Authors: Brian Baltz, John Ayanian, Cheryl Haas, and Emily Gordy
On Jan. 30, 2023, the Securities and Exchange Commission’s Division of Examinations (Division) released a Risk Alert, “Observations from Broker-Dealer Examinations Related to Regulation Best Interest,” in which the Division discussed perceived weaknesses in broker-dealers’ compliance with the disclosure, care, conflicts of interest and compliance obligations of Regulation Best Interest (“Reg BI”). These observations, while light on context and details, appear to reflect evolving expectations during examinations as to compliance with Reg BI. We have summarized the Division’s observations below.
Disclosure Obligation
- The Division believes that only posting Reg BI disclosures on a broker-dealer’s website or referencing the Reg BI disclosures in other documents does not satisfy the requirement to deliver the Reg BI disclosures in writing.
- The Division observed some broker-dealers with dually licensed financial professionals failed to establish reasonably designed policies and procedures to ensure that the dually licensed financial professionals were disclosing to retail customers the capacity in which the dually licensed financial professional were acting
- Some broker-dealers failed to establish policies and procedures reasonably designed to identify the disclosures that should be made with respect to conflicts of interest specific to dually licensed financial professionals.
Care Obligation
- Some broker-dealers or financial professionals failed to understand the product recommended; obtain or consider the customer’s investment profile; and understand the potential risks and costs associated with the recommendation.
Conflicts of Interest Obligation
- The Division noted that broker-dealers did not have written policies and procedures reasonably designed to specify how conflicts are to be identified or addressed, such as assigning responsibility to identify and address conflicts to a specific position or unit; or that did not prohibit sales contests based on the sales of specific securities or types of securities within a limited period of time.
- Some broker-dealers limited the identified conflicts to those associated with prohibited activities or used high-level, generic language that did not identify the actual conflict and did not reflect all conflicts of interest associated with the recommendations made by the firm or its financial professionals.
- The Division observed that broker-dealers relied on disclosure to mitigate conflicts of interest that appeared to create an incentive for a financial professional to place his or her interest ahead of the interest of the retail customer and did not establish ways to mitigate those conflicts.
Compliance Obligation
- The Division noted that some broker-dealers had policies and procedures that did not specify when disclosures should be created or updated (i.e., when the disclosures contain materially outdated, incomplete, or inaccurate information), including who is responsible for creating or updating disclosures, how to identify material changes, when material changes should result in new or updated disclosures, or how the updated disclosures should be delivered to retail customers.
- The Division observed that some broker-dealers did not have a process to demonstrate that disclosures had been provided to retail customers.
- Some broker-dealers had policies and procedures that directed financial professionals to consider reasonably available alternatives and cost in making recommendations without providing any guidance as to how to do so. Broker-dealers also created systems that allowed financial professionals to evaluate costs or reasonably available alternatives but did not mandate their use. The Division acknowledged that Reg BI does not require broker-dealers to document the basis for a recommendation, but noted that broker-dealers may wish to do so in certain contexts such as complex products, rollovers, and account choice.
- The Division noted that broker-dealers relied on Surveillance systems that existed before the effective date of Reg BI without considering whether those systems need modification to effectively monitor compliance with Reg BI;Documentation maintained locally, rather than in a central location, so that reviews designed to achieve compliance could occur only during branch examinations; andSurveillance systems that captured only executed transactions, and not hold recommendations or recommendations that are not accepted by the retail customer, to monitor for compliance with Reg BI.
- Surveillance systems that existed before the effective date of Reg BI without considering whether those systems need modification to effectively monitor compliance with Reg BI;
- Documentation maintained locally, rather than in a central location, so that reviews designed to achieve compliance could occur only during branch examinations; and
- Surveillance systems that captured only executed transactions, and not hold recommendations or recommendations that are not accepted by the retail customer, to monitor for compliance with Reg BI.
- Some broker-dealers offered training that included information on Reg BI but did not identify the firms’ processes for compliance with Reg BI.
Observations
The Risk Alert in some respects appears to restate prior SEC guidance regarding compliance with Reg BI. Notably, the Division does not provide context or additional details about many of the observations, leaving open questions about the staff’s expectations. Where the Division appears to be breaking new ground, such as by questioning the use of existing surveillance systems, it remains unclear why the Division views those surveillance systems as insufficient or what the Division would expect during examinations.
The Division’s observations regarding capacity and documenting the basis for recommendations follows a lengthy bulletin issued by the SEC staff in 2022 on those subjects, titled “Standards of Conduct for Broker Dealers and Investment Advisers Account Recommendations for Retail Investors.” McGuireWoods partners Brian Baltz and John Ayanian published an article in “The Review of Securities & Commodities Regulation,” Vol. 55 No. 13, July 20, 2022, that dissects and questions some interpretations taken by the SEC staff in that bulletin. For details, see McGuireWoods’ Subject to Inquiry post, which includes a link to the article.
Please reach out to the McGuireWoods attorneys in the People drop-down of this alert if you have any questions about the Risk Alert.
McGuireWoods’ Securities Enforcement and Regulatory Counseling (SERC) practice is a national leader in securities enforcement defense and broker-dealer and investment adviser regulatory counseling. Anchored by former SEC and FINRA attorneys from enforcement and trading and markets, as well as prominent federal prosecutors, the team manages complex securities investigations at every stage — from informal inquiries and routine exams through investigations, litigation and appeals — all while staying at the forefront of the ever-developing issues confronting the securities industry.