FINRA Rule 4512 defines institutional account as any person with total assets of at least

On 2 April 2020, Chairman Jay Clayton issued a statement (the "Statement") announcing the compliance date for SEC Regulation Best Interest ("Reg BI") and Form CRS will remain 30 June 2020, despite the widespread disruptions caused by COVID-19.[1] Instead of postponing implementation, the SEC urges firms to continue to make "good faith efforts" to comply with the upcoming compliance date. On 7 April 2020, following the Statement, the SEC's Office of Compliance Inspections and Examinations ("OCIE") issued two Risk Alerts[2] containing information about the scope and content of initial examinations of firms for compliance with Reg BI's requirements. Earlier in March, the Financial Industry Regulatory Authority, Inc. (“FINRA”) also filed several proposed rule changes designed to align its suitability and non-cash compensation rules with Reg BI. We discuss these developments here, as well as certain state standards of conduct developments, to provide an overview of the conduct standards for broker-dealers and our view of what firms should do now to prepare for Reg BI implementation.

[If you are interested in joining an interactive Baker McKenzie working session on Reg BI implementation, please click here.]

Reg BI and Form CRS: No Extension for 30 June 2020 Implementation Deadline

In the Statement, the Chairman notes that the implementation of Reg BI and Form CRS is of particular importance during "times of uncertainty" such as the COVID-19 pandemic. The Statement reiterates the importance of aligning obligations for broker-dealers and investment advisers with respect to the best interests of retail investors, while preserving investors’ access to a variety of investment services and products. This policy position of safeguarding the interests of retail investors partially explains why the SEC is not delaying Reg BI and Form CRS implementation, as does the year-long implementation period. Given that the COVID-19 disruptions began two-thirds of the way into the Reg BI and Form CRS implementation period, the Statement notes that firms have already made "considerable progress" in preparing to implement these requirements and they should continue to make "good faith efforts" to ensure compliance.

While the Statement does not grant uniform relief, to the extent that a firm is unable to make certain filings or meet other requirements because of disruptions caused by COVID-19, the SEC Staff will take the firm-specific effects of such unforeseen circumstances (and related operational constraints and resource needs) into account in examination and enforcement efforts. According to the Statement, firms should continue to make good faith efforts towards compliance and, if they expect that they will be "unable to make certain filings or meet other requirements because of disruptions caused by COVID-19," these firms should "engage" with the SEC Staff. The Statement suggests that any relief granted will be tailored to the particular facts and circumstances of the requesting firm.

We recommend that a firm seeking Reg BI relief from the SEC be prepared to substantiate its request by demonstrating the impact of the COVID-19 pandemic upon the specific process of implementing Reg BI and Form CRS (and not more general disruptions in day-to-day operations), and that the firm be able to demonstrate robust Reg BI implementation efforts up to when COVID-19 affected this process. Moreover, we expect any possible relief will be explicitly linked to "the disruptions caused by efforts to comply with national, state or local health and safety directives and guidance." We also note that obtaining such relief could incur risk of additional regulatory scrutiny—though that is a risk associated with regulatory relief in general, as addressed in our past alert.

OCIE Reg BI Risk Alert & FINRA Statement on the Alert

OCIE's description of the program for initial examinations of Reg BI reiterates Chairman Clayton's emphasis on "good faith efforts" towards compliance, in connection with assessing whether firms have implemented policies and procedures reasonably designed to comply with Reg BI, including the operational effectiveness of broker-dealers’ policies and procedures. The Risk Alert[3] notes that examinations will commence during the first year after the Reg BI compliance date; however, the primary purpose of the examinations will be to determine whether firms have established policies and procedures and made reasonable progress in implementing them, including in response to firms' experience rolling out a Reg BI compliance program. The Risk Alert provides a sample document request aimed at assessing a firm's compliance with each of the four requisite duties and obligations of Reg BI: (i) Disclosure, (ii) Care, (iii) Conflicts of Interest, and (iv) Compliance.

The Risk Alert is consistent with our expectations of its contents, but the timeline for initial examinations is slightly longer than contemplated by other informal SEC Staff remarks relating to Reg BI (e.g., the FINRA Reg BI conference in December 2019). In this way, the Risk Alert offers some consolation to broker-dealers that the SEC will be primarily assessing a firm's written program and readiness in terms of implementation. Additionally, on 8 April 2020, FINRA issued a statement in response to the OCIE Risk Alerts, noting that it will take the same approach as set forth in the Risk Alerts when examining broker-dealers and their associated persons for compliance with Reg BI and Form CRS, with the initial focus on assessing whether firms have made a good faith effort to establish and implement policies and procedures reasonably designed to comply with Reg BI and Form CRS. Nevertheless, FINRA notes that it will take action in the event that "FINRA observes indications of customer harm or conduct that would have violated current standards (e.g., suitability)." Given that the Reg BI conduct standards generally exceed those contained within FINRA Rule 2111, firms should ensure that any potential gaps (e.g., with respect to institutional customers) are considered and addressed through appropriate policies and procedures.

The sample documentation request provides a useful roadmap and reinforces the document-intensive nature of the requirements of Reg BI. Sample documents and their contents needed to comply with the requisite duties include:

• Disclosure Obligations:
  • Fees and charges, including product- or service-specific charges;
  • Compensation to registered personnel;
  • Disclosures related to monitoring of accounts; and
  • Details related to proprietary products and limitations on services or account types.
• Care Obligation:
  • New Account forms and other documentation used to gather and develop investment profiles;
  • Documentation of the broker-dealer's process to assess a recommendation and establish a reasonable belief that recommendations are in the customer's best interest; and
  • Documentation of processes related to specific events such as rollovers and account-type recommendations as well as more complex products.
• Conflict of Interest:
  • Ensuring that policies and procedures assess and mitigate conflicts associated with limited products or investment options;
  • Elimination of incentives such as sales contests, quotas and non-cash compensation; and
  • Assessment of the process to identify existing conflicts.
• Compliance Obligation:
  • Policies and procedures, training materials, evidence of reviews and testing.

FINRA Proposes Rule Changes to Align with Reg BI

FINRA recently filed proposed changes to its suitability and non-cash compensation rules to align relevant provisions with Reg BI. Notably, FINRA did not issue a regulatory notice for these amendments, moving directly to an SEC filing and relying on its continued engagement with FINRA members and broker-dealer industry associations regarding Reg BI implementation, as well as previous comment requests.[4] The proposed changes would:

• Exclude recommendations that are subject to Reg BI from the FINRA suitability rule (Rule 2111)[5];
• Remove the element of control from the quantitative suitability obligation under Rule 2111; and
• Conform FINRA rules governing non-cash compensation to Reg BI's limitations on sales contests, sales quotas, bonuses, and non-cash compensation.

FINRA Suitability Rule

Although the standard of care under Reg BI is based on FINRA suitability concepts, Reg BI establishes a higher standard of conduct, applies a broader range of obligations that are triggered by a recommendation, defines the concept of a recommendation broadly to include account type recommendations, and applies solely to retail customers (though, in practice, that could include applying to a high net worth or family office that qualified as institutional customers under FINRA Rule 4152). In order to avoid confusion and eliminate the application of different regulatory standards, FINRA is proposing amendments to make clear that Rule 2111 does not apply to recommendations that are subject to Reg BI. Rule 2111 would still govern recommendations to entities and institutions,[6] as well as natural persons who do not qualify as retail customers (i.e., natural persons who do not use the recommendations primarily for personal, family, or household purposes). It is important to note that a natural person who would otherwise qualify as an institutional customer—because under FINRA Rule 4512 they have assets in excess of $50 million—would still be considered a retail customer that would be covered by Reg BI. The SEC expressly included high net-worth individuals within the protections provided by Reg BI to retail investors, based on its view that net worth does not necessarily correlate to a particular level of financial sophistication and "conflicted recommendations can also result in harm to high net-worth individuals."[7]

Quantitative Suitability

Current Rule 2111 includes a quantitative suitability requirement that requires a broker-dealer to have a reasonable basis for believing that a series of recommended transactions is not excessive and is suitable given the customer's investment profile, even if each transaction would be reasonable if viewed in isolation. Under the current Rule 2111, quantitative suitability only applies when a broker-dealer has "actual or de facto control over a customer account" (a holdover from case law eventually codified into Rule 2111). Reg BI similarly includes the concept of quantitative suitability in its Care Obligation; however it does not include the control provision. Removing the control element from FINRA Rule 2111 aligns with Reg BI and the prior proposal under Regulatory Notice 18-13. FINRA views this change as important from an enforcement perspective because "[i]n cases where excessive trading is alleged, customers would benefit from the reduced burden on FINRA of not having to prove control while firms and associated persons engaged in excessive trading could experience a higher number of findings of violations." In Regulatory Notice 18-13, FINRA similarly expressed concern "that the control element serves as an impediment to investor protection and an unwarranted defense to unscrupulous brokers."

Sales Contests and Non-Cash Compensation

FINRA is proposing to amend its rules governing the payment and receipt of non-cash compensation in connection with the sale and distribution of securities, by clarifying that any such non-cash compensation arrangements must comply with Reg BI.[8] The current rules permit internal firm sales contests based on sales of specific types of securities (such as mutual funds or variable annuities). In contrast, Reg BI's Conflict of Interest Obligation requires that broker-dealers develop policies and procedures to identify and eliminate 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. In August 2016, FINRA proposed a similar rule change in Regulatory Notice 16-29, which would have prohibited non-cash compensation tied to product-specific internal sales contests. FINRA based the 2016 proposal (which has not been adopted) on its belief that product-specific internal sales contests "potentially create an incentive to engage in sales conduct contrary to the best interests of customers." FINRA is now also proposing to eliminate the provisions of Rules 2320 and 2341 that require non-cash compensation arrangements to be based on total production and equal weighting of securities sales. If adopted, the proposed updates to Rules 2320 and 2341 would mean that firms may no longer sponsor or maintain internal sales contests based on sales of securities within a product category within a limited time, even if based on total production and equal weighting.

Timing and Procedure for Proposed Rule Changes

If the SEC approves the proposed rules changes, FINRA will issue a Regulatory Notice announcing the approval no later than sixty (60) days after the SEC's approval. The effective date of the amended rules would be the compliance date of Reg BI, which the SEC has set as 30 June 2020. 
 

Additional State Regulatory and Litigation Developments

• Iowa Best Interest Rule Proposal – Comment Period Ending 28 April 2020: The Iowa Insurance Division (the "Division”), which oversees both insurance and securities activities, filed proposed regulations that would require annuity agents and securities agents (Iowa-specific term for broker-dealer representatives) to act in the best interest of their customers. In addition to regulating the suitability of annuity transactions, the Division’s proposal imposes a best interest obligation on broker-dealers and their representatives (new rule 191—50.104(502) Best interest obligations in the brokerage business). The proposed best interest rule for broker-dealers and their representatives aligns closely with Reg BI in structure and requirements; however, the Iowa proposal does not directly refer to Reg BI compliance as a path for compliance with this state rule.
   
• Massachusetts Securities Division Fiduciary Rule for Brokers – 1 September 2020 Enforcement Date Unlikely to Change: The Massachusetts Securities Division’s final regulations governing the standard of conduct applicable to broker-dealers and their agents became effective 6 March 2020 (see our alert on the rule, which includes a comparison to Reg BI). In light of Reg BI’s unchanged implementation deadline, we do not expect the enforcement date for the Massachusetts Securities Division final regulation to change.

Court Challenge to Reg BI Remains Ongoing 

In September 2019, a small group of states (New York, California, Connecticut, Delaware, Maine, New Mexico, and Oregon), the District of Columbia and a private company (XY Planning Network) filed suit against the SEC in the Second Circuit, alleging that the promulgation of Reg BI was beyond the SEC's statutory authority and that the rulemaking was arbitrary and capricious. Although filed separately, the suits were consolidated nearly immediately. Petitioners' reply briefs were due on 24 March, but the deadline has been delayed to 14 April because of the COVID-19 pandemic. Because the compliance date for Reg BI is 30 June, the parties have requested that the court schedule the case for oral argument as soon as practicable after the completion of briefing.
 

Download the full alert here

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Baker McKenzie's Financial Regulation and Enforcement Practice provides our clients with a full range of regulatory advice and enforcement counseling. This integrated approach helps clients navigate the challenges presented by developing new products and offering financial services in a rapidly changing regulatory environment, while simultaneously considering how to assess and minimize potential enforcement exposure. Enforcement investigations and regulatory examinations are similarly addressed, not only with considerable enforcement experience, but also by fully leveraging the enormous value added by regulatory expertise.
 

[1] See "Investors Remain Front of Mind at the SEC: Approach to Allocation of Resources, Oversight and Rulemaking; Implementation of Regulation Best Interest and Form CRS," avail. at: https://www.sec.gov/news/public-statement/statement-clayton-investors-rbi-form-crs.
[2] OCIE issued two separate Risk Alerts, with each alert focusing separately on the expectations regarding Reg BI and Form CRS respectively. Our analysis in this alert addresses the Risk Alert focused on Reg BI.
[3] See “Examinations that Focus on Compliance with Regulation Best Interest,” OCIE Risk Alert (April 7, 2020).
[4] See “FINRA Requests Comment on Proposed Amendments to the Quantitative Suitability Obligation Under FINRA Rule 2111,” Regulatory Notice 18-13 (April 20, 2018) and “FINRA Requests Comment on Proposed Amendments to its Gifts, Gratuities and Non-Cash Compensation Rules,” Regulatory Notice 16-29 (Aug. 2016).
[5] FINRA proposed the same change to CAB Rule 211, which governs the suitability obligations of capital acquisition brokers.
[6] Although, a FINRA member firm can satisfy Rule 2111's suitability obligations for institutional accounts if (1) it has a reasonable basis to believe the institutional customer is capable of independently evaluating the risks associated with its investments and investment strategies, and, (2) the institutional customer certifies that it exercises independent judgment in evaluating the firm's recommendations. FINRA Rule 4512 defines "institutional account" to include several types of financial services entities, as well as any person (natural or otherwise) with total assets of at least $50 million.
[7] “Regulation Best Interest: The Broker-Dealer Standard of Conduct,” Exchange Act Release No. 86031 (July 12, 2019) at Section II.B.3.
[8] FINRA is proposing to amend Rule 2310 (Direct Participation Programs), 2320 (Variable Contracts of an Insurance Company), 2341 (Investment Company Securities), and 5110 (Corporate Financing Rule – Underwriting Terms and Arrangements).


This alert was coauthored by Valerie Mirko, Amy Greer, Jennifer Klass, Jennifer Connors, Jonathan Hoffman and Kurt Oldenburg.

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