Issa Hanna, Counsel at Eversheds Sutherland recently spoke with InvestorCOM’s Parham Nasseri to discuss Regulation Best Interest (Reg BI), specifically:
- What we can take away from the initial round of Reg BI exams.
- What hints the regulators have given about how they plan to approach the next round of Reg BI exams.
- Why regulators are keen to see financial professionals assess investment costs and reasonably available alternatives.
Parham Nasseri (PN): One of the common terms we’ve heard during the first six months of Reg BI was the notion of “good faith effort” compliance. What does this mean and how did it translate into practical implementation steps for Broker-Dealers (B-Ds)?
Issa Hanna (IH): I would say the notion of good faith efforts compliance can be traced back to a couple of things. There were some statements to that effect in two OCIE risk alerts that came out last April where OCIE, now the Division of Examinations at the SEC, explained what they were going to be taking a look at as part of their initial round of Reg BI and Form CRS exams.
The notion can also be traced back to a letter former SEC Chairman Clayton issued to the industry in June 2020, where he was responding to some industry requests that the compliance effective date for Reg BI be pushed back in light of disruptions caused by the pandemic. The SEC was of course sympathetic to those concerns that were caused by pandemic-related disruptions. They were very much trying to work with the industry and they took an approach that was more collaborative in nature as opposed to adversarial.
In terms of how good faith efforts were viewed back around the time when Reg BI went into effect, regulators said they were looking to see if firms had adopted policies and procedures that were reasonably designed to meet Reg BI. They were looking for reasonable progress in implementing those policies and procedures, although they did not expect to see full implementation or perfection in terms of the implementation. And finally, from a comparative perspective what they viewed as not good faith were those firms who missed the boat on basic compliance issues, including those that:
- didn’t have policies and procedures in place,
- had policies and procedures that weren’t tailored to the particular needs of their specific business,
- didn’t conduct any gap analysis with respect to disclosures, or
- hadn’t addressed or identified conflicts.
Fortunately, however, in the SEC’s view, for the most part, the industry had met that good faith compliance standard at around that time.
PN: Following the initial set of good faith compliance examinations, staffers from the SEC and FINRA hosted a Roundtable on Regulation Best Interest and Form CRS on October 26, 2020. Can you expand on the staffers’ comments around the Care Obligation and the importance of comparing a reasonable range of alternatives?
IH: During the Roundtable, key staffers from the SEC and FINRA spoke about key observations from the initial round of Reg BI exams. They spoke about common deficiencies they saw as part of that initial round of exams but also some good practices they observed. In terms of common deficiencies, they highlighted a number of things, but there were two things they mentioned that are relevant to the discussion.
Firstly, in some cases they observed a lack of meaningful improvement in existing suitability based policies and they saw that some firms were not training reps on which costs to consider and how to identify reasonably available alternatives. They mentioned that they noticed some firms were solely relying on certifications or self-attestations for making recommendations in the best interest of their clients.
In terms of good practices, they observed things that are relevant to our specific discussion. For example, some firms have developed new systems to document recommendations and comparisons of reasonably available alternatives. The regulators also liked that certain firms were reviewing their overall product mix for costly outliers and eliminating those from the product mix, and also reviewing that product mix to ensure that each product type had available alternatives. Finally, they saw that certain firms were requiring their reps to take notes around each recommendation to document compliance with the care obligation and provide supervisors a trail to monitor compliance.
PN: For those who may not be familiar with the concept of considering reasonably available alternatives, can you talk about the ‘why’ behind this requirement – what will a financial professional accomplish by considering alternatives?
IH: If you take a look at the Reg BI adopting release and what they say about this new supposed requirement, they say that as part of determining whether a broker-dealer has a reasonable basis to believe that a recommendation is in the best interest of the retail customer, a financial professional should consider reasonably available alternatives offered by the broker-dealer. In the SEC’s view, such a consideration is an inherent aspect of making a best interest recommendation and is a key enhancement over existing broker-dealer suitability obligations which do not necessarily require a comparative assessment among such alternatives.
The SEC also says in the Reg BI Adopting Release that this concept already exists in the context of guidance regarding suitability and heightened supervision of complex product recommendations. In particular, FINRA states in Regulatory Notice 12-03 that when B-Ds are recommending complex or costly products, they should first consider whether less complex or costly products could achieve the same objectives for their retail customers.
In sum, the SEC believes that by formalizing this prior guidance as part of Reg BI’s Care Obligation, it will effectively be adding another key tool into its toolbox to help serve its overall investor protection goal of enhancing the B-D standard of conduct from a suitability standard to a best interest standard and you need look no further than a December 21, 2020 letter from the SEC’s Division of Examinations to confirm that.
That letter lists five specific components of Reg BI that may be the subject of focus during the second round of examinations and they included consideration of reasonably available alternatives in that “top five,” so to speak, seemingly putting this priority on par with topics such as adopting and implementing reasonably designed policies and procedures, consideration of costs, rollover advice and conflict management. I think that’s an important thing to take away from that letter – that they view this consideration of reasonably available alternatives as a priority that’s on the same level as things that are really also getting significant headliners, and which the SEC has lauded as tangible and significant improvements over the prior suitability regime.
PN: Thank you Issa. I think the takeaway from this message is to focus on the principle of investor protection and how the consideration of alternatives, not only meets the regulatory requirements but ensures B-Ds are acting in their client’s best interest.
Issa Hanna, Counsel, Eversheds Sutherland
With over a decade of experience in securities and insurance law, Issa Hanna helps broker-dealers, investment advisers, investment funds and insurance producers comply with the regulatory requirements applicable to their businesses. He has deep experience counseling and advising clients on the evolving standards of conduct in the financial services space, and closely follows developments relating to SEC Regulation Best Interest, the investment adviser fiduciary duty, and state securities and insurance laws imposing standards of conduct on broker-dealers, investment advisers and insurance producers.
Parham Nasseri, VP Regulatory Strategy, InvestorCOM
Parham Nasseri has over a decade of wealth management and regulatory experience. He is the Chair of the Canadian Advocacy Council of CFA Societies Canada and previously held roles at the Ombudsman for Banking Services & Investments and the Brattle Group. Mr. Nasseri holds a CFA Charter and an MBA from Schulich School of Business.