On April 2, Securities and Exchange Commission (SEC or Commission) Chairman Jay Clayton announced that the SEC will not extend the June 30, 2020 compliance date for Regulation Best Interest (Reg BI) despite the coronavirus disease 2019 (COVID-19) pandemic and work-at-home status of many industry employees. During a conference call held on March 24, 2020, by the National Society of Compliance Professionals, senior SEC staff noted that the possibility of a Reg BI compliance date delay had been brought to the attention of SEC leadership.
In explaining the SEC’s rationale for standing by the compliance date, Chairman Clayton noted that particularly in times of uncertainty, investment professionals should not put their interests ahead of the interests of their clients and customers, and Reg BI codifies this fundamental principle. The Commission believes that “firms with account relationships comprising a substantial majority of retail investor assets have made considerable progress in (1) adjusting their business practices, (2) supplementing and modifying their policies and procedures, and (3) otherwise aligning their operations and preparing for the requirements of Reg BI and the obligation to file and begin delivering Form CRS.” Accordingly, the SEC believes the current compliance date remains appropriate.
Consistent with past guidance, Chairman Clayton emphasized that firms “should continue to make good faith efforts around operational matters to ensure compliance by June 30, 2020, including devoting resources as necessary and available in light of the circumstances.” Firms are encouraged to engage with the Commission about disruptions caused by COVID-19, and the Commission and the staff will “take the firm-specific effects of such unforeseen circumstances (and related operational constraints and resource needs) into account in our examination and enforcement efforts.” Chairman Clayton noted that the Office of Compliance Inspections and Examinations will be issuing two Risk Alerts in the coming days to provide additional information about the scope and content of initial examinations for Reg BI and guidance for broker-dealers and investment advisers with respect to Form CRS.
Other securities regulators are continuing their efforts to be prepared as well. Earlier this month the Financial Industry Regulatory Authority, Inc. (FINRA) submitted proposed rules changes to the Commission to conform certain FINRA rules with Reg BI and leave in place current suitability rules for customers not covered by Reg BI. The proposal would amend:
- FINRA Rule 2111 (Suitability);
- FINRA Rule 2310 (Direct Participation Programs);
- FINRA Rule 2320 (Variable Contracts of an Insurance Company);
- FINRA Rule 2341 (Investment Company Securities);
- FINRA Rule 5110 (Corporate Financing Rule – Underwriting Terms and Arrangements); and
- Capital Acquisition Broker (CAB) Rule 211 (Suitability).
FINRA’s proposal (1) amends its suitability rules to state that they do not apply to recommendations subject to Reg BI and to remove the element of control from FINRA’s quantitative suitability obligation and (2) conforms the remaining rules, which have similar provisions concerning non-cash compensation, to Reg BI’s limitations on sales contests, sales quotas, bonuses, and non-cash compensation.
FINRA proposes to make its rule changes effective on the Reg BI compliance date. Comments on the FINRA proposal are due by April 15, 2020. On its COVID-19 pandemic webpage, the SEC acknowledges that comments may be delayed due to the pandemic and notes its long-standing practice of considering comments submitted after a comment period closes but before adoption of a final rule or order.
Best interest and suitability
As described in our prior alert, in June 2019, the SEC adopted Reg BI, a new rule that establishes a standard of conduct for broker-dealers and their associated persons when they recommend securities transactions or investment strategies involving securities to a retail customer. A retail customer is defined as a natural person, or the legal representative of such natural person, who receives a recommendation of any such securities transaction or investment strategy from a broker-dealer or its associated persons and uses the recommendation primarily for personal, family or household purposes.
The key differences between Reg BI and FINRA’s suitability rules are the standard of conduct, which is higher under Reg BI, and the different definitions of retail versus institutional customers (as described in more detail below). To reduce the potential for conflict or confusion, FINRA proposes to limit the application of its suitability rules to circumstances in which Reg BI does not apply. To do so, FINRA would simply add new text to the rules stating that they do not apply to recommendations subject to the SEC rule.
FINRA’s suitability rule, Rule 2111, requires that a broker-dealer have a reasonable basis to believe that a recommended transaction or investment strategy is suitable for the customer, based on the information obtained through the reasonable diligence of the broker-dealer to ascertain the customer’s investment profile. The investment profile includes the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, and risk tolerance. The suitability obligation under Rule 2111 has three components: reasonable basis suitability, customer-specific suitability, and quantitative suitability. Reasonable basis suitability requires a broker-dealer to have a reasonable basis to believe that the recommendation is suitable for at least some investors. Customer-specific suitability requires a broker-dealer to have a reasonable basis to believe that the recommendation is suitable for a particular customer based on that customer’s investment profile. Quantitative suitability requires a broker-dealer that has actual or de facto control over a customer account to have a reasonable basis for believing that a series of recommended transactions, even if suitable in isolation, are not excessive and unsuitable for the customer when taken together.
Rather than defining the term “retail customer,” FINRA provides an exemption to customer-specific suitability for recommendations to institutional customers under specified circumstances. For this exemption to apply, three criteria must be satisfied:
- The account must meet the definition of “institutional account” found in FINRA Rule 4512(c), ie, an account for (1) a bank, savings and loan association, insurance company or registered investment company; (2) an investment adviser registered either with the SEC or with a state securities commission; or (3) any other person (including a natural person, as well as any corporation, partnership, trust or otherwise) with total assets of at least $50 million;
- The broker-dealer must have a reasonable basis to believe that the institutional customer can evaluate investment risks independently, both in general and with regard to particular transactions and investment strategies involving a security or securities; and
- The institutional customer must affirmatively indicate that it is exercising independent judgment in evaluating the recommendation.
Reg BI’s “best interest” standard requires firms to satisfy four component obligations: disclosure, care, conflict of interest and compliance, with the care obligation incorporating and enhancing principles that are also found in Rule 2111. Those enhancements include the higher best interest standard that also applies to account type recommendations, as well as a requirement to consider costs and reasonably available alternatives. Reg BI also eliminates the “control” element of the quantitative suitability obligation.
To reconcile these differences, FINRA’s proposal leaves its suitability rules in place for all persons who do not fall under the Reg BI definition of retail customer. Thus, accounts for individuals with $50 million or more in total assets can no longer be treated as institutional accounts because Reg BI has no comparable wealth threshold. However, according to FINRA, its suitability rules are still needed for entities and institutions (eg, pension funds), as well as for natural persons who will not use recommendations primarily for personal, family, or household purposes (eg, small business owners and charitable trusts). FINRA also would modify the quantitative suitability obligation to remove the element of control that currently must be proved to demonstrate a violation, thus aligning the obligation with Reg BI.
FINRA Rules 2310, 2320, 2341, and 5110 include restrictions on non-cash compensation in connection with the sale and distribution of securities governed by those rules. Generally, these rules permit:
- Gifts of $100 or less in value that are not preconditioned on the achievement of a sales target;
- An occasional meal, a ticket to a sporting event or the theater, or other comparable; entertainment that does not raise any question of propriety and is not preconditioned on the achievement of a sales target;
- Payment or receipt by “offerors” (generally product sponsors and their affiliates) in connection with training or education meetings, subject to certain conditions, including that compensation is not conditioned on achieving a sales target; and
- Internal non-cash compensation arrangements between a broker-dealer and its associated persons, subject to specified conditions. If the internal non-cash compensation arrangement is in the form of a sales contest, the contest must be based on the total production of associated persons with respect to all securities within the rule’s product category, and credit for those sales must be equally weighted.
Reg BI’s Conflict of Interest Obligation 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. To achieve consistency with Reg BI, FINRA proposes to modify its rules to specify that any non-cash compensation arrangement permitted by those rules must be consistent with the requirements of Reg BI and eliminate provisions in Rules 2320 and 2341 that require internal non-cash compensation arrangements to be based on total production and equal weighting of securities sales. Accordingly, broker-dealers would no longer be permitted to sponsor or maintain internal sales contests based on sales of securities within a product category within a limited time, even if they are based on total production and equal weighting, and the requirement also would apply to the non-cash compensation provisions governing gifts, business entertainment and training or education meetings.
If you have any questions concerning FINRA’s proposal or need assistance in preparing for Reg BI, please contact your DLA Piper relationship partner or a member of the DLA Piper Financial Services team.
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This information does not, and is not intended to, constitute legal advice. All information, content, and materials are for general informational purposes only. No reader should act, or refrain from acting, with respect to any particular legal matter on the basis of this information without first seeking legal advice from counsel in the relevant jurisdiction.