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It's Thumbs Up for New Suitability Rule, but Questions Remain

Posted by Duane Thompson on October 09, 2013 in Regulatory Update

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Little more than a year after FINRA’s new beefed-up suitability rule went into effect, some law firms are crediting the SRO and its members with a successful roll-out.  One prominent law firm, reading between the lines of a report from FINRA on its recent examination observations, declared the updated rule “a fairly successful work in progress.”  Another firm’s analysis interpreted the report as FINRA giving its member firms a “thumbs up on suitability rule compliance.”

Although the new suitability standard sounds like a box office hit, if it’s an effort to align broker suitability recommendations more closely with investment adviser practices, the new rule falls short in a number of areas.

The actual report, published as Regulatory Notice 13-31, is fairly dry and technical.  FINRA states that for the most part firms had adopted policies and procedures to address the new requirements of Rule 2111.  In regulatory parlance, that is perhaps a nice pat on the back for both regulator and its members.

In retrospect, the updated rule was long overdue.  Although many broker-dealers have included some or all of the new suitability factors on their risk tolerance questionnaires for years, it is somewhat surprising that Wall Street’s main regulator took this long to respond to changes in the marketplace.  Effective July 9, 2012, brokers were required to add the customer’s age, investment experience, time horizon and liquidity needs, and risk tolerance to their criteria in making suitable investment recommendations.  Among other things, investment strategies – including a recommendation to buy-and-hold – were added to the suitability menu as well.

FINRA did not say how many firms were examined in the suitability review, but the exercise appears to have been a part of the regular two-year cycle examination of its 4,200 member firms.  According to the report, more than a dozen questions were asked to obtain information about policies and procedures with regard to a firm’s changes to its suitability procedures. 

Overall, the SRO noted that most of the firms had updated their systems, trained staff, and obtained the additional customer information. However, a “small percentage” did not take a comprehensive approach, according to FINRA.

It’s not clear what motivated FINRA to make the changes to its suitability rules other than merging old NASD and New York Stock Exchange rules into its consolidated rulebook.  Given FINRA’s efforts at the time to regulate investment advisers, perhaps another reason was to polish its resume should Congress revisit the adviser SRO issue.  No matter the underlying reasons, by tilting the broker suitability standard closer to a true fiduciary duty of care for retail investment advice, investors should benefit. 

It’s the inattention to the fiduciary duty of loyalty – disclosing and managing conflicts of interest -- that is troubling, but on the flip side of the coin, FINRA’s new rule makes no explicit mention of the higher standard.

FINRA guidance to Rule 2111 did state that brokers' recommendations must be consistent with their customers' "best interests," noting that “some of the cases in which FINRA and the SEC have found that brokers placed their interests ahead of their customers' interests involved cost-related issues.”  However, the case law cited refers to a "fair dealing" commercial standard of conduct, not the fiduciary standard of care.   

FINRA guidance elaborates on the meaning of a best interest standard by providing examples of typical conflicts.  The examples include maximizing commissions at the expense of an appropriate portfolio and a broker recommending new issues pushed by the broker’s firm because of a fear of being terminated for failing to do so. 

Unfortunately, the "best interest" standard is nowhere to be found in the dozen or so questions asked by FINRA examiners, so it remains unclear whether the new suitability rule is making progress in addressing the inherent conflicts of interest that underlie the broker-dealer business model. 

Of course, FINRA has never explicitly stated that it is testing the fiduciary waters with its new rule.  To do so would be politically reckless and a clear preemption of the SEC’s current deliberations over a fiduciary standard for brokers.

The one area in its review where FINRA identified compliance shortcomings was inadequate procedures by some brokerage firms for “hold” recommendations.  In this instance, the absence of documentation was the most commonly cited deficiency although, interestingly, FINRA does not impose explicit documentation requirements.  It should.  Broker-dealers would be well-advised – if they haven't done so already – to take precautionary measures by developing consistent processes for documenting buy-and-hold recommendations.  Next to claims of fiduciary violations in FINRA arbitrations, negligence ranks a close second.

Stepping back for a moment and reviewing this problem in a broader context, the hold recommendation hearkens back to the mid-2000s when fee-based brokerage accounts were examined by FINRA for reverse churning.  This, too, was a form of buy-and-hold but on steroids.  A FINRA sweep of these accounts found significant abuse in which brokers simply collected an asset management fee while doing nothing with the accounts for months at a time and sometimes even "double-dipping" by charging a commission for securities in the portfolios.  Where there was a prolonged period of trading inactivity, FINRA believed that some customers could have benefited more from a commission-based arrangement.  Ironically, some brokers who recommended passive investment strategies were closely questioned by puzzled FINRA examiners over this seemingly unorthodox approach to investing that the regulator imagined could only be reverse-churning.

The new suitability rule, as new and improved as it is over the old one, is still not ready for prime time in the fiduciary space.  But then perhaps it was never intended to compete.  There still appear to be some kinks to be worked out if the SEC eventually adopts a fiduciary standard for Wall Street.  

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