The compliance date for two rules adopted by the US Securities and Exchange Commission (SEC) last year, Regulation Best Interest (Reg BI)¹ and the Form CRS Relationship Summary (Form CRS)² is rapidly approaching for broker-dealers and investment advisers. As the effects of the COVID-19 pandemic on the financial markets continue, SEC Chairman Jay Clayton has placed particular emphasis on good faith efforts to comply with Reg BI and Form CRS by the June 30, 2020 compliance date and has noted several areas of focus for firms to consider when aligning their operations and preparing for the requirements of Reg BI and Form CRS.

With Chairman Clayton’s remarks in mind, there are many recent regulatory developments and important legal questions that in-house counsel and compliance professionals should consider. This alert examines the recent regulatory developments related to Reg BI and Form CRS, sets forth a brief summary of the rules, and then concludes with several important considerations for broker-dealers and investment advisers as we close in on the June 30 compliance deadline.

Recent Regulatory Developments

SEC Public Statements

Chairman Clayton recently confirmed that the SEC will not extend the compliance date of June 30, 2020 for Reg BI and Form CRS, despite industry challenges associated with the recent COVID-19 pandemic.³ Chairman Clayton emphasized that the SEC has engaged extensively with broker-dealers and investment advisers regarding implementation of Reg BI and Form CRS since the rules were adopted in June 2019. Based on this industry engagement, the SEC felt that the June 30 compliance date was still appropriate amidst the current COVID-19 pandemic and related market turmoil.

At the same time, Chairman Clayton offered some limited flexibility for the financial services industry, noting that firms should focus on “good faith” compliance efforts and that the SEC would “engage” with firms unable to comply with Reg BI and Form CRS by June 30, 2020, due to disruptions caused by COVID-19: “To the extent that a firm is unable to make certain filings or meet other requirements because of disruptions caused by COVID-19, including as a result of efforts to comply with national, state or local health and safety directives and guidance, the firm should engage with us. I expect that the [SEC] will take the firm-specific effects of such unforeseen circumstances (and related operational constraints and resource needs) into account in our examination and enforcement efforts.”

As a follow-up to Chairman Clayton’s remarks, the SEC’s Office of Compliance Inspections and Examinations (OCIE) released two risk alerts on April 7, 2020; one focused on Reg BI examinations⁴ and another focused on Form CRS examinations.⁵ These risk alerts provide broker-dealers and investment advisers with information about the expected scope and content of the initial examinations for compliance with Reg BI and Form CRS, which are expected to begin shortly after June 30, 2020.

SEC’s OCIE Risk Alerts

Perhaps most importantly, both OCIE risk alerts emphasized that the SEC would focus their initial examinations on assessing whether firms have made a “good faith effort” to implement Reg BI and Form CRS. While the SEC didn’t offer much clarity regarding what would meet this “good faith” standard, many broker-dealers and investment advisers are interpreting this statement to mean that the SEC will primarily focus its initial examination findings on only the most serious or egregious compliance deficiencies.

More specifically, the OCIE risk alerts offer helpful tips and considerations for in-house counsel and compliance professionals preparing their firms for SEC examinations. In the Reg BI risk alert, OCIE indicated that initial examinations would evaluate primarily whether firms have established policies and procedures reasonably designed to achieve compliance with Reg BI. OCIE also noted that it may review the content of Reg BI disclosures, including comparing those disclosures to the firm’s schedule of fees or compensation practices, in order to determine whether the Reg BI disclosures provide the required information to retail customers.

OCIE also included a sample document request list as an appendix to the Reg BI alert, which contained information that OCIE may request in connection with its Reg BI examinations. Among other items, the sample document request list included requests for the following documents: descriptions of brokerage and non-brokerage account types, fee schedules, lists of proprietary products, compensation paid to registered representatives by third parties, and Reg BI training materials.

In the Form CRS risk alert, OCIE emphasized its focus on reviewing delivery and filing requirements for Form CRS, including delivery to both new and existing retail investors and posting the relationship summary on the firm’s public website. OCIE’s initial examinations for Form CRS compliance will also review the content of the firm’s relationship summary, as well as the firm’s procedures for updating the relationship summary when the information becomes materially inaccurate.

FINRA Developments

Shortly after the OCIE risk alerts were issued, the Financial Industry Regulatory Authority, Inc. (FINRA) issued a public statement that it would adopt the “same approach” as set forth in the OCIE risk alerts when examining broker-dealers and their associated persons for compliance with Reg BI and Form CRS.⁶ In particular, FINRA’s initial approach to examinations would – like the SEC’s approach – focus on whether firms have made a “good faith effort” to establish and implement policies and procedures reasonably designed to comply with Reg BI and form CRS.

In addition, FINRA published a Reg BI “preparedness” report to present common industry practices it observed during its reviews of small, mid-size, and large broker-dealers in late 2019 to assess their preparedness for Reg BI and Form CRS.⁷ Among its observations, FINRA noted that broker-dealers were identifying gaps in current policies and procedures, creating conflicts inventories, and implementing automated tools to track, report, and document existing conflicts in advance of the Reg BI and Form CRS compliance date. The FINRA report also observed that firms were reviewing compensation practices, including compensation differentials across investments and potentially imposing compensation caps, to ensure compliance with Reg BI.

Finally, on March 12, 2020, FINRA filed with the SEC a proposed rule change to amend FINRA’s suitability and non-cash compensation rules to align with Reg BI.⁸ The initial rule proposal created some confusion regarding whether mutual fund or variable product sales contests would be considered prohibited sales contests under Reg BI. However, FINRA has since clarified the rule proposal by amendment to note that its amendments should be read consistent with the SEC’s interpretation of Reg BI.

Summary of Reg BI and Form CRS

Set forth below is a brief summary of the Reg BI and Form CRS legal requirements, which sets the stage for the important questions that in-house counsel and compliance professionals should consider before the June 30 compliance deadline.

Reg BI

On June 5, 2019, the SEC formally adopted Reg BI, which established a “best interest” standard of conduct for broker-dealers and their natural associated persons when making recommendations to retail customers of any securities transaction or investment strategy involving securities or regarding the opening of an account.⁹

While this new best interest standard is not specifically defined in the Reg BI Adopting Release, the SEC clarified that acting in the best interest of the retail customer means not placing the broker-dealer’s own interests (or the interests of its associated persons) ahead of the retail customer’s interests. To satisfy Reg. BI’s general best interest obligation, a broker-dealer must comply with each of the four component obligations, outlined generally below:

• Disclosure Obligation: providing certain prescribed “full and fair” disclosure before or at the time of the recommendation, about the recommendation and the relationship between the retail customer and the broker-dealer. The disclosure must be in writing and must disclose all material facts relating to the scope and terms of the relationship with the retail customer, including disclosures regarding material fees and costs, capacity, material limitations, and all material facts relating to conflicts of interest associated with the recommendation.
• Care Obligation: exercising reasonable diligence, care, and skill in making the recommendation. The Care Obligation contains a three-part “reasonable basis,” “customer-specific,” and “quantitative” best interest requirement. Notably, the Care Obligation requires broker-dealers to consider the costs associated with a recommendation, and whether any “reasonably available alternatives” are offered by the firm when evaluating the recommendation.
• Conflict of Interest Obligation: establishing, maintaining, and enforcing policies and procedures reasonably designed to address the conflicts of interest associated with recommendations. These policies and procedures must be reasonably designed to identify all such conflicts and at a minimum disclose or eliminate them. In addition, the Conflict of Interest Obligation requires firms to identify and eliminate any sales contests, sales quotas, bonuses, and non-cash compensation based on the sales of specific securities or specific types of securities within a limited period of time.
• Compliance Obligation: establishing, maintaining, and enforcing policies and procedures reasonably designed to achieve compliance with Reg BI as a whole.

Form CRS

As part of the same Reg BI rulemaking package, the SEC also formally adopted Form CRS on June 5, 2019.¹⁰ Form CRS requires broker-dealers and investment advisers to deliver relationship summaries to retail investors, which contain succinct disclosures of the services retail investors may receive, the cost of those services, the potential conflicts of interest that may exist for the firm and its financial professionals, and the disciplinary history of the firm and its financial professionals.

In addition to the required disclosures in the relationship summary, several sections must also include required “conversation starters,” which are questions that retail investors are encouraged to ask their financial professional with the intention of prompting a discussion about the distinctions between brokerage and advisory services. If a conversation starter is not applicable to a firm’s business, the Form CRS Adopting Release permits the firm to omit or modify the conversation starter in its relationship summary. 

Important Considerations for June 30 Compliance Date

As the June 30 compliance date approaches, we’ve highlighted several important considerations for in-house counsel and compliance professionals seeking to implement Reg BI and Form CRS at their firms.

• “Good Faith Efforts.” As mentioned above, the SEC will look for good faith effort compliance in the initial examinations of Reg BI and Form CRS. Although the SEC’s published statements have not elaborated on what would constitute “good faith efforts,” recent remarks by the SEC staff have suggested that “good faith” would at a minimum entail adopting policies and procedures to meet the Reg BI and Form CRS requirements and making reasonable progress in implementing or tailoring those policies and procedures to the firm’s business activities. Further, the SEC staff remarks also provided certain examples that would not meet the “good faith” standard, such as failing to perform a gap analysis of current disclosures compared to those required by Reg BI, and failing to identify or address existing conflicts of interest.
• Additional FAQ Guidance before June 30. In recent remarks, the SEC staff has noted that they may issue additional “frequently asked questions” (FAQs) or other guidance before June 30. The SEC has also previously commented that FAQ guidance would be provided only when there is a critical mass of interest in a given question and would avoid highly fact-specific questions. The SEC staff has advised that fact-specific questions would be better addressed through the advice of counsel or through the no-action letter process.
• Expectations if Additional FAQ Guidance Issued after June 30. The SEC may also continue issuing FAQ guidance after June 30. It remains unclear how the SEC would evaluate a firm that has already implemented systems to comply Reg BI or Form CRS, and then a FAQ is issued after June 30 requiring changes to that firm’s systems and implementation efforts. However, in recent remarks, the SEC staff has suggested firms should document and explain their original implementation decision if a subsequently issued FAQ requires changes to that decision.
• Retirement Account Rollovers and Withdrawals. In a recent statement, Chairman Clayton emphasized that firms should ensure that the proper care is applied to recommendations of rollovers and withdrawals from retirement accounts, especially given current economic conditions.¹¹ In particular, recommendations to rollover retirement assets from an employer sponsored plan to an individual retirement account (IRA) pose certain legal and compliance challenges in connection with Reg BI’s “best interest” standard. According to the Reg BI Adopting Release, the IRA rollover recommendation should be compared to the retail customer’s existing account, including a comparison of fees and expenses, services, available investment options, ability to take penalty-free withdrawals, required minimum distributions, holdings of employer stock, and any special features of the existing account.¹² The challenges with evaluating IRA rollover recommendations are also compounded when plan-specific information for the retail customer’s existing retirement plan is not readily available. Further, firms should be particularly attuned to their regulatory obligations in light of the flexibility Congress recently provided to investors taking early withdrawals from certain accounts in order to weather the financial hardships related to the COVID-19 pandemic.¹³ Given the obligations under Reg BI and Form CRS, firms should consider how to handle recommendations to take such early withdrawals or otherwise roll-over retirement funds to invest in other products.
• Training. Firms must ensure that its registered representatives or investment adviser representatives have been properly trained regarding Reg BI and Form CRS. FINRA’s Reg BI “preparedness” report, which was discussed above, suggested providing training through multiple channels, including newsletters or notices, “lunch and learn” events, dedicated in-person or on-line training, seminars or sessions at firm events (such as sales summits), and regularly scheduled ongoing meetings between compliance and business personnel. Given the impact of COVID-19, in-house counsel and compliance professionals should consider how to modify their Reg BI and Form CRS training plans to account for these new remote working arrangements.
• Updating Disclosures. Firms are generally required to update their Reg BI or Form CRS disclosures if the information becomes materially outdated, incomplete, or inaccurate. Given this requirement, firms should consider implementing a periodic review of their Reg BI disclosure and Form CRS relationship summary documents to ensure that the information is accurate.
• Delivery of Updated Disclosures. Once the Form CRS has been updated, the SEC was clear that firms must communicate any changes to each retail investor who is an existing customer of the firm within 60 days after the update is required to be made. However, the SEC was not clear on whether the updated Reg BI disclosure document also needs to be delivered to existing retail customers. Firms should consider how they plan to handle re-delivering the updated Reg BI disclosure anytime the information becomes materially outdated, incomplete, or inaccurate.
• Ongoing recommendations. The “best interest” standard under Reg BI applies when a broker-dealer recommends any securities transaction or investment strategy involving securities, including account recommendations, to retail customers. In-house counsel and compliance professionals should evaluate how ongoing or periodic recommendations to certain retail customers meet this “best interest” standard, including whether a new Reg BI disclosure document needs to be provided to the retail customer in connection with each recommendation. In recent remarks, the SEC staff has indicated that a new Reg BI disclosure document may need to be re-delivered to the customer, depending on the facts and circumstances of each recommendation.

As we close in on June 30, 2020, firms will be very focused on making sure their Reg BI and Form CRS compliance efforts satisfy the SEC and FINRA “good faith” standard. At the same time, even after June 30, SEC and FINRA will expect Reg BI and Form CRS compliance to be a work in progress, with firms continuing to evaluate their programs on an ongoing basis and determine whether any enhancements are needed.

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