Recently, the U.S. Securities and Exchange Commission’s (“SEC”) Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert to provide broker-dealers with guidance on examinations regarding regulation Best Interest (“Reg BI”).  Reg BI requires that when broker-dealers make a recommendation regarding securities to a retail customer it must act in the best interest of the customer, without placing its own financial or other interest ahead of the retail customer’s interest.  The Financial Industry Regulatory Authority (“FINRA”) also stated that it would take the same approach in its examinations of broker-dealers and their associated persons for compliance with Reg BI.

The SEC stated that the initial examinations are designed primarily to evaluate whether firms have made “a good faith effort to implement policies and procedures reasonably designed to comply” with Reg BI and it provided guidance on the four obligations under Reg BI:

Disclosure obligation:  Broker-dealers are required to provide retail customers written disclosure regarding the scope and terms of the relationship and any conflicts of interest that are associated with the recommendation.  To assess compliance with this obligation, staff may review documents such as: (i) schedules of fees and charges assessed against retail customers and the disclosures regarding such fees and charges; (ii) the broker-dealer’s compensation methods for registered personnel; (iii) disclosures related to monitoring of retail customers’ accounts; (iv) disclosures on material limitations on accounts or services recommended to retail customers; and (v) lists of proprietary products sold to retail customers.

Care obligation:  Broker-dealers are required to exercise reasonable diligence, care and skill when making a recommendation to a retail customer.  To assess compliance with this obligation, staff may review documents such as:  (i) information collected from retail customers to develop their investment profiles; (ii) the broker-dealer’s process for having a reasonable basis to believe that a recommendation is in the customers’ best interest; and (iii) how the broker-dealer makes recommendations related to significant investment decisions or more complex, risky or expensive investments and how it has a reasonable basis to believe they are in the retail customers’ best interest.

Conflict of interest obligation:  Broker-dealers are required to establish, maintain and enforce written policies and procedures reasonably designed to address conflicts of interest associated with its recommendations.  To assess compliance with this obligation, staff may review a broker-dealers’ policies and procedures to determine how they address the requirement of Reg BI and how they provide for mitigation or elimination of conflicts.

Compliance obligation:  Broker-dealers are required to establish, maintain and enforce written policies and procedures reasonably designed to achieve compliance with Reg BI.  To assess compliance with this obligation, staff may review the broker-dealer’s policies and procedures and evaluate any controls, training and testing.  Also, to the extent the broker-dealer remediated any non-compliance with Reg BI, the staff may review documentation around such issues.

In its Risk Alert, the SEC recognized that not every document is applicable to all broker-dealers and stated that it will review broker-dealers based on the profile of each broker-dealer.  The Risk Alert and the types of documents the staff may review, however, provide guidance to broker-dealers regarding the steps they should take prior to an examination to ensure compliance with Reg BI.  Beyond having documents reflecting disclosures to clients, broker-dealers should make sure that they have sufficient policies and procedures to reasonably comply with Reg BI, their registered representatives received training on Reg BI, and such training is documented.  Broker-dealers should also maintain evidence of supervision for compliance with Reg BI, including ensuring that customers receive consistent, timely and accurate information.

Lastly, the SEC also stated that the June 30, 2020 deadline for complying with Reg BI will not be changed in light of COVID-19.  Consequently, firms should be prepared for examinations on Reg BI as early as this summer.