Nearly ten years ago, FINRA decided to update its old suitability rule, NASD Rule 2310. It had been around a long time, and while it seemed to work fine, FINRA decided to incorporate into the new amended rule – FINRA Rule 2111 – some new concepts. One such concept concerned recommendations to hold. Under the old rule, only recommendations to purchase, sell or exchange a security had to be suitable. Under the new rule, FINRA added to that list recommendations to hold, provided, of course, that such recommendations are “explicit.”
And that’s been the law of the land since July 2012. There was a great deal of consternation, at first, as firms tried to figure out what, exactly, constituted an explicit recommendation to hold, and, more troubling, the best way to capture such recommendations from a books-and-records perspective. (Since no order ticket is generated by a hold recommendation, firms had to come up with some method of memorializing them, and that was a bit tricky.) But, really, it hasn’t turned out to be that big of a deal. To be honest, I don’t think I’ve ever seen a FINRA disciplinary action that involved an allegation that a broker made an unsuitable recommendation to hold.
The only place where recommendations to hold have managed to become the focus of any attention are in customer arbitrations, particularly cases where the recommendation to buy the investment at issue was made a long time ago. Pursuant to the “eligibility rule,” FINRA Rule 12206, for a claim even to be eligible for arbitration, the Statement of Claim must be filed within six years of the date of the event or occurrence which gives rise to the claim. Thus, if the purchase was made more than six years before the Statement of Claim was filed, the case is subject to dismissal. To avoid such dismissals, clever lawyers representing investors bake into their Statements of Claim vague allegations that at some time – typically no date is specifically identified – within the six-year period preceding the filing of the Statement of Claim, the BD and/or the broker made an unsuitable recommendation to hold the investment at issue. These claims serve one purpose: to avoid dismissal for being untimely. At the hearings, if the cases get that far, claimants devote almost no effort to pursue their hold claims.
Anyway, apart from that particular situation, no one really pays much attention to recommendations to hold, since it’s pretty hard to establish that a recommendation was sufficiently explicit to be actionable.
Under Regulation BI, however, things will be different. The reason is that Regulation BI states that, under certain circumstances, even implicit recommendations to hold must be suitable. This will undoubtedly open the door both to increased regulatory actions and customer arbitrations.
What are the circumstances? According to the SEC,
when a broker-dealer agrees with a retail customer to monitor that customer’s account . . . such agreed-upon monitoring involves an implicit recommendation to hold (i.e., recommendation not to buy, sell, or exchange assets pursuant to that securities account review) at the time the agreed-upon monitoring occurs, which is a recommendation “of any securities transaction or investment strategy involving securities” covered by Regulation Best Interest.
What’s troubling about this to me is that the SEC has also concluded that “[a]n agreement to provide account monitoring services to a retail customer is not required to be in writing.” Thus, “a broker-dealer’s oral undertaking that the broker-dealer will monitor the retail customer’s account on a periodic basis would create an agreement to monitor the account on the terms specified orally.”
That, my friends, is quite the slippery slope, opening the door to potentially ugly arguments about who said what to whom about account monitoring. In an entirely unhelpful passage addressing this issue, the SEC says, “[w]hether an agreement with the retail customer has been established in the absence of a written agreement or express oral undertaking will depend on an objective inquiry of the particular facts and circumstances, including reasonable retail customer expectations arising from the broker-dealer’s course of conduct.”
Ugh. The dreaded “facts and circumstances” regulatory cop out. That means it’s going to be the wild west. No legal precedent, no guidance from the regulators, just lawyers posturing about what they think the SEC meant.
So, is there anything to do about it, to avoid this problem? It seems that there is. After announcing this problematic standard, the SEC offered this advice:
In cases where a broker-dealer does not intend to create an implied agreement to monitor the retail customer’s account through course of conduct or otherwise, and to avoid ambiguity over whether an implied agreement has been formed, broker-dealers should take steps to ensure that all communications with the retail customer are consistent with its disclosures required under the Disclosure Obligation, which in this case would require the broker-dealer to clearly disclose that the broker-dealer does not monitor the retail customer’s account.
I am not entirely clear what this means. But, on its face, it appears to say that if a BD wants to avoid having any of customer being able to establish that the firm orally agreed to monitor his or her accounts – thus subjecting the firm to an argument that it made unsuitable albeit implicit recommendations to hold – the BD must clearly and consistently deny, in writing, that it monitors accounts. As you can divine for yourself, this is hardly a foolproof defense, since no matter what is disclosed in writing, it doesn’t mean the customer can’t claim he was orally told something different by his broker. But, hey, if the SEC says this is what you need to do, then, by all means, load up your customer agreement with disclaimers about account monitoring.
What’s the good news? Clearly, according to the SEC, there is no duty to monitor a customer’s account in the absence of an agreement to do so. That may seem like an obvious, uncontroversial proposition to some of you. I can assure you, however, that when defending a customer arbitration, it is extremely common for the claimant to argue that my client had some duty – after making the initial recommendation to buy the security at issue – to monitor the account on an ongoing basis, and, based on market conditions, to make some other recommendation (typically to sell and buy something else). Most hearing panels understand this duty doesn’t actually exist, but there are a couple of old reported cases out there from random jurisdictions that employ language sloppy enough to support a duty-to-monitor argument, and claimants’ counsel can be counted on to trot out these same decisions, case after case. In light of the SEC’s new pronouncement, however, that argument goes out the window.
One final point. The SEC isn’t stupid, and understands that its view that an implicit recommendation to hold must be suitable is contrary to FINRA’s suitability rule, which applies only to explicit hold recommendations. In an effort to assuage any concern that it is dissing FINRA, the SEC said that it
recognizes that its position with respect to Regulation Best Interest differs from that provided in FINRA guidance regarding whether implicit hold recommendations are subject to the suitability rule. This interpretation applies in the context of the protections of Regulation Best Interest, and does not change the scope of the application of the FINRA suitability rule. Further, while for purposes of Regulation Best Interest implicit hold recommendations are generally recommendations of “any securities transaction or investment strategy regarding securities” where a broker-dealer agrees to provide account monitoring services, we are not otherwise addressing the treatment of implicit hold recommendations in other contexts. In other words, except where a broker-dealer agrees to provide account monitoring services as described, consistent with existing FINRA guidance, Regulation Best Interest will only apply to explicit hold recommendations.
Ok, so both views are valid? I can’t wait to see how this let’s-figure-out-if-there-was-an-agreement-to-monitor thing plays out.
