How FINRA Rule 2111 Affects Fee-Based Accounts

Law360, New York (September 10, 2012, 12:01 PM ET) — The Financial Industry Regulatory Authority’s new suitability rule may well have an unintended positive effect on fee-based accounts for member firms. For some time, member firms have grappled with utilization issues relating to fee-based, or so-called “wrap-fee,” accounts. In certain circumstances, the fees charged to fee-based customers may appear to outweigh the actual trading or “activity” in their accounts, and the securities regulators have fined several firms for failing to have systems in place to adequately monitor utilization to identify potentially “underutilized” accounts.

With FINRA’s recent implementation of its new suitability rule, member firms and brokers must address the enhanced requirements and responsibilities created by the new rule. Among the more significant changes, FINRA now considers a recommendation to “hold” a security a “call to action” that is the same as a recommendation to buy or sell a security. Thus, while the new rule imposes more onerous responsibilities on firms and brokers, it may allow them to better address underutilization issues with the regulators by perhaps justifying “limited activity” fee-based accounts.

The New Suitability Rule

With certain notable modifications and additions, FINRA’s new suitability rule — Rule 2111 — is derived from NASD Rule 2310. Rule 2111 codifies the three main interpretations of Rule 2310: (1) reasonable-basis suitability — where a broker must use “reasonable diligence” to determine risks and rewards associated with a security and to determine whether an investment may be suitable for at least some investors; (2) customer-specific suitability — based on a customer’s investment portfolio; and (3) quantitative suitability — where a broker in control of a customer account must ensure that transactions are not excessive when viewed in the aggregate.[1]

Rule 2111 also addresses investment strategies, noting that an “investment strategy” may be considered a recommendation and may be interpreted broadly to include “holds.”[2] And because a recommendation to hold a security, rather than to buy or sell, is now a recommendation that must meet suitability requirements, a transaction in the traditional sense does not actually need to occur for brokers to be subject to the new suitability rule.[3]

When considering whether a recommendation is suitable for an investor, brokers must now consider additional factors prescribed in Rule 2111 such as age, investment experience, time horizon, liquidity needs and risk tolerance.[4] In general, compliance with Rule 2111 is risk-based, so firms must deduce the level of risk associated with a recommendation and the type of documentation that might be required to satisfy the rule.[5]

The goal of the new rule is to ensure that recommendations are made in the customer’s “best interest.”[6] However, Rule 2111 only applies to recommendations when they are actually made, meaning that firms and brokers do not have an ongoing responsibility to monitor securities after having made an initial recommendation.

Also noteworthy about the new suitability rule is that implicit recommendations to hold do not require compliance with Rule 2111. If, for example, during a transfer of assets from an employer-sponsored 401k account to an individual retirement account, a customer asks her broker whether any changes should be made to her portfolio and the broker suggests that the client not make any changes, the advice to hold would probably not trigger Rule 2111 or require documenting the advice.[7]

The same would hold true when a broker remains silent about whether an investor should sell a security.[8] Rule 2111 will, however, be triggered when a broker makes an “explicit recommendation.” This includes situations, from a risk-based perspective, where a broker recommends that her client hold a security that was originally recommended to the client by a different broker.[9]

History of Fee-Based Accounts

Before fee-based accounts became popular in the late 1990s, investors were mostly limited to opening commission-based accounts in which they were charged a fee for each transaction. Commission-based accounts were the industry norm for decades.[10]

By 1994, however, the U.S. Securities and Exchange Commission expressed concerns over potential conflicts of interests at investment banks and the increased number of Americans who were opening brokerage accounts and becoming investors in the securities markets.[11] As the number of direct investors rose to one-in-three Americans in 1995, regulatory concern for improved investor protection had become a focus.[12]

In 1994, Arthur Levitt, then Chairman of the SEC, requested a committee report for both the securities industry and investors regarding “best practices” to eliminate, or at least mitigate, perceived conflicts of interest.[13] This resulted in the Tully Report, which highlighted that fee-based accounts appeared to reduce potential conflicts between member firms and traditional commission-based account holders.[14]

The fee-based system is based on a percentage of total assets in an account, with annual fees generally ranging between 1 percent and 1.5 percent of total assets. Customers generally pay an annual fee for trades, investment advice, and custodial and recordkeeping services, among other things, regardless of whether transactions occur.

Such accounts provide an alternative to paying individual commissions and became popular around the time of the online trading boom during the late 1990s. Fee-based accounts have become an increasingly popular alternative to commission-based accounts,[15] with assets in such accounts ballooning fifty percent by the early 2000s, and currently estimated at approximately $300 billion.[16]

Regulators initially favored fee-based accounts because they reduced the potential customer-broker conflicts about which regulators were concerned. In fact, the SEC created a rule specifically exempting brokers that operated fee-based accounts and were offering “incidental advice” to customers from having to register as “investment advisers” under the Investment Advisers Act of 1940. As noted in one very early release, “brokers and dealers commonly give a certain amount of advice to their customers in the course of their regular business and that it would be inappropriate to bring them within the scope of the [Advisers Act] merely because of this aspect of their business.”[17]

The SEC’s concern was that overregulation of fee-based accounts would curtail their success and curb beneficial developments for both brokers and customers. But, amid 1,700 comments to the SEC’s proposed rule (first in 1999, and again in 2005),[18] an obvious divide emerged between broker-dealer support for the rule and investment adviser opposition.[19] In 2007, the District of Columbia Circuit Court struck down the SEC rule, claiming that the SEC had overstepped its authority in exempting brokers from the ‘40 Act.[20]

Problem of Under-Utilization in Fee-Based Accounts

While the concern with commission-based accounts is that brokers might trade too frequently and at a rate that does not comport with customer needs, regulators have focused on fees being charged to customers in fee-based accounts where there is minimal to no activity.[21]

Regulators quickly responded to the conundrum between the positive movement toward fee-based accounts and the potential for abuse by virtue of inactivity. In November 2003, the NASD published Notice to Members 03-68 to remind member firms that they should have “reasonable grounds for believing that a fee-based program is appropriate for that particular customer” before opening a fee-based account.[22]

Among the things that the NASD advised member firms and associated persons to consider before making recommendations were “services provided, the projected cost to the customer, alternative fee structures available and the customer’s fee structure preference.”[23] The NASD also reminded firms to continue to supervise fee-based accounts to ensure that they remain beneficial for each customer.[24]

In 2005, two broker-dealers entered into settlements with the NASD regarding the supervision of their fee-based brokerage platforms. One firm paid a $1.5 million fine and $4.6 million in restitution to affected account owners. The other paid a $750,000 fine and $138,000 in restitution.

On June 22, 2005, the SEC approved NYSE Rule 405A (“Non-Managed Fee-Based Account Programs — Disclosure and Monitoring”). The rule required brokers to disclose information to customers about the types of services they would offer, and other options that might be available, before opening a fee-based account.[25] Firms were also required to disclose how they calculated costs. In addition, Rule 405A required firms to track the “health” of fee-based accounts to ensure that adherence with the fee-based structure would continue to benefit each of their customers.[26]

How Firms Have Addressed Utilization Concerns

In response to increased scrutiny of fee-based account utilization by regulators, some firms initially began looking for alternative systems that required less disclosure, while other firms increased disclosures to customers by informing them of the costs they would have incurred had they been enrolled in commission accounts.

Some firms immediately established non-disclosure advisory programs to which they began migrating assets, while other firms made no changes to their fee-based platforms.For fear of failing to comply with the new regulations, several firms announced plans to close fee-based accounts if they became inactive or if customers failed to sign disclosure forms.

An assessment of the current market, however, signals that fee-based accounts are here to stay. Statistics indicate that the industry continues to move in the direction of fee-based accounts and away from commission-based relationships.[27] The remaining hurdle in this continued movement towards fee-based accounts is how firms will implement appropriate supervisory programs in line with the new suitability rule.[28]

Recommendations to Hold in the Context of Fee-Based Accounts

The question that arises is whether the new suitability rule will lend support to member firms regarding limited-activity fee-based accounts. The Tully Report warned that fee-based accounts would be inappropriate for customer-accounts with low frequency trading, and regulators quickly became concerned that investors would be paying fees even when brokers were not performing adequate services. Now that the new rule considers advice to hold a recommendation, the utilization analysis of fee-based accounts becomes more opaque.

A broker can now theoretically provide, for example, ten hold recommendations within a quarterly period in a fee-based account, and perhaps create adequate grounds for the firm to conclude that the fee-based account had not been underutilized and was thus, “suitable.”

Of course, when a broker makes a hold recommendation, he or she will have to believe that the recommendation aligns with the customer’s investment goals given the customer’s trading history and financial capabilities. As the new suitability rule states, a reasonable suitability check will be particularly necessary if a recommendation contains high risk. The suitability rule therefore guards against imprudent recommendations, even when a broker is simply suggesting a hold.

One way for firms to circumvent confusion about the suitability of hold recommendations is to enhance documentation records for fee-based accounts. That is, ensure that the firm’s systems track recommendations to hold in a manner similar to the way the firm tracks buy and sell recommendations. This may require firms to provide additional training to their brokers and revise certain policies and procedures. While firms decide how to handle the hold requirement imposed by the new rule, it is unlikely that they will opt to move away from the fee-based model.

Conclusion

What’s certain about FINRA’s new suitability rule is that it imposes added requirements for firms and brokers. But it may also, albeit unintentionally, have created an opportunity for firms in regard to dealing with utilization issues in fee-based accounts.

By requiring firms to supervise and perhaps document hold recommendations, the new rule may offer a solution — with the ability to quantify hold recommendations and thereby validate apparent “inactivity” in an account — for situations where brokers provide ongoing advice to fee-based customers who do not “actively” trade in their accounts. Because we are only two months into the new world of suitability, it will be interesting indeed to see how the industry responds to and how firms integrate the new suitability rule with respect to fee-based accounts.

–By Bryan I. Reyhani, Dimitri Nemirovsky and Teisha Ruggiero, Reyhani Nemirovsky LLP

Bryan Reyhani and Dimitri Nemirovsky are the founding partners of Reyhani Nemirovsky. The firm specializes in representing financial services clients in enforcement investigations, regulatory proceedings and private client arbitrations. Reyhani and Nemirovsky also advise clients on regulatory and compliance matters.

Teisha Ruggiero is a J.D. candidate at Brooklyn Law School.

The opinions expressed are those of the authors and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] Additional Guidance on FINRA’s New Suitability Rule, Regulatory Notice 12-25 (May 2012), http://www.finra.org.

[2] Id.

[3] Id. at 6.

[4] Id. at 2.

[5] Id.

[6] Id.

[7] Id.

[8] Id.

[9] Id.

[10] Daniel P. Tully, Report of the Committee on Compensation Practices (April 10, 1995), http://www.sec.gov/news/studies/bkrcomp.txt.

[11] Id. at 3.

[12] Id.

[13] Id. at 1.

[14] Id. at 7.

[15] Fee-Based Compensation. Notice to Members 03-68 (November 2003), http://www.finra.org.

[16] Lori A. Martin, Financial Planning Association v. SEC: Fee Based Brokerage (May 2007), http://www.sifma.org.

[17] See Opinion of the General Counsel Relating to Section 202(a)(11)(C) of the Investment Advisers Act of 1940, Investment Advisers Act Release No. 2 (Oct. 28, 1940) [11 FR 10996 (Sept. 27, 1946)] (“Advisers Act Release No. 2”).

[18] 70 Fed. Reg. 2718 (proposed Jan. 14, 2005).

[19] Id.

[20] See Financial Planning Ass’n v. S.E.C., 482 F.3d 481 (2007).

[21] Tully, Supra note 12.

[22] Fee-Based Compensation, Supra note 17.

[23] Id. at 744.

[24] Id.

[25] Information Memo 05-51 (July 26, 2005), http://www.cecouncil.com/Documents/00002282.htm.

[26] Id.

[27] Financial Planning Association v. SEC: Fee Based Brokerage, Supra note 18.

[28] Additional Guidance on FINRA’s New Suitability Rule, Supra note 1, at 2 (FINRA acknowledges that member firms will inevitably have different approaches for complying with the new rule).

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