Securities and Financial Services

Prepping for SEC Reg BI Exams: What ‘Good-Faith’ Compliance Efforts Look Like

Prepping for SEC Reg BI Exams: What ‘Good-Faith’ Compliance Efforts Look Like

Regulators won’t demand perfect compliance right away, but firms need to show that they’re working to disclose and mitigate conflicts.

On June 30, the Securities and Exchange Commission finally implemented its long-awaited Regulation Best Interest, or Reg BI. This new regulation addresses the obligations of SEC-registered firms and their representatives to make recommendations that are in their retail customers’ best interest and that do not place the firm or broker’s interests above the customer’s.

Specifically, Reg BI imposes four primary obligations when making recommendations: (1) disclosure obligations, (2) care obligations, (3) conflict of interest obligations, and (4) compliance obligations.

SEC and FINRA examinations will now evaluate compliance with Reg BI. Both the SEC and FINRA have stated that their examiners will determine whether there have been “good faith” efforts to comply with Reg BI. Perfection is not required, but firms must demonstrate that they are attempting to implement each of the new Reg BI obligations.

Of Reg BI’s four obligations, the conflict of interest obligation is arguably the key component. Importantly, this obligation is applicable only to firms, not directly to its registered representatives. This is because firms are the entities responsible for implementing and enforcing plans that ensure compliance with this obligation.

Here are some critical elements of the conflict of interest obligation and ways firms can demonstrate “good faith” in attempting to comply with them.

Reg BI’s conflict of interest obligation requires firms to establish and enforce policies and procedures identifying conflicts of interest, which are loosely defined as situations in which a firm or representative consciously or unconsciously puts their own or their firm’s interests before the client’s interest.

For example, when making a recommendation across products that are in a similar asset class, choosing to recommend a higher commission option would fall into the category of a conflict of interest that must be identified under Reg BI. Identifying actual or potential conflicts of interest in recommendations given to customers is critical to fulfilling the rest of this obligation.

Reg BI requires firms to put their new conflict-identifying policies and procedures in writing. In this first wave of examinations, regulators likely will not treat firms harshly if every new policy and procedure has not been complied with to the letter; however, not having written policies and procedures in place at all will likely result in an examiner finding a lack of good faith.

In addition, registered representatives and their staff need to have received, been trained on, and be familiarized with these conflict identification policies and procedures. FINRA will not require firms to demonstrate that their representatives know and comply with each of these new policies perfectly, but familiarity with the new polices and steps taken toward full compliance likely will be required.

Ideally, conflicts of interest — which place the firm’s or broker’s own interest ahead of the customer’s — should be completely eliminated by firm policy and procedure changes, but if they cannot, then they must be disclosed to customers.

In the aforementioned example, the conflict of interest (recommendation of a higher commission product) could potentially be addressed by having a broker identify investment options available to the customer that disclose the commissions for each product, in addition to other management fees and costs. While the variance in commissions cannot be eliminated, the disclosure of this commission-created conflict of interest will inform the customer and likely be sufficient to comply with Reg BI.

In addition, if the broker-dealer has particular structural limitations on the panoply of recommendations that its registered representatives can make (for example, if the firm limits its product offerings or only offers proprietary products), then these limitations must be identified and disclosed, as these limitations likely benefit the firm and simultaneously limit customers’ choices.

The conflict of interest obligation requires firms to identify and then eliminate some specific situations in which brokers have incentives (such as sales quotas or contests or bonuses to benefit the broker directly) that are targeted to particular products or categories of securities for a limited time. Eliminating these specific programs is an easy way to demonstrate to the regulators that your firm is working in good faith to comply with Reg BI.

While these specific programs must be eliminated, other incentive programs should be evaluated and likely limited or altered to ensure that they are not creating or exacerbating existing conflicts of interest.

Where incentive programs do result in conflicts of interest, Reg BI requires firms to mitigate them as much as possible, and if the conflicts of interest they create cannot be eliminated, they must be disclosed.

Where conflicts do exist in light of incentive programs (such as compensation thresholds, etc.), firms may consider implementing additional, intensive monitoring of brokers’ sales practices as they approach certain compensation thresholds or engage in other activity that could contribute to incentive program rewards.

Firms need to be flexible. Regulators will be looking to see if firms are testing and reviewing how policies are actually implemented and how they function to determine if they need to be adjusted to reflect the day-to-day realities of the firm, its representatives, and, most importantly, its customer base.

Implementing new conflict of interest policies and procedures will be difficult, but fear not! Perfection is not required. However, firms must be able to demonstrate to the SEC and FINRA that they did not write these new policies and procedures and then put them on a shelf to gather dust.

Firms should have already taken the big steps required under this specific Reg BI obligation and are hopefully already making conflict recognition, disclosures, and mitigation and/or elimination an everyday affair.

Going forward, it will be key to engage in testing and in frequent evaluations and check-ins to ensure that the firm is working toward full compliance with conflict of interest obligations. Perfection may not be mandatory, but good-faith effort is.

Reprinted with permission from the August 21, 2020 edition of the ThinkAdvisor © 2020 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or