“Regulation Best Interest” Is Nearly Here. What Regulators Want to See. What Broker-Dealers Need to Know and Do.
On June 5, 2019, the United States Securities and Exchange Commission (“Commission”) adopted Rule 15l-1 (“Regulation Best Interest” or “Reg. BI”) under the Securities Exchange Act of 1934 (“Exchange Act”), which has a compliance date of June 30, 2020.[1] What broker-dealers and their compliance and supervisory personnel need to know and do to prepare for July 1, 2020 is priority number one. This second article in this series examining Reg. BI provides tips and tools for, in particular, independent broker-dealers to consider what needs to be done by July 1, 2020 and the balance of the year.
To recap the first article in this series,[2] in broadest terms, Reg. BI provides that when recommending a securities transaction or investment strategy to a retail customer, a broker-dealer, including its associated persons, must act in the customer’s best interest by not putting its financial interests ahead of the interests of the customer when making a recommendation. Reg. BI has four (4) component parts with which a broker-dealer must comply in order to satisfy this “best interest” standard: a (i) Disclosure Obligation; (ii) Care Obligation; (iii) Conflict of Interest Obligation; and (iv) Compliance Obligation. Broker-dealers have an additional thirty (30) days from that filing deadline to provide all existing retail customers with a copy of the initial Form CRS.[3]
While the largest networks of independently managed firms may have the infrastructure and resources to prepare for and to implement the obligations of Reg. BI, technology, resour⇪ces and training remain significant obstacles for independent firms that vary by size, business lines, retail customer profiles and geographic locales. Given the breadth of Reg. BI and the limited technical guidance that has been issued by the Commission and FINRA, independent broker-dealers, in particular, face significant challenges.
On May 5, 2020, FINRA hosted a “Virtual Conference Panel” comprised of staff from the Commission’s Office of Compliance Inspections and Examination (“OCIE”) and FINRA as well as industry professionals to discuss how they intend to examine and inspect for compliance with Reg. BI. Here’s what broker-dealers, investment advisers, dual-registrants, and compliance and supervisory personnel need to know and do [4]:
First, let’s re-state the obvious: June 30, 2020 remains the deadline for Reg. BI, and, therefore, July 1, 2020 is the “go” date for the start of the first year of examinations. John Polise, Executive Director of the Broker-Dealer and Exchange Group in OCIE, explained that examinations will start in July and continue through the summer for a small portion of registrants with examinations across the larger broker-dealer marketplace continuing later in the year and into the first-half of 2021. Mr. Polise noted that, as with any new regulation, the Commission will undertake an implementation phase with firms that are trying to grasp what Reg. BI requires.
Second, at least in this first phase, OCIE is not looking for “gotcha” moments of non-compliance; rather, OCIE will focus on evidence that broker-dealers firms have read Reg. BI and attempted to reasonably design policies and procedures intended to ensure compliance with Reg. BI. Likewise, Bill St. Louis, Senior Vice President and Firm Group Leader for FINRA Member firms assigned to the Retail and Capital Markets firm groupings explained that FINRA’s examiners will follow a similar and consistent approach to the Commission that, at least initially, is focused on the operational effectiveness of firms’ policies and procedures.
To that end, FINRA’s energies have been focused on developing and implementing internal training materials and cases studies, examination content to assist examiners in Reg. BI and Form CRS reviews and content preparedness, so that examiners can better understand and evaluate how firms of different sizes and business models are implementing Reg. BI. Of note, representatives from the Commission and FINRA both emphasized that Member firms should document all steps taken to evidence good faith compliance with the requirements of Reg. BI and Form CRS. For many independent broker-dealers that may lack the financial and personnel resources of larger Member firms and other independents to allocate to each of the four core obligations of Reg. BI, documenting good faith compliance effort is particularly important.
Both the Commission and FINRA acknowledged that ensuring consistent examinations and standards across differing firm types, approved lines of business and customer profiles will be a priority. To that end, Member firms should focus on demonstrating and documenting how the elements or obligations of Reg. BI apply in their Written Supervisory Procedures and business models. From the regulatory side, training modules and kits have been distributed to examiners so that they are conversant in the demands of Reg. BI and the challenges for different firm types. The Commission also noted that examination findings, in the form of deficiency letters and enforcement referrals will be reviewed by OCIE Washington D.C. and its chief counsel’s office to ensure consistent application across the country.
Third, representatives of the Commission and FINRA emphasized that the roll-out of Reg. BI and initial examination cycles is not a “free pass” to ignore existing “know your customer” obligations and to prevent customer harms, such as violations of qualitative suitability requirements that already exist for all Member firms and their representatives. Likewise, sales practice violations that occur pre-Reg. BI effective date could still result in an enforcement referral. Mr. Polise also cautioned that although Reg. BI and Form CRS examinations will be part of Member firms’ overall examination, evidence of customer complaints, sales practice violations, compensation disclosure concerns or questions concerning Form CRS content could escalate to stand-alone examinations concerning the Disclosure Obligation, Care Obligation, Conflict of Interest Obligation and/or Compliance Obligation under Reg. BI
Fourth, given the multi-fold challenges impacting Member firms, staff and associated persons during the COVID-19 pandemic, both the Commission and FINRA recommended that Member firms with questions, challenges or concerns use their remaining days proactively and contact the Commission and/or FINRA to seek guidance before the initial cycle of examinations commenced in July 2020. Questions for the Commission can be directed to iabdquestions@sec.gov. FINRA reminds Member firms that their designated risk analysts and FINRA’s Reg. BI links on its website offer similar resources. The clear takeaway from these representatives was this: the Commission and FINRA want to see Member firms document their good faith efforts to implement policies and procedures necessary to comply with Reg. BI and Form CRS (and any additional guidance that may come out after July 1, 2020) regardless of whether firms’ decisions ate later determined to be in conflict with Reg. BI and Form CRS.
Finally, we offer a non-exhaustive list of reminder items for firms to address in their policies and procedures and, if possible, implement with less than thirty (30) days until Reg. BI and Form CRS are effective:
- Draft and finalize Written Supervisory Procedures and Associated Persons Policies and Procedures (and document the changes made specific to Reg. BI and Form CRS).
- Determine if your firm’s lines of business interact with retail investors who will need to receive a Form CRS and retail customers as to whom Reg. BI applies.
- Identify and gather data for disclosures, including “mapping” the instances when disclosures are communicated by your firm and its associated persons to retail customers and investors (e.g., account agreements and updates, mailing of account statements and trade and subscription confirmations, mailing of offering materials, prospectuses and memorandums, alternative investment risk disclosures, IPO certifications, account “activity” letters and account “supervisory” letters).
- Map existing conflict disclosures, including firm research reports, account statements and trade confirmations that may disclose riskless principal or agency transactions and markups and markdowns (and if such transactions are facilitated by associated persons versus dual registrants). Document your firm’s updated measures to mitigate compensation-based conflicts and to satisfy the Conflict of Interest Obligation and Compliance Obligation.
- Develop IT and diligence infrastructure to record delivery of disclosures, including how your firm will document disclosures that are made orally by associated persons and/or supervisory staff.
- Address requirement to post Form CRS on your firm’s website.
- Identify and track customers subject to Reg. BI and their investment profile information and develop IT infrastructures and training updates for your firm’s associated persons relating to obtaining, tracking and updating retail customer investor profile information consistent with the Care Obligation (and document the changes made specific to Reg. BI).
- Update your firm’s surveillance tools to evidence its efforts to satisfy the Compliance Obligation with particular attention to tools and training that will assist supervisors and compliance personnel in both OSJ and single-person branch location setting (and document the changes made specific to Reg. BI).
- Review brokerage account agreements to determine if your firm has agreed to monitor account activity and any obligations relating to the making of a recommendation.
- Inventory and analyze products and services (including complex and proprietary products) that your firm makes available for retail customers to determine what information regarding those products and services (including fees and costs) is provided to associated persons and whether there are any material limitations on securities or strategies that may be recommended. Update how your firm will notify its associated persons of changes to products, fees and costs on a going forward basis to satisfy the Conflict of Interest Obligation (and document the changes made specific to Reg. BI).
- Examine default settings for account types – such as margin accounts – that may implicate additional disclosure of costs, fees and penalties to satisfy the Conflict of Interest Obligation (and document the changes made specific to Reg. BI).
- Review client records for consent to electronic delivery.
- Review your firm’s training, policies and procedures for core obligations under Reg. BI and Form CRS, and, if applicable, how same apply to dual registrants.
- Update your firm’s protocols for disclosing to retail customers and investors the capacity in which a dual-registrant acts.
- Train all associated persons and supervisory staff who interact with retail investors/customers as to new Reg. BI and Form CRS requirements (and document the changes made specific to Reg. BI).
- Ensure that retail customers’ investor profiles are updated by June 30 so that associated persons can make their client-suitability assessments by July 1, 2020.
- Review associated persons’ compensation and bonus structure and programs to determine conflicts that require disclosure and/or elimination, including, but not limited to, sales contests, sales quotas, bonuses and non-cash compensation related to sales of securities or types of securities (complex and proprietary) to identify actions that must be eliminated.
- Review due diligence process/checklist for firm and associated persons and how costs are considered in suitability determinations.
Conclusion
Regulation Best Interest will significantly influence how broker-dealers and their associated persons engage with retail customers, drive the development, maintenance and testing of broker-dealers’ WSPs and other policies and procedures; and require substantial staffing and resource commitments on a going-forward basis of independent broker-dealers effective July 1, 2020.
If you have any questions about the issues addressed in this Broker-Dealer Regulation Alert, if you would like a copy of any of the materials mentioned in it, if you would like to continue to receive Broker-Dealer Regulation Alerts or if you have questions regarding compliance with Regulation Best Interest and Form CRS, please do not hesitate to call or email Securities and Commercial Litigation and Securities Regulatory Practice Partner Daniel Scott Furst at (646) 810-2185 or sfurst@srf.law.[5]
About The Author
[1] See Exchange Act Release No. 86031 (June 5, 2019) (“Regulation Best Interest Adopting Release”).
[2] For a review of first article in its entirety, see “60 Days and Counting: “Regulation Best Interest” Is Nearly Here. Are Independent broker-Dealers Ready? What They Need to Know and Do.” Daniel Scott Furst, Esq. (April 29, 2020), http://www.srf.law.com.
[3] As previously discussed in the first article in this series, broker-dealers must deliver a relationship summary to each retail investor, before or at the earliest of (i) a recommendation of an account type, a securities transaction, or an investment strategy involving securities; (ii) placing an order for the retail investor; or (iii) the opening of a brokerage account for the retail investor. The Commission’s guidance also provides that Commission-registered investment advisers must deliver a relationship summary to each retail investor before or at the time the firm enters into an investment advisory contract with the retail investor, even if the agreement is oral. Finally, dual registrants must deliver the relationship summary at the earlier of the delivery requirements for the broker-dealer or investment adviser.
[4] As discussed in the first article in this series, on April 7, 2020, OCIE issued a “Risk Alert” “to provide broker-dealers with information about the scope and content of initial examinations after the compliance date for Regulation Best Interest.” See https://www.sec.gov/ocie/announcement/risk-alert-regulation-best-interest.
[5]Scott Furst has extensive civil litigation and regulatory experience with a specialization in securities, business and complex commercial litigation in state and federal courts, before the Securities and Exchange Commission, Financial Industry Regulatory Authority, American Arbitration Association, and JAMS. He represents public and private companies, officers, directors, shareholders, broker-dealers, clearing firms, registered investment advisors, investment managers, and associated persons in a wide array of matters including, but not limited to, securities transactions, business disputes, civil bench and jury trials, regulatory investigations and enforcement proceedings, and investor and securities industry arbitrations throughout the United States. This Broker-Dealer Regulation Alert is for general information purposes and is not intended to advertise our services, solicit clients or represent our legal advice.
