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It Gets BIgger: FINRA Joins the SEC In Bringing Reg BI Enforcement Actions

It’s official: Reg BI is no longer an idle tool in FINRA’s arsenal.  In its first disciplinary action related to Regulation Best Interest (“Reg BI”), the Financial Regulatory Authority (“FINRA”) levied a $5,000 fine and a six-month suspension for excessive trading, charging that a broker caused a client to pay tens of thousands of dollars in commissions to the broker. 

This action stems from the Securities and Exchange Commission’s (“SEC”) enactment of Reg BI, which went into effect in June 2020 but remained dormant for almost two years.  In June 2020, the SEC finally brought its first enforcement action alleging violations of Reg BI, charging Western International Securities Inc. and five of its registered representatives with violating the rule by recommending and selling highly-speculative “L” bonds.  See Mintz Insight, “High Risk, No Reward: SEC’s First Reg BI Enforcement Action” for more information on the SEC’s action.   

Reg BI

Reg BI prohibits brokers from putting their own interests above those of their retail customers when making investment recommendations (the “Best Interest Obligation”).  To meet this standard, firms must comply with four component obligations: Disclosure, Care, Conflict of Interest, and Compliance.  Reg BI also binds registered representatives, who must individually comply with the Disclosure and Care obligations.

FINRA’s First Disciplinary Action

In FINRA’s first disciplinary action based on violations of Reg BI, Charles Malico, formerly a registered representative with Network 1 Financial Securities of Huntington Station, NY, is charged with recommending a series of transactions in one client’s account that “was excessive in light of the customer’s investment profile and therefore was not in that customer’s best interest.” See FINRA Letter of Acceptance, Waiver and Consent.  According to FINRA, Malico willfully violated the Best Interest Obligation under Rule 15l-1 of the Securities Exchange Act of 1934 and violated FINRA Rule 2010. 

More specifically, Malico recommended that his client – a 63-year-old tax preparer with an annual income of $100,000, a liquid net worth of $50,000, and an average account balance of $30,000 – make more than 350 trades in his account, resulting in the client paying more than $54,000 in commissions and other costs.  On many occasions, Malico allegedly recommended that the client buy and sell a security only to buy it back mere days or weeks later.  This “in-and-out trading” resulted in over $6,000 in losses for the customer, meanwhile generating over $3,200 in commissions for the broker and his firm.

FINRA was made aware of Malico’s conduct through a review of a customer-initiated arbitration.  The arbitration stemmed from a December 6, 2021 customer complaint that alleged negligence, breach of fiduciary duty, and negligent supervision.  That matter remains pending.

FINRA commented that, “collectively, the trades that Malico recommended in Customer A’s account resulted in an annualized cost-to-equity ratio exceeding 158 percent—meaning that Customer A’s account would have had to grow by more than 158 percent annually just to break even.”  In all, the client lost more than $17,500 during the period in which Malico allegedly recommended these excessive and inappropriate trades.

As is common practice for FINRA enforcement actions, Malico settled the charges with FINRA without admitting or denying them in a Letter of Acceptance, Waiver, and Consent, but nevertheless agreed to pay a $5,000 fine in addition to receiving a six-month suspension.

Identifying Excessive Trading Factors

As discussed in a prior Mintz Insight, Reg BI establishes a “best interest” standard of conduct when making investments recommendations to retail customers.  In determining whether the Malico action involved a Reg BI violation, FINRA indicated there was no single test to identify excessive trading, but “factors such as the turnover rate, the cost-to-equity ratio and the use of in-and-out trading” in the client’s account were relevant.  FINRA provided the following definitions for each of these factors:

  • The turnover rate represents the number of times that a portfolio of securities is exchanged for another portfolio of securities.
  • The cost-to-equity ratio measures the amount an account must appreciate just to cover commissions and other expenses.
  • In-and-out trading involves purchasing and selling the same security in a customer’s account multiple times over a brief period.

FINRA noted that a turnover rate of six, or a cost-to-equity ratio above 20%, generally indicates the occurrence of excessive transactions.

In order to comply with Reg BI, broker-dealers and their registered representatives must learn the risks associated with each transaction they may recommend and must consider these three factors.  Broker-dealers should be mindful of engaging in any pattern of in-and-out trading, as this generally indicates that a series of recommended transactions are excessive and not in the retail customer’s best interest, and now it seems FINRA will not be willing to tolerate this behavior.

First SEC; now FINRA.  One thing is clear:  we can expect more cases from those agencies based on alleged violations of Reg BI and it is likely that state securities regulators will follow suit and start going “Reg BIg,” as well.

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Authors

Pete S. Michaels

Member / Co-Chair, Financial Services Practice

Pete S. Michaels is a Mintz attorney who focuses his practice on securities litigation, regulatory proceedings involving financial service companies and products, and compliance matters. He represents financial services firms and insurance companies and their employees, directors, and officers.
Alyssa C. Scruggs focuses on complex commercial litigation, including mortgage and consumer banking cases, bankruptcy and related adversary proceedings, and class actions. She has worked on cases involving MA consumer protection, state and federal unfair competition, and antitrust laws.
Taylor M. Carter is an Associate at Mintz and a litigator who focuses her practice on complex commercial disputes.