Wednesday, April 08. 2020
SEC’s Office of Compliance Inspections and Examinations Publishes Risk Alerts Regarding Initial Inspections
Initial examinations of Regulation Best Interest will focus on assessing whether broker-dealers have made a good faith effort to implement policies and procedures reasonably designed to comply with the rules of the regulation, including the operational effectiveness of broker-dealers’ policies and procedures. Initial examinations of Form CRS will focus on assessing whether firms have made a good faith effort to implement the form’s rules, including reviewing the filing and posting of a firm’s relationship summary as well as its process for delivering the relationship summary to existing and new retail investors. The compliance date for Regulation Best Interest and Form CRS is June 30, 2020.
Examinations that Focus on Compliance with Regulation Best Interest
This risk alert is intended to provide broker-dealers with information about the scope and content of initial examinations after the compliance date for Regulation Best Interest. When a broker-dealer makes a recommendation of any securities transaction or investment strategy involving securities (including account recommendations) to a retail customer, that broker-dealer must act in the best interest of the retail customer at the time the recommendation is made without placing its own financial or other interest ahead of the retail customer’s interest. This obligation is satisfied only if a broker-dealer complies with four component obligations: a Disclosure Obligation, a Care Obligation, a Conflict of Interest Obligation, and a Compliance Obligation.
The Disclosure Obligation requires a broker-dealer, prior to or at the time of the recommendation, to provide a retail customer, in writing, full and fair disclosure of all material facts relating to:
- the scope and terms of the relationship with the retail customer
- conflicts of interest that are associated with the recommendation
To assess compliance with the Disclosure Obligation, SEC staff may review the content of the disclosures and other firm records to determine if the disclosures provide the required information to retail customers. Staff may also review the timing of the disclosures. Review may involve documents such as:
- Schedules of fees and charges assessed against retail customers and disclosures regarding such fees and charges
- Compensation methods for personnel registered with the broker-dealer
- Disclosures related to monitoring of retail customers’ accounts
- Disclosures on material limitations on accounts or services recommended to retail customers
- Lists of proprietary products sold to retail customers
The Care Obligation requires a broker-dealer to exercise reasonable diligence, care, and skill when making a recommendation to a retail customer. The broker-dealer must understand potential risks, rewards, and costs
associated with the recommendation. The broker-dealer must also consider these factors in light of the retail customer’s investment profile and make a recommendation that is in the retail customer’s best interest.
To assess compliance with this obligation, SEC staff may review:
- Information collected from retail customers to develop their investment profiles
- A broker-dealer’s process for having a reasonable basis to believe that its recommendations are in the best interest of the retail customer. This may include the factors the broker-dealer considers to assess the potential risks, rewards, and costs of the recommendations in light of the retail customer’s investment profile as well as the broker-dealer’s process for having a reasonable basis to believe that it does not place its own financial or other interest ahead of the interest of the retail customer
- How the broker-dealer makes recommendations related to significant investment decisions and how it has a reasonable basis to believe that such investment strategies are in a retail customer’s best interest
- How the broker-dealer makes recommendations related to more complex, risky, or expensive products and how it has a reasonable basis to believe that such investments are in a retail customer’s best interest.
Conflict of Interest Obligation
This obligation requires a broker-dealer to establish, maintain, and enforce written policies and procedures reasonably designed to address conflicts of interest associated with its recommendations to retail customers.
To assess compliance with this obligation, SEC staff may review how the policies and procedures:
- Address the following points as required by Regulation Best Interest:
- conflicts that create an incentive for an associated person to place its interest or the interest the broker-dealer ahead of the interest of the retail customer
- conflicts associated with material limitations on the securities or investment strategies involving securities that may be recommended to a retail customer
- the elimination of the following conflicts: sales contests, sales quotas, bonuses, and non-cash compensation based on the sale of specific securities or specific types of securities within a limited period of time.
- Establish a structure for identifying the conflicts that the broker-dealer or its associated person may face.
- Establish a structure to identify and assess conflicts in the broker-dealer’s business as it evolves.
- Provide for disclosure of conflicts and what conflicts are disclosed.
- Provide for mitigation or elimination of conflicts and what conflicts are mitigated or eliminated.
The Compliance Obligation requires a broker-dealer to establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Regulation Best Interest as a whole. To assess compliance with this obligation, SEC staff may review the broker-dealer’s policies and procedures. It may also evaluate any controls, remediation of noncompliance, training, and periodic review and testing included as part of those policies and procedures.
OCIE is prepared to work with firms and colleagues in the Division of Trading and Markets on issues that may arise in the course of examinations. The office understands that the coronavirus disease 2019 (COVID-19) has created challenges for firms. Firms are encouraged to contact the office with questions. In addition, the risk alert contains a sample request for documents to assess compliance to help firms prepare.
Examinations that Focus on Compliance with Form CRS
Form CRS and its related rules require firms to deliver to retail investors a brief customer or client relationship summary that provides information about the firm. Firms must also file their initial relationship summaries (and any amendments) with the SEC using the Central Registration Depository (Web CRD) or Investment Adviser Registration Depository (IARD) as applicable. Firms must and post the current relationship summary on the firm’s public website, if the firm has one. After the compliance date, OCIE will begin examinations to determine compliance with Form CRS. Initial assessments conducted after June 30, 2020 will focus on analyzing if firms have made a good faith effort to implement Form CRS. These examinations of firms with retail investors may include the following areas:
Delivery and Filing
SEC staff may review whether the firm has filed its relationship summary, including any amendments, and whether the relationship summary is posted on the firm’s public website, if any. In addition, they will evaluate the process for delivering the relationship summary to existing and new retail investors. Policies and procedures will also be reviewed to assess whether they address the required relationship summary delivery processes and dates. The staff may examine records of the dates that each relationship summary was provided to retail investors in particular to validate whether the firm has complied with the following delivery obligations:
- Existing Retail Investors. The initial delivery of the relationship summary to existing retail investors by July 30, 2020, 9 and before or at the time of one of the following:
- The opening of a new account that is different from the retail investor’s existing account
- A recommendation of a rollover of assets from a retirement account into a new or existing account or investment
- A recommendation of a new brokerage or investment advisory service or investment that does not necessarily involve the opening of a new account and would not be held in an existing account
- New Retail Investors. The delivery of the relationship summary to new retail investors before or at the earliest of:
- Entering into an investment advisory contract with the retail investor
- A recommendation to a retail investor of an account type, a securities transaction, or an investment strategy involving securities
- Placing an order for the retail investor
- The opening of a brokerage account for the retail investor
- Content. SEC staff may review a firm’s relationship summary to assess whether it includes all required information and contains true and accurate information. The summary may not omit any material facts necessary in order to make the required disclosures, in light of the circumstances under which they were made, not misleading. SEC staff may review relationship summaries for information about:
- How the firm describes the relationships and services it offers to retail investors
- How the firm describes its fees and costs (including disclosures about 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 firm’s retail investors)
- How the firm describes the manner in which its financial professionals are compensated, including cash and non-cash compensation, and the conflicts of interest those payments create
- How the firm describes its conflicts of interest, including incentives related to proprietary products, third-party payments, revenue sharing, and principal trading
- Whether the firm accurately discloses if it or its financial professionals have legal or disciplinary history
- Formatting. SEC staff may review a firm’s relationship summary to assess whether it is formatted in accordance with the instructions (for example, that it includes particular wording where required, that it uses text features where required, and that it is written in plain English)
- Updates. SEC staff may review a firm’s policies and procedures for updating the relationship summary to assess:
- How and whether a firm updates and files its relationship summary within 30 days after any information becomes materially inaccurate
- How and whether a firm communicates these changes to retail investors within 60 days after the updates are required to be made
- The firm’s process for highlighting to retail investors the most recent changes and including an exhibit highlighting or summarizing material changes with any filed updates
- Recordkeeping. Staff may review the firm’s records related to the delivery of the relationship summary and the policies and procedures regarding record-making and recordkeeping to examine how the firm complies with applicable delivery and recordkeeping obligations.
OCIE encourages firms to assess their implementation plans for Form CRS. This risk alert is intended to empower firms to assess their level of preparedness as the compliance date nears.