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.


The SEC National Exam Program has issued a new Risk Alert addressing some of the most common deficiencies associated with advisers’ best execution obligations identified by OCIE staff.  In addressing the deficiencies, the alert reminds advisers of existing requirement that in determining best execution an adviser must seek to obtain the execution of transactions for clients in such a manner that the client’s total cost in each transaction is the most favorable under the circumstances. “[T]he  determinative factor [in an adviser’s best execution analysis] is not the lowest possible commission cost but whether the transaction represents the best qualitative execution for the managed account.” The SEC has brought enforcement actions against advisers who fail to meet this standard.

Common adviser best execution deficiencies that were observed by the staff include:

failure to demonstrate periodic and systematic evaluation of the execution performance of broker-dealers used to execute client transactions.

failure to consider the full range and quality of a broker-dealer’s services in directing brokerage.

failure to seek or consider the quality and costs of services available from other broker-dealers.

advisers who failed to provide full disclosure of best execution practices.

•failure to provide full and fair disclosure in Form ADV of their soft dollar arrangements.

•advisers who did not “appear to make a reasonable allocation of the cost of a mixed use product or service according to its use or did not produce support, through documentation or otherwise, of the rationale for mixed use allocations.”

•advisers that appeared to fail to have adequate compliance policies and procedures or internal controls for best execution.

advisers who failed to follow their policies and procedures regarding best execution, including failing to seek comparisons from competing broker-dealers to test for pricing and execution, not allocating soft dollar expenses in accordance with their policies, and not conducting ongoing monitoring of execution price, research, and responsiveness of their broker-dealers.

Advisers should remember that as fiduciaries, they have a duty to obtain best execution in client transactions. The alert list several actions advisers may want to consider when cleaning up such deficiencies.  Actions that might be taken by advisers include, amending their best execution or soft dollar arrangements disclosures, revising compliance policies and procedures, and changing their practices regarding best execution or soft dollar arrangements.

SEC Risk Alert: Business Continuity and Disaster Recovery Planning

The SEC has issued a new Risk Alert stemming from its observations of  the  business continuity and disaster recovery planning practices of  a number of  investment advisers.  The alert follows an National Examination Program (“NEP”) review of the plans of approximately 40 investment advisers following  Hurricane Sandy.  The SEC says the goal is to encourage investment advisers to review their business continuity and disaster recorvery plans (“BCPs”) to improve responses and recovery times for threats that might disrupt market operations.

Certain weakenesses observed, and that advisers would do well to heed,  include the following areas:

  • Preparation for widespread disruption. Some advisers whose BCPs did not adequately address and anticipate widespread events experienced more interruptions in their key business operations and inconsistent communications with clients and employees.
  • Planning for alternative locations.  Some advisers who switched to back-up sites or systems reported that the buildings where they usually conduct their business were closed for days.  At least, one adviser reported its building was closed for several weeks.  Other problems included extended outages of power, phone systems, and internet service and lack of geographically diverse office operations.
  • Preparedness of key vendors.  Some advisers failed to even evaluate the BCPs of their service providers or keep a list of vendor’s contact information.  Some advisers did not acquire or critically review service providers’ Statement on Standards for Attestation Engagements No. 16 reports. 
  • Telecommunications services and technology.  Some advisers failed to hire service providers to make sure back-up servers functioned properly, relying solely on self-maintenance, which led to more interruptions in their operations.
  • Communication plans.  Poor planning, inconsistencies and weak deployment in how to contact employees during a crisis.  Some plans did not identify which employees would execute and implement  various parts of the BCP.
  • Reviewing and testing.  Inadequate testing of operations and systems relative to size and nature of  advisory businesses.  Some problems here were based on adviser failures to conduct certain critical tests based on costs and other disincentives.  

The risk alert also encourages advisers to consider those best practices and lessons learned that were described in the Joint Review of Business Continuity and Disaster Recovery of Firms by the Commission’s National Examination Program, the Commodity Futures Trading Commission’s Division of Swap Dealers and Intermediary Oversight and the Financial Industry Regulatory Authority on August 16, 2013.  They are  available at

While the alert serves as a friendly reminder, to avoid a potential enforcement action, the advice covered should be reviewed, and where appropriate, implemented.  The days of  preparing a boilerplate disaster recovery handbook to be left to collect dust on an adviser’s bookshelf have long passed.

SEC Risk Alert: Options Trading That Evades Short-Sale Rule Requirements

risk managementShort sale activity continues to be a significant focus of the SEC, particularly when it involves short sales without delivery, or “failures to deliver.”

The SEC’s Office of Compliance Inspections and Examinations (OCIE) has now  issued a new Risk Alert raised by its examination staff’s observation that some options trading strategies are being used to evade the short-sale rule, Rule 10b-21.  The alert addresses the need for customers, broker-dealers and clearing firms to be aware of options trading activity that could be used to avoid complying with the close-out requirements of Reg SHO.

Under the rule,  it is fraudulent to sell an equity security if it deceives a person participating in the transaction about the seller’s  intention or ability to deliver the security by settlement date.  Rule 10b-21 covers such situations where a seller deceives a broker-dealer, participant of a registered clearing agency, or a purchaser about its intention to deliver securities by settlement date, and the seller then fails to deliver securities by settlement date.  The violative activity would include broker-dealers (including market makers) acting for their own accounts.  Broker-dealers could also be held liable for aiding and abetting a customer’s fraud under Rule 10b-21.

In addition to addressing, with examples, trading strategies that could be used to circumvent Reg SHO requirements, and other helpful ways that OCIE has observed that some firms have used to effectively detect and prevent violation of the rule, the alert provides summary guidance covering (a) Reg SHO Close-out Requirement; (b) Reg SHO Locate Requirement; (c) Rule 10b-21; (d) Key Trading Terms and Concepts; and (d) Option Activity Related to Hard to Borrow and/or Threshold Securities.