Introduction

Last year, the Securities and Exchange Commission (“SEC”) adopted measures intended to enhance the protection of retail investors who engage financial professionals to assist them with investments. Regulation Best Interest (“Reg. BI”) establishes a new standard of conduct for broker-dealers who make investment recommendations to retail clients. In addition, all broker-dealers and investment advisers who offer services to retail investors are required to file and deliver to such investors a new client relationship summary (“Form CRS”) that provides information about such services, describes associated fees and costs, and advises the investor of conflicts of interest that might affect the financial professional. The new requirements become effective on June 30, 2020, although initial filing of the Form CRS is permitted prior to that date.

The SEC recently made it clear that, notwithstanding the disruptive effect of COVID-19, it does not intend to extend the effective dates for compliance with Reg. BI and Form CRS.[1] In addition, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) announced its intention to begin examinations of registrants’ implementation of these new regulations. Such examinations are expected to occur during the first year after the effective dates. The Financial Industry Regulatory Authority (FINRA) also announced its intent to follow a similar approach with respect to examinations of broker-dealers, focusing on whether firms are making a good-faith effort to establish and implement policies and procedures reasonably designed to ensure that a broker-dealer complies with Reg. BI and Form CRS.

In short, compliance staff whose attention may have been directed elsewhere over the last several weeks should re-focus on their implementation plans and ensure that broker-dealers and/or investment advisers are ready for the rapidly approaching effective dates for Reg. BI and Form CRS.

Broker-Dealers and Reg. BI

Reg. BI requires that broker-dealers and their associated persons act in the best interest of their customers when making recommendations to retail customers about securities transactions or investment strategies (including account recommendations). For these purposes, a “retail customer” is defined to include any natural person, irrespective of their wealth or sophistication, and the legal representatives of entities formed to invest for personal or family purposes such as the trustees of family trusts. Broker-dealers that limit their business to institutional investors or other brokers and do not have any retail customer accounts are not subject to Reg. BI. Under Reg. BI, a broker-dealer may not place its own financial or other interest ahead of those of its retail customers when making recommendations. In general, Reg. BI requires a broker-dealer to comply with the following four components: a Disclosure Obligation, a Care Obligation, a Conflict of Interest Obligation, and a Compliance Obligation.

Disclosure Obligation. Prior to or at the time of a recommendation, a broker-dealer must provide a retail customer with written disclosure of: (i) all material facts relating to the scope and terms of the broker-dealer’s relationship with the retail customer; and (ii) all material facts relating to any conflicts of interest associated with the recommendation. This may include, for example, applicable fees and costs, the recommendation of proprietary products, any material limitations on the range of products recommended, and potential conflicts arising from third-party payments.

• OCIE’s Approach. In order to assess a broker-dealer’s compliance with this obligation, OCIE may review underlying documentation as well as the timing and content of disclosures made to retail customers regarding matters such as:
  • Fee schedules and disclosures about other costs and fees that might be incurred by the retail customer, such as custodian fees, account maintenance fees, and fees incurred when investing in mutual funds or ETFs.
  • The methods employed by the broker-dealer to compensate its financial professionals.
  • Proprietary products sold to retail investors and other potential conflicts of interest.
  • Whether the broker-dealer’s account monitoring practices conform with their disclosures.

Care Obligation. Under the Care Obligation, broker-dealers are required toexercise reasonable diligence, care, and skill when making a recommendation to a retail customer. The broker-dealer must ensure that its financial professionals understand the potential risks, rewards, and costs associated with a recommendation and the broker-dealer must consider these factors in determining whether there is a reasonable basis to believe that a recommendation would be in the best interest of the customer based on its knowledge of the customer’s investment profile.

• OCIE’s Approach. In addressing this obligation, OCIE will examine how a broker-dealer develops a customer’s investment profile as well as its process for determining if there is a reasonable basis to believe that a recommendation is in the best interest of a retail client. Some of the questions which OCIE may examine include:
  • Were risks, rewards, and costs properly considered?
  • Were alternative investments considered?
  • How did the broker-dealer determine that it was not placing its interests ahead of its customer?
  • What process was utilized in formulating investment recommendations with respect to significant investment decisions, such as account rollovers, or with respect to recommendations involving risky, complex, and expensive products?

Conflict of Interest Obligation. Under the Conflict of Interest Obligation, a broker-dealer is required to establish, maintain, and enforce written policies and procedures reasonably designed to address conflicts of interest. Conflicts must be identified and either eliminated or mitigated and disclosed. Disclosure of conflicts of interest may not in and of itself suffice in all cases to adequately comply with Reg. BI. Certain sales practices are prohibited by Reg. BI as involving severe conflicts of interest that cannot be remedied through mitigation and disclosure.

• OCIE’s Approach. To assess compliance with this obligation, OCIE will examine a broker-dealer’s policies and procedures to evaluate how they address:
  • The broker-dealer’s process for identifying conflicts of interest and for updating relevant conflicts as the broker-dealer’s business evolves.
  • Compensation arrangements that create a conflict of interest or that might incentivize a broker-dealer or its financial professionals to place their interests ahead of retail customers.
  • Conflicts resulting from the sale of proprietary products or material limitations on the products and strategies offered by the broker-dealer.
  • The process for eliminating or mitigating conflicts of interest.
  • The process for ensuring proper disclosure is made of conflicts that are not eliminated.
  • Whether the broker-dealer has eliminated sales contests, sales quotas, and similar sales practices that are prohibited by Reg. BI.

Compliance Obligation. Under the Compliance Obligation, a broker-dealer is required to establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Regulation BI.

• OCIE’s Approach. In its examinations, OCIE will review and evaluate a broker-dealer’s policies and procedures. Among the questions OCIE will consider are:
  • Do the policies and procedures include appropriate controls to reasonably ensure compliance with Reg. BI?
  • What is the process for remediation of noncompliance?
  • What provisions are included for training personnel regarding the requirements of Regulation BI?
  • What is the protocol for periodically reviewing and testing the adequacy of the compliance procedures?

Broker-Dealers, Investment Advisers and Form CRS

Form CRS and related rules require broker-dealers and investments advisers to deliver to retail investors a brief client relationship summary that provides information about: (i) the types of client relationships and services the firm offers; (ii) fees, costs, conflicts of interest, and the required standard of conduct associated with those relationships and services; (iii) reportable disciplinary history about the firm and its financial professionals; and (iv) how a retail investor can obtain additional information about the firm. For purposes of Form CRS, a “retail investor” is defined as “a natural person, or the legal representative of such natural person, who seeks to receive or receives services primarily for personal, family or household purposes.” After June 30, 2020, OCIE’s examinations of firms that have retail investors may include an assessment related to Form CRS.

Delivery and filing of Form CRS. Investment advisers are required to deliver a relationship summary to each new or prospective client who is a retail investor before or at the time of entering into an investment advisory contract with the retail investor. Broker-dealers must deliver the relationship summary to each new or prospective customer who is a retail investor before or at the earliest of: (i) a recommendation of an account type, a securities transaction, or an investment strategy involving securities; (ii) placing an order for the retail investor; or (iii) opening a brokerage account for the retail investor. Dual registrants must deliver the relationship summary at the earlier of the initial delivery triggers for an investment adviser or a broker-dealer, including a recommendation of account type. Firms are required to file their Form CRS with the SEC via the Central Registration Depository (in the case of a broker-dealer) or the Investment Adviser Registration Depository (in the case of an investment adviser) between May 1, 2020, and June 30, 2020, and must deliver a relationship summary to their existing retail investor clients within 30 days after the date the Firm first files its Form CRS with the SEC.

• OCIE’s Approach. In its examinations, OCIE will review a firm’s records to determine the dates that relationship summaries were provided to existing retail investors by July 30, 2020, and prior to: (i) opening a new account for an existing retail investor; (ii) recommending that the investor rollover their retirement assets into a new or existing account or investment; or (iii) recommending a new brokerage or investment advisory service or investment that does not necessarily involve the opening of a new account and would not be held in an existing account. OCIE will also want to verify that the firm is providing its relationship summary to new retail investors before or at the earliest of: (i) entering into an investment advisory contract; (ii) recommending an account type, a securities transaction, or an investment strategy; (iii) placing an order for the investor; or (iv) opening a brokerage account for the investor

Content. The relationship summary is designed to provide succinct information about (i) relationships and services the firm offers to retail investors; (ii) fees and costs that retail investors will pay, conflicts of interest, and the applicable standard of conduct; and (iii) disciplinary history. Form CRS prescribes a standardized question and answer format designed to elicit this information and must be written in plain English.

• OCIE’s Approach. OCIE may review a firm’s relationship summary to assess whether it includes all of the required information and does not omit any material facts necessary to make the disclosure, in light of the circumstances in which it is made, not misleading, content of the relationship summary, policies, and procedures regarding updating the Form CRS, and compliance with recordkeeping obligations. This may include, for example:
  • How the firm describes the services it offers to retail investors, including how it monitors investor accounts and the level of its investment authority.
  • Descriptions of the principal fees and costs that retail investors will incur directly or indirectly, and examples of the categories of the most common fees and costs applicable to the firm’s retail investors, including, for example, custodian fees, account maintenance fees, fees related to mutual funds and variable annuities, and other transactional fees and product level fees. Registrants should expect that OCIE staff will ask to review fee schedules, advisory agreements, and brokerage agreements, and will compare the fees detailed in those documents against the disclosure in the relationship summary.
  • Descriptions of how the firm compensates its financial professionals, including cash and non-cash compensation, and the conflicts of interest those compensation arrangements may create.
  • How the firm describes its conflicts of interest more generally, including incentives related to proprietary products, third-party payments, revenue sharing, and principal trading.

Updates. Form CRS must be updated within 30 days after any of the material in the relationship summary becomes materially inaccurate. The updated Form CRS must be posted on a firm’s website and filed with the SEC. Firms must also communicate the changes to retail investors within 60 days after the updates are required.

• OCIE’s Approach. OCIE will review a firm’s compliance policies and procedures to ensure that the written procedures address the requirement to update the relationship summary when the content becomes materially inaccurate and to communicate such changes to retail investors. OCIE will also review filings of such updates to ensure that they appropriately highlight the changes made in each amendment. OCIE will also assess a firm’s policies and procedures related to delivery of the relationship summary to retail investors.

Our Takeaway

The SEC’s determination to stick with its original implementation dates for Reg. BI and Form CRS, as well as its intention to roll out a quick examination program to assess implementation, attest to its serious concern about protecting retail investors. Although OCIE has indicated that it will work cooperatively with broker-dealers and investment advisers during the initial implementation stages, the policy of cooperation is predicated on a determination that firms make a good faith effort to comply with the new regulations. Firms that fail to make such a good-faith effort can expect to be subjected to administrative remedies or enforcement proceedings.

It is therefore essential for broker-dealers, investment advisers, and their compliance personnel to utilize the remaining time before the implementation dates to ensure that they have adequately considered the issues addressed by the new regulations, adopted appropriate policies and procedures, identified material conflicts and prepared required disclosures.

[1] The SEC indicated that broker-dealers or investment advisers who are facing difficulties in meeting these compliance dates because of COVID-19 should contact SEC staff to discuss their issues.

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