Last week, the Securities and Exchange Commission (SEC or Commission) Office of Compliance Inspections and Examinations (OCIE) and the Financial Industry Regulatory Authority (FINRA) issued helpful guidance to assist broker-dealers in preparing for Regulation Best Interest (Reg BI), which has a June 30, 2020 compliance date. On April 7, 2020, OCIE issued a risk alert on Reg BI examinations, which included a sample document request list, and a risk alert on Form CRS examinations. On April 8, 2020, FINRA followed with a statement supporting the SEC’s examination approach and a report highlighting practices that FINRA observed in its preparedness reviews of small, mid-size and large firms in late 2019 and early 2020 to assess their readiness for Reg BI and Form CRS.
A summary of the four publications is set forth below. Key takeaways are that the SEC and FINRA have closely coordinated their approaches to Reg BI and Form CRS examinations and will focus on whether broker-dealers have made good faith efforts toward compliance with the new rules and achieved reasonable progress in implementing their policies and procedures by the compliance date. Examinations will be tailored to individual firm profiles. Together the four documents substantially increase the transparency of the expected examination processes and priorities.
On Friday, April 17, 2020, DLA Piper will host a webinar for small- and medium-sized broker-dealers on Regulation BI preparedness. You may register for the event here.
OCIE risk alert on Reg BI examinations
OCIE stated that initial examinations during the first year after the compliance date will be designed primarily to evaluate whether firms have established policies and procedures reasonably designed to achieve compliance with Reg BI and made “reasonable progress” in implementing them. OCIE also noted that it will assess whether firms have made modifications as may be necessary or appropriate in light of information gained from the implementation process and other facts and circumstances.
OCIE provided specific examples of focus areas related to each of Reg BI’s four component obligations as well as a sample document request list, which is expected to be tailored to a firm’s profile.
Documents reviewed in connection with the disclosure obligation may include:
- Fee schedules and related disclosures regarding such fees and charges, including disclosures regarding the both direct and indirect fees and costs
- Compensation methods for registered personnel, including (i) compensation associated with recommendations to retail customers, (ii) sources and types of compensation, and (iii) related conflicts of interest (eg, 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.
Documents reviewed in connection with the care obligation may include:
- Customer investment profiles (including any new account forms, account agreements, and correspondence)
- The broker-dealer’s process for having a reasonable basis to believe that recommendations are in the retail customer’s best interest (including any process for establishing, understanding, and implementing the scope of reasonably available alternatives when making a recommendation)
- The factors the broker-dealer considers in assessing the potential risks, rewards, and costs of 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.
Documents reviewed in connection with the conflicts of interest obligation may include:
- Whether and how the firm’s policies and procedures address the following:
- conflicts that create an incentive for an associated person to place her or his interest or the broker-dealer’s interest ahead of the interest of the retail customer
- conflicts associated with material limitations (eg, 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 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
- 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
- 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.
Documents reviewed in connection with the compliance obligation may include the broker-dealer’s policies and procedures relating to controls, remediation of noncompliance, training, and periodic review and testing of the policies and procedures.
OCIE risk alert on Form CRS examinations
OCIE noted five areas of examination focus for Form CRS:
Delivery and filing: OCIE may (1) review whether the firm has filed Form CRS with the Commission and posted it on the firm’s public website (if any); (2) evaluate the process for delivering Form CRS to existing and new retail investors; and (3) review policies and procedures to assess whether they address the required delivery processes and dates. In particular, the staff may review records of the dates that each Form CRS was provided to retail investors to validate whether the firm has complied with various delivery obligations.
Content. OCIE may review Form CRS for accuracy and completeness, for example:
- How the firm describes the relationships and services it offers to retail investors, including statements regarding account monitoring and investment authority
- How the firm describes its fees and costs, including disclosures about the principal fees and costs that retail investors will incur, other fees and costs that retail investors will pay directly or indirectly, and examples of the categories of the most common fees and costs
- OCIE may review fee schedules, advisory agreements, and brokerage agreements and compare the fees listed in those documents against the fees listed in Form CRS
- How the firm describes the way its financial professionals are compensated, including cash and non-cash compensation, and the conflicts of interest those payments may create
- How the firm describes its conflicts of interest, including incentives related to proprietary products, third-party payments, revenue sharing, and principal trading
- Whether the firm accurately discloses if the firm or its financial professionals have legal or disciplinary history.
Formatting: OCIE may review a firm’s Form CRS to assess whether it is formatted in accordance with the instructions and written in plain English.
Updates: OCIE may assess a firm’s policies and procedures for updating Form CRS within 30 days after any information becomes materially inaccurate, communicating these changes to retail investors within 60 days, and highlighting to retail investors the most recent changes.
Recordkeeping: OCIE may review the firm’s records related to Form CRS delivery and other recordkeeping requirements.
FINRA statement on OCIE’s Reg BI and Form CRS risk alerts
FINRA’s statement confirmed that it will take the same approach as OCIE when examining firms for Reg BI and Form CRS compliance. Its primary focus will be on firms showing good faith and reasonable efforts to establish and implement policies and procedures reasonably designed to comply with Reg BI and Form CRS. FINRA also said it will take action if there are indications of harm to customers or conduct violating current requirements such as the suitability rule.
FINRA emphasized its readiness to work with firms and with the SEC on issues that may arise in the course of examining firms for Reg BI/Form CRS compliance, including any problems that arise during the implementation process.
FINRA highlights firm practices from Reg BI preparedness reviews
FINRA published a report highlighting practices it observed when conducting preparedness reviews of small, mid-size and large firms in late 2019 and early 2020 to (1) assess their readiness for Reg BI and Form CRS and (2) establish a dialogue with firms about their efforts and the potential implementation challenges. The report is intended to help firms assess their own compliance initiatives by providing examples of what other firms are doing. FINRA emphasized it is not requiring firms to implement any of the practices described in the report, nor is it suggesting that any particular practice will constitute compliance with Reg BI and/or Form CRS requirements.
Governance and implementation management. Some firms have developed structures to lead and manage Reg BI and Form CRS compliance efforts, including:
- Project teams and working groups: Larger firms generally have multi-member committees representing multiple functions. Committees are generally structured around the four component obligations of Reg BI – disclosure, duty of care, conflicts of interest and compliance – and have members from business units, compliance, legal and, in some cases, corporate communications. Smaller firms generally rely on a small team of designated staff.
- Timelines: Firms developed timelines and project plans for required changes and updates, prioritizing those with longer implementation time and/or that are clearly required by the new rules. Some are using reverse timelines, setting deadlines for major goals and working backwards to establish intermediate goals, and multistage review processes for projects. In addition, some firms are:
- Designating individuals to update and review project calendars and hold periodic meetings to keep teams working towards meeting target dates
- Running pilots to confirm updates can be rolled out in time and
- Developing contingency plans to account for technology updates that may not be ready by the compliance date.
- Training: Some firms have already begun training staff and supervisors. Others are well into developing training programs by identifying outside training vendors, planning to train prior to the compliance date or during initial implementation, and using cross-functional approaches to develop training plans and determine relevant topics. Firms are providing (or planning to provide) training through multiple channels, including written notices, in-person and on-line training, seminars, and regular meetings between compliance and business units.
Written supervisory procedures (WSPs) and supervisory systems. Firms were developing policies and procedures and implementing technological tools such as:
- Inventory: Identifying gaps where new or amended procedures or supervisory systems are needed, including exercises to review Reg BI obligations, trace them back to existing procedures, and assess the need for changes or new ones. Some firms are categorizing changes into tiers to better organize the process.
- WSPs: Some firms are planning their changes to policies and procedures; some already have made them. Some will have new policies and procedures and others are modifying existing ones. Firms are using both internal resources and outside counsel and consultants. According to FINRA, firms that already had updated policies and procedures to implement the Department of Labor (DOL) Fiduciary Rule generally intended to leverage them with limited modifications.
- Technology tools: Even prior to completing policies and procedures, firms had begun to identify and develop modifications to supervisory systems through discussions with clearing firms and vendors about system capabilities; leveraging existing technology to monitor for Reg BI compliance; and rolling out systems, tools and reporting on a pilot basis to confirm they are functioning correctly.
Conflicts of interest. FINRA observed several methods to identify and deal with conflicts of interest.
- Conflict inventories: Creating or leveraging existing inventories and logs of conflicts; automated tools to track, report and document existing conflicts; and reviews of controls for mitigating or eliminating conflicts.
- Conflicts committees: Committees (either new or existing), composed of various functions including compliance, legal, finance and business unit representatives, to identify existing and potential new conflicts. Some work with other firm committees and with subject matter experts and relevant workstreams. Some review new product/services presentations and related conflicts.
- Limitations on products: Firms addressed product-related conflicts by creating automatic point-of-sale alerts or “product menus” to organize products by risk, narrowing available products, placing additional restrictions on less experienced associated persons, and prohibiting specified products for all customers.
- Compensation: Firms were planning or had begun addressing product sales that could result differential compensation. Some added compensation caps, leveled compensation across comparable products within a category, made changes to compensation for certain products, and addressed compensation concerns with issuers. According to FINRA, firms that changed compensation practices for the DOL Fiduciary Rule generally believed they could leverage them.
- Surveillance: Firms updated existing surveillance or created new surveillance tools to review for excessive trading or unusual commissions and to address conflict requirements, including compensation and other forms of recognition.
- Disclosure: Firms had either reviewed and updated account documentation and customer disclosure forms or created new ones; examples of actions included:
- Working with internal technology departments and outside vendors to confirm disclosures will be available to customers
- Creating new commission and fee schedules for prospective customers
- Developing new processes and implementing technology solutions to deliver required disclosures at the earliest triggering event and
- Preparing summary fact sheets and templates for each product to educate associated persons on the relevant conflicts of interest standards and other Reg BI implications for each product.
- Use of the terms “adviser” or “advisor”: Some firms already had restricted use of those terms, reviewed marketing content, and/or were developing surveillance tools to review email, social media and other sources to confirm that associated persons had relevant state licenses or used new titles.
- Sales contests: FINRA noted that some firms already had prohibited sales contests, sales quotas, bonuses and non-cash compensation practices based on the sales of specific securities or types of securities.
Form CRS. Firms already were developing forms and delivery timelines, including:
- Drafting: Firms had prepared and/or revised drafts of Form CRS, focusing on the size limitations and making the form simple to understand. Some were planning to get feedback on drafts from industry forums and conferences.
- Timely delivery: Firms had or were developing procedures and timelines to provide Form CRS within required timeframes, including working with internal departments, vendors, clearing firms and consultants; considering web portals for certain disclosures; evaluating customer needs, preferences and limitations; and developing processes to capture, supervise and audit Form CRS delivery.
If you have further questions about the SEC or FINRA guidance, please contact the authors.