Regulation Best Interest: What SEC Examiners Want to Know and See

What it describes as an effort to promote transparency in future examinations, the OCIE recently issued a Risk Alert providing broker-dealers with information about the scope and content of its initial examinations that will occur after the compliance date for Regulation Best Interest. It has also provided with the alert a sample request for information and documents. The purpose of the exams will be to evaluate whether firms are implementing and modifying, where necessary, to ensure they have in place policies and procedures reasonably designed to achieve compliance with Reg BI.

While the OCIE is careful to state that other areas may be considered, four appear to be the primary focus, and include the following:

Disclosure Obligation: This includes specific disclosures of material facts relating to the scope and terms of the customer/client relationship, including conflicts of interest, fees and costs of transactions, holdings and accounts and limitations applicable to related securities or investment strategies recommended to customers.

What will they be looking for? With this obligation,examiners might want to review records, including the timing of disclosure content of the disclosures to ensure required information is disclosed to customers. Staff may also review the timing of the disclosures. This may include reviews of fee schedules (i.e. “custodian fees, account maintenance fees, fees related to mutual funds and variable annuities, and other transactional fees and product-level fees”); compensation methods, types and sources, related conflicts of interest; disclosures of monitoring and limitations on accounts or services to customers, and proprietary products.

Care Obligation: A broker-dealer must exercise reasonable diligence, care, and skill in making recommendations to customers. This includes understanding potential risks, rewards, and costs associated with a recommendation, considering the customer’s investment profile, while making recommendations in the customer’s best interest.

What will they be looking for? Examiners will review customer investment profiles (“including any new account forms, correspondence, and any agreements the customer has with the broker-dealer”); will assess a broker-dealer’s process for determining a reasonable basis to believe recommendations were in the best interest of the customer; factors considered when assessing potential risk and costs in based on the customer’s investment profile; process used to conclude that broker-dealer did not place its own financial or other interest ahead of that of the customer.

Conflict of Interest Obligation: Are the broker-dealer’s written policies and procedures reasonably designed to address conflicts of interest associated with its recommendations to customers?

What will they be looking for? As noted above, examiners will be asking whether and how the policies and procedures meet Reg BI; including existence of incentives for an associated person to place theirs or the broker-dealer’s interest ahead of the customer; conflicts associated with material limitations (“e.g., a limited product menu, offering only proprietary products, or products with third-party arrangements”) on securities or investment strategies recommended to retail customers; and whether other conflicts have been eliminated entirely, including “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 of time;” Do the policies and procedures establish a structure for identifying the conflicts, including documentation identifying all conflicts associated with the broker-dealer’s recommendations as they exist and as they evolve? Do the policies and procedures provide for mitigation or elimination of conflicts and which ones are mitigated or eliminated?

Compliance Obligation: Broker-dealers must establish, maintain, and enforce written policies and procedures reasonably designed to comply fully with Reg BI.

What will they be looking for? The OCIE states that examiners may review a broker-dealer’s policies and procedures and evaluate controls, remediation of noncompliance, training, and periodic review and testing included as part of those policies and procedures. A copy of the risk alert can be found here.

SEC and FINRA To Hold 2014 Regional Outreach to Broker-Dealers

Broker-dealers are reminded, beginning this  spring, the SEC’s Office of Compliance Inspections and Examinations (OCIE), and the SEC’s Division of Trading and Markets, is partnering with FINRA to sponsor regional compliance outreach programs for broker-dealers. The programs will take place in Denver, Los Angeles, Chicago, Miami, Philadelphia, and New York.  Registration is open to all broker-dealer risk, audit, legal, and compliance professionals. Continue reading “SEC and FINRA To Hold 2014 Regional Outreach to Broker-Dealers”

SEC Report: Broker-Dealers’ Handling of Material NonPublic Information

The Securities and Exchange Commission, through the Office of Compliance Inspections and Examinations (OCIE), has announced and issued a staff report aimed at aiding broker-dealers in safeguarding confidential information from misuse.

Taken from examinations of broker-dealers conducted by the SEC, FINRA, and the NYSE’s Division of Market Regulation, the report reflects strengths and weaknesses OCIE identified in examining how broker-dealers handle material nonpublic information to prevent improper uses.  Misuses might include insider trading, trading during a tender offer in violation of SEC rules or through issuance of a research report based on  material non-public information.

When facing the challenge of designing their controls, the report may be particularly beneficial to broker-dealers dually-registered as investment advisers or who are closely integrated with an affiliated investment adviser.

Carefully pointing out that no one size fits all, and from a “best practices” perspective, OCIE found two practices among some broker-dealers to be particularly effective. The first involved those included broker-dealers who developed processes that differentiated between types of material non-public information based on the source of information coming from within the broker-dealer or the nature (e.g., transaction type) of the information.  In certain instances, the report notes, ” broker-dealers were creating tailored exception reports that took into account the different characteristics of the information.”

The second practice involves broker-dealers who expanded the scope of instruments that they reviewed for potential material non-public information misuse  by traders.  Included are credit default swaps, equity or total return swaps, loans, components of pooled securities such as unit investment trusts and exchange traded funds, warrants, and bond options.

In addition to defining  many of the sources of material non-public information, the report also provides an overview of broker-dealers’ controls structure and their controls – both in terms of  public versus private side of transactions, and in how firms limit and prevent authorized and unauthorized access (physical and technical barriers) to such information.

A look at SEC litigation releases, in the past few six months alone, show no shortage of cases involving misuse of material nonpublic information being either filed or settled.   As the report states, look for OCIE to continue reviewing broker-dealer practices in these areas in future examinations.