FINRA Regulatory Notices Demonstrate Focus on Excessive Trading, Supervision

April 27, 2018

While the securities industry focused on parsing the Securities and Exchange Commission’s recently proposed best-interest standard and speculating about the ultimate fate of the Department of Labor’s vacated fiduciary rule, the Financial Industry Regulatory Authority issued two important Regulatory Notices regarding brokers’ liability for excessive trading and firms’ supervisory responsibilities over registered representatives.

First, on April 20, FINRA issued Regulatory Notice 18-13 requesting comment on proposed amendments to brokers’ quantitative suitability obligation under Rule 2111. As currently written, quantitative suitability requires a broker who has control over a customer’s account to have a reasonable basis for believing that a series of transactions the broker recommends are not excessive and therefore unsuitable. (Quantitative suitability is often referred to as “churning.”)

The control exercised by a broker can be either de jure, as when a broker has formal discretionary authority over an account, or de facto, as when the evidence shows that a customer routinely follows the broker’s advice because the customer is unsophisticated. De facto control historically has been difficult to prove. As FINRA explained in its notice, de facto control assessments “can be difficult to make and they place a heavy and unnecessary burden on customers by, in effect, asking them to admit that they lack sophistication or the ability to evaluate a broker’s recommendations.” Regulators often have felt constrained from bringing an action when the turnover ratios are particularly high, but the broker does not have actual or de facto control.

FINRA’s proposed amendments would remove the element of control from the quantitative suitability obligation. Importantly, the rule would retain the “recommendation” element. In support of this change, FINRA noted that the requirement of control came from the codification of historical case law regarding culpability for excessive trading under the anti-fraud provisions of the federal securities laws. FINRA believes that the control requirement is not necessary because a broker’s recommendation of the series of transactions, if excessive, demonstrates culpability even absent a showing of control. As FINRA notes, the need to establish control is “unnecessary,” given the requirements and obligations in the suitability rule.

To further support its position, FINRA points to the SEC’s recently proposed Regulation Best Interest, which states that the fact that a customer may have some knowledge of financial markets or some control over his or her account should not absolve a broker of ultimate responsibility for his or her recommendations. FINRA also argued that the control element “may impede investor protection … because of the difficulty in assessing and proving de facto control” under the current rule.

The proposed amendments would not alter what constitutes “excessive and unsuitable” trading under Rule 2111, and FINRA explained in its notice that there is already extensive case law concerning when trading activity is deemed excessive. However, the removal of the control element — if codified — very likely will lead to a greater number of excessive trading actions brought by FINRA Enforcement. In its request for comment, FINRA noted that it is seeking input from firms on how they monitor for excessive trading and whether the continuing requirement that a transaction be recommended is sufficient to ensure that culpability rests with the appropriate party. Because the amendments likely would make it easier for FINRA to bring excessive trading actions against brokers who do not have discretion (and therefore do not have de jure control), firms whose brokers must seek client authorization before trading may be particularly interested in commenting.

Second, on April 24, FINRA issued Regulatory Notice 18-14 seeking comment on the efficacy of Rule 3110(a)(7), which requires each registered representative to participate at least once a year in a compliance meeting or interview. The request for comment comes as part of a retrospective review of the rule, in which FINRA will first assess its effectiveness (in part, through seeking comments from interested parties) and then determine whether additional steps are required. These additional steps may include modifications to the rule, updated or additional guidance, or other administrative changes.

In the notice, FINRA focused in particular on its guidance that the annual compliance meeting need not be in person but, if it is conducted remotely, the firm must ensure that each registered person attends the entire meeting. For example, if the annual compliance meeting takes the form of an online presentation, a firm may require participants to affirmatively click through the slides of the presentation and complete an attestation at the end. FINRA seeks comments from firms regarding whether the rule furthers the supervision of registered persons, and, in particular, the factors that firms consider in deciding whether to conduct in-person or remote compliance meetings. The notice highlights not only FINRA’s ongoing evaluation of how firms meet their supervisory responsibilities, but also its interest in how firms are using technology in this space.

McGuireWoods’ experienced broker-dealer/investment adviser team will continue to monitor and report on important regulatory compliance updates. For more information, contact the authors of this article or any member of the team.