Interpreting SEC Risk Alerts on Reg BI and Form CRS

By David McNeal, Contributor of My Compliance Blog 

By Cory Roberson, Principal of FIN Compliance, Lancer, Ventures

April 15, 2020.   On April 7^th, the SEC Office of Compliance Inspections and Examinations (OCIE) published two risk alerts detailing the expected scope of its initial examinations for compliance with Regulation Best Interest (“Reg BI”) and the ADV Part 3: Client Relationship Summary (“Form CRS”).

This article summarizes the two major components of this new rule: (1) A firm’s best interest standards as a fiduciary and (2) the creation of a client relationship disclosure document.

Notes from SEC Chairman on Covid-19: Chairman Jay Clayton announced that the SEC will not extend the June 30, 2020 compliance date for Reg BI despite the coronavirus (COVID-19) pandemic and the shelter in place status of most industry employees.

Mr. Clayton also acknowledged that implementation will be an iterative process and that the SEC’s focus will be on firms' "continuing good faith and reasonable efforts, including taking into account firm-specific effects from disruptions caused by COVID-19."

Form CRS Risk Alert Summary

The Form CRS risk alert highlights the OCIE's plans to examine whether firms have made a "good faith effort to implement Form CRS" in five primary areas of focus:

Delivery and filing

Content

Formatting

Updates

Record keeping

Broker-dealers (SEC/FINRA) and Registered Investment Advisers (SEC) must now provide retail investors with a customer relationship summary that contains:

Types of client/customer relationships and services the firm offers.

The fees, costs, conflicts of interest, and required standard of conduct associated with those relationships and services.

Whether the firm and its financial professionals have a reportable legal or disciplinary history.

How to obtain additional information about the firm.

1. Delivery and filing

Form CRS must be delivered to existing retail investors by July 30, 2020.

After that date, firms must provide a Form CRS when an investor opens a new account, is recommended a rollover of assets by the broker-dealer and/or starts a new brokerage or investment advisory service.

To assess compliance, OCIE staff may review the contents of the firm's policies, procedures, and other firm records related to the Delivery and Filing of Form CRS, including:

Checking whether the company timely filed the Form CRS (via CRD/IARD) and posted it on the company's public website.

The company's policies and procedures for the Form CRS.

The company's delivery process of Form CRS to investors.

The delivery record dates to ensure that the Form CRS was sent to clients.

In particular, the staff may review records of the dates that each relationship summary was provided to retail investors in the following manner:

Existing Retail Investors — The initial delivery of the client relationship summary must be made to existing retail investors by July 30, 2020, and before or at the time of:

The opening of a new account, different from the retail investor's existing account.

A recommendation of a rollover of assets from a retirement account into a new or existing account or investment.

A recommendation of a new brokerage or investment advisory service or other service that does not involve the opening of a new account and would not be held in an existing account, such as a first time purchase of a direct-sold mutual fund through a "check and application" process.

New Retail Investors — The delivery of the relationship summary must be made to new retail investors before or at the earliest of:

Entering into an investment advisory contract with the retail investor.

A recommendation to a retail investor of an account type, a securities transaction, or an investment strategy involving securities.

Placing an order for the retail investor.

The opening of a brokerage account for the retail investor.

2. Form CRS Content

Must be clear and easy for your client to understand, written in plain English, and must remain consistent with the other documents about investors, including policies, procedures, review fee schedules, advisory agreements, and brokerage agreements.

To assess compliance, OCIE staff may review the contents of fee schedules, advisory agreements, and brokerage agreements, policies, procedures, and other firm records related to Form CRS to examine:

How the firm describes the relationships and services it offers to retail investors, including statements regarding account monitoring and investment authority.

How the firm describes its fees and costs, including disclosures about the principal fees, categories of the most common fees, and any other transactional fees and product-level fees that retail investors will incur.

How the firm describes how its financial professionals are compensated, including cash and non-cash compensation, and the conflicts of interest those payments create.

How the firm describes its conflicts of interest, including incentives related to proprietary products, third-party payments, revenue sharing, and principal trading.

Whether the firm accurately discloses if the firm or its financial professionals have a legal or disciplinary history.

3. Formatting

Every broker-dealer or investment advisor must prepare only one overview of the relationship, summarizing all the key relationships and services it provides to retail investors. The form must include specific information and, in some cases, specific wording prescribed in the instructions to Form CRS.

To assess compliance, OCIE staff may review a firm's relationship summary to assess whether its Formatting is in compliance with the SEC's General Instructions to Form CRS, such as using particular wording where required, using text features where required, and writing in plain English.

4. Form CRS Updates

Must be communicated to retail investors there is a material change to its pertinent information. Furthermore, BDs and RIAs must file each amended relationship summary electronically with the Commission, on IARD if you are an investment adviser or dual registrant, and on EDGAR if you are a broker-dealer.

To assess compliance, OCIE staff may review the contents of the firm's policies, procedures, and other records related to Updating Form CRS to:

Assess how and whether a firm updates and files its relationship summary within 30 days after any information becomes materially inaccurate.

Assess how and whether a firm communicates these changes to retail investors within 60 days after the updates are required to be made.

Assess the firm's process for highlighting to retail investors the most recent changes and including an exhibit highlighting or summarizing material changes with any filed updates.

5.  Form CRS Recordkeeping

Requires a BD and RIA to maintain and preserve client relationship records in an easily accessible place for at least six years after such record of its creation, including a copy of each relationship summary, as well as all records of the dates that each relationship summary was provided to each retail investor, including any relationship summary that was provided before such retail investor opens an account.

To assess compliance, OCIE staff may review policies and procedure documents related to the Recordkeeping of Form CRS related information, including all those required by the SEC regarding customer relationships and Form CRS.

Q.  What is the Client Relationship Summary (in laymen's terms)

A. The Client Relationship Summary (Form CRS) is a disclosure form for clients to reference while: (1) deciding whether to establish an investment advisory or brokerage relationship, (2) engaging a particular firm or financial professional, and/or (3) terminating or switching a relationship or specific service.

For advisors, alongside the ADV Part 2A disclosure brochure, the Form CRS provides a two-page overview of firm services, fees, the nature of the firm’s relationship with its client (or prospect). 

Reg BI Risk Alert Summary (broker-dealers)

Similarly, the OCIE announced its plans to engage in examinations to assess broker-dealers' implementation and operational effectiveness of Reg BI "during the first year after the compliance date on June 30, 2020."

In particular, the Alert highlights the OCIE's plans to examine "whether broker-dealers have made a good faith effort in implementing and enforcing policies and procedures," and highlights four primary obligations of focus:

1.    Disclosures Obligation

2.    Care Obligation

3.    Conflict of Interest Obligation

4.    Compliance Obligation

Reminder: Reg BI significantly overhauls and redefines broker-dealers' obligations to their retail customers and imposes a heightened "best interest," standard.

According to the SEC, this new language requires that recommendations actually "be in the best interest of the retail customer," and "enhances the broker-dealer standard of conduct beyond existing suitability obligations, and aligns the standard of conduct with retail customers' reasonable expectations" as well as it prohibits those that "place the broker-dealer's interests ahead of the retail customer's interests."

1. Disclosures Obligations - Require firms to disclose material facts relating to the relationship with its retail customers, including:

The capacity in which the recommendation is being made.

Material fees and costs that apply to the retail customer's transactions, holdings, and accounts.

Material limitations on the investment strategies involving securities that may be recommended to the retail customer.

During an evaluation, OCIE staff may review the content of the firm's Disclosures to ensure they include:

All material facts relating to the scope and terms of the relationship with the retail customer.

All material facts relating to conflicts of interest associated with the recommendation.

To assess compliance, OCIE staff may also review the contents of the firm's policies, procedures, and other firm records related to its Disclosures, including:

Schedules of fees and charges assessed against retail customers and disclosures regarding those transactions, such as custodian fees, account maintenance fees, fees related to mutual funds and variable annuities, and other transactional fees and product-level fees.

The broker-dealer's documented compensation associated with recommendations to retail customers, sources and types of compensation, and related conflicts of interest associated with recommending proprietary products or with receiving payments for inclusion on a product menu.

Disclosures related to the monitoring of retail customers' accounts.

Disclosures on material limitations on accounts or services recommended to retail customers.

Lists of proprietary products sold to retail customers.

2. The Care Obligation - requires Broker-Dealers to exercise reasonable diligence, care, and skill when making recommendations to a retail customer.

The broker-dealer must take into account the retail customer's investment profile and consider any potential risks, rewards, and costs associated with the recommendation.

Broker-dealers should establish a process for evaluating the "reasonably available alternatives" to determine which recommendation is in the retail customer's best interest.

To assess compliance, OCIE staff may review the contents of the firm's policies, procedures, and other firm records related to its Recommendations, including:

Information collected from retail customers to develop their investment profiles such as any new account forms, correspondence, and any agreements the customer has with the broker-dealer.

The broker-dealer's process to determine that the best interest of the retail customer which may include any process for establishing, understanding, and implementing reasonably available alternatives.

The factors assessed by the broker-dealer to determine the potential risks, rewards, and costs of the recommendations.

The broker-dealer's process to ensure it does not place the financial or other interest of the broker-dealer ahead of the interest of the retail customer.

How the broker-dealer makes recommendations in a retail customer's best interest related to significant investment decisions, such as rollovers and account recommendations.

How the broker-dealer makes recommendations in a retail customer's best interest related to more complex, risky or expensive products.

3. The Conflict of Interest Obligation - requires broker-dealers to establish, maintain, and enforce written policies and procedures reasonably designed to address conflicts of interest associated with its recommendations to retail customers.

To assess compliance, OCIE staff may review the contents of the firm's policies, procedures, and other firm records related to Conflicts of Interest, including:

Whether and how the policies and procedures address conflicts that pose an incentive for an associated person to position its interest (or one of a broker-dealer) ahead of its retail customers.

Whether and how the policies and procedures address conflicts associated with material restrictions on securities offered or investment strategies recommended to a retail customer, including a limited product menu, offering only proprietary products, or products with third-party arrangements.

Whether and how the policies and procedures address the elimination of conflicts, such as sales contests, sales quotas, bonuses, and non-cash compensation.

Staff may request documentation of all conflicts associated with the broker-dealer's recommendations during a specified time to evaluate:

How the policies and procedures provide for identifying and adjusting to conflicts as they occur.

·         How the policies and procedures provide for disclosure of conflicts and documentation.

·         How the policies and procedures provide for mitigation or elimination of conflicts and documenting those cases.

4. The Compliance Obligation - requires the broker-dealer to establish, maintain, and enforce written policies and procedures reasonably designed to comply with the obligations of Reg BI.

To assess compliance, OCIE staff may review the contents of the firm's policies, procedures, and other firm records related to its Reg BI Compliance Program, including any controls, remediation of noncompliance, training, and periodic review and testing.

Conclusion

The OCIE noted in the risk alert, "While these are the primary focus areas, staff may select additional areas for review based on risks identified during the examinations."

For the specific requirements of Reg BI, go to https://www.sec.gov/rules/final/2019/34-86031.pdf and https://www.sec.gov/info/smallbus/secg/regulation-best-interest

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