Notwithstanding the COVID-19 pandemic and disruption in the financial markets, the U.S. Securities and Exchange Commission (SEC) continues to press forward on implementation of Regulation BI and Form CRS. Recent examination risk alerts provide guidance for financial intermediaries.
Regulation BI And Form CRS
According to a statement by Chair Clayton on April 2, 2020, the Commission plans to maintain the June 30, 2020 implementation date for Regulation Best Interest, including the requirement to file the new Form CRS. Regulation BI establishes a new standard of conduct for broker-dealers and associated persons when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer. Form CRS requires registered investment advisors and broker-dealers to deliver to retail investors and to file with the Commission a brief customer or client relationship summary that provides information about the firm. Given the Chair’s support for continued implementation, expect additional scrutiny from the examination and enforcement programs in the coming years.
Examination Risk Alerts
Particularly for broker-dealer firms and investment advisors, the SEC examination program is the leading edge of enforcement activity. Today’s examination imperatives fuel tomorrow’s enforcement actions. Broker-dealers and dual registrants should pay particular attention to recent examination risk alerts focused on Regulation BI and Form CRS.
Regulation BI
After June 30, 2020, the Office of Compliance Inspections and Examinations (OCIE) will begin examinations assessing whether a broker-dealer has satisfied its Regulation BI obligations. According to the OCIE risk alert, a broker-dealer must comply with four component obligations to satisfy its obligation under Regulation BI:
• Disclosure Obligation: A broker-dealer is required to disclose to a retail customer all material facts regarding (1) the scope and terms of the relationship and (2) conflicts of interest associated with the recommendation. To determine compliance, staff may assess the capacity in which the recommendation was made, material fees and costs assessed to the retail customer, and material limitations on the recommended investments.
• Care Obligation: A broker-dealer must practice reasonable diligence, care, and skill when making a recommendation to a retail customer. A broker-dealer must understand and consider potential risks, rewards, and costs with respect to the retail customer’s investment profile when making a recommendation to the retail customer.
• Conflict-of-Interest Obligation: A broker-dealer is required to establish, maintain, and enforce written policies and procedures to address any conflicts of interest related to recommendations made to retail customers.
• Compliance Obligation: A broker-dealer must establish, maintain, and enforce written policies for complying with the entirety of Regulation BI.
OCIE outlines the types of documents a broker-dealer can expect the staff to request when assessing compliance with each component obligation of Regulation BI. The staff will review disclosures made to retail customers, fee and expense schedules, materials related to compensation, account opening files and customer risk profiles, documents relating to the process for making recommendations and monitoring accounts, documentation of conflicts, lists of proprietary products sold to customers, and written policies and procedures for compliance with Regulation BI. As part of the examinations, staff may select additional topics beyond the identified focus areas for review if they identify additional risks.
From a substantive point of view, examination and enforcement staff are likely to scrutinize fees and expenses, compensation arrangements, rollovers, and the sale of high-priced and complex products. Given other Commission priorities, registrants also should be mindful of accounts held for elderly customers.
Form CRS
Initial examinations to assess compliance with Form CRS also will begin after June 30, 2020. In a separate risk alert, OCIE identifies several areas firms should be prepared to address in the initial examinations:
• Delivery and Filing: The staff may review the firm’s filing of its relationship summary. The staff also may evaluate the process for delivering the summary to both existing and new retail customers and review policies and procedures for delivering the relationship summary. The firm should be prepared to review records showing the dates retail customers received the relationship summary from the firm. Existing retail customers must receive the relationship summary by July 30, 2020 and before opening new accounts, recommending a rollover, or recommending new products or services not held in an existing account. New retail customers should receive the summary at the initiation of the investment relationship, before making an investment recommendation, placing an order, or opening a brokerage account.
• Content: Examination staff may assess whether the relationship summary includes all required information and whether the information that it contains is true and accurate and is not misleading. The staff will review the firm’s description of the relationships and services it offers to retail customers, costs and fees, compensation, conflicts of interest, and disciplinary or legal history.
• Formatting: The staff plans to review the format of the summary to determine if it complies with the instructions, including whether it is written in plain English and includes certain required wording.
• Updates: OCIE may evaluate firm policies and procedures for updating the relationship summary, including how and whether the firm updates and files the summary within thirty days after information becomes materially inaccurate, how and whether the firm communicates changes to retail customers within sixty days after the updates must be made, and the firm’s process for highlighting changes for retail customers.
• Recordkeeping: A review of the firm’s records documenting delivery of the relationship summary and policies and procedures for related recordkeeping also may occur during the examination.
Guidance
The recent examination alerts are the next step in the chain from regulatory initiative, to guidance and compliance assessments, to enforcement actions. To reduce the risk of SEC enforcement action, broker-dealers and dual registrants should consider taking the following steps:
• Methodically catalogue all forms of compensation and potential conflicts of interest. For example, identify revenue streams and material agreements with third parties, as well as all expenses charged to customers. The examination staff will do the same when it conducts the examination.
• Use available data to identify high-risk accounts—accounts for elderly customers or holding certain types of high-risk products.
• Good disclosure will avoid concerns about compensation arrangements and potential conflicts. Pay particular attention to representative incentives and material limitations on product offerings.
• Written policies and procedures and documentation of compliance are critical to the examination process. Take the time to customize off-the-shelf procedures and document compliance with those procedures. Specifically document any remediation of noncompliance, training, and periodic review and testing.
• Document the initial delivery of Form CRS and any updates.
The examination response is critical to avoiding enforcement referrals. Given the novelty of this regulatory scheme, the examination and enforcement programs likely will be forgiving of reasonable lapses that quickly are corrected by registrants. However, that same novelty also will encourage the Commission to identify more egregious failures through public enforcement action.
Paul Helms, a partner at international law firm McDermott Will & Emery and a former SEC Enforcement attorney, manages risk associated with complex securities issues. He defends clients facing SEC and government inquiries, conducts internal investigations and handles securities litigation. Emilie O’Toole, an associate at McDermott, focuses her practice on litigation matters and investigations.