As financial professionals grapple with a new regulatory mandate for the suitability of investment advice, a leading industry advocacy group is continuing its opposition to two key provisions of the new rules from the Financial Industry Regulatory Authority (FINRA) that took effect Monday.
The Financial Services Institute (FSI), which represents broker-dealers and advisers who will be affected by the new rule, is warning that the expansion of the suitability standard to include investment strategies and hold recommendations creates new uncertainties and potentially burdensome compliance obligations.
FINRA's Rule 2111 mandates that brokers conduct "reasonable diligence" to understand a recommended security or investment strategy and its potential risks and rewards. The suitability rules also require brokers to have a "reasonable basis" for recommending a security or investment strategy to a customer based on an investor profile and, in cases where the broker controls the customer's account, to refrain from making excessive securities transactions.
But for financial firms, particularly independents, the new rule invites the worrisome possibility that all manner of client interactions concerning investment options could fall under the suitability standard, according to David Bellaire, FSI's general counsel and director of government affairs.
"One of our concerns is that FINRA makes it clear in its rule that the term 'investment strategies' is to be interpreted broadly," Bellaire said. "Since firms are required to review the suitability of these investment strategies, it's questionable whether that's a fair requirement for firms to be experts on things outside of their business."
For instance, if a client mentions to a broker-dealer that he is considering liquidating holdings in a mutual fund to invest in real estate, will the broker-dealer be expected to have conducted "reasonable diligence" on the property his client is thinking of buying before responding?
"That goes far afield from the business that our members are engaged in of selling securities and monitoring the suitability of those securities," Bellaire said, warning that the rule sets "no outside limit" on what constitutes a covered investment strategy.
FINRA is indeed giving itself a wide berth in overseeing investment strategies. Two spokeswomen for the self-regulatory organization did not immediately respond to requests for comment, but FINRA's most recent guidance on the rule offers an expansive definition.
"Not only does the new rule now explicitly cover recommended investment strategies involving a security or securities, but it also states that the term 'investment strategy' is to be interpreted 'broadly' and includes recommendations to 'hold' a security or securities," FINRA explained.
"The new rule would cover a recommended investment strategy involving a security or securities regardless of whether the recommendation results in a securities transaction or even mentions a specific security or securities," it said.
FSI intends to continue to press FINRA to further clarify and limit the scope of the investment strategy provision.
FINRA has already included some boundaries. Most broad recommendations that customers invest in equities or fixed-income securities, for instance, would be exempted from the investment strategy provision of the suitability standard, but more targeted advice, such as steering customers toward high-dividend companies, would be covered.
FSI is also concerned about the provision of the suitability rule that would cover "explicit" recommendations to hold a security.
As a practical matter, that could saddle firms with a significant burden in collecting data on interactions for which no record is typically created.
"It's very easy for firms to monitor a transaction," Bellaire said. "Things happen -- products are purchased or sold."
But "the recommendation to hold is a situation where suitability rules now apply in which there is no clear moment, no resulting transaction," he added.
FINRA is also adding new factors that comprise a customer's investment profile. Brokers must now consider the customer's age, investment experience, time horizon, liquidity needs and risk tolerance, in addition to factors such as tax status and investment objectives that were outlined in FINRA's earlier rule.
In its advocacy on the issue, FSI succeeded in winning exemptions to the data-collection mandates in cases where the information is considered irrelevant, so that certain types of accounts might not have to include the customer's age, for example.
FSI also scored a victory in holding off implementation of the new suitability standard to give its member companies more time to establish a compliance structure. The Securities and Exchange Commission approved FINRA's new rules in November 2010.
In its guidance on the new rule, FINRA explained that the standard maintains many of the existing provisions of its earlier suitability rule, but adds new and more specific stipulations that the organization says were drawn from case law.
"Existing guidance and interpretations regarding suitability obligations continue to apply to the extent that they are not inconsistent with the new rule," FINRA said.
As an example of those continuities, FINRA cited prior cases when brokers have been found to have violated the suitability rule for pushing one product over another in order to receive a larger commission or because their firm was pressuring them to sell specific securities.
But Bellaire countered that FINRA is understating the extent to which the new provisions represent a departure, pointing to the lengthy "frequently asked questions" section of FINRA's most recent guidance on the rule. That it took 15 pages and 75 endnotes to respond to the uncertainty in the industry suggests that the new rules are not merely a restatement of past precedent and case law.
"I think it's clear that the industry sees that it's more than that," he said.
"I think for the broker-dealer firms there will be a fairly significant additional burden," Bellaire added. "I think this will be an ongoing challenge for broker-dealers -- really learning how to use the data, how to monitor the data, how to ensure compliance and protect the firm from the new risks."
Register or login for access to this item and much more
All Financial Planning content is archived after seven days.
Community members receive:
- All recent and archived articles
- Conference offers and updates
- A full menu of enewsletter options
- Web seminars, white papers, ebooks
Already have an account? Log In
Don't have an account? Register for Free Unlimited Access