Bates Research | 02-10-23
FINRA and SEC Increase Focus on Reg BI Compliance – What You Need to Know
In its latest annual report on examinations and risk monitoring, FINRA offered the regulator’s perspective on strengthening compliance programs on Regulation Best Interest (“Reg BI”) and the corresponding Form CRS. FINRA included observations from its compliance reviews on each of the core duties under the two-plus-year-old rule, including addressing the care in handling recommendations, conflicts of interest, required disclosure of material facts to retail clients, establishment of supervisory policies and procedures, and all aspects related to preparing a Form CRS. These areas were also the focus of an SEC Division of Examination Alert on broker-dealer compliance with Reg BI and in the SEC’s 2023 Priorities list released earlier this month.
A few weeks prior to the issuance of the FINRA annual report, Bates held a webinar on the same subject, joining colleagues from the legal and compliance community to delve deeper into how broker-dealer firms—including small- and mid-size firms—are adapting their compliance programs in light of repeated communications by the SEC and FINRA that Reg BI will be a focus of their examinations. The insights offered from both the regulatory officials and private consulting community offer perspective on what lies ahead. Here are the takeaways.
FINRA 2023 Report: Highlights on Reg BI and Form CRS
On Reg BI, the FINRA report references the four-duty standard (duties on care, conflicts of interest, disclosure, and compliance) under the regulation. Under the categorical heading “Communications and Sales,” FINRA poses questions, based on examinations to date, prompting broker dealers to consider whether they are covering their obligations under each of these duties.
Reg BI Duty of Care
Under the Reg BI duty of care, FINRA asks broker dealers to consider whether the firm is exercising an appropriate level of diligence, care and skill before making recommendations to retail investors.
- Observations: FINRA observed that firms made recommendations that failed the duty of care standard that were based on inadequate consideration of product risks, costs, account types, the investor’s profile (particularly with respect to retirement accounts,) and alternative products, among others. In a list of “effective practices,”
- Recommendations: FINRA suggested that firms include in their procedures and processes (i) the costs and reasonably available alternatives to recommended products; (ii) outlines of documentation practices; (iii) limitations on complex or higher-risk products; (iv) supervisory steps for reviewing recommendations; (v) heightened scrutiny of investments for retail customers (including mitigation and review processes to identify and categorize product risk and complexity).
Reg BI Conflicts of Interest
Under the Reg BI duty on conflicts of interest, FINRA asked broker dealers to consider whether the firm’s policies and procedures are adequate to identify, monitor for, disclose, mitigate or eliminate any conflicts.
- Observations: FINRA cited firm failings around conflicts arising from compensation incentives, investment strategies (such as only making recommendations of the firm’s proprietary products,) and material limitations on those strategies, that caused “an associated person or the firm to place their interests ahead of the retail customer’s interest.” (The agency provided a “non-exhaustive” list of examples of these practices.)
- Recommendations: FINRA also asked firms to ensure their supervisory procedures (including monitoring for, and imposing penalties on, associated persons who fail to manage for conflicts) are adequate to the task. Among highlighted practices, FINRA suggested that firms use conflicts committees or create “matrices” that “address conflicts across business lines and how to eliminate, mitigate or disclose those conflicts;” and “broadly prohibit” all sales contests.
Reg BI Duty to Disclose
Under the Reg BI duty to disclose, FINRA asked firms to consider whether their disclosures fully and fairly contain all material facts as to the firm’s relationship with their retail clients.
- Observations: Examples of representative’s failures to adequately disclose transaction fees and costs, investment strategies and other material information) at the time of the transaction. FINRA also prompted firms to consider the adequacy of their controls on electronic disclosure and updates to disclosures around changed circumstances concerning products and recommendations.
- Recommendations: FINRA suggested that firms implement systems for tracking delivery of Form CRS and Reg BI-related documents to retail investors and retail customers in a timely manner and a process to memorialize delivery of required disclosures “at the earliest triggering event.”
Reg BI Duty of Compliance
Under the Reg BI duty of compliance, FINRA questioned firms on whether their policies and procedures (including written supervisory procedures and the provision of staff training) were tailored to address the firm’s retail customers and product and service offerings.
- Observations: FINRA underscored that policies and procedures must be kept updated (particularly for supervision) and tested to ensure adequacy. FINRA emphasized that firms should consider how they will demonstrate (i.e. document) compliance with these requirements.
- Recommendations: FINRA suggested that firms (i) monitor associated persons’ compliance on a monthly basis (at least), and (ii) create systemic alerts for conflicts, high risk products and “account type or rollover or transfer recommendations that may be inconsistent with a retail customer’s best interest.”
FINRA also prompted firms to periodically update their Form CRS to ensure that it is consistent with changes to its business of product offering and ensure that procedures adequately “track and memorialize” the delivery of disclosure documents to retail customers.
SEC Risk Alert
On January 30, 2023, the SEC Division of Examinations issued a Risk Alert on broker dealer compliance deficiencies with Reg BI which mirror many concerns raised in the FINRA Annual Report, including failures to have tailored written policies and procedures, continued use of pre-Reg BI surveillance and training programs, insufficient compliance programs on identifying and mitigating conflicts of interest, and disclosure failures. The SEC reiterated their focus on Reg BI in their 2023 Priorities Report released this week.
Bates Webinar on Reg BI Compliance
Bates and NICE Actimize shared recent experiences with broker-dealer firms navigating compliance with Reg BI.
Rhonda Davis, Managing Director of the BD/RIA Compliance Practice at Bates Group, offered practical advice for responding to regulator expectations and highlighted the “process gaps” that exist for many firms, particularly small- and medium-sized firms. First, she recommended establishing a conflicts committee (or, depending on size, a conflicts officer) to look across all the business lines and consolidate a list of all potential conflicts into an inventory of identified conflicts and how the firm intends to mitigate or eliminate them. This is what regulators are looking to see, she said.
Second, Ms. Davis recommended a more robust effort on disclosure, beyond reliance solely on Form CRS (or, for dual registrants, in combination with Form ADV). She sharedthat the limitations on these forms (page length, required scripts) does not provide enough room to disclose all identified conflicts or to adequately describe products. She noted, “We’ve helped firms write an additional disclosure document such as a ‘Broker Dealer Services Disclosure Summary’ in which we evaluate identified conflicts, identify sources of revenue (e.g., trading execution, mark-up or -down costs, clearing firm costs), and disclose conflicts that may not be disclosed on Form CRS or ADV.”
Third, she recommended customized training relevant to the firm. She cautioned that training by a third-party service provider will usually include some standard elements but may lack the specificity of what is required for a particular firm or for the products they sell. She said, “It is clear that the SEC and FINRA are now looking for very specific training, particularly in the alternative space.” This is echoed in issues that come up in reviewing policy and procedure. She went on to note that “some firms tend to buy off-the-shelf manuals, so what they get is largely templated language that describes the regulation, but fails to specify the who, what, when, where and how the policy is actually implemented and how the activity is supervised.”
Jan Folena (Partner, Stradley Ronon) honed in on the latest lessons from recent enforcement actions, sharing insights on the four Reg BI standards.
- On duty of care, she noted that a recent enforcement action looked at whether the registered representatives fully understood the product they were selling—the benefits, risks, costs and whether the firm offered alternative products. “Unlike the fiduciary requirement for advisers,” she said, “Reg BI looks at the circumstances around the recommendations you are making at the point of sale.”
- On conflicts, she urged firms to (i) identify the areas that create a real or potential conflict, and (ii) understand that the requirement to mitigate any conflict is risky for firms because the term “mitigate” is not defined in the broker-dealer context. She recommended that firms consider avoiding compensation thresholds, minimizing compensation incentives, potentially capping credit to avoid favoring one product over another, but to be careful about limiting investor choices.
- On disclosure, she emphasized that representatives have a duty to disclose material facts about the scope and terms of the relationship with the client, conflicts of interest and any material information about the security being offering including material changes in circumstance—all at the time of sale.
- On the Reg BI duty of compliance, she observed that “compliance violations go hand-in-hand with substantive violations of a rule.” She pointed to the one enforcement case brought to date to emphasize that regulators are looking to see whether a representative understands the product they are recommending. If the SEC concludes that they didn’t understand the product, she said, the representative is out of compliance with the duty of care and SEC will look to flag the firm for a compliance violation. She urged representatives to be able to demonstrate document that they “understand the product, why it was appropriate for the client, and what the alternatives are.”
Anand Maheshwari, Senior Product Manager, NICE Actimize, concentrated his remarks on how automation can help firms comply with Reg BI requirements. In particular, he asserted that automation can help with creating an evidentiary trail to back up a recommendation and show that the representative did what they had to do at point of sale. He said that “automated measures can help compliance officers answer whether advisers recommended x, understanding their customers’ risk tolerances and other circumstances.” He stated that these processes can help to “produce written supervisory procedures, inform audit reports, provide access to product alternatives when recommendations are being made, and create alerts to stop a suspect transaction.” He also suggested that automated processes can help supervisors to better understand training needs.
The FINRA report and the SEC Examinations Division observations and report are must-reads for compliance officers looking to address the full scope of their responsibilities. As to Reg BI, the FINRA and SEC guidance reflects the continuing complexity of complying with the rule more than two years after implementation. That complexity shows up in the Bates-NICE discussion which highlighted that there remains significant uncertainty about how to satisfy the requirements and how to demonstrate that compliance. Shoring up process gaps, making greater disclosures beyond Form CRS, conduct product training , and using technology to evidence that the firm offered alternatives are some recommended steps for firms to consider. Bates will keep you appraised.
 The SEC issued two bulletins since Reg BI went into effect: one in March, 2022 on broker dealer account recommendations to retail investors, and one in August, 2022 on conflicts of interest. That interpretive guidance was described recently by Aaron Ellias, Senior counsel, SEC Division of Investment Management in an SEC Compliance Outreach National Seminar held in December. He highlighted the following: the “first bulletin reflects staff understanding that selection of account type is an extremely consequential decision for retail investors, particularly given the extent to which characteristics of a particular account type can impact its appropriateness for a given investor and their objectives; we also understand that this decision can be associated with potentially significant conflicts of interest.” The first bulletin’s key takeaway was that “the firm or financial professional have a reasonable basis for their account recommendation based on a reasonable understanding of the retail investor’s profile, as well as the account characteristics.”
Mr. Ellias stated: “the second bulletin addresses the fact that all broker dealers and investment advisers and their financial professionals have at least some conflicts of interest with their retail investors … economic or other incentives to recommend products or services or account types that provide more revenue or benefits for the firm, their financial professionals even where those recommendations may not be in the best interest of their retail investors.”
How Bates Compliance Can Help
Bates Group’s Compliance team helps firms navigate and achieve compliance with Reg BI and Form CRS, including:
- Disclosure obligations
- Duty of care obligations
- Conflicts of interest obligations
- Additional compliance obligations
We can assist you with:
- Developing and reviewing Reg BI Client Relationship Summary (“Form CRS”)
- Conflicts of interest assessment
- New product approval processes
- Drafting new policies and procedures
- Training for compliance and sales professionals on how to comply with Reg BI and Form CRS