OCIE Publishes Risk Alerts Providing Advance Information Regarding Inspections for Compliance with Regulation Best Interest and Form CRS

The Securities and Exchange Commission’s Office of Compliance Inspections and Examinations issued two Risk Alerts (Risk Alerts)¹ on April 7, 2020, identifying the scope and content of OCIE’s initial examinations following the June 30, 2020 dates for compliance with Regulation Best Interest² (Reg. BI Risk Alert) and Form CRS³ (CRS Risk Alert).

Reg. BI Risk Alert

Regulation Best Interest requires broker-dealers and their associated persons to act in the best interest of their retail customers at the time of making recommendations regarding any “securities transaction or investment strategy involving securities (including account recommendations)” and to place the interests of the retail customers ahead of the financial or other interests of the broker-dealer and its associated persons. Regulation Best Interest consists of four component obligations: the Disclosure Obligation; the Care Obligation; the Conflict of Interest Obligation; and the Compliance Obligation.

The Reg. BI Risk Alert indicates that: OCIE will examine broker-dealers to assess their compliance with Regulation Best Interest; and the emphasis of such examinations will be on whether broker-dealers have made a “good faith effort to implement policies and procedures reasonably designed to comply with Regulation Best Interest, including the operational effectiveness of broker-dealers’ policies and procedures.” Although the Reg. BI Risk Alert describes the four “primary focus areas for the initial Regulation Best Interest Exams,” it also cautions that “the staff may select additional areas for review based on risks identified during the course of examinations.” According to the Reg. BI Risk Alert, “initial examinations ... will likely occur during the first year after the [June 30, 2020,] compliance date.”

Disclosure Obligation

Under Regulation Best Interest, broker-dealers must provide each retail customer with full and fair written disclosure of “all material facts relating to the scope and terms of the relationship,” including: the capacity in which the broker-dealer or its associated persons are acting; all material fees and costs associated with a customer’s transactions, holdings and accounts; the type and scope of services being provided, as well as any material limitations on the securities or investment strategies that may be recommended; and all material facts relating to conflicts of interest associated with the recommendation. The Disclosure Obligation requires that disclosure be provided at or prior to the time of the recommendation.

In reviewing compliance with the Disclosure Obligation, the Reg. BI Risk Alert states that OCIE may review the content of broker-dealers’ disclosures and other records to determine whether all required disclosures have been made to retail customers covered by Regulation Best Interest. In addition, OCIE may review broker-dealers’ timing in delivering their disclosures. Among the documents that OCIE may request in reviewing compliance with the Disclosure Obligation are:

• Fee schedules;
  
  
• Documents outlining compensation methods for registered personnel (e.g., compensation tied to retail customer recommendations, sources and types of compensations, and related conflicts of interest);
  
  
• Disclosures related to the monitoring of customer accounts; disclosures of material limitations on accounts or services recommended to retail customers; and
  
  
• Lists of proprietary products offered to retail customers.
  

Care Obligation

Regulation Best Interest “requires a broker-dealer to exercise reasonable diligence care, and skill when making a recommendation to a retail customer.” The broker-dealer must have a reasonable basis to believe that its recommendation with respect to a particular security or investment strategy could be in the best interest of “at least some” retail customers, taking into account the “potential risks, rewards, and costs associated with the recommendation.” The broker-dealer also must have a reasonable basis to believe that a recommendation is in the best interest of the retail customer at the time the recommendation is made “based on that retail customer’s investment profile and the potential risks, rewards and costs associated with the recommendation and [which] does not place the financial or other interest of the [broker-dealer or the associated person of the broker-dealer] ahead of the interest of the retail customer.” Further, in the case of a series of transactions, the broker-dealer must have a reasonable basis to believe that the series, viewed as a whole, is in the best interests of the retail customer and is not excessive, even if each transaction would be in the retail customer’s best interest when viewed individually.

To assess compliance with the Care Obligation, the Reg. BI Risk Alert states that OCIE may review the information collected by a broker-dealer from its retail customers for purposes of developing retail customer investment profiles, as well as a broker-dealer’s:

• Procedures for forming reasonable basis recommendations for retail customers, including the factors that the broker-dealer uses to evaluate the potential risks, rewards and costs of recommendations in view of a retail customer’s investment profile;
  
  
• Processes for achieving a reasonable basis to believe that it has not placed its interests ahead of those of the retail customers;
  
  
• Processes for making recommendations related to “significant investment decisions,” including rollovers of retirement accounts and account recommendations; and
  
  
• Methodology for determining that it has a reasonable basis to believe that more complex, risky or expensive products are in a retail customers’ best interest, and its processes for recommending such products.
  

Conflict of Interest Obligation

Under Regulation Best Interest, a broker-dealer must have in place and enforce written policies and procedures that are reasonably designed to identify, and, at a minimum disclose, all conflicts of interest associated with recommendations to retail customers. In the case of conflicts of interest that create incentives for associated persons to place their or the broker-dealer’s interest ahead of a retail customer when making recommendations, the broker-dealer also must mitigate such conflicts. However, in the case of any sales contests, sales quotas, bonuses or non-cash compensation that are based on the sales of specific securities or types of securities within a limited period of time, such practices must be eliminated.⁴

In reviewing for compliance with the Conflict of Interest Obligation, OCIE may review a broker-dealer’s policies and procedures, including those with respect to:

• Conflicts associated with:
  
  
  • Incentives for associated persons to place their or the broker-dealer’s interests ahead of the retail customer’s interest;
    
    
  • Material limitations on the securities, or investment strategies involving securities (particularly, limited product menus, proprietary product-only offerings, or products with third-party arrangements), which may be recommended to a retail customer; and
    
    
  • The elimination of all sales contests, sales quotas, bonuses and non-cash compensation that are based on the sales of specific securities or types of securities within a limited period of time.
    
    
• Demonstrating its “structure for identifying the conflicts that the broker-dealer or its associated person[s] may face,” which can include documentation identifying “all conflicts associated with the broker-dealer’s recommendations.”
  
  
• How the broker-dealer uses its policies and procedures to: identify and assess conflicts as its business changes over time; disclose conflicts; and, as appropriate, eliminate or mitigate conflicts (including “what conflicts are mitigated or eliminated”).
  

OCIE’s requests may include production of “all policies and procedures in place during the [examination] period,” which could extend to points in time prior to the Regulation Best Interest compliance date of June 30, 2020.

Compliance Obligation

In addition to policies and procedures related to the Conflict of Interest Obligation, Regulation Best Interest requires that broker-dealers implement and enforce written policies and procedures reasonably designed to ensure compliance with Regulation Best Interest generally.

In order to assess a broker-dealer’s compliance with the Compliance Obligation, the Reg. BI Risk Alert states that OCIE may review a broker-dealer’s policies and procedures and evaluate “any controls, remediation of noncompliance, training, and periodic review and testing included as part of those policies and procedures.”

Sample Information List

In the Reg. BI Risk Alert, OCIE included a three-page sample list of information that it may request from a broker-dealer when conducting a Regulation Best Interest examination (Sample Request). Although the Sample Request should not be considered to be all-inclusive, and the Reg. BI Risk Alert acknowledges that “[n]ot every document listed ... will be applicable to every firm,” the Sample Request is a helpful tool for a broker-dealer to assess whether it has the core documents that OCIE might request in connection with a potential Regulation Best Interest examination. The Sample Request includes requests for information about the four component obligations outlined above, as well as information regarding the broker-dealer’s: retail customers; brokerage and non-brokerage accounts; products offered (including proprietary products); retail marketing materials; selling arrangements with third parties; Regulation Best Interest disclosure document; processes for making oral disclosures; and Form CRS. The Sample Request also includes all policies, procedures and other materials related to Regulation Best Interest compliance, training materials on Regulation Best Interest and compliance monitoring reports.

CRS Risk Alert

The Form CRS relationship summary is intended to provide clarity and assist investors in comparing firms, by providing information about: “(i) the types of client and customer relationships and services the firm offers; (ii) the fees, costs, conflicts of interest, and required standard of conduct associated with those relationships and services; (iii) whether the firm and its financial professionals currently have reportable legal or disciplinary history; and (iv) how to obtain additional information about the firm.” For investment advisers, the relationship summary is new Part 3 of Form ADV.

The CRS Risk Alert, as with the Reg. BI Risk Alert, states that, after June 30, 2020, OCIE will begin examinations focusing on Form CRS compliance by broker-dealers, SEC-registered investment advisers and investment advisers with registration applications pending before the SEC (collectively, covered firms), with a focus on whether the covered firm has “made a good faith effort to implement Form CRS.”

Delivery and Filing

Covered firms must electronically file their initial relationship summaries on Form CRS with the SEC between May 1, 2020, and June 30, 2020. Broker-dealers that are required to deliver Forms CRS to investors will file the form electronically through FINRA’s Central Registration Depository, and investment advisers that are required to deliver Part 3 of Form ADV to investors will file electronically through the Investment Adviser Registration Depository (IARD) system.

After June 30, 2020, newly registered broker-dealers will be required to file Form CRS before the effective date of their registration with the SEC, and investment advisers seeking SEC registration (and which expect to have clients to whom a Part 3 must be delivered) will include their Part 3 with the initial application for registration on Form ADV. In addition, covered firms must deliver their relationship summaries to all existing retail investors on an initial, one-time, basis within 30 days after the date the covered firm is required to file its relationship summary with the SEC. For new retail investors, the Form CRS must be delivered before or at the time an account is opened.

The CRS Risk Alert explains that OCIE’s examinations may include an assessment of: (1) whether the covered firm has filed the Form CRS and any amendments, and whether the Form CRS is posted publicly on the covered firm’s website (if the firm maintains a public website); (2) the covered firm’s mechanism for delivering the Form CRS to new and existing retail investors; and (3) the covered firm’s Form CRS policies and procedures, to determine if they address the required delivery processes (including timing for deliveries). OCIE also may review a covered firm’s records showing its delivery of each Form CRS, in order to determine if the delivery obligations with respect to new and existing investors were met with respect to: the opening of new accounts (or entering into new advisory agreements);  placing of orders; recommendations of retirement account rollovers; and recommendations of new brokerage or investment advisory services or investments, even if no new account is opened or the investment is not held in an existing account.

Content

Form CRS provides information related to certain categories of data that the SEC believes to be important for retail investors to consider when choosing a firm or financial professional. Form CRS sets forth general content and presentation requirements for a relationship summary. It also requires specific disclosures within each category of information, to the extent applicable to the firm.

The CRS Risk Alert explains that OCIE may review the content of a covered firm’s Form CRS to evaluate whether: all required information has been included; the information is true and accurate; and there are any omissions of material facts.⁵ In this regard, OCIE may review the covered firm’s descriptions of the services and relationships it offers to retail investors, including: account monitoring and investment authority; the compensation that it and its associated persons receive; and conflicts of interest.⁶ OCIE also may review the disclosures related to fees and costs,⁷ which may include an examination of the firm’s fee schedules and other agreements to confirm that fee disclosures in the Form CRS are consistent.

Formatting

Form CRS includes specific formatting instructions, including page limits. The CRS Risk Alert explains that OCIE may review whether the covered firm followed these instructions, including whether the Form CRS contains “particular wording where required, it uses text features where required, and it is written in plain English.”

Updates

Form CRS must be updated and filed within 30 days after the relationship summary becomes materially inaccurate, with such updates being communicated to retail investors within 60 days after the relationship summary becomes materially inaccurate. The CRS Risk Alert explains that OCIE may review a covered firm’s policies and procedures related to updating Form CRS and communicating updates to retail investors. OCIE also may evaluate how such firms: notify retail investors of changes to Form CRS; and identify or summarize material changes with any filed updates.

Recordkeeping

Form CRS imposes certain recordkeeping requirements. Registered investment advisers must retain records in accordance with Rule 204-2 under the Investment Advisers Act of 1940, and broker-dealers must maintain Form CRS-related records for at least six years pursuant to Rule 17a-4 under the Securities Exchange Act of 1934. The CRS Risk Alert explains that OCIE may review a covered firm’s records relating to its Form CRS delivery obligations, as well as its policies and procedures relating to record making and retention to evaluate whether a covered firm complies with the Form CRS delivery and recordkeeping requirements.

FINRA

Following the SEC’s publication of the Risk Alerts, FINRA issued a press release stating that it would take the same approach as OCIE with respect to examinations of broker-dealers and their associated persons for compliance with Regulation Best Interest and Form CRS. In particular, FINRA stated that its “initial approach will focus primarily on assessing whether [broker-dealers] have made a good faith effort to establish and implement policies and procedures reasonably designed to comply with Reg BI and Form CRS.” FINRA noted, however, that it will take action if it sees indications of customer harm or conduct that would have violated Rule 2111 (Suitability Rule) or other FINRA conduct standards.

Conclusion

The SEC (and FINRA) have indicated that these regulators understand that the COVID-19 coronavirus has created challenges for covered firms. Accordingly, both regulators have indicated that their initial examinations will focus primarily on whether covered firms are making, and continuing, good faith and reasonable efforts to comply with Regulation Best Interest and Form CRS. The Risk Alerts provide useful tools to help firms evaluate their preparations, practices and procedures in advance of the June 30, 2020 compliance date for Regulation Best Interest and Form CRS.

Footnotes

1) All statements in this OnPoint as to as to the intent or plans of OCIE are based on the text of the Risk Alerts.

2) Regulation Best Interest: The Broker-Dealer Standard of Conduct, 84 Fed. Reg. 33318 (2019).

3) Form CRS Relationship Summary; Amendments to Form ADV, Release Nos. 84 Fed. Reg. 33492 (2019).

4) FINRA recently proposed to update to its non-cash compensation rules to also eliminate sales contests, sales quotas, bonuses or non-cash compensation, which are based on the sales of specific securities or types of securities within a limited period of time, in order to align with Regulation Best Interest. For further information regarding this proposal, please refer to Dechert OnPoint, FINRA Moves Forward with Proposed Amendments to its Suitability and Non-Cash Compensation Rules.

5) This includes assessing whether accurate information regarding the legal and disciplinary history of the covered firm and its registered persons has been provided in the Form CRS.

6) OCIE stated that this would include “incentives related to proprietary products, third-party payments, revenue sharing, and principal trading.”

7) OCIE stated that this includes “the principal fees and costs that retail investors will incur, other fees and costs related to services and investments that retail investors will pay directly or indirectly, and examples of the categories of the most common fees and costs applicable to the covered firm’s retail investors (e.g., custodian fees, account maintenance fees, fees related to mutual funds and variable annuities, and other transactional fees and product level fees).”