It should come as no surprise to financial industry participants that the first Risk Alert published by the SEC’s Division of Examinations (the “Division”) in 2023 relates to Regulation Best Interest (“Reg BI”). The Risk Alert presents the Division’s observations from previously announced exam initiatives and reminds firms that the Division will be focused on Reg BI matters during retail examinations – especially where sales practice considerations are in the scope of an exam. Diligent firms have spent significant resources to understand and address Reg BI compliance. In continuing those efforts, firms are encouraged to absorb key lessons presented by this broad – initial – glimpse into the SEC’s view on real world applications of the Reg BI standards.

Care Obligation: Exercise reasonable diligence, care, and skill when making a recommendation to a retail customer.

  • The Division noted instances where broker-dealers or financial professionals failed to understand the recommended product.
  • The Risk Alert refers to firms failing to obtain, or otherwise consider, the customer’s investment profile, and their failure to understand the potential risks and costs associated with certain recommendations.

Conflict of Interest Obligation: Establish, maintain, and enforce reasonably designed written policies and procedures addressing conflicts of interest associated with recommendations to retail customers.

  • Policies and procedures must describe how conflicts of interest are to be identified or addressed with reasonable specificity. Furthermore, the policies and procedures should reflect all conflicts of interest related to recommendations made by the firm or financial professionals, and not just the more significant or egregious conflicts of interest.
  • Disclosure of conflicts of interest alone is not sufficient under Reg BI. Firms are also required to establish policies and procedures that identify and mitigate conflicts of interest at the financial professional level.

Disclosure Obligation: Before or at the time of a recommendation, a broker-dealer must disclose, in writing, all material facts about the scope and terms of its relationship with the customer.

  • Firms fail to meet their obligations under Reg BI where they only post the Reg BI disclosures on their website, or reference the disclosures in other documents delivered to customers.
  • Policies and procedures must ensure that financial professionals acting in multiple roles (e., are registered representatives and investment adviser representatives) disclose to customers the capacity in which they are acting prior to or at the time of a recommendation. Similarly, the policies and procedures must also identify the specific conflicts of interest associated with the multiples roles that should be disclosed. 

Compliance Obligation: Establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Reg BI.

  • Generic written policies and procedures that are not tailored to the firms’ business model, or otherwise simply restate Reg BI’s requirements are insufficient.
  • Policies and procedures must be sufficiently detailed to comply with the obligations imposed by Reg BI.
  • An appropriate compliance program must have an adequate training program and periodic review and testing. Notably, the Division indicated that firms relying on surveillance systems in place prior to the effective date of Reg BI should consider whether those systems require modification or update in light of the newer standard. 
  • Employee trainings should not only provide information on Reg BI, but also incorporate the firms’ processes for compliance.

The Division has made it clear that it intends to incorporate compliance with Reg BI into retail focused examinations of firms, particularly those examinations relating to sales practices. In addition, we are increasingly seeing significant state inquiries and sweeps designed to assess Reg BI compliance.

In other words, in the coming year firms will be expected to have addressed the deficiencies highlighted in this Risk Alert.  We anticipate that regulatory assessments will focus increasingly more on recommendations made by financial professionals, disclosure practices, and firm’s supervisory controls supporting compliance with applicable policies.  We therefore encourage our clients to continue to conduct up-to-date assessments of their Reg BI policies and procedures, as well as to continue to educate and train relevant personnel. Doing so will support the firms’ efforts to comply with Reg BI and ensure their readiness for anticipated regulatory scrutiny from the SEC and state securities regulators.

The SEC Risk Alert can be found here.

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