On April 20, 2018, FINRA released Regulatory Notice 18-13 to announce a proposed amendment to its Suitability Rule (Rule 2111). Specifically, FINRA’s proposal would eliminate the requirement to prove control by a broker in an excessive trading claim, while maintaining the other requirements, namely that the transactions were recommended by the broker and that the level of trading was excessive and unsuitable in light of the investment profile of the customer. A copy of the Regulatory Notice can be found at http://www.finra.org/sites/default/files/notice_doc_file_ref/Regulatory-Notice-18-13.pdf
Under the current Suitability Rule, to prove an excessive trading claim, there must be a showing of control, either actual or de facto, by the broker. Actual control exists where the broker has formal discretionary trading authority over the customer’s account. De facto control is where the broker does not have formal discretionary trading authority, but the relationship is such that the customer, according to FINRA, “routinely follows the broker’s advice because the customer is unable to evaluate the broker’s recommendations and exercise independent judgment.” The reason for the proposed Rule change, according to the Regulatory Notice, is that “FINRA is concerned that the control element serves as an impediment to investor protection and an unwarranted defense to unscrupulous brokers.” FINRA believes that “[t]he 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 inconsistent with the customer’s investment profile).” The requirement to prove that the broker recommended the transactions will still serve the purpose of identifying the responsible party, according to FINRA.
Notably, even if the control element were to be removed, FINRA would still need to prove that the series of transactions (recommended by the broker) were excessive and unsuitable. “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.” The proposed rule amendment would not affect the extensive case law on this requirement.
Although it is well settled that there is no private right of action for violation of FINRA rules, if approved this rule change will inevitably find its way into civil litigation. Certainly, the proposed change opens the door for claimants’ counsel to argue that it is only the broker’s recommendation of the “excessive” transactions at issue that matters and that panels should disregard the customer’s sophistication, involvement in the investment decisions and history of rejecting investment recommendations in the past (i.e., the broker did not control the account). How receptive arbitration panels are to ignoring the customer’s sophistication and past conduct will remain to be seen.
The comment period on FINRA’s proposed rule change runs through June 19, 2018.