by Howard Haykin

FINRA does not often cite “de facto control” in its disciplinary cases – i.e., AWC’s or ‘Acceptance, Waiver and Consent’ Letters – but it did so in 3 recent cases. [see FINRA case studies]  Instead, FINRA has tended to cite brokers for ‘exercising unauthorized discretion’ while excessively trading – aka “churning” - in customers' accounts.  

DIFFERENTIATING ‘ACTUAL’ FROM ‘DE FACTO’ CONTROL   Under the quantitative suitability obligation, control can be actual or de facto. In general,…

• actual control exists when a broker has formal discretionary authority over a customer’s account.
• de facto control over a customer’s account depends on whether the customer routinely follows the broker’s advice because the customer is unable to evaluate the broker’s recommendations and exercise independent judgment.

In practice, however, these assessments can be difficult to make and they place a heavy and unnecessary burden on customers by, in effect, asking them to admit that they lack sophistication or the ability to evaluate a broker’s recommendations. This is true even where it is otherwise clear that the broker recommended the transactions and that they were excessive and unsuitable.

FINRA is concerned that the control element serves as an impediment to investor protection and an unwarranted defense to unscrupulous brokers.

SO, WHERE ARE WE HEADED?    Going forward, FINRA member firms and their associated persons can expect FINRA to expand its references to “De Facto Control” – buttressed in part by FINRA’s proposal to amend Rule 2111 (Suitability). [see Regulatory Notice 18-13, “Quantitative Suitability FINRA Requests Comment on Proposed Amendments to the Quantitative Suitability Obligation Under FINRA Rule 2111.” - - - Comment Period ends Tuesday, June 19th.]

As proposed, FINRA would revise the quantitative suitability obligation under FINRA Rule 2111 to more effectively address instances of excessive trading in customers’ accounts. FINRA would remove the element of control that currently must be proved to demonstrate a violation, without changing the obligations to prove that: (i) the transactions were recommended; and; (ii) the level of trading was excessive and unsuitable in light of the customer’s investment profile.

DELETED AND ADDED WORDING TO RULE 2111. 

2111. Suitability

(a) through (b)  No Change.

• • • Supplementary Material: --------------

.01 through .04  No Change

.05 Components of Suitability Obligations. Rule 2111 is composed of three main obligations: reasonable-basis suitability, customer-specific suitability, and quantitative suitability.

(a) through (b) No Change.

(c) 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 the member or associated person recommended to the customer account, 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). 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.

.06 through .07  No Change.