Securities and Financial Services

Implementing Reg-BI and Preparing for Examinations: The Compliance Obligation

Implementing Reg-BI and Preparing for Examinations: The Compliance Obligation

With SEC Regulation Best Interest (“Reg-BI”) effective as of June 30, 2020, SEC examiners will now focus on whether firms have made a good faith effort to implement policies and procedures (“P&Ps”) that are necessary for compliance. Reg-BI imposes a general best interest obligation that is only satisfied when four component obligations are met: (i) the Care Obligation; (ii) the Disclosure Obligation; (ii) the Conflict of Interest Obligation and (iv) the Compliance Obligation. This article will focus on what firms should be doing to fulfill the Compliance Obligation, including some of the P&Ps that should be implemented and some of the information that should be captured and reviewed.

The SEC’s Small Entity Compliance Guide makes clear that firms must establish, maintain and enforce written P&Ps reasonably designed to achieve compliance with Reg-BI. According to the SEC, the firm’s P&Ps should both take into account the nature of the firm’s operations and be designed to prevent, detect and quickly correct violations of Reg-BI. The SEC’s adopting release for Reg-BI makes it clear that P&Ps should also include controls, remediation of non-compliance, training, and periodic review and testing.

As a practical matter, in the regulatory context, if it isn’t documented, it didn’t happen.  With that in mind, let’s begin.

Demonstrating Compliance with the Care Obligation

How does a firm or a registered representative (“RR”) demonstrate what was reviewed to determine that a recommendation was in a retail customer’s (“RC’s”) best interest?

Under Reg-BI, firms and their RRs need to obtain and analyze enough information from the RC to have a reasonable basis for believing that the recommendation is in the best interest of that RC. The SEC requires that the RC’s investment profile must include her “age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance and any other information the customer may disclose.”  When making a recommendation, the firm must weigh the potential risks, rewards, and costs of a security or investment strategy in light of the documented profile.

A firm should determine what it needs to capture and review in addition to the RC’s investment profile to ascertain if and how the potential risks, rewards, and costs of a recommended security or investment strategy were weighed in light of that profile. It should also make sure its P&Ps reflect how this information is to be captured and reviewed in a manner reasonably designed to prevent, detect, and correct violations of Reg-BI. 

What costs were considered?

Although the potential costs of a particular recommendation is not necessarily dispositive in determining whether an investment is in a RC’s best interest, they must be considered. These costs include purchase costs and those that might apply to future sales or exchanges, like deferred sales charges or liquidation costs. A firm’s P&Ps should address how it is documenting and reviewing these considered costs.

What reasonably available alternatives (“RAAs”) were considered?

P&Ps must also comport with the SEC’s position that RAAs should be considered. Although Reg-BI does not require that every possible alternative be considered or that the recommendation made must be the absolute best, firms should capture which RAAs were considered. Moreover, firm P&Ps should outline how to identify RAAs and how those RAAs that are considered are documented and reviewed. 

OCIE’s April 7, 2020 Reg-BI Exam Alert notes it will be reviewing P&Ps and other firm materials to ensure Reg-BI compliance with processes for the following areas: 

  • obtaining and updating RC investment profiles;
  • understanding risks, rewards, and costs of securities offered to RCs;
  • ascertaining if there was a reasonable basis for concluding that a recommendation is in a RC’s best interest; and
  • monitoring and surveilling trading and account openings.         

OCIE also indicated that it would examine a firm’s required supervisory and compliance reviews or approvals prior to an RR’s recommendation of accounts or securities.

Demonstrating Compliance with the Disclosure Obligation

OCIE will examine whether firms can demonstrate that they are disclosing the following in writing to RCs: 

  • fees and charges;
  • RR compensation methods;
  • how it monitors RC accounts; and
  • any significant limits on the types of accounts or services available.

Firms will also want to be able to demonstrate its P&Ps addressing:  

  • creating, updating, filing, and delivering to RCs disclosures like the Relationship Summary; and
  • making and documenting oral disclosures.

Demonstrating Compliance with the Conflict of Interest Obligation

Firm P&Ps should address potential conflicts related to RCs, including:  

  • any incentives for RRAs to place their or the firm’s interests ahead of those of the RC; and
  • any material limitations on what securities or investment strategies can be recommended.

Firms must also eliminate any sales contests, sales quotas, bonuses, and non-cash compensation based on the sale of specific securities or types of securities within a limited period of time and should prohibit these explicitly in their P&Ps.P&Ps should also address how and what conflicts the firm discloses and how conflicts are mitigated and eliminated. In addition, the firm’s P&Ps should cover how it identifies these potential conflicts and how it will continue to identify and assess conflicts as its business evolves.

Firms should be on alert for forthcoming FINRA guidance regarding what firms should be focused on concerning Reg-BI compliance. But, now is the time to determine that the Reg-BI changes you have implemented address the regulators’ initial concerns, to ensure that your RRs and staff have been trained on these changes, and to assess how well your P&Ps are ensuring Reg-BI compliance. Taking these actions now will likely demonstrate good faith compliance efforts when your firm is examined under Reg-BI.