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Compliance January 31, 2023
SEC Cites Broker/Dealers for Not Meeting Reg BI Standards
The SEC issued a warning after finding issues, including advisers not properly disclosing conflicts of interest or maintaining written policies.
Reported by Paul Mulholland
The Securities and Exchange Commission issued a risk alert on Monday to broker/dealers after finding that many are not properly adhering to a relatively new standard of conduct when recommending security transactions or investment strategies.
The SEC issued the risk alert after conducting early compliance examinations on broker/dealers regarding Regulation Best Interest, or Reg BI, since the regulation went into effect on June 30, 2020. The compliance issues ranged from weak or generic compliance policies to not identifying and addressing conflicts of interest when advisers can earn bonuses or other incentives for recommending certain investments.
Reg BI requires that broker/dealers who recommend securities and strategies involving securities put their client’s interest ahead of their own. To do this, they are required to disclose and mitigate all conflicts of interest; disclose the scope and terms of any conflicted relationships; conduct reasonable diligence in recommendation-making; maintain policies for mitigating conflicts of interest; and maintain policies for generally complying with the regulation by putting clients’ interest first.
According to a compliance guide published by the SEC, a recommendation does not have a “bright line definition” and is determined by using the facts and circumstances of a case. But, in general, a recommendation is a “call to action,” or communication that could reasonably influence someone. The more tailored a communication is to a client, the more likely it is to be a recommendation. Additionally, if a broker/dealer has agreed to monitor client accounts, then silence can be an implicit hold recommendation and subject to Reg BI.
The SEC observed multiple common errors in its testing. Many broker/dealers kept weak or generic written compliance policies that did not account for the specifics of their business model, suggesting they were made with little thought or care. The SEC also found disclosure policies lacking, often by not specifying the manner in which disclosures are to be made, such as how often or whose responsibility it is to make them.
For the due diligence requirement, also known as the Care Obligation, many broker/dealers have inadequate policies on how to consider alternative recommendations and relative costs. Under the Care Obligation, broker/dealers must have a reasonable basis for their recommendations and include factors such as the investor’s age, liquidity needs, other investments and financial goals.
For conflicts of interest, some broker/dealers did not have a structure for identifying and addressing those conflicts, such as designating an officer or department for this purpose. The SEC also observed an overreliance on meeting the obligation simply by disclosing conflicts, rather than mitigating them, when they are required to do both.
Conflicts of interest often arise from compensation structures that incentivize sales, and the regulation forbids sales contests, quotas and bonuses based on sales of specific securities within a specific timeframe, according to the regulator. The SEC’s suggested mitigation measures mostly emphasize the importance of limiting the use of incentive pay.
Finally, the SEC highlighted a compliance issue with financial professionals who are licensed as both brokers and financial advisers, or who work for dually licensed firms. Such actors are required to disclose to a client which capacity they are acting in and to apply Reg BI if they are acting as a broker/dealer, but a rule known as the Advisers Act if acting as an adviser. They also must disclose any unique conflicts that may arise as a consequence of their dual licensure, the regulator said.
