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What Investors Can Learn from the 2023 FINRA Examination

Securities Lawyer Jonathan Kurta
By: Jonathan Kurta Author
February 21, 2023 at 8:51pm

Regulation Best Interest (Reg BI) appears in the 2023 FINRA Examination Risk Monitoring Program, suggesting that FINRA will be scrutinizing firms more closely this year for their compliance with this new regulation. Reg BI is designed to enhance protections for investors against predatory brokerage firms. But with only two enforcement in 2022, regulators will need to ramp up enforcement if investors are to experience a widespread benefit.

What is Regulation Best Interest?

Regulation Best Interest expands on the requirements of FINRA Rule 2111, which requires that brokers exclusively recommend investments that are in line with the investor’s financial needs. Their financial needs should account for their tax status, financial goals, age, and risk tolerance.

In addition to these concerns, Reg BI has added a Duty of Care Obligation, a Conflict of Interest Obligation, and a Disclosure Obligation to the list of broker responsibilities.

Duty of Care Obligation

Under the “Duty of Care” obligation, brokers must understand how a product works before they recommend it to their clients. Brokerage firms and the associated brokers must exercise reasonable diligence, care, and skill to understand a product’s potential risks, rewards, and costs. This means that brokers who recommend complex products should be aware if there are any products on the market that offer similar rewards at a lower cost.

One of the questions mentioned in the Care Obligation section of the Risk Monitoring Report asks:

  • Does your firm consider a sufficient array of reasonable alternatives, including lower cost or lower-risk alternatives your firm offers?
  • Has your firm considered applying heightened scrutiny as to whether recommended investments that are high-risk, high-cost, complex, or represent a high conflict of interest are in a retail customer’s best interest?

Conflict of Interest Obligation

The FINRA exam asks:

Are your firm’s policies reasonably designed to identify, and, at a minimum, disclose or eliminate conflicts associated with recommendations?

What Are Conflicts of Interest?

A conflict of interest might involve a broker recommending shares of a company that he or she also owns shares of. Firms should also disclose if they intend to limit their recommendations to the firm’s own products.

What Steps Should Firms Take to Avoid Conflicts of Interest?

The exam also asks firms to take the following steps to avoid conflicts of interest:

  • Minimize financial incentives for brokers to favor one type of account over another.
  • Adjust compensation for financial professionals who fail to adequately manage conflicts of interest.

Disclosure Obligation

Brokerage firms should disclose all material facts relating to their relationships with their retail customers.

Material facts include:

  • Fees and costs associated with transactions,
  • Minimum account sizes, and
  • The philosophy behind the firm’s overall investment strategy.
Securities Lawyer Jonathan Kurta
Written by: Jonathan Kurta

Jonathan Kurta is an accomplished securities attorney and a founding partner at Kurta Law.

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Reg BI Enforcements

2022 saw two Reg BI regulatory actions–one brought by SEC against an advisory firm and the other by FINRA against a broker. These enforcement actions may give some clue as to what types of enforcement actions FINRA and the SEC will bring in 2023.

SEC and Western International Securities

In June 2022, the SEC brought a Reg BI enforcement action against Western International Securities, alleging that Western brokers had failed to meet their duty of care obligation under Reg BI when they recommended L Bonds issued by GWG Holdings.

According to the complaint, the L Bonds were “high risk, illiquid, and only suitable for customers with substantial resources.” Five Western brokers allegedly sold approximately $13.3 million in L Bonds to retail customers with moderate-conservative or moderate risk tolerances.

The SEC seeks to impose civil penalties and wants brokers to repay any unjust enrichment.

FINRA Regulatory Action Against Network 1 Broker

FINRA issued its first Reg BI enforcement action in September of 2022. The regulator alleged that a broker associated with Network 1 Financial Securities violated Reg BI by recommending an excessive number of trades in one customer’s account.

  • FINRA determines excessive trading by examining the cost-to-equity ratio and the turnover rate.
  • The cost-to-equity ratio compares the value of the account to the cost associated with transactions. It measures how much the account would need to grow in order to break even.
  • The turnover rate is the number of times a broker exchanges one portfolio of securities for another portfolio of securities.
  • A cost-to-equity ratio of above 20% or a turnover rate of 6 or higher indicates excessive trading.

An Acceptance, Waiver, and Consent agreement alleges that from July 2020 to November 2021, a Network 1 broker recommended an excessive number of trades for a 63-year-old customer with a liquid net worth of approximately $50,000. The broker allegedly recommended 350 trades, causing the customer to pay more than $54,000 in commissions.

The customer allegedly lost $17,500 during the relevant period, and the broker’s trading pattern resulted in a cost-to-equity ratio of over 158%, meaning the account value would have to grow by 158% in order to break even. It was therefore highly unlikely the investor would see any profit, meaning that the investment strategy constituted a violation of Reg BI.

As part of the terms of the AWC, the Network 1 broker consented to a six-month suspension and a $5,000 fine.

Does My Firm Comply with Reg BI?

If you have significant, unexpected losses in your portfolio, especially if you are an investor with conservative goals, your brokerage firm and associated brokers may not have complied with Reg BI. Investors should carefully review their portfolios if their broker recommended an alternative or high-risk investment – like a non-traded REIT, an oil and gas investment, or a leveraged, inverse ETF. Contacting a securities attorney is the best way to determine if you have a case. Call (877) 600-0098 or email info@kurtalawfirm.com.