The Securities Litigation Expert Blog

SEC Regulation Best Interest - State Fiduciary Laws

Posted by Jack Duval

Oct 26, 2018 7:52:58 AM

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This blog post continues my series on SEC Regulation Best Interest ("RBI") and the DOL Rule.

There has been some hand-wringing over the past year about the potential of a fractured fiduciary duty landscape for Broker-Dealers ("BDs") and their Registered Representatives.  The concern is that individual states will impose a fiduciary standard on Registered Representatives while the FINRA suitability standard, and ultimately SEC Regulation Best Interest ("RBI"), cover the rest.

Allow me to allay these concerns:  the fractured fiduciary landscape already exists, and has for decades.

Nevada's Fiduciary Statues

The event that started the concern was Nevada passing legislation that imposed a fiduciary duty on anyone giving financial advice.  In short, the Nevada law:  "imposes a statutory fiduciary duty as set for in Chapter 628A of the Nevada Revised Statutes on Broker-Dealers and Investment Advisers."[1]

However, four other states have common law fiduciary duties for registered representatives and 31 additional states have quasi-fiduciary duties required under common law.[2]  I'm defining "quasi-fiduciary" obligations as Finke and Langdon do: those that exceed the FINRA suitability rules but do not expressly classify BDs as fiduciaries.[3]

Table 1: Fiduciary Status of Registered Representatives by State[4]

 Accelerant LLC Jack Duval - table of fiduciary status of registered representatives by state

Thus, 36 states already have some form of fiduciary duty required of registered representatives.

Voluntary Fiduciary Status for Broker-Dealers?

The existing uneven fiduciary duty landscape has not hampered BDs business efforts and I wouldn't expect it to in the future.[5]  Furthermore, if BDs were to find complying with the varying standards too taxing, they could just implement a fiduciary standard nation-wide.

Given SIFMA’s[6] long-standing resistance to a fiduciary standard, voluntary adherence to one is highly unlikely.   However, this might be more economical in the long-run, especially if more states pass their own fiduciary statutes.

As I have discussed in this blog posts series, I believe the pseudo-fiduciary standard under RBI will be difficult and expensive to implement.  BDs and their clients would be better off under a fiduciary standard.  Further, from a purely business perspective, adopting a fiduciary standard would help BDs compete with registered investment advisory firms which have been winning the battle for clients and assets.

Given the disappointment in many states with the defeat of the DOL Fiduciary Rule and RBI, it would not be surprising to see more states adopt fiduciary statutes.  Fiduciary expert James Watkins opines that “So long as states enact fiduciary laws that don’t impact a pension plan like a 401(k), they have every right to act,”.[7]

__________

Notes:

 

[1]       Nevada Secretary of State; Website; Available at: https://www.nvsos.gov/sos/licensing/securities/new-fiduciary-duty; Accessed October 25, 2018.

[2]       Michael Finke and Thomas Langdon; The Impact of the Broker-Dealer Fiduciary Standard on Financial Advice; March 9, 2012; Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2019090; Accessed October 26, 2018; 13.

[3]       Id. at 14.

[4]       Id.

[5]       See supra Note 2.

[6]       Securities Industry and Financial Markets Association; https://www.sifma.org/about/.

[7]       Mark Miller; U.S. states eye protections for investors if federal regulation falters; Reuters; April 12, 2018; Available at: https://www.reuters.com/article/us-column-miller-fiduciary/u-s-states-eye-protections-for-investors-if-federal-regulation-falters-idUSKBN1HJ1NT?feedType=RSS&feedName=PersonalFinance; Accessed October 25, 2018.

 

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Topics: Investment Suitability, Suitability Expert, Securities Exchange Commission, Regulation Best Interest, supervision, FINRA Suitability Rule 2111

SEC Regulation Best Interest - Lost Gains Cases

Posted by Jack Duval

Oct 4, 2018 9:12:46 AM

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This blog post continues my series on SEC Regulation Best Interest ("RBI") and the DOL Rule.

A "lost gains" case is one in which the claimant is asking for gains they believe they should have earned but did not.  These cases are different from the traditional securities litigation, where the claimant is asking for actual losses that have been incurred. 

Because the damage theory involves foregone gains instead of out-of-pocket losses, lost gains cases are generally considered to have a higher degree of difficulty.

On the face of it, this is common sense.  If an investor puts $10 million into an account and it declines to $5 million.  Most arbitrators can understand how the client has been damaged.  However, if the same investor puts $10 million into an account and six years later it's still worth $10 million, this is likely to generate less sympathy.

However, in my experience, lost gains cases can represent some of the most abusive fact patterns.

In the lost gains cases I have been involved with, the client’s accounts were essentially treated as an ATM for the Registered Representative.  These fact patterns involved extremely high fees charged for products that were churned into and out of the accounts at issue (as well as account-level fees).  The results were that the Registered Representative appropriated the growth of the accounts.

What growth wasn't appropriated was lost to the short-term holding of the investments.  That is, the investments were never invested as intended and allowed the time needed to generate returns.

In these cases, the clients were invested during strong bull markets but did not participate because of the abusive nature of the trading in their accounts.  

Six years later, they had experienced no growth while their Registered Representatives had made millions (literally).  In a bear market, such a pattern would exacerbate the decline in the accounts due to market forces and be discovered much sooner.  Bull markets hide these kinds of abuses, and the current historic bull market will surely be no exception.

However, what is different this time is the SEC’s pending Regulation Best Interest (“RBI”), which could be made law before the market declines.

Lost Gains Cases Under Regulation Best Interest

Under SEC Regulation Best Interest, lost gains cases should be easy.

This is because the burden of proof will be on the respondents to show their strategy was in the client's best interest and, as I've discussed in my RBI blog post series, they will need to produce contemporaneous evidence of their analyses showing how they came to that conclusion.[1]

In the fact pattern discussed above, this will be impossible.  Furthermore, a key defense will be removed.

Long-Term Time Horizons and the Risks of “Time Diversification”

In many securities litigations, a client's long-term time horizon is used as a defense to justify aggressive investments.  The logic is that the longer an investment is held, the less likely it is to generate a loss.  This is known as “time diversification”.  The problem with time diversification is that it is, at best, only partially correct, at worst it is a setup for disastrous portfolio decisions.[2]

The paradox of time diversification is that in order to benefit from higher returns (in equities usually) the client must increase their risk of interim declines in order to reduce their risk of a terminal loss.[3]

If RBI becomes law, the long-term time horizon will take on a different implication. 

Time Horizon, Fees, and Taxes under Regulation Best Interest

It has always been true that the longer a client's time horizon, the more important minimizing fees and avoiding taxes become.  This is not a matter of debate.  This is not something that reasonable minds can differ upon.  This is a 100 percent mathematical certainty.

Under RBI, this will become a key focal point.

If a client with a long-term time horizon is put into high fee products, charged high account-level fees, and/or churned into and out of commission product on a short-term basis, there is no way to argue it is in their best interest.

For instance, if fees can be reduced by one full percentage point per year, in 30 years time, the difference in terminal values will be about 30 percent.[4] 

For taxable accounts, the difference can be even more stark.  Annual after-tax returns of mutual funds often fall between one and two full percentage points compared to their pre-tax returns (the ones that are advertised).[5]

When combined, high expenses and tax-inefficient investing destroy investor returns.  In such a scenario, the broker, investment manager, and government all get paid before the investor, who is taking all the risk.[6]

Furthermore, the deleterious effects of high fees and taxes are completely return agnostic.  The return-destroying math holds true through all markets, good, bad, or sideways and compounds over time, to the investors disadvantage.

Costs Under Regulation Best Interest

As I have written about here, the SEC has recognized the importance of costs under RBI.[7]

While cost is not the only factor when evaluating an investment or investment strategy, it is one of the most important, if not the most important.  The customers tax status is also critical, which is why it is part of the profiling required under FINRA Rule 2111 and under RBI.[8]

RBI requires the Registered Representative undertake a fact specific analysis before the recommendation is made.  As mentioned above, this analysis will need to show why the recommended investment or strategy is in the best interest of the client compared to other investments offered by the firm.[9]

Any firm that can effectuate stock transactions for a client can purchase index ETFs for the same client (and most will have selling agreements with index mutual fund providers).  Thus, virtually every Broker-Dealer will be required to show why their investment or strategy  recommendation is better over the long-term than an index ETF or mutual fund on a net after-fee, after-tax basis (for their long-term investors).

This will present a significant hurdle for BDs because almost all equity investors are categorized as long-term investors, which is as it should be.[10]

Thus, all client accounts with a long-term time horizon will require an analysis that justifies the fees charged and taxes generated compared to low-fee, low-tax alternatives such as index ETFs and mutual funds.  In my opinion, this analysis will have to be rigorous, mathematical in nature, and be based on conservative assumptions.

Supervision to Avoid Lost Gains Cases

Supervisors will need to insure their Registered Representatives have undertaken a fact specific analysis for all their clients.  For those clients with a long-term time horizon, supervisors will need to insure the analyses comport to industry standards, reflect the client’s best interest given their particular facts and circumstances, and that the findings are reflected in the client’s portfolio.

__________

Notes:

[1]      Regulation Best Interest; Jack Duval; Available at: http://blog.accelerant.biz/blog/topic/regulation-best-interest; Accessed October 4, 2018.

[2]      “The Myth of Time Diversification: Analysis, Application, and Incorrect New Account Forms”; Jack Duval; PIABA Bar Journal; Spring 2006; Available at: http://blog.accelerant.biz/myth-of-time-diversification-whitepaper-0; Accessed October 4, 2018.

[3]       Statistically, the risk of interim declines is known as “first passage time probability”.

[4]       Reducing Attorney Fees (Investment Fees, that is); Jack Duval; Available at: https://blog.bant.am/index.php/2018/04/03/reducing-attorney-fees-investment-fees/; Accessed October 4, 2018.

[5]       Taxes – Another Killer of Attorney Returns; Jack Duval; Available at: https://blog.bant.am/index.php/2018/06/04/taxes-another-killer-of-attorney-returns/; Accessed October 4, 2018.

[6]        Wealth Confiscation by Your Three Investment “Partners”; Jack Duval; Available at: https://blog.bant.am/index.php/2018/09/07/wealth-confiscation-by-your-three-investment-partners/; Accessed October 4, 2018.

[7]         SEC Regulation Best Interest – Reasonable Care; Jack Duval; Available at: http://blog.accelerant.biz/blog/sec-regulation-best-interest-reasonable-care; Accessed October 4, 2018.

[8]         Under RBI, the Retail Customer Investment Profile includes “tax status”; SEC Regulation Best Interest; Release No. 34-83062; File No. S7-07-18; 406.  Available at: https://www.sec.gov/rules/proposed/2018/34-83062.pdf; Accessed October 4, 2018.

[9]          A separate issue is investments not offered by the firm.  This will likely come up for advisors who only sell one type of product such as insurance.  This is a key difference between RBI and the fiduciary duty imposed upon Registered Investment Advisors.  An Investment Advisor's duties are not limited to the products their firm sells.  This is a non-trivial difference and a significant shortfall in RBI.

[10]        Short-term investors should not be invested in equities.  The received view is that only funds which can be held for five years or more should be invested in equities, although some authors suggest avoiding equities unless having a 12-year time horizon.

 

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Topics: Investment Suitability, Suitability Expert, FINRA Rule 2111 (Suitability), Securities Exchange Commission, Regulation Best Interest, Fact Specific Analysis, Lost Gains Cases, supervision

SEC Regulation Best Interest - Reasonable Care

Posted by Jack Duval

Sep 14, 2018 8:12:46 AM

Accelerant SEC Regulation Best Interest - Logo 

This blog post continues my series on SEC Regulation Best Interest ("RBI") and the DOL Rule.

Knowing the Client and the Investment

As I’ve written previously, a Registered Representative must know both the client and the investment in order to make a Best Interest recommendation under the proposed SEC rules.  (This is also true under the existing FINRA Suitability Rule 2111.)

Under RBI, the SEC addresses this directly, writing: [1]

... we believe acting in the best interest of the retail customer would require a broker-dealer to have a reasonable basis to believe that a specific recommendation is in the best interest of the particular retail customer based on its understanding of the investment or investment strategy under proposed paragraph (a)(2)(ii)(A), and in light of the retail customer's investment objectives, financial situation, and needs.  (Emphasis added)

Additionally, the SEC believes the principals that underlie the RBI requirements are the same as those under the DOL’s Best Interest Standard (which was a fiduciary standard):

We believe that the principles underlying our proposed best interest obligation as discussed above, and the specific Disclosure, Care, and Conflict of Interest Obligations described in more detail below, generally draw from underlying principles similar to the principles underlying the DOL's best interest standard, as described by the DOL in the BIC Exemption.[2]  (Emphasis added)

Although RBI does not impose a fiduciary duty, the SEC refers to the DOL Rule (as well as obligations under RBI) regarding how Registered Representatives will be held to a prudent expert standard:

(The DOL Rule) defines advice to be in the "best interest" if the person providing the advice acts "with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with the such (sic) matter would use... without regard to the financial or other interests" of the person.[3]

Further, the proposed Disclosure Obligation, Care Obligation and Conflict of Interest Obligations described in more detail below, establish standards of professional conduct that, among other things, would require the broker-dealer to employ reasonable care when making a recommendation.[4]  (Emphasis added)

Reasonable Care

An important question, then, is what constitutes “reasonable care”?  (I am here only focusing on the reasonable care obligation concerning investments, not those regarding the obligation to know the client.)

At a minimum, reasonable care requires the Registered Representative to undertake an analysis of the potential recommended investments to express her investment thesis and choose one that is in the best interest of the client.

In short, reasonable care requires that the Registered Representative do her homework.  Additionally, the diligence undertaken will need to be evidenced in writing so that it can be supervised, and for the broker’s own protection, should litigation ensue.

Choosing Between Investments

The SEC has provided guidance on the analysis of investments in RBI, writing: [5]

We reiterate that we recognize that it may be consistent with a retail customer's investment objectives - and in many cases, in a retail customer's best interest - for a retail customer to allocate investments across a variety of investment products, or to invest in riskier or more costly products, such as some actively managed mutual funds, variable annuities, and structured products.

However, in recommending such products, a broker-dealer must satisfy its obligations under proposed Regulation Best Interest.  Such recommendations would continue to be evaluated under a fact specific analysis based on the security or investment strategy recommended in connection with the retail customer's investment profile, consistent with the proposed best interest obligation.  (Emphasis added)

Fact Specific Analysis

The “fact specific analysis” is a new requirement and, as mentioned above, will need to be evidenced for each recommendation and supervised by the broker-dealer (“BD”).

The SEC mentions variable annuities as an example of a “more costly product”.  A fact specific analysis would need to show that a variable annuity was in the client’s best interest after accounting for those costs and compared to other available options.  For most variable annuities, this will be exceedingly difficult.

In a typical variable annuity contract the client is charged two to four percent per year in total fees.  These consist of asset management fees, mortality and expense fees, administrative fees, and riders.  Academic literature has shown a typical death benefit guaranteeing the principal to be worth between one and 10 basis points per year.[6]  However, most variable annuity contracts charge 100 to 125 basis points for the guarantee.

Such a high markup is very difficult to justify (as are all the other fees).

The advantage of tax-deferred growth inside a variable annuity is overwhelmed by these extremely high fees and the net investment returns will likely never overcome them when compared to a similar allocation into index funds, which typically distribute no capital gains.

Furthermore, most variable annuities require the sacrifice of liquidity, a risk that is completely uncompensated.[7]

In order to justify the recommendation of a variable annuity under RBI, a Registered Representative would have to show, in a fact specific analysis, how it is in her client’s best interest to buy the variable annuity versus a similar allocation in index funds.

I have yet to see such an analysis and am highly skeptical that one could pass the prudent expert standard.

The Importance of Costs

The SEC recognizes the importance of costs when undertaking a fact specific analysis, writing:[8]

… we emphasize that the costs and financial incentives associated with a recommendation would generally be one of many important factors...

Furthermore, the SEC states clearly that when choosing among identical securities, RBI requires the less expensive security be recommended:[9]

Thus, where, for example, a broker-dealer is choosing among identical securities available to the broker-dealer, it would be inconsistent with the Care Obligation to recommend the more expensive alternative for the customer…

If a broker-dealer recommends a more expensive security or strategy over another reasonably available alternative offered by the broker-dealer, they must have a reasonable basis to believe the higher cost is justified and that the recommendation is in the customer's best interest.

A key word in the quote above is “identical”.  Very few investments are likely to be identical in the literal sense.  However, many are certain to be highly comparable with differences that are essentially trivial.  For instance, in the variable annuity example, a large cap blend sub-account inside the variable annuity is likely to be highly comparable to an S&P 500 Index fund.

A simple correlation analysis would almost certainly reveal that the differences were small, as would an analysis of the holdings and the sub-accounts active share.  Indeed, most funds (or sub-accounts) in the same size and style category are likely to be close to identical, although none would likely meet the literal meaning of “identical”.

The more comparable two investments are, the more important it will be to choose the less expensive option.  For products that have insurance or other features such as principal protection, an additional analysis of the costs, liquidity, guarantor risk, and other factors will be required.

Importantly, the case of identical investments isn’t the only standard the SEC sets out, indeed, it is only a special case.

Comparable Product Factors

The SEC has provided guidance on what a BD must consider when undertaking their fact specific analysis for comparable products or strategies offered by the firm:[10]

While every inquiry will be specific to the broker-dealer and the investment or investment strategy, broker-dealers may wish to consider questions such as: 

  • Can less costly, complex, or risky products available at the broker-dealer achieve the objective of the product?
  • What assumptions underlie the product, and how sound are they? What market or performance factors determine the investor’s return?
  • What are the risks specific to retail customers? If the product was designed mainly to generate yield, does the yield justify the risk to principal?
  • What costs and fees for the retail customer are associated with this product? Why are they appropriate?  Are all of the costs and fees transparent?  How do they compare with comparable products offered by the firm?[11]
  • What financial incentives are associated with the product, and how will costs, fees and compensation relating to the product impact an investor’s return?
  • Does the product present any novel legal, tax, market, investment, or credit risks?
  • How liquid is the product? Is there a secondary market for the product?

As described above, the broker-dealer's diligence and understanding of the risks and rewards would generally involve consideration of factors, such as the costs; the investment objectives and characteristics associated with a product or strategy (including any special or unusual features, liquidity, risks and potential benefits, volatility and likely performance in a variety of market and economic conditions), as well as the financial and other benefits to the broker-dealer.

Fact Specific Analysis Supervision

Perhaps most important is that Registered Representatives will have to undertake their fact specific analysis before the recommendation is made.  As discussed above, that analysis would need to be in writing and show how the recommendation is in the client’s best interest and comports with all their particular facts and circumstances, including risk tolerance and investment objectives.

If there was no analysis, or the analysis was deficient, then the recommendation would likely fail to meet the RBI standard (or might only meet it by chance) and would certainly have failed to have been supervised.

The requirement of a fact specific analysis will necessitate additional supervisory systems and oversight, and BDs will need to implement policies and procedures to make sure they comply with RBI.

__________

Notes:

[1]           SEC Regulation Best Interest; Release No. 34-83062; File No. S7-07-18; Available at: https://www.sec.gov/rules/proposed/2018/34-83062.pdf; Accessed September 12, 2018.

at 141.

[2]           Id. at 58.

[3]           Id. at 108.

[4]           Id. at 59.

[5]           Id. at 147.

[6]           Mose Arye Milevsky and Steven E. Posner; The Titanic Option: Valuation of the Guaranteed Minimum Death Benefit in Variable Annuities and Mutual Funds; The Journal of Risk and Insurance, 2001; Vol. 68; No. 1, 93-128.  Available at: http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.178.1519&rep=rep1&type=pdf;  Accessed September 12, 2018.

[7]           Many variable annuities allow the withdrawal of up to 10 percent of the original investment on a penalty-free basis every year.  However, withdrawals above that amount often have eight to 10 percent penalties in the first year and decline each year after that.

            Typically, investors in illiquid investments such as hedge funds and private equity funds demand an illiquidity premium of three percent per year for the loss of liquidity.  Variable annuities provide no such return premium.  Indeed, because of their fee structure, they are likely to return three percent less than the benchmark each year.

[8]           RBI at 147.

[9]           Id. at 148.

[10]         Id. at 139-40 and 143.

[11]         An interesting question arises about firms that only offer one type of product, such as insurance carriers that only sell insurance or variable products.  I will address this in later posts.

 

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Topics: fiduciary obligations, Investment Suitability, Suitability Expert, FINRA Rule 2111 (Suitability), Securities Exchange Commission, Regulation Best Interest, prudent expert standard, Reasonable Care, Fact Specific Analysis

SEC Regulation Best Interest - The Prudent Expert Standard

Posted by Jack Duval

Aug 23, 2018 9:38:27 AM

Accelerant SEC Regulation Best Interest - Logo 

As discussed in my previous posts, SEC Regulation Best Interest (“RBI”) will require broker-dealers and their agents to put the best interests of their clients first.  What is less well understood is that RBI will also impose a prudent expert standard on Registered Representatives.

There are three broad obligations to RBI:[1]

  • Disclosure;
  • Care, and;
  • Conflicts of Interest.

The Prudent Expert Standard

I am here focusing on the Care Obligation, which the SEC has described as:

The broker, dealer, or natural person who is an associated person of a broker or dealer, in making the recommendation exercises reasonable diligence, care, skill, and prudence to:[2]

  • Understand the potential risks and rewards associated with the recommendation, and have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers;
  • Have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks and rewards associated with the recommendation; and
  • Have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer’s best interest when viewed in isolation, is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile. (Emphasis added)

While RBI does not establish a fiduciary obligation, the SEC is clear that it views the duty to exercise reasonable diligence, care, skill, and prudence as similar to a fiduciary duty, writing:[3]

Under Regulation Best Interest, as proposed, a broker-dealer’s duty to exercise reasonable diligence, care, skill and prudence is designed to be similar to the standard of conduct that has been imposed on broker-dealers found to be acting in a fiduciary capacity.  (Emphasis added)

The “reasonable diligence, care, skill, and prudence” language, as well as the process of understanding “potential risks and rewards”, applying that understanding to the retail customer’s investment profile, and evaluating a series of recommended transactions, all necessitate coming to an expert opinion.

Indeed, coming to an expert opinion will be the only way the Care Obligation can be fulfilled.

The SEC points to the prudent expert standard in RBI, writing:[4]

We believe that the principles underlying our proposed best interest obligation as discussed above, and the specific Disclosure, Care, and Conflict of Interest Obligations described in more detail below, generally draw from underlying principles similar to the principles underlying the DOL’s best interest standard, as described by the DOL in the BIC Exemption

The BIC Exemption’s best interest Impartial Conduct Standard would require (as here relevant) that advice be in a retirement investor’s best interest, and further defines advice to be in the “best interest” if the person providing the advice acts “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with the (sic) such matters would use… without regard to the financial or other interests” of the person..  (Emphasis added)

The SEC believes the principles underlying RBI are consistent with those of the DOL rule.  The DOL language of “a prudent person acting in a like capacity and familiar with such matter” is the prudent expert standard.  Thus, that is the standard that should apply to Registered Representatives making recommendations to retail customers.

Furthermore, the SEC refers to RBI as establishing “standards of professional conduct”:[5]

… the proposed Disclosure Obligation, Care Obligation and Conflict of Interest Obligations described in more detail below, establish standards of professional conduct that, among other things, would require the broker-dealer to employ reasonable care when making a recommendation.  (Emphasis added)

Knowing the Investment and the Client

As with the FINRA Suitability standard, the registered representative must know both the investment and the client in order to meet the Best Interest standard.  The SEC makes this clear in RBI, writing about:

Knowing the investment

Without establishing such a threshold understanding of its particular recommendation, we do not believe that a broker-dealer could, as required by Regulation Best Interest, act in the best interest of a retail customer when making a recommendation…[6]

Knowing the customer

A broker-dealer that makes a recommendation to a retail customer for whom it lacks sufficient information to have a reasonable basis to believe that the recommendation is in the best interest of that retail customer based on the retail customer’s investment profile would not meet its obligations under the proposed rule.[7]

Anyone arguing that the prudent expert standard will not apply under RBI will need to overcome the SEC’s own language, the shingle theory,[8] as well as what will likely be a mountain of advertising and marketing material from the broker-dealer extoling its expertise.[9]  Furthermore, there will be the matter of the CRS Relationship Summary, which will affirm the BDs adherence to the securities law and regulations (including RBI and all the attendant obligations) and will nowhere disavow the firm’s expertise with investments.[10]

Supervisory Implications of the Prudent Expert Standard

Under RBI, broker-dealer supervisors will be tasked with making sure their registered representatives know both their clients and the investments recommended.  In theory, they are doing this already.  However, RBI, by requiring recommendations in the client’s best interest (instead of being merely suitable) will necessitate more work and documentation around knowing the investment.

I will discuss this in more detail in my next post.

__________

Notes:

[1]       SEC Regulation Best Interest; Release No. 34-83062; File No. S7-07-18; Available at: https://www.sec.gov/rules/proposed/2018/34-83062.pdf; Accessed August 23, 2018.

[2]       Id. at 404-5.

[3]       Id. at 134.

[4]       Id. at 58 and footnote 108.  Also see, Accelerant blog post: The DOL Fiduciary Rule – Prudent Expert Standard; Available at: http://blog.accelerant.biz/blog/the-dol-fiduciary-rule-prudent-expert-standard; Accessed August 23, 2018.

[5]       Id. at 59.

[6]       Id. at 137.  This language also exits in FINRA RN 12-25 at Q22.  “Brokers cannot fulfill their suitability responsibilities to customers… when they fail to understand the securities and investment strategies they recommend.”

[7]       Id. at 145.

[8]       The “shingle theory” goes back to a 1943 Second Circuit decision, Charles Hughes & Co., Inc. v. SEC (139 F.2d 434; 2d Cir. 1943).  As Louis Loss wrote: “the theory was that even a dealer at arms’ length implicitly represents when he or she hangs out a shingle that he or she will deal fairly with the public.”  Fundamentals of Securities Regulation, Fourth Edition; Louis Loss and Joel Seligman; Aspen Publishers (New York); 2004; 1063.  Of course, RBI makes the relationship similar that of a fiduciary, which is far higher than one of “arms’ length”.

[9]       See, for instance, Merrill Lynch website of its Private Banking & Investment Group:  “Your private wealth advisor is dedicated to understanding your goals and experienced in the complexities of managing significant wealth.”  Available at: https://www.pbig.ml.com/; Accessed August 23, 2018.

[10]      SEC Form CRS Relationship Summary;  Release No. 34-83063;  IA-4888; File No. S7-08-18.  Available at: https://www.sec.gov/rules/proposed/2018/34-83063.pdf; Accessed August 23, 2018.

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Topics: fiduciary obligations, Investment Suitability, Suitability Expert, FINRA Rule 2111 (Suitability), Securities Exchange Commission, Regulation Best Interest, prudent expert standard

Comparing SEC Regulation Best Interest to Existing FINRA Rules

Posted by Jack Duval

Apr 27, 2018 9:30:35 AM

 

SEC Regulation Best Interest - Commissioner Kara Stein

AGENCE FRANCE-PRESSE/GETTY IMAGES US Securities and Exchange Commissioner Kara Stein.

This blog post continues a series exploring the fiduciary rules proposed by the DOL and now the SEC.  The DOL Rule posts can be found here and the SEC Rule post can be found here.

The SEC's proposed Regulation Best Interest ("RBI") is remarkable in how poorly it is crafted.  Indeed, it is a disaster.

If passed in it's current form, RBI will:

  • Not create a unified fiduciary standard as it was supposed to under the Dodd-Frank Act Section 913;
  • Confuse clients as to the duties of broker-dealers compared to investment advisors, and;
  • Pass off existing FINRA Rules and interpretations as some kind of heightened standard.

Table 1:  Comparing SEC Regulation Best Interest to Existing FINRA Rules

SEC Regulation Best Interest v. Existing FINRA Rules

For a PDF of this table click here.

As can be seen above, the only thing RBI adds are the disclosures relating to the scope and terms of the relationship and material conflicts of interest.  While these are good additions, they fall far short of increasing investor protections.

Everything else in RBI already exists within the FINRA rules.

Kara M. Stein Comments

SEC Commissioner Kara M. Stein has savaged RBI in her public statement:

... does this proposal require financial professionals to put their customers' interest first, and fully and fairly disclose any conflicting interests? No.  Does this proposal require all financial professionals who make investment recommendations related to retail customers to do so as fiduciaries? No.  Does this proposal require financial professionals to provide retail customers with the best available options? No.

Commissioner Stein also points out, as have others, that nowhere in the 1,000+ pages of related documents does RBI define what "best interest" means.  Instead, the RBI states the best interest obligation will be satisfied "if the broker-dealer complies with four component requirements: a Disclosure Obligation, a Care Obligation,and two Conflict of Interest Obligations."  (96)

Thus, broker-dealers will be able to check the boxes to prove that they complied with an undefined "best interest" obligation that already exists under FINRA rules.  This can only weaken investor protection.

To learn more about fiduciary expert Jack Duval, click here.

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Topics: fiduciary obligations, Investment Suitability, Suitability Expert, FINRA Rule 2111 (Suitability), Securities Exchange Commission, Regulation Best Interest, erisa fiduciary expert, fiduciary expert

SEC Regulation Best Interest

Posted by Jack Duval

Apr 20, 2018 8:18:52 AM

Accelerant SEC Regulation Best Interest - Logo 

 

This blog post continues a series exploring the fiduciary rules proposed by the DOL and now the SEC.  My previous blog posts can be found here.

On Wednesday, April 18, 2018, the SEC issued a number of rule proposals designed, in theory, to "unify" the obligations of registered representatives of broker dealers with those of registered investment advisors.

It does no such thing.

Broker-dealers and their registered representatives will not be fiduciaries under Regulation Best Interest.  Investment advisors will remain fiduciaries.

Essentially, Regulation Best Interest will take many of the obligations that already exist in the FINRA Rules and Regulatory Notices and bring them under the SEC's aegis.  Indeed, the SEC stated:

As discussed herein, some of the enhancements that Regulation Best Interest would make to existing suitability obligations under the federal securities laws, such as the collection of information requirement related to a customer's investment profile, the inability to disclose away a broker-dealer's suitability obligation, and a requirement to make recommendations that are "consistent with his customers' best interest," reflect obligations that already exist under the FINRA suitability rule or have been articulated in related FINRA interpretations and case law.  (Emphasis added.  Regulation Best Interest; 10)

This means the suitability standard will remain for registered representatives with some additional language about the "best interests" of the client.  I will try to define exactly what the additional "best interest" language actually means in subsequent posts.

The SEC has released approximately 1,000 pages relating to this proposal.  You can find the three related releases here:

Release No. 34-83062; Regulation Best Interest;

Release No. IA-4889; Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on Enhancing Investment Adviser Regulation;

Release No. 34-83063; form CRS Relationship Summary; Amendments to Form ADV; Required Disclosures in Retail Communications and Restrictions on the use of Certain Names or Titles.

To learn more about fiduciary expert Jack Duval, click here.

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Topics: fiduciary obligations, Investment Suitability, Suitability Expert, FINRA Rule 2111 (Suitability), Securities Exchange Commission, Regulation Best Interest

Understanding FINRA Suitability Rule 2111 - Prospectus Delivery and Suitability

Posted by Jack Duval

Dec 19, 2013 10:27:00 AM

This blog post continues our expert 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 this post we examine the obligation of prospectus delivery and how it interacts with the suitability rule.

Prospectus Delivery and Suitability

Many securities transactions require the delivery of a prospectus.  At the same time, the obligation to deliver a prospectus exists side by side with the suitability obligation.  However, the delivery of a prospectus does not remove the suitability obligation, nor is it a substitute for the the customer-specific and reasonable-basis suitability process that must accompany each recommendation.

More directly, FINRA has been, and remains, crystal clear in its position that the delivery of a prospectus to a client does not cure an otherwise unsuitable recommendation nor any material misstatements or omissions that were made during the recommendation.

This position goes back in the FINRA literature at least to 1994.  For instance, in NASD NTM 94-16, the (then) NASD advised:

Members are also advised that, although the prospectus and sales material of a fund include disclosures on many matters, oral representations by sales personnel that contradict the disclosures in the prospectus or sale literature may nullify the effect of the written disclosures and may make the member liable for rule violations and civil damages to the customers that result from such oral representations.[1] (Emphasis added)

Furthermore, a number of FINRA Enforcement decisions reiterate this position, including the following:

  • Department of Enforcement v. Hornblower & Weeks, 2004. “Respondent could not cure defects in disclosure by providing more detail and further disclosure in the same package or by answering questions.” [2]
  • Department of Enforcement v. Ryan Mark Reynolds, 2001.  “The SEC has held that, in the enforcement context, a registered representative may be found in violation of the NASD’s rules and the federal securities laws for failure to fully disclose risks to customers even through such risks may have been discussed in a prospectus delivered to customers.”[3] (Emphasis added)
  • Department of Enforcement v. Pacific On-Line Trading & Securities, 2002. “Finding that the subsequent dissemination of disclosure information does not cure earlier misleading disclosures.”[4]

Lastly, under Rule 2111, Supplementary Material 2111.02 states explicitly:  “Disclaimers. A member or associated person cannot disclaim any responsibilities under the suitability rule.” This is consistent with all of FINRAs previous guidance.[5] 

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]        NASD NTM 04-16, Mutual Fund Sales Practice Obligations; available at http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=1759&element_id=1518&highlight=94-16#r1759; accessed June 23, 2013.

[2]        FINRA NTM 05-59, Structured Products; available at http://www.complinet.com/file_store/pdf/rulebooks/nasd_0559ntm.pdf; accessed June 23, 2013.

[3]        Id.

[4]        Id.

[5]        See, for instance, FINRA RN 12-25, “FINRA reiterates, however, that many of the obligations under the new rule are the same as those under the predecessor rule and related case law. Existing guidance and interpretations regarding suitability obligations continue to apply to the extent that they are not inconsistent with the new rule.”  (Emphasis added) May 2012, 2.

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Topics: FINRA Suitability Rule 2111, Suitability Expert, Customer-specific Suitability, Prospectus Delivery, Reasonable

Understanding FINRA Suitability Rule 2111 - Leveraged and Inverse ETF Suitability

Posted by Jack Duval

Dec 17, 2013 6:56:00 AM

This blog post continues our expert 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.

ETF Specific Suitability

Leveraged and inverse ETFs are not suitable for most investors because they are (respectively) speculative and aggressive investments.  In order to understand why these investments are speculative and aggressive it is helpful to define those terms.

Speculation

Speculation is a term of art within the investment world and it has a very specific meaning, in particular, it indicates the high probability of the complete, or near complete, loss of the entire investment.  A classic example of a speculative investment is purchasing an out-of-the-money (“OTM”) call option on a stock.

When you purchase an OTM call option, it has a fixed amount of time before it expires worthless.  If the underlying stock does not rise above the strike price before the expiration date, the call option will become worthless and the investor will have lost the entire premium she paid for it.

Aggressive

Aggressive investments are also a term of art within the investment world.  An aggressive investment is one in which there can be expected large and violent price movements, but which do not have a high likelihood of a total loss. A good example of an aggressive investment is an investment in a stock market index such as the S&P 500 or the NASDAQ index.

As recent investors in the above indicies can attest, both have experienced extreme volatility over the past 14 years. Indeed, the S&P 500 declined approximately 45 percent twice and the NASDAQ declined approximately 70 percent and 50 percent over the same time period.  While these investments are extremely volatile, they carry a much smaller risk of complete loss than a stock option, and thus are in a different category.

Investment Math

Additionally, the more speculative or aggressive an investment is, the more closely it must be watched and the more active management it requires.  This is due to what is commonly referred to as “investment math”. If an investor holds an investment that declines by 50 percent and then rises by 50 percent, they are still down 25 percent on a dollar basis.  The reason for this is that the positive 50 percent return came after the investment had already declined by 50 percent, so it was a 50 percent return on a “50 percent investment”.  Thus that return was only 25 percent of the original investment.

A simple example is instructive. If an investor invests $100,000 and it declines to $50,000, a 50 percent return on the $50,000 only gets her back to $75,000.  She is still down $25,000 on her original investment.  What is needed is a 100 percent return after the original decline (because a 100 percent return on $50,000 is $50,000 and this would get her back to her original investment value).

This investment math is why investors who have been invested in the broad stock market since 2000 have the same portfolio value 13 years later.  They suffered through two declines of around 50 percent and subsequent recoveries of around 100 percent but their portfolios are at the same approximate value as when they started.

Using broad asset allocation rebalancing on a quarterly or annual basis is a way to more actively manage aggressive positions. However, more frequent management may be warranted given an investment’s specific traits. In particular, leveraged and inverse ETFs require constant vigilance and frequent (even daily) rebalancing by the advisor if they are held longer than one day.

As discussed in other posts, leveraged ETFs are speculative because the use of leverage magnifies the deleterious effects of internal rebalancing to maintain constant leverage. Simply put, the more leverage used, the faster the ETF declines towards zero.

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.  

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

 

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Topics: Investment Suitability, FINRA Suitability Rule 2111, Suitability Expert, Leveraged and Inverse ETF, Speculative and Aggressive Investments

Understanding FINRA Suitability Rule 2111

Posted by Jack Duval

Dec 13, 2013 9:25:00 AM

This blog post is the first in 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.

Suitability

The concept of suitability can be succinctly stated as appropriately matching investments to the investor. In order to accomplish a suitability determination, a broker must know and understand both the investments and the investor.  Given that the FINRA suitability rule has recently been updated to explicitly include both elements, both will be examined.

FINRA Rule 2010 (Standards of Commercial Honor and Principals of Trade)

Before addressing suitability it is worth noting that FIRNA Rule 2010 sets forth the standard for member conduct. This Rule states simply:

 A member, in the conduct of its business, shall observe high standards of commercial honor and just and equitable principles of trade.[1]              

While not a fiduciary standard, FINRA is clearly setting the bar beyond mere arms length transactions and caveat emptor. This standard should be kept in mind by member firms and their associated persons in all their dealings with customers and other member firms.

FINRA Rule 2310 (Recommendations to Customers)

During the initial popularity of leveraged and inverse ETFs in 2006-2007, Registered Representatives (hereafter “brokers”) working for FINRA member firms, were required under Rule 2310 to insure each recommendation made to a client was “suitable”.  FINRA Suitability Rule 2310 stated (in part):

(a)   In recommending to a customer the purchase, sale or exchange of any security, a member shall 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.
(b)   Prior to the execution of a transaction recommended to a non-institutional customer, other than transactions with customers where investments are limited to money market mutual funds, a member shall make reasonable efforts to obtain information concerning:
(1) the customer's financial status;
(2) the customer's tax status;
(3) the customer's investment objectives; and
(4) such other information used or considered to be reasonable by such member or registered representative in making recommendations to the customer. [2]

In order to comply with FINRA Rule 2310, the broker must know her client.  In order to know her client, a broker must conduct the necessary due diligence by gathering all the pertinent facts, goals, objectives, and circumstances of the client. In the industry, this process is known as “profiling”.

Similarly, in order to know an investment, a broker must conduct the necessary due diligence by reading the prospectus, prospectus supplements, statements of additional information, and other documents, depending on the type of investment being recommended.

Once the broker knows her client and many different investments, she can go about selecting investments that are within the client’s risk tolerance and investment objectives and will help achieve her client’s goals and objectives.

Importantly, if either side of the suitability due diligence equation is not completed, the recommendation cannot be said to be suitable.  More specifically, if the broker does not know the client or the investment, or both, then she cannot have “reasonable grounds” for believing the recommendation is suitable.

FINRA Rule 2111 (Suitability)

On July 9th, 2012, FINRA updated Rule 2310 with a new suitability rule, 2111.  FINRA Rule 2111 states, in part:

(a)   A member or an associated person 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 member or associated person to ascertain the customer's investment profile. A customer's investment profile includes, but is not limited to, the customer's age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation.[3]

A few aspects of this are worth highlighting:  the explicit inclusion of investment strategies; the explicit description of the three components of the suitability obligation; and the treatment of a recommendation to hold as a recommendation.

As will be discussed, all three of these aspects existed before the new suitability rule, with Rule 2111, FINRA has merely brought them together in one place.[4] This has greatly simplified the rule for brokers and broker-dealer firms and should lead to better supervisory practices and customer outcomes.

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]                 FINRA Rule 2010 (Standards of Commercial Honor and Principles of Trade); available at http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=6905&element_id=5504&highlight=2010#r6905; accessed June 20, 2013.

[2]                 FINRA Rule 2310 (Recommendations to Customers), FINRA Manual; available at http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=4315&element_id=3638&highlight=2310#r4315; accessed June 16, 2013.

[3]                 FINRA Rule 2111, FINRA Manual; available at http://finra.complinet.com/en/display/display.html?rbid=2403&element_id=9859; accessed June 16, 2013.

[4]                 See, for instance, FINRA RN 12-25, “FINRA reiterates, however, that many of the obligations under the new rule are the same as those under the predecessor rule and related case law. Existing guidance and interpretations regarding suitability obligations continue to apply to the extent that they are not inconsistent with the new rule.”  (Emphasis added) May 2012, 2.

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Topics: Investment Suitability, FINRA Suitability Rule 2111, Suitability Expert

Understanding FINRA Suitability Rule 2111 - Recommendations to Hold

Posted by Jack Duval

Dec 13, 2013 8:46:00 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 hold recommendations.

Hold as a Recommendation

Advice to hold a security is now clearly considered a recommendation, and is captured in the “investment strategy” language of Rule 2111.[1] FINRA RN 11-25 makes it clear that even recommendations which do not result in transactions come under the aegis of the Rule:

The rule explicitly states that the term “strategy” should be interpreted broadly.The rule would cover a recommended investment strategy regardless of whetherthe recommendation results in a securities transaction or even references a specificsecurity or securities. For instance, the rule would cover a recommendation topurchase securities using marginor liquefied home equityor engage in daytrading,irrespective of whether the recommendation results in a transaction orreferences particular securities.[2] (Emphasis added)

And then even more specifically:

The term also would capture an explicit recommendation to hold a security or securities.  While a decision to hold might be considered a passive strategy, an explicit recommendation to hold does constitute the type of advice upon which a customer can be expected to rely. An explicit recommendation to hold is tantamount to a “call to action”[3] in the sense of a suggestion that the customer stay the course with the investment. The rule would apply, for example, when an associated person meets with a customer during a quarterly or annual investment review and explicitly advises the customer not to sell any securities in or make any changes to the account or portfolio.[4] (Emphasis added).

Importantly, FINRA RN 12-25 addresses the documentation of hold recommendations, and highlights those involving leveraged and inverse ETFs:

For "hold" recommendations, FINRA has stated that a firm may want to focus on securities that by their nature or due to particular circumstances could be viewed as having a shorter-term investment component; that have a periodic reset or similar mechanism that could alter a product's character over time; that are particularly susceptible to changes in market conditions; or that are otherwise potentially risky or problematic to hold at the time the recommendations are made. 

Some possible examples could include leveraged ETFs (because they reset daily and their performance over long periods can differ significantly from the performance of the underlying index or benchmark during the same period)…”[5] (Emphasis added)

These requirements are in addition to the general obligation of member firms to evidence compliance with applicable FINRA rules.[6]

---------------

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]        Under NYSE Rule 472 (Communication with the Public) a hold was included in the definition of a recommendation.  Under Rule 472.10/09:  “For purposes of these standards, the term ‘recommendation’ includes any advice, suggestion or other statement, written or oral, that is intended, or can reasonably be expected to influence a customer to purchase, sell or hold a security.”  (Emphasis added); available at http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=15076&element_id=11054&highlight=472#r15076; accessed August 1, 2013.

[2]        FINRA Regulatory Notice 11-25, Know Your Customer and Suitability; May 2011; (Implementation Date: July 9, 2012); A7; available at http://finra.complinet.com/net_file_store/new_rulebooks/f/i/finra_11-25.pdf; accessed June 19, 2013.

[3]        The “call to action” standard is addressed in NASD NTM 01-23, which was issued in response to the proliferation of online trading firms putting out generic “tip sheets”, “top 10 lists” and other communications regarding stocks. The primary question this NTM addresses is whether or not these types of generic communication constitute a recommendation and thus would be subject to Rule 2310.  In short, they do not.

              The guidance principles enumerated in NTM 01-23 were that: (1) the communication had to be a call to action on the part of the investor; and (2) the more tailored the communication was to an individual’s particular facts and circumstances, the more likely it was to be a recommendation.

              While generic tip sheets may constitute a call to action (buy these five stocks now!), they fail in the second criteria, and thus are not recommendations.

[4]        Id.

[5]        FINRA Regulatory Notice 12-25 at A13.

[6]        Id. at A12.

 

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Topics: hold recommendations, Investment Suitability, FINRA Suitability Rule 2111, Suitability Expert, Customer-specific Suitability

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