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
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.
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.
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.
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.
Use of “advisor”. Broker-dealers will be restricted in their use of the term “advisor” or “adviser.”
Due Diligence. Advisers will have a need to conduct a greater amount of due diligence on retail clients (as compared to institutional clients).
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.
Conflicts Disclosure. An adviser must include specific disclosure about applicable conflicts of interest and not merely describe conflicts as hypothetical or possible.
Investment Discretion. Absent limiting circumstances, a broker dealer with investment discretion must register as an investment adviser.
Monitoring Compensation. Receiving compensation to provide ongoing account monitoring would require investment adviser registration.
It is unclear how much due diligence is enough, but an investment that promises a 1000% return likely requires more than a few phone calls. When financial professionals recommend a losing investment, they bear the burden of proving that their recommendations and due diligence satisfied their fiduciary and/or suitability obligations.
At the very least, member firms should review their 529 Plan recommendations to see if they have exposure and then take action to remediate. Because of the broader implications of an enforcement action and individual liability, we recommend consulting counsel about whether to self-report.
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.
The SEC fined a large IA/BD $8 Million because it failed to implement compliance policies and procedures for the sale of single-inverse ETFs. Following warnings from FINRA and SEC OCIE staff, the respondent adopted policies and procedures requiring (i) every client to sign a Client Disclosure Notice and (ii) a supervisor to review all recommendations for suitability. However, over a 5-year period thereafter, the SEC maintains that 44% of clients did not sign a Disclosure Notice and most did not undergo adequate supervisory reviews. Consequently, the firm made several unsuitable recommendations including to retirement account clients. The SEC cites violations of the Adviser’s Act’s compliance rule (206(4)-7), which requires advisers to adopt and implement policies and procedures reasonably designed to ensure compliance with the Advisers Act.
OUR TAKE: The SEC will severely punish recidivists who were notified of deficiencies during a prior exam. In this case, the IA/BD specifically undertook to fix the identified suitability concerns but failed to implement those policies, thereby allowing the violative conduct to continue.
A large broker-dealer agreed to pay over $15 Million in disgorgement and fines for failing to adequately train its reps about the risks of structured notes sold to retail investors. The SEC maintains that its rep training did not include sufficient information about volatility and breach risk such that the reps could satisfy their reasonable basis suitability obligations. Over a 3-year period, the firm sold over $500 Million (notional amount) in the subject structured notes to more than 8,000 retail customers. The SEC charges the firm with failure to supervise.
OUR TAKE: What is interesting about this case is that the SEC holds the firm accountable for failure to properly train the reps, rather than pointing the finger at the compliance department or the reps themselves. This continues the trend of holding organizations and senior executives accountable for compliance failures. Also, firms have a high regulatory burden when selling complex financial products to retail investors.