SEC and FINRA Provide Road Map for Initial Regulation Best Interest ExamsDownload
With the Regulation Best Interest compliance date set for June 30, 2020, the Securities and Exchange Commission (SEC) Office of Compliance Inspections and Examinations (OCIE) recently announced that it would begin conducting broker‑dealer examinations focused on Reg BI compliance and outlined the scope of exams likely to occur in the first year following the compliance date. OCIE provided specific examples of likely document requests and explained that initial exams will focus on evaluating whether firms have established policies and procedures reasonably designed to achieve compliance with the new rule. The Financial Industry Regulatory Authority, Inc. (FINRA) issued guidance that it would take the same approach in its examinations. The SEC recently declined to delay the compliance date despite the current COVID-19 pandemic but both OCIE and FINRA noted that they understand that firms face challenges in the current environment and stand ready to work with firms on issues that arise in the course of exams. OCIE also provided a sample document request for Reg BI exams. The guidance is available at the following links: OCIE and FINRA.
OCIE and FINRA also issued guidance on Form CRS exam issues. For more information, see our Client Alert available here.
Reg BI establishes a new standard of conduct under the Securities Exchange Act of 1934 for broker-dealers and their associated persons. When making a recommendation of any securities transaction or investment strategy involving securities (including account recommendations) to a retail customer, a broker-dealer must act in the best interest of the retail customer at the time the recommendation is made, without placing its own financial or other interest ahead of the retail customer’s interest. A broker-dealer satisfies this obligation only if it complies with four component obligations:
- Disclosure Obligation—disclosure of all material facts relating to (1) the scope and terms of the relationship with the customer and (2) conflicts of interest that are associated with the recommendation.
- Care Obligation—exercise reasonable diligence, care, and skill when making a recommendation; understand potential risks, rewards, and costs associated with the recommendation; consider these factors in light of the customer’s investment profile; and make a recommendation that is in the retail customer’s best
- Conflict of Interest Obligation—establish, maintain, and enforce written policies and procedures reasonably designed to address conflicts of interest associated with recommendations.
- Compliance Obligation—establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Reg BI as a
Focus Areas for Exams
Initial examinations will focus on assessing whether firms have made a good faith effort to implement policies and procedures reasonably designed to comply with Reg BI, including the operational effectiveness of policies and procedures. Firms should expect exam staff to focus on the four Reg BI compliance areas discussed below but also remember that exam staff may select additional areas for review based on risks identified during the course of an exam.
Firms should be able to demonstrate how they disclose material facts relating to the scope and terms of the customer relationship, including: (1) the capacity in which the firm is acting when making a recommendation, (2) material fees and costs that apply to a customer, and (3) material limitations on the securities or investment strategies the firm recommends. Firms should be prepared to deliver to exam staff the disclosures provided to customers and ensure that they contain the required information. Firms should also be able to demonstrate that the disclosures are being delivered within the required timeframe (prior to or at the time of a recommendation). Firms should expect to be asked to deliver the following documents during an exam:
- schedules of direct and indirect fees and charges assessed to or borne by customers and disclosures of such fees and charges;
- compensation methods for registered personnel, including compensation associated with recommendations, sources and types of compensation, and related conflicts of interest;
- disclosures related to monitoring of customers’ accounts;
- disclosures on material limitations on recommended accounts or services; and
- lists of proprietary products sold to retail
Firms should be prepared for exams to review information collected from retail customers to develop their investment profiles and be able to demonstrate the process used for establishing a reasonable basis to believe that recommendations are in the best interest of customers. In particular, firms should be prepared to deliver documents that illustrate the factors the firm considers to assess the potential risks, rewards, and costs of the recommendations in light of a customer’s investment profile and how the firm determines that it does not place its financial or other interests ahead of the interest of the customer. Firms should expect that regulators will review how the firm makes recommendations related to significant investment decisions, such as rollovers and account recommendations. Firm should also be prepared for a focus on recommendations of more complex, risky or expensive products.
Conflict of Interest Obligation
The conflict of interest obligation focuses on policies and procedures. Accordingly, firms should be prepared to deliver the related policies and procedures to exam staff. Firms should specifically be able to show whether and how the policies and procedures address key Reg BI areas, such as:
- conflicts that create an incentive for an associated person to place its or the firm’s interests ahead of the interest of a customer;
- conflicts associated with material limitations on recommended securities or investment strategies, such as limited product menu, offering only proprietary products, or products with third-party arrangements; and
- elimination of sales contests, sales quotas, bonuses, and non-cash compensation based on the sale of securities within a limited period of
Firms should be prepared to demonstrate how policies and procedures establish a structure for identifying and assessing conflicts that the firm or its associated person may face, including as business evolves over time, and be able to deliver documentation identifying all conflicts associated with the firm’s recommendations. Firms should also be able to show how policies and procedures provide for disclosure of conflicts and what conflicts are disclosed, as well as how the policies and procedures provide for mitigation or elimination of conflicts and what conflicts are mitigated or eliminated.
The compliance obligation is similar to the conflict of interest obligation in that it focuses on policies and procedures but the compliance obligation focuses on broader compliance with Reg BI as a whole. Again, firms should expect for exam staff to review all Reg BI-related compliance policies and procedures to assess compliance with this obligation. Firms should expect the exam staff to specifically evaluate controls, remediation of noncompliance, training, and periodic review and testing included as part of the Reg BI policies and procedures.
What Should I Do Now?
Firms should review the OCIE guidance in developing and assessing their Reg BI compliance policies and procedures. Firms should specifically focus on the appendix to the OCIE guidance that sets forth a sample request for information and documents to be reviewed during these exams to ensure that they are able to address each point, while keeping in mind that exam staff could make different or additional requests. The OCIE guidance is also not intended to be an explanation of the requirements of Reg BI, so firms should also use resources such as FINRA’s Reg BI Resource Page and the SEC’s Reg BI Resource Page. Among other things, these resources include FINRA’s Reg BI and Form CRS Checklist, FAQs on Reg BI and the Reg BI Small Entity Compliance Guide.