(Article from Registered Funds Regulatory Update, April 2023)
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The SEC issued a Risk Alert highlighting a series of deficiencies it has observed in its initial examinations conducted since Reg BI’s June 2020 compliance date. The Risk Alert is intended to assist broker-dealers in enhancing their compliance programs, as the SEC intends to include compliance with Reg BI into its retail-focused examinations of broker-dealers going forward.
When making recommendations of securities transactions or investment strategies to a retail customer, Reg BI provides that a broker-dealer must act in the customer’s best interest at the time the recommendation is made and not place its own interests ahead of its customer. In particular, Reg BI requires that a broker-dealer comply with four core obligations:
Disclosure Obligation: requires certain disclosure about the recommendation and the relationship between the customer and the broker-dealer before or at the time the recommendation is made.
Care Obligation: requires the exercise of reasonable diligence, care, and skill to understand potential risks, rewards, and costs associated with a recommendation as well as having a reasonable basis for believing that a recommendation is in the customer’s best interest.
Conflict of Interest Obligation: requires that written policies and procedures designed to identify and address conflicts of interest are established, maintained, and enforced.
Compliance Obligation: requires that written policies and procedures reasonably designed to achieve compliance with Reg BI and its various obligations are established, maintained, and enforced.
Compliance Obligation Deficiencies
With respect to policies and procedures intended to comply with the Disclosure Obligation, the Staff noted that examples of deficiencies included: not specifying when disclosures must be made or updated or how such disclosures will be delivered to customers; not identifying the parties responsible for disclosures; and not having processes in place to track the delivery of disclosures to customers.
The Staff also found certain policies and procedures to be inadequate to ensure compliance with the Care Obligation. Observed deficiencies included: directing financial professionals to consider costs and reasonably available alternatives without providing guidance as to how to do so; allowing but not mandating financial professionals to evaluate costs or reasonably available alternatives; and directing financial professionals to document the basis for their recommendations without instructing them as to when documentation is required or the type of information to be documented.
Compliance programs may include training programs and periodic reviews and testing. Examples of weaknesses in such compliance programs included: relying on monitoring systems put in place prior to the adoption of Reg BI without considering whether updates were required and/or relying on systems that captured only executed transactions; maintaining documentation locally rather than at central locations to facilitate firm-wide reviews; and conducting trainings on Reg BI without discussing the firm’s specific processes for compliance.
In addition to the above, the Staff observed several instances of generic policies and procedures that were not tailored to the broker-dealer’s firm or were merely restatements of Reg BI’s requirements.
Conflict of Interest Obligation
The Staff found that broker-dealers did not always have written policies and procedures reasonably designed to address how conflicts of interest are to be identified or mitigated. Observed deficiencies included: not identifying the parties responsible for identifying and addressing conflicts; not reflecting all types of conflicts that may be associated with recommendations made by the broker-dealer firm; and improperly relying on disclosure as a mitigating act, instead of establishing policies and procedures that would “modify practices to reasonably reduce” conflicts of interest.
Disclosure Obligation
Deficiencies observed that relate to the Disclosure Obligation included: providing only references to Reg BI disclosures, and not the disclosures themselves, on websites or in documents delivered to customers and not adequately disclosing the capacity in which financial professionals may act in multiple roles or disclosing additional conflicts of interests that may arise as a result of the multiple relationships.
Observations from Broker-Dealer Examinations Related to Regulation Best Interest, SEC Risk Alert (Jan. 30, 2023), available at: https://www.sec.gov/file/exams-reg-bi-alert-13023.pdf.