On October 27, 2010, the Financial Industry Regulatory Authority (“FINRA”) issued a concept proposal (the “Proposal”)1 that would require FINRA-member firms (“Members”) to provide every retail customer with a written disclosure statement (“Disclosure Statement”) prior to establishing a business relationship with that customer. The Disclosure Statement would describe the kinds of accounts and services the Member offers to retail customers and the costs of those services. The Disclosure Statement also would explain the conflicts of interest associated with those services, as well as limits on the duties a Member owes to its retail customers. FINRA compares the proposed Disclosure Statement to the Form ADV Part II that investment advisers are required to provide to their customers.
The Disclosure Statement
As described by FINRA, the Proposal would require Members to provide “retail customers” with a Disclosure Statement prior to the commencement of their business relationship. A “retail customer” would be defined as a customer that does not fall under the definition of an “institutional account” under NASD Rule 3110(c)(4), which essentially includes any entity (including natural persons) with total assets of at least $50 million.
The Disclosure Statement would be required to describe and/or contain:
The type of brokerage accounts and services the Member provides to its retail customers and all fees associated with each such brokerage account and service (specifically showing the service provided for each fee and whether fees are negotiable), all presented in a manner permitting customers to compare such accounts, services, and fees among competing broker-dealers;
Information “reasonably designed” to allow existing and prospective retail customers to evaluate the scope of and limits on the Member’s product offerings and services. Examples of such limits could include the type of securities or research services offered by a Member that are attributable to its own operations (e.g., proprietary trading or sponsoring and originating certain products) or its relationships with issuers (e.g., issuers for which the Member acts as investment banker);
Any financial or other incentives that the Member or its registered representatives have to recommend a particular product, strategy, or service over competing alternatives, such as:
direct payments from offerors;
other economic benefits from any person that provide an incentive for the sale of a particular product, strategy, or service;
any arrangement providing an incentive for the Member to refer retail customers from or to a particular individual or firm; and
any arrangement which provides a Member’s representatives differing compensation for certain products or services so that the representatives would be “reasonably likely” to offer those products or services over alternatives offered by the Member;
Any potential conflicts that may arise between a Member and its customers, as well as those that may result from the Member needing to address the competing needs of customers, and how the Member manages such conflicts; and
Limits on the duties a Member owes to its customers, such as limits on the oversight of the ongoing suitability of an investment or portfolio of investments, or whether the Member oversees the “propriety” of unsolicited orders.
FINRA asks whether the proposed disclosures should be delivered in paper form, electronically, or both, and whether there should be a two-tiered disclosure with more detailed information available through hyper-links. FINRA asks how detailed the disclosures should be and whether they would overwhelm retail investors. And FINRA asks how often the disclosures should be updated and delivered to customers.
Ongoing Reforms to Financial Regulation
The Proposal represents one in a series of regulatory efforts to improve disclosures to retail investors and impose fiduciary duties on financial services firms. It comes at a time when several similar issues are under consideration by the SEC:
- The FINRA Proposal is similar to the SEC’s “Point of Sale” disclosures for mutual funds that would have been required under Proposed Rule 15c2-3, which was released for comment by the SEC in 20042 and 2005.3 Proposed Rule 15c2-3 would have required similar disclosures prior to the execution of a transaction in an investment company security. By contrast, the FINRA Proposal would require that the Disclosure Statement be provided prior to the establishment of a business relationship with a retail client. Proposed Rule 15c2-3 remains open for consideration at the Commission, and Section 919 of the Dodd-Frank Act specifically grants the SEC authority to impose point-of-sale disclosure requirements.
- The FINRA Proposal comes at the same time that the SEC is seeking comment on the proposed rescission of Rule 12b-1.4 The SEC’s proposed rules replacing Rule 12b-1 would dramatically alter the disclosure required for mutual fund marketing and distribution expenses, but much of that disclosure would come on transaction confirmations delivered after the completion of the transaction. Last year, FINRA proposed new FINRA Rule 2341, which would replace current NASD Rule 2830, and would require substantial additional prospectus disclosure for mutual funds, as well as account opening disclosure for broker-dealers.
- The FINRA Proposal comes shortly after the SEC has adopted amendments to the Form ADV Part II, which are designed to improve the disclosure of business practices and potential conflicts of interest on the part of investment advisers, and to make those disclosures available online.5 A major difference between the FINRA Proposal and the Form ADV Part II amendments is that the FINRA Proposal does not include any mandatory disclosures about the particular registered representatives who will serve a customer.
- Furthermore, the Proposal arrives in the wake of the passage of the Dodd-Frank Act, which requires the SEC to assess the standard of care broker-dealers and investment advisers provide to their retail clients when making personalized investment recommendations, and gives the SEC rulemaking authority to establish a fiduciary duty on the part of broker-dealers to retail clients.
FINRA states that before the Dodd-Frank Act, FINRA was actively considering how to implement an increased standard of care for broker-dealers. FINRA notes that the Dodd-Frank Act specifically calls for the SEC to analyze the gaps between regulation of broker-dealers and investment advisers, and requires the SEC to develop rules requiring the disclosure of material conflicts of interest. Therefore, FINRA explains, the Proposal represents a response to the Dodd-Frank Act’s call for a revised standard of care for broker-dealers, as well as a necessary filling of a gap between the regulation of broker-dealers and investment advisers.
FINRA is soliciting comments to the Proposal, which must be submitted to FINRA in writing no later than December 27, 2010. Many broker-dealers with retail clients already have account-opening or website disclosures that cover many of the issues addressed in the FINRA Proposal. Firms should consider whether they should revise those disclosures in light of what FINRA has proposed.
For additional information concerning this alert, please contact the following lawyers:
Margaret (Peggy) Blake, Of Counsel, Broker-Dealer
David Boch, Partner, Broker-Dealer Group
Amy Natterson Kroll, Partner, Broker-Dealer
Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Financial Services Area email@example.com, 617.951.8247
Edwin E. Smith, Partner, Financial Restructuring; Co-chair, Financial Services Area
Tim Burke, Practice Group Leader, Broker-Dealer Group; Co-chair, Financial Services Area
Regulatory Notice 10-54 (October 27, 2010).
Exchange Act Release No. 49148 (January 29, 2004).
Exchange Act Release No. 51274 (February 28, 2005).
Exchange Act Release No. 62544 (July 21, 2010).
Investment Advisers Act Release No. 3060 (July 28, 2010).