Regulation BI: Four Key Areas to Address with Electronic Communications Review
The SEC’s Regulation Best Interest or “Reg BI” is expected to become effective on June 30. Reg BI requires any security transaction that a broker-dealer or associated person recommends to a retail customer be in the best interest of the customer. The broker should not place the interests of the firm or him/herself ahead of the interests of the retail investor.
Many broker-dealer firms had hoped for an SEC postponement of the implementation date as a result of COVID-19, but were not afforded such relief. To prepare for this upcoming change and its related requirements, we’ve put together some guidance for affected firms.
How Should Electronic Communication Reviews Change Under Reg BI?
Reg BI is a sizeable 800-page document that can be broken down into four component obligations. Each of these components creates its own set of compliance challenges that may affect a broker-dealer’s current electronic communication reviews and policies. The four obligations are:
1. Disclosure
2. Care
3. Conflict of Interest
4. Compliance
We’ve highlighted some of the more pertinent compliance obligations and how electronic communication reviews can help firms satisfy them.
Reg BI: Disclosure Obligation
Reg BI requires — prior to or at the time of a recommendation— that a full and fair disclosure be provided, in writing, of all material facts relating to the scope and terms of the relationship with the customer. This includes capacity (broker-dealer or dual registrant), material fees and costs, type and scope of services, and any material limitations on the securities recommended. These disclosures are in addition to Form CRS, which is a separate but related requirement for firms to standardize disclosure of the customer relationship. The SEC did not prescribe the method and/or exact timing of disclosures, so each firm must devise its own procedures on how to comply.
Whether they have revised their existing disclosures to incorporate Reg BI methods and policies or created standalone Reg BI disclosure documents, firms have to make sure that they comply with the layered disclosure obligation. Additionally, firms need to make sure their marketing materials are consistent with, and compliant with, Reg BI. Specifically, policies and procedures on complying with the Reg BI Disclosure Obligation must be noted.
For the Disclosure Obligation, it is easy to see how electronic communication reviews will play an integral part in Reg BI compliance. Firms will be better prepared to meet regulatory expectations for this obligation by:
- Reviewing communications for the proper Reg BI disclosure language
- Examining the consistency of marketing brochures with a firm’s Form CRS disclosures and reg BI policy disclosures
- Looking at the timing of disclosures to customers and, to the extent the reviewer can, the fullness and fairness of the disclosure
Reg BI: Care Obligation
The Care Obligation requires a broker-dealer to exercise reasonable diligence, care and skill to satisfy three requirements — the reasonable basis, customer-specific and quantitative obligations — when recommending a security or investment strategy. At a high level, these three sub-components boil down to the recommendation (on a reasonable basis) being in the interests of:
- At least some retail investors
- The particular retail customer based on investment profile and potential risks, rewards and costs
- The customer when viewed through a series of transactions, instead of in isolation
Firms must have specific policies and procedures on how their associated persons will need to comply with these Care Obligation sub-components. The sub-components may include disclosures, revised product offerings, automated recommendations and/or alternative products, transaction series modeling, etc. The SEC has provided no specific requirement to document compliance, leaving it up to the firms to decide how best to evidence their adherence to compliance requirements.
No matter the method of compliance, firms will have new policies and procedures that must be followed when broker-dealers are making a recommendation to retail customers. Communication reviews can be enhanced to support those requirements.
Reg BI: Conflict of Interest Obligation
This obligation requires a firm to establish, maintain and enforce written policies and procedures reasonably designed to identify and disclose (at a minimum) all conflicts of interest associated with a recommendation or to eliminate or mitigate them. Firms have been identifying these conflicts for years as part of their own policies, or in anticipation of Reg BI adoption. They should have also developed policies for identification, and for when and how to disclose, mitigate or eliminate conflicts of interest. The SEC also requires the elimination of sales contests on specific types of securities within a limited period of time.
While firms will most likely use multiple procedural, structural and technology-based methods to identify conflicts, electronic communication reviews historically have identified conflicts of interest. This includes those that are required to be disclosed (such as outside business activities). Clearly electronic communication reviews can also be used to identify conflicts of interest in the Reg BI context. They can be used as a tool to make sure mitigation or elimination are happening as prescribed by the firm to assist in complying with the Conflicts of Interest Obligation.
Reg BI: Compliance Obligation
This obligation requires firms to establish, maintain and enforce written policies and procedures reasonably designed to achieve compliance with Reg BI. Seasoned compliance officers want reasonably designed written policies and procedures to protect their firms from regulatory violations. This includes a “failure to supervise” violation. However, this obligation creates an affirmative requirement to have such policies and procedures. A lack thereof would itself be a potential violation.
Regardless of how your firm chooses to implement the Disclosure, Care or Conflicts of Interest Obligation components, electronic communication reviews will play a role. They should be incorporated into reasonably designed policies and procedures. This could be as simple as modifying an electronic communication written supervisory procedure (WSP) so that reviewers incorporate a few Reg BI-specific reviews.
Should You Update Lexicons for Reg BI?
FINRA Notice to Members 07-59 recommends firms use a combination of lexicon and randomly selected electronic communications for review. If you are using lexicons for review selection it should be designed for your firm’s compliance risks. The guidance states, you “…should also consider regular periodic reviews of the lexicon system to determine whether any changes/updates are necessary, such as adding or deleting phrases and/or words.”
The guidance also states one of the factors in assessing the effectiveness of a lexicon-based system should be the consideration of “…a meaningful list of phrases and/or words based on the size of the member, its type of business, its customer base and its location.” If your firm has a retail customer base and engages in recommendations as defined in Reg BI, then it may be prudent to review your current lexicon list versus Reg BI requirements and firm policies. This way you can see if you can enhance your lexicon searches for more targeted, concentrated reviews for Reg BI compliance.
To get you started below is a short and non-exhaustive list of ten suggested keywords you may want to add, along with their derivatives based on the rule:
- recommendation
- advice
- advisor
- fee/fees
- taxes
- contest
- win
- monitor
- perfect
- best
Some of these can be coupled with other words for lexicon phrases, such as “best investment option” or “perfect investment.” If part of your electronic communication review will be to check for certain Reg BI disclosures, then you may want to include lexicon words or phrases to ensure the proper disclosure is being provided. Alternatively, you may include words or phrases that are not aligned with your firm’s disclosures policies and procedures to identify the inconsistency.
Reg BI is almost here, and strong preparation is key to making sure your firm is ready to implement it. We recommend keeping this guidance in mind when updating your policies, procedures and lexicons to incorporate Reg BI into your electronic communication review program.
Join us for a webinar with Elin Cherry of Elinphant, LLC to discuss compliance and technology trends uncovered through a survey of industry professionals.
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Prior to joining Elinphant, Bill was a Managing Director in KPMG’s Operational and Regulatory Risk Advisory Practice. Prior to KPMG, Bill was an Executive Director and Head of Capital Markets Compliance at CIBC World Markets Corp. where he provided advisory coverage for Equities, Fixed Income, and Commodity sales and trading businesses. At CIBC Bill led the formation of their Swap Dealer registration and regulatory program and led their global Volcker Compliance implementation.
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