[Federal Register Volume 85, Number 58 (Wednesday, March 25, 2020)]
[Notices]
[Pages 16974-16977]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-06187]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-88422; File No. SR-FINRA-2020-007]


Self-Regulatory Organizations; Financial Industry Regulatory 
Authority, Inc.; Notice of Filing of a Proposed Rule Change to FINRA's 
Suitability, Non-Cash Compensation and Capital Acquisition Broker (CAB) 
Rules in Response to Regulation Best Interest

March 19, 2020.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on March 12, 2020, Financial Industry Regulatory Authority, Inc. 
(``FINRA'') filed with the Securities and Exchange Commission (``SEC'' 
or ``Commission'') the proposed rule change as described in Items I, 
II, and III below, which Items have been prepared by FINRA. The 
Commission is publishing this notice to solicit comments on the 
proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    FINRA is proposing amendments to FINRA Rules 2111 (Suitability), 
2310 (Direct Participation Programs), 2320 (Variable Contracts of an 
Insurance Company), 2341 (Investment Company Securities), and 5110 
(Corporate Financing Rule--Underwriting Terms and Arrangements), and 
Capital Acquisition Broker (CAB) Rule 211 (Suitability). The proposed 
rule change would: (1) Amend the FINRA and CAB suitability rules to 
state that the rules do not apply to recommendations subject to 
Regulation Best Interest (``Reg BI''),\3\ and to remove the element of 
control from the quantitative suitability obligation; and (2) conform 
the rules governing non-cash compensation to Reg BI's limitations on 
sales contests, sales quotas, bonuses and non-cash compensation.
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    \3\ 17 CFR 240.15l-1.
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    The text of the proposed rule change is available on FINRA's 
website at http://www.finra.org, at the principal office of FINRA and 
at the Commission's Public Reference Room.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, FINRA included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. FINRA has prepared summaries, set forth in sections A, 
B, and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
Background
    On June 5, 2019, the SEC adopted Reg BI, a new rule under the 
Exchange Act, which establishes a standard of conduct for broker-
dealers and natural persons who are associated persons of a broker-
dealer (unless otherwise indicated, together referred to as ``broker-
dealer'') when they make a recommendation to a retail customer of any 
securities transaction or investment strategy involving securities.\4\ 
The SEC stated that Reg BI will improve investor protection by 
enhancing the obligations that apply when a broker-dealer makes a 
recommendation to a retail customer, and reducing the potential harm to 
retail customers from conflicts of interest that may affect the 
recommendation.\5\ The date by which broker-dealers must comply with 
Reg BI is June 30, 2020.\6\
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    \4\ See Securities Exchange Act Release No. 86031 (June 5, 
2019), 84 FR 33318 (July 12, 2019) (Final Rule; Regulation Best 
Interest: The Broker-Dealer Standard of Conduct) (the ``Release'').
    \5\ See Release, 84 FR at 33318-33319.
    \6\ See Release, 84 FR at 33400.
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    FINRA proposes to amend the suitability and non-cash compensation 
rules to provide clarity on which standard applies and to address 
inconsistencies with Reg BI. The changes would amend the FINRA 
suitability rule (Rule 2111) to state that it will not apply to 
recommendations subject to Reg BI, and to remove the element of control 
from the quantitative suitability obligation. In addition, the proposed 
rule change would conform the CAB suitability rule, CAB Rule 211, to 
the proposed amendments to Rule 2111, and would conform FINRA's rules 
governing non-cash compensation to Reg BI's limitations on sales 
contests, sales quotas, bonuses, and non-cash compensation.
    As noted below, Reg BI addresses the same conduct that is addressed 
by Rule 2111, but employs a best interest, rather than a suitability, 
standard. Absent action by FINRA, a broker-dealer would be required to 
comply with both Reg BI and Rule 2111 regarding recommendations to 
retail customers. In such circumstances, FINRA believes that compliance 
with Reg BI would result in compliance with Rule 2111 because a broker-
dealer that meets the best interest standard would necessarily meet the 
suitability standard. Accordingly, in order to reduce the potential for 
confusion, FINRA is proposing limiting the application of Rule 2111 to 
circumstances in which Reg BI does not apply. To do so, FINRA would add 
new paragraph .08 to the FINRA Rule 2111 Supplementary Material and new 
paragraph .03 to the CAB Rule 211 Supplementary Material that states 
that those rules shall not apply to recommendations subject to Reg BI.

[[Page 16975]]

Suitability
    FINRA Rule 2111 requires that a broker-dealer ``have a reasonable 
basis to believe that a recommended transaction or investment strategy 
involving a security or securities is suitable for the customer, based 
on the information obtained through the reasonable diligence of the 
member or associated person to ascertain the customer's investment 
profile.'' The rule further explains that a ``customer's investment 
profile includes, but is not limited to, the customer's age, other 
investments, financial situation and needs, tax status, investment 
objectives, investment experience, investment time horizon, liquidity 
needs, risk tolerance, and any other information the customer may 
disclose to the member or associated person in connection with such 
recommendation.'' \7\
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    \7\ See FINRA Rule 2111(a).
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    Rule 2111 imposes three main suitability obligations: Reasonable 
basis suitability, customer-specific suitability and quantitative 
suitability. Reasonable basis suitability requires a member or 
associated person to have a reasonable basis to believe, based on 
reasonable diligence, that the recommendation is suitable for at least 
some investors. Customer-specific suitability requires that a member or 
associated person have a reasonable basis to believe that the 
recommendation is suitable for a particular customer based on that 
customer's investment profile. 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, 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.\8\
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    \8\ See FINRA Rule 2111.05.
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    Rule 2111(b) provides an exemption to customer-specific suitability 
for recommendations to institutional customers under specified 
circumstances. In order for this exemption to apply, three criteria 
must be satisfied. First, the account must meet the definition of 
institutional account as defined in FINRA Rule 4512(c).\9\ Second, the 
broker-dealer must have a reasonable basis to believe that the 
institutional customer is capable of evaluating investment risks 
independently, both in general and with regard to particular 
transactions and investment strategies involving a security or 
securities. Third, the institutional customer must affirmatively 
indicate that it is exercising independent judgment in evaluating the 
member's or associated person's recommendations. Where an institutional 
customer has delegated decision making authority to an agent, such as 
an investment adviser or a bank trust department, these factors are 
applied to the agent.\10\
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    \9\ Rule 4512(c) defines ``institutional account'' to mean the 
account of: (1) A bank, savings and loan association, insurance 
company or registered investment company; (2) an investment adviser 
registered either with the SEC or with a state securities 
commission; or (3) any other person (whether a natural person, 
corporation, partnership, trust or otherwise) with total assets of 
at least $50 million.
    \10\ See FINRA Rule 2111(b).
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    Reg BI's ``best interest'' standard requires firms to satisfy four 
component obligations: Disclosure, Care, Conflict of Interest and 
Compliance. Reg BI's Care Obligation incorporates and enhances 
principles that are also found in Rule 2111. Two key enhancements are 
that Reg BI explicitly imposes a best interest standard and explicitly 
requires a consideration of costs. In addition, Reg BI places greater 
emphasis than the suitability rule on consideration of reasonably 
available alternatives.\11\ Moreover, Reg BI explicitly applies to 
recommendations of types of accounts (e.g., broker-dealer or investment 
adviser, or among broker-dealer accounts, including recommendations of 
IRA rollovers). Reg BI also eliminates the ``control'' element of the 
quantitative suitability obligation.
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    \11\ See Release, 84 FR at 33381 (``It is our view that such a 
consideration [of reasonably available alternatives offered by the 
broker-dealer] is an inherent aspect of making a `best interest' 
recommendation, and is a key enhancement over existing broker-dealer 
suitability obligations, which do not necessarily require such a 
comparative assessment among such alternatives'').
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    In light of these enhancements and to provide clarity on which 
standard applies, FINRA proposes that its suitability rule state that 
it will not apply to recommendations subject to Reg BI.\12\ FINRA does 
not propose to eliminate the suitability rule because it applies 
broadly to all recommendations to customers whereas Reg BI applies only 
to recommendations to ``retail customers,'' which Reg BI defines as a 
natural person, or the legal representative of such natural person, who 
receives a recommendation of any securities transaction or investment 
strategy involving securities from a broker-dealer and uses the 
recommendation primarily for personal, family, or household 
purposes.\13\ Thus, FINRA's suitability rule is still needed for 
entities and institutions (e.g., pension funds), and natural persons 
who will not use recommendations primarily for personal, family, or 
household purposes (e.g., small business owners and charitable trusts).
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    \12\ See proposed FINRA Rule 2111.08.
    \13\ See 17 CFR 240.15l-1(b)(1).
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    In addition, the proposal would modify the quantitative suitability 
obligation under FINRA Rule 2111.05(c) to remove the element of control 
that currently must be proved to demonstrate a violation.\14\ This 
change is consistent with Reg BI, which eliminates the control element 
from its Care obligation.
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    \14\ See proposed FINRA Rule 2111.05(c).
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    Finally, the proposed rule change would amend CAB Rule 211 to state 
that it will not apply to recommendations subject to Reg BI.\15\
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    \15\ See proposed CAB Rule 211.03.
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Non-Cash Compensation
    FINRA Rules 2310 (Direct Participation Programs), 2320 (Variable 
Contracts of an Insurance Company), 2341 (Investment Company 
Securities), and 5110 (Corporate Financing Rule--Underwriting Terms and 
Arrangements) each includes provisions restricting the payment and 
receipt of non-cash compensation in connection with the sale and 
distribution of securities governed by those rules. As a general 
matter, these rules limit non-cash compensation arrangements to:
     Gifts that do not exceed $100 in value and that are not 
preconditioned on the achievement of a sales target;
     An occasional meal, a ticket to a sporting event or the 
theater, or other comparable entertainment that does not raise any 
question of propriety and is not preconditioned on the achievement of a 
sales target;
     Payment or receipt by ``offerors'' (generally product 
sponsors and their affiliates) in connection with training or education 
meetings, subject to specified conditions, including that the payment 
of such compensation is not conditioned on achieving a sales target; 
and
     Internal non-cash compensation arrangements between a 
member and its associated persons, subject to specified conditions. If 
the internal non-cash compensation arrangement is in the form of a 
sales contest, the contest must be based on the total production of 
associated persons with respect to all securities within the rule's 
product category, and credit for those sales must be equally 
weighted.\16\
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    \16\ See FINRA Rules 2310(c), 2320(g), 2341(l)(5), and 5110(h). 
Rules 2310(c) and 5110(h) do not require internal non-cash 
compensation arrangements to be based on total production and equal 
weighting of securities sales.

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[[Page 16976]]

    Reg BI's Conflict of Interest Obligation requires broker-dealers to 
establish, maintain, and enforce written policies and procedures 
reasonably designed to identify and eliminate any sales contests, sales 
quotas, bonuses, and non-cash compensation that are based on the sales 
of specific securities or specific types of securities within a limited 
time period.\17\ As discussed above, FINRA's current non-cash 
compensation rules permit internal firm sales contests that may not 
meet this standard, since they permit contests based on sales of 
specific types of securities (such as mutual funds or variable 
annuities).
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    \17\ See 17 CFR 240.15l-1(a)(2)(iii)(D).
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    FINRA proposes to modify its rules governing non-cash compensation 
arrangements to specify that any non-cash compensation arrangement 
permitted by those rules must be consistent with the requirements of 
Reg BI. FINRA also proposes to eliminate provisions in Rules 2320 and 
2341 that require internal non-cash compensation arrangements to be 
based on total production and equal weighting of securities sales.\18\ 
Thus, firms generally would no longer be permitted to sponsor or 
maintain internal sales contests based on sales of securities within a 
product category within a limited time, even if they are based on total 
production and equal weighting. This requirement also would apply to 
the non-cash compensation provisions governing gifts, business 
entertainment and training or education meetings. As discussed above, 
these forms of non-cash compensation may not be preconditioned on 
achievement of a sales target. Nevertheless, FINRA believes that it 
must make clear that these provisions do not permit arrangements that 
conflict with Reg BI.
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    \18\ See proposed amendments to FINRA Rules 2310(c), 2320(g), 
2341(l)(5), and 5110(h).
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    If the Commission approves the proposed rule change, FINRA will 
announce the approval of the proposed rule change in a Regulatory 
Notice to be published no later than 60 days following Commission 
approval. The effective date will be the compliance date of Reg BI.
2. Statutory Basis
    FINRA believes that the proposed rule change is consistent with the 
provisions of Section 15A(b)(6) of the Act,\19\ which requires, among 
other things, that FINRA rules must be designed to prevent fraudulent 
and manipulative acts and practices, to promote just and equitable 
principles of trade, and, in general, to protect investors and the 
public interest. The proposed changes to FINRA's suitability rules will 
clarify when Reg BI versus the suitability rules apply, eliminating 
confusion and allowing firms to focus on compliance with the higher 
standards in Reg BI, when applicable. At the same time, the change will 
provide continued protection for customers that are not retail 
customers covered by Reg BI. Moreover, the removal of the element of 
control from the quantitative suitability obligation will align this 
standard with the corresponding quantitative component of the Care 
Obligation under Reg BI. Finally, the proposed amendments to FINRA's 
rules on non-cash compensation arrangements will eliminate any 
potential inconsistency with the requirements of Reg BI.
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    \19\ 15 U.S.C. 78o-3(b)(6).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    FINRA does not believe that the proposed rule change will result in 
any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act. FINRA has undertaken an 
economic impact assessment, as set forth below, to analyze the 
regulatory need for the proposed rulemaking, its potential economic 
impacts, including anticipated costs and benefits, and the alternatives 
FINRA considered in assessing how to best meet its regulatory 
objectives.
Economic Impact Assessment
    Reg BI imposes new obligations on broker-dealers and associated 
persons. As such, FINRA is proposing to modify existing FINRA rules to 
better align them with the new obligations. The alignment of FINRA 
rules to Reg BI requirements is expected to provide greater protections 
to customers against investor abuse from firms and their associated 
persons. It also reduces uncertainty for firms about which standard 
applies, thus potentially avoiding unintentional rule violations and 
reducing compliance costs on the margin. The Economic Impact Assessment 
analyzes only the impacts directly attributable to the proposed rule 
change. The impacts attributable to Reg BI are assumed to have been 
evaluated by the SEC during the adoption process.
    The proposed rule changes would better align the existing FINRA 
suitability rule with Reg BI's obligations. The proposed rule change 
would provide that the suitability rule does not apply to any 
recommendation that is subject to Reg BI. The benefits of this approach 
are that it would reduce regulatory uncertainty for firms and clarify 
to retail customers that Reg BI's ``best interest'' standard applies to 
recommendations they receive from their broker-dealer and its 
associated persons. FINRA does not believe that this change will 
negatively impact firms in any material way, since in almost all cases, 
retail customer recommendations would be governed by Reg BI, making the 
application of the suitability rule in these contexts superfluous. 
Firms also would benefit by focusing their regulatory review of 
recommendations to retail customers solely on Reg BI, thus increasing 
the efficiency of such reviews.
    The proposed rule change also would eliminate the control element 
from the quantitative suitability obligation in the suitability rule. 
This change is consistent with Reg BI, which similarly does not require 
a showing of control. FINRA had previously analyzed the economic impact 
of this change when it proposed it in Regulatory Notice 18-13. 
Potential economic impacts are even less significant at this time, as 
the SEC has since adopted Reg BI, which expressly excludes the control 
element and will now apply to a large portion of recommendations (i.e., 
recommendations to retail customers).
    The proposed change is expected to provide greater protections to 
customers against investor abuse from firms and their associated 
persons. In cases where excessive trading is alleged, customers would 
benefit from the reduced burden on FINRA of not having to prove control 
while firms and associated persons engaged in excessive trading could 
experience a higher number of findings of violations. FINRA believes 
the proposed change would impose minimal, if any, additional compliance 
burdens on members because FINRA staff understands firms generally 
perform compliance reviews for excessive trading activity without 
consideration of whether a broker controls the account.
    Lastly, the proposed rule change would align FINRA's non-cash 
compensation rules with Reg BI's Conflict of Interest Obligation. Reg 
BI requires broker-dealers to establish, maintain and enforce written 
policies and procedures reasonably designed to identify and eliminate 
any sales contests, sales quotas, bonuses, and non-cash compensation 
that are based on the sales of specific securities or specific types of 
securities within a limited time period, whereas current FINRA non-cash 
compensation rules permit sales contests for specific types of 
securities. FINRA believes that this proposed rule change will benefit 
firms by eliminating regulatory uncertainty

[[Page 16977]]

created by existing FINRA non-cash compensation rules. To the extent 
that sales contests and other non-cash compensation arrangements lead 
brokers to recommend suboptimal investments for customers, banning 
these practices may benefit customers. However, as for-profit entities, 
firms may be more limited in their ability to create incentives for 
their brokers to generate sales.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    Comments were neither solicited nor received on this proposed rule 
change. However, in April 2018, FINRA published Regulatory Notice 18-
13, soliciting comment on a proposal to remove the control element from 
the quantitative suitability obligation in FINRA Rule 2111, consistent 
with the then-proposed Reg BI. Eleven comments were received in 
response to the Notice. A copy of the Notice is attached [sic] as 
Exhibit 2a. Copies of the comment letters received in response to the 
Notice are attached [sic] as Exhibit 2c.\20\
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    \20\ See Exhibit 2b for a list of abbreviations assigned to 
commenters.
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    Since the publication of Regulatory Notice 18-13, the SEC has 
adopted Reg BI, which applies to recommendations to retail customers as 
defined in Reg BI. With the proposed changes to FINRA Rule 2111.08, as 
discussed above, the suitability rule, including the quantitative 
suitability obligation, will no longer apply to recommendations to 
retail customers. As a result, the impact of the removal of the control 
element of the quantitative suitability obligation is significantly 
less than when originally proposed. Nevertheless, a majority of 
commenters to Regulatory Notice 18-13 indicated general support for the 
proposal to remove the control element from the quantitative 
suitability obligation of FINRA Rule 2111.\21\ In general, these 
commenters expressed that the proposed rule change was a reasonable and 
effective approach to improving the rule,\22\ and believe it would 
heighten investor protection.\23\ Some commenters raised questions with 
particular aspects of the proposal or potential unintended 
consequences.\24\ Several commenters were not supportive and raised 
concerns with the proposal.\25\ Many of the comments have been rendered 
moot by the SEC's adoption of Reg BI or the concerns raised have become 
less relevant given that Reg BI is now the governing standard that 
applies to recommendations to retail customers. For example, while some 
commenters supported FINRA's proposal to remove the control element 
from the quantitative suitability obligation because it was consistent 
with the approach set forth in the proposed Reg BI,\26\ several 
commenters indicated that FINRA's proposal was premature and that FINRA 
should await the outcome of the SEC's proposed rulemaking.\27\ FINRA 
did hold off in filing with the Commission the rule change proposed in 
Regulatory Notice 18-13. With the final adoption of Reg BI, however, 
the time is ripe to finalize this change. As a result, for 
recommendations that remain subject to FINRA Rule 2111 (i.e., 
recommendations that are not covered by Reg BI), this aspect of the 
proposed rule change will enable FINRA to more effectively address 
instances of excessive trading by removing the element of control that 
currently must be proved to demonstrate a violation and will align this 
integral element of FINRA's suitability rule with corresponding 
provision of Reg BI.
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    \21\ See Cornell; FSI; NASAA; Pace; PIABA; SEC OIA.
    \22\ See NASAA.
    \23\ See Cornell; FSI; NASAA; Pace; PIABA.
    \24\ See FSI; PIABA; SER.
    \25\ See Cambridge; Capital Forensics; Keesal; SIFMA.
    \26\ See FSI.
    \27\ See Cambridge; Keesal; SIFMA.
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III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 45 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:
    (A) By order approve or disapprove such proposed rule change, or
    (B) institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Comments may be submitted by any of 
the following methods:

Electronic Comments

     Use the Commission's internet comment form (http://www.sec.gov/rules/sro.shtml); or
     Send an email to rule-comments@sec.gov. Please include 
File Number SR-FINRA-2020-007 on the subject line.

Paper Comments

     Send paper comments in triplicate to Secretary, Securities 
and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090.

All submissions should refer to File Number SR-FINRA-2020-007. This 
file number should be included on the subject line if email is used. To 
help the Commission process and review your comments more efficiently, 
please use only one method. The Commission will post all comments on 
the Commission's internet website (http://www.sec.gov/rules/sro.shtml). 
Copies of the submission, all subsequent amendments, all written 
statements with respect to the proposed rule change that are filed with 
the Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for website viewing and printing in 
the Commission's Public Reference Room, 100 F Street NE, Washington, DC 
20549, on official business days between the hours of 10 a.m. and 3 
p.m. Copies of such filing also will be available for inspection and 
copying at the principal office of FINRA. All comments received will be 
posted without change. Persons submitting comments are cautioned that 
we do not redact or edit personal identifying information from comment 
submissions. You should submit only information that you wish to make 
available publicly. All submissions should refer to File Number SR-
FINRA-2020-007 and should be submitted on or before April 15, 2020.

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\28\
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    \28\ 17 CFR 200.30-3(a)(12).
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J. Matthew DeLesDernier,
Assistant Secretary.
[FR Doc. 2020-06187 Filed 3-24-20; 8:45 am]
BILLING CODE 8011-01-P


