Home Compliance The Rise of a New FINRA Risk & How to Navigate It

The Rise of a New FINRA Risk & How to Navigate It

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Reg BI says brokers should act in the best interest of their retail customers, but are they? Sarah Hutchins and Corri Hopkins of Parker Poe dig into the details of the SEC’s first Reg BI enforcement action and consumer claims to reveal where advisers are still being tripped up.

Broker-dealers face increasing risks tied to a 2019 regulation that had previously flown under the radar: Regulation Best Interest — Reg BI for short. Both the SEC and the Financial Industry Regulatory Authority (FINRA) took their first disciplinary actions to enforce the regulation last year. In addition, the number of claims customers filed alleging a Reg BI violation surged last year, increasing faster than any other type of FINRA arbitration claim.

As regulators and individual investors become increasingly familiar with Reg BI, broker firms should ensure they are following best practices under the new standards. That includes establishing policies and procedures to satisfy Reg BI’s disclosure requirements, conducting annual mandatory employee training related to Reg BI and reevaluating broker compensation models to eliminate conflicts of interest.

What is Reg BI?

Reg BI is an SEC regulation that imposes upon brokers the obligation to act in the “best interest” of their retail customers and to avoid putting their own interests ahead of their customers’. The “best interest” standard requires brokers to comply with four component obligations: care, disclosure, conflict of interest and compliance, explained below in more detail

  • Disclosure: This requires a broker to provide a retail customer with a written “full and fair disclosure” of all material facts related to the capacity in which the broker is acting, the costs associated with the retail customer’s transactions, the type and scope of services provided to the customer and any material limitations on recommended products, among other things.
  • Care: This requires brokers to exercise “reasonable diligence, care and skill” in making a recommendation, including understanding the risks and costs of a recommendation, and not placing the best interests of the broker ahead of the customer.
  • Conflicts of interest: This obligation requires brokers to establish and enforce written policies and procedures designed to, among other things, identify, disclose, and mitigate conflicts of interest associated with a recommendation, and identify and eliminate any sales contest, quotas, bonuses, and non-cash compensation that is based on the sales of specific securities.
  • Compliance: This requires brokers to establish and enforce written policies and procedures designed to achieve compliance with Reg BI.

In addition to these federal requirements, several U.S. states have incorporated at least part of the Reg BI standards into laws governing financial professionals. For example, Texas, Hawaii, South Dakota and Ohio appear to have adopted the requirements of Reg BI in full. North Carolina, on the other hand, recently adopted a rule that requires financial professionals to comply with standards similar to those in Reg BI when recommending annuity products. 

The purpose of Reg BI

The SEC has said the purpose of Reg BI is to enhance investor protections by improving the quality of recommendations made to retail customers. To achieve these goals, Reg BI imposes a heightened standard of care on brokers that loosely mirrors the fiduciary duties owed by investment advisors under federal law.

Brokers and investment advisors are subject to different legal standards because they offer different services and are compensated under different models. Brokers typically provide transaction-specific recommendations to customers and are often compensated in the form of commissions earned on each transaction. This compensation model raises an inherent conflict of interest between a customer and its broker, who may be incentivized to increase its own compensation at the expense of the customer. 

To mitigate this inherent conflict, brokers have long been subject to FINRA Rule 2111, commonly known as the “Suitability Rule.” The rule requires brokers to have a reasonable basis for believing that a particular recommendation is appropriate for a customer, based on that customer’s investment profile. The Suitability Rule, however, does not require brokers to act in a customer’s best interest.

By contrast, investment advisers typically provide ongoing financial services by managing a customer’s investment portfolio, and they are often compensated through a fixed-fee arrangement. Unlike brokers, investment advisers owe fiduciary duties to their customers under the Investment Advisers Act of 1940. By requiring that brokers act in a customer’s best interest, Reg BI elevates the standard of care owed by brokers to a similar standard to that owed by investment advisers under the Advisers Act.

SEC & FINRA enforcement of Reg BI

On June 15, 2022 — nearly two years after Reg BI went into effect — the SEC brought its first Reg BI enforcement action in federal court in California in the case of SEC v. Western International Securities. The SEC alleged that a broker firm and several representatives failed to satisfy their care and compliance obligations under Reg BI by selling more than $13 million in high-risk bonds to customers with only moderate risk tolerance on their investor profile and by failing to maintain and enforce policies designed to achieve compliance with Reg BI.

Prior to this enforcement action, the SEC settled 27 claims against brokers and investment advisers for failing to timely file Form CRS, a customer relationship summary that requires disclosure of much of the information required by Reg BI.

FINRA took its first disciplinary action under Reg BI a few months later, imposing a six-month suspension and a $5,000 fine on a broker for “recommending a series of transactions in the account of one retail customer that was excessive in light of the customer’s investment profile and therefore was not in that customer’s best interest,” according to FINRA.

FINRA arbitrations involving Reg BI

Recent data released by FINRA suggests that customers are beginning to include claims for violation of Reg BI in lawsuits filed through the FINRA arbitration process. In 2022, customers filed 216 arbitration actions alleging a violation of Reg BI. That is more than five times as many claims as the year before, far and away the steepest increase of any type of claim. 

While customer claims for breach of fiduciary duty (1,340) and negligence (1,261) still far outnumber those under Reg BI, that may soon change. The sixth-most commonly asserted customer claim in 2022 was suitability (416), which involves allegations that a broker recommended products that do not fit the customer’s investment profile under FINRA’s Suitability Rule. Because Reg BI and the Suitability Rule both obligate brokers to act reasonably when making recommendations to customers, attorneys may not hesitate to add a claim for violation of Reg BI to lawsuits that assert suitability claims. And, because the standard to satisfy Reg BI is higher than the standard required under the Suitability Rule, allegations that a broker violated Reg BI could be even more enticing to claimants’ attorneys than suitability claims. 

Importantly, despite the increase in Reg BI customer claims, Reg BI does not expressly create a private right of action. In fact, the SEC has said that it “do[es] not believe Regulation Best Interest creates any new private right of action or right of rescission[.]” However, customer-claimants in FINRA arbitrations routinely assert claims for violation of industry standards for which there is no private right of action, and thus the lack of a private right of action under Reg BI may not deter such claims. More concerning for brokers, however, is the possibility that the heightened standards in Reg BI may serve as the industry standard of care for a negligence claim or similar tort.

Despite the looming threat of customer claims under Reg BI, brokers should not panic. So far, FINRA arbitration panels have only issued arbitration awards in two cases involving alleged violations of Reg BI and, in both cases, the customer-claimants were unsuccessful.

Best practices

The first SEC enforcement action and the customer claims under Reg BI serve as important reminders that brokers should ensure that their conduct and internal policies and procedures follow the new Reg BI standards. SEC and FINRA have provided brokers with an array of guidance documents that suggest best practices for achieving compliance with Reg BI. Some of those best practices include the following:

  • Conduct annual mandatory employee training related to Reg BI. In the two years since the regulation became effective, FINRA has conducted more than 570 reviews of firms for compliance with Reg BI. FINRA found that firms that did not satisfy the rule often failed to continually train employees on Reg BI’s new standards. As a result, brokers who only received training on Reg BI before it went into effect often failed to comply with their firm’s updated policies, such as by recommending affiliated products to customers in violation of a firm’s new conflict of interest policies. The SEC recommends firms conduct Reg BI employee training on an annual basis.
  • For dually registered professionals, clarify the capacity in which you are making recommendations to customers. Reg BI assumes that dual-registrants create new account disclosures related to the capacity in which they are making recommendations.
  • Ensure that any brokers who are not dually registered as investment advisors do not use “advisor” or “adviser” in their title. While this is not an express requirement of Reg BI, SEC and FINRA guidance documents strongly recommend this step to avoid violation of the disclosure obligation.
  • Reevaluate broker compensation models to eliminate conflicts of interest, particularly for firms that offer affiliated products. Reg BI imposes express limitations on broker compensation models in an effort to eliminate conflicts of interest. FINRA found that one firm successfully obviated a potential conflict of interest by providing identical compensation incentives to brokers for recommendations of affiliated and unaffiliated products.
  • Establish policies and procedures that satisfy Reg BI’s new disclosure requirements. Consider creating specific policies that satisfy each of Reg BI’s requisite disclosures. For example, a specific policy might identify the circumstances in which a broker must disclose the basis for a particular recommendation to a retail customer.

Establish recordkeeping practices that satisfy Reg BI’s new disclosure requirements. For example, the SEC recommends that brokers record the basis for their recommendations, “especially for more complex, risky or expensive products and significant investment decisions, such as rollovers and choice of accounts,” as a potential way to demonstrate compliance with the care obligation. Likewise, the agency recommends that brokers follow any oral disclosure with a timely written disclosure summarizing the oral communication.

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