutions Advisory & Financial Regulatory

+1 212 848 7312

+1 212 848 7312

New York

Taylor Pugliese

Associate

Financial Institutions Advisory & Financial Regulatory

+1 212 848 7294

+1 212 848 7294

New York