New Finra suitability rules worry industry
July 9, 2012 by Dan Jamieson
B-Ds see broad interpretation as approaching a fiduciary standard
By Dan Jamieson
July 5, 2012
A major revamp of suitability mandates taking effect July 9 has some in the broker-dealer world worried about much broader obligations to oversee customer accounts and investment strategies.
Of particular note is guidance Finra issued in late May about the new rule. The guidance is seen by some as coming awfully close to a fiduciary standard for broker-dealers and registered representatives.
Overall, the rule requires brokers to perform reasonable diligence on products, understand those investments and have a reasonable basis to believe that a security or investment strategy is suitable. It also adds age, investment experience, time horizon, liquidity needs and risk tolerance to the list of factors that affect a suitability determination.
Perhaps of most concern to broker-dealers, the rule imposes suitability obligations on investment strategies. In its rule filing, the Financial Industry Regulatory Authority Inc. said the term “investment strategy” would be interpreted broadly and cover a recommendation to hold an investment as well as a “buy” or “sell” recommendation.
The rule was approved by the SEC in November 2010. Implementation was delayed to July 9, 2012, to give the industry time to prepare.
Adding to concerns is the May guidance from Finra (Regulatory Notice 12-25), which laid out a “best interests” standard of care for customers. The notice also said the new suitability rule would apply to “potential” customers and to “investment-related” products that were not securities.
The notice “was surprising to us and some of our [brokerage] clients, coming so quickly before the implementation was to occur,” said W. Hardy Callcott, a partner at Bingham McCutchen LLP.
“It has caused people to go back to the drawing board on some of the training” they had developed for registered representatives, Mr. Callcott said.
The best-interests standard in particular caught some off guard, since the Securities and Exchange Commission is working on developing a fiduciary standard under the Dodd-Frank Act.
“Usually, when you talk about a fiduciary duty, ‘best interests’ is the standard you use,” said Brian Rubin, a partner at Sutherland Asbill & Brennan LLP.
Mr. Callcott thinks Finra is trying to get a jump on overseeing a fiduciary duty in an attempt to bolster its case for getting oversight of advisers.
For its part, Finra said most the changes in the new suitability rule simply codify case law and past interpretations.
“The requirement that a broker’s recommendations be consistent with the customer’s best interests is not a new standard,” said Finra spokeswoman Michelle Ong in an email.
Regarding a best-interests standard, Finra cited a number of enforcement cases that have held that brokers’ recommendations must be consistent with customers’ best interests.
“Despite what Finra says, I do not think that is what has been the Finra standard,” Mr. Callcott said. “They should have proposed [the best-interests standard] as part of the rule change.”
The rule itself doesn’t mention a best-interests standard, so brokers are still obligated only to make suitable recommendations, said Joel Beck, founder of The Beck Law Firm LLC.
Still, “best interest is rather subjective,” Mr. Beck added. “For that reason, it’s problematic.”
In its notice, Finra said a best-interests standard doesn’t mean brokers have to sell the lowest-cost product.
Finra’s May notice also resurrected a controversial effort to get broker-dealers to more closely supervise non-securities activities in which their representatives may be involved, such as mortgages or insurance.
“Suitability obligations apply … to a broker’s recommendation of an investment strategy to use home equity to purchase securities or to liquidate securities to purchase an investment-related product that is not a security,” the notice said.
In 2009, Finra asked for comment about expanding suitability obligations to any product or service made in connection with a firm’s business, whether or not it was a security. But it backtracked on that idea after encountering industry opposition.
The latest notice “seems like a bit of jurisdiction creep,” said Lisa Roth, chief executive of Keystone Capital Corp.
“It gets fuzzy when you get into issues of where do you get the money” to buy a non-security, said Gary Sanders, vice president of securities and state government affairs for the National Association of Insurance and Financial Advisors.
But tracking sources of funds used to purchase securities has always been part of the suitability rule, Mr. Sanders said.
The impending changes have caused broker-dealers to scramble to figure out how to oversee various strategies and document the supervisory process.
The most challenging issue is defining and tracking what strategies a representative is recommending, observers said, including recommendations to hold an investment that are not recorded in any trade records.
“You’ve got to understand what the overall [customer] profile and strategy is, and where [their] account fits into it,” Ms. Roth said.
The new rule is “kind of broad and gray,” she said.
A good example of that uncertainty is figuring out exactly to whom the rule applies, now that potential clients are covered, Mr. Callcott said.
“It’s the ‘cocktail party’ rule, as I call it, where you have a conversation with someone,” Mr. Callcott said. “That could be a recommendation you have to capture in the firm’s system.”
Despite the uncertainty over the new rule, Mr. Rubin said it’s unlikely that Finra will take any immediate enforcement action against firms that have made an effort to comply.
