Bates Research  |  10-29-21

SEC Director Advocates for “Proactive Enforcement” as Challenges Develop for Reg. BI

Enforcement warnings and regulatory chatter on Regulation Best Interest (“Reg. BI”) are picking up. On October 6, 2021, in his first speech as SEC Enforcement Division, Director Gurbir Grewal urged participants at a PLI Broker/Dealer Regulation and Enforcement Conference to take a “proactive approach” and engage in real “cooperation” in order to “promote better conduct among market participants.” He made that pitch right before he detailed how his Division “brought enforcement actions against more than two dozen firms that had failed to timely file or to deliver their Forms CRS to their clients and customers,”(see also, Bates’ post). Director Grewal also warned that he would be much more demanding when it comes to the SEC’s cooperation credit policy and penalty authority. Recent reports suggest that the SEC has begun a get-tough approach by sending out examination deficiency letters to “a wide array of broker-dealers” for Reg. BI compliance failures, focusing primarily on proper consideration of available alternative investments and deficiencies concerning conflicts of interests.

The enforcement speech and recent enforcement activity conveyed the SEC’s carrot-and-stick approach, but appeared also to be intended to reassure legislators, among others, that the SEC is fully committed to the regulation going forward. That was the message that SEC Chair Gary Gensler delivered at a recent House Financial Services Committee hearing in which he emphasized his intention to fully implement Reg. BI “to make sure that brokers ensure that the investing public truly gets best interest.” That said, Chair Gensler also signaled his likely consideration of revisions to the regulation, in particular, changes related to whether it adequately covers digital engagement practices (“DEPs”) – the subject of an August 27, 2021, SEC Request for Information (comments closed on October 1, 2021). The subject of DEPs was the entire focus of an October 13, 2021, address by SEC Investor Advocate Rick Fleming, who argued that investors will not receive the benefits of Reg. BI protections for unsolicited trading influenced by DEPs using “game-like” features. Here’s a closer look.

SEC Enforcement Division Director Wants More Cooperation 

Asking for cooperation, but promising aggressive enforcement action, Enforcement Division Director Grewal pleaded with “lawyers, counselors and gatekeepers” to stay away from “grey areas” of compliance – “ambiguity in the text or a footnote [that] may not be consistent with the law and its purpose” – and drive practices and policies based on how “business models and products interact with both emerging risks and enforcement priorities.” He reaffirmed that fiduciary principles underscore Reg. BI, highlighting that those are the principles that enhance broker-dealer standards of conduct beyond the suitability obligation. Accordingly, he urged firms to engage in “proactive compliance” by giving their representatives “the tools and information that will enable them to identify, disclose, and mitigate conflicts prohibited under Reg. BI.” 

On compliance, Director Grewal focused in on (i) recordkeeping obligations, which he said are vital to the SEC’s ability to investigate and resolve issues of “accountability, integrity and spoliation;” (ii) filing and disclosure obligations (Form CRS, in particular) to proactively prevent investor harm; and (iii) compliance issues related to the use of personal devices, new communications channels, and other technological developments like ephemeral apps.

On cooperation and cooperation settlement credit, the director was expansive about what it was not. For example, he said that cooperation was not the “absence of obstruction,” nor “self-reporting” of an impending announcement, nor “conducting a purportedly independent investigation” that “is nothing more than an advocacy piece.” He reaffirmed longstanding SEC cooperation policy and highlighted recent cases in which a respondent “substantially advanced the quality and efficiency of the Staff’s investigation and conserved Commission resources,” but added that he would be looking to whether a cooperator took “significant, tangible steps,” and/or “allowed us … to bring charges more quickly, or helped us to identify additional conduct or other violators that contributed to the wrongdoing.”

Finally, Director Grewal expounded on the use of penalties to change behavior, emphasizing that the Division looks to assess a penalty that will deter future misconduct and reduce violations. In that respect, he suggested that “it may be appropriate to impose more significant penalties for comparable behavior over time” for firms to be deterred from simply pricing-in the costs of a violation. In other words, penalties levied in the past may need to be increased if they have not had a deterrent effect. As a result, he warned market participants to expect larger penalties in settlement negotiations and in litigation.

For Reg BI and Form CRS resources and support, visit Bates Group’s Reg BI and Form CRS service page.

SEC Investor Advocate on Gamification - May Expose Flaw in Reg. BI Rule

In his speech on DEPs, “Investor Protection in the Age of Gamification: Game Over for Regulation Best Interest?”, Investor Advocate Fleming questioned whether Reg. BI. -  which he called “well-intentioned” – was “worth the effort at all” given that new DEPs and the “gamification” of retail stock trading “may expose what may be a significant flaw” in the rule. He acknowledged that DEPs, which involve the use of technology “to make trading easier and more exciting,” can have significant positive effects, including providing greater access to the financial markets (especially for underserved communities) and creating opportunities to educate investors. However, he argued, a significant downside exists for investor safety, arguing that gamification induces trading “that is more frequent or higher-risk than an investor would choose for herself in the absence of DEPs.” He cited the unexpected, unprecedented, and volatile retail trading in certain public companies spurred by DEPs in January 2021. One consequence of that market event was an SEC Request for Information on DEPs issued in late August. Mr. Fleming focused on one aspect of that broad inquiry: “how does the use of DEPs intersect with Reg. BI?

His analysis started with the regulatory framework for Reg. BI. He said that investor protections built in to Reg. BI are triggered first by a recommendation and do not “apply to self-directed or otherwise unsolicited transactions by a retail customer.” He also said that without that recommendation, “the broker does not have to consider any of the component obligations in carrying out the trade.” He concluded that DEPs “may blur the line between solicited and unsolicited transactions” because they may “nudge” investors to trade without a recommendation. 

Mr. Fleming advocated for the SEC to (i) interpret that “recommendations” include instances where a broker-dealer utilizes DEPs to encourage trading, and (ii) “use its enforcement authority to back up its position.” He acknowledged the difficulty of that solution, given the complexity of determining when a DEP rises to the level of a recommendation. He also argued the flaw in linking a broker’s obligations under Reg. BI to “whether the customer technically initiates the trades after the broker has used subtle techniques to influence the customer to engage in active trading, trade on margin, trade options, and engage in other risky practices.” Mr. Fleming then suggested that the Commission might want to “go back to the drawing board so that its critical investor protections no longer rise and fall on whether the broker-dealer made a specific recommendation.” (Note: A counter to these arguments can be found in SIFMA’s Comment on the SEC Request for Information here.)  

Conclusion

It is not difficult to see why legislators may question Chair Gensler’s commitment to Reg. BI. The answer can be found in the competing public voices of his leadership team. The Division of Enforcement Director conveyed his intention to enforce strict compliance with Reg. BI, beef up investigations, raise penalties, and demand more meaningful cooperation before bestowing credit in a settlement or litigation. The Investor Advocate charged that Reg. BI may be unworkable framework given recent technological developments and, given the trajectory of those developments, an increasingly meaningless distinction between broker-dealers and investment advisers. 

This story is far from over. As this continues to play out, heed the warnings of the Enforcement Director. Bates will keep you apprised.

How Bates Can Help: 

The Bates Compliance team helps BD, IA and Hybrid firms meet their Form CRS and Reg. BI compliance obligations, including further defining conflicts, determining your disclosure approach and mitigating risk to your firm. We develop, review and update Form CRS, and also support firms with Form CRS gap analyses, risk assessments, consistency reviews, and training. For a full list of services, visit our Reg. BI and Form CRS resource page.

To locate a Reg-BI consulting or testifying expert witness, please go to: Expert Search | Bates Group

For a list of Bates Group’s Litigation and Regulatory related services, visit our Financial Securities Litigation & Consulting and Regulatory and Internal Investigations resource pages.

Contact us today at contact@batesgroup.com or call us at: 503-670-7772 to learn how we can support your team and your clients.

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