After having proudly served for decades, and surviving a dramatic face-lift in 2012 (when old NASD Rule 2310 was replaced by shiny new FINRA Rule 2111), it seems that the “suitability rule,” as we’ve come to know it, has, at long last, been quietly sent out to pasture by FINRA. Although the title of Reg Notice 20-18 – “FINRA Amends Its Suitability . . . Rule . . . in Response to Regulation Best Interest” – suggests that the suitability rule has only been amended, not replaced, that would not be a fair reading of what happened. In fact, with the exception of a few specific circumstances, suitability has been relegated to the clearance rack of regulatory rules. Here is how FINRA phrased its epitaph:
Reg BI’s Care Obligation addresses the same conduct with respect to retail customers that is addressed by Rule 2111, but employs a best interest, rather than a suitability, standard, in addition to other key enhancements. Absent action by FINRA, a broker-dealer would be required to comply with both Reg BI and Rule 2111 regarding recommendations to retail customers. In such circumstances, compliance with Reg BI would result in compliance with Rule 2111 because a broker-dealer that meets the best interest standard would necessarily meet the suitability standard. To provide clarity on which standard applies and to avoid unnecessary duplication, FINRA has amended Rule 2111 to state that it will not apply to recommendations subject to Reg BI.
The problem I have, having read dozens of articles and attended a bunch of pandemic friendly webinars on Reg BI, is figuring out the practical impact of complying with Reg BI. I mean, if you are a registered rep with retail customers, what, if anything, do you need to do differently to demonstrate compliance with Reg BI vs. Rule 2111? Upon closer look, I am beginning to think that it may not amount to much.
Consider, as a starting point, this language from the SEC’s Reg BI Release:
We emphasize that what is in the “best interest” of a retail customer depends on the facts and circumstances of a recommendation at the time it is made, including matching the recommended security or investment strategy to the retail customer’s investment profile at the time of the recommendation, and the process for coming to that conclusion. Whether a broker-dealer has complied with the Care Obligation will be evaluated based on the facts and circumstances at the time of the recommendation (and not in hindsight) and will focus on whether the broker-dealer had a reasonable basis to believe that the recommendation is in best interest of the retail customer.
Later in the same release, the SEC used this “matching” concept in the very same way:
In circumstances where the “match” between the retail customer profile and the recommendation appears less reasonable on its face (for example, where a retail customer’s account objective is preservation of income and the recommendation involves higher risk, or where there are more significant conflicts of interest present), the more important the process will likely be for a broker-dealer to establish that it had a reasonable belief that the recommendation was in the best interest of the retail customer and did not place the broker-dealer’s interest ahead of the retail customer.
Read these excerpts and see if you agree with me that this concept of “matching” is, basically, exactly what RRs and BDs do today under Rule 2111 when making suitability determinations. The same two-step process that has always existed. First, under FINRA Rule 2090, you “use reasonable diligence . . . to know (and retain) the essential facts concerning every customer.” Those “essential facts” are outlined in Rule 2310(a): “the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation.” Then, armed with those facts, you “match” the customer to a recommendation. If the recommendation is a mismatch, e.g., because it is too risky for a customer with a conservative risk tolerance, or provides no liquidity for a customer with liquidity needs, or has a lengthy pay-off for a customer with a much shorter time horizon, then the recommendation may not be suitable.
Seems like the same conclusion will be true under Reg BI, but instead of calling the recommendation “unsuitable,” the regulators will simply say it was not in the customer’s best interest. Maybe this isn’t quite the sea change that people maintain.
Granted, however, not everything will be the same. Importantly, while Reg BI, like Rule 2111, requires that a recommendation “must be based on information reasonably known to the associated person (based on her reasonable diligence, care, and skill) at the time the recommendation is made,” it goes beyond that. Because Reg BI requires that a recommendation be in the retail customer’s best interest, in addition to “matching” the recommendation to the customer’s suitability profile, an RR must also “exercise reasonable diligence, care, and skill to consider reasonably available alternatives offered by the broker-dealer. This exercise would require the associated person to conduct a review of such reasonably available alternatives that is reasonable under the circumstances.”
Now this is something totally new. You not only have to know what you’re recommending, you also have to know what you’re NOT recommending, just in case something else would have been, um, more suitable. Happily (or unhappily, perhaps), the SEC has provided pretty loosy-goosy guidance regarding what this review of “available alternatives” must look like. Indeed, they had the temerity to break out – again, ugh – that old standby, the dreaded “facts and circumstances” standard: “What will be a reasonable determination of the scope of alternatives considered will depend on the facts and circumstances, at the time of the recommendation, including both the nature of the retail customer and the retail customer’s investment profile, and the particular associated persons or groups of associated persons that are providing the recommendations.”
I don’t want to get too deep in the weeds here, so I will cut this off by providing this nugget of good news from the SEC: “A reasonable process would not need to consider every alternative that may exist (either outside the broker-dealer or on the broker-dealer’s platform) or to consider a greater number of alternatives than is necessary in order for the associated person to exercise reasonable diligence, care, and skill in providing a recommendation that complies with the Care Obligation.” So, take heart that you don’t necessarily need to know every stinkin’ product that your BD offers, or that any BD offers.
One last point about this Reg Notice, concerning quantitative suitability, a/k/a churning or excessive trading. This is an age-old problem. The legal framework of a churning case has been the same forever, consisting of three elements: (1) intent to defraud, (2) control of the account by the RR, and (3) excessive trading. FINRA Rule 2111, not surprisingly, comported with that definition. Supplementary Material .05(c) requires that an RR have “actual or de facto control” over an account to be capable of churning it. Well, not anymore.
According to the Reg Notice, “FINRA has also removed the element of control from the quantitative suitability obligation, a change that is consistent with Reg BI.” What?
Sure enough. Reg BI does not require control, either actual or de facto:
[T]he third component of the Care Obligation would require a broker-dealer to exercise reasonable diligence, care, skill, and prudence to have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer’s best interest when viewed in isolation, is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile. The Proposing Release noted that this requirement is intended to incorporate and enhance a broker-dealer’s existing “quantitative suitability” obligation by applying the requirement irrespective of whether a broker-dealer exercises actual or de facto control over a customer’s account, thereby making the obligation consistent with the current requirements for “reasonable basis suitability” and “customer specific suitability.
So now there is a major difference between, on the one hand, what courts and arbitration panels require to establish churning and, on the other hand, what FINRA and the SEC say is necessary. I look forward to seeing how this plays out, as the “control” element often turns out to be the one on which Respondents hang their hats in defending churning cases. If a Claimant no longer has to prove that element, these cases have just become much, much harder to defend. But, since there is no private right of action for breach of a FINRA Rule, or Reg BI, it remains to be seen what standard will, in fact, be applied in churning cases after Reg BI becomes effective next week.
 Because Reg BI applies only to recommendations to “retail customers,” who are defined to be “a natural person, or the legal representative of such natural person, who receives a recommendation of any securities transaction or investment strategy involving securities from a broker-dealer and uses the recommendation primarily for personal, family, or household purposes,” Rule 2111 still applies, therefore to: (1) recommendations to institutional customers under specified circumstances, (2) entities and institutions (e.g., pension funds), and (3) natural persons who will not use recommendations primarily for personal, family, or household purposes (e.g., small business owners and charitable trusts). FINRA also notes that some of its other rules “have a suitability or suitability-like component (e.g., FINRA Rule 2330 (Members’ Responsibilities Regarding Deferred Variable Annuities) and FINRA Rule 2360 (Options))” which are not impacted by the rule changes and will still be viable.