INSIGHT: When Precedent Doesn’t Really Stand for That Proposition: FINRA’s Suitability Rule and the Meaning of “Best Interest”

Everyone knows that broker-dealers and investment advisers have different duties and obligations to their clients. Well, not quite everyone. In particular, not the Financial Industry Regulatory Authority (FINRA), the self-regulatory organization (SRO) authorized by Congress as the primary regulator of broker-dealers. This article explores why FINRA got it wrong three times in a series of pronouncements.

Introduction

The Congressional Research Service is one of many institutions that knows the difference between broker-dealers and investment advisers:

Under the Investment Advisers Act of 1940, registered investment advisers are fiduciaries and must act in their clients’ best interest. Securities brokers and dealers are not covered by the act if the advice they provide is incidental to the transaction and they do not receive a fee for the advice. The Financial Industry Regulatory Authority (FINRA), the self-regulatory organization of securities brokers, which is overseen by the SEC, requires that recommendations by brokers and dealers be suitable for the customer, taking into account the customer’s investment profile.

The difference between “suitable” and “best interest” led both the Department of Labor (DOL) and later the Securities and Exchange Commission (SEC) to propose specific regulations aimed at requiring broker-dealers to act the same as or similar to investment advisers. First, on April 20, 2015, the DOL proposed what came to be known as the “Fiduciary Rule,” which would have imposed a fiduciary duty on broker-dealers that “provide investment advice or recommendations for a fee or other compensation with respect to assets of a plan or IRA as fiduciaries in a wider array of advice relationships.” After much public debate, on June 21, 2018, the Fifth Circuit Court of Appeals vacated the Fiduciary Rule finding, among other things, that the DOL acted arbitrarily and capriciously in adopting the Rule.

After the DOL proposed its rule, on April 18, 2018, the SEC proposed its own regulation (“Regulation Best Interest” or “Reg BI”), which would require broker-dealers to “act in the best interest of the retail customer at the time the recommendation [of any securities transaction or investment strategy] is made.” When it proposed the rule, the SEC observed that while broker-dealers currently operate under an “extensive” framework of rules and regulations, “there is no specific obligation . . . that broker-dealers make recommendations that are in their customers’ best interest.” The SEC stated that its regulation would provide retail customers greater clarity about the “obligations broker-dealers owe when making recommendations,” while also providing “clear, understandable, and consistent standards for brokerage recommendations across a brokerage relationship (i.e., for both retirement and non-retirement purposes) and better aligning this standard with other advice relationships (e.g., a relationship with an investment adviser).” On November 7, 2018, the SEC’s Investor Advisory Committee (IAC) recommended that the Commission clarify the proposed regulation to more explicitly state that “a best interest standard is a fiduciary standard.” (Emphasis in original.) At this point in time, it is unknown whether the final rule will be implemented or whether the SEC will provide further clarification as to what it meant by “best interest.”

Despite the apparent clear differences between the duties of broker-dealers and investment advisers, FINRA has a different view. On three occasions, FINRA has stated that broker-dealers must act consistently with their clients’ best interests.

• In an August 3, 2018, comment letter regarding Reg BI, FINRA stated, “FINRA’s suitability rule implicitly requires a broker-dealer’s recommendations to be consistent with customers’ best interest.”
• In a May 2012 Regulatory Notice regarding its then-new suitability rule, FINRA stated that, “[t]he suitability requirement that a broker make only those recommendations that are consistent with the customer’s best interests prohibits a broker from placing his or her interests ahead of the customer’s interests.”
• Finally, in a January 2011 Regulatory Notice, FINRA stated that it is “well-settled that a broker’s recommendations must be consistent with his customer’s best interests.’”

In all three instances, FINRA cited SEC and FINRA case law for its position.

What’s going on? How can FINRA make these statements when the conventional wisdom believes something to the contrary? And how can SEC case law support this proposition, when the SEC itself proposed requiring broker-dealers to “act in the best interest of the retail customer”? The answer to these questions appears to be that the legal precedent doesn’t really stand for the proposition currently being cited by FINRA. Somewhere along the way, the precedent got flipped sideways, but in the American legal tradition, once precedent is set, it is difficult to correct due to the doctrine of stare decisis, which literally means “to stand by things decided.” Indeed, Justice Scalia once noted that the “whole function” of stare decisis is “to make us say that what is false under proper analysis must nonetheless be held to be true, all in the interest of stability.”

Legal Standards

Broker-dealers, who receive transaction-based compensation, include “any person engaged in the business of effecting transactions in securities for the accounts of others.” Generally, broker-dealers are subject to FINRA’s and the SEC’s rules. The overwhelming majority of broker-dealers are members of FINRA, which regulates and examines firms to ensure compliance with FINRA’s rules as well as applicable SEC rules. When broker-dealers or their salesforce, called registered representatives, make recommendations, they must follow FINRA Rule 2111, which provides that each broker-dealer must “have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the [firm] or associated person to ascertain the customer’s investment profile.”

Investment advisers, on the other hand, receive compensation for providing advice about securities transactions to their clients, rather than simply transacting in the securities. The SEC regulates investment advisers over a certain size pursuant to the Investment Advisers Act of 1940 and the rules adopted thereunder. In Transamerica Mortg. Advisors, Inc. v. Lewis, 444 U.S. 11, 17 (1979), the Supreme Court of the United States held that the Investment Advisers Act establishes “federal fiduciary standards” to govern the conduct of investment advisors. Therefore, investment advisers have a fiduciary relationship with their clients and owe clients a fiduciary duty, which means investment advisers have to act in their clients’ best interest, putting their clients’ interests before their own.

Proposed Changes to the Legal Standards

The difference between these standards caused the DOL to propose an overhaul of the investment advice fiduciary definition. The final regulations, known collectively as the DOL’s Fiduciary Rule, were issued in April 2016. The Rule would have expanded the class of industry participants subject to the fiduciary standard. According to the DOL, the “final rule treats persons who provide investment advice or recommendations for a fee or other compensation with respect to assets of a plan or IRA as fiduciaries in a wider array of advice relationships.” Before the Fiduciary Rule, broker-dealers that provided services to retirement plans or IRA clients were not required to act in their clients’ best interest unless the firms were acting as fiduciaries. Instead, their recommendations had to meet FINRA’s suitability standard, which requires that recommendations be suitable, a lower standard than the fiduciary standard.

The Fiduciary Rule was supposed to go into effect in April 2018, but after President Trump’s election, he derailed it through a Presidential Memorandum that mandated additional study. Before President Trump’s election, a group of industry participants had challenged the Fiduciary Rule in court. On March 15, 2018, the Fifth Circuit struck down the DOL’s Fiduciary Rule in Chamber of Commerce v. DOL, No. 17-10238 (5th Cir. March 15, 2018). In reaching that conclusion, the Fifth Circuit cited two key reasons: 1) the DOL did not have the authority to adopt the new fiduciary advice definition because it was inconsistent with ERISA’s fiduciary definition; and 2) the DOL acted arbitrarily and capriciously in adopting the Rule. The Fifth Circuit explained that the Rule’s purpose was “to regulate in an entirely new way hundreds of thousands of financial service providers and insurance companies in the trillion-dollar markets for ERISA plans and individual retirement accounts.” On June 21, 2018, the Fifth Circuit issued a mandate vacating the rule, making it ineffective nationwide.

On April 18, 2018, following the Fifth Circuit’s initial decision, the SEC proposed “Reg BI,” to require broker-dealers and their associated persons to “act in the best interest of the retail customer at the time a recommendation is made without placing the financial or other interest of the broker-dealer or natural person who is an associated person making the recommendation ahead of the interest of the retail customer.” In developing the proposal, the SEC “recognized the importance of providing, to the extent possible, clear, understandable, and consistent standards for brokerage recommendations across a brokerage relationship (i.e., for both retirement and non-retirement purposes) and better aligning this standard with other advice relationships (e.g., a relationship with an investment adviser).”

Reactions to the Proposed Rules

When the DOL and the SEC proposed applying a best interest standard to broker-dealers, how did the industry react? Did they say, “We don’t need no stinkin’ fiduciary badges because FINRA’s suitability rule already requires broker-dealers to act in their clients’ best interest”? No, not really. For the most part, they confirmed that broker-dealers and investment advisers have different duties.

In response to the DOL’s rule proposal, then-SEC Commissioner Michael S. Piwowar stated that while “an investment adviser is a fiduciary with a duty to serve the best interests of its clients,” the corresponding duty for broker-dealers was a “suitability obligation [that] requires a broker-dealer to make recommendations that are consistent with their investment profile” while also satisfying “best execution” obligations. The North American Securities Administrators Association (NASAA), which is the association of state securities regulators, similarly noted that “extending the definition of fiduciary duty . . . would ensure that these transactions, often undertaken by broker-dealers, would be subject to a best interest standard, rather than the current suitability standard broker-dealers are subject to under the securities laws.”

The reaction to proposed Reg BI was similar. While some comment letters parroted FINRA’s prior statements about the suitability rule encompassing the best interest standard, most commenters noted that imposing a best interest standard on broker-dealers would not only be a change from the current suitability standard, but would also markedly raise the bar for broker-dealer conduct:

• The Financial Services Institute, an association of independent financial services firms and independent financial advisers, stated that, “Proposed Regulation Best Interest clearly extends to broker-dealers a duty to act in the customer’s best interest – that is, putting the customer’s needs first . . . .” and that, “the Proposed Rulemaking Package enhances [FINRA’s existing suitability] obligations by requiring the broker-dealer to have a reasonable basis that the recommendation is in the best interest of the retail customer.”
• NASAA describe Reg IA as “[m]oving from the current investor protection floor of FINRA’s suitability standards to a true heightened standard akin to an investment adviser’s fiduciary duty.”
• SIFMA, a trade association of broker-dealers, investment banks and asset managers, stated that “Proposed Reg BI enhances the standard of conduct . . . . the proposed standard requires that recommendations must not only be suitable, but also in the retail customer’s ‘best interest.’”
• The Mercatus Center at George Mason University, a university-based research center for market-oriented ideas, also stated that “[Regulation BI] recommends adding a best interest standard to the Financial Industry Regulatory Authority’s (FINRA’s) well-established suitability rule for retail brokers when they provide their clients with investment advice incidental to their main function of executing the client’s trades.”
• The SEC’s IAC distinguished the existing suitability standard under FINRA’s rules from the proposed Reg BI noting that “[a] key difference is that the best interest standard, in contrast with the suitability standard, would not be satisfied by recommending any of what may be many suitable options. Instead, the broker, adviser, and their associated persons would be required to narrow down the selection to those that are most favorable for the investor . . . .”

The Legal Precedent

As noted above, FINRA’s statements regarding suitability and best interest did not come out of whole cloth—rather, these statements were based on SEC and FINRA legal precedent. But unraveling the web of precedent shows that FINRA’s statements confused the original standards articulated in cases. Before examining the precedent, it is important to explain the disciplinary process for broker-dealers.
Broker-dealers and registered representatives are subject to FINRA disciplinary hearings before an Office of Hearing Officers (OHO) panel, composed of three persons, including a Hearing Officer who is a FINRA employee and two industry panelists. OHO decisions may be appealed to a FINRA committee called the National Adjudicatory Council (NAC). The NAC may remand a proceeding, or affirm, dismiss, or modify any finding. NAC decisions may be appealed to the SEC. Previously, when FINRA was constituted somewhat differently and was called the National Association of Securities Dealers (NASD), disciplinary matters were initially heard by District Business Conduct Committees and then appealed to the National Business Conduct Committee. Independently of FINRA’s disciplinary proceedings, the SEC may bring its own administrative proceedings against broker-dealers.

Given this background, FINRA’s statements regarding “best interest” and its cited precedent can now be examined:

1. “FINRA’s suitability rule implicitly requires a broker-dealer’s recommendations to be consistent with customers’ best interest.”

2. “The suitability requirement that a broker make only those recommendations that are consistent with the customer’s best interests prohibits a broker from placing his or her interests ahead of the customer’s interests.”

3. “[I]t is ‘well-settled that a broker’s recommendations must be consistent with his customer’s best interests. . .’”

A close review of FINRA’s cited cases shows how FINRA ended up making its bold pronouncements. The initial discussion of a best interest standard for broker-dealers occurred in a 1964 case Powell & McGowan, Inc, Exchange Act Rel. No. 7302 (Apr. 24, 1964). There, the SEC suggested that, in certain circumstances, a broker-dealer cannot make recommendations “clearly contrary to the best interests of the customer.” But importantly, this case was an SEC Enforcement action, where the SEC charged the broker-dealer with committing fraud under the securities laws—that is, making material misrepresentations or omitting material facts. The case was not premised on a violation of the suitability rule of NASD, FINRA’s predecessor. The facts involved a sympathetic customer: a 79-year-old retiree whose health had deteriorated to the point that he likely could not understand investments or financial matters. Even though the broker-dealer’s president knew the financial, physical, and mental state of the customer, he nevertheless recommended that the customer enter into a loan agreement that would provide capital to the broker-dealer at substantial risk to the customer. The SEC found this conduct willfully violated the antifraud provisions of securities regulations, specifically noting: “In the context of the circumstances here and the facts concerning this customer known to it and the special risks involved, [the broker-dealer] had an obligation not to recommend a course of action clearly contrary to the best interests of the customer, whether or not there was full disclosure.” Although FINRA cited this language in Regulatory Notice 12-25 as a source of conflating a best interest standard with FINRA’s suitability rule, the facts of this SEC case show that this conflation is inappropriate.

In its three proclamations regarding suitability and the best interest standard, FINRA did not cite John M. Reynolds, Exchange Act Rel. No. 30036, 50 S.E.C. 805 (Dec. 4, 1991), which is the most relevant case on this issue. Reynolds was a 1992 SEC decision affirming an NASD disciplinary decision and articulating the best interest language related to suitability. With the exception of Powell & McGowan, each case cited by FINRA to support its articulation of the best interest standard traces back to Reynolds. While this case does state that a registered representative must make recommendations in his customer’s best interest, it does so with a clear, crucial caveat: this heightened standard applies only when the representative also acts as a fiduciary. Reynolds, a registered representative, controlled trading in a church’s account, traded in it excessively, and disregarded the church’s conservative strategy. The finding that Reynolds controlled the account made him a fiduciary, thereby heightening his duty of care. Indeed, the SEC explicitly qualified its language: “As a fiduciary, a broker is charged with making recommendations in the best interests of his customer even when such recommendations contradict the customer’s wishes.” (Emphasis added.)

The cases that followed Reynolds, however, dropped the fiduciary qualification, but claimed to simply regurgitate precedent. These cases all involved registered representatives who appealed an NASD or FINRA decision to the SEC or who were found liable by NASD or FINRA. Beginning in 2002, Reynolds was repeatedly cited for a proposition it did not state. For example, Daniel Howard, Exchange Act Rel. No. 46269 (July 26, 2002), adopted the Reynolds language, but disregarded the fiduciary qualification. Solely citing Reynolds for authority, Howard sweepingly declared: “As we have frequently pointed out, a broker’s recommendations must be consistent with his customer’s best interests.” The next year, the SEC again restated its position with the same language in Wendell D. Belden, Exchange Act Rel. No. 47859 (May 14, 2003): “As we have frequently pointed out, a broker’s recommendations must be consistent with his customer’s best interests,” this time citing to Howard and Reynolds as authority. This language was repeated again, with the same citations, in later years. The 2004 decision in Dane S. Faber, Exchange Act Rel. No. 49216 (Feb. 10, 2004), for example, cited Howard and Reynolds and repeated the same “consistent with his customer’s best interests” language. The SEC used this exact language again in 2006 in Raghavan Sathianathan, Exchange Act Rel. No. 54722 (Nov. 8, 2006) and in 2009 in Scott Epstein, Exchange Act. Rel. No. 59328 (Jan. 30, 2009), again relying on Howard and the above precedent.

The SEC’s 2003 decision in Dale E. Frey, Exchange Act Rel. No. 221 (Feb. 5, 2003) is reminiscent of Reynolds because it used the same fiduciary qualification: “As a registered representative, [he] owed a fiduciary duty to his customers to act in their best interests and recommend stocks that were suitable for their investment objectives.” Both Powell & McGowan and Reynolds were cited as sources. As with the Reynolds examples, subsequent citations to Frey failed to include the fiduciary language qualifier and did not explain that broker-dealers and their representatives are generally not considered fiduciaries.

In addition to SEC cases, FINRA’s best interest pronouncements relied on its own decisions or NASD decisions to support its thesis. FINRA’s NAC decisions repeatedly cited the SEC cases for the same standard. For example, in Dep’t of Enforcement v. Richard G. Cody, Complaint No. 2005003188901 (NAC May 10, 2010), the NAC used the “consistent with his customer’s best interests” language as the standard for suitability under NASD Rule 2310, the precursor to FINRA Rule 2011 (citing Faber). At times, the NAC also used slightly different language, such as “a broker’s recommendations must serve his client’s best interests,” which is the standard set forth in Dep’t of Enforcement v. Brookes McIntosh Bendetsen, Complaint No. C01020025 (NAC Aug. 16, 2004).

When the SEC proposed Reg BI, it stated in a footnote that “FINRA and a number of cases have interpreted the suitability rule as requiring a broker-dealer to make recommendations that are ‘consistent with his customers’ best interests’ or are not ‘clearly contrary to the best interest of the customer.’” The SEC did not adopt this interpretation and, in fact, implicitly rejected FINRA’s reading. Initially, it is important to note that the SEC did not say, “FINRA and a number of our cases have interpreted”; thus, the SEC distanced itself from the prior SEC cases. The SEC did more than simply distance itself. It also rejected this “interpret[ation],” by stating that this purported standard was “not an explicit requirement of FINRA’s suitability rule.” Finally, as part of this footnoted discussion, the SEC acknowledged that “under certain circumstances,” a broker-dealer may have a fiduciary duty. Although the SEC didn’t cite Reynolds for this proposition, it certainly could have. The SEC’s conclusion was clear: despite FINRA interpretation of its own rule, which would have negated the need for a new regulation, the SEC (like the DOL before it) decided to push ahead.

Conclusion

Now that we’ve taken a stroll down Stare Decisis Lane, where have we ended up? Despite the language contained in these cases, most industry participants recognize that investment advisers must act in their client’s best interest due to the presence of a fiduciary relationship, but that broker-dealers are held to a less-stringent, reasonable basis suitability standard. FINRA, on the other hand, relying on misconstrued legal precedent, has asserted that acting in a client’s best interest is already implicitly required of broker-dealers. It is surprising that FINRA (as well as, at times, the SEC) accepted certain statements contained in cases without questioning them. Both regulators, after all, always warn investors to be wary of something that is “too good to be true.” From FINRA’s perspective, it was simply too good to be true if it believed that its suitability rule met the needs expressed by the DOL and the SEC.

Had the SEC and FINRA read the cases and analyzed the issues carefully, a few “red flags” would have popped up. First, if broker-dealers were already required to act in their clients’ best interest, why did the DOL and the SEC propose new rules? In particular, the fact that the SEC proposed a new rule suggested that the current SEC didn’t fully embrace the language cited by FINRA (even the SEC’s own language). Indeed, the SEC’s reaction to FINRA’s “interpretation” demonstrates that the SEC did not accept FINRA’s view. Second, if such requirements already existed, then why was there such an outcry over the DOL’s rule and the SEC’s proposed rule, with thousands of comment letters filed in response to each? The answer is that the industry didn’t agree with FINRA’s interpretation, but it did think that a fiduciary rule or a best interest standard for broker-dealers would have a profound effect on the industry. Third, if the SEC and FINRA had simply read a few of the decisions, they would have seen that the genesis of this misconception arose when the SEC and FINRA dropped (or ignored) a key distinction from Reynolds: Reynolds controlled his client’s account and he was acting as a fiduciary. That’s what prompted the SEC to state: “As a fiduciary, a broker is charged with making recommendations in the best interests of his customer even when such recommendations contradict the customer’s wishes.” (Emphasis added.) The lesson here appears to be that the next time that the SEC or FINRA relies on precedent that sounds too good to be true and appears to be contrary to accepted wisdom, the regulator should review the cases thoroughly before citing them (even if the regulators don’t owe a fiduciary duty to the entities that they regulate).

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Brian Rubin is a partner at Eversheds Sutherland (US) LLP. He is the Washington office leader of the Litigation group and the head of the firm’s SEC, FINRA and state securities enforcement practice. He has more than 20 years of experience in federal securities law, including being on the Enforcement staffs at both the SEC and NASD (now FINRA). While Mr. Rubin was with NASD, he was on the trial and appellate teams in the case involving Dane S. Faber, the respondent in one of the cases discussed in this article.

Amanda Giffin is an associate at Eversheds Sutherland. She is a commercial litigator, counseling clients on a variety of complex business litigation. Her practice focuses on professional liability matters.

Melissa Fox is an associate at Eversheds Sutherland. She counsels clients on a variety of business and commercial litigation matters, including financial services, labor and employment, securities litigation and enforcement, and professional liability.

Yvonne Williams-Wass, a former Eversheds Sutherland litigation counsel, also assisted with drafting this article.