Amid the general disruptions related to COVID-19, SEC Chairman Jay Clayton nonetheless confirmed on April 2, 2020 that Regulation Best Interest (“Reg BI”) and corresponding Form CRS will continue to have an implementation date of June 30, 2020.1 Reg BI and its corresponding Form CRS was enacted on June 5, 2019.2 Reg BI provides a new standard of conduct for broker-dealers and natural persons who are associated persons of a broker-dealer that provide recommendations to retail customers. Form CRS and its related rules require broker-dealers and investment advisers to provide retail investors with a brief summary of the nature of the customer or client relationship.3
No Delay on Compliance Implementation
Chairman Clayton reiterated that Reg BI is “a key component of a broader package of rules and interpretations . . . to enhance the quality and transparency of retail investors’ relationships with broker-dealers and investment advisers.” He further stated that SEC registered broker-dealers and investment advisers “should continue to make good faith efforts around operational matters to ensure compliance by June 30, 2020 (the “Compliance Date”), including devoting resources as necessary and available in light of the circumstances.” To the extent a firm is unable to make certain filings or meet other requirements because of disruptions caused by COVID-19, including as a result of efforts to comply with national, state and local health and safety directives and guidance, that firm is encouraged to reach out to SEC staff; the SEC and staff is expected to take a firm-specific approach into account in both examination and enforcement efforts regarding unforeseen circumstances and related operational constraints and resource needs.
Chairman Clayton indicated that during the initial period after the compliance date, SEC examiners will be focusing on whether firms have made a “good faith effort” to institute policies and procedures necessary to implement Reg BI, and will also work with firms on compliance and other questions.
On April 7, 2020, the SEC Office of Compliance and Inspections and Examinations (“OCIE”) published Risk Alerts with additional information regarding the scope and content of initial examinations for Reg BI and similar information regarding Form CRS.4 Both alerts specifically reiterate that OCIE understands that coronavirus disease (COVID-19) has created challenges for broker-dealers and investment advisers and OCIE will work with firms on issues that may arise during examinations.
Examinations that Focus on Compliance with Reg BI
OCIE reminds broker-dealers that when making a recommendation of any securities transaction or investment strategy involving securities (including account recommendations) to a retail customer,5 a broker-dealer must act in the best interest of the retail customer at the time the recommendation is made, without placing its own financial or other interest ahead of the retail customer’s interest. This obligation is satisfied if the broker-dealer complies with the following four obligations: (i) Disclosure Obligation, (ii) Care Obligation, (iii) Conflict of Interest Obligation and (iv) Compliance Obligation.
As of the Compliance Date, OCIE will begin examinations to assess the implementation of Reg BI. These examinations are anticipated to occur during the first year after the Compliance Date and will evaluate whether the broker-dealers have established policies and procedures “reasonably designed to achieve compliance with” Reg BI and have made reasonable progress in implementing those policies and procedures, as necessary and appropriate.
In particular, initial examinations will focus on the following areas:
- Disclosure Obligation: Prior to or at the time of a recommendation, a broker-dealer must provide a retail customer with full and fair written disclosure of: (a) all material facts relating to the scope and terms of the relationship between the broker-dealer and the retail customer, and (b) all material facts related to any conflicts of interest associated with the recommendation. The OCIE Staff will assess how the broker-dealer has met the Disclosure Obligation, including reviewing disclosure regarding (i) the capacity in which the recommendation was made, (ii) material fees and costs that apply to the retail customer’s transactions, holdings, and accounts, and (iii) material limitations on any securities or investment strategies involving securities that may be recommended. To assess compliance, OCIE Staff may review content of disclosures and firm records. Reviews may include the following types of documentation: schedules of fees and charges and disclosure of such fees, the broker-dealer’s compensation methods for its personnel and additional types of compensation, disclosure of monitoring of retail customer’s accounts, disclosure of material limitations on accounts or services recommended and lists of proprietary products sold.
- Care Obligation: The Care Obligation requires a broker-dealer to exercise reasonable diligence, care and skill when making a recommendation to a retail customer. The broker-dealer must understand potential risks, rewards and costs associated with a recommendation, must consider these factors as they apply to the retail investor’s investment profile, and must make a recommendation that is in the retail customer’s best interest. To assess compliance, OCIE Staff may review information collected from retail customers to development investment profiles and the broker-dealer’s process for having a reasonable basis to conclude that recommendations are in the best interest of the retail customer, including factors the broker-dealer considers to determine potential risk, reward and cost of the recommendation in light of the retail customer’s investment profile, and the broker-dealer’s process for having a reasonable belief that it did not place its own financial or other interest ahead of the interest of the retail customer. In addition, the OCIE Staff may review the process for recommendations related to significant investment decisions, including rollovers and account recommendations and more complex, risky or expensive products, and how the broker-dealer determined it had a reasonable basis for determining that these investment strategies and products were in the retail customer’s best interest.
- Conflict of Interest Obligation: A broker-dealer must establish, maintain and enforce written policies and procedures reasonably designed to address conflicts of interest associated with recommendations to retail customers. To assess compliance, OCIE Staff may review the broker-dealer’s policies and procedures to assess the following types of conflicts, as required by Reg BI: conflicts that create an incentive for an associated person to place their interest of the interest of the broker-dealer ahead of retail customer’s interest and conflicts associated with material limitations (including product menus only offering proprietary products or those with third party referral arrangements) on securities or investment strategies that may be recommended to a retail customer. OCIE Staff may review the broker-dealer’s policies and procedures to assess the elimination of conflicts related to: sales contests, sales quotas, bonuses and non-cash consideration for sales of specific securities within a limited time frame. In addition, OCIE Staff may assess how the broker-dealer’s policies and procedures establish a structure for identifying conflicts facing a broker-dealer and its associated persons and the disclosure of those conflicts, and may expect that the broker-dealer has documented all conflicts associated with its recommendations. The policies and procedures should also establish a structure to identify conflicts as the broker-dealer’s business evolves and provide for the mitigation or elimination of conflicts. OCIE Staff may also review all policies and procedures in place over the scope of the period of the examination.
- Compliance Obligation: A broker-dealer must establish, maintain and enforce written policies and procedures reasonably designed to achieve compliance with Reg BI. To assess compliance with this obligation, OCIE Staff may review the broker-dealer’s policies and procedures to evaluate any controls, remediation, training, review and testing included as a part of the policies and procedures.
Examinations that Focus on Compliance with Form CRS
Form CRS and its related rules require the broker-dealers and registered investment advisers (“firms”) deliver to retail customers a brief relationship summary that provides information about the firm. Firms must file their initial relationship summaries with the SEC and post the current relationship summary on the firm’s website. After the Compliance Date, OCIE will begin examinations to assess compliance with Form CRS, with initial examinations focusing on whether firms have made a good faith effort to implement Form CRS.
Initial examinations will focus on the following:
- Delivery and Filing – OCIE Staff may review whether the firm has filed its relationship summary with the SEC and whether it is posted on the firm’s website, evaluate the process for delivery to existing and new retail investors, and review the firm’s policies and procedures to assure that they address the required relationship summary delivery process.
- Delivery Dates for Existing Retail Investors: Initial delivery of the relationship summary by the Compliance Date, or at the earliest of:
- The opening of a new account;
- A recommendation for a rollover of assets from a retirement account into a new or existing account or investment; or
- A recommendation of a new brokerage or investment advisory service or investment that does not necessarily involve the opening of a new account, but would not be held in an existing account.
- Delivery Dates for New Retail Investors: Delivery of the relationship summary must occur before or at the earliest of:
- Entering into an investment advisory contract with the retail investor;
- Making a recommendation to a retail investor of an account type, a securities transaction or an investment strategy involving securities;
- Placing an order for the retail investor; or
- Opening of a brokerage account for the retail investor.
- Delivery Dates for Existing Retail Investors: Initial delivery of the relationship summary by the Compliance Date, or at the earliest of:
- Content – OCIE Staff may review the firm’s relationship summary to assess whether it includes all required information and contains true and accurate information and does not omit any material facts necessary in order to make the required disclosures not misleading in light of the circumstances in which they were made. This review may include:
- the firm’s description of relationships and services offered to retail investors;
- description of fees and costs, including principal fees and costs incurred directly and indirectly by retail investors;
- description of compensation and payments to financial professionals, and conflicts of interest the payments may create,
- description of conflicts of interest related to proprietary products, third-party payments, revenue sharing, and principal trading; and
- the firm’s disclosure of its or its financial professionals legal or disciplinary history.
- Formatting: The OCIE Staff may review a firm’s relationship summary to assess whether it is formatted in accordance with the instructions.
- Updates: The OCIE Staff may review a firm’s policies and procedures for updating the relationship summary in light of the requirements to update the summary when there are material changes.
- Recordkeeping: OCIE staff may review the firm’s records related to delivery of the relationship summary and policies and procedures related to record-making and recordkeeping to assess compliance with applicable delivery and recordkeeping obligations.
In addition, the SEC and staff have provided the following resources to assist firms:
A dedicated SEC mailbox for firms and others to submit questions: [email protected]
A Small Entity Compliance Guide on Regulation Best Interest, available here.
Staff answers to frequently asked questions, available here.
A Spotlight Page for relevant materials including releases, comment letters, speeches, press releases and transcripts, available here.
While we expect that there will be additional statements and guidance regarding Reg BI and Form CRS, it seems likely that it will be effective as expected in June, and broker dealers and investment advisers should continue to plan to make the operational changes and provide the disclosure as described in the Release by the Compliance Date.
1 See Public Statement by Chairman Jay Clayton, April 2, 2020, available at: https://www.sec.gov/news/public-statement/statement-clayton-investors-rbi-form-crs.
2 See Release 34-86031 (June 5, 2019) (the “Release”), at pp. 371-372, available at: https://www.sec.gov/rules/final/2019/34-86031.pdf
3 For a more detailed description of the Release, see our previous alert here, available here: https://www.whitecase.com/publications/alert/broker-dealers-should-be-ready-regulation-best-interest.
4 Risk Alert: Examinations that Focus on Compliance with Regulation Best Interest, April 7, 2020, available at: https://www.sec.gov/files/Risk%20Alert-%20Regulation%20Best%20Interest%20Exams.pdf, and Risk Alert: Examinations that Focus on Compliance with Form CRS, April 7, 2020, available at: https://www.sec.gov/files/Risk%20Alert%20-%20Form%20CRS%20Exams.pdf
5 A “retail customer” is defined as “a natural person, or the legal representative of such natural person, who: (A) receives a recommendation of any securities transaction or investment strategy involving securities from a broker, dealer, or a natural person who is an associated person of a broker or dealer; and (B) uses the recommendation primarily for personal, family, or household purposes.” See Securities Exchange Act Rule 15l-1(b)(1).
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