September 22, 2023

Regulation BI: Key Perspectives from Recent Report by State Regulators

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The North American Securities Administrators Association (NASAA) recently released a report prepared by its Broker-Dealer Section Committee (Committee) presenting the findings of Phase II (B) of its National Examination Initiative. The report is noteworthy, in part, because it represents a well-organized presentation of the Committee’s assessment of broker-dealers’ implementation of Regulation Best Interest (Reg BI) and identifies conduct categorized as “presumptive breaches” of Reg BI. Moreover, the report (Reg BI Report) was published on the same day NASAA released proposed revisions to its Broker-Dealer Conduct Model Rule intended to support the incorporation of key aspects of Reg BI into state laws. There is certainly room to debate the Committee’s assessments, but broker-dealers should not ignore the Reg BI Report – even if they disagree with some of the views expressed therein. Accordingly, this client alert summarizes the Reg BI Report and presents our initial observations.

The Coordinated National Examination Initiative

The information underlying the Reg BI Report was collected by state securities regulators in 25 jurisdictions via on-site and remote examinations of more than 200 broker-dealers. Although the information reviewed by the Committee did not identify the firms examined, it observed that the broker-dealers examined varied in “size, business model, and location.”

The examinations were aimed at assessing compliance in years “two and three of Reg BI.” Thus, presumably all of the findings discussed in the Reg BI Report are based on information associated with activity between June 2021 and June 2023.

It should be noted that the examinations underlying the Reg BI Report focused on transaction-level reviews of what NASAA refers to as “complex, costly, and risky product types,” which it described as:

Leveraged and inverse ETFs;
Non-traded real estate investment trusts (non-traded REITS);
Private placements, and;
Variable annuities.

The objective of the Reg BI Report was to present “qualitative findings” of how broker-dealer firms have been “meeting or exceeding state expectations . . . as well as identifying areas where FINRA firm compliance appeared weak (opportunities for improvement).”

Key Findings, Best Practices and Presumptive Breaches

Consistent with the stated objective, the Reg BI Report discusses the Committee’s assessments as to both strengths and weaknesses in practices observed. The identified best practices are likely welcome news for firms that have implemented the same. But they also present valuable insight into state regulators’ expectations, which is great information for firms as they consider ongoing compliance needs. On the other hand, the Reg BI Report’s discussion of weaknesses and “presumptive breaches” foreshadows future exam findings and enforcement actions, and thereby warrants consideration by broker-dealers across the country.

Noteworthy Findings

The following table presents a brief summary of findings, key observations, and concerns raised by the Committee during Phase II (B) with relation to firms’ Reg BI obligations, as well as best practices identified by the Committee. The below is not an exhaustive list of all observations discussed in the report, and we suggest firms take the time to read the report in its entirety.

Key Committee Observations or Concerns Noted

Associated Best Practice(s) Noted in Report

Reg BI Obligation:[1] Care

Investor Profile Forms

Firms have increased focus on Reg BI obligations via collection of additional data points on standard forms.
Firms have implemented alternative investment-specific forms to document prior investment experience and other investment holdings.
There were instances of failure to collect information about the customer’s education level, which may compromise firms’ ability to assess for sufficient sophistication in connection with recommendations of complex or private investment offerings.
In some cases, transactions were approved without firms addressing inconsistent customer profile information among different firm-required documents.
The exam revealed transactions where changes in profile information shortly before/at time of a recommendation to line up with product type and/or concentration limits.
In some instances, the approval of recommendations was inconsistent with limitations established by firm policies (e.g., risk and concentration criteria).

Investor profile forms should collect all “key investor data, including investor debt and education.”
Increase scrutiny to verify conflicting profile information on multiple client forms exists and certain responses satisfy investment criteria requirements and others do not.
Do not limit concentration considerations for alternative investments to net worth; instead, also incorporate attributes such as age, risk tolerance, and investment objective into consideration of maximum concentration limits.

[1] This chart references the obligation category utilized in the Reg BI Report and incorporates points associated with the Compliance Obligation under a relevant conduct Obligation standard. As such, the categorizations used herein may not identify the correct or all Reg BI obligations associated with each topic.

Consideration of Reasonably Available Alternatives (RAAs)

The Committee identified a number of specific firm policies that “fell short of [the] mark” under the firm’s Care obligation, including without limitation:
- Policies that require consideration of lower-cost, lower-risk alternatives without documentation or explanation of which were actually considered or recommended.
- Use of “checkbox-style” affirmations to document consideration of reasonably available alternatives with no detailed documentation of alternatives considered.
- Failure to educate or otherwise provide any guidance regarding the consideration of reasonably available alternatives (this was additionally identified by the Committee as a Presumptive Breach of a firm’s compliance obligation).
A few firms examined maintained a list of specific product types that should be considered as an alternative. The Committee noted that the use of questionnaires, lists or software would be helpful in this regard.
In certain instances, the Committee noted that transactions were approved despite:
- No discussion of RAAs
- Use of identical/boilerplate explanation of RAAs consideration
- Listing of products that carried significantly different risks than product recommended.

Improve documentation practices with regard to the alternatives actually considered to identify the products considered and why ones rejected were rejected.

Consideration of costs

Certain firms included instructions on documenting cost considerations in recommendation explanations.
Many firms are using cost-comparison tools that support consideration of RAAs.
Even with policies in place, firms approved transactions where there is no documentation of cost consideration.
A number of firms are still “ignoring” lower-cost, lower-risk products.
Lack of policies and procedures discussing how costs should be considered for product recommendations.

Obtain clear written documentation of the lower-cost/lower-risk alternatives considered as RAAs and why those alternatives were rejected in factor of products with higher costs and/or risks.
Document point-of-sale disclosures of all material fees and costs.
Firms should utilize product and cost comparison tools.

Reg BI Obligation: Disclosure

Method and Terminology Considerations

Use of “advisor” or “adviser” where the person is a broker agent but not an investment adviser representative (this was also identified as a Presumptive Breach of a firm’s Disclosure Obligation).
Use of boilerplate and “complex financial jargon” as to fees/costs did not meet “plain English” standard.
Some firms failed to disclose the anticipated amount of up-front sales commission or material risks associated with the product outside the Form CRS and product prospectus.
The Committee raised concern that based on continued firm reliance on prospectus disclosures, the additional details regarding disclosed conflicts required by the SEC Adopting Release cannot satisfactorily be achieved through a product prospectus.
Half of the examined firms had no “formal policy” requiring discussion of lower-cost/lower-risk options available at the firm.
Insufficient enhancement of point-of-sale disclosures. Exclusive reliance on Form CRS and product prospectuses is likely to be viewed as insufficient to satisfy Disclosure Obligation.

Create disclosure documents specific to products. The Committee noted its view that the use of one-page documents detailing risks specific to a product class were “clearer and more specific” than more generalized alternative investment disclosures.
Obtain clear written documentation explaining which lower-cost and lower risk alternatives were considered and why they were rejected in favor of higher-cost/higher-risk products.
Make clear point-of-sale disclosure of all material fees and costs that apply to the recommendation and clearly identify third-party compensation arrangements.
Act proactively to identify conflicts of interest and consider forming a conflict committee to review business lines for potential conflicts or incorporate conflict analysis into initial product level due diligence.

Delivery of Required Documents

Failures to require documentation of Form CRS delivery (identified as a Presumptive Breach of a firm’s Compliance Obligation).
Firms have devoted “significant” resources to compliance by preparing Form CRS and detailed supplemental disclosures.

Reg BI Obligation: Conflict of Interest

Conflict Identification

Firm procedures lacked details on how the firm identifies conflicts of interest.
Certain firms maintained procedures acknowledging the duties associated with conflict identification.

Proactively identify conflicts; Examples – utilize conflict committees to review business practices regularly; incorporate conflict identification as an aspect of product diligence efforts.
Develop conflict registers or other methods to document conflicts identified and how they were resolved.

Conflict Mitigation

Some firms had no conflict mitigation procedures in place for associated persons’ recommendations of higher commission products.

Apply a conflict avoidance policy and implement “reward-centric” mitigation strategies.

Conflict Disclosure

The Committee has an overarching view that firms are relying on “general supervision” for mitigation and the disclosures included in CRS and supplements as sufficient disclosure. The Committee identifies that approach as “misguided.”

More clearly identify compensation arrangements with third-parties. Indication that would consider the use of product/asset-class specific compensation disclosures to be specifically identified.

Presumptive Breaches

The Reg BI Report includes multiple references to “presumptive breaches” of Reg BI. Notably, the “presumptive breach” language is only found in the SEC’s Reg BI Adopting Release in connection with the use of the “adviser/advisor” title for persons who are not supervised persons of an investment adviser. The states appear to be taking the position that certain provisions of Reg BI establish “clear requirements,” and that failures to comply with those requirements should be a presumptive breach. Yet, some of the requirements pointed to by the Committee are not exactly purely objective standards and involve sufficient room for judgement, which will likely complicate the view that non-compliance would be a presumptive breach of Regulation BI.

Regardless, the Committee has identified six specific forms of conduct that “States would generally view . . . as presumptive breaches of Reg BI,” including:

Failure to timely file a proper Form CRS.
Failure to supplement the Form CRS with detailed disclosure of fees, costs and conflicts associated with recommendation prior to or at the time of the recommendation.
Improper use of adviser/advisor title.
Continued use of time-sensitive, product-specific sales contests.
Failure to adopt policies and procedures reasonably designed to identify, eliminate or mitigate conflicts of interest.
Failure to adopt policies and procedures reasonably designed to achieve compliance with Reg BI as a whole.

Product Specific Observations

The below chart provides a brief summary of key observations and guidance raised by the Committee with relation to “complex, costly, and risky product types” it describes in the report. We suggest firms review this section of the report carefully when considering their practices and policies related to these specific product types.

Key Committee Observations	Committee Guidance
Non-Traded REITs (NTRs)
NRT considered to be “riskier illiquid products”. Some firms limited sales of NTRs to accredited investors. Nearly all firms set self-imposed concentration limits higher than prospectus or state-imposed limits. Nearly all firms restricted non-traded REIT sales based on one or more of the following factors: age, stated risk profile, need for liquidity, and time horizon. Firms were more likely to impose limitations than to prohibit recommendations outright.	The Committee highlighted that both the SEC Adopting Release and FINRA’s Guidance recommend that firms mitigate potential Reg BI risk by limiting recommendations to specific customer types. Firms should review the charges in SEC v. Western Intl. Secs., Inc., Case No. 2:22-cv-04119 (C.D. Cal. 2022), to ensure they are properly addressing suitability of NTRs for customers. The Committee identified certain lower-cost and lower-risk products which it considers to be viable alternative product to non-traded REITs: individual equity of a company in the real estate sector; a real estate focused mutual fund; a real estate focused ETF, or; a traded REIT.
Private Placements
The Committee considers Private Placements to be “illiquid, high-risk products”. Firms mostly treat Private Placements similar to NTRs with regard to restrictions on sales to accredited investors, customers with specific risk profiles and net worth/concentration limits. NASAA Enforcement has identified Private Placements as a primary source of customer complaints and regulatory actions for firms. “[M]ultiple firms did not require agents to consider any lower-cost and lower-risk alternatives to private placements when making such a recommendation.”	Emphasizes that firms should review the SEC’s Western International complaint “specifically for more information on the application of Reg BI to illiquid alternative investments.”
Variable Annuities
The Committee considers to be “complex and costly” products requiring “long-term holding to fully maximize benefits”. Although firms generally had some product restrictions, such as concentration limits, multiple had no restrictions tied to key features of the product – i.e., a documented need for a death benefit and/or lifetime income payments. Firms showed shortcomings in identifying “perhaps the biggest sales practice risk of variable annuities: a customer incurring substantial surrender charges as variable annuities are repeatedly replaced.” While some firms required agents to present lower-cost, lower-risk alternatives, they were not required to document the options, or were not required to present them at all.	The Committee reminds firms that the SEC Adopting Release specifically addresses the importance of making a best interest determination regarding Variable Annuities.
Leveraged and Inverse ETFs
Committee considers these products to be speculative and high risk but not generally high cost. Most firms examined either prohibited or severely restricted recommendations of non-traditional ETFs. Almost all firms examined implemented surveillance reports monitoring for transactions in these products outside firm requirements.	The Committee noted that leveraged and inverse ETFs may not be considered in the best interest of retail customers absent an identified, short-term trading objective.

Conclusion

In sum, the Reg BI Report has identified a number of key observations and concerns raised by the Committee related to firms’ Reg BI obligations and specific products and highlighted specific guidance or Best Practices suggested by the Committee to help firms better their compliance efforts. It is important to note that NASAA is a membership of sovereign states, and the findings and guidance suggested in its Phase II (B) of its National Examination Initiative may be more – or less – stringent than the standards applied by any particular sovereign. Nonetheless, the points noted – especially those that seem to be strong interpretations of the Reg BI obligations – are critical considerations in ongoing guidance to broker-dealers and their associated persons.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations. Attorney Advertising.