FINRA Proposes Rule Changes to Conform to Reg BI
Commentary by Steven Lofchie
FINRA proposed modifying its suitability requirements and rules governing non-cash compensation to conform to the stricter standards of Regulation Best Interest ("Reg BI").
According to FINRA, the proposed rule changes would: (i) amend the FINRA and Capital Acquisition Broker ("CAB") suitability rules "to state that the rules do not apply to recommendations subject to" Reg BI, and "to remove the element of control from the quantitative suitability obligation"; and (ii) to "conform the rules governing non-cash compensation to Reg BI’s limitations on sales contests, sales quotas, bonuses and non-cash compensation."
FINRA is proposing that its suitability requirements do not apply to recommendations subject to Reg BI; i.e., recommendations to natural persons. FINRA's purpose is to make clear that the stricter standards of Reg BI will govern broker-dealer recommendations, when both Reg BI and the FINRA Rules as currently written would apply. In addition to its application to FINRA Rule 2111 (Suitability), the FINRA amendments would apply to Rule 2310 (Direct Participation Programs), Rule 2320 (Variable Contracts of an Insurance Company), Rule 2341 (Investment Company Securities), Rule 5110 (Corporate Financing Rule - Underwriting Terms and Arrangements), and Capital Acquisition Broker Rule 211 (Suitability). The FINRA suitability rules would continue to apply to recommendations outside the scope of Reg BI; e.g., recommendations made to legal entities other than natural persons.
FINRA is also removing the requirement that an allegation of the "quantitative" element of the suitability rule (a churning violation) include an assertion that the broker-dealer exercised control over the relevant account.
FINRA is modifying its rules governing non-cash compensation arrangements to provide that any such arrangements must be consistent with the stricter standards of Reg BI. As described in the proposing notice:
"Thus firms generally 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. This requirement also would apply to the non-cash compensation provisions governing gifts, business entertainment and training or education meetings. As discussed above, these forms of non-cash compensation may not be preconditioned on achievement of a sales target."
If the SEC approves the proposal, FINRA will notify market participants in the Federal Register no later than 60 days following the approval. The effective date of the rule changes will be the compliance date of Reg BI.
Commentary
On a substantive basis, this rule proposal may be seen as a non-event. Broker-dealers must adhere to the rules of both the SEC and FINRA. Where the two regulators have adopted requirements as to the same topic; e.g., suitability, and the SEC's rules are tougher, the FINRA rules are effectively irrelevant. This FINRA rule proposal simply recognizes that legal reality, and is thus of no real substantive effect.
From a process standpoint, however, this rule proposal raises a more significant question: what role does, or should, "self-regulation" have in the securities markets. Effectively, Regulation BI made irrelevant what was arguably FINRA's most important conduct regulations. The result is that FINRA's role is that of being a non-governmental enforcement agency for a governmental rule. It is hard to describe that role as "self-regulation," particularly as FINRA will have no legal authority to interpret the SEC's rule.
This diminution in FINRA's role is but the continuation of a long-term trend. The most significant, though not the earlier, marker of this trend were the amendments to the Securities Exchange Act made in 1975 (Public Law 94-29), where Congress gave the SEC authority in SEA Section 19 to approve or disapprove any rule change made by FINRA, and even to force FINRA to adopt such rule changes as the SEC might require. See, e.g. SEA Rule 19b-4 (Filings with respect to proposed rule changes by SROs). See also, "SEC Proposes to Delete "S" from SRO," a memorandum from 2005 on the diminishing role of SROs (and note one of the authors).
The diminishing significance of the SROs is not an issue specific to FINRA. After all, the exchanges are now private corporations. One can make any number of arguments as to both the potential value or, conversely, as to the ultimate ineffectuality of self-regulation. What is not in dispute is that there is much less "self-regulation" in the securities markets than there appears to be. Whether that is a good or bad thing is a question worthy of some greater focus.
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