Be sure you’re following best practices before regulators come knocking.

The Securities and Exchange Commission requires that any broker-dealer (firm) and their associated persons (RRs) must be acting in the retail customer’s best interest at the time of the recommendation and must not place their own financial interests above the customer’s interest.

To comply with Reg BI, four obligations to the customer must be met: (i) the Disclosure Obligation; (ii) the Care Obligation; (ii) the Conflict of Interest Obligation and (iv) the Compliance Obligation. See the SEC’s Small Entity Guide.

The Disclosure Obligation requires firms and RRs to provide in writing “full and fair disclosure” of certain material facts to retail customers before or at the time a recommendation is made.   

Timing and Documentation of the Disclosures

Written disclosures must be made at the time a new customer account is opened or at the time of any new recommendation for existing customers. Oral disclosures are specifically limited to providing a customer an update of information that was not known or knowable at the time of the recommendation.

To satisfy the Disclosure Obligation, the firm must keep a written record of any after-the-fact oral update disclosures. It is imperative for RRs to keep detailed notes or records of any oral communications with customers providing them with updates related to their investments, and have policies in place regarding oral update disclosures. Firms should provide RRs with training specifically related to documenting any after-the-fact discussions regarding a recommendation. Documentation is key to demonstrating compliance.

What Must Be Disclosed

Any material fact must be disclosed. The SEC advised of two main categories of material facts that must be disclosed: (1) facts relating to the “scope and terms of the relationship with the retail customer” and (2) facts relating to “conflicts of interest that are associated with the recommendation.”

What is considered a material fact for Reg BI is the same objective materiality standard that has long been recognized in federal securities law. To satisfy the requirement, customers should be given sufficient information to make a fully informed decision regarding the RR’s recommendation.

At a minimum, disclosures relating to the “scope and terms of the relationship with the retail customer” include:

The capacity in which the firm or RR is acting. A firm that is not dually registered will likely be able to satisfy this disclosure requirement in the Form CRS. However, RRs of dually registered firms who do not offer advisory services must disclose that they are only acting as an associated person of a firm. If the firm is not dually registered, using the term “advisor” or “adviser” is presumed to be a violation of the Disclosure Obligation.

Material fees and costs that the customer will be charged for the transactions, holdings and accounts. Reg BI does not require firms to disclose fees and costs at a granular level for each customer. Instead, it is sufficient to provide standardized numerical amounts (reasonable dollar or percentage ranges). Disclosures should clearly and accurately convey when and why a fee is being charged, and if the fee is being paid per transaction or on a quarterly basis.

Disclosures should also accurately describe commissions and markup fees and avoid vague terms like “handling fees” or “handling services.” Fees should be periodically reviewed with customers.

The scope of the services that the firm’s RRs can recommend, including any material limitations on securities or investment strategies. Material limitations to disclose include if an RR can only offer proprietary products, certain asset classes, only products from a select list of issues, and limitations on IPOs to certain customers.

Disclosures related to recommendations must also include (1) the bases for the recommendation, which should include the recommended investment approach, philosophy or strategy; (2) the associated risks of the recommendation in standardized items; and, (3) any other material facts given the facts and circumstances of the recommendation and the customer.

Whether the account will be monitored and frequency of monitoring, and the requirements to maintain an account. For existing customers, it is necessary to describe the type of account monitoring services that will be provided (if any). New and existing customers should also be aware of any barriers or requirements for opening accounts (account balance requirements, asset requirements). Fees associated with low balance requirements must also be identified.

Further disclosures are required under the Conflict of Interest Obligation, including: (1) any interest that “might incline” a RR to make a recommendation; (2) conflicts associated with proprietary products; (3) compensation for RRs; and (4) fees and costs borne by the customer.

Delivery of the Disclosures

Reg BI imposes certain delivery requirements. Mailing disclosures to a customer satisfies the Disclosure Obligation, but the time and expense makes physical delivery unrealistic. To satisfy the Disclosure Obligation via electronic delivery: (1) notice must be provided to the customer that the information is available electronically; (2) the access that is provided must be comparable to what would have been provided to the customer in paper format via physical mail or hand delivery; and (3) there must be evidence of delivery.

To satisfy the “evidence of delivery” prong, it is a best practice to obtain the informed consent of the customer to deliver the documents electronically. Instead of including generic language in an account opening document related to consent for electronic delivery, it is a best practice to have a separate Informed consent form that a customer must execute prior to the electronic delivery of documents.

Once the customer consents to electronic delivery, the information must be sent correctly. Firms must send disclosures either as an email attachment or as an embedded hyperlink that jumps directly to the disclosure.  Merely hyperlinking the disclosures on the firm’s website or emailing the customer that the disclosures are available on the firm’s website is insufficient to satisfy delivery requirement.

What to Expect From SEC and FINRA Exams

Initially, both the SEC and FINRA will be focused on whether or not firms and their RRs have engaged in “good faith” efforts to comply with Reg BI. As it relates to the Disclosure Obligation, examinations will focus on how firms meet the obligation to disclose material facts to the customer and will likely assess the content and timing of the disclosures.

Simply adopting policies and procedures will not demonstrate firm’s “good faith” effort to comply. Firms should continually review and test internal policies and procedures for compliance by RRs and for effectiveness. If a policy or procedure is not working or RRs are failing to comply with the policies and procedures, address it before your SEC or FINRA exam begins — either further clarify the policies or procedures, provide further training to RRs, or implement corrective actions with RRs.

Reprinted with permission from the September 29, 2020 edition of ThinkAdvisor © 2020 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com.