SEC roundtable highlights exam observations on Regulation Best Interest and Form CRS compliance

The Securities and Exchange Commission (SEC) held a roundtable on Regulation Best Interest (Reg BI) and Form CRS on October 26, 2020 featuring senior staff from the SEC and the Financial Industry Regulatory Authority (FINRA).  The roundtable identified issues and observations about how firms are complying with the new rules since the June 30, 2020 compliance date.  A recording of the roundtable and list of panelists are available on the SEC’s website.  Key guidance discussed during the roundtable is set forth below.

REGULATION BEST INTEREST

Compliance Obligation

The panelists noted that written policies and procedures form the foundation of this obligation, and regulators generally observed good faith efforts among firms on this score.  They emphasized that policies and procedures should not just restate the rules, but rather should include descriptions of how a firm will achieve compliance (for example, by describing which costs or alternatives should be considered).  They commented that that the use of third-party systems for implementing such processes may be appropriate for some business models.

The panelists explained that while firms can build on existing compliance systems, Reg BI has a broader mandate than past rules with respect to care, conflicts and disclosure, and firms should carefully consider whether existing systems are still appropriate.  For example, Reg BI covers a broader set of investors, and some formerly considered institutional customers under FINRA rules (e.g., individual investors with $50 million or more in assets) are now considered retail customers under Reg BI.  Similarly, Reg BI requires consideration of the costs of investments, reasonable alternatives to the recommended investments and the impact of rollovers.

FINRA panelists reported that their examinations were ongoing and that firms were taking good steps.  Their key concerns were that in some instances procedures were not memorialized or adequate, lacking specificity about who was responsible for carrying out a procedure, when it was or would be carried out and how it would be carried out.  This lack of detail was also evident in some firms’ testing of both their procedures and recordkeeping.  Some firms did not have adequate plans for testing.

The regulators observed that there was a wide variety of approaches to training for Reg BI.  Given the events of this year, firms that planned for in-person training had to pivot and move toward online and written materials for training.  Some firms required personnel to be tested on the training, which the regulators viewed as an effective way to confirm that the training was understood.  Other firms fined personnel for failing to complete training.  A noted weakness at some firms was that training merely covered rule requirements without addressing the processes by which the firm was complying with the rule.  Handing out a copy of written procedures was not viewed as meeting the training requirement.  The panelists advised that if a firm had not completed its training program, it should do so now.

Care Obligation

The regulators commented that some firms had developed internal systems to compare investment alternatives and document the reason for the investment selected, but they recognized this process would not work for all firms or all products.  The panelists also noted the availability of third-party products to evaluate variable annuities, mutual funds and rollovers.  Other firms are relying on up-front product reviews. 

Some firms are using questionnaires or risk scores to reconcile customer investment objectives to recommendations.  Some of these firms require personnel to input comments around each recommendation for documentation and to provide a basis for supervisory review, but the regulators confirmed that this was not required and a risk-based approach was acceptable, with documentation more critical for complex products or recommendations that appear inconsistent with investment objectives.  The panelists reported that many firms have reviewed their product mix as it relates to costs and alternatives, particularly with respect to mutual funds and their share classes.

One issue addressed related to the failure of some firms to properly distinguish Reg BI from FINRA’s suitability rule, which continues to apply to non-retail customers.  Simply substituting the terms in written procedures would not achieve compliance; rather, the panelists stated, it is important for procedures to highlight the differences between the rules.

Consistent with that observation, SEC staff noted that the biggest compliance struggle appeared to be that firms’ materials still seemed skewed toward FINRA’s suitability rule, with a focus on risk and not enough attention to costs and alternatives, particularly with respect to firms’ compliance and supervisory reviews.  They cautioned that systems need to reach beyond investment objectives.  The use of certifications by registered personnel that recommendations are consistent with Reg BI is a good idea but insufficient if the firm cannot demonstrate that costs and alternatives were adequately considered. 

FINRA staff reported that it had observed struggles related to complex products, consideration of alternatives and the level of disclosures required.  FINRA has also seen some confusion about what constitutes a recommendation, with some firms stating that they didn’t make recommendations although FINRA’s discussions with those firms about their activities suggested otherwise.  SEC staff reminded market participants that guidance about what is a recommendation has not changed, and that the closer a communication is to a personalized call to action, the more likely it is a recommendation.  They further noted that Reg BI applies at the time of the recommendation, even if it is not implemented.

The panelists noted that there were more recent questions about account transfers, particularly those involving mutual funds with a front-end charge.  They highlighted the posting of an August 4, 2020 FAQ on this point.

Conflicts Obligation

The regulators stated that some firms were taking a suitability-based approach to meeting the Conflicts Obligation, which is not consistent with the more robust obligations under Reg BI; simply substituting one term for the other is not acceptable. They emphasized that Reg BI has new obligations, and old approaches will not be sufficient.  Some firms had taken appropriate steps by detailing their conflicts and remediation in inventories or matrices and conducting assessments of high-risk products or share classes and removing some of them from their approved product lists.  Some firms instituted annual reviews of their compensation agreements, affiliate relationships and registered representative activity.  Other firms have worked with product sponsors on compensation and leveled compensation across like products.  The panelists encouraged review of the FAQs on conflicts. 

The regulators also called attention to less transparent forms of compensation, such as vendor reimbursements or gifts.  They noted that such compensation might be prohibited under Reg BI if it related to specific securities over a limited period, even if the employing broker-dealer was not providing the compensation.

Disclosure Obligation

The regulators found that most firms are supplementing Form CRS with a separate Reg BI disclosure document containing more detail.  Some firms are creating disclosure documents for specific topics, such as rollovers, fees and compensation.  The panelists cautioned against highly legalistic text since Plain English is required and encouraged dating disclosure documents to clarify their period of use.

The panelists also commented that some firms had developed good technical solutions to record the delivery of disclosure documents and processes to track delivery at client onboarding.  The regulators observed good training on disclosure and delivery requirements but cautioned that some firms’ procedures were silent on delivery recordkeeping, which is an important requirement.  They cautioned that although the SEC was revisiting its electronic delivery guidance, it still needed to be followed (and is set forth in the FAQs linked above).

Finally, regulators noted that firms were generally doing a good job in identifying the capacity in which recommendations are made (broker-dealer or investment adviser) and had generally stopped using the term “advisor” where it was no longer permitted.  Some firms are monitoring social media and emails to confirm continued compliance.

FORM CRS

The panelists began by explaining that Form CRS – the “Relationship Summary” that must be delivered to retail customers by broker-dealers and registered investment advisers – is designed to help retail investors make informed choices with respect to the kind of relationship (brokerage, investment advisory, both) that best fits their circumstances and investment objectives.  To this end, firms must write the form in plain, easy to understand language and must clearly disclose specific information under standardized headings, presented in a prescribed order to promote transparency and enable retail investors to more easily compare and contrast the services of different providers.  The Relationship Summary must be delivered to retail customers, posted on the firm’s website and filed with the SEC.

Both the SEC and FINRA have been reviewing Relationship Summaries to evaluate compliance with the requirements of the form and the related delivery, website posting and recordkeeping requirements.

General compliance

The majority of firms successfully implemented appropriate systems and processes to file the Relationship Summary, deliver it and post it to their websites.  For the most part, all required information was included in the correct order, and prescribed wording generally was used for headings, conversation starters and specific disclosures related to matters such as the impact of fees, costs of investments and the prescribed standards of conduct when providing recommendations and advice. 

The panelists noted, however, that some forms omitted required disclosures or addressed topics in a general way but without required descriptions or explanations that would help retail investors better understand the information.  Other firms had improperly modified or omitted headings.  Several firms altered the language of conversation starters and other firms put them at the end of the form rather than in the relevant section.  The panelists explained that some firms may have used the model versions provided in the SEC’s proposing release, which were not included in the adopting release, and cautioned that firms should follow the requirements in the final rule and not the forms in the proposing release.  The need for appropriate policies and procedures was mentioned several times, including with respect to the filing and delivery obligations, the requirement to post the Relationship Summary on the firm’s website and monitoring for compliance with the form update requirements.

Plain language

Most firms created concise and readable documents that avoided legal jargon and technical terms.  The SEC determined, however, that the average reading level for Relationship Summaries was 11th grade.  To maximize readability, the SEC is encouraging firms to target an 8th grade reading level.  The SEC and FINRA also found practices that could make it harder for investors to focus on and understand the information, including vague or boilerplate information, and disclaimers containing small text and legal jargon.  The panelists warned that Relationship Summaries may not include disclosure not required by the instructions, exaggerated or unsubstantiated claims, or vague and imprecise boilerplate.

Layered disclosure

Many forms included cross-references to more detailed disclosure, as required by the instructions, and hyperlinks to provide quick and direct access to information such as fee schedules, conflict disclosures and other pertinent disclosures.  However, both the SEC and FINRA found instances of information in Relationship Summaries that did not include required references, and forms that simply mentioned other disclosures (such as Form ADV brochures) but provided no means to access the information from the form.  There were also incorrect hyperlinks and inaccurate electronic addresses.  Firms were encouraged to make it as easy as possible for an investor to access additional detail regarding disclosed information.

Design and formatting

The SEC encourages visually appealing and accessible disclosure to make the Relationship Summary easy to read.  Many forms had a good balance of white space and text features to draw attention to headings and conversation starters.  Some dual investment adviser/broker-dealer firms used side-by-side comparisons of brokerage and advisory services, account characteristics, fees and conflicts.  Some firms provided website disclosures that made use of interactive features to aid readability.

Some Relationship Summaries, however, included dense text that covered every bit of space in the document.  The panelists advised firms to consider whether their forms make good use of white space and use graphs, charts, labels and similar devices, as well as text features, to improve readability.

Use of “marketing” language

Most Relationship Summaries were limited to balanced, objective discussions about the firm and its services.  They kept their statements factual and avoided unsubstantiated or exaggerated claims.  However, some summaries included language touting the firm’s abilities or using superlatives or similar descriptors.  The panelists cautioned that Form CRS is not intended to be marketing material and advised firms to limit their Relationship Summaries to concise and factual disclosures to help retail investors evaluate their services.

Affiliates

Dual registrants and affiliated broker-dealer and investment adviser firms are permitted to use a single Relationship Summary.  The panelists recognized that many firms have numerous and intricate affiliate relationships that make it challenging to clearly describe the services offered by each entity.  Some firms were successful in clearly describing these relationships, but others listed numerous affiliates without describing the relationships between them and did not clearly state which firm offered which services or products and/or failed to attribute specific disclosures or conflicts to a particular firm.  Firms were encouraged to confirm that the discussion of affiliate services and relationships is clear and that statements are readily attributable to a particular firm.

Specific content requirements

Form CRS is divided into five items of information, beginning with an introduction (Item 1) that sets forth basic information and moving to specific information requirements.  Firms generally did a good job providing the required information but both the SEC and FINRA found weaknesses.

Item 2. Relationships and services

Forms generally included the high-level overview the SEC expected.  The best examples had succinct descriptions of relationships and services and were clearly designed to facilitate retail investor access to more detailed layers of disclosure.  Some forms explained that firm offerings were limited to certain services or products but that a wider range or lower cost products could be found elsewhere.  Many clearly described material limitations and triggering events for the exercise of discretionary authority.

The panelists observed, however, that some firms did not explain whether they make available or offer advice only with respect to proprietary products or a limited menu of products or investments.  Other firms indicated that they limited their offerings but did not explain the limitations.  Some firms failed to explain whether they monitor investments or the frequency and material limitations on monitoring.  Firms were advised to review the descriptions of their monitoring services and disclosures relating to discretionary authority and to be sure to make clear who will be making the final decision regarding investments.

Item 3.  Fees, costs, conflicts and standard of conduct

Fees:  Many firms directly and concisely disclosed their fees, how often their fees are assessed and how the fee structure incentivizes the firm or its financial professionals.  Some provided hyperlinks to fee information or tables showing how fees are attributable to specific services.  But a number of firms had only vague descriptions of fees and did not address frequency of assessment or billing.  Some failed to describe services included in wrap free programs or failed to describe fees and costs associated with those programs.  Firms were encouraged to review their Relationship Summaries to confirm that the descriptions of fees and costs allow retail investors to understand the nature of those fees and costs

Standard of conduct:  Most firms included the relevant standard of conduct in the appropriate place and did not alter the specifically prescribed wording, but some investment advisers referred to themselves as “fiduciaries” or stated that they are subject to a fiduciary duty.  The panelists made clear that such language is neither required nor permitted and should not be included.  

Conflicts of interest: Many firms included the required information regarding conflicts and incentives with how the firm and its financial professionals make money.  A number included examples to help investors understand incentives associated with proprietary products, third-party payments, revenue sharing and principal trading, including cash sweep programs and payment for order flow arrangements.  There were, however, a number of deficiencies in this area, including:

• failure to provide clear conflict disclosures
• failure to explain incentives
• vague phrasing suggesting that the firm might have a particular conflict
• disclosures that included vague or extraneous descriptions of how the firm addresses or mitigates a conflict of interest
• other attempts to downplay or minimize the conflict and
• failure to disclose conflicts created by compensation arrangements. 

These types of statements were characterized as undermining the SEC’s goal of highlighting conflicts and helping investors understand the interconnectedness between how the firm makes money and the incentives they create.  

Item 4.  Disciplinary history 

The discussion began with a clear statement that firms must answer “yes” or “no” to this item.  A number of firms either answered “no” when they should have answered “yes” or didn’t affirmatively answer at all when they should have answered “yes,” despite the fact that non-answers are not permitted.  Other deficiencies included responses lacking required information and extraneous language in the response.  The panelists also warned that it is impermissible to add descriptive or qualitative language or to attempt to explain disciplinary history in this section, although firms can separately provide copies of additional regulatory disclosures such as the relevant section of an IAPD or BrokerCheck report.  The panelists referenced new FAQs this month on the disclosure of disciplinary history consistent with this guidance.

Item 5.  Additional information

Most firms satisfactorily identified where retail investors can find additional information about brokerage or advisory services and request a copy of the Relationship Summary.  There were, however, weaknesses, including failure to prominently display the information at the end of the Relationship Summary.

Filing, posting, delivery and recordkeeping

Despite some late filers, most firms that were obviously required to file Form CRS, deliver it to customers and post it on their websites did so.  Most used clearly worded website statements or direct links to Form CRS on their home pages.  However, some firms made the form hard to find, including hiding it under numerous “click throughs,” and some firms used hard to read text in hyperlinks, non-descriptive terms such as “regulatory disclosure” to label the Relationship Summary, or placed it on a page with numerous other disclosures and/or promotional documents.  Most firms delivered the form to customers and adequately documented delivery; failures were for the most part due to the use of third-party delivery services.

FINRA also surveyed a number of non-filing firms believed to have a potential filing obligation.  42 percent of these firms agreed they should have filed and would do so.  Reasons for not filing included a misunderstanding the definition of “retail investor” and misconceptions that firms with a small number of retail customers or that did not make recommendations were exempt.  Some firms uploaded the form but it didn’t go through; others prepared a form but didn’t know they had to file it.  Some dually registered firms that filed through IARD didn’t check the box to send it to CRD.  Many of these firms did, however, deliver the form to customers.

The remaining 58 percent argued they did not have a filing obligation.  The panelists acknowledged that these firms could be correct but recommended that all firms carefully review their businesses to confirm whether or not they are subject to the requirement.

NEXT STEPS

Earlier this year, regulators pledged to provide guidance and feedback in the months immediately following the compliance date for Reg BI and Form CRS in order to give firms time to refine and adjust their compliance programs accordingly, particularly because the SEC decided to stick with the original compliance date despite the events of this year.  The roundtable fulfills that pledge at least in part, and the SEC stated that it will continue to update its FAQs.  Firms should carefully evaluate their programs in light of the insights provided by the roundtable and the SEC’s FAQs, giving consideration to whether they should make any adjustments particularly since regulators may begin to move toward more vigorous enforcement in the months to come. 

If you have any questions regarding Reg BI or Form CRS compliance in light of the roundtable guidance, please contact one of the authors or a member of the DLA Piper Financial Services team.