Regulatory Outlook | 02.04.19
Client Suitability Remains a Regulatory Focus in 2019
With new advisor customer-care rules inching closer to being finalized by the Securities and Exchange Commission (SEC), industry members should brace for a 2019 that will surely bring continued emphasis on suitability.
Regulators, as usual, certainly seem preoccupied with the term and concept of retail customer suitability. This issue is a veritable thicket of compliance duties — and it soon could become thornier.
Shortly before Christmas, the Financial Industry Regulatory Authority (FINRA) released its annual Examination Findings Report. It begins with "Highlighted Observations" on noteworthy trends. The lead-off section includes an overview of situations relating to "Suitability for Retail Customers."
FINRA issues the report as a roadmap for firms to buttress supervisory controls, and no specific firms are uncompliant shamed.
- Situations where registered representatives did not adequately consider the customer’s financial situation when making recommendations. In other words, "profile factors," such as investment experience, risk tolerance, time horizon, objectives and liquidity needs were either ignored or never learned.
- Examples of reps failing to take into account total costs (i.e., cumulative fees, sales charges or commissions).
- Cases of unsuitable recommendations involving complex products, including leveraged Exchange Traded Products (ETPs). Volatility-linked products proved particularly unsuitable and problematic, especially in February 2018 when some of them suffered steep declines.
Although FINRA flagged it in 2018, reps recommending unsuitable mutual fund share classes and Unit Investment Trusts nevertheless still remains an area of concern in 2019.
"Regarding suitability, I suspect that we will continue to see FINRA and the SEC bring enforcement cases and perhaps even more of them," said Dan Viola, Partner at New York law firm Sadis & Goldberg.
Proposed SEC Rules Get Stricter
As currently drafted, the SEC's "Regulation Best Interest" (Reg BI) would go further than the current FINRA Rule No. 2111 (Suitability). The latter establishes a "fundamental responsibility for firms and associated persons to deal with customers fairly."
The rule contains three suitability obligations that advisors must satisfy: reasonable basis, customer-specific and quantitative.
Reg BI has a different definition of retail customer compared to FINRA’s suitability rule, to which registered reps are beholden.
"The FINRA suitability rule is not as protective as Reg BI," Viola said.
That's because Reg BI mandates that conduct not only be suitable on a reasonable basis in client-specific context and quantitatively, but also the rep cannot put their financial or other interests ahead of those of the retail customer, Viola explained.
Last summer, Robert Cook, FINRA’s president and CEO, attempted to differentiate between FINRA's suitability rule and the SEC’s advice standards proposal, Reg BI. FINRA's suitability rule “implicitly requires a broker-dealer's recommendations to be consistent with customers' best interests,” Cook wrote in a letter to Senate Democrats. However, he explained, the SEC's proposed Reg BI for brokers “explicitly establishes the customer's best interest as an overarching standard of care."
In the August 3, 2018, letter, Cook also said the SEC's proposals extend in “certain significant areas” the requirements for broker-dealers under current FINRA rules, including the suitability rule. The SEC proposals clarify the rules that apply to broker-dealers, Cook wrote.
FINRA and the SEC both have a role in supervising broker-dealer compliance, consistent with SEC rules. That would continue to be the case with approval of Reg BI, should it come to be.
“FINRA does not independently interpret the SEC’s rules,” Cook said in his letter. “Rather, FINRA examines broker-dealers for compliance with the SEC’s rules and enforces those rules in a manner consistent with the SEC’s authoritative interpretations.”
Even with Reg BI still on the drawing board, FINRA, which is considered a Self-Regulatory Organization (SRO), somehow managed to find examples of best interests not being served.
In a variety of situations last year, FINRA examiners observed how reps had put clients in unsuitable investment products not only because they failed to understand the needs of the client, but also because they didn’t understand the products (the reps conducted "inadequate product due diligence" per the FINRA report).
Failure to understand the specific features and terms of products recommended to customers was a common misstep, FINRA found.
“Hard Blocks” and Other Best Practices
FINRA observed firms with sound supervisory practices, specifically pertaining to the issue of suitability. Firms on solid supervisory footing generally identified pitfalls and problem areas, and developed policies to combat them by implementing a regimen tailored to the specific nature of the products they offered and their customer base.
These control measures included, for example, restricting or prohibiting recommendations of products for certain investors, as well as establishing systems-based controls, known as “hard blocks,” for recommendations of certain products to retail investors to ensure that registered representatives adhered to those restrictions or prohibitions, the FINRA report said.
Some firms also implemented methods to verify the source of funds for variable annuity transactions, the report said. In addition, certain firms required registered representatives, including principals with supervisory responsibilities, to receive training on specific complex or high-risk products before the representatives recommended them. This ensured representatives understood the products’ risks and performance characteristics, as well as the types of investors for whom the product might be suitable, the FINRA report said.
Back at the start of 2018, FINRA, spelling out its coming examination priorities, made a point to target dually registered brokers, or dual hats — those professionals who can act as both brokers and investment advisors. What was the worry?
"FINRA will review situations in which registered representatives recommend a switch from a brokerage account where that switch clearly disadvantages the customer, such as where the registered representative recommended that the customer purchase a securities product subject to a front-end sales charge in a brokerage account and then shortly thereafter recommends that account be transferred to a fee-based account," the letter stated.
Although regulation of investment advisors is mainly within the purview of the SEC, there is a role for FINRA, and so the SRO endeavors to keep in lockstep with the federal agency. FINRA’s jurisdiction mainly applies to broker-dealers, but FINRA occasionally regulates investment advisors to some extent, particularly when a dually registered firm is making recommendations impacting both brokerage and advisory accounts.
Rich Blake A veteran journalist based in New York City, Blake has covered the financial world for numerous publications, including Institutional Investor, ABCNews.com and Reuters. Blake was a co-founder and executive editor of Trader Monthly magazine. The Buffalo native is the author of three nonfiction books, including “The Day Donny Herbert Woke Up,” which is currently being adapted into a motion picture. In 2004, Blake was nominated for a National Magazine Award in the Reporting category for Institutional Investor.