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The Friday List: The 10 Most Important Changes Required by Regulation Best Interest and Its Companions

Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues.  Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic.

Earlier in the summer, the SEC adopted Regulation Best Interest and new Form CRS and issued interpretations of an adviser’s fiduciary responsibilities and the “solely incidental” exception to adviser registration for broker-dealers.  All-in-all, the SEC published more than 1300 pages of regulatory information.  The compliance date for Regulation BI and Form CRS is June 30, 2020.  Many firms (including ours) have authored excellent pieces describing the new rules.  However, as we do nearly every day, we will attempt to provide the most important changes for your regulatory consideration.

The 10 Most Important Changes Required by Regulation Best Interest and Its Companions

  1. Best Interest. Instead of ensuring that a recommendation is merely suitable, broker-dealers must act in the best interest of retail customers when making a securities transaction recommendation or an investment strategy.
  2. BD Disclosure. Broker-dealers must disclose (see Form CRS) material facts (e.g. fees/costs, services, conflicts, discipline) to retail customers at or before any recommendation is made.
  3. Policies and Procedures. Broker-dealers must adopt and implement written policies and procedures that address conflicts of interest (including proprietary products, sales contests, and non-cash compensation) and ensure compliance with Regulation Best Interest, which would include training, reviews, and testing.
  4. Form CRS. At or before entering into a relationship with a retail client, both investment advisers and broker-dealers must deliver new Form CRS (also filed with the SEC), which includes information about the firm’s regulatory status and obligations, fees/costs, and services.
  5. Use of “advisor”. Broker-dealers will be restricted in their use of the term “advisor” or “adviser.”
  6. Due Diligence. Advisers will have a need to conduct a greater amount of due diligence on retail clients (as compared to institutional clients).
  7. Account Monitoring. An adviser must continually monitor a retail client’s investment profile and situation to ensure that advice continues in the best interest of the client.
  8. Conflicts Disclosure. An adviser must include specific disclosure about applicable conflicts of interest and not merely describe conflicts as hypothetical or possible.
  9. Investment Discretion. Absent limiting circumstances, a broker dealer with investment discretion must register as an investment adviser.
  10. Monitoring Compensation. Receiving compensation to provide ongoing account monitoring would require investment adviser registration.

Withdrawing BD Registration Doesn’t Stop the SEC from Prosecuting for Failure to Supervise

 

The SEC fined a broker-dealer and its CEO for failure to supervise even though the firm withdrew its registration.  A broker at the firm pleaded guilty to providing inflated quotes to an investment manager as a quid pro quo for receiving future trading business.  The SEC alleges that the CEO knew that the trader provided quotes but failed to adopt and implement reasonable procedures to supervise the trader and his provision of price quotes to third parties.  The BD withdrew from registration, but an SEC Enforcement official warned, “Deregistering with the Commission in the midst of an enforcement investigation will not enable such firms to evade liability.”

Just because you abandon your car before the police can stop you doesn’t mean that you can’t get arrested.  It appears that the respondent’s efforts to avoid prosecution by withdrawing may have exacerbated their SEC problems by making them look more guilty. 

The Friday List: 10 Examples of Brokers Behaving Badly

Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues.  Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic.

The debate about the now-vacated DoL fiduciary rule and the recently proposed Regulation Best Interest continues.  We have argued that a uniform fiduciary standard should apply to both retail brokers and advisers.  Why?  We accept the position that retail consumers should not have to hire a lawyer to determine the advice standards to which his/her financial professional adheres.   More significant, however, is that brokers behave badly and need a higher standard.  An academic study that was first published in 2016 reported that 7% of broker-advisers have misconduct records, prior offenders are 5 times more likely to engage in misconduct, and 44% of brokers fired for misconduct are re-employed within a year.  The authors concluded: “We find that financial adviser misconduct is broader than a few heavily publicized scandals.”   They also argued that a more stringent standard would help the industry by improving the low reputation of financial professionals.  Our reporting of cases also shows endemic broker misconduct.  In today’s list, we highlight examples of brokers behaving badly, which should inform the debate on a uniform fiduciary standard.

 

10 Examples of Broker Behaving Badly

  1. Stealing from clientsA broker exploited a weakness in his firm’s control systems that allowed third party disbursements, enabling him to misappropriate $7 Million from clients.
  2. Churning.   A broker recommended an unsuitable in-and-out trading strategy that generated significant commissions.
  3. Misrepresenting disciplinary recordA broker’s website claimed he never had a complaint, even though several customers filed and settled complaints over the course of an 8-year period.
  4. Misusing client information. A broker shared nonpublic personal information (including holdings and cash balances) about clients with a person no longer affiliated with his firm.
  5. Revenue sharing.   A broker received undisclosed revenue sharing on mutual fund trades from the clearing broker.
  6. Undisclosed markups/markdownsAn interdealer failed to disclose markups and markdowns on securities traded for clients.
  7. Commission kickbacksA trading supervisor demanded commission kickbacks from junior traders to whom he assigned clients.
  8. Pump-and dumpA broker engaged in an ongoing penny stock pump-and-dump scheme.
  9. Bribing public officials.    A broker spent nearly $20,000 on hotels, meals and concert tickets to bribe a public plan official to secure brokerage business from a public plan.
  10. IPO kickbacks.   A broker and his client conspired in a kickback scheme whereby the customer would pay back 24% of his profits in exchange for preferred IPO and secondary offering allocations.

The Friday List: 10 Things You Need to Know About Regulation Best Interest

Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues.  Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic.

A few weeks ago, the SEC proposed Regulation Best Interest, which requires a broker to act in the best interest of each retail customer at the time the recommendation is made, notwithstanding the broker’s own financial interests.  The SEC has been pondering a broker fiduciary rule for many years but lost the regulatory race to the Department of Labor, which promulgated its own rule.  Now that the 5th Circuit has vacated the DoL Rule and the SEC has proposed its own rule, the current state of the law is unclear.  Regardless, we have read the release and offer our list of the 10 things you need to know about proposed Regulation Best Interest.

10 Things You Need to Know About Regulation Best Interest

  1. Reasonable basis.  A broker must have a reasonable basis that the recommendation is in the best interest of the client.
  2. Applies to retail customers.  A retail customer is defined as a person who uses the recommendation primarily for personal, family, or household purposes.
  3. “Recommendation” remains the same.  The proposal does not seek to change the definition of “recommendation,” preferring to defer to the current FINRA interpretations.
  4. No definition of “best interest”.  In 400+ pages, the SEC never defines the term “best interest” when proposing Regulation Best Interest.
  5. More than suitability, less than fiduciary.  Regulation Best Interest combines elements of the current suitability standard (e.g. suitable at time of transaction) with a few fiduciary-like elements (e.g. disclosure).
  6. Fails to harmonize RIA and BD standards.  Advocates of a uniform fiduciary standard want a single standard so that consumers are not confused by the differing standards of care applicable to advisers vs. brokers.  This proposal fails to ensure a “uniform” standard.
  7. Disclosure of conflicts of interest.  The most significant new requirement is that brokers must disclose (or mitigate) conflicts of interest.
  8. Must consider series of transactions.  Expanding traditional suitability, a broker must also consider the series of recommended transactions.
  9. Product neutrality not required.  Brokers can make more money on recommended products, including proprietary products, so long as the conflict is properly disclosed and mitigated.
  10. Regulation Best Interest is not law.  Comments are due on this controversial proposal by August 7, 2018.  Thereafter, we expect much debate and re-drafting before any final rule is adopted.

FINRA Proposal Eliminates Control/Discretion Defense to Churning

FINRA has proposed changing the suitability standard so that brokers could have liability for excessive trading even if the broker did not exert control or discretion over the client’s account.  Current FINRA rules require a showing of control before FINRA could charge a broker with churning.  FINRA questions whether this control element puts a “heavy and unnecessary burden on customers by, in effect, asking them to admit that they lack sophistication or the ability to evaluate a broker’s recommendation.”  FINRA says that this control element may not be appropriate in light of the recently proposed SEC’s Regulation Best Interest.  FINRA would evaluate churning based on the total facts and circumstances including turnover rate (e.g. greater than 6), cost-to-equity ratio (e.g. greater than 20%), or the use of in-and-out trading.

OUR TAKE: Brokers, and their compliance officers, have long relied on the regulatory distinction between accounts over which they exercised discretion versus directed accounts.  This proposal eliminates that ostensible compliance bright line which really has very little meaning in the real world where retail clients rely on broker recommendations.  Acting in a client’s best interest should not depend on how much control a broker exercises.

http://www.finra.org/sites/default/files/notice_doc_file_ref/Regulatory-Notice-18-13.pdf

SEC Upholds FINRA Bar Based on Untruthful Form U4

 

The SEC has upheld a statutory disqualification imposed by FINRA for failing to file a truthful U4 and lying on compliance questionnaires.  FINRA barred the appellant from the securities industry because his Form U4 failed to disclose federal tax liens and a bankruptcy and because he provided false responses on his firm’s annual compliance questionnaires.  The appellant sought a stay of the disqualification on the grounds that he would get fired from his current job and suffer economic harm.  The SEC rejected his argument and denied the appeal because FINRA has an interest in protecting investors, and a stay of the statutory disqualification for material failures on Form U4 “could endanger investors.”

OUR TAKE: FINRA and the SEC take Form U4 (and annual compliance questionnaires) very seriously.  The regulators view the disclosure as a lynchpin to protecting investors.

 

Brokers Can Block Disbursements to Senior Investors Under New FINRA Rule

 

Following recent SEC approval, FINRA’s new rule allowing firms to block disbursements to senior investors goes into effect on February 5, 2018.  The rules allow members to put a 25-day hold on suspicious disbursements of funds for any customers over the age of 65 and for any other customer that the member reasonably believes has a relevant mental or physical impairment.  The rule allows, but does not require, a member to hold funds if the member “reasonably believes that financial exploitation…has occurred, is occurring, has been attempted, or will be attempted.”  During the hold, the member must try to contact the designated “Trusted Contact Person” previously named by the account holder.  To enforce the rules, members must adopt and implement applicable written supervisory procedures and ensure retention of relevant records.

 

OUR TAKE: The new rules create significant compliance obligations for account opening, procedures, testing, and record retention.  They also will likely require a process to resolve potential conflicts between senior investors and the brokers that hold their assets.

 

http://www.finra.org/sites/default/files/Regulatory-Notice-17-11.pdf

Adviser Barred for Failing to Register as BD for Private Fund Sales

A financial adviser was barred from the industry and ordered to pay over $400,000 in disgorgement and interest for failing to register as a broker-dealer while selling interests in a private fund.  According to the SEC, the respondent identified investors, communicated with them (including in person), advised prospective investors on the merits of the investment, assisted handling funds, and collected transaction-based commissions.  The adviser sold notes issued by a third party fund that ultimately defaulted.  The SEC charges that the respondent’s activities violated Section 15(a)(1) of the Exchange Act, which requires registration as a broker-dealer to sell securities.

OUR TAKE: Over the last couple of years, the SEC has increased enforcement efforts to prosecute individuals and firms who sell private funds without registering as, or becoming affiliated with, a broker-dealer.

 

SEC, Not FINRA, Brings Churning Case Against 2 Brokers

trust me

 

The SEC charged two brokers with churning and excessive trading in customer accounts.  The SEC accuses the brokers of engaging in excessive short-term trading that had little chance of benefiting customers after payment of fees.  Both brokers, who had significant disciplinary histories, used telemarketing and cold-calling to find clients who they pressured with pre-filled agreements and margin arrangements.  An SEC official commented, “This case marks another chapter in the SEC’s pursuit of brokers who deploy excessive trading as a strategy in customer accounts to enrich themselves at customers’ expense.”

OUR TAKE: It is very unusual for the SEC to bring suitability and churning cases against individual brokers.  These types of cases are usually FINRA’s jurisdiction.  Perhaps this is the beginning of the SEC moving to regulate retail brokers in response to the DoL fiduciary rule.