SEC Exam Guidance for Reg BI Compliance

On April 7, 2020, the Securities and Exchange Commission’s (SEC) Office of Compliance Inspections and Examinations (OCIE) issued a Risk Alert providing guidance for the SEC’s post June 30, 2020 examinations of firms’ compliance with “Reg BI.” This was one of two Risk Alerts issued by the OCIE that day. The other covers the SEC prospective examinations of firms’ Form CRS compliance and is covered in a separate article.

The Reg BI Risk Alert which is discussed here advises that the “OCIE is providing transparency into its plans regarding Regulation Best Interest examinations to empower broker-dealers to assess their level of preparedness as the compliance date nears.” It encourages firms to use the documents listed in the Risk Alert relevant to their broker-dealers to assess their implementation plans for Regulation Best Interest. That list is contained in a three-page Appendix that provides an example of an OCIE Reg BI examination document and information request list. Firms should study this exemplar request list closely. In addition, the Risk Alert provides firms with information regarding the scope and content of the SEC initial Reg BI examinations which will occur during the first year after the June 30, 2020 compliance date.

These examinations are designed primarily to evaluate whether broker-dealers established policies and procedures reasonably designed to achieve compliance with Reg BI. The SEC acknowledges that the coronavirus disease (COVID-19) has created challenges for firms; nonetheless, as Chairman Clayton announced last week, the SEC will not be extending the June 30, 2020 compliance date.

OCIE’s guidance aligns with the four “obligations” of Reg BI: the Disclosure Obligation; the Care Obligation; the Conflict of Interest Obligation; and the Compliance Obligation. Accordingly, we summarize OCIE’s guidance below.

Disclosure Obligation

OCIE advises that it may assess specific disclosures regarding: the capacity in which the recommendation is being made; the material fees and costs that apply to transactions, holdings and accounts; and material limitations on the securities or investment strategies. OCIE specifically advises that it may review firm documents such as:

• Schedules of fees and charges assessed against retail customers and disclosures regarding such fees and charges, including disclosures regarding the fees and costs related to services and investments that retail customers will pay or incur directly and indirectly (e.g., custodian fees, account maintenance fees, fees related to mutual funds and variable annuities, and other transactional fees and product level fees);
• The broker-dealer’s compensation methods for registered personnel, including (i) compensation associated with recommendations to retail customers, (ii) sources and types of compensation (e.g., direct payments by an investor, payments by a product sponsor), and (iii) related conflicts of interest (e.g., conflicts associated with recommending proprietary products or with receiving payments for inclusion on a product menu);
• Disclosures related to monitoring of retail customers’ accounts;
• Disclosures on material limitations on accounts or services recommended to retail customers; and
• Lists of proprietary products sold to retail customers.

For the Care Obligation, and to assess compliance with it, OCIE may review:

• Information collected from retail customers to develop their investment profiles (including any new account forms, correspondence, and any agreements the customer has with the broker-dealer).
• The broker-dealer’s process for having a reasonable basis to believe that the recommendations are in the best interest of the retail customer (which may include, e.g., any process for establishing, understanding and implementing the scope of reasonably available alternatives when making a recommendation).
  • The factors the broker-dealer considers to assess the potential risks, rewards and costs of the recommendations in light of the retail customer’s investment profile.
  • The broker-dealer’s process for having a reasonable basis to believe that it does not place the financial or other interest of the broker-dealer ahead of the interest of the retail customer.
• How the broker-dealer makes recommendations related to significant investment decisions, such as rollovers and account recommendations, and how the broker-dealer has a reasonable basis to believe that such investment strategies are in a retail customer’s best interest.
• How the broker-dealer makes recommendations related to more complex, risky or expensive products and how the broker-dealer has a reasonable basis to believe that such investments are in a retail customer’s best interest.

Conflict of Interest Obligation

OCIE shares that it may review broker-dealer’s policies and procedures to assess:

• Whether and how the policies and procedures address the following, as required by Regulation Best Interest:
  • Conflicts that create an incentive for an associated person to place its interest or the interest of a broker-dealer ahead of the interest of the retail customer;
  • Conflicts associated with material limitations (e.g., a limited product menu, offering only proprietary products or products with third-party arrangements) on the securities or investment strategies involving securities that may be recommended to a retail customer; and
  • The elimination of the following conflicts: sales contests, sales quotas, bonuses and non-cash compensation based on the sale of specific securities or specific types of securities within a limited period of time.
• How the policies and procedures establish a structure for identifying the conflicts that the broker-dealer or its associated person may face. Staff may request documentation identifying all conflicts associated with the broker-dealer’s recommendations.
• How the policies and procedures establish a structure to identify and assess conflicts in the broker-dealer’s business as it evolves. Staff may request to see all policies and procedures in place during the scope period of the examination.
• How the policies and procedures provide for disclosure of conflicts and what conflicts are disclosed.
• How the policies and procedures provide for mitigation or elimination of conflicts and what conflicts are mitigated or eliminated.

“Compliance Obligation”

This part of the Risk Alert is much more succinct. OCIE advises that it will assess compliance with this obligation by reviewing the broker-dealer’s “policies and procedures and evaluate any controls, remediation of noncompliance, training, and periodic review and testing.”

The document list provided in the OCIE’s Appendix to the risk alert is invaluable. As the OCIE advises, their “[i]nitial examinations will focus on assessing whether firms have made a good faith effort to implement policies and procedures reasonably designed to comply with Regulation Best Interest, including the operational effectiveness of broker-dealers’ policies and procedures.” To reach its conclusion regarding the firms’ efforts, the SEC will review the documents in the Risk Alert’s Appendix relevant to your business. Therefore, this is the time to review, revise and finalize your policies and procedure and assess your books and records to ensure the documents the SEC will ask you for to demonstrate your compliance will in fact be available and in good condition.

Should you have any questions about this alert or need assistance in your readiness efforts you may contact us as indicated below.