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.

FINRA AND SEC GUIDANCE: EFFECTIVE RISK MANAGEMENT FOR BRANCH AUDITS

In its continual focus on the importance of effective risk management for broker-dealers (as well as investment advisers) the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations and FINRA have issued a National Exam Risk Alert aimed at providing broker-dealer firms with information on developing effective policies and procedures for branch office inspections.  In addition to reminding firms of their supervisory obligations under FINRA’s supervision rule, the alert notes some common deficiencies found during SEC and FINRA examination of branch office audit practices and emphasizes the need for firms to adopt a comprehensive risk approach to compliance practices. 

The Alert, including FINRA’s Regulator Notice 11-54 , contains a number of best practices that Chief Compliance Officers and other compliance professionals of broker-dealers should consider incorporating as part of their mandated supervisory oversight of branch offices.  The Alert warns that some practices FINRA and SEC examiners have observed, including

  • firms utilizing generic examination procedures for all branch offices, regardless of business mix
  •  leveraging  novice or unseasoned branch office examiners who lack the experience or understanding of the business to challenge assumptions, and
  •  devoting minimal time to each exam and little, if any, resources to reviewing the effectiveness of the branch office exam program

will not be tolerated.  In short, the alert is a reminder that the SEC and FINRA view branch office inspections as integral to determining whether a firm’s culture of compliance eliminates risks to the firm and its clients or contributes to violations of the securities laws.