Bates Research  |  06-03-21

Regulators Get Tough on Reg BI and Form CRS Phase Two Compliance – Part 2: Reg BI

Regulators Get Tough on Reg BI and Form CRS Phase Two Compliance – Part 2: Reg BI

As we previously relayed in Part 1 of this article, the honeymoon period in which firms needed to show merely a “good faith” effort at compliance with Regulation Best Interest (“Reg BI”) and Customer Relationship Summary Form (“Form CRS”) requirements has come to an end. Peter Driscoll (Director of the SEC Division of Examinations), Emily Westerberg Russell (Chief Counsel of the SEC Division of Trading and Markets) and William “Bill” St. Louis (FINRA Senior VP and Firm Group Leader for Member Supervision) made clear that the regulators are moving to the next, more aggressive examination phase to ensure compliance with the new standard.

On the Transition to Phase Two

Reflecting on the past year, SEC Director Driscoll noted the implementation of Reg BI and Form CRS amid remarkable events—the pandemic, the election, market volatility, SolarWinds, GameStop, Archegos, and even Colonial Pipeline—events that, he said, would have been considered material in any other given year. Against that backdrop, he described the SEC’s approach in “Phase One” as encouraging firms to get to the “right place” in their efforts to establish policies and procedures, identify key risk areas, plan for implementation, and train their staffs during a period of adjustment. Through the publication of risk alerts, FAQs, leadership statements, and the SEC’s October 2020 staff roundtable (and despite the logistical challenges brought by COVID), the SEC and FINRA engaged in a wide variety of efforts to communicate their expectations under the new rules. The regulators referred to these efforts repeatedly and encouraged firms to review resources available on the SEC and FINRA websites for additional understanding of Reg BI and Form CRS requirements.

Part 2 of our article focuses on commentary from FINRA’s 2021 Annual Conference concerning Reg BI and what firms should expect during examinations in Phase Two. Read Part 1 concerning Form CRS here.

On Reg BI

Director Driscoll identified key takeaways from the early examination of firm compliance on Reg BI (“Phase One”) where they looked at small, medium and large firm implementation. These include (i) a “divergence” between examined written procedures and the rule, meaning that upon examination, the SEC expects to find written policies and procedures that are not a mere restatement of the rule, but that include guidance to employees and representatives on the application of the rule to the firm’s business. “Telling the representatives to consider costs and alternatives, but not what cost to consider or how to identify the reasonable alternatives” is not what firms should be doing, Driscoll explained. Similarly, he said that (ii) trainings on Reg BI requirements should ensure that they are tailored for the firm’s products and services. He urged firms to go back and review that any guidance given during the pandemic remains sound. Further, he said that the Division is monitoring (iii) developments in systems and technology (particularly automated systems to help document compliance), and that examiners will look to see “how firms are using and incorporating these tools in their procedures.” He mentioned that they saw a reliance on proprietary third-party assistance for evaluating rollovers, variable products and mutual funds, and that examiners will be questioning these developments. Driscoll also suggested “giving registered representatives guidance not just on what Reg BI requires, but specific examples on how to accomplish in a real-life setting.”

Director Driscoll had additional advice for firms when preparing for a Reg BI examination. He said that firms should consider whether there are adequate controls and processes in place on conflicts disclosures, particularly as they relate to changes in vendors, providers and affiliates and to registered representatives’ compensation. He also suggested that while Reg BI does not require documenting the basis for a recommendation, firms might want to show the risk-based approach used for deciding when it may be useful to document the recommendation. This was in reference to recommendations on complex products, warning caution “if it seems on its face” not to make sense. Another step firms can take is to identify areas new to Reg BI where they do not have supervisory or compliance reviews—account recommendations, for example—and put policies and procedures in place. “We are always looking at policies and procedures and how it relates to the practice,” said Driscoll, “as well as good controls for conflicts and disclosures as vendors, providers and affiliates change.”

Learn more about Reg BI support from Bates Compliance

Chief Counsel Russell focused on the need for firms to pay attention to processes that ensure costs and reasonable available alternatives are considered as part of any recommendation. She reminded firms that costs are always a factor, but that a recommendation on lowest cost alone would not be consistent with Reg BI. The regulation, she emphasized, requires consideration of other factors like customer profiles, risks and rewards, and product complexities. She also pointed to the SEC Reg BI FAQ regarding rollover account recommendations. Considerations could include deferred sales charges, liquidation costs, taxability, loss of rights of accumulation or rights of exchange or other benefits.

As for ensuring consideration of reasonably available alternatives, Ms. Russell said that regulators will consider facts and circumstances, but that firms should have a process for evaluating what reasonably available alternatives their representatives should be considering in their recommendations. “Reg BI does not prohibit firms from having a limited product menu, but that can’t be used to justify that a recommendation is not in the best interest of the customer,” she said.

FINRA's Mr. St. Louis added that FINRA exams will be looking at policies and procedures in addition to questionable recommendations, using analytics to cover the examination time period. He reminded firms that FINRA’s 2111 suitability rule “still applies for entities and small business owners.” In certain circumstances, firms mistakenly “searched and replaced” suitability obligations with the Reg BI standard in automated systems. He flagged how this was a “mistake,” because “recommendations of strategy and account type are covered by the new rule.” He further pointed out that “VA and options suitability rules are still on the books and apply, so in some instances it is 'Reg BI-plus.'”

On training, he said that recent observations show firms are doing a “layered and deep review” on obligations under the rule. He suggested that supervisory training to enforce the duty of care standard will be evaluated. He also reminded the audience that high net worth individuals are retail investors, too, and that there are no exclusions for high net worth investors under Reg BI. Conflicts should be an ongoing effort, and FINRA will focus on this too. Finally, Mr. St. Louis reminded firms about FINRA’s “cause investigations program,” which is precipitated by customer complaints, terminations for cause and arbitration filings. These usually generate numerous quantitative and qualitative suitability investigations. He concluded that the program would likely continue to generate a number of duty of care investigations.

Conclusion

The examination phase of regulatory oversight for Form CRS and Reg BI will not be forgiving. Given the ramp-up time and the “good faith” period to prepare for implementation, the regulators’ expectations are high. As Director Driscoll said, Reg BI is a “huge priority for our broker dealer examinations.” To emphasize that point, he made clear that the Division is “employ[ing] our quantitative analytics unit” and will be mining the trading data and a lot of the recommendations. From this perspective, he said, examiners will be able to take a deep look at “account turnover, new fees, old fees, conversions of different types of accounts,” and recommendations for different types of complex products, in addition to costs, policy and procedures, product offerings, and rollovers.

Based on the information conveyed during this session, the regulators will be using all their tools and examining all aspects of a firm’s compliance with Reg BI and Form CRS. Bates will continue to keep you informed.

*This article will be available soon in its entirety on our White Papers page.

Bates Group’s Compliance team helps BD, IA and Hybrid firms navigate Reg BI and Form CRS compliance. We also offer Reg BI and Form CRS consulting and expert testimony. To learn more, please visit our Reg BI and Form CRS resource page or our individual practice area pages, below.

 

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For more information about how Bates can support your firm, please contact:

David Birnbaum, Managing Director - dbirnbaum@batesgroup.com or 917-273-2682

Hank Sanchez, Managing Director, Bates Compliance - hsanchez@batesgroup.com or 504-450-9632

Rory O'Connor, Director, Bates Compliance - roconnor@batesgroup.com or 860-671-7270

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