Bates Research - 04-03-20

Reg BI: SEC Keeps June 30th Deadline, FINRA Seeks to Amend Suitability Rule

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Over the past few weeks the coronavirus pandemic has overtaken the nation’s financial agenda and diverted the attention of financial regulators who are struggling to keep up and address urgent market needs. With recent actions to provide temporary delays from certain compliance deadlines and other relief, regulators have worked hard to accommodate the practical difficulties of operating under business contingency plans. These actions have left some firms curious as to whether the rollout of Regulation Best Interest (“Reg BI”) may be affected. Well, the wait is over, and SEC Chair Clayton has finally weighed in. Meanwhile, FINRA has pushed forward amendments to its rules on suitability and non-cash compensation “to provide clarity on which standard applies and to address inconsistencies with Reg BI.” And the SEC has filed a brief in the Second Circuit Court of Appeals arguing for rejection of state petitions for review of the Reg BI final rule. Here’s what you need to know.

The Reg BI Compliance Deadline Will Not Be Delayed 

After reported consideration of requests by broker-dealer advocacy groups like the Financial Services Institute (FSI), SEC Chair Jay Clayton issued a statement saying that the June 30, 2020 compliance date will not be moved. He explained that the agency has been engaged extensively with market participants as well as with FINRA on the implementation of Reg BI and Form CRS, and 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.” 

That said, Chair Clayton did note that if a firm “is unable to make certain filings or meet other requirements because of disruptions caused by COVID-19” the firm should “engage with us.” He stated that “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.” 

Chair Clayton relayed that, following the compliance date, “SEC examiners will be focusing on whether firms have made a good faith effort to implement policies and procedures necessary to comply with Reg BI, while also providing an opportunity to work with firms on compliance and other questions.”  

He also mentioned that the SEC Office of Compliance Inspections and Examinations “will be issuing two Risk Alerts providing broker-dealers with specific information about the scope and content for (i) initial examinations of Reg BI and (ii) Form CRS.” In a nutshell, Chair Clayton was clear: game on.

FINRA Proposes Modifications to Suitability Rules

In its March 12, 2020 rule proposal, FINRA seeks to clarify its existing suitability and non-cash compensation rules in the context of Reg BI. The amendments apply to FINRA Rule 2111 (Suitability), 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).

First, the proposed amendments clarify that these pre-existing FINRA rules would not apply to broker-dealer recommendations for retail customers under Reg BI. Though it may be clear, as FINRA explained, that any broker-dealer in compliance with Reg BI would meet the suitability standard under Rule 2111, FINRA opted to propose to formally limit the application of Rule 2111 to “reduce the potential for confusion.” In so doing, the amendments make explicit that the higher Reg BI standards apply to broker-dealer recommendations for retail customers.

FINRA explained that it is not eliminating the suitability rule altogether. Rather, it is drawing a distinction between Reg BI’s applicability to “retail customers” and the suitability rule’s continuing applicability to “entities and institutions (e.g. pension funds), and natural persons who will not use recommendations primarily for personal, family, or household purposes (e.g. small business owners and charitable trusts.”)

Second, the self-regulatory organization is removing the "element of control from the quantitative suitability obligation," thus removing the requirement that a broker-dealer must exercise control over an account. This is one of the three prongs of the suitability rule (along with “reasonable basis suitability” and “customer-specific suitability”). This change is consistent with considerations contained in Reg BI, which replaces the suitability rule with four “enhanced” obligations: disclosure, care, conflict of interest and compliance.

Third, FINRA is proposing to apply Reg BI’s conflict of interest limitations on sales contests, sales quotas, bonuses and non-cash compensation to its existing rules governing non-cash compensation. The proposed amendments state that going forward, FINRA rule provisions will not permit non-cash compensations arrangements that conflict with Reg BI.

Comments on the FINRA proposal must be submitted by April 15, 2020. Notably, the effective date will be the compliance date of Reg BI.

SEC Defends Reg BI in Court

Back on September 9, 2019, attorneys general of seven states and the District of Columbia sued the SEC, challenging the issuance of Reg BI on numerous grounds. As Bates described previously, the petitioners asserted, in part, that Reg BI is invalid because the SEC exceeded its statutory authority and acted in an arbitrary and capricious manner by issuing the rule. (These are similar arguments as those that were raised in 2018 successfully challenging the Department of Labor’s Fiduciary Duty Rule.) The petitioners asked the Court to vacate and set aside the rule, and to permanently prevent the SEC from “implementing, applying, or taking any action” under it.

On March 3, 2020, the SEC filed a brief responding to these arguments and defending the agency’s issuance of Reg BI. The SEC asserted that the AG’s argument that the agency exceeded its authority in issuing Reg BI “disregards the text of Dodd Frank, which gave the Commission express, but discretionary, power to adopt a rule imposing a standard of care for broker-dealers.” The SEC also defended the process against arbitrary and capricious claims arguing that the “Commission assessed multiple viewpoints and promulgated a standard of conduct tailored to broker-dealers that will enhance protections for investors against potential harms caused by conflicts of interest while preserving investors’ ability to choose the type of relationship and fee arrangement that best suits them.” (Brief at pp.16-17).

The SEC also defended against a claim that retail consumers will be more “confused” by the different standards for broker dealers and investment advisers created by Reg BI. The SEC said that such a claim is unsupported by any evidence.

Finally, the SEC argued that the state AGs are making “only policy arguments” about what they want to see (a uniform fiduciary duty rule for both investment advisers and brokers) rather than what Congress directed the SEC to do (“evaluate multiple alternatives”). The SEC argued that it did exactly what Congress intended when it gave “the Commission broad authority to balance investor protection with access to services.”

Conclusion

Following SEC Chair Clayton’s statement, firms must now set aside any hope for a Reg BI reprieve through a temporary order of relief. FINRA’s proposed amendments leave little doubt that Reg BI will likely be the controlling standard on recommendations to retail customers. That said, as Bates noted previously, getting past the compliance deadline—and a possible Second Circuit decision—does not end the conversation. There is still the conflicting fiduciary regulation promulgated by states like Massachusetts to contend with. But, the momentum toward an end game continues and firms must continue to stay the Reg BI course.


Bates Group’s Compliance team helps firms implement Reg BI and navigate compliance concerning investor and consumer protection standards. To learn more about Reg BI compliance consulting support for your firm, please visit our Reg BI service page or contact Robert Lavigne, Managing Director, Bates Compliance, at rlavigne@batesgroup.com.

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