The Securities and Exchange Commission’s Division of Examinations (Division) issued a Risk Alert (Risk Alert)1 on January 30, 2023 highlighting deficiencies its Staff observed during recent Regulation Best Interest2 examinations.3 According to the Division, the Risk Alert is intended to assist broker-dealers in reviewing and enhancing their Regulation Best Interest compliance programs by identifying what the Division considers common weak practices that could result in deficiencies.
As background, 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 Compliance Obligation; and the Conflict of Interest 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” between the retail customer and the broker-dealer. This includes any material facts relating to conflicts of interest associated with a recommendation. The Disclosure Obligation requires that disclosure be provided at or before the time of a recommendation. The Division provided the following examples of deficiencies and weaknesses the Staff observed during examinations for compliance with Regulation Best Interest:
- Website Postings. Some broker-dealers “only posted the Regulation Best Interest disclosures on their website or referenced the disclosures in other documents delivered to customers.” The Division noted that broker-dealers do not fulfill their disclosure obligations merely by “providing customers references to disclosures on a website or in another document.”
- Registered Representatives Acting in Multiple Roles. Where broker-dealers had dually licensed financial professionals, the Staff observed that some broker-dealers failed to properly disclose the capacity in which the financial professionals were acting as well as potential conflicts specific to the financial professionals.
- Other Failures. Some broker-dealers failed to specify when disclosures should be created or updated or how the updated disclosures should be delivered to retail customers. Additionally, some broker-dealers failed to include a process to document that required disclosures had been provided to retail customers.
Care Obligation and Compliance Obligation
The Care Obligation requires that a broker-dealer not place the financial or other interest of the broker-dealer, or an associated person of the broker-dealer, ahead of the interest of the retail customer. Under the Care Obligation, a broker-dealer is required to: exercise reasonable diligence, care and skill when making a recommendation to a retail customer; understand the potential risks, rewards and costs associated with a recommendation; and have a reasonable basis to believe that a recommendation is in the best interest of a retail customer at the time the recommendation is made.
The Compliance Obligation requires that a broker-dealer implement and enforce written policies and procedures reasonably designed to ensure compliance with Regulation Best Interest, generally. The Staff observed several situations in which broker-dealers failed to have and implement written policies and procedures reasonably designed to achieve compliance with the Care Obligation and the Compliance Obligation. Specifically, the Staff observed generic written policies and procedures that were not tailored to the firm’s business model or otherwise were limited to merely restating the rule’s requirements.
- Policies and Procedures to Comply with the Care Obligation. The Risk Alert provides examples of policies and procedures where the Staff found deficiencies and weaknesses, including:
- Policies and procedures that directed financial professionals to consider “reasonably available alternatives” without providing any guidance.
- Policies and Procedures that directed financial professionals to consider costs without providing any guidance as to how to do so.
- Systems that firms created for financial professionals to evaluate reasonably available alternatives or costs, but as to which the firms did not mandate their use.
- Policies and Procedures that directed financial professionals to document the basis for their recommendations but did not give instructions as to when documentation is necessary or appropriate, or the specific information to be gathered.
- Policies and Procedures Related to the Compliance Obligation. The Division noted that, depending on the size and complexity of the firm, a reasonably designed compliance program generally would include, among other things, a training program and periodic reviews and testing. The Risk Alert provides examples of policies and procedures where the Staff found deficiencies and weaknesses, including:
- Policies and Procedures that relied heavily on surveillance systems that existed before the effective date of Regulation Best Interest but had not been modified to comply with Regulation Best Interest.
- Policies and Procedures that relied on documentation maintained locally, rather than in a central location.
- Policies and procedures that relied on surveillance systems that captured executed transactions but did not capture hold recommendations or recommendations that are not accepted by the retail customer.
- Employee Training. The Division noted that some broker-dealers offered employee training on Regulation Best Interest but did not identify the firms’ processes for compliance with Regulation Best Interest (e.g., the tools or methods that employees could use to comply with the Regulation).
Conflict of Interest Obligation
Under Regulation Best Interest, a broker-dealer must establish, maintain 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 relation to the Conflict of Interest Obligation, the Division noted the following deficiencies and weaknesses in broker-dealers’ compliance with Regulation Best Interest:
- Written Procedures. The Division noted that some broker-dealers failed to implement written policies and procedures “reasonably designed to specify how conflicts are to be identified or addressed.” The Staff found that certain policies and procedures did not provide enough detail to “establish a structure to identify and address conflicts, such as assigning responsibility to identify and address conflicts to a specific position or unit.” The Staff also found that some written policies and procedures failed to ban sales contests, sales quotas, bonuses and non-cash compensation, practices that are prohibited under Regulation Best Interest.
- Identification of Conflicts. The Staff observed that some broker-dealers failed to disclose all conflicts of interests in relation to recommendations to retail customers. Instead, broker-dealers limited the identified conflicts to conflicts associated with prohibited activities or used high-level, generic language that did not identify the actual conflict.
- Failure to Mitigate. The Staff further observed that some broker-dealers failed to properly mitigate conflicts that appeared to create an incentive for the financial professional to place its interest ahead of the interest of the retail customer by relying solely on disclosures.
The Risk Alert provides useful tools to help firms identify possible deficiencies in their approach to Regulation Best Interest compliance. Firms may wish to review their policies and procedures in light of the observations reported by the Division.