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.
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REGULATION BI AND FINRA RULE 2111—KEY SUBSTANTIVE DIFFERENCES
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REGULATION BI
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CURRENT FINRA RULE 2111
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PROPOSED AMENDMENTS TO FINRA RULE 2111
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Broker-Dealer Obligations
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Four distinct obligations under the general obligation of Regulation BI:
- Disclosure;
- Care (Suitability);
- Conflicts of Interest; and
- Compliance
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- Suitability requirements
- Detailed guidance regarding recordkeeping
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No change
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Customer Applicability
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All “retail customers” (as defined in Regulation BI)
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All customers, although there is an exemption available for “institutional accounts” (including natural persons with total assets of at least $50 million)
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No change, although FINRA Rule 2111 will not apply to recommendations subject to Regulation BI
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Quantitative Suitability
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Applies regardless of whether broker-dealer has actual or de facto control over the customer’s account[9]
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Only applies when the broker-dealer has actual or de facto control over the customer’s account
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Will apply regardless of whether broker-dealer has actual or de facto control over the customer’s account
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Types of Recommendations
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- “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
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- “Standard” recommendations; and
- Explicit recommendations to hold a security
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No change
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DOES REGULATION BI OR FINRA RULE 2111 APPLY?
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REGULATION BI
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CURRENT FINRA RULE 2111
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PROPOSED AMENDMENTS TO FINRA RULE 2111
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Natural persons, or the legal representative of such natural person, using recommendation primarily for personal, family or household purposes[10]
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Yes
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Yes (less than $50 million in total assets)
Exemption Available ($50 million or more in total assets)
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FINRA Rule 2111 will not apply to recommendations subject to Regulation BI.
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Natural persons, or the legal representative of such natural person, using recommendation primarily for commercial or business purposes
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No
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Yes (less than $50 million in total assets)
Exemption Available ($50 million or more in total assets)
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Yes (less than $50 million in total assets)
Exemption Available ($50 million or more in total assets)
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Entities
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No
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Yes (non-institutional accounts)
Exemption Available (institutional accounts)
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Yes (non-institutional accounts)
Exemption Available (institutional accounts)
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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
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