On April 20, 2018, FINRA issued Regulatory Notice 18-13 – Quantitative Suitability, requesting comments on amendments to Suitability Rule 2111. This is the first FINRA response to SEC Regulation Best Interest. In it, FINRA is trying to square the existing suitability rule with a new proposal in SEC Regulation Best Interest. (My writings on SEC Regulation Best Interest can be found here.)
Proposed Changes to FINRA Suitability Rule 2111.05(c) – Quantitative Suitability
The proposed changes would be made to the Supplementary Material to Rule 2111 dealing with quantitative suitability found in under section .05(c). In short, section .05(c) would be amended to "remove the element of control that currently must be proved to demonstrate a violation (of the suitability rule) ..." What would remain are "… the obligations to prove that the transactions were recommended and that the level of trading was excessive and unsuitable in light of the customer's investment profile."
The comment period expires on June 19, 2018.
According to FINRA, it is removing the control element from the rule because it is unnecessary. FINRA writes (from the enforcement action perspective):
The inclusion of the control element has its historic roots, in part, in the perceived need to ensure that the culpability for excessive trading rested with the party responsible for initiating the transactions in actions brought pursuant to the antifraud provisions of the federal securities laws. That concern is not present under FINRA's suitability rule. Because FINRA must show that the broker recommended the transactions in order to prove a Rule 2111 violation, culpability for excessive trading will still rest with the appropriate party even absent the control element.
... FINRA's suitability rule will continue to require FINRA to prove that the broker recommended the transactions and that the transactions were excessive and unsuitable in light of the customer's investment profile.
… The control element is an unnecessary layer of proof regarding the identity of the responsible party (i.e., the party initiating the transactions) and does not in any way touch on the proof needed to establish the underlying, substantive misconduct (i.e., the excessive trading activity inconsistent with the customer's investment profile.) (Emphasis in the original, notes omitted)
Churning is the effectuating of a trade for the sole purpose of generating a commission. It can be for one transaction and does not have to be for multiple transactions, although the high transaction version is far more common. (My previous post on churning can be found here.)
Critically, the level of activity and costs associated with the trading strategy must be judged against the individual client's profile, investment objective, risk tolerance, and involvement. FINRA writes:
Although no single test defines excessive activity, factors such as turnover rate, cost-to-equity ratio or the use of in-and-out trading may provide a basis for a finding of excessive trading. A turnover rate of six or a cost-to-equity ratio above 20 percent generally is indicative of excessive trading. However, lower ratios have supported findings of excessive trading for customers with very conservative investment objectives, while somewhat higher ratios have not supported findings of excessive trading for some customers with highly speculative investment objectives and the financial resources to withstand potential losses.
Most clients are buy-and-hold type of investors with moderate risk tolerances. In these cases, even low levels of turnover and cost/equity ratios can be indicative of churning. For example, I have seen such clients churned in portfolios laden with structured products. These products were tax-inefficient and resulted in costs of 1.5 to 2 percent per year, when publicly traded equivalents would have cost a small fraction of that.
Alternately, a client with a speculative investment objective that wanted to trade actively (especially with only a portion of her assets) could have much higher turnover and cost/equity ratios without them be indicative of churning.
Another indicator is the level of commissions being assessed on each trade. Is the broker charging full freight commissions (even if only on the buys)? If so, this is more likely to be abusive than a broker charging firm minimum (or heavily discounted) commissions on each trade.
Ultimately, the assessment of any recommended investment strategy will be based on its comportment with the client's investment objective, risk tolerance, and overall profile.
Very few investors want to actively trade. Most have no interest in the markets and even fewer have the leisure time to devote to following individual securities on a tick-by-tick basis.
These types of clients give their money to an investment professional and pay that professional to manage the money for them. If speculative trading develops in these accounts, it is likely to be churning, even at low levels of turnover and cost/equity ratios.
Where an investor chooses a speculative trading strategy and knowingly takes the risks and is willing to pay the costs (which can add up quickly, even at low commission levels), that is their right.
Unfortunately, most speculative trading strategies don't work. The investor is up against buildings full of computer servers engaged in algorithmic trading strategies that get the price data faster, and process their trades nearly instantaneously, before the client can even start typing in an order.
As always, broker-dealer supervisors will need to monitor accounts for churning. These efforts should trigger red flags for accounts with high turnover and cost/equity ratios, those with a significant amount of the client's investable assets involved in the trading, those with large amounts of losses, and those where the trading does not comport with the client's profile.
Almost all compliance systems today can monitor for these triggers and generate exception reports for supervisors on an automated basis.
 SEC Regulation Best Interest; Release No. 34-83062; Available at: https://www.sec.gov/rules/proposed/2018/34-83062.pdf; Accessed May 24, 2018; 150. “… Regulation Best Interest would include the existing ‘quantitative suitability’ obligation, but without the ‘control’ element.”
 FINRA Regulatory Notice 18-13 – Quantitative Suitability; April 20, 2018; 1. Available at: http://www.finra.org/sites/default/files/notice_doc_file_ref/Regulatory-Notice-18-13.pdf; Accessed May 24, 2018.
 Id. at 3-4.
 Id. at 3.
 See Michael Lewis’ Flash Boys: A Wall Street Revolt explaining how algorithmic traders are scalping even the largest institutional investors.
For information about securities expert Jack Duval, click here.