If there is one thing the financial industry can depend on, it’s change. Surviving in the industry is dependent on your firm’s ability to adapt to the changing regulatory landscape. Thriving, however, is an art form based around staying ahead of change. There has been no bigger area of change than the constantly evolving standard of care regulations applicable to broker-dealers serving retail customers. From the previous DOL Fiduciary Rule, to the patchwork of state regulations, firms have been under increased pressure to keep up with their compliance. In June 2019, the US Securities and Exchange Commission (SEC) introduced and enacted Regulation Best Interest (Reg BI) to throw in another challenge. And while Reg BI has not stopped the advancement of state regulations, nor the advancement of a new fiduciary rule by the DOL, there are several things we can say with reasonable certainty:
• Reg BI requires compliance very soon and broker-dealers should be implementing procedures now, if they have not already done so.
• Broker-dealers will be subject to a heightened standard of care when dealing with retail investors.
• The final federal standard of care will include enhanced disclosure obligations.
• Any final state-mandated standards of care will most likely include enhanced disclosure obligations.
• Upcoming broker-dealer examinations will focus on preparation for Reg BI.
It is unlikely that litigation challenging Reg BI will be resolved by the compliance date of June 30, 2020. This means broker-dealer exams specifically will focus on how, and whether, firms are complying with their obligations under Reg BI and whether firms are supervising their registered representatives (RRs) in fulfilling their individual obligations.
Not if…But when?
The SEC and FINRA announced that their 2020 exam and risk monitoring efforts will focus on how firms are preparing for Reg BI and, after June 30, 2020, will focus on firms’ compliance with Reg BI. Thus, the issue is not whether your firm will be examined on how it is preparing for or, after June 30, complying with Regulation Best Interest, the question is if your firm will be prepared?
The secret formula for your exam – supervise, disclose and document (S+D+D)
Regulators will be placing emphasis on supervision and will focus on whether firms are collecting the information they need to supervise RR recommendations, whether the collected information is sufficient to inform firms regarding the basis of RRs’ recommendations and what, if any, conflicts of interest exist that may impact the nature or quality of the RRs’ recommendations. Individual RR disclosures are an extremely logical step towards complying with this aspect of Regulation Best Interest, and something the industry is overlooking. Disclosures have been a central regulator focus for some time. Firms cannot disclose what they do not know; and firms will not know what they have not asked.
This is the very problem that individual RR disclosures can solve. Individual RR disclosures document that:
• your firm is collecting information to review/supervise its RRs’ recommendations;
• firms are collecting information regarding RRs’ specific conflicts of interest;
• firms have the documentation on hand to assess whether, and how, those specific conflicts impacted the RRs’ ability to make a recommendation that is in the retail investor’s best interest; and
• the scope and nature of the information collected.
And, if last year’s FINRA 529 Plan Share Class Initiative (529 Plan Initiative) told us anything, it is that documentation will go a long way in defending your firm’s supervisory effort. In particular, the SEC’s Office of Compliance Inspections and Examinations noted that firms did not document advisers’ assessments, including the factors that went into those assessments. While that guidance is not applicable to broker-dealers, it demonstrates the importance the SEC places on documentation. Broker-dealers may need to create a separate disclosure document for each RR to ensure they meet Reg BI’s Disclosure Obligation.
FINRA’s 529 Plan Initiative underscored the importance of having adequate documentation. Firms participating in the 529 Plan Initiative were encouraged to self-report potential supervisory and suitability violations in respect of 529 plan recommendations. In its subsequently published Frequently Asked Questions regarding the 529 Plan Initiative, FINRA advised that the initiative arose from concerns regarding how firms were supervising representatives’ 529 plan recommendations. In particular, FINRA noted that as it was examining firms, it was finding that many firms did not even have the documentation needed to supervise recommendations. Thus, it’s clear that explaining what a firm did to fulfill its supervisory obligations will not be enough. FINRA will want firms to “show their work” through documentation.
Conclusion
These efforts were, essentially, a reminder to the industry that it will not be enough to show that recommendations were in the retail investor’s best interest. Instead, firms that want to be prepared for these examinations should be in a position to show regulators:
• They collected information to assess recommendations; and
• Had reasonable procedures in place to review that information.
Firms should be guided by this not-so gentle reminder as they prepare for Regulation Best Interest, and individual RR disclosure should be an integral part of your firm’s S+D+D preparation process.
