FINRA Moves Forward with Proposed Amendments to its Suitability and Non-Cash Compensation Rules

The Financial Industry Regulatory Authority, Inc. filed proposed amendments with the Securities and Exchange Commission on March 19, 2020,¹ to FINRA Rule 2111 (Suitability Rule) and Capital Acquisition Broker (CAB) Rule 211 (Rule 211), as well as to its rules governing non-cash compensation: 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) (collectively, Non-Cash Compensation Rules). If approved by the SEC, the Suitability Rule, Rule 211 and the Non-Cash Compensation Rules (collectively, Proposed Amendments) would:

• Amend the Suitability Rule and Rule 211 to apply only to recommendations that are not subject to Rule 15l-1 (Regulation Best Interest);
• Apply the quantitative suitability requirement of the Suitability Rule to FINRA members and their associated persons even if they do not have actual or de facto control over a customer account; and
• Conform the Non-Cash Compensation Rules to Regulation Best Interest’s limitations on sales contests, sales quotas, bonuses and non-cash compensation.

If approved by the SEC, the effective date of the Proposed Amendments will be June 30, 2020, the compliance date for Regulation Best Interest.² Comments on the Proposed Amendments are due by April 15, 2020.

Background

On June 5, 2019, the SEC adopted Regulation Best Interest, which requires broker-dealers and their associated persons, “when making a recommendation of any securities transaction or investment strategy involving securities (including account recommendations) to a retail customer, [to] act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the [broker-dealer or associated person] making the recommendation ahead of the interest of the retail customer.”³ Regulation Best Interest consists of four obligations: the Disclosure Obligation; the Care Obligation; the Conflict of Interest Obligation; and the Compliance Obligation.

Generally, the Care Obligation requires, in part, that broker-dealers and their associated persons exercise reasonable diligence, care and skill when making recommendations. This obligation includes a requirement to have a reasonable basis to believe that:

• The recommendation could be in the best interest of at least some retail customers;
• The recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile; and
• A series of recommended transactions, even if in the best interest of the retail customer “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.”⁴

The Conflicts of Interest Obligation requires broker-dealers to establish, maintain and enforce written policies and procedures that are reasonably designed to “identify and eliminate any quotas, bonuses, and non-cash compensation that are based on the sales of specific securities or specific types of securities within a limited period of time.”⁵

FINRA filed the Proposed Amendments with the SEC because Regulation Best Interest addresses the same conduct with respect to retail customers as is addressed by FINRA’s Suitability Rule, Rule 211 and the Non-Cash Compensation Rules. The Proposed Amendments are intended to reduce resulting confusion.

Proposed Amendments to the Suitability Rule and Rule 211

The Care Obligation is largely based on the Suitability Rule, which imposes three key suitability obligations requiring a FINRA member or its associated person to have a reasonable basis to believe that:

• based on reasonable diligence, the recommendation is suitable for at least some customers;
• the recommendation is suitable for a particular customer based on that customer’s investment profile; and
• a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together in light of the customer’s investment profile (the “quantitative suitability obligation”).

Unlike Regulation Best Interest, the quantitative suitability obligation of the Suitability Rule applies only to FINRA members and their associated persons who have “actual or de facto” control over a customer account. Other differences between Regulation Best Interest and the Suitability Rule include, among others, that Regulation Best Interest explicitly applies to account recommendations and requires broker-dealers and their associated persons to consider costs when making recommendations. The SEC has also stated that broker-dealers and their associated persons need to consider reasonably available alternatives, and that Regulation Best Interest applies to “implicit” hold recommendations, although FINRA has not interpreted the Suitability Rule to apply to inferred recommendations.

Further, unlike Regulation Best Interest, the Suitability Rule applies to recommendations to institutional customers as well as to retail customers. Similarly, Rule 211 imposes reasonable basis and customer-specific suitability obligations that apply to institutional and retail customers. Nevertheless, both the Suitability Rule and Rule 211 include conditional exemptions from the customer-specific suitability obligation that applies if an institutional customers affirmatively indicates that it is exercising independent judgment.

FINRA proposes to add Supplementary Material .08 to the Suitability Rule and Supplementary Material .03 to Rule 211, which would state that the Suitability Rule and Rule 211, respectively, are inapplicable to recommendations subject to Rule 15l-1.

In addition, FINRA proposes to amend the quantitative suitability obligation so that it applies regardless of whether the FINRA member or associated person has control (whether actual or de facto) of a customer’s account. This change would make the Suitability Rule consistent with Regulation Best Interest, which does not include a “control” element in the Care Obligation. The change also would make it easier to prove a violation of the Suitability Rule.

Proposed Amendments to the Non-Cash Compensation Rules

FINRA Rules 2310(c), 2320(g), 2341(l)(5), and 5110(h) each limit the receipt and payment of non-cash compensation in connection with the sale and distribution of the securities covered by each particular rule. Generally, the only forms of non-cash compensation currently permitted are:

• Gifts of no more than $100 in value if they are not preconditioned on the achievement of a sales target;
• An occasional meal, or a ticket to the theater, a sports event, or other comparable entertainment that does not raise any question of impropriety and is not preconditioned on the achievement of a sales target;
• Payment or receipt by offerors (e.g., product sponsors and their affiliates) in connection with training or education meetings, subject to specified conditions (including that the payment is not conditioned on achieving a sales target); and
• Certain limited internal non-cash compensation arrangements between a FINRA member and its associated persons (including the requirements in FINRA Rules 2320 and 2341 that sales contests must be based on the total production of associated persons with respect to all securities within the rule’s product category, and credit for sales must be weighted equally).

As noted above, the Conflict Obligation of Regulation Best Interest requires broker-dealers to 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. Accordingly, absent the Proposed Amendments, FINRA’s Non-Cash Compensation Rules are inconsistent with Regulation Best Interest because the internal sales contests permitted under these rules may violate Rule 15l-1(a)(2)(iii)(D) (e.g., in circumstances where they only include certain securities, such as mutual funds or variable annuities).

The Proposed Amendments would revise the Non-Cash Compensation Rules to require that these rules comply with Regulation Best Interest. This means that internal sales contests based on sales of securities within a product category during a limited period of time generally would be prohibited, even if such contests are based on total production and equal weighting. This requirement also would apply to non-cash compensation in the form of gifts and business entertainment, as well as training or education meetings.

Conclusion

As part of broker-dealers’ preparation for compliance with Regulation Best Interest, they may want to review their policies and procedures and training modules to determine whether modifications are needed to reflect the Proposed Amendments.

Footnotes

1) FINRA Proposed Rule, 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, Rel. No. 34–88422; File No. SR FINRA 2020 007 (Mar. 19, 2020). 

2) Regulation Best Interest: The Broker-Dealer Standard of Conduct, Rel. No. 34-86031 (June 5, 2019). For further information regarding the compliance date, please refer to Dechert NewsFlash, Firms Should Move Full Steam Ahead on Regulation Best Interest and Form CRS. 

3) Rule 15l-1(a)(1).

4) Rule 15l-1(a)(2)(ii)(C).

5) Rule 15l-1(a)(2)(iii)(D).