Now that Regulation BI is in effect, a reminder of FINRA’s 2020 exam priorities
In light of the June 30, 2020, effective date of the SEC’s Regulation Best Interest, we wanted to remind firms that both the SEC and FINRA will expect them to update their policies and procedures regarding conflicts disclosures, how recommendations are made, and the content and delivery of Form CRS. As we wrote in January, FINRA’s 2020 exam priorities cover these specific topics:
- Does a firm have procedures and training in place to ensure recommendations are in the best interest of the customer? This is a change from the suitability standard of FINRA Rule 2111, and it requires each recommendation to meet four core obligations – care, disclosure, conflicts of interest, and compliance – in addition to meeting the suitability standard.
- Does a firm apply the best interest standard to recommendations regarding the type of an account a customer should use? The decision to use a brokerage account versus an advisory account should consider the following: (1) services, features and products offered in the account; (2) projected costs of the account; (3) alternative types of accounts; (4) any services the customer may request; and (5) the customer’s investment profile. With respect to IRAs, additional considerations are (1) fees and expenses; (2) level of services available; (3) ability to take penalty-free withdrawals; (4) application of required minimum distributions, which now begin at age 72; (5) protections from creditors and judgments; (6) holdings of employer stock; and (7) any special features of the existing account.
- Whether account monitoring is offered and accepted by a customer. While there is no duty to monitor, if it is agreed to the best interest standard will apply to both explicit and implicit hold recommendations. Review and recommendations will be required per the specified, periodic basis that is agreed to. In such circumstances, a firm's silence will represent an implicit recommendation to hold and must be in the best interest of the customer.
- Do a firm and associated persons consider the express new elements of care, skill and costs when making recommendations to retail customers? The reasonable-basis and customer-specific suitability obligations set forth in FINRA Rule 2111(a) still apply. However, Regulation BI adds elements of care, skill and cost to the analyses. Care and skill require one providing a recommendation to understand the risks and rewards of the recommendation and have a reasonable basis that it is in the best interest of the customer at the time of the recommendation. The cost factor is not limited to the immediate, up-front cost of a particular purchase, but also includes expected costs from the future sale or exchange of a security, any deferred sales charges, or liquidation costs. Moreover, costs of reasonably available alternatives offered by the firm should also be considered but should not be the end-all consideration. To be sure, FINRA has stated the cost element "is not intended to limit or foreclose a recommendation of a more costly product if there is a reasonable basis to believe that the product is in the best interest of a particular retail customer.”
- Do a firm and associated persons consider reasonably available alternatives to a specific recommendation? What other alternatives are offered by the firm? Are they lower cost? Firms should establish a process – reasonable within their business models – to identify the scope of reasonably available alternatives when certain products and strategies are considered for a recommendation.
- Do a firm and associated persons guard against excessive trading, even if they do not control an account? Regulation BI requires that a recommended series of transactions – regardless of whether a firm exercises actual or de facto control over an account – is not excessive and is in the best interest of the customer. This removes the element of actual or de facto control required by quantitative suitability in FINRA Rule 2111(a).
- Does a firm have policies and procedures to provide the Regulation BI disclosures? These include:
(a) Whether a recommendation is made in the capacity as a broker-dealer or an investment advisor. FINRA has stated that for dually registered firms/individuals, Form CRS will not be sufficient to disclose the specific capacity for a particular recommendation. Likewise, any limitation, such as an associated person not registered as an IAR, but working for a dually registered firm or otherwise registered in a limited capacity (Series 6), must also be disclosed;
(b) Material fees and costs that apply to a retail customer's transactions, holdings and account. This does not require individualized disclosure for each customer, however, it must be more specific than the fee/cost disclosure in Form CRS. Standardized numerical, reasonable dollar or percentage ranges are permissible;
(c) Whether the firm will be providing account monitoring services, and if so, the scope and frequency of such services;
(d) What the requirements are for a retail customer to open and maintain an account, such as minimum account size or other thresholds that will result in lower or avoided fees;
(e) Whether there are material limitations on the types of securities or investment strategies offered by the firm. This would include if a firm limits recommendations to proprietary products, specific asset classes, or products offered via third-party arrangement;
(f) A standardized summary of the basis for recommendations, such as a firm's investment approach/philosophy/strategy. The disclosure should also inform the customer of how a firm will notify them when a standardized basis does not apply to a recommendation; and
(g) Risks associated with a recommendation, which may be in a standardized disclosure.
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Does a firm have policies and procedures reasonably designed to identify and address conflicts of interest? Regulation BI defines a “conflict of interest” as “an interest that might incline a broker, dealer, or a natural person who is an associated person of a broker or dealer – consciously or unconsciously – to make a recommendation that is not disinterested.” As an example, the SEC's 2020 exam priorities provides “fee and compensation-based conflicts of interest may take many forms, including revenue sharing arrangements between a registered firm and issuers, service providers, and others.”
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Does a firm have policies and procedures in place regarding the filing, updating and delivery of Form CRS? The form must be filed on Web CRD, and dual registrants must file using both Web CRD and IARD. Delivery to new customers must be made before or at the earliest of: any recommendation of an account type, transaction, placing an order, account opening or implementation of an investment strategy. If in a packet of information, Form CRS must be placed first. For existing customers, delivery must take place within 30 days after the date by which the form must be electronically filed with the SEC, which would include providing it with June 2020 account statements, as long as it is placed first in the packet.
- Does a firm have policies and procedures reasonably designed to identify and address conflicts of interest? Regulation BI defines a “conflict of interest” as “an interest that might incline a broker, dealer, or a natural person who is an associated person of a broker or dealer – consciously or unconsciously – to make a recommendation that is not disinterested.” As an example, the SEC's 2020 exam priorities provides “fee and compensation-based conflicts of interest may take many forms, including revenue sharing arrangements between a registered firm and issuers, service providers, and others.”
- Does a firm have policies and procedures in place regarding the filing, updating and delivery of Form CRS? The form must be filed on Web CRD, and dual registrants must file using both Web CRD and IARD. Delivery to new customers must be made before or at the earliest of: any recommendation of an account type, transaction, placing an order, account opening or implementation of an investment strategy. If in a packet of information, Form CRS must be placed first. For existing customers, delivery must take place within 30 days after the date by which the form must be electronically filed with the SEC, which would include providing it with June 2020 account statements, as long as it is placed first in the packet.
If you have questions about this update, please contact Don McBride in Greensfelder’s Financial Services Industry Group.