The SEC recently issued a Risk Alert (the “Alert”) presenting findings from the Commission’s examinations of broker-dealers’ compliance with Regulation Best Interest (“Reg BI”).
In the Alert, the Commission reiterated that Reg BI “established a new, enhanced standard of conduct” for broker-dealers and their associated persons “when making recommendations of securities transactions or investment strategies (including account recommendation) to retail customers”. The Commission then summarized the deficiencies in broker-dealers’ compliance with the four (4) general Obligations contained within Reg BI: (i) Compliance Obligation, (ii) Care Obligation, (iii) Conflict of Interest Obligation, and (iv) Disclosure Obligation.
1. Compliance Obligation
- The Staff observed instances in which firms did not maintain adequate policies and procedures, and specifically called out instances in which firms only maintained generic policies not tailored to the firm.
- The Staff observed that certain firms did not maintain adequate policies and procedures to comply with the Disclosure Obligation:
- The Staff observed that several firms did not specify when disclosures should be created or updated or how updated disclosures should be delivered to retail customers. Firms also could not demonstrate whether a disclosure was delivered, making it difficult for firms to determine whether disclosures had been provided prior to or at the time of a recommendation.
- The Staff also observed inadequate policies and procedures relating to firms’ compliance with the Care Obligation:
- The Staff found several weaknesses in firms’ written policies and procedures, including failing to provide any guidance on how to consider alternatives in formulating a recommendation, how to consider costs when making a recommendation, and how/when to document the basis for recommendations.
- Further, the Staff found that many firms that established systems that enabled the evaluation of costs or available alternatives failed to mandate their use and could not determine whether or not the systems were used.
- Observations regarding Training and Periodic Reviews and Testing:
- The Staff found that firms improperly relied on surveillance systems that (a) existed before the effective date of Reg BI without considering whether such systems warranted modification; and (b) captured only executed transactions and therefore did not review “hold” recommendations for compliance with Reg BI.
- Certain firms relied upon documentation held locally rather than centrally, so that reviews designed to achieve compliance could only occur during branch examinations, and not in a timely manner to achieve compliance with the Care Obligation.
- Firms did not provide targeted training that identified the firms’ processes for compliance with Reg BI.
- The Staff observed that certain firms did not maintain adequate policies and procedures to comply with the Disclosure Obligation:
2. Care Obligation
- The Staff observed instances where broker-dealers/financial professionals failed to understand the recommended product, failed to obtain or consider the customer’s investment profile, and failed to understand the potential risks and costs associated with a recommendation.
3. Conflict of Interest Obligation
- Some firms’ written policies and procedures did not provide sufficient guidance on how to identify and address conflicts, such as assigning surveillance and review responsibilities to a specific position or unit. Additionally, certain firms’ policies and procedures failed to prohibit sales contests, sales quotas, bonuses, and non-cash compensation that were based on the sales of specific securities or specific types of securities within a limited period of time.
- The Staff found that firms limited the identified conflicts to conflicts associated with prohibited activities or used generic language that did not identify the actual conflict.
- Firms overly relied on disclosures purporting to “mitigate” conflicts, which appeared to create an incentive for financial professionals to place their interests ahead of the interests of retail customers.
4. Disclosure Obligation
- The Staff found that firms failed to satisfy their written disclosure obligation where they only posted the Reg BI disclosures on their website or referenced the disclosures in documents delivered to customers.
- Some firms with dually licensed financial professionals did not establish policies and procedures requiring disclosure to retail customers of (a) the capacity in which the financial professional acted; and (b) the attendant risks of conflict of working with a dually licensed professional.
Client Alert 2023-034
