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ANALYSIS: Goodbye Good Faith Reg BI Compliance Exams

Dec. 30, 2020, 3:47 PM

Out with the old, in with the new. No, not the long-awaited farewell to 2020. Rather, financial firms will soon say goodbye to the “good faith efforts” exam standard currently used to evaluate compliance with the SEC’s advice standard package, and hello to tougher examinations in 2021.

On Dec. 21, the SEC announced that Regulation Best Interest (Reg BI) examinations, the package’s centerpiece, will be assessing compliance using a tougher standard starting next month. The Commission makes this change, launching its “next phase” of conducting more focused exams, after reviewing six months of firms’ good faith efforts to implement Reg BI.

The statement does not reference Form CRS Relationship Summary (Form CRS). We are unsure why this is the case but we still recommend that firms prepare for more rigorous examinations of Form CRS requirements.

The ‘Why’ in Changing the Exam Standard

We have been tracking these rules since their adoption in 2019, so the new approach is not a total surprise. The Commission’s statement aligns with what Bari Havlik, the head of exams at FINRA, said earlier in the year when discussing FINRA’s plans to evaluate compliance with Reg BI. The first six months after implementation, the focus would be on Reg BI policies, procedures, and controls to comply with the rules. Havlik noted that following initial exams and additional guidance based on their results, firms should expect examiners to take a “harder line.” It looks like the SEC will be doing the same.

The tougher exam standard might not be a surprise, but the timing of the Commission’s statement was a bit unexpected—a new administration starts in less than a month and SEC leadership is certain to change. We have expected the new administration will ramp up examinations and enforcement of Reg BI, moving the option of an overhaul to the backburner despite pressure from some members of Congress. Perhaps the SEC’s examination unit’s new name, the Division of Examinations, had something to do with the announcement’s timing? The exam unit’s recent promotion to division status may portend a more forceful approach to examining Reg BI by both the SEC and FINRA.

Good Faith Exams

As a quick refresher, Reg BI raises the standard for advice from suitability to best interest, imposing an enhanced standard of conduct for broker-dealers’ recommendations to retail customers. It has withstood many challenges, facing lawsuits, strong objections within the SEC and in Congress, and states opting for their own fiduciary standard laws.

Reg BI has also been pandemic-proof, offering no extension or pause to its original June 30 compliance date. In the lead-up to that critical date, the SEC and FINRA provided insights into the good faith exam approach via two Apr. 7 risk alerts. We discussed the alerts and related efforts in detail in an earlier piece.

To sum up the Reg BI Risk Alert, the Commission indicated its review would focus on the rule’s four obligations:

— the disclosure obligation;
— the care obligation;
— the conflict of interest obligation; and
— the compliance obligation.

In considering these obligations, examiners would review whether firms have, at a minimum, developed policies and procedures to comply with Reg BI, and made “reasonable progress” in implementing these policies and procedures.

Not long after the compliance date, reports trickled in on initial exam results primarily focused on Form CRS issues. In October, the regulators offered more details about these initial exams at a roundtable co-hosted by the SEC and FINRA. The consensus view was that firms were making good faith efforts to comply with Reg BI and Form CRS, but there was still room for improvement.

Preparing for More-Focused Exams

It looks like the “iterative process” chapter of Reg BI’s implementation will end shortly. Precisely how exam staff will apply the new “more focused” exam standard remains unclear. However, the Commission’s statement gives us some clues about focus areas potentially subject to enhanced scrutiny and heightened expectations for compliance.

Clue #1: Adequacy of Controls. Building on Reg BI initial reviews, Division staff will expand their exam scope to look at the adequacy of firms’ policies and procedures, supervision, and compliance oversight. The SEC statement warns that failure to have adequate controls may be linked to recurring issues in Reg BI compliance.

Clue #2: Recommendations. Division staff will evaluate how firms have implemented Reg BI’s specific requirements beyond relying on the suitability standard. For example, examiners may review whether a firm requires a reasonable basis to believe that recommendations made are in retail customers’ best interests.

Clue #3: Transaction Testing. Division staff will also conduct enhanced transaction testing to evaluate whether firms have implemented their written policies and procedures effectively.

The SEC also detailed potential focus areas that firms should expect may be covered in 2021 exams. The outline from the SEC can serve as a next-steps starting point for firms.

Policies and Procedures. Firms should expect examiners will continue to review their policies and procedures, including whether firms altered product offerings to remove higher-cost products when lower-cost products were available.

Costs. There may be questions in an exam about how a firm’s recommendations factor costs, evaluating: 1) the information available to firm personnel to identify relevant costs, 2) how this information is used, and 3) any documentation that reflects the consideration of costs.

New Customer Processes. Examiners may go deep into firms’ processes used to make recommendations to new customers. The SEC’s statement offers as an example that exams may focus on recommendations involving a rollover from an employee benefit plan. In that case, examiners may assess: 1) the information collected from new customers, 2) disclosures made at the time, 3) if and how alternatives were considered, and 4) any documents retained. Examiners may also inquire about the firm’s processes for recommending complex products, including what information was available and used to consider reasonably available alternatives.

Conflicts. Examiners may inquire about processes used to identify and address conflicts related to recommendations.

The SEC expects firms to evaluate whether existing controls implemented to comply with the rule’s June compliance date will clear the higher bar being set for 2021. We would encourage firms to address the above focus areas as well as any updates to the Reg BI and Form CRS FAQ resources.

Bloomberg Law subscribers can find related content on our In Focus: SEC Regulation Best Interest page.

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