The U.S. Securities and Exchange Commission's (SEC) Office of Compliance Inspections and Examinations issued an Examinations that Focus on Compliance with Regulation Best Interest Risk Alert on April 7, 2020. The SEC alert provides broker-dealers and investment advisors information about the expected scope and content of the SEC's upcoming examinations for compliance with Regulation Best Interest.

Regulation Best Interest was adopted on June 5, 2019, with the aim of enhancing the quality and transparency of retail investors' relationships with broker-dealers and investment advisers. Broker-dealers and investment advisors should fully understand the information provided in the SEC's recently issued risk alert so that they can best prepare themselves for the upcoming examinations, which will likely begin next year.

(See Holland & Knight's related alert, "SEC Office of Compliance Inspections and Examinations Issues Form CRS Risk Alert," May 7, 2020.)

The Risk Alert for Examinations that Focus on Compliance with Regulation Best Interest

On June 5, 2019, the SEC adopted Rule 15l-1, otherwise known as Regulation Best Interest,1 which has a compliance date of June 30, 2020. Regulation Best Interest establishes a new standard of conduct for broker-dealers and associated persons of broker-dealers. Under Regulation Best Interest, "when making a recommendation of any securities transaction or investment strategy involving securities (including account recommendations) to a retail customer, [a broker-dealer] shall act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the [broker-dealer] ahead of the interest of the retail customer."2 The broker-dealer's Best Interest Obligation is only satisfied if the broker-dealer fulfills four underlying obligations: Disclosure Obligation, Care Obligation, Conflict of Interest Obligation and Compliance Obligation.3

The Focus of Initial Regulation Best Interest Examinations

The SEC's initial Regulation Best Interest examinations, which will likely begin in 2021, will evaluate 1) "whether firms have established policies and procedures reasonably designed to achieve compliance with Regulation Best Interest," 2) "whether firms have made reasonable progress in implementing those policies and procedures," and 3) whether those policies and procedures are "operational[ly] effective[]."4 Examples of the areas that the SEC may focus on include the following:

Disclosure Obligation: The Disclosure Obligation requires that the broker-dealer, "prior to or at the time of the recommendation, provides the retail customer, in writing, full and fair disclosure of:

(A) All material facts relating to the scope and terms of the relationship with the retail customer . . . ; and

(B) All material facts relating to conflicts of interest that are associated with the recommendation."5

Potential Disclosure Obligation Document Requests: To assess compliance with the Disclosure Obligation, SEC staff may request and review the following during the upcoming Best Interest Regulation examinations:

  • "Schedules of fees and charges assessed against retail customers and disclosures regarding such fees and charges . . . ;
  • The broker-dealer's compensation methods for registered personnel . . . ;
  • Disclosures related to monitoring of retail customers' accounts;
  • Disclosures on material limitations on accounts or services recommended to retail customers; and

Care Obligation: The Care Obligation requires that the broker-dealer, "in making the recommendation, exercises reasonable diligence, care, and skill to:

(A) Understand the potential risks, rewards, and costs associated with the recommendation, and have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers;

(B) Have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer's investment profile and the potential risks, rewards, and costs associated with the recommendation and does not place the financial or other interest of the [broker-dealer] ahead of the interest of the retail customer; [and]

(C) Have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer's best interest when viewed in isolation, is not excessive and is in the retail customer's best interest when taken together in light of the retail customer's investment profile and does not place the financial or other interest of the [broker-dealer] making the series of recommendations ahead of the interest of the retail customer."7

Potential Care Obligation Document Requests: To assess compliance with the Care Obligation, SEC staff may request and review the following during the upcoming Regulation Best Interest examinations:

  • "Information collected from retail customers to develop their investment profiles"
  • "The broker-dealer's process for having a reasonable basis to believe that the recommendations are in the best interest of the retail customer"
  • "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"
  • "The broker-dealer's process for having a reasonable basis to believe that it does not place the financial or other interest of the broker-dealer ahead of the interest of the retail customer"
  • "How the broker-dealer makes recommendations related to significant investment decisions and how the broker-dealer has a reasonable basis to believe that such investment strategies are in a retail customer's best interest," and
  • "How the broker-dealer makes recommendations related to more complex, risky or expensive products and how the broker-dealer has a reasonable basis to believe that such investments are in a retail customer's best interest."8

Conflict of Interest Obligation: The Conflict of Interest Obligation requires that the broker-dealer "establishes, maintains, and enforces written policies and procedures reasonably designed to:

(A) Identify and at a minimum disclose . . . or eliminate, all conflicts of interest associated with such recommendations;

(B) Identify and mitigate any conflicts of interest associated with such recommendations that create an incentive for . . . an associated person of a broker or dealer to place the interest of the broker, dealer, or such [associated] person ahead of the interest of the retail customer;

(C)

(1) Identify and disclose any material limitations placed on the securities or investment strategies involving securities that may be recommended to a retail customer and any conflicts of interest associated with such limitations, . . . and

(2) Prevent such limitations and associated conflicts of interest from causing the broker, dealer, or . . . an associated person of the broker or dealer to make recommendations that place the interest of the broker, dealer, or such [associated] person ahead of the interest of the retail customer; and

(D) Identify and eliminate any sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sales of specific securities or specific types of securities within a limited period of time."9

Potential Conflict of Interest Document Requests: To assess compliance with the Conflict of Interest Obligation, SEC staff may request and review the broker-dealer's policies and procedures to determine whether and how the policies and procedures address the following during the upcoming Regulation Best Interest examinations:

  • "conflicts that create an incentive for an associated person to place its interest or the interest of a 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; and
  • 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."10

SEC staff may also request and review the broker-dealer's policies and procedures to assess:

  • "How the policies and procedures establish a structure for identifying the conflicts that the broker-dealer or its associated person may face"
  • "How the policies and procedures establish a structure to identify and assess conflicts in the broker-dealer's business as it evolves"
  • "How the policies and procedures provide for disclosure of conflicts and what conflicts are disclosed," and
  • "How the policies and procedures provide for mitigation or elimination of conflicts and what conflicts are mitigated or eliminated."11

Compliance Obligation: The Compliance Obligation requires that the broker-dealer "establishes, maintains, and enforces written policies and procedures reasonably designed to achieve compliance with Regulation Best Interest" as a whole.12

Potential Compliance Obligation Documents Requests: To assess compliance with the Compliance Obligation, SEC staff may request and review "the broker-dealer's policies and procedures and evaluate any controls, remediation of noncompliance, training, and periodic review and testing included as part of those policies and procedures."13