February 13, 2020

The SEC Trading and Markets Reg BI FAQ and the SEC’s and FINRA’s Plans for Reg BI Exams

In light of the significance of the final rules and Commission interpretations issued by the Securities and Exchange Commission (SEC) on June 5, 2019, our Best Interest Compliance Team issued a series of articles on the subject. The first article, “The Final Reg BI Package: What to Know and What’s Next,” summarized the final package of rules and interpretations. The second and third articles covered Form CRS and the Commission Interpretation Regarding Standard of Conduct for Investment Advisers.

This fourth article covers the SEC Division of Trading and Markets recently released “Frequently Asked Questions on Regulation Best Interest” (Reg BI FAQ). Further, we discuss the guidance from the SEC’s Office of Compliance Inspections and Examinations (OCIE), “2020 Examination Priorities,” and FINRA’s “2020 Risk Monitoring and Examination Priorities Letter,” which discuss their plans for examinations on Reg BI compliance. While much of the coverage of Reg BI has been historical and focused on analyzing and summarizing the final rule package, this alert looks to the future regarding how the Division of Trading and Markets, OCIE and FINRA are interpreting and planning to examine for Reg BI compliance.

The Reg BI FAQ provides helpful guidance to the brokerage industry. Unlike the first Form CRS FAQ released last fall, which was very brief, the Reg BI FAQ provides specific guidance on a variety of important topics covered by Reg BI, specifically recommendations, the disclosure obligation, the care obligation and the conflict of interest obligation.

Recommendation

The “Recommendation” guidance starts by amplifying the importance of account recommendations and investment strategies covered by the final rule. Specifically:

Accordingly, the staff reminds broker-dealers that the term “investment strategy” (which includes account recommendations) is to be interpreted broadly. Further, account recommendations almost always will involve a “securities transaction” (such as a securities purchase, sale or exchange), and thus would generally be subject to Regulation Best Interest in any case.

The guidance on recommendations continues to address a controversial area regarding the availability of accounts and products and whether, for example, both brokerage and advisory accounts need to be taken into consideration to be in compliance with Reg BI. The response to this particular FAQ starts out by stating that, “If you are only registered as an associated person of a broker-dealer (regardless of whether you work for a dual-registrant or a broker-dealer affiliated with an investment adviser), you would need to take into consideration only the brokerage accounts available at your firm.” The guidance hedges, though, by further providing: “The Commission noted that even if your firm only offers brokerage accounts, you would still need to have a reasonable basis to believe that the recommended account is in the best interest of the retail customer.”

As a result, broker-dealers should have policies, procedures, and processes in place by June 30, 2020 to ensure that their registered representatives are considering the account types reasonably available for retail customers and determining which account type or types is in the best interest of the retail customer. In addition, if none of the account types are reasonably in the best interest of a particular retail customer, the registered representative needs to be trained and prepared to advise the retail customer accordingly.

This Recommendation section continues with an attempt to address another controversial topic: when is an initial communication subject to Reg BI, in particular in informal social settings. The answer to this FAQ starts with some general guidance, but the best way to summarize this topic is to cite to the hypothetical provided in the FAQ:

Not all communications with a prospective retail customer will rise to the level of a recommendation. For example, consider a scenario where you meet a prospective retail customer at a dinner party and say: “I have been working with our mutual friend, Bob, for fifteen years, helping him to invest for his kids’ college tuition and for retirement. I would love to talk with you about the types of services my firm offers, and how I could help you meet your goals. Here is my business card. Please give me a call on Monday so that we can discuss.”

Absent other factors, in the staff’s view this communication would not be a “recommendation” subject to Regulation Best Interest, as the staff does not believe this communication in and of itself would reasonably be viewed as a “call to action” to open an account, engage in a securities transaction or act on an investment strategy.

Lastly for this section, the Reg BI FAQ addresses the issue of “education” versus “recommendations,” in particular in the context of retirement accounts and IRAs. Consistent with Reg BI, this FAQ states that, “Consistent with existing broker-dealer regulation, certain communications are treated as ‘education’ rather than ‘recommendations.’” Thus, Reg BI still allows for investment education (or descriptive information) provided that it does not cross the line to a recommendation regarding specific securities to be transacted

Disclosure Obligation

The “Disclosure Obligation” section starts with the issue of whether there are certain circumstances where oral disclosures can be made, provided that written disclosures are made after the recommendation. The response to this FAQ starts by advising that this is permissible “[only] in limited circumstances.” This cannot be overemphasized. To the extent that this is a valid risk for a firm’s business, we recommend that they analyze and apply the guidance in this FAQ as specifically as possible.

This section then provides guidance regarding the Reg BI Disclosure Obligation versus Form CRS. First, this guidance confirms that the Reg BI Disclosure Obligation generally cannot be satisfied with the Form CRS Relationship Summary. The next FAQ goes on to say that each has distinct delivery obligations and certain requirements for electronic delivery. Regarding the latter, the guidance states that the existing framework consists of the following elements:

(1) notice to the investor that information is available electronically; (2) access to information comparable to that which would have been provided in paper form and that is not so burdensome that the intended recipients cannot effectively access it; and (3) evidence to show delivery (i.e., reason to believe that electronically delivered information will result in the satisfaction of the delivery requirements under the federal securities laws). One method to satisfy the evidence of delivery element is to obtain informed consent from investors.

In practice, this guidance, while appearing somewhat straightforward, may be more difficult to satisfy. As a result, firms should review their internal processes for notices, access, delivery, and appropriate and reasonable evidence to be in compliance with said guidance.

Care Obligation

The “Care Obligation” topic only addresses one issue: what constitutes a “series of transactions” and whether a particular transaction is part of a “series of transactions.” Thus, this FAQ focuses on “churning.” In response, the Reg BI FAQ advises that Reg BI “does not change” the “well-established approach[es]” in assessing what constitutes excessive trading.

Conflict of Interest Obligation

The “Conflict of Interest Obligation” topic starts by emphasizing that Reg BI’s prohibition of certain incentives, such as certain types of sales contests, sales quotas, bonuses and non-cash compensation based on the sales of specific securities or types of securities within a limited time period, does not mean that all other incentives are presumptively compliant with Reg BI. This guidance continues:

Such other incentives and practices that are not explicitly prohibited are permitted provided that the broker-dealer establishes reasonably designed policies and procedures to disclose and mitigate the incentives created, and the broker-dealer and its associated persons comply with the Care Obligation and the Disclosure Obligation.

This topic then provides specific guidance regarding mitigation practices that could be used to obtain compliance with Reg BI in that regard. While this list is not exhaustive, it is helpful for firms to consider as they develop and implement mitigation practices tailored to their particular firm:

  • Avoiding compensation thresholds that disproportionately increase compensation through incremental increases in sales
  • Minimizing compensation incentives for employees to favor one type of account over another, or to favor one type of product over another, proprietary or preferred provider products, or comparable products sold on a principal basis, for example, by establishing differential compensation based on neutral factors
  • Eliminating compensation incentives within comparable product lines by, for example, capping the credit that an associated person may receive across mutual funds or other comparable products across providers
  • Implementing supervisory procedures to monitor recommendations that are: near compensation thresholds; near thresholds for firm recognition; involve higher compensating products, proprietary products or transactions in a principal capacity; or involve the rollover or transfer of assets from one type of account to another (such as recommendations to roll over or transfer assets in an ERISA account to an IRA) or from one product class to another
  • Adjusting compensation for associated persons who fail to adequately manage conflicts of interest
  • Limiting the types of retail customer to whom a product, transaction or strategy may be recommended

To satisfy these criteria, broker-dealers, in particular, need to examine their programs that could arguably provide the highest level of incentive to sell particular securities or strategies that might be in the best interest of at least some retail customers.

OCIE and FINRA 2020 Examination Plans for Reg BI

Around the same time as the release of the Reg BI FAQ, OCIE released its “2020 Examination Priorities” and FINRA released its “2020 Risk Monitoring and Examination Priorities Letter.” With this alert, we focus only on the Reg BI examination planning discussions in these releases.

OCIE, in the “Anticipated Impact of Significant Rulemaking” section, stated that Reg BI, the Form CRS Relationship Summary and the two separate interpretations under the Investment Advisers Act of 1940 “will be FY 2020 examination priorities.” In the “Standards of Care” section, OCIE continued:

To further assist broker-dealers before the June 30, 2020, compliance date for Regulation Best Interest and Form CRS, OCIE will engage with broker-dealers during examinations on their progress on implementing the new rules and questions they may have regarding the new rules. After the compliance dates, OCIE intends to assess implementation of the requirements of Regulation Best Interest, including policies and procedures regarding conflicts disclosures, and for both broker-dealers and RIAs, the content and delivery of Form CRS. Moreover, OCIE has already integrated the Interpretation Regarding Standard of Conduct for Investment Advisers into the IAIC examination program.

Finally regarding OCIE’s 2020 efforts, and not surprisingly with the SEC’s continued focus on “Main Street” issues, OCIE advises that, “Examinations will focus on recommendations and advice given to retail investors, with a particular focus on: (1) seniors, including recommendations and advice made by entities and individuals targeting retirement communities; and (2) teachers and military personnel.”

FINRA also provides specific guidance regarding its 2020 plans for examining Reg BI. Specifically, FINRA advised, “In the first part of the year, FINRA will review firms’ preparedness for Reg BI to gain an understanding of implementation challenges they face and, after the compliance date, will examine firms’ compliance with Reg BI, Form CRS and related SEC guidance and interpretations.” FINRA then described the factors, among other issues, that it will take into consideration when reviewing for compliance with Reg BI after June 30, 2020:

  • Does your firm have procedures and training in place to assess recommendations using a best interest standard?
  • Do your firm and your associated persons apply a best interest standard to recommendations of types of accounts?
  • If your firm and your associated persons agree to provide account monitoring, do you apply the best interest standard to both explicit and implicit hold recommendations?
  • Do your firm and your associated persons consider the express new elements of care, skill and costs when making recommendations to retail customers?
  • Do your firm and your associated persons consider reasonably available alternatives to the recommendation?
  • Do your firm and your registered representatives guard against excessive trading, irrespective of whether the broker-dealer or associated person “controls” the account?
  • Does your firm have policies and procedures to provide the disclosures required by Reg BI?
  • Does your firm have policies and procedures to identify and address conflicts of interest?
  • Does your firm have policies and procedures in place regarding the filing, updating and delivery of Form CRS?

FINRA also has published a “Reg BI and Form CRS Firm Checklist” that sets forth 20 items FINRA believes brokerage firms should consider in their Reg BI compliance efforts. That Checklist provides a comparison of Reg BI to FINRA’s suitability rule and explains how standards will change.

Both OCIE and FINRA will spend the next five months reviewing the progress made toward compliance by June 30, 2020. Both will examine for compliance beginning on June 30, 2020. Given the proactive guidance provided by both OCIE and FINRA, it appears that little leeway will be given for failures to show at least a good faith effort toward full compliance by June 30, 2020. Also of note is the fact that the investment adviser interpretation has already been incorporated into the exam materials for investment advisers. Therefore, the SEC is unlikely to provide leeway with investment advisers or dual registrants.

Conclusion

The Reg BI FAQ is required reading – and deserves a close read – for all firms working on Reg BI compliance by June 30, 2020. While the FAQ starts with the usual caveats (1) that it reflects the views of the staff of the Division of Trading and Markets, not the Commission, and (2) that they do not constitute rules, the reality is that OCIE staff and Division of Enforcement staff will look to this guidance and apply it to their examinations and investigations. Indeed, OCIE and FINRA state that they will prioritize Reg BI compliance examinations after June 30, 2020. Using history as a guide, certain of these examinations will turn into referrals to the Division of Enforcement and certain investigations will result in firms being charged with Reg BI violations. In addition, while FINRA has indicated its intention to work with the SEC to avoid duplication of efforts, FINRA examinations may lead to separate enforcement actions by FINRA. To avoid this path, firms should heed the guidance in the Reg BI FAQ and review FINRA’s “Reg BI and Form CRS Firm Checklist.” The time is now for firms to continue to focus on their vigilance in their efforts to be in full compliance by June 30, 2020.

For further information or guidance relating to the SEC’s Reg BI FAQ, Form CRS, the Commission Interpretation Regarding Standard of Conduct for Investment Advisers, or FINRA’s focus on compliance reviews, please contact Faegre Drinker’s Best Interest Compliance Team and we will be happy to assist you.

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