When FINRA first proposed changes to its broker suitability rules in 2010, industry commenters argued that the regulator should delay action. After all, it looked like a uniform standard of care for both brokers and investment advisors was coming down the pike from the Securities and Exchange Commission. This was cause for concern; broker/dealers didn’t want to re-rip their internal procedures to comply with FINRA's new rules only to turn around and do it all over again for the SEC.
A uniform standard for brokers and investment advisors is almost certainly in the cards. In early 2011, the SEC completed a study, mandated under Dodd-Frank reform legislation, which recommended extending to brokers who advise retail clients the same fiduciary standard that now applies to investment advisors. SEC Chairman Mary Schapiro has said over and over again that this is a high priority. But no definite timeline for rulemaking is set. At this point it’s hard to say how long it will be before a rule is written, what that rule might look like or when it would take effect.
FINRA has decided not to wait, opting to tighten up its suitability requirements. FINRA’s rules will take effect July 9, and some firms are scrambling to figure out just what they mean. Two major components: Suitability will now apply not just to investment security recommendations but to strategy recommendations, too. Also, broker/dealers will become responsible for overseeing certain outside business activities conducted by their advisors. The implications for financial advisors and broker/dealers are huge.
Some say FINRA is overstepping its authority with the new rules. Others say upgrading suitability now is a smart strategic move. Having a tougher standard for investment advice may make FINRA a more credible candidate for the job of overseeing not just broker/dealers but investment advisers, too—and that’s something FINRA has been lobbying hard to win. Because of the way the rule is written, it could also get member firms one step closer to complying with a fiduciary standard, if and when that rule does come down. It could even give the b/d industry a little more lobbying power to get the kind of “business neutral” fiduciary standard it wants.
By now you know the fiduciary standard is considered the higher standard of care. It dictates that the customer’s interests must always come first and that all conflicts of interest must be disclosed. Under suitability rules, an investment recommendation must simply be suitable for the client, not necessarily “best.” Applying suitability does require, however, that the financial advisor know the customer well enough to determine what will suit his or her needs.
The New Suitability Rule
In November 2010, the SEC approved FINRA’s new suitability rule, 2111, which expands NASD Rule 2310. First, the new rule clarifies three main suitability obligations that have only been referenced in case law. It also broadens the list of customer-specific data that must be collected and tracked.
While historically brokers have only had a suitability obligation when recommending securities transactions, the new rule expands that obligation to cover investment strategy recommendations, including purchase of a non-security with proceeds of a security sale, investment in a bond ladder, and use of margin, day trading, or ‘liquefied home equity.’ It also applies to recommendations to ‘hold’ a security or securities. But it may apply to other kinds of strategy recommendations, as well. FINRA has said, “the term ‘investment strategy’ is to be interpreted ‘broadly.’”
One big worry for firms: the application of suitability to a recommendation to purchase non-securities with the proceeds of securities sale. Under the new rules, if an advisor recommends an investor liquidate securities to purchase an investment that is not a security—i.e. real estate or insurance—the advisor then has an obligation to make sure this transaction is suitable for the investor, and his firm is responsible for supervising such a transaction. In the broker/dealer world, such non-securities investments are known as outside business activities (OBAs).
Overstepping Its Boundaries?
In fact, many broker/dealers are so concerned about their responsibility to supervise OBAs, that they plan to take action. In early June, the Financial Services Institute, the advocacy organization for independent b/ds and advisors, held a conference call to discuss the issue.
Why are FSI members up in arms? They are comfortable evaluating the suitability of liquidating certain assets to free up cash, but they don’t have a basis upon which to evaluate non-securities purchases, says Dave Bellaire, general counsel and director of government affairs. They simply don’t have the expertise to judge the suitability of investments such as fine art, real estate, coins, or timber.
This is not an entirely new concept, however; FINRA has made public statements about the need for vigilance when securities are being liquidated to acquire non-security investments. (And in 2008, FINRA barred a broker for recommending customers sell securities to purchase equity indexed annuities that were unsuitable.) But regulatory guidance and the occasional disciplinary action are very different from writing a new rule. Bellaire says FSI is talking with FINRA about adjusting some of the language of the rule or else creating a follow-up amendment that would correct the rule or clarify FINRA’s interpretation.
Don Runkle, chief compliace officer of Raymond James Financial Services, asks whether FINRA is getting out of its jurisdiction with the non-security recommendation clause. Of course, any recommendation that involves swapping out a security for a non-security has major implications for client investment portfolios, and so, seems like fair game for FINRA regulation, but Runkle says the problem is knowing what kinds of parameters apply to the evaluation of the non-securities in such a transaction.
“Is it appropriate to take $500,000 out of your Apple stock today? Well, I don’t know. Part of that depends on what you’re telling the client to do with it. They may do a lot of things that are well outside the scope of anything they do with Raymond James whatsoever.”
Like it or not, the rule is going into effect in early July. Firms can hold on for dear life and hope they can convince FINRA to narrow its interpretation of the application of the suitability standard. But most firms can’t take that bet.
FINRA typically gives an unofficial grace period of about two to three years before enforcing new rules, says Amy Lynch, founder and president of FrontLine Compliance and a former executive in FINRA’s enforcement department. But this is not a new rule. It’s an enhancement of an existing rule, and Lynch expects FINRA to start incorporating it into exams within a year.
Runkle says some b/ds will simply scale back on the kinds of non-securities activities they allow their FAs to get involved with outside the firm because it will be too difficult to determine whether such OBA strategies are appropriate. The problem with this approach is that it could drive advisors away, toward thesegment of the industry. “I think it will just be another push towards the RIA-only front, where [FAs] don’t face these sorts of regulations; they don’t face these sorts of limitations.”
Del Lang, a vice president at Insurance Technologies, agrees that some b/ds are evaluating whether to restrict advisor OBAs, although he hasn’t encountered any that have made a hard and fast decision. Lang is responsible for Insurance Technologies’ VisibleChoice product, an annuity sales and suitability software.
FSI’s Bellaire says advisors should expect more questions on the front end when they request the opportunity to participate in OBAs. They should also expect to see more of a focus on these OBAs during branch office examinations.
FINRA says firms can use a risk-based approach to monitoring these situations—focusing on the “detection, investigation and follow-up of ‘red flags’ indicating that a broker may have recommended an unsuitable investment strategy with both a security and non-security component.”
For FAs, the challenge will be to properly document why every recommendation is suitable. Runkle says broker/dealers will need to require that advisors keep track of what facts and circumstances were in place that made a particular recommendation a good one.
Overseeing Investment Strategy
The broad application of the suitability standard to investment strategy recommendations is also causing concern. Under the new rules, the standard will be triggered when a firm or associated person recommends a security or strategy regardless of whether the recommendation results in a transaction.
“For broker/dealers, that pretty much invites a certain amount of confusion,” says Lang. Lang has also seen a disparity between firms in what they think they need to do to comply with the rule, which points to a certain lack of clarity about how to interpret investment strategy.
Previously, advisors were required to consider a client’s financial picture when determining the suitability of an individual transaction, but now they will have to examine the client’s total financial situation every time they recommend an investment strategy. Seems logical, but it means a lot more work. It has always been good practice to learn as much as possible about the customer, but the new rule adds specific requirements to obtain information, such as annual expenses and transactions per year by asset class and investment holdings held away from the b/d, says David Fetter, CEO of Quadron Data Solutions. Advisors will now have to press for a more comprehensive profile of the customer.
“Fact of the matter is, sometimes clients don’t want to share information about their other investments and accounts,” says George Guerra, a lawyer with Wiand Guerra King in Tampa, Fla.
If the client refuses to provide this comprehensive information, the advisor will have to document his or her attempts to obtain it.
RIAs have a similar challenge, but some say that because the RIA client enters into the relationship expecting more of a financial planning approach, he is better prepared to offer all of his financial information.
Application of the suitability standard to explicit hold recommendations is also troublesome for firms.
Paul Tolley, chief compliance officer at, says only the advisor will know when an explicit hold recommendation occurs. “You can’t prove a negative.”
Hold recommendations will carry a perceived risk, so advisors might start charging a fee for hold advice, says Jodee Brubaker-Rager, chief compliance officer of Geneos Wealth Management. “I think there may be unintended consequences whereby a registered representative may not want to give hold advice. They may just tell the client, ‘I can’t advise you on that, and if you want an advisory relationship where I’m providing you advice, you need to sign an advisory agreement and pay me for that advice.’”
Some firms are worried that this new requirement could hurt the client-advisor relationship because what is now a natural conversation with the client will be stacked with documentation and onerous paperwork, says Lang. (Of course, this is a common refrain when it comes to regulation of any sort.)
A ‘Fundamental Fiduciary’?
The idea of looking at a client’s entire financial picture isn’t new; this is how registered investment advisors and financial planners operate under the SEC’s fiduciary standard. In fact, many believe FINRA’s new regulation to be a precursor to a uniform fiduciary standard for all.
“It’s taking all those practices that are part of a fiduciary standard, that have been inherent in the RIA business for a long time, and they’re applying some of those standards and requirements to thespace,” says Fetter.
Quadron’s broker/dealer clients have expanded new brokerage account applications to include an inventory of transactions that the customer is doing per year. They’re also requiring brokers to gather information on assets held away, and it must total 100 percent. It looks more like the inputs into a financial planning software program, Fetter says.
“The dividing line isn’t more clear between fiduciary and non-fiduciary,” says Blaine Aikin, CEO of fi360. “If anything, it’s getting more fuzzy by this [rule].”
Aikin says some of the language is similar to that of the fiduciary standard. For example, the rule points out that recommendations must be “consistent with the customer’s best interests,” and the rule recognizes that customers may rely on firms’ associated person’s investment expertise and knowledge.
“Reliance is one of the classic ways that you become recognized as operating in a fiduciary capacity,” Aikin says. “It’s certainly well-known that FINRA would like to be the self-regulatory organization for advisers as well as brokers, so that could be an element.”
Guerra agrees. If FINRA does become the regulator for SEC-registered investment advisers, it would be easy for them to tweak the suitability rule a bit and have one rule that applies to everybody. It’s also a way to show they’re poised to become the regulator.
“If they can bring the groups that they do regulate in closer to that fiduciary standard then I think it’s easier to demonstrate, ‘Look, we’re already regulating a group with that standard or close to that standard,’” Guerra says.
As brokers move closer to fiduciary principles with this rule, it may prepare broker/dealers and advisors for a uniform fiduciary standard, whatever that may look like. Some firms, wirehouses in particular, are already preparing for that day, lining up some of their advisors as fiduciaries, fi360’s Aikin says. Such firms recognize that to be competitive with investment advisors, who can call themselves fiduciaries, they need to get out in front of a fiduciary standard. To illustrate, Aikin quotes Wayne Gretzky, the famous hockey player:
“‘You don’t go where the puck is; you go where it’s going to be.’ I think that’s what happening.”