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FINRA's Proposed Changes to the Churning Rule

Posted by Jack Duval

May 29, 2018 8:03:39 AM

Accelerant - FINRA - Churning - Quantitative Suitability - Jack Duval

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.[1]  (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) ..."[2]  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."[3]

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):[4]

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)

Defining Churning

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:[5]

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.[6]

Supervision

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.

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Notes:

[1]      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.”

[2]      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.

[3]      Id.

[4]      Id. at 3-4.

[5]      Id. at 3.

[6]      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.

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Topics: FINRA, supervision, Quantitative Suitability, Churning, turnover ratio, cost/equity ratio

Understanding FINRA Suitability Rule 2111 - The Three Components of Suitability

Posted by Jack Duval

Dec 12, 2013 8:03:00 AM

This blog post is part of a series addressing FINRA Suitability Rule 2111.  Our suitability experts will examine the genealogy of the rule and how it has evolved over the years through Notices to Members, Regulatory Notices, and changes to the rule itself.  In particular, customer-specific and reasonable-basis suitability will be examined.

In this post we examine the three components of suitability obligations due under FINRA Rule 2111.

Components of Suitability Obligations

Under FINRA Suitability Rule 2111, there are three components to the suitability obligation: reasonable-basis suitability; customer-specific suitability; and quantitative suitability. Each will be discussed in turn.

As discussed in previous blog posts, the concept of suitability can be succinctly stated as appropriately matching investments to the investor. With Rule 2111, FINRA has now made both ends of this task explicit.

Customer-Specific Suitability

FINRA Rule 2310 clearly dealt with the customer and required that for each recommendation to a customer, “a member have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.”[1]

The “basis of the facts, if any” language was essentially voided for retail clients under NTM 90-52, which imposed an affirmative duty upon the broker to profile the client.[2] This modification was addressed originally in Article III, Sections 2 and 21 (c) of the Rules of Fair Practice[3], and later in Rule 2310(b), which added the explicit requirements for the broker to gather basic information about non-institutional clients.

FINRA Rule 2111 continues the client profiling requirement (and incorporates the phrase “customer’s investment profile”) of Rule 2310(b) and adds more specific areas of inquiry.  Most important among the new profiling questions are: the customer’s needs; the customer’s investment time horizon; the customer’s liquidity needs; and the customer’s risk tolerance.[4]

While explicitly listing the new profiling questions in the Rule is helpful, they have been part of industry profiling practices for decades, if not longer.  Indeed, most member firm New Account Forms have required the broker to inquire about the customer’s time horizon and risk tolerance as well as other aspects of their financial life.

Lastly, it is worth noting that FINRA has also incorporated the New York Stock Exchange (“NYSE”) Rule 405 into FINRA Rule 2090 (Know Your Customer).  As with NYSE Rule 405, FINRA Rule 2090 is a due diligence based rule.  Rule 2090 states:

Every member shall use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer and concerning the authority of each person acting on behalf of such customer.[5]

Instead of approaching suitability by focusing on what is required for broker recommendations (as does Rule 2111), Rule 2090 approaches suitability by concentrating on the due diligence required for every customer relationship.  Under Rule 2090, suitability is ensured by knowing and understanding the customer prior to account opening, and maintaining the account in accord with what is known.

Importantly, the “maintenance” language in Rule 2090 creates an ongoing requirement to know the customer.  That is to say, the broker must continue to conduct her due diligence on the customer’s particular facts and circumstances during the lifetime of the relationship.

This is an important element of profiling as a customer’s life situation can change and thus require changes in her investments or strategies.  As with the new profiling questions of Rule 2111, these have been an industry practice for decades, if not longer.

Reasonable-Basis Suitability

The reasonable-basis suitability component addresses how broker-dealers and their associated persons must perform due diligence on investments before they recommend them.  The first level of due diligence is performed at the firm level and requires the member firm to first determine that the investment is at least suitable for some of its investors.[6]

Methods employed by firms to determine this first level of suitability will “vary depending on, among other things, the complexity of and risks associated with the security or investment strategy and the member's or associated person's familiarity with the security or investment strategy.”[7]

The second reasonable basis suitability determination is carried out by the broker when she educates herself about the investment. This is how the broker comes to “know the investment”.

One of the primary goals of the reasonable basis suitability obligation is that:

A member's or associated person's reasonable diligence must provide the member or associated person with an understanding of the potential risks and rewards associated with the recommended security or strategy.[8]

As mentioned above, a failure to “know the investment” makes the recommendation unsuitable.  FINRA clearly states this in the Supplementary Material to Rule 2111:

The lack of such an understanding (about the potential risks and rewards of the recommending security or strategy) when recommending a security or strategy violates the suitability rule.[9]

Quantitative Suitability

The explicit quantitative suitability component highlights the potential for abuse in instances where accounts are “churned” by frequent purchases and sales of securities in order to generate excess commissions. As mentioned above, there can be instances where one trade, viewed in isolation could be suitable, but if made repeatedly, would change all the trades to unsuitable transactions. FINRA Rule 2111 addresses this potential head on, stating:

Quantitative suitability requires a member or associated person who has actual or de facto control over a customer account to have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together in light of the customer's investment profile, as delineated in Rule 2111(a). [10] (Emphasis added)

The Rule also addresses common metrics used to evaluate churning:

No single test defines excessive activity, but factors such as the turnover rate, the cost-equity ratio, and the use of in-and-out trading in a customer's account may provide a basis for a finding that a member or associated person has violated the quantitative suitability obligation.[11]

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The Accelerant Securities Practice Group has many experts on FINRA Suitability Rule 2111, including: Gerry Guild, John Duval, Sr., Tom Brakke, and Jack Duval.

Notes

Portions of this blog originally appeared in the Accelerant white paper Leveraged and Inverse ETFs:  Trojan Horses for Long-Term Investors, by Jack Duval.  

[1]                 See supra Note 33.

[2]                 FINRA NTM 90-52; available at http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=1514&element_id=1273&highlight=90-52#r1514; accessed July 31, 2013.

[3]                 The Rules of Fair Practice was what the original NASD Manual was called.  The numbering system was changed in May 1996.

[4]                 See supra Note 34 and accompanying text.

[5]                 FINRA Rule 2090 (Know Your Customer); available at http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=13389&element_id=9858&highlight=2090#r13389; accessed August 1, 2013.

[6]                 See supra Note 34.  FINRA Rule 2111 Supplementary Material .05 Components of Suitability Obligations.

[7]                 Id.  See also FINRA NTM 05-26 for suggested best practices for vetting new products.

[8]                 Id.

[9]                 Id.

[10]               Id.

[11]               Id.

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Topics: reasonable basis suitability, Investment Suitability, FINRA Suitability Rule 2111, Suitability Expert, Quantitative Suitability, Customer-specific Suitability

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