Earlier this month the SEC’s Office of Compliance Inspections and Examinations (OCIE) issued two related risk alerts on the subjects of Form CRS and Regulation Best Interest (Reg BI). The purpose of the risk alerts was to provide investment advisers and broker-dealers information regarding the anticipated scope and content of the examinations OCIE will conduct following the compliance date for Regulation Best Interest, and the filing deadline for Form ADV, Part 3. In this post, we summarize the risk alert relating to Reg BI.
The initial broker-dealer examinations will focus on whether firms have established policies and procedures reasonably designed to comply with Regulation Best Interest’s for distinct obligations: the duty to disclose; the duty of care; the duty to avoid or disclose conflict of interest; and the duty to adopt compliance procedures. In addition to assessing whether a registrant has adopted policies and procedures reasonably designed to comply with Regulation BI, the examinations will also assess the operational effectiveness of those procedures.
For example, under Reg BI, a broker-dealer has an obligation to disclose to a retail customer, in writing, a description of the scope and terms of the relationship. That disclosure must be both full and fair, and include a description of all material facts relating to conflicts of interest associated with any particular recommendation. In order to evaluate compliance with those requirements, OCIE explains that it will review a particular firm’s disclosure regarding the capacity in which any recommendation is being made, the totality of any and all fees relating to the recommendation, and whether any material limitations exist as to the securities or strategies being recommended or which may be recommended to the customer. The risk alert lists a sample of the types of documents and other firm records that may be examined to determine compliance, including fee schedules, disclosures regarding fees and other costs, documents reflecting compensation methods for registered personnel, disclosures relating to account monitoring, disclosures relating to material limitations on accounts or services, and a list of proprietary products sold by the broker-dealer to retail customers.
The duty of care requires a broker-dealer to exercise reasonable care when making a recommendation to a retail customer. In order to fulfill this duty, the broker-dealer must understand possible risks, rewards and costs associated with the recommendation, and consider all those factors as they relate to the customer’s investment profile, including the investment objective and risk tolerance. The broker may only make recommendations that are in the retail customer’s best interest. In order to examine for compliance with that requirement, the risk alert lists among the documents that may be reviewed during an examination: new account forms, correspondence with clients, agreements between the customer and the broker-dealer, copies of the broker-dealer’s written process for determining when a reasonable basis exists to make a recommendation in the best interest of the customer, and processes which exist for establishing available alternatives. OCIE staff will expect the broker-dealer to have a process in place that demonstrates that the firm has a reasonable basis to believe that it has not placed its own interest or the interest of the representative ahead of the interest of the customer. Among the specific examples of documents that may be reviewed to establish the firm’s compliance with that requirement are the firm’s policies and procedures for making rollover recommendations, including an explanation of how the broker-dealer determines there is a reasonable basis to conclude that a rollover strategy is in the customer’s best interest. If the broker-dealer ever recommends complex, risky or expensive products, OCIE staff expects to review written processes that establish when the broker-dealer may make recommendations for such products consistently with the client’s best interest.
The conflict of interest obligation requires a broker-dealer to minimize, eliminate or, at minimum, disclose conflicts of interest relating to recommendations to clients. In order to meet that obligation, the broker-dealer must establish and enforce written procedures designed to address such conflicts. OCIE staff may review the broker-dealer’s policies and procedures, documents that reflect any incentives created for associated persons to place their interests above those of the client, and documents pertaining to any material limitations on securities or strategies that may be recommended to a customer (for example, limited product menus). OCIE may also ask about and review documentation reflecting that prohibited conflicts such as sales contests, sales quotas, bonuses, and non-cash compensation. More broadly, staff expects to review documents that demonstrate how policies and procedures establish a framework for identifying conflicts that the broker-dealer or its associated person may have. This suggests that one of the first orders of business for any firm in complying with Reg. BI would be to make a list or other detailed memorandum documenting all conflicts of interests that could be associated with a particular broker-dealer’s recommendations. Once those conflicts of interest are identified, OCIE will expect the firm to have created documents that explain how the conflicts will be disclosed, mitigated or eliminated as the case may be.
Finally, the compliance obligation requires a broker-dealer to establish and enforce written procedures reasonably designed to comply with Reg BI as a whole. In order to assess compliance with that requirement, OCIE staff will likely ask to review the broker-dealer’s policies and procedures and will evaluate the firm’s controls, training, and review and testing of those procedures to determine their effectiveness.
Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds, and issuers of securities, among others. Our Broker-Dealer Group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules. Please visit our Broker-Dealer Practice Group page for more information.