Introduction
In advance of the June 30, 2020 deadline for complying with Regulation Best Interest (Reg BI)—which created a new enhanced standard of conduct governing broker-dealers' recommendations to their retail customers1 —Jay Clayton, the Chair of the US Securities and Exchange Commission (SEC or Commission), issued a statement on April 1, 2020, that the deadline remain in effect and not be extended due to the Coronavirus pandemic. Although the SEC relied on the current health emergency to offer relief, including extensions and exemptions from other regulatory deadlines, Chairman Clayton explained that, "particularly in times of uncertainty, investment professionals should not put their interests ahead of the interests of their clients and customers."2 He also noted that firms have devoted resources over the past several months to comply with Reg BI. He stated that the Commission's Office of Compliance, Inspections and Examinations (OCIE) would be issuing two Risk Alerts to provide additional guidance.
On April 7, 2020, OCIE issued two Risk Alerts, one regarding Reg BI and one regarding Form CRS (short for "client relationship summary") and Form CRS's related rules, which require firms to deliver a brief summary of their client relationships to their retail investors.3 The alerts provide an outline of the areas on which OCIE plans to focus once its initial examinations are underway and important insight regarding the steps firms must take to comply with Reg BI and Form CRS. In the same release, OCIE announced that the initial examinations "will likely occur during the first year after the compliance date."4 Despite the SEC's determination to push forward with the June 30, 2020 compliance date and initial examinations, Commissioner Allison Herren Lee recently announced that regulatory action unrelated to Coronavirus will "rarely be warranted;" therefore, it is unlikely that there will be significant enforcement action in the near term, including relating to Reg BI.5
Background
After a lengthy process that began with a study mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank),6 the SEC proposed Reg BI7 in April 2018.8 On June 5, 2019, after receiving more than 6,000 comments and undertaking further analysis, which resulted in additional enhancements and additions, the Commission issued the final version of the regulation.9
Prior to Reg BI, broker-dealers were required to comply with the Financial Industry Regulatory Authority (FINRA) "suitability standard" found in FINRA Rule 2111: "A member or an associated person must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer's investment profile." Reg BI significantly overhauls and redefines broker-dealers' obligations to their retail customers and imposes a heightened "best interest" standard. According to the SEC, Reg BI "enhances the broker-dealer standard of conduct beyond existing suitability obligations, and aligns the standard of conduct with retail customers' reasonable expectations."10
Reg BI imposes a new general obligation on broker-dealers in addition to the component obligations discussed below. The general obligation requires that: "A broker, dealer, or a natural person who is an associated person of a broker or dealer, when making a recommendation of any securities transaction or investment strategy involving securities (including account recommendations) to a retail customer, shall act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker, dealer, or natural person who is an associated person of a broker or dealer making the recommendation ahead of the interest of the retail customer."11 According to the SEC, this new language requires that recommendations actually "be in the best interest of the retail customer," and prohibits those that "place the broker-dealer's interests ahead of the retail customer's interests."12
The SEC contemporaneously adopted new rules and forms to implement the change. Broker-dealers and registered investment advisers must now provide retail investors with a customer relationship summary, which must be reported on a Form CRS. That Form, which firms must file for the first time by June 30, 2020, must inform retail investors about: (i) types of client/customer relationships and services the firm offers; (ii) the fees, costs, conflicts of interest, and required standard of conduct associated with those relationships and services; (iii) whether the firm and its financial professionals currently have reportable legal or disciplinary history; and (iv) how to obtain additional information about the firm.
Focus on Compliance with Reg BI Component Obligations
As the deadline for compliance with Reg BI approaches, OCIE has provided additional insight about how it will measure compliance. In particular, its April 7, 2020 Risk Alerts describe (i) the areas on which its initial examinations will focus, and (ii) the corresponding documentation it will review to assess firms' compliance with Reg BI's four component obligations of disclosure, care, conflicts of interest, and compliance.13
Disclosure Obligation: A broker-dealer must make a "full and fair" disclosure in writing of all material facts about the scope and terms of its relationship with a retail customer, including: (i) the capacity in which recommendations are made; (ii) material fees and costs, and (iii) material limitations on securities or investment strategies that may be recommended.14
To assess whether a firm appropriately disclosed those material facts, the staff may request documents, including schedules of fees and costs charged to retail customers, compensation methods for registered personnel, and lists of proprietary products it has sold to retail customers. The staff also may review the timing and documentation of the broker-dealer's disclosures related to monitoring of retail customers' accounts and material limitations on recommended accounts or services.15
Care Obligation: A broker-dealer must exercise "reasonable diligence, care, and skill" when making a recommendation to a retail customer and must understand the potential risks, rewards, and costs associated with that recommendation. The broker-deal must do so in light of a customer's investment profile, and must have a "reasonable basis to believe" that its recommendation is consistent with the customer's best interest. The broker-dealer cannot place its own financial or other interests ahead of the customer's.16
To assess compliance with this component obligation, the examiners may request to review information that firms have collected to develop their customers' investment profiles. The examiners may also look at documents reflecting the broker-dealer's processes for establishing, understanding, and implementing reasonably available alternatives when making recommendations, including any factors that are taken into account to assess potential risks or rewards.17
Conflict of Interest Obligation: A broker-dealer is required to establish, maintain, and enforce written policies and procedures that address the conflicts of interest associated with recommendations to a retail customer. Reg BI makes clear that these policies and procedures should be "reasonably designed" to disclose, mitigate, or eliminate all conflicts of interests.18
Consistent with those requirements, the staff will review broker-dealers' policies and procedures to assess whether they adequately establish a structure for identifying and assessing conflicts as they arise and evolve, require sufficient disclosure, and provide for sufficient mitigation or elimination of conflicts. In particular, the staff will focus on conflicts created by 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.19
Compliance Obligation: A broker-dealer must establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with the general and component obligations of Reg BI.20
To assess compliance with this obligation, the staff may review the broker-dealer's policies and procedures and evaluate any controls, remediation of noncompliance, training, and periodic review and testing.21
Finally, OCIE's Risk Alert attached an Appendix providing further detail of the types of documents and information that may be requested from broker-dealers during its initial examinations.
Focus on Compliance with Form CRS
OCIE's corresponding Risk Alert regarding Form CRS similarly clarifies the five areas where it plans to focus when assessing whether firms have made a good faith effort to implement Form CRS: 1) delivery and filing; 2) content; 3) formatting; 4) updates; and 5) recordkeeping.22
Delivery and Filing: In addition to confirming that a firm has properly and timely filed its relationship summary with the SEC, and posted that summary to its website, the examiners will also evaluate the firm's process for delivering the relationship summary to existing and new retail investors. The firm must deliver the initial relationship summary to existing retail investors by July 30, 2020; after that date, it must provide it when an investor opens a new account, or when the broker-dealer recommends a rollover of assets from a retirement account or a new brokerage or investment advisory service.
Content/Formatting: OCIE staff will review the content of the relationship summaries for completeness and accuracy, and will check that the format complies with the General Instructions to Form CRS. Specifically, the staff will review the disclosures relating to the firm's fees and costs, its financial professionals' compensation, conflicts of interest, and prior legal or disciplinary history.
Updates: OCIE examiners may review the firm's policies and procedures for updating its relationship summary. In particular, the staff will look for policies requiring that the firm submits updated summaries to the SEC within 30 days, and to retail investors within 60 days of content becoming materially inaccurate.
Recordkeeping: The staff may review the firm's records related to delivery of the relationship summary to its retailer investors, and its policies and procedures regarding record-making and recordkeeping.
Conclusion
OCIE's Risk Alerts provide useful insight to broker-dealers as they attempt to complete the process of implementing Reg BI, and broker-dealers and registered investment advisers as they complete their initial Form CRS filings. OCIE has expressed its intention to focus its initial examinations on a number of areas, including firms' fees, costs, and financial professionals' compensation; broker-dealers' recommendations to their retail customers and evaluation of alternatives; and firms' policies and procedures, specifically regarding identifying and mitigating conflicts. OCIE has expressed the view that it expects implementation of Reg BI to be an "iterative process" and that it will focus on "firms continuing good faith and reasonable efforts."23
Nevertheless, broker-dealers and registered investment advisers should review these alerts carefully as the June 30, 2020 deadline approaches because the SEC has made it clear that protecting retail investors through the implementation of Reg BI and Form CRS remains a top priority especially in the current environment. Although the SEC has indicated that it will prioritize enforcement actions related to the impact of Coronavirus—an approach that would seem to exclude this area—it has reiterated that it will proceed as planned with initial examinations soon after the compliance deadline. As a general practice, the SEC adopts a "lighter touch" when enforcing new regulations, but we expect it will be closely monitoring broker-dealers' compliance with Reg BI and likely will not hesitate to open an investigation or bring an enforcement action if it uncovers evidence of intentional violations.
Footnotes
1. "Retail customers" for this purpose means a natural person (or their representative) who receives a recommendation of any securities transaction or investment strategy involving securities from a broker-dealer and uses the recommendation primarily for personal, family or household purposes. Release No. 34-86031, Regulation Best Interest: The Broker-Dealer Standard of Conduct, at 769 (June 5, 2019) ("Reg BI Adopting Release").
2. Investors Remain Front of Mind at the SEC: Approach to Allocation of Resources, Oversight and Rulemaking; Implementation of Regulation Best Interest and Form CR (April 2, 2020).
3. OCIE, Risk Alert, Examinations that Focus on Compliance with Regulation Best Interest (April 7, 2020) ("Reg BI Risk Alert"); OCIE, Risk Alert, Examinations that Focus on Compliance with Form CRS (April 7, 2020) ("Form CRS Risk Alert").
5. Regulatory Priorities and COVID-19 (April 3, 2020).
6. The Reg BI process took a diversion through a Department of Labor (DOL) fiduciary rule. The DOL fiduciary rule (which was first proposed in 2010, re-proposed in 2015, and adopted in 2016) was controversial, in part because of the potentially different standards of care it established for broker-dealers, investment advisers, and bank trust departments, depending on the types of accounts they were managing. After a number of financial industry trade associations challenged the fiduciary rule in federal court, the Court of Appeals for the Fifth Circuit vacated the entire rule in March 2018, and the vacatur went into effect in June 2018 when the Fifth Circuit issued a final mandate certifying its decision. See Arnold & Porter Advisory, DOL's Fiduciary Rule Vacated—But the Best Interest Concept Appears Here to Stay(July 9, 2018); Arnold & Porter Advisory DOL Delays Fiduciary Rule—But Significant Portions of New Rule Are Likely to Take Effect in June 2017 (April 17, 2017); Arnold & Porter Advisory, Department of Labor Adopts Sweeping Rules Regarding Fiduciary Investment Advice (April 21, 2016).
7. For more detail on the background of Reg BI and Form CRS, see Arnold & Porter Advisory, The SEC's "Regulation Best Interest," Form CRS, and Investment Advisor Interpretations; Does the New Framework Actually Protect the Best Interest of Customers and Clients? (June 27, 2019)
8. Release No. 34-83062, Regulation Best Interest (April 18, 2018).
9. Reg BI Adopting Release at 5.
10. Id. at 1, 5.
11. Id. at 765-66.
12. Id. at 252-54.
13. For more detail on the prior guidance and Reg BI's component obligations, see Arnold & Porter Advisory, The SEC's "Regulation Best Interest," Form CRS, and Investment Advisor Interpretations; Does the New Framework Actually Protect the Best Interest of Customers and Clients? (June 27, 2019).
14. Reg BI Adopting Release at 14-15, 130-245, 319, 766; Reg BI Risk Alert at 2.
15. Reg BI Risk Alert at 2-3.
16. Reg BI Adopting Release at 15, 38-39, 245-302, 766-67; Reg BI Risk Alert at 4.
17. Reg BI Risk Alert at 3-4.
18. Reg BI Adopting Release at 15-16, 62, 302-56, 767-68; Reg BI Risk Alert at 4.
19. Reg BI Risk Alert at 4-5.
20. Reg BI Adopting Releaseat 16, 357-60, 768; Reg BI Risk Alert at 5.
21. Reg BI Risk Alert at 5.
22. Form CRS Risk Alert at 2-3.
23. SEC Office of Compliance Inspections and Examinations Publishes Risk Alerts Providing Advance Information Regarding Inspections for Compliance with Regulation Best Interest and Form CRS (April 7, 2020).
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