This is the first in a series of alerts discussing topics covered by FINRA in its 2022 Examination and Risk Monitoring Program Report (the "Report"). Here we take a look at Regulation Best Interest ("Reg. BI") and Form CRS, including some of the key considerations for firms' compliance programs, noteworthy findings from FINRA's recent examinations, and effective practices FINRA observed during its oversight. 

REG. BI

Reg. BI establishes a "best interest" standard of conduct for broker-dealers and associated persons when they make recommendations to retail customers of any securities transaction or investment strategy involving securities. When applicable, broker-dealers and their associated persons must put the interests of retail customers ahead of their own financial or other interests.

FINRA identified the following Reg. BI-related focus areas in the Report:

  1. Obligation to comply with Reg. BI;
  2. Adherence to Reg. BI's Care Obligation;
  3. Adherence to Reg. BI's Conflict of Interest Obligation;
  4. Adequacy of policies and procedures and complementary testing;
  5. Full and fair disclosure and associated controls; and
  6. Other firm guidance and training.

FORM CRS

As a corollary to Reg. BI, Form CRS requires that all broker-dealers (and registered investment advisers) that offer services to retail investors provide a brief relationship summary in plain English that discloses material information, such as investment services provided, fees, conflicts of interest, and legal and disciplinary history of the firm and financial professionals. FINRA's Report echoed many observations that the SEC highlighted in its latest Form CRS disclosure guidance, which we recently summarized.

FINRA identified the following Form CRS-related focus areas in the Report:

  1. Obligation to file with the SEC;
  2. Delivery to new or prospective customers and existing retail customers;
  3. Filing with the SEC and processes for updating the filing;
  4. Posting to the firm's public website;
  5. Adequacy of policies and procedures and testing; and
  6. Adequacy of staff training.

The focus on Form CRS is further illustrated by the SEC's recently announced settlements with 12 broker-dealers and investment advisers for failing to satisfy related obligations. These settlements come on the heels of 27 settlements last year for similar violations. The SEC has increasingly shown that it has moved beyond assessing whether firms have made a good faith effort to implement Form CRS requirements and has begun looking more closely at the content and quality of firms' disclosures.

HELPING HAND TO DISTILL THE REPORT'S SALIENT POINTS

There are many overlapping themes across the key considerations for firm compliance programs, exam findings, and effective practices identified by FINRA. We categorize and contrast these considerations, exam findings, and practices in the table below, and will continue to monitor FINRA's additional findings as it conducts exams and gathers further information about firms' practices.

But first, some key takeaways:

  • Reg. BI, not the Suitability Rule, for recommendations to retail investors. Internalize the four component Reg. BI obligations of care, disclosure, conflicts, and compliance.
  • Dig beneath the surface. Identify and mitigate and disclose your actual and potential conflicts of interest. Understand the relationship between your compensation for selling different securities products and the risk and reward characteristics for customers.
  • For timely delivery of Form CRS, consider delivering before the triggering event. And, track the date of delivery.
  • Form CRS and Reg. BI-related documents should be revisited regularly. They are living documents that evolve along with the nature of your business and financial professionals. 
  • Document, test, and train. Don't forget to document and test your policies, procedures, and controls and provide training and guidance to associated persons and supervisory staff. It's imperative to set forth how you will comply with the rule.
 Obligations  Considerations
FINRA urges firms to consider whether the firm and its associated persons, as applicable...		  Exam Findings  Effective Practices
REGULATION BEST INTEREST
Obligation to comply with Reg. BI
  • Correctly apply definitions of the terms "retail customer" and "uses" of a recommendation of a securities transaction or investment strategy involving securities in the context of the rule when determining its obligation to comply with Reg. BI.
    
Adherence to Reg. BI's Care Obligation
  • Exercise reasonable diligence, care and skill to understand the potential risks, rewards and costs associated with a recommendation generally and in light of a retail customer's investment profile, and have a reasonable basis to believe, based on such understanding, that the recommendation is in the best interest of at least some retail investors and each recommendation is in a particular customer's best interest and does not place the interest of the broker-dealer ahead of the customer.
  • Have a reasonable basis to believe that a series of recommended transactions taken together are not excessive and are in a retail customer's best interest in light of the retail customer's investment profile.
  • Consider costs and reasonably available alternatives when making recommendations to retail customers.
  • Made "recommendations that were not 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."
  • Broker-dealer's or associated person's interest placed ahead of retail customer's by recommending a series of transactions that were excessive in light of a retail customer's investment profile.
  • In an effort to mitigate the risk of making recommendations that might not be in a retail customer's best interest, effective practices include:
    • Establishing product review processes to identify and categorize risk and complexity levels for existing and new products;
    • Limiting high-risk or complex product, transaction or strategy recommendations to specific customer types; and
    • Applying heightened supervision to recommendations of high-risk or complex products.
  • Implementing new surveillance processes to monitor associated persons' compliance with Reg. BI (e.g., conducting monthly reviews to confirm that recommendations meet requirements of the Care Obligation, including system-driven alerts or trend criteria to identify account type or rollover recommendations that may be inconsistent with a customer's best interest, excessive trading, and sale of same product(s) to a high number of retail customers).
Adherence to Reg. BI's Conflict of Interest Obligation  
  • Failed to identify conflicts or inadequately addressed identified conflicts.
  • Identifying, disclosing, and eliminating or mitigating conflicts of interest across business lines, compensation arrangements, relationships or agreements with affiliates, and activities of associated persons by:
    • Establishing and implementing policies and procedures to identify and address conflicts of interest (e.g., use of conflicts committees or other mechanisms, creating conflicts matrices tailored to firm business that address how to eliminate, mitigate or disclose conflicts, for example, across business lines);
    • Evaluating how costs and reasonably available alternatives were considered by sampling recommended transactions;
    • Providing resources that account for reasonably available alternatives with comparable performance, risk and return that may be available at a lower cost to associated persons making recommendations (e.g., worksheets to compare costs and reasonably available alternatives, and provide guidance on relevant factors to consider when evaluating reasonably available alternatives to a recommended product);
    • Updating client relationship management tools that compare recommended products to reasonably available alternatives automatically;
    • Revising commission schedules to flatten the percentage rate within product types; and
    • Broadly prohibiting all sales contests.
Adequacy of policies and procedures and complementary testing
  • Address Reg. BI (including new obligations that did not exist prior to Reg. BI).
  • Identify and disclose or eliminate conflicts, and mitigate conflicts that create incentives for the interests of the firm or their associated persons to be placed ahead of the interests of its retail customers.
  • Set forth framework to sufficiently supervise compliance with Reg. BI by:
    • Identifying specific individual(s) responsible for supervising compliance with Reg. BI;
    • Specifying supervisory steps and reviews that should be taken by designated supervisor(s), including their frequency; and
    • Noting how supervisory reviews should be documented.
  • Test the adequacy and performance of Reg. BI policies and procedures.
  • Failed to modify existing policies and procedures to reflect Reg. BI's requirements (i.e., not addressing how costs and reasonably available alternatives should be considered when making recommendations of securities or account types, not addressing conflicts that create an incentive for associated persons to place their interests ahead of those of their customers, and not including provisions to address recordkeeping obligations and testing of policies, procedures and controls).
  • Provided "insufficiently precise guidance" (i.e., not identifying specific individuals responsible for supervising compliance, not detailing how the firm will comply with rule requirements).
  • Failed to develop adequate controls (or developed adequate controls but failed to memorialize them).
  • Implementing new surveillance processes to monitor associated persons' compliance with Reg. BI by incorporating Reg. BI specific reviews into the branch exam program, focused on documenting Reg. BI compliance and following firm Reg. BI protocols.
Full and fair disclosure and associated controls
  • Disclose all material facts relating to:
    • The scope and terms of the firm's relationship with retail customers (e.g., material fees and costs associated with transactions or accounts, material limitations involving securities recommendations); and
    • Conflicts of interest that are associated with the recommendation.
  • Disclose material limitations on the securities or investment strategies involving securities that may be recommended to a retail customer, and otherwise prevent the firm or its associated persons from making a recommendation that place the interests of a retail customer ahead of the interests of the firm or its associated persons.
  • Establish controls to assess disclosures to determine whether they are provided timely, and in compliance with the SEC's electronic delivery guidance, if provided electronically.
  • Failed to provide retail customers with "full and fair" disclosures of all material facts related to the scope and terms of their relationship with customers (e.g., no disclosure of material fees, including revenue sharing or other payments received from product providers or issuers, and other fees tied to recommendations to rollover qualified accounts), potential conflicts of interest associated with the recommendations made (e.g., associated persons trading in the same securities in their personal account(s) or outside employment), and material limitations in securities offerings.
  • Implementing systems enhancements for tracking delivery of Reg. BI-related documents to retail investors and retail customers in a timely manner by automating tracking mechanisms to determine who received relevant disclosures and memorializing delivery of such disclosures at the earliest triggering event.
Other firm guidance and training
  • Provides adequate training to associated persons, including supervisory staff.
  • Provides guidance:
    • To assist dually-registered associated persons with determining and disclosing the capacity in which they are acting.
    • Regarding use of the term "adviser" or "advisor" in name or title if not dually registered.
  • Failed to sufficiently "prepare associated persons to comply with the requirements of Reg. BI beyond previous suitability obligations" (e.g., failed to deliver initial training before the compliance date, delivered training that did not make clear Reg. BI's new obligations or focused on Reg. BI requirements without explaining how associated persons should comply).
  • Use of terms "advisor" or "adviser" in firm names or titles of associated persons without appropriate registration.
  • Implementing new surveillance processes to monitor communication channels (e.g., email, social media) to confirm that associated persons are not using the word "adviser" or "advisor" in their titles if they are not IARs.
FORM CRS
Obligation to file with the SEC
  • Incorrectly "determine[ed] that filing hinges solely on making recommendations, rather than offering services to a retail investor."
  • Inaccurately claimed that because of customer base (e.g., retail investors who are high-net-worth individuals) or the services offered (e.g., investment company products held directly by an issuer, self-directed accounts), among other things, that the firm is not subject to the delivery obligation.
Delivery to new or prospective customers and existing retail customers
  • To each new or prospective customer who is a retail investor before the earliest of:
    • A recommendation of an account type, securities transaction or investment strategy involving securities;
    • Placing an order for the retail investor; or
    • Opening a brokerage account for the investor.
  • To existing retail customers, before or at the time the firm:
    • Opens a new account that is different from the retail customer's existing account;
    • Recommends that the retail customer roll over assets from a retirement account; or
    • Recommends or provides a new service or investment outside of a formal account.
  • Implementing systems enhancements for tracking delivery of relationship summaries to retail investors in a timely manner by automating tracking mechanisms to determine who received them and memorializing delivery at the earliest triggering event.
Filing with the SEC and processes for updating such filing
  • File the relationship summary through CRD, if the firm is registered as a broker-dealer and through IARD, if the firm is registered as an investment adviser, or both CRD and IARD, if the firm is a dual-registrant.
  • Establish processes to:
    • Update and file the amended relationship summary within 30 days whenever any information becomes materially inaccurate; and
    • Communicate, without charge, any changes in the updated relationship summary to retail investors who are existing customers within 60 days after the updates are required to be made.
  • Filed deficient relationship summary that significantly departed from Form CRS instructions or guidance from the SEC's FAQ on Form CRS (e.g., exceeding prescribed page length, omitting material facts, misrepresenting financial professionals' disciplinary histories, failing to describe types of compensation and related conflicts, incorrectly stating that the firm does not provide recommendations, changing or excluding language required by Form CRS, not resembling a relationship summary).
  • Failed to re-file the relationship summary in CRD in a timely manner (i.e., within 30 days of the date when it became materially inaccurate).
  • Failed to timely communicate changes to existing retail investor customers.
Posting to public website
  • Firms with a public website failed to post or prominently post the current version of the relationship summary (i.e., in a location and format that is not easily accessible to retail investors), using confusing descriptions or requiring multiple click-throughs to navigate to the relationship summary.
Adequacy of policies and procedures and testing
  • Failed to include provisions to address testing of related policies, procedures and controls.
Adequacy of staff training
  • Failed to adequately prepare associated persons to comply with the requirements of Form CRS (e.g., failed to deliver initial training before the compliance date, or delivered training that focused on Form CRS requirements without explaining how associated persons should comply).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.