During its first-ever review of compliance with Regulation Best Interest (Reg BI), the Financial Industry Regulatory Authority (FINRA) found significant numbers of broker dealers failing to achieve full compliance. By reporting the most common deficiencies, the agency presents a guide to help industry members focus their due diligence. RumbergerKirk partner Pete Tepley walks us through it.
The SEC’s 2019 adoption of Reg BI, which I wrote about in 2020, imposed a standard of conduct for financial advisers and other broker-dealers, as well as mandating additional transparency for clients. Under the Reg BI standard, broker-dealers and their associated persons (APs) may never place their own or their firm’s financial interests ahead of those of their retail customers.
More recently, in February 2022, FINRA published its first detailed examination of performance against Reg BI and related regulatory compliance. As that report makes clear, too many in the industry have failed to fully embrace or implement the requirements of Reg BI.
Recalling the fundamentals of Reg BI, when recommending a securities transaction or investment strategy or making account recommendations, firms and APs must meet four fundamental obligations relating to:
- Disclosure: What must be shared with clients?
- Care: What processes are in place to ensure strategies and products are appropriate for any specific client?
- Conflicts of interest: These must be eliminated, mitigated, or if unavoidable, fully disclosed.
- Compliance: Demonstrate governance to ensure these obligations are being met
The Reg BI portion of FINRA’s 2022 Report looks at a range of deficiencies. Here are some of the highlights.
Learn From Others’ Mistakes
Regarding the compliance obligation, FINRA breaks deficiencies into two major categories:
- Written supervisory procedures (WSP) that do not achieve compliance with Reg BI
- Inadequate training of APs on how to comply with the requirements of Reg BI
Specifically, FINRA found that some firms’ WSPs:
- Merely stated Reg BI’s requirements without detailing how the firm would comply
- Did not address how its APs should consider costs and registered annuity advisors (RAA) when making recommendations
- Did not address conflicts of interest that create an incentive for APs to place their interests ahead of their customers
FINRA also found that some firms had failed to develop adequate controls or alternatively developed but failed to document their controls. Firms also conducted inadequate training, failing to prepare their APs for compliance with Reg BI. FINRA found specifically that training was unclear or did not provide APs with specific steps to follow.
In terms of the care obligation, FINRA found that firms and APs were:
- Making recommendations that were not in the best interest of the customer based upon the customer’s individual circumstances
- Recommending a series of transactions that were excessive considering the customer’s investment profile
Moving to conflicts of interest, FINRA found situations in which such issues were either not identified or, if identified, not adequately addressed. As for disclosure obligations, FINRA found that customers were not being provided full and fair disclosure of material facts, including:
- Material fees received from recommendations, such as revenue-sharing, payments from product providers or issuers or fees tied to roll-over recommendations
- Potential conflicts of interest where the AP was trading in the same securities or had outside employment
- Material limitations on the securities offered
FINRA’s Recommended Best Practices
To help counter deficiencies, FINRA provided a list of effective practices it views as effective for meeting Reg BI obligations. Key steps include:
- Providing resources to help APs and RAAs evaluate annuities such as:
- Electronic or paperwork sheets to compare investment costs
- Guidance on relevant factors for APs to consider when they are evaluating competing and often less risky or complex products
- Tools that automatically compare recommended products
- Reviewing samples of customer transactions to determine how the AP considered costs of investments
- Revising commission schedules
- Eliminating sales contests
- Limiting high-risk or complex products for customers by:
- Product reviews that categorize risk and complexity level of products offered to customers
- Limit high-risk or complex products to specific customer types
- Apply heightened supervision to recommendations of high-risk or complex products
- Implementing surveillance processes that look for the sale of the same products to a high number of customers
- Conducting branch exams with Reg BI specific reviews
FINRA also advises that if a firm has not yet done so, it should take steps to ensure:
- Its WSPs address with detail how Reg BI’s obligations are being met. It is not sufficient to merely mention Reg BI obligations or to remove the words “suitable” or “suitability” in existing WSPs and replace them with some variation of “best interest.”
- Its APs are trained on Reg BI’s obligations and how to meet them and have adequate resources and tools to do so
- It is checking and testing for compliance with Reg BI’s obligations
- It is identifying and monitoring complex and high-risk products, limiting to customers to whom they can be offered and providing heightened supervision when they are offered
- It is eliminating and mitigating conflicts of interest, including eliminating sales contests, and disclosing conflicts where they cannot be eliminated
While compliance with any new regulation can be difficult, thorough implementation of measures to address Reg BI can help protect customers from investments that are not in their best interest while helping protect firms and APs from litigation risks.