Financial services firms are facing increased scrutiny around Regulation Best Interest as more brokers and their firms see enforcement actions and large fines
Securities regulators in the United States have stepped up their oversight of Regulation Best Interest (Reg BI), with a rising number of enforcement actions and large fines against individuals and firms that violate sales practice rules.
The number of Financial Industry Regulatory Authority (FINRA) actions has tripled over last year, when a moratorium on enforcement during the pandemic was rolled back. Examiners are making compliance with the comprehensive sales practice rules a top priority.
Recent enforcement shows that FINRA and the Securities and Exchange Commission (SEC) expect firms to significantly enhance sales supervision to comply with Reg BI, which requires firms to prioritize customer interests ahead of their own. The actions signal the start of what securities regulators have warned would be a “more substantive” phase in enforcing Reg BI. Indeed, SEC Chair Gary Gensler has said Reg BI will be enforced “to the letter.”
In one new action settled recently, FINRA imposed a 20-month suspension on former Spartan Capital Securities broker Troy Allen Orlando and ordered him to pay $58,000 in restitution to harmed customers. It marked the 22nd FINRA enforcement action citing Reg BI so far in 2023, after just eight cases the prior year, based on a search of the FINRA Disciplinary Actions Online website. The enforcement strategy of imposing personal fines for sales practice violations also surfaced in the case.
Recent enforcement shows that FINRA and the SEC expect firms to significantly enhance sales supervision to comply with Reg BI
Actions by the SEC, as well, have become more frequent and more costly for firms and individual investment professionals. In a settlement announced on Nov. 20, the SEC charged Laidlaw and Company (UK) Ltd. with violations of the Reg BI Care Obligation. Laidlaw allegedly failed to supervise excessive account trading by its brokers and settled charges by paying $800,000 in fines, showing that penalties are escalating to become a material concern.
Laidlaw had a monitoring system to review for excessive trading but no system for addressing red flags, the SEC alleged. The regulator settled excessive trading charges with two individuals at the firm: Richard Michalski was suspended for six months, and Michael Murray paid $93,000 in restitution and fines.
The SEC and FINRA in November both took enforcement actions that required individual investment advisers to pay back a portion of customer losses. These actions suggested a departure from past enforcements that typically required firms, not individual brokers, to compensate harmed investors and rarely required the same of registered representatives. By targeting individuals, regulators are aiming to deter sales practice misconduct by representatives who undermine firms’ fiduciary standards or by firm supervisors who ignore rule breakers.
The recent actions also showed that enforcement citing firms for Reg BI-type fiduciary violations can cover misconduct that took place prior to Reg BI going into effect in 2020. While the recent FINRA and SEC actions cited Reg BI, they alleged patterns of behavior that predated the new rules and took actions based on brokers conducting trades in client accounts without regard to risk tolerance and personal profiles.
‘More and more’ enforcement coming
SEC and FINRA officials at an enforcement conference earlier this year forecasted an expansion in both the number and scope of Reg BI cases. FINRA’s then-senior vice president and acting head of enforcement, Chris Kelly, said there would be “more and more” cases involving all four pillars of Reg BI, instead of smaller actions involving overdue filings and incomplete disclosures. Reg BI pillars include the disclosure obligation, care obligation, conflict of interest obligation, and compliance obligation.
Skeptics of the sales practice rules have argued that the principles-based Reg BI for brokers and similar investment adviser practice rules would have little impact unless securities regulators took action against front-line investment professionals responsible for wrongdoing.
In the past, individuals have faced suspensions and modest fines while firms bore nearly all the cost of compensating harmed investors. With the Reg BI-related rules and enhanced surveillance under the consolidated audit trail, firms have more powerful tools to ensure compliance. Indeed, failure to use those tools effectively to curb abusive sales practices, the new cases show, has raised the liability for supervisors and firms.
Compliance experts see excessive trading as just the first category of violations in securities regulators’ sights, and SEC and FINRA enforcement officials have warned they will apply it more broadly in areas
The alleged abusive actions in the Orlando case took place at three different firms between December 2018 and November 2020, with just four months of his activity covered by Reg BI, which, among other things, eliminated the defense that brokers were immune to liability if their clients had approved active trading strategies.
Regulators assessing de facto account control
The regulators in all of the recent account-churning cases charged firms with violating the newly revised Rule 2111 (concerning suitability) that makes firms liable for trades even when clients give representatives “actual or de facto control” of their accounts. The rule tweak makes it easier for enforcers to open cases based on trade surveillance showing unusual levels of account activity.
FINRA alleged that Orlando generated more than $200,000 in five accounts over which he had “de facto” control while causing trading losses for customers of between $40,000 to $80,000.
Under the new rules for quantitative suitability, the broker was found to have violated the Reg BI care obligation when he, “recommended a series of trades in five customers’ accounts that were excessive, unsuitable, and not in the customers’ best interest,” over two years. In fact, the investigation found that Orlando traded funds of five customers with limited or moderate means at annual turnover rates between six- to 93-times the value of their accounts. FINRA generally views any turnover rate of six-times the account value as excessive.
Before these latest actions, agency enforcers had taken mostly small Reg BI enforcement actions alleging disclosure or process violations. As recently as 2021, they cited Reg BI violations as a factor in only two enforcement cases for the entire year, the FINRA database shows. Since then, excessive trading has been cited in more numerous cases of alleged Reg BI violations, along with a growing number of cases stemming from examinations that found deficiencies in Reg BI compliance, most often for failing to update processes and procedures to reflect the new sales practice rules or failing to put specific controls in place to implement the 1,500-word sales practice suite of rules that marked the most comprehensive regulatory effort in decades. Moreover, the number and type of Reg BI actions could be set to expand further, regulators have said.
Compliance experts see excessive trading as just the first category of violations in securities regulators’ sights, and SEC and FINRA enforcement officials have warned they will apply it more broadly in areas such as complex products, investments that charge high fees, and commissions that undermine clients’ best interests.
The scope of potential enforcement categories was previewed in an SEC Division of Examinations Reg BI Risk Alert earlier this year, which listed 20 potential violations surfacing at firms. And FINRA’s 2023 report on its Examination and Risk Monitoring Program listed more than 50 Reg BI red flags based on examination of the agency’s findings over the past year.
Additional reporting was done by Todd Ehret, a Senior Regulatory Intelligence Expert for Thomson Reuters Regulatory Intelligence.
