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Reg BI Podcasts
2020 Exam Priorities Letters – Part 1
Oyster: Welcome to this week’s serving of Oyster Stew a mix of financial services, commentary and insights. Each week we’ll discuss what is happening in the industry based on what we see as we work with regulators and clients. We hope you come away with the knowledge and tools to help you make the best decisions for your firm’s future. Today’s episode is part one of a series of podcasts discussing the SEC’s 2020 Exam Priorities.
Buddy Doyle: Hi everybody. This is Buddy Doyle. I’m Chief Executive Officer of Oyster Consulting, and welcome to this latest version of Oyster Stew, our podcast that we use to talk about the financial services industry. I’m fortunate enough today to be joined by Evan Rosser and Joe Turner, both of whom are former regulators, have worked in the broker-dealer and investment advisor business for quite a while, and have transitioned to consulting as they go through their career. They have been with Oyster Consulting for some time. So thank you Evan, thank you, Joe, for joining us. What we’re talking about today is the examination priorities, from the SEC and FINRA. If you’re wondering what’s on their mind, it’s fortunate that they tell you every year. So Evan, I think what I’d like to do is maybe get some observations about the Letter and sort of some overarching thoughts about how FINRA is a approaching this.
Evan Rosser: Thank you, Buddy. The Exam Priority letter starts with a cover letter, and I just wanted to mention a few items that appear in the cover letter. One, they talk about the new five categories of firms: retail capital markets, carrying and clearing, trading and execution, and diversified. And they talk a little bit about the efficiencies they hope to realize with this new categorization. But I think it’s still up in the air and they don’t go into much detail on how that’s going to affect the exam process. Another thing about this year’s letter, which I think is very helpful, it includes a list of practical considerations for firms that they can use an invalid evaluating their compliance programs, as well as links to additional resources. So I think that’s a very helpful tool that is in this year’s letter. Finally, I just wanted to make one observation that some of the initiatives in this letter are the result of new regulations and new rules, particularly Reg BI, which we’ll talk about in a minute, but many others are areas where FINRA has concerns with compliance and about compliance with existing longstanding rules. So not everything in the letter is a new area. In fact, there are many repeat areas, but it’s important to realize that this is not all new regulations, but it’s reviewing existing as well.
Buddy Doyle: And Joe, as I haven’t mentioned, there are certainly a lot of areas of focus for the regulators that are not new. Maybe you could give us a quick rundown of some of the things that we see consistently brought out by the regulators and examiners and maybe some thoughts on those topics.
Joe Turner: There are certainly some items on the list that we’ve seen before, and we want to emphasize the fact that just because they’ve been there before doesn’t mean they’re just as important now as they were previously. Okay. We’ve got some items such as communications with the public, always an important topic. Always one that FINRA is concerned with and wants to be sure that you’ve got your policies and procedures in order, and that you are in fact doing surveillance and follow up to make sure that you’re in compliance with those. Sometimes the challenging part of the program, for a lot of firms, we want you to know that there are some alternatives out there for third parties to assist you in that, and we think that the communications with the public is something that you certainly are going to want to spend some time on. Trading authorization, is another area.
Joe Turner: Certainly trading without written authorization is a problem. That’s always been a focus of theirs. We think that going forward that will continue to be an issue that they’re going to be focused on – any unauthorized trading. It is something they want you to have policies and procedures around. They want, “Do you look for any patterns that might suggest that that type of activity is ongoing and that you’ve got your policies and procedures in line to address that when it happens?” These again are items that have been around for a long time. I think they are certainly items worth spending more time on again this year.
Buddy Doyle: Okay. Well thank you for that. And yes, certainly the communication with the public continues to be a really important because it is how you describe generally what you do for your clients is through communication. And so, the regulators like to make sure that you’re fully describing your services in a fair and balanced way, and sometimes their judgment and your judgment might be a little bit different on that. Trading authorization again and having a focus on that. I don’t think you’ll be considering that a waste of time when you get your exit interview from an examiner. Evan, you mentioned Reg BI earlier. Maybe you can kind of roll into that topic and give us a little insight into the state of mind on Reg BI.
Evan Rosser: Yes. I think Reg BI is kind of one of the highlights of the letter. It’s also a highlight of the SEC’s exam priority letter back in June of 2019. The SEC adopted Regulation Best Interest, which establishes a best interest standard of conduct for broker-dealers and registered reps. When they make a recommendation to a retail customer, their recommendation can be a recommendation of a security. It can be a recommendation of an investment strategy involving securities or it can be the recommendation of a type of account in the 1300 pages of Reg BI. Best interest is not really defined; however it, can be met through meeting four obligations: a disclosure obligation, which means you disclose your conflict, your any relationship you have with the product or the issuer of that product; a care obligation, which is for the most part similar to the suitability standard in FINRA Rule, 2111.
Evan Rosser: Conflict obligation is where you must disclose your conflicts, anything that might impair the firm’s or the registered reps’ objectivity in that recommendation, and a compliance obligation where you need to have procedures to make sure that these obligations are met. The is effective June 30, 2020. Up until that time, FINRA will be reviewing firms and their preparedness for Reg BI compliance. After that, after June 30, after the effective date, my hunch is, they will be reviewing your programs and while much is up in the air, I think though, and this is not in the letter, but they will be looking to see if you’ve made a good faith effort to comply with the rule. This year’s letter has a number of considerations for firms. When they start to develop and implement their Reg BI policies.
Evan Rosser: FINRA will be looking to see if your firm has procedures and training in place to assess your recommendations to customers. Does your firm consider reasonably alternative or available alternatives to the recommendation? Do they guard against excessive trading irrespective of whether the broker-dealer or associated person controls the account? Does the firm have procedures to identify and address conflicts of interest? And in the work we’ve done around Reg BI, that’s really the starting point. Does your firm have a process to identify its conflicts and conflicts for the most part are compensation? And you need to look at where you get any revenue from a product you sell. What compensation you receive any trailing revenues from mutual funds, any additional compensation you have. And as I noted, are there reasonably available alternatives to your recommendation? And finally, it’s necessary to have a Form CRS customer relationship summary that explains your role and the transaction. And that’s something that’s required of both broker-dealers and investment advisors.
Buddy Doyle: And I think Evan, as you mentioned, the bulk of the work that plays that we’ve been starting with organizations, it’s really been around that conflict list and whether they can manage those conflicts and mitigate those conflicts, or they have to eliminate those conflicts, or whether they have to disclose those conflicts and how are they going to disclose those conflicts. It’s been interesting going through Reg BI conversations with so many organizations, and it always seems like the focus has been on the Form CRS, the disclosure from the very beginning. And in reality what goes into that Form, CRS disclosure has to come from a thoughtful process and evaluation. Joe, you talked a little bit about communication with the public. To me disclosure is hand in glove with that. But can you give us a little bit of a sense of what firms need to do with respect to the Form? CRS?
Joe Turner: Well, as a Evan mentioned, this is really a relationship summary, and it is in fact a disclosure as required for delivery to all the retail investors. It is a common part of Reg BI between broker-dealers and investment advisors. It is largely made up of the conflicts of interest that Evan was referencing. The good news is that the SEC has given us some very detailed and specific set of instructions, step by step instructions on how to put this document together. And two of the most important parts of it are critical parts of it. Number one, it should be in plain English. This is designed to give to your clients so they can understand exactly what your relationship is all about. It is not to be a bunch of legalese. Number two is, it’s limited in scope. In other words, you don’t want to bury your clients a 30-page document, so they say very specifically, two pages, nothing more. Now, that is slightly tweaked when you start talking about dual registrars. If your firms are in fact a broker-dealer and an RIA, then that two pages becomes four pages and you’ve got four pages to explain all of the items required for both the advisor and the broker-dealer. Now if you’ve got an affiliated investment advisor, separate entity, you go back to two pages for both of broker-dealer and two pages for the IA. The important thing in the end is that this has to make it to the clients. You need policies and procedures around the entire creation of the Form CRS. And, lastly, but not leastly, then those should include how you’re going to get the document in the hands of your clients and establish a possible process that is kind of foolproof so that everybody gets the Form CRS.
Buddy Doyle: And I think that to Joe’s point, it’s, it’s very important to have a documented process for doing that. It’s also very important to have a documented process to prove you did it. Many firms will go through the exercise of delivering this, drafting it, doing a really good job of having blunt disclosures, plain disclosures, which I’m a huge fan of. Okay. And then they give it to them, and we know they won’t read it because history shows that they probably won’t read it, which means write it bluntly, I think, and ask yourself how many times you’ve gotten a question about your Form ADV from a client. The second thing is to, again, make sure that you document that you sent it to them and in some reasonable fashion, so that when they come and examine, the evidence is there to prove that you fulfilled your obligation.
Evan Rosser: When we work with firms on Reg BI and Form CRS, we always start with what the firm did to get ready for the now vacated DOL Fiduciary Rule, because that rule required you to identify those conflicts, identify the compensation streams that might create conflicts, and not just the commission or the compensation from the product perhaps, but also how you incentivize your registered representatives. So firms that had done that work have already taken a huge leap in preparing for Reg BI and the Form CRS. If you look at some of the FAQs for the DOL rule, they’re very similar to the conflicts and issues that are raised by Reg BI and Form CRS.
Buddy Doyle: Well, with that I would like to thank you all for your time. Joe. Evan, thank you so much. If you are looking for any guidance or thought on your regulatory compliance program or the focus of the regulators, feel free to reach out to us and we will get back to you right away.
Oyster: Thanks again for listening to the Oyster Stew podcast. Don’t forget to subscribe so we can continue to bring you resources to help you make the best decisions for your firm. If you’re struggling with a topic and you’d like us to do a podcast on it, or you’d like a free consultation, feel free to reach out to us at (804) 965-5400 or by visiting our website at oysterllc.com.
Reg BI – What’s Required in Form CRS – January 29, 2020
Oyster: Welcome to this week’s serving of Oyster Stew, a mix of financial services, commentary and insight. Each week we’ll discuss what is happening in the industry based on what we see as we work with regulators and clients. We hope you come away with the knowledge and tools to help you make the best decisions for your firm’s future. You can learn more about Oyster Consulting and the value we can add to your firm by going to our website, www.oysterllc.com.
Polly Cordle: Okay, welcome to another episode of Oyster Stew. I am Polly Cordle, the Managing Director of the Oyster Solutions platform. Today I am joined by Bob Tuch, one of our Senior Consultants. Hello Bob. How are you doing?
Bob Tuch: I’m doing well, thank you.
Polly Cordle: So today we are talking about the Form CRS, which is part of the Regulation Best Interest, or Reg BI, from the Securities Exchange Commission. So Bob, maybe you could explain to us the purpose of the Form CRS.
Bob Tuch: Sure. Later this year, the SEC will require registered investment advisors and registered broker-dealers to provide a brief relationship summary to retail investors. The relationship summary is intended to inform retail investors about the types of client and customer relationships and services the firm offers. It will also cover fees, costs, conflicts of interest, and the required standard of conduct associated with those relationships and services. Retail investors will receive a relationship summary at the beginning of a relationship with the firm, communications of updated information following a material change in the relationship summary, and an updated relationship summary upon the occurrence of certain events. The relationship summary is part of an approach that requires layered disclosure. This means the provision of brief, concise descriptions of the topics that I just previously mentioned, and inter-relationship summary coupled with additional information about those topics, and a more comprehensive detailed disclosure document.
Polly Cordle: So the relationship summary would be kind of a summary of a bigger document that also comes to the retail investor.
Bob Tuch: That is correct.
Polly Cordle: So what’s required to be covered in the Form CRS?
Bob Tuch: The instructions in Form CRS require firms to present information under standardized headings, and to respond to all the required topics in a prescribed order. Thee instructions also provide for page limits to promote brevity, specifically for dual registrants – that is, firms that are registered to provide brokerage services and investment advisory services. They can include information about both types of services in a single relationship summary, which cannot exceed the four pages. For stand alone broker dealers and stand alone investment advisors, t,he relationship summary cannot exceed two pages. These pages limit references to a paper format or the equivalent if delivered electronically. The SEC staff has stated that it supports the use of layered disclosure and believes that investors will benefit from receiving a relationship summary containing high level information that they would be more likely to read and understand with the ability to access more detailed information.
Bob Tuch: Another requirement in the relationship summary instructions is the use of conversation starters. They are in the form of questions in each section, other than the introduction, and are suggested follow-up questions for retail investors to ask when they’re with their financial professional. With all of this in mind, I’d like to briefly cover each of the specific item instructions in Formed CRS.
New Speaker: Sure. Bob, why don’t you walk us through some of those instructions? So you said the headings are in the form of questions?
Bob Tuch: Yes. Before I do that, however, I want to go back to who must receive a relationship summary. I mentioned earlier that retail investors will receive a relationship summary at certain times. The SEC defines the term retail investor as a natural person or the legal representative of such natural person who seeks to receive, or received, services primarily for personal family or household purposes.
Bob Tuch: Keep in mind here that broker-dealers and investment advisors with customers or clients who meet this definition will need to make plans to ensure that each of these retail investors will receive a relationship summary at appropriate times, regardless of whether a recommendation is made. Okay – on to the specific item instructions. Item one is entitled “Introduction.” It requires identifying information, including if the firm is a broker-dealer, a registered investment advisor or both. It also requires some boilerplate language designed to inform the reader that services and fees differ depending upon the capacity in which the firm is operating. There’s also a boilerplate language that refers to a location that provides educational materials. Item two is entitled “Relationships and Services.” It calls for a heading and a description of services. The heading is ,”What investment services and advice can you provide me?” The description calls for a high level explanation of the principles, services, accounts, and investments that are provided.
Bob Tuch: Firms must specifically address the following: Broker-dealers must address the principal brokerage services that are offered and must state whether recommendations are made. Investment advisors must address the principal investment advisory services that are offered. Each firm must explain whether investments are monitored along with some details, if they are. Investment advisors must include a discussion of discretionary authority. Each firm must describe limitations on investments that are offered and must address requirements pertaining to opening and maintaining accounts, such as a minimum investment amount or a minimum account size. Also, each firm must provide a cross reference to the more detailed information that is disclosed pursuant to the Reg BI disclosure obligation. And last but not least, there are five conversation starters.
Bob Tuch: Item three is “Entitled Fees, Costs, Conflicts and Standard of Conduct.” It calls for a heading and a description of principal fees and costs. “The Heading is what fees will I pay?” Each firm must summarize the principal fees and costs, and address how frequently they’re assessed, and the conflicts of interest they create. Broker-Dealers must describe their transaction based fees, and investment advisors must describe their ongoing asset based fees. Examples are given regarding how certain conflicts of interest could be described. Each firm must describe additional fees and costs related to its services, and provide examples of common fees and costs that would apply. In addition, the following must be included: “You will pay fees and costs. Whether you make or lose money on your investments. Fees and costs will reduce any amount of money you make on your investments over time. Please make sure you understand what fees and costs you are paying,” in addition to some additional conversation starters that must be included in this section. Item three requires firms to include a heading in the form of a question that addresses their legal obligations to investors, how else they make money and conflicts of interest that they have.
Bob Tuch: Underneath that heading, broker-dealers that provide recommendations subject to Reg BI must include prescribed language that describes the Reg BI Best Interest Standard and makes reference to conflicts with investors’ interests. Examples of those conflicts must be provided. Similar language and examples must be used by investment advisors. Specific references to more detailed information about conflicts of interest must be provided. Next in item three is another heading in the form of a question: “How do your financial professionals make money?” Firms must summarize how their financial professionals are compensated and the conflicts of interests that this compensation creates. Certain specifics regarding how compensation is structured must be addressed as well.
Bob Tuch: Moving on to item four, which is entitled “Disciplinary History.” This item calls for the following heading: “Do you or your financial professionals have legal or disciplinary history?” Firms must provide a “yes” answer if legal or disciplinary history must be disclosed in certain forms, including Form ADV, Form BD and Form U-4. In addition, firms must direct retail investors to a search tool that can be used to research this, and they must include a conversation starter that prompts readers to inquire about this. Item five is entitled, “Additional Information,” and it requires contact information for investors to use to seek additional information. It also requires inclusion of a following conversation starter: “Who is my primary contact person? Is he or she a representative of an investment advisor or a broker-dealer? Who can I talk to if I have concerns about how this person is treating me.”
New Speaker: So it seems like there’s a lot of required language in there which could fill up two pages pretty quickly. So if you’ve got conflicts, they’d have to be pretty succinctly defined and refer you to that more detailed document.
Bob Tuch: That’s absolutely right.
New Speaker: Two pages doesn’t sound like a lot to work with if you’re an investment advisor who has affiliates, so it’s probably a good idea to get started on this form pretty quickly so you can start to figure out how to concisely describe this and fit in all those conversation starters and all that required language.
Bob Tuch: And of course, Oyster is ready, willing and able to help with that.
New Speaker: We are always ready, willing and able to help. So I think we’ve talked about required delivery. Is there anything else you want to tell us about when it needs to be required? I think you said it could be delivered electronically. Is that correct?
Bob Tuch: Sure. Let me go ahead and go over the Form CRS instructions that address filing and delivery requirements for the relationship summary. The initial filing must be done electronically using the investment advisor registration depository, or IARD, for investment advisors and the central registration depository, or web CRD, for broker-dealers. Dual registrants must file using both the IARD and the web CRD when filing. Firms are required to use a text searchable format with machine readable headings. For currently registered firms, the initial relationship summary will need to be filed between May 1st and June 30th of this year. Now, let’s talk about initial delivery. Investment advisors must deliver a relationship summary to each retail investor before or at the time they enter into an investment advisory contract with a retail investor. Broker-Dealers must deliver a relationship summary to each retail investor before or at the earliest of: 1) a recommendation of an account type, a securities transaction or an investment strategy involving securities; 2) the placing of an order for the retail investor; or 3) the opening of a brokerage account for the retail investor. These initial delivery times kick in for new and prospective clients and customers as of the date firms are first required to file this summary with the SEC. They kick in for existing clients and customers within 30 days after the date firms are required to file. Again, keep in mind that it is retail investors who must receive the relationship summary. There are additional instructions that address updating the relationship summary, the filing of amendments and additional delivery requirements. These filing and delivery requirements can be found in Section 7 of the Form CRS general instructions.
Polly Cordle: So Bob, that first filing, when is that due?
Bob Tuch: Folks need to keep in mind the following time period, May 1st, 2020 through June 30th. So that’s basically the window for filing. The staff doesn’t want to be dealing with filings before that. As the Oyster practice lead for our software program known as Oyster Solutions,you can help folks understand how Oyster Solutions can be a valuable tool for preparing and delivering relationship summaries. I thought I’d give you a few moments to talk about that.
Polly Cordle: Sure. So in Solutions, what we did is we kind of took all of that guidance that you just gave and we built it out in a survey for clients and let them answer questions that would then create a document for them, and that would at least give them a draft document to build off of. So for our clients where we are offering compliance support or outsource compliance officer positions, we can go through and answer basic questions for them, and then that will at least build them a draft Form CRS based on all of that guidance. As you know, in reading the instructions you have some required language based on whether you’re a broker-dealer or an advisor, and whether you’re a duly-registered firm. And then you also have some requirements in the language that you use. So it has to be very plain English.
Polly Cordle: You have to use words like “our, we, our firmand “you” in reference to the client. So we made sure that we built all of that kind of guidance in the conversation starters were required to be called out in some sort of fashion. And so we built that into our template for our clients. And that way they’re kind of locked into fitting the instructions that the SEC provided without having to put quite as much effort into reading the instructions. We still recommend, of course, that they read those instructions, and we still recommend that they read all of the guidance that the SEC has provided, but it gives them a much easier way to at least formulate that first draft. And we try to do that in a lot of the forms that we build in Solutions. And that way the system does a lot of the work for them. So that’s one of the things we’re trying to do with the software to make sure the system does as much of the work for our clients as it can.
Bob Tuch: And I’ll just mention back to the topic of conversation starters, firms need to be careful in terms of how they present those questions, so that it’s clear to the reader that these are questions that are being suggested for retail investors to consider asking their financial professional, as opposed to questions that need to be answered on the Form. The way you built the software that you just described is designed to make that really clear and avoid that potential confusion.
Polly Cordle: Yeah, we tried to spell it out right at the beginning that we’ve got these conversation starters within the form that are really meant for you as the client to engage us and get to know us. So yeah, we try to make it very clear and we recommend that our clients do the same as they’re building out their Form CRS. There’s a lot that’s required in those instructions, and so it can be a bit daunting when you print off those pages of instructions and start to read them. But as you plow through it,I think it’s a very helpful document that’s provided for the firms. But I definitely think it means getting involved sooner rather than later in that process, so that daunting task doesn’t feel quite so daunting if you can get ahead of it.
Bob Tuch: And of course it’ll give folks an important head start on what they’re going to have to do when it comes time to develop the full-blown disclosure document that they’ll have to use to comply with the Reg BI disclosure obligation.
Polly Cordle: Sure. Our advisory firms have their brochure documents that they’re used to writing, and so they’ve kind of built that out in the past. But the broker-dealers are not used to having a more extensive disclosure document. So this will be new for them. As you said, Oyster is definitely here to help. We have quite a few clients that this Reg applies to, so we’re definitely in the weeds on the Reg and we’re happy to provide guidance wherever we can for our clients.
New Speaker: This has been another episode of Oyster Stew. We hope everybody has gotten something out of it and we welcome you to subscribing to the podcast. We try to make sure that the topics that we cover are pertinent to the industry and helpful to clients and others out there in the industry. If there’s a topic you’d like to hear about, please feel free to reach out. You can find out more about Oyster at www.oysterllc.com. Or, you can contact us directly at (804) 965-5400. Thanks everybody. We look forward to talking to you next week.
Advertising Rule Part 2 – November 15, 2019
Molly Bryson: Welcome back everyone to the second of our two-part podcast series talking about the SEC proposed advertising rule changes. I’m Molly Bryson, and today with me are Bill Reilly and Michelle Craft. We’ll discuss the pertinent SEC enforcement actions and how Reg BI will impact advertising and marketing practices. Bill’s been with Oyster for seven years. Prior to that, Bill was a state of Florida regulator for 30 years. He has deep experience with broker-dealer and investment advisor compliance programs, and frequently acts as an expert witness. Michelle Craft has been with Oyster for eight years, and in the financial services industry for 24 years. She has held various roles from Registration Analyst to Chief Compliance Officer for regional and national broker dealers as well as investment advisors. So let’s get started. Bill, could you start us off?
Bill Reilly: Yes, I’d be glad to. What I did in researching for this presentation, is I went ahead and looked for the last couple of years at SEC enforcement actions and came up with three that I thought were noteworthy of speaking about. The first of the cases I’m going to talk about our robo advisors, and the reason that I chose those is, number one, robo advisors is a type of advisor that has been looked at substantially over the last couple of years by the Commission. The violations that were found for these robo advisors are also going to be found in your more standard type of investment advisor. But the first case I want to talk about is that the SEC found that a robo advisor with over $11 billion in assets under management made false statements about tax loss harvesting strategy, offered to clients. What the firm did was, it disclosed to clients employing it’s tax loss harvesting strategy, and the strategy was the selling of securities at a loss to offset capital gains tax liabilities. And, the firm would monitor all client accounts for any transactions that might trigger a wash sale. And of course, a wash sale occurs when it’s security is sold at a loss, but the same security is also purchased within 30 days before or after the sale. The losses from the wash sales are not recognized for tax purposes. But what the SEC found was that the investment advisor, it’s system failed to monitor for wash sales over a period of more than three years, during the time of this three years, while sales occurred in at least 31% of accounts enrolled in the firm’s tax loss harvesting strategy. The firm said it was going to offer a service and it never held it’s part of the bargain. The SEC also found that the investment advisor improperly retweeted client testimonials without necessary disclosures, paid bloggers for client referrals without the required disclosure and documentation to comply with the Solicitors Rule, and failed to maintain a compliance program reasonably designed to prevent violations of the securities laws. As a result of these issues, the SEC fined the investment advisor $250,000 for violating the anti-fraud advertising compliance and some other provisions of the Investment Advisers Act of 1940. This case that I just talked about, and the case I’m going to talk about, were actions brought in 2018.
Bill Reilly: In the second case, the SEC found that the investment advisor, which had approximately $81 million in assets under management, made a series of misleading statements about it’s investment performance. What the commission found was that from 2016 until mid-2017, the investment advisor posted on its website and social media comparisons of the investment performance of the investment advisor with those of two other robo advisors, or competitors. By doing this, the SEC stated that the performance comparisons were misleading because the advisor included less than 4% of his clients’ accounts, and those 4% had higher-than-average returns; the investment advisor compared this with rates of return that were not based on a competitor’s actual trading models.
Bill Reilly: The SEC also found that the advisor failed to maintain required documentation, and failed to maintain a compliance program reasonably designed to prevent violations of the securities laws. They also found that the advisor violated the anti-fraud advertising compliance and books and records provision of the Adviser’s Act. These are somewhat fairly common types of violations that we find on the in the advisor area.
Bill Reilly: The last case I want to talk about is an action brought by the Commission against 13 investment advisors. Now, this action was brought in 2016, but I still think it’s very appropriate, based upon the number of advisors named and some of the violations. In this case, the SEC brought action against 13 investment advisory firms, found they violated securities laws by spreading the false claims made by an investment management firm about its flagship product. As a result of an investment sweep, the Commission found the 13 firms accepted and negligently relied upon claims by the registered investment advisor, that one of its strategies for investing in exchange traded funds had outperformed the S&P Index for several years. The firms repeated many of the investment advisors’ claims, while recommending the investment to their own clients. This is the important part of the action: recommending the investment to their own clients without obtaining sufficient documentation to substantiate information being advertised. And basically, through this enforcement process, the advisor admitted in an SEC enforcement case that what was purportedly it’s real historical track record was only back tested performance that turned out to be substantially inflated. As a result of this, I thought that there was a quote that was provided by the commission relating to this activity. Let me go ahead and read the quote:
“When an investment advisor echos another firm’s performance claims in its own advertisements, it must verify the information first, rather than merely accept it as fact. These advisors negligently pass many of the investment advisors’ claims onto their own clients, who were consequently relying on false and misleading information when making investment decisions. I think the point to be gained here is that you cannot take information provided to you – you must actually take the steps to verify to the best of your ability, and confirm data that you are publishing and providing to your own clients.
Molly Bryson: In addition to the proposed Advertising Rule changes, the June 30th, 2020 Reg BI implementation date is looming. CCOs and marketing and compliance teams will be extremely busy reviewing the potentially thousands of marketing and advertising pieces which may be produced against these new requirements. Michelle, what will the Reg BI implementation mean for firms with regard to advertising?
Michelle Craft: So, when we think about the Reg BI impact to firms, we see that there’s going to be potentially a larger impact to our broker-dealer firms. And specifically, as we talk about advertising here today, the titles that are being used by registered representatives of broker-dealers. So it’s important to note that if an individual is referring to themselves as a Financial Advisor currently, and they are only registered with a broker-dealer, they do not maintain any kind of license with a registered investment advisor. They are going to be prohibited from using the word “Advisor” in their title. So, no longer can they be referred to as a Financial Advisor. And there’s probably, I would say, 80% or more of the individuals in the industry using that term even if they are only broker-dealer registered. So that’s going to require firms to take a look at their approved titles that can be used by individuals, and potentially come up with new titles.
Michelle Craft: There’s nothing in the rule that states that you can only call yourself a registered representative if you are solely broker-dealer licensed. But, the rule is really intended to target the clients’ understanding of the services that they’re being provided. So if you’re calling yourself a Financial Advisor, there’s an assumption that you could be providing those services as a registered investment advisor, or a representative of an investment advisory firm. Again, people are going to need to start taking a look at business cards, stationary, email signatures. If your firm website has bio bio pages where you’ve listed an individual and their title, that could potentially need to be updated. A social media page where you’re listing your name and title; or any flyer, brochure, seminar material. Basically, any kind of advertising or communication that’s personalized to the representative themselves, if it includes the words Financial Advisor and they are solely registered with a FINRA firm as a registered representative, they cannot represent themselves as a Financial Advisor.
Michelle Craft: Now I will mention that if you’re a dually registered individuals, so you are registered with FINRA as well as being registered with a registered investment advisory firm, then you can still use the Financial Advisor title. Similarly, if you are registered solely with a registered investment advisory firm, you can still use the title Financial Advisor. Dually registered firms and or individuals, and solely registered investment advisor representatives, can still use Financial Advisor. If you are broker-dealer licensed only – so Series 7 licensed only as an agent through FINRA, you may no longer use the Financial Advisor title. They may choose to use “wealth advisor” or “financial consultant.” There’s a variety of different titles that those individuals can still use. Certainly there’s registered representative, which is the term that’s typically used as reference from a regulatory standpoint to delineate the difference between a broker-dealer representative and an IA representative.
Michelle Craft: But it’s up to firms to make a decision as to what titles they will allow moving forward. We recommend that once you’ve determined what titles would be allowed for individuals that are solely-registered within with a broker-dealer, communicate that information to your supervisory principals, to those individuals that are reviewing materials to look for instances where individuals are still using Financial Advisor. And remember, this role does go into effect in June of 2020. So for firms that have mass amounts of advertising materials (I have worked myself with firms that have issued 4,000 pieces of advertising in a year), it may be a piece of advertising that is then approved, but then it’s tailored to fit the individual that’s issuing the material. You need to clearly make sure that you’ve communicated with your associates the changes in titles. Make sure that your supervisors are looking for it so it doesn’t sneak through. Update your policies and procedures to make sure that you have specifically addressed what titles can be used depending on the types of registrations held. So, I see that as one of the biggest impacts from an advertising perspective, as it relates to the Reg BI rule, which again goes into effect in June of 2020.
Molly Bryson: Okay, thanks Michelle and Bill. There’ll be a lot for folks to do in the upcoming months and, of course, Oyster is ready to help. Oysters experts can assess your firm’s marketing and advertising materials against the Reg BI requirements and the proposed rule changes. Our team is also well-prepared to assist with other aspects of your Reg BI implementation. If you have any questions about anything we’ve discussed today, or if you have a topic you’d like to hear in future Oysters Stew podcasts, please feel free to call us at (804) 965-5400 or visit our website at www.oysterllc.com.
Reg BI – The Compliance Obligation – November 6, 2019
Buddy Doyle: Hi, everybody. Welcome to our podcast today on the Compliance Obligation of Reg BI. This is Buddy Doyle. I’m the Chief Executive Officer and one of the founders of Oyster Consulting. I’m joined today by Patrick Dennis, our General Counsel and head of Expert Witness and Litigation for the firm, and Polly Cordle, also a leader in our organization. She runs our Oyster Solutions software product for Oyster Consulting. Thank you both for being here and sharing your time with our listeners today.
Patrick Dennis: Thank you, buddy. Thanks. Glad to be here.
Buddy Doyle: All right. So let’s talk a little bit about the Compliance Obligations and some of the core things that need to be covered around things that firms need to be focused on with their compliance programs.
Patrick Dennis: Well, one of the four obligations of Reg BI is a Compliance Obligation, and what it generally states is that the firm is required to have a compliance program in place to ensure that they comply and meet all the requirements of the Compliance Obligation of Reg BI. That means, like with any other compliance program, that they have policies and procedures put together to ensure that they have figured out a way to document their compliance and meet this obligation and its requirements.
Buddy Doyle: So Polly, with Oyster Solutions, as you’re building compliance programs and and amending them to comply with Reg BI or just building them in general, what are some of the things that you look for in a good compliance program?
Polly Cordle: So, ideally, when we build out a policy and process in Solutions software, we like to see an overview for the chapter (we call it a chapter), and then we like to see a policy; that’s really what your firm stands by so you will comply by Regulation BI. Then we like to see processes and those processes we link to an actual workflow. Ideally you would schedule that workflow to kick off automatically, and that workflow will force your policy. So it might be a testing workflow, it might be an actual process that enforces the policy itself. That way you can’t get out of alignment with your actual policy.
Buddy Doyle: It sounds like a classic kind of three lines of defense of operational controls. You need to look at how your team is building their controls and are there systematic controls that prevent issues? Are there supervisory controls that monitor the activity on a routine basis to make sure that your registered representatives are following your policies and procedures? (It’s still hard not to call them financial advisors after all this time.) And to have good oversight into that from a surveillance perspective, to make sure the supervisors are doing what they need to do every day; and then, the testing controls, the assurance that goes along with that are all sort of core components when I’m thinking of a compliance program. I think when we’re looking at some of the core issues that come up in Reg BI around conflicts of interest, there are some specific policies that firms ought to be focused on. Polly, would you like to talk a little bit about maybe some of the key things that you need to have really good policies around?
Polly Cordle: Well sure. Anytime that you have a conflict that you can’t eliminate, establish a policy that will just eliminate that conflict entirely, such as sales contests. If you aren’t going to eliminate that, you’ve got a problem already. So your policy should be to eliminate sales contests. That’s an easy one. If you have a conflict you can’t completely eliminate, then you’re going to have to mitigate it. Now, what we do in the software is we give you a dashboard where you can see the conflict score, and then you can see your mitigating control score and compare those two visually, and make a decision whether you want to improve the control that mitigates that conflict and ultimately put workflows in place that can also help to control that.
Buddy Doyle: And Patrick, are there specific things that you ought to be looking out for?
Patrick Dennis: In terms of conflicts of interest? I think it’s things that you need to understand, or go through an inventory of all of your relationships, all of the things that your firm does, including fees and everything else, that gives you a complete inventory of all of the potential conflicts. Once you’ve figured out all of those, and it can be fairly significant. I mean, it can be a fairly elaborate matrix, if you will, of conflicts because depending on the size of your firm, the number of outside vendors you use, the number of different products you offer and all of those things. So, once you have figured that inventory out and put it together, you need to make sure that either you, as Polly mentioned, need to eliminate the conflict, mitigate the conflict, or, in certain cases, disclose it and make sure that it’s in your disclosure, and make sure it’s in your compliance.
Patrick Dennis: As we know, business continues to be dynamic. Your firm continues to grow, continues to build relationships, continues to take on new vendors, new products, new funds, all sorts of different things. And to stay on top of all that and make sure that when you have somebody in a different department that signs on new business, people bring on a product, or bring on something that potentially is a conflict, you’ve got to have a fairly dynamic process to make sure that you’re aware of those, that you’ve either eliminated it, mitigated it, or disclosed it as you’re required to do.
Buddy Doyle: I think when you were talking you mentioned products three times in that answer. And as we kind of get into looking at products, one of the core things that firms are doing in response to Reg BI is taking a look at the products they have on the shelf and what the conflicts are related to those products. We’ve talked since we started the firm about new product committees and new product selection, and making sure that you’re not delivering the same kind of product, that you’re moving clients from one to the other, unless there’s sort of a material difference in those products.
Patrick Dennis: (inaudible)…difference or a material benefit, frankly, to move them from one product to the other. The reason I mentioned product as often as I did is because, let’s face it, that’s what firms are in the business to do – to sell products, sell the appropriate products to their clients, make sure that they are giving the client the best possible options, coming up with products that meet the needs. Products are always changing. All of the wholesalers, manufacturers, if you will, are coming up with new products and trying to figure out ways to meet the needs of clients better, more efficiently, more effectively, at lower fees, all of those things. So this is one of the areas that comes in often. I, years and years ago, sat on new product committees and sat through long presentations about products and things like that. But that’s one of the things that differentiates one from the other, and I think is one of the things that registered reps try and sell is the advantages they have with certain products over other firms. So that’s an area that I think is one of the things that folks need to pay very close attention to in terms of the compliance program around the new products, the disclosure, the mitigation, however they’re going to deal with essentially a conflict. And, how are we going to deal with it.
Buddy Doyle: I think, when you’re looking at products, product selection and product due diligence, that’s certainly a key component to focus on as you’re building out your compliance program. Another component that I think you really have to focus on is how you talk about those products publicly and not publicly, quite frankly. I think that there is going to be an awful lot of work for the people in your organization that approve advertising and marketing. Given that, again, as I mentioned earlier, there’s sort of this go-to default. You’re out of compliance if you use the term financial advisor for the Series 7 registered reps, Series 6 registered rep who isn’t an investment advisory representative. And so, I think that firms need to make sure, as you’re thinking about changing every business card, every stationary, every piece of paper, that you have or your website or LinkedIn page that refers to a specific title that might be changing. That’s an awful lot of volume to take a look at. And while you’re looking at those marketing pieces, Polly, do you think you have to look at other things as well?
Polly Cordle: I think you’re going to have to look at your people and educate them. That’s a big change for them and how they refer to themselves and how they talk to their clients. And I think they’re going to need to really be educated and trained up on this change, and how they approach not only their sales, but their clients as well.
Buddy Doyle: Yeah. I think after all this time, we’re where change is really hard, right? Every time you make a change, it’s as hard as the last time you made a change and old habits die hard. That ought to be a saying. It seems like at this point in time, registered reps need to be very careful to document the rationale for recommendations that they’re making and probably specifically, and most concerning about things where fee structures might be changing for their retail clients. Is there any kind of advice you have, POlly, for firms looking to understand sort of the nature of fee changes the clients may be going under?
Polly Cordle: Well, if you go back to our Care Obligation podcast, there’s a lot of discussion about how those discussions should work and, in particular, what needs to be documented. I think there’s some good guidance in that, about particularly documenting when the recommendation being made, it could appear, but not necessarily is, out of alignment with the investment objective or profile that you have on file. And, if you don’t have a piece of information in the profile, why you don’t have that piece of information or why do you think that doesn’t apply to the recommendation that you made? But I do recommend going back and listening to that entire podcast.
Buddy Doyle: Very good. Another fee structure change that a lot of folks like us are talking about in the regulatory space is related to rollovers and a good process around rollovers. Patrick, any thoughts on ways to document the rationale of a rollover?
Patrick Dennis: Well, sure. I think the things you have to consider in a rollover are: Why is it being done? What is the purpose of it? What is the objective? Why roll it over? As happens often when folks go from one employer to another, they have a 401K sitting someplace and they often want to roll it over into an IRA so they have control over the investments as opposed to the investments that may have been more dictated by the employers. But the challenge is to make sure that you document the reasons for the rollover, other than just another product to sell or another account to open. But the reasons that it’s being done, why it makes sense for the client, why it makes sense for the firm to put the person in this IRA rollover – that happens all the time.
Patrick Dennis: It’s a fact these days that you know, people don’t go with one employer and stay there for 40 years, get their gold watch and walk out the door. The latest things that I’ve read is, people move at least seven times in their career from one employer to another, and that’s an opportunity for a rollover at each one of those. But you have to make sure that you document and really understand the reasons for the rollover – what’s the advantages to the client, why it makes sense to do that rather than just leave it in the 401K. A lot of it is going to be in the analysis of the investments and the investment objectives, both the investments in the 401K and the investment objectives of the individual in making the decision about those rollovers.
Polly Cordle: And I think there was a lot of energy around rollovers in the now defunct DOL rule. Some firms may have gone through some analysis back then. I know that we did a lot of work around it at Oyster, and so we’re able to leverage some of that work, and help our clients out there.
Buddy Doyle: Certainly the firms we worked with on the DOL fiduciary rule, we are leveraging the risk assessments that were put together, the conflicts matrices that were established with them. And the ones that we didn’t work with that we’re working with on Reg BI implementations, we are going back to those documents; some went ahead and adopted some of the best practices that they were moving towards in that project. But I do think that one of the things with rollovers that you often forget as we’re going through and building your compliance programs around surveillance and testing is to monitor the overall activity and patterns of activities that a rep may have. Because a lot of times, when you’re a supervisor and you’re looking at one piece of paper, you may not get the magnitude of the actual activity that’s going on.
Buddy Doyle: When you see a pattern of activity occurring in a particular rep’s book that may stand out from other reps in terms of volumes of transactions, and while there can be very good rational documentation for those, when you look at them as a whole, they may be very different. So keep in mind that you may want to tweak some of the surveillance that you’re doing. As you’re looking at this, certainly you want to amend some of the testing that you’re doing in your branch exams or in your departmental testing to look for things. Patrick, you’ve got some thoughts?
Patrick Dennis: One thing I wanted to mention about rollovers is don’t lose sight of the fact that the DOL is, there is plenty of things in the press right now about the DOL coming in with some new regulations specific to rollovers in those things. Alot of folks have suggested that’s coming or maybe coming. I’ve seen some things that suggested it may be coming as soon as before the end of the year, which is 60 days from now. Keep that in mind – that there may be some specific rollover requirements and specific things. They are the regulator for ERISA. There is a lot of discussion about the fact that they may be coming out with some new DOL regulations specific to rollovers. So keep that in mind because that may be in addition to reg BI
Polly Cordle: Buddy, to your point about supervision and surveillance, I think we’ve come a long, long way since the paper trade blotter. I hope a lot of firms have given that up at this point. But I think we also have a long way to go and looking at training not only our reps but our supervisors as well to see if things are getting through a supervisor. I know that when we look at the software and our monitoring platform, those are the kinds of things that we’re building out to make it a stronger compliance program. And really getting down to that trending of behavior as someone reaches a new commission break point, payout schedule hit, are they increasing their activity the closer they get to that? And those are tough things to watch in just a regular trade blotter if you’re not looking for them specifically.
Buddy Doyle: And so technology….
Patrick Dennis: There’s work for sure to be done here, that as that technology work is getting completed. There’s regulation around that and making sure that your systems work as designed when you’re using these risk-based platforms. The record keeping that goes along with that testing, to make sure that you can prove that you’ve actually done it, is a real component of a compliance program that needs to be considered. And we’re seeing firms take a couple of different approaches to record keeping. Some firms are simply taking their existing policies of record keeping and tweaking them a little bit, while other organizations are really starting to beef up – specifically the way that they prove the way their new product committees work, The way that they’re doing their surveillance and monitoring. Don’t be surprised if you get asked the question, “How many times does your surveillance lead to a different outcome for your clients?”
Buddy Doyle: It’s one thing to know how many rollovers are happening. It’s another thing to do something to change the behavior of a rep. If you don’t feel great about what you’re looking at, those are going to be very interesting conversations that happen. We’ve all rolled out policies and had the blow back that occurs. It happens all the time, but in this case, these are core fundamental things that are changing. While some of it will be done by systems, and some of those system changes need to be done a lot quicker than you’re probably thinking. We know that some of the service providers out there that do client mailings, for example, they need to know your Form CRS drafts in January so they can get their code done and get that in with the statements on June 30th.
Buddy Doyle: We’re really getting tight on, on time, not just for the podcast, but for the regulations as well.
Patrick Dennis: There’s long lead times, much longer lead times then most people think. And imagine that clearing firms, if you want to get something, you want to get your form CRS in the statement stuffers, you need to give them information by early January to meet the July statement stuffer, which seems like a long time, but I understand there’s a lot needs to be done, a lot of programming technology that needs to be included. The other thing that is maybe even more concerning in terms of a time frame is most firms certainly changed their comp plans, or announced the comp plans, usually in early January or at the end of the year. That’s 60 days away, and clearly your comp plan and how you’re paying your registered reps should be impacted by Reg BI and how this is all gonna work. So the deadlines are coming fast and furious, at least to my way of thinking.
Buddy Doyle: Yeah, I think they are. So there’s definitely a lot to do to build out your compliance program. There’s a lot of things you have to do before you really get down to that tactic, including certainly that conflicts matrix that you need to work on so that you make sure you adequately disclose the risk, the crafting of your Form, CRS, the amending of your marketing materials, writing policies and procedures to close gaps, or just amend that you’re doing to document the fact that you’re probably going to be doing it in a different way. It may be the same process, you might even call it the same thing, but it’s probably going to have some unique twists and turns. Certainly how your supervisors view things, the systems that they’re using to monitor the record keeping practices and then your testing programs. There is an awful lot to do to meet the Compliance Obligation of Reg BI, and be able to prove it, which is as important as meeting the obligation.
Patrick Dennis: And if you have any thoughts about how much is really involved and how much work needs to be done, I’d refer you to SIFMA’s release on September 27th, “The Firm’s Guide to Implementation of Regulation Best Interest” and the “Form CRS Relationship Summary.” It’s only 88 pages. I think there’s a little bit to be done here. It goes through it very thoroughly in terms of the things that you need to consider, but just to give you an idea of what’s coming and how complicated this is, you might want to take a look at that.
Buddy Doyle: Yeah, definitely. If you want to see that, sifma.org is the website that holds this – it was worked on by Deloitte. They did a great job, I think, putting this together. Deloitte is obviously a competitor to us, but honestly our approaches are probably pretty similar. As we move forward, given the way that you look at compliance programs, there’s classic ways to do this and I think our firm and their firm are certainly aligned on that.
Patrick Dennis: I heard a speaker not long ago that explained that the relationship with competitors is, don’t call them competitors, call them worthy rivals. Perhaps we could consider Deloitte our worthy rival?
Buddy Doyle: I certainly do. If you’d like to learn more about how we do things, uh, please visit us on the web at www.oysterllc.com. You can call us at (804) 965-5403. I hope you’ll listen to the other podcasts. We will continue to do podcasts on a weekly basis and there’ll be, I’m sure, lot more to come on Reg BI. I want to thank you both for your time today and sharing your wisdom with their clients and listeners. I appreciate it. Have a great week.
Reg BI – The Disclosure Obligation – October 30, 2019
Polly: Welcome to our latest episode of Oyster Stew and this week we are on our 4th Reg Bi podcast, and today I think our focus is the disclosure obligation – is that right?
Nikki Brinkerhoff: I think that’s right, Polly.
Polly Cordle: My name is Polly Cordle. I am a Managing Director at Oyster and I am joined by Nikki Brinkerhoff, one of our Associate Directors and Lance Whittemore, of one of our Senior Consultants. Now, as I understand it, and you guys will probably correct me because I’m probably wrong but most firms when include their disclosures in the new Form CRS, is that correct?
Lance Whittemore: That’s right, Pauly.
Polly Cordle: All right. So I’m doing pretty good so far. Lance, I know you work with a lot of investment advisory firms and they have their ADV brochures. Is this going to be similar to an ADV brochure? Anything kind of the same between the forum and the brochure?
Lance Whittemore: Yeah, Polly. For investment advisers who are already a pure fiduciary, this is certainly a more straightforward process than it is for the broker dealer community. If firms like that have stayed current on their conflict inventories and kept their compliance manual and Form ADV updated to reflect the business practices they’re in. And if they reviewed their advisory agreements to ensure that they include all the ways that they earn fees in a relationship, then they’ve got a really good start on finishing this process. It’s just different enough though, so that it is a helpful exercise for an overall compliance program. It’s always a good way to examine your own practices and consider how you want to disclose those, and if they’re disclosing it in a good way, to put those practices in context against your overall client relationship.
Polly Cordle: All right, well thank you. We know like Lance said, this rule isn’t just about advisory firms, it’s about all kinds of firms. So are there differences across the different kinds of firms about how they’ll have to do their disclosures and what types of disclosures they should include?
Nikki Brinkerhoff: Well, Polly, I think for all firms it’s different because every firm has a different compensation structure, has different product partners, has internal partners versus external partners. So, like Lance said, being able to conduct an analysis, understand where and how your business works and then properly disclose it is going to be different for every firm. A hybrid firm that does nothing but retail customers is going to have a whole different- looking disclosure then an institutional firm that serves retail customers as an accommodation. So each one of those firms, between the inventory of their disclosures, like Lance said, conducting that gap analysis – is going to be a different exercise for both.
Polly Cordle: So Lance, give me one or two of the top things you think every firm should really have on our minds when they go about making these disclosures. It seems like it could be a, a big task to take on to think about all of the things that you should include in your disclosure. So give me just a couple things that can get them started and get them going in the right direction.
Lance Whittemore: Certainly. I think Nikki really made a very good point when she said some of these some larger and hybrid firms and broker dealer firms with multiple lines of business can think of this as a very daunting task. One place to start is with the firm’s general ledger. Any source of income is obviously going to be a potential conflict to be disclosed. Taking that approach and starting by listing all the ways that a firm generates its own income can serve to demystify the process and maybe give you a place to start. I mean certainly there are conflicts that don’t necessarily earn fees. There are practices that are just intrinsic conflicts that may not show up on the balance sheet, but that’s one place to look at if you’re having a hard time getting going.
Polly Cordle: Okay. And what else should they be thinking about?
Nikki Brinkerhoff: Lance, I think you’re right in the taking your balance sheet, but you also have to look at incentives and trips and you know, if you get a discount or soft dollars by the volume you do with somebody, those are all pieces. Don’t you think that have to go into the thought process?
Lance Whittemore: Yeah, I would absolutely agree with that. I also think that other things that you can make revenue neutral but still have some sort of un-measurable influence on the way that you do your business, also count. For example, larger firms that may have an affiliated fund that they manage themselves and might want to use that in some of their client accounts – even if you’re rebating your management fees from a self-managed fund to a client, you still have some intrinsic incentives to use that fund just to make it bigger. So those are the kinds of things you want to look at.
Nikki Brinkerhoff: I think the point is start with your GL and then identify what makes your GL bigger or potential to make your GL bigger. Does that sound right, Lance?
Lance Whittemore: Absolutely, and I think other things like a self-managed fund or that sort of thing, which can give you a larger space in the marketplace of ideas, or something that can promote your name out there and make you a bigger player in the overall marketplace. Those are also things that have non-financial incentives that you want to consider when you think about disclosing conflicts of interest for the sake of form CRS and for investment advisors, also for your Form ADV Part 2.
Nikki Brinkerhoff: I think Lance brings up a really good point, which is, if you don’t do a thorough gap analysis, and then identify all the things you have in that inventory, you can’t disclose them. So start with the first step and then move out and map out how you’ll be able to either mitigate, or disclose, or actually in some cases you could eliminate those conflicts.
Polly Cordle: Yeah, and that first step being that inventory of conflicts you named.
Nikki Brinkerhoff: Yeah. I think you have to have that, like Lance said, to start with.
Polly Cordle: I thought Lance, your point about the mutual fund having an internal mutual fund and even if you rebate the fees, the growth of that mutual fund itself could be a conflict even though you’re not receiving direct revenue from it. That’s a very interesting point that I’m not sure many people would consider. So I think that’s also an interesting point. It seems like the disclosures could get huge, and I think, if I understand correctly, there is some limit to the length of the form. Is that correct?
Lance Whittemore: Yes. For pure investment advisors I believe it’s two pages and there are even limits to the size of type you can use. They must be at least 8- or 10-point type I think. And you’re not allowed to make it any longer than that. There’s also the requirement that it be plain English. Nikki can correct me, but I believe that for broker dealers and hybrids you have a little more room to work with. But you’re under a lot of pressure to make this very succinct and clear at the same time.
Polly Cordle: So that in of itself could be a challenge, just getting it down to the two pages or three or four pages, if that’s what the requirement is on the BD (broker dealer) side of that. That seems like that could be a challenge for firms and it almost like lands on the advisory side. Would you describe it as kind of a summary of the ADV brochure at that point?
Lance Whittemore: I wouldn’t exactly call it a summary, but it certainly should rhyme. They should be consistent. I think it’s also interesting to note too that in the SEC’s release about the standards of conduct for investment advisors, they don’t just limit disclosure to Form CRS. In fact, they’re pretty consistent in returning to the concept of informed consent as being a key component of fiduciary duty, and they talk about how informed consent can not just come in the ADV Part 2, a brochure. They do mention that they also specify that the language and the framework of the investment advisory agreement can also shape your relationship. When they talk about informed consent, they seem to really key in on the advisory agreement as one of the places that that can happen. It seems that they expect your advisory agreement and your ADV Part 2 to act in conjunction to shape the relationship with a client.
Polly Cordle: Interesting. And then, of course, that presents the risk later on for firms, that all of them get out of sync.
Lance Whittemore: That is true. And that’s why it’s important to review both your ADV Part 2 and your advisory agreement fairly frequently and make sure that they agree with one another, and also that they’re consistent with your actual practices in your manual.
Polly Cordle: All right. So that tells us a little bit about the advisory forms. Nikki, can you tell us a little bit about the length for the broker dealers or hybrid firms?
Nikki Brinkerhoff: Sure. For the investment advisors, they’re limited in two pages, like Lance Said. And for dual registrants, they’ll be limited to four pages. So investment advisors, broker dealers, two pages for the summary and dual registrants are limited to four pages or the equivalent of four pages in an electronic format.
Polly Cordle: So they get a little bit more space to deal with. I know in our third podcast on the top end we talked about the conflict inventory a great deal. If you have this huge conflict inventory, are you going to end up disclosing every one of those conflicts?
Nikki Brinkerhoff: Well, I think you can eliminate some. Your first and easy pass is what can you eliminate? But then I think there’s things you can’t eliminate, and you have to find a way to disclose it. Lance, what do you think?
Lance Whittemore: Well, I think that’s especially important on the investment advisor side. Going back to the standards of conduct for IAs (investment advisors) that were released back in June, those specify that the advisor may shape the relationship by agreement provided that there’s full and fair disclosure, and informed consent. So what that means is that if there are any conflicts that you can’t or won’t mitigate, it becomes increasingly important to ensure that those get specified in your agreement, in your ADV Form. For example, going back to what I was talking about earlier about an affiliate managed mutual fund. If you’re going to use that inside your own client’s advisory accounts, obviously that presents a great conflict of interest. But if you can specify that inside the advisory agreement to such a degree that it is part of your relationship, if it shapes the relationship as they said, then you don’t need to mitigate that and you don’t need to eliminate it.
Nikki Brinkerhoff: Polly, I think Lance is right. It’s all about informed investors being able to make a decision based on what the business looks like and who they’re doing business with. And that comes back to clear English and providing them the information, and they can decide to have a relationship with an advisor or a BD based on what their current structure looks like.
Polly Cordle: Okay. It looks like FINRA came out with some additional guidance around Reg BI, and they’ve got a page dedicated to Reg BI and a pretty big checklist around the Form CRS. It looks like they’re coming up with some resources for firms now, and I know the SEC has published that piece. When did you say that came out? Last year?
Lance Whittemore: It was in June. It was part of the original Reg BI release. It was about a 45-page segment where they formalized the standards of conduct for investment advisors, and this is the piece that people described as a further clarification of the definition of fiduciary duty.
Polly Cordle: So we’re getting some resources now from the regulators, which will help firms out. But I think it’s still a pretty daunting task, especially the conflict inventory and figuring out what you can mitigate, what you can eliminate. And of course, we at Oyster Consulting are always happy to help our clients. We have a number of ways that we can do that with all four of the obligations under Reg BI and we’re happy to do that. We hope that everyone has gotten something out of this podcast. Lance, any last comments before we end?
Lance Whittemore: I think one last thought on this is that generally with big rule-making packages like this, you tend to see some frequently asked question releases as they get closer to implementation. Definitely be on the lookout for FAQs for further guidance. That may narrowed down the focus on some of these questions that still seem pretty vague. The other thing I’d say is that even though I make it sound like the investment advisor side is simpler than the broker dealer side, it’s certainly no less important. It may be less complicated to have a pure investment advisor business, but you definitely want to be as accurate as you can in what you say and do.
Polly Cordle: Absolutely. And Nicky, any, any last thoughts from you before we finish up here?
Nikki Brinkerhoff: I agree with Lance. There’ll be a lot of guidance that comes out but firms should start now. If they don’t understand what they have that they’re going to have to address or disclose, they can’t easily apply the additional guidance as it comes time to comply. And it’s going to become time to comply before we know it.
Polly Cordle: Yes, absolutely it does. It seems far away, but it’s actually not that far away, and you’d rather be prepared and just tweak what you have, than get to that point and have waited for the guidance and not be prepared at all. So again, everybody, thanks for listening to the podcast. We hope you enjoyed it. We’ve got one more podcast coming out on Reg BI. There are five in the series. If you want more information about Oyster Consulting, you can visit us at oysterllc.com and learn about our services and our consultants. You can learn more about Lance and Nikki on our site, on the “About” page, and we hope you got something out of the podcast. We hope you’ll be listening for future podcasts and thanks everybody.
Reg BI – The Care Obligation – October 23, 2019
Patrick Dennis: All right, this is Patrick Dennis with Oyster Consulting. I am here today with Joseph Sisti and Bob Tuch, both of whom are senior consultants with Oyster. This is the third in a series of five podcasts that Oyster is doing in connection with Reg BI, and, if you haven’t had a chance, you can go back and listen to the other podcasts. Reg BI is relatively complicated. There’s a lot to it. The first couple of times you read through it, you may not get that or understand how complicated are all of the things you need to do. But we’re here today to talk specifically about the Care Obligation, which is one of the four obligations under Reg BI. So with that, I’ll let Bob talk about the summary of the requirements for the Care Obligation and we’ll go from there.
Bob Tuch: Thank you. Patrick. Reg BI contains a general requirement that applies to broker-dealer personnel when they make recommendations to retail customers. This general requirement imposes a standard of care when there’s a recommendation of any securities, transaction or investment strategy involving securities. When broker-dealer personnel make these recommendations, they must act in the best interest of the retail customer at the time of the recommendation without placing the financial or other interests of the firm or the firm’s representatives ahead of the interests of the customer. This standard of care must also be met when broker-dealer personnel make account recommendations, including recommendations to rollover or transfer assets in a workplace retirement plan to an IRA, and recommendations to take a plan distribution. And finally, the standard of care must also be adhered to in connection with implicit hold recommendations that result from agreed upon account monitoring to supplement this general standard of care requirement.
Reg BI imposes additional obligations in the form of a Disclosure Obligation, the Care Obligation that we’ll be addressing in some detail today, a Conflicts of Interest Obligation that requires policies and procedures that are reasonably designed to identify, disclose and manage conflicts of interest, and finally a Compliance Obligation that requires written policies and procedures designed to achieve compliance with reg BI. With that general overview in mind, let’s focus on the Care Obligation. The Care Obligation requires broker-dealer personnel to exercise reasonable diligence, care and skill to achieve the following when making recommendations to retail customers: First, understand the potential risks, rewards and costs associated with the recommendation and have a reasonable basis to believe that their recommendation could be in the best interest of some of the firm’s retail customers. Next, have a reasonable basis to believe that their recommendation is in the best interest of a particular retail customer based on that customer’s investment profile and the potential risks, rewards and costs associated with the recommendation, and refrain from placing the financial or other interests of the firm or from representatives ahead of the interest of the customer. And finally, having a reasonable basis to believe that a series of recommended transactions, even if they are all in the customer’s best interest when viewed in isolation, is not extensive and is in the customer’s best interest when taken together in light of a customer’s investment profile, and does not place the financial or other interests of the firm over the interest of the customer.
Patrick Dennis: Thanks for that. Bob, would you mind giving us a little bit more detail on the important factors to keep in mind when you’re talking about the Care Obligation under reg BI?
Sure. First, let me mention that the best interest standard doesn’t necessarily require the lowest cost option. While cost is clearly a very important factor that always needs to be taken into consideration, it is not the only one. Here are a few more things to keep in mind. What constitutes reasonable diligence, care and skill will vary depending on all relevant factors to be considered. Firms should consider reasonably available alternatives as part of having a reasonable basis to believe that a recommendation is in the best interest of a retail customer. Next, the SEC has no intent to limit or foreclose recommendations of complex or more costly products or strategies when there’s a reasonable basis to believe that these recommendations could be in a retail customer’s best interest. A quick example here: a firm may have a retail customer who expresses an interest in having exposure within a certain asset class. It may result in having a portfolio of securities that are somewhat complex or have limited liquidity. If the customer demonstrates a good understanding of the risks involved and has a strong desire to own these, recommendation of particular securities within the desired asset class could very well meet the best interest standard. Another important consideration is taking a risk-based approach when deciding whether or not to document an evaluation of a recommendation and the basis for the particular recommendation. This could take place, for example, when the recommendation is of a complex product or where a recommendation may seem inconsistent with a customer’s investment objective on its face. When a firm determines not to obtain or analyze one or more of the factors specifically identified in the SEC’s definition of retail customer investment profile, the firm should document it’s determination that a factor is not a relevant component of a customer’s investment profile in light of the facts and circumstances related to the particular recommendation. And finally, when recommending that a customer open an IRA account, or rollover assets to an IRA account, rather than keeping assets in or moving assets to a workplace retirement plan, firms should consider a variety of factors. We’ll have more on that later.
Patrick Dennis: Thanks Bob. That was great to hear about the important things that people should keep in mind when they’re making these recommendations. And now I want to turn it over to Joe, if you don’t mind. Joe, could you talk to us about the factors that registered reps should consider when making a recommendation to a retail client?
Joe Sisti: Sure. Patrick. I think the first factor to consider when making a recommendation is that the recommendations you’re thinking of suggesting to your retail customers must not only be suitable for that customer, but come July 2020, recommendations must be in the best interest of that customer. So, what does that mean and how do you comply with the rule? Well, the SEC has listed a number of important factors to consider based on the retail customer’s investment profile. However, we know deciding whether or not to recommend a security or investment strategy entails much more than just considering a customer’s investment profile. As Bob mentioned earlier, we think broker-dealers should take a risk-based approach and they should document the basis for their recommendations in those situations where the securities or strategies are not aligned with the customer’s investment profile. So with that being said, some factors may carry more or less weight depending on whether the registered representative feels they have a reasonable basis for determining if a recommendation is in the customer’s best interest. There really has been a lot written on the rule already, but the guidance doesn’t provide an exhaustive list of factors to consider. You’re not checking boxes here, so I think there’s a lot of flexibility for firms to consider when trying to adopt their policies and procedures to fit their business and comply with the rule. I really want to emphasize the importance of analyzing enough information to have a reasonable basis for believing that a recommendation is in the customer’s best interest. Broker-dealers should consider factors included in the customer’s investment profile, of course including risk tolerance and investment time horizon, but they should also realize that cost is clearly a focus of the rule and of the regulators. There are multiple factors that can be used to make a reasonable decision, and cost definitely should be one of them. I also think that having a complete updated customer investment profile on file should also be considered.
While that may not be an issue for many broker-dealers, it clearly should be a focus for others. I would also note the guidance suggest that specific post-trade exception reports be created by compliance to identify specific trades for review with a focus on the Care Obligation. The key here is that there really is a lot for broker-dealers to consider in the months ahead. Policies and procedures will have to be created or amended. Post-trade exception reports will have to be created, training for associated persons, as suggested. All of this aligned with the risk-based approach to documenting recommendations where appropriate.
Patrick Dennis: So Joe, it sounds like, as we’ve always heard or were frequently reminded in terms of regulatory obligations, is that documentation is key. Is that appropriate here as well?
Joe Sisti: It definitely will be, but most certainly in those instances where the recommendation is not aligned with the client’s investment profile. I think that’s a critical feature of this. I wouldn’t say that every single recommendation needs to be documented, but those that don’t clearly align, or where there’s some question, I would recommend that.
Patrick Dennis: Thanks Joe. Let me ask you this. What kind of alternatives are available or suitable for clients? When you’re talking about, you know, one of the things is reasonably available alternatives, how do you make that determination?
Joe Sisti: Well, I think it’s important that broker-dealers spend some time evaluating the available product offerings at the firm to determine whether what is available gives their registered representatives a reasonable basis to make a recommendation in the best interest of their customers. It’s important to understand that having reasonably available alternatives does not mean that a broker-dealer has to evaluate every possible alternative out there. The goal of the rule is not to ask registered representatives to recommend the single best of all possible alternatives. That wouldn’t be fair to anyone. But instead, I think the broker-dealers should ensure that their registered representatives understand the potential risks, the rewards, the costs associated with a given recommendation. And one that is selected from the group of reasonably available alternatives. So what does this mean to you and your firm? Well, every broker is different. So the short answer is it means different things to different firms. I think some of the factors that should be considered are the firm’s customer base, the investment and services available to the registered representatives and any other products, specific limitations on certain investments that may apply to their customers. Finally, I think part of the firm’s training for associated persons should include helping them understand the products and investment strategies available, each of which that should be evaluated as reasonably available alternatives before making a recommendation to their retail customers.
Patrick Dennis: Thanks, Joe. I think one of the things that we ought to remind folks is, while the reasonably available alternative standard is one factor, when you’re looking at the States and various States, particularly in New Jersey, Massachusetts, depending on where Nevada goes with this, their standards essentially require you to use or to select the best of the reasonably available alternatives. More on that later, but frankly, it’s just something that folks need to keep in mind and we’ll see where the States come out on this. Joe, can you give us your thoughts on how to go about or how to make the right account selection or recommendation to clients in this context?
Joe Sisti: Sure. Come June 30th, 2020, Patrick, the Care Obligation will require broker-dealers to have a reasonable basis to believe that the recommendation is not only in the best interest of the customer, but that the specific security account type is also in the best interest of the customer. So some of the factors to consider here are the services and products provided in the account, the projected cost to the customer of the account, any alternative account types that may be available to the customer. Of course, the services specifically requested by the customer, and the customer’s investment profile. For dual registrants I think there’s some more variables here. An associated person would need to make an evaluation of the entire spectrum of account types offered and not just brokerage accounts. I think it’s pretty reasonable to assume that there may be instances where it may be in the customer’s best interest to have both a brokerage account and an advisory fee based account. For advisory accounts with this established by dual registrants, firms should also periodically review them to determine whether they remain appropriate over time. Firms should consider documenting their review to validate the appropriateness of the investment advisory services that have been provided. And in those instances where firms monitoring determines there may be an issue, firms should establish a process to potentially convert advisory back to a brokerage account. One last thing I think we should consider is that in a recent enforcement action, a large well established dual registrant was sanctioned because the monitoring process and its policies and procedures was not followed. It resulted in a significant number of reverse churning occurrences. This is certainly something I think firms should be aware of when trying to comply with this aspect of the Care Obligation.
Patrick Dennis: We’ve learned through the reverse churning fee, in lieu of commission investigations and sanctions and all those things, that Reg BI is not going to bail you out from making sure that your clients are in the appropriate type of account, whether it’s a commission based account or a fee based account for dual registrants. And you still owe the client the obligation of giving them a best cost alternative between a commission based account and a fee based account on the investment advisory side. Correct?
Joe Sisti: Yeah, that’s true. I agree with that 100%.
Patrick Dennins: Well with that we’d like to turn back to both Joe and Bob to talk about rollover recommendations, which is obviously an important factor in Reg BI because of the emphasis and scrutiny that accounts, IRAs and retirement accounts get. So if you guys could help us understand some of those issues, that’d be great.
Bob Tuch: Yes. Thank you Patrick. I’ll go ahead and get us started on this. When determining how to go about enhancing your policies and procedures relating to IRA rollover recommendations, a good starting point would be FINRA Reg Notice 13-45. This notice reminded FINRA members of the options that may be available to retail customers who are participants in an employer-sponsored retirement plan, and terminate their employment. Those options include leaving the money in the former employer’s plan if permitted; rolling over the assets to a new employer’s plan if one is available and rollovers are permitted; rolling over the assets into an IRA; and, cashing out the account value. The notice indicates that these options offer advantages and disadvantages depending on desire to investment options and services, fees and expenses, withdrawal options, required minimum distributions, tax treatment, and the investor’s unique financial needs and retirement plans.
We can recommend best practices in this space given our experience, including our engagements, advising firms that they’re preparing to comply with the Department of Labor’s Fiduciary Rule. Despite the fate of that rule, which was vacated in March of last year, we benefited from DOL interpretive guidance related to the evaluation of relevant factors when contemplating an IRA rollover recommendation. That evaluation process will need to be comprehensive and includes such things as obtaining relevant employer plan information, considering fees and expenses associated with the employer plan and the proposed IRA, and evaluating the level of services and the underlying investments that are available under each option.
Patrick Dennis: Thanks Bob for that insight. So Joe, could you spend a couple of minutes and explain how Oyster can help firms deal with not only the Care Obligation, but all of the obligations and challenges put in place by Reg BI?
Joe Sisti: I’d be happy to, Patrick. I really do think there’s a lot we can do. We certainly can help them review and enhance their policies and procedures. We can help them review their product offerings for customers to help meet their needs. We can assist in evaluating reasonably available alternatives and also identifying considerations for recommending things like appropriate account types and recommending an IRA account or the rollover of assets into an IRA. Our focus here is really been on the Care Obligation, but as you know, there are other obligations out there and there are many other facets to the rule that also may require assistance. I think we are well-prepared to assist with each of those. And in discussing this topic, we clearly have highlighted some of the areas we can help with the Care Obligation.
Patrick Dennis: Thanks Joe. I know that there are certainly a lot of other things that need to be done. Clearly one of them is identifying the conflicts of interest and making sure that you disclose all the conflicts, or remediate or eliminate the conflicts of interest, which is another area that I think we can help on. So far we’re seeing one of the bigger challenges for firms. But with that, I would like to thank both Joe Sisti and Bob Tuch for all the time and effort they put into helping us with this podcast. Once again, this is the third in a series of five podcasts dealing with Reg BI. You can certainly access the prior ones through our website and stay tuned for the upcoming podcasts on Reg BI. Thanks.
Reg BI – The Conflicts of Interest Obligation – October 16, 2019
Buddy Doyle: Hi everybody. This is Buddy Doyle of Oyster Consulting. Welcome to our Reg BI podcast. Today we’re going to be talking about Conflicts of Interest Obligation under the new Reg BI rule as it relates to Conflicts of Interest. Joining me today are Bob Tuch and Bill Reilly. Bob Tuch is a former general counsel for a broker-dealer. He’s also got experience with the Securities and Exchange Commission. Bill Reilly is a former regulator from the state of Florida. Both have been consultants at Oyster Consulting for awhile, and we’re really excited to have you guys on to help our listeners understand the obligations that are required under Reg BI. So with that, Bob, maybe you could give us a little bit of a summary of the rule requirements as it relates to Conflicts of Interest.
Bob Tuch: Sure. I’d be happy to. Reg BI contains a general requirement that applies to broker-dealer personnel when they make recommendations to retail customers. This general requirement imposes a standard of care when there’s a recommendation of any securities, transaction or investment strategy involving securities. When broker-dealer personnel make these recommendations, they must act in the best interest of the retail customer at the time of the recommendation without placing the financial or other interests to the firm or the firm’s representatives ahead of the interests of the customer. This standard of care must also be met when broker-dealer personnel make account recommendations, including recommendations to roll over or transfer assets in a workplace retirement plan to an IRA, and recommendations to take a plan distribution. And finally, the standard of care must also be adhered to in connection with implicit hold recommendations that result from agreed upon account monitoring to settlement at this general standard of care requirement.
Reg BI imposes additional obligations in the form of a Disclosure Obligation, a Care Obligation that provides details regarding how the standard of care must be met, the Conflict of Interest Obligation that we will be addressing in some detail today, and a Compliance Obligation that requires written policies and procedures designed to achieve compliance with Reg BI. With that general overview in mind, let’s focus on the Conflict of Interest Obligation. The Conflict of Interest Obligation requires that reasonably designed written policies and procedures be established, maintained, and enforced and that they address these four things: 1) identify conflicts associated with firm recommendations and at a minimum disclose or eliminate those conflicts; 2) identify and mitigate any conflicts associated with firm recommendations. They create an incentive for personnel to place, firm interests or firm representative interests ahead of customer interests; 3) identify and disclose material limitations placed on the transactions or strategies that may be recommended, and any conflicts associated with those limitations. In addition, prevent those limitations and associated conflicts from causing from personnel to make recommendations that plays from related interests ahead of customer interests ;and 4) identify and eliminate sales contests, sales quotas, bonuses and non-cash compensation that are based on the sales of specific securities or specific types of securities within a limited period of time. With these requirements in mind, I would like to touch on some important things that you should be thinking about when addressing the conflict of interest. First, identify conflicts and have a process for assessing the nature and severity of the conflicts, as we’ll cover later. Oyster can help firms create a conflicts inventory by using a matrix. Next, conduct periodic reviews of the firm’s conflicts inventory. Be prepared to assess how conflicts should be disclosed, monitored, mitigated, and where appropriate, Eliminated. Review new product offerings with a view toward addressing potential conflicts. Create a process for escalating conflicts of interest. Establish an enhanced surveillance program to monitor associated persons’ recommendations under specified circumstances. Conduct periodic reviews of disclosures and determine whether disclosures must be updated, and create a conflicts of interest training program for your associates.
Buddy Doyle: So Bill, Bob talked about outlining how firms identify conflicts and the nature and severity of those things. Can you give us a little bit of a hint as to how firms should go about identifying their conflicts?
Bill Reilly: Yes, thank you Buddy. As Bob just discussed, the firm should create a process to identify conflicts and prepare conflicts inventory. The one thing that’s important to remember is that this Risk Inventory list is not a onetime creation, but it’s what I would call a living, breathing document, which must be updated as new conflicts are identified or previously identified. Conflicts need to be amended. The review of conflicts should occur on an ongoing basis. But one exception to this might be if a small firm has small number of registered reps and a limited number of products offered. That review could be conducted on a quarterly, semi-annual, or annual basis. But also an important note is that all reviews for conflicts should be documented in writing.
Let’s talk for a minute now about the firm’s business practice, which could give rise to a conflict of interest. As usual, we need to remember that no two firms operate the same, and as a result of the conflicts, identifying the means by which a firm addresses those conflicts may not be the same. And so we thought the one thing that we would do is go through a list. This is not an exhaustive list, but it is a list of the more common type of conflicts that may be encountered by most firms. The first one we are talking about is compensation structure: compensation received by the firm and ultimately provided to the registered representatives. The next one is revenue sharing arrangements. And what we’re talking about here are 12b-1 fees. We’re also talking about revenue sharing fees from direct participation firms, and product sponsors for the broker-dealer engaging in items such as marketing support and or due diligence.
Bill Reilly: The next area that we want to talk about is gifts and entertainment. What we’re talking about here are gifts that are provided to or provided by registered representatives, and these gifts should be placed on the firm’s gifts and entertainment logs . These logs should be reviewed by an appropriate principal and on an ongoing basis. One other area that is a major concern to a lot of firms is outside of business activities. An example of an outside business activity would include the sale of a product to a client which may or may not be a security, which is not on the approved sales list by their broker-dealer. So it’s very important to make sure that all outside business activities are disclosed and approved by the company.
Another area that we’re looking at as far as the conflict inventory is transactions involving proprietary products. Proprietary products are those products that can only be bought and sold through that broker-dealer, and what are the concerns that there could be a different compensation structure for payouts. And one other concern is a lack of portability of their proprietary product when the account is closed and moved to a new company, that a proprietary product may or may not be eligible to be transferred to the new firm when they know when the account is opened there. Another area is personal trading, and the concern in this area is as to whether or not the firm is approving the opening of accounts that are held at other firms or financial institutions and, more importantly, are the firms reviewing the trading activity in those accounts on an ongoing basis.
So it’s very important to determine where outside accounts are and to review that activity. The next area is vendor and service provider relationships. The concern in this area is, is there undisclosed compensation or services being provided and not being disclosed. It is important to make sure that all those areas are disclosed and known to clients. One other area of importance is the new and existing products, and Bob kind of touched on this in the opening part of the presentation. Is there a process in place? Is there a group or a committee to review new products and services that may be offered by the firm and its registered representatives? Are those products approved in total or are there certain restrictions and so forth? Well, one thing to also remember as we’re going through these inventories is to make sure that in the process under which the inventory item was discussed that there’s written documentation that actually describes the process, their review and the approval process.
And one of the last item. The last item we want to talk about is what is the process for obtaining the initial and, or continuing approval for securities offered by the firm? Now, very similar to what we have on the new and existing products, is that, do we have a procedure? Is there a group or a committee that has been formed that can talk about these new products, these new securities or existing securities being continued to be allowed to be traded by the registered representatives? So is there a review process? Is a documented in writing? If approved, are the sales restricted to certain classes of investors with a certain level of experience? Net worth and age? One of the big areas that we’re talking about here, since it’s been a large focus since the very start of the retirement of the baby boomers, are sales of certain products with or without restrictions for sales to retired clients over the age of 65. One other area we want to talk about are transactions and relationships with affiliates. And one of the more common types of issues in this area would include a firm sharing undisclosed fees and services with an affiliated investment advisor. So we’ve seen a whole lot of concerns in this general area.
Buddy Doyle: So Bill, thank you for sharing that. It sounds like this is a really big deal when you’re talking about looking at the compensation structure. You know how you get money as a broker-dealer, where that money goes, what products you’re trading. This seems to have tentacles into every section of an organization. So it seems to me like as you’re sitting down and you start putting together a list of conflicts, you’re almost putting together a list of everything that you do and looking for conflicts. And that’s a pretty big a review. How are firms supposed to manage through their conflicts inventory, Bill? What are some of the things that firms should be looking to do?
Bill Reilly: Yeah, thank you Buddy. Let me talk a bit about that. Once the firm has identified its conflicts inventory, the firm will need to develop a plan. One of the conflicts that Bob mentioned earlier were things like sales contests which were no longer permitted by the provisions of Reg BI, and to the means by which the firm can mitigate and manage the conflict. As part of the process for our clients, Oyster has developed a matrix which, among other categories, includes the name of the conflict, the identification as to whether the conflict is between the firm and the registered representative, the firm and the client, or registered representative and the client. Or, in some instances, the firm and a vendor. Other categories we have on our matrix include how will the conflict be mitigated? And the name of the title, name and tag of the person responsible for the management of the conflict. So we have this broad matrix that allows us to monitor activity, identify who’s in charge of it, and eventually, when we get to the point of testing, which will come after this is established and implemented, we can actually have some testing going on and determine what the degree of the testing was, who the testing was completed by and what the results of the testing was.
Buddy Doyle: Now, Bob, I’m listening to Bill talk about making the list of conflicts and thinking about the things that you’ve said. Now, I don’t recall working with registered reps, and I noticed Bill use the term “registered reps” to describe folks that work at broker-dealers, but I don’t recall any registered reps sort of ever saying they’re trying to put their own interest ahead of their clients. It seems to me like generally in the industry, people want to do right by their clients. And I know that the term financial advisor is now supposedly out of favor; if you work for a broker-dealer, you’re not allowed to use the term financial advisor. Is it fair to say though that most of those folks that are out giving advice related to finances, are they going to see any real change in how they operate or do you think that we’re going to see a major impact on how retail customers get served?
Bob Tuch: I would say that many of these registered reps have been operating in a very appropriate and acceptable way. However, I’m operating under a suitability standard of care. It was something that was believed by many to be an inadequate level of protection for investors. And one of the best examples that comes to mind would be variable annuity exchanges. I’ve assisted some firms where some reps get the idea that there’s this new shiny object that should be offered to a customer and have that person do an exchange out of their current holdings. And, in some instances, it’s really not in the best interest of the customer when you take into account all the bells and whistles of the existing product and all the bells and whistles of the proposed product. So I guess what I’m seeing here is that Reg BI is hopefully going to be a better safeguard in terms of firms and their reps paying close attention to everything that needs to be looked at to really feel comfortable that they’re acting in the best interest of the customer. And I guess that’s the way I see it at this point.
Buddy Doyle: So, thank you for that. So it sounds to me like firms are going to have to take some extra steps, that registered reps are going to have to go through maybe some additional hoops to get a more thorough analysis before recommending a client move from one product to another. Bill, maybe you could share with us some other measures that firms potentially may take to try to help identify and avoid some conflicts as they move forward.
Bill Reilly: I think it’s important, Buddy, because what we’ve talked about at this time, complex inventory, documenting and processing the writing to obtain the conflicts, and possible creation of a matrix for monitoring the conflicts. I think it is time now to take a look at some examples of conflict mitigation measures that firms may consider. And we’ve actually got a couple that are pretty common across the board when we’re talking about most firms. We’re talking about avoiding compensation thresholds that disproportionately increased compensation through incremental increases in sales. And to go along with that, we’re talking about minimizing compensation of incentives for RRs (Registered Reps) who favor one type of account over another ,or those that favor one type of product over another, by establishing differential compensation based on neutral factors, eliminating compensations incentives with comparable product lines.
So I think one of the things that we’re talking about here as looking at compensation levels, compensation needs, and also looking at activity where people may be looking at moving from a threshold of a certain payout to another payout, and also favoring certain types of accounts or products over other accounts. I think that’s a very vital part of this role. Another part of the measures that you would maybe want to implement are procedures to monitor recommendations that are made near these compensation thresholds. So again, when you’re talking about moving from one payout threshold to another, are there people out there that may push the envelope, that may engage in certain activity that may not be in the best interest of their clients because again, they’re moving from one payout threshold to another.
So, supervisors should be aware when people are on the cusp of these levels to make sure that the activity engaged in is in fact in the best interest of the client. Recommendations involving higher compensation products or other recommendations that may be more likely than others to cause an RR to place his or her interest ahead of the customer’s interest. And again, this is a situation where supervisors, branch managers and compliance people should be aware and actively reviewing activity where compensation levels are are ratcheting up, and just to make sure that in fact the RR has the best interests of the clients, and not his or her best interest, in mind. Another one we’re talking about are limiting types of retail customers who have a product transaction or strategy may be recommended.
We talked about this a little bit in the previous category and a good example of this would be limits or restrictions on the sale of certain products. And maybe we’re talking high-risk products, or products that may not have tremendous transparency, may not be actively traded. Firms may decide to limit or restrict the sales of those products to certain classes, including retired investors here, only because of the fact that, again, the interest of the client should be at the forefront of any and all of these recommendations.
Buddy Doyle: Okay. Well, thanks Bill. And so it seems to me listening through this, to your perspective and Bob’s perspective on building the conflicts inventory, what the rule requires, there is a lot of focus on compensation, and I think it’s going to require firms to operate a little bit differently than they have in the past. Again, my belief, knowing what I know and talking to what used to be called financial advisors for so long and kind of listening to how they serve their clients and help them grow, I think there’s some things to keep in mind for the compliance folks that might be listening, for the payroll folks in broker-dealers that are listening here. Most compensation plans go January 1 to December 31. Remember, this is a rule that the implementation date is June 30th.
If you’re going to be making changes to your comp structure in the middle of the year, you should be thinking about how that’s going to work mechanically. Otherwise, you need to be making some pretty tough decisions right now on what you’re going to do to govern the compensation that registered reps are achieving, and to look at how you can make a more product-neutral approach to your compensation structure. A lot of firms who have supervisors monitoring trade blotters and looking at activity of reps don’t consider the next hurdle on the payout grid. So generally speaking, the industry is operated that as you become a more successful registered rep, and as your production goes up, the firm’s profitability goes up and you share that with the registered rep. So they may have some challenges proving to regulators that they’re not just chasing a bonus.
Buddy Doyle: They’re really sitting across from their clients and trying to understand their goals and objectives and doing their best to meet them. So compensation is a really big deal. Incentives across product lines is a really big deal, and listening to Bill talk about limiting the products that you can offer to your retail customers in order to keep yourself safe from regulators, I think, is something else to keep in mind as you’re going through this decision and thinking about risk to your firm. Keep in mind what Bill said about transparency, about liquidity and these complex products in particular. And ask yourself, even if you think it’s appropriate for a customer to get one, is that going to be okay or not? Am I overthinking this, Bill and Bob, or is that probably something that firms really need to be doing right now?
Bob Tuch: No, I think that’s good. I mean, a couple of things come to mind that you might want to throw in. As a reminder for listeners, and one of which is there are a lot of incentives and other compensation packages for registered reps that are entirely acceptable, and we can help firms kind of sift through what’s acceptable and what isn’t. And finally, on a lot of these recommendations, it’s really important to document all the thinking behind it including consideration of conflicts of interests.
Buddy Doyle: And that’s not really been a natural way that I’ve seen registered reps think in terms of documentation and making sure that things are always, the I’s are dotted and the T’s are crossed. You’re going to have to take these entrepreneurial registered reps, and the independent rep firms, and really the entrepreneurial ones in wirehouses even, and sort of try to make sure that you’re checking behind them often to make sure they’re documenting things in a way that makes sense to us compliance types. So, with that, we would love to help you if you need help implementing your conflicts inventory and your Reg BI compliance programs. It’s often hard to see a conflict when you’re looking at it because, as I’ve said, that typically no one’s out trying to take advantage of customers. That’s not something that people in the industry, the vast majority of people in the industry, do. And so as you’re going through this, if you want to have an independent look, a set of eyes that can think like a regulator to point out things to make sure that you’ve got yourself prepared, we’d love to be able to help you. Feel free to reach out to us at (804) 965-5400 or visit us on the web at www.oysterllc.com. And Bill, Bob, thank you so much for sharing your wisdom with our listeners today.
Reg BI – It’s Bigger Than You Might Think – October 9, 2019
Buddy: Hi everybody, this is Buddy Doyle with Oyster Consulting and I’m joined today by Patrick Dennis, our general counsel and Polly Cordle who runs the Oyster Solutions practice area for the firm. This is the first of a five part series of podcasts on Reg BI. It’s been 4 months since the SEC announced Reg BI and we’re nine months away from the time firms need to implement their Reg BI programs. June 30th is the date. So, hopefully, everybody has been looking at it and trying to get ready for it. But, just to help you think through the things that you need to do. Patrick, maybe you can tell us a little bit about what firms do need to do to be ready for this.
Patrick: So, Reg BI really requires 4 obligations on the part of firms to be ready for this. I think you really need to look at it and understand it. But, briefly I can tell you there are four obligations and the first one is the disclosure obligation which requires the firm with respect to all their detail customers to disclose all of their potential conflicts of interest. This is a little bit complicated because you need to then look at all of your vendors and all of your relationships and anything that could potentially be a conflict and then you need to disclose that conflict, mitigate that conflict, or eliminate it. So, those things need to be done and it’s a little more complicated than a lot of folks initially thought when they heard about this. So, it takes some time and effort to figure out what the conflicts are, who you have conflicts with, what needs to be disclosed, how you mitigate or how you eliminate those conflicts.
The second obligation is the care obligation. And that essentially, requires you to review and enhance all of your policies and procedures to ensure that all of your offerings, your products, all of those things are appropriate for your clients; appropriate not only for your clients in general, but also for the specific client.
The third obligation is the conflict of interest obligation. And, this, again, requires you to make sure that you have an inventory of all your conflicts, have disclosed them, eliminated them or mitigated them. But it’s a complicated and difficult situation to make sure that you do examine thoroughly all the things that effect your firm and all of its potential clients. It also requires you obviously to disclose all the fees you are charging, how you’re earning those fees and how you’re going to deal with that.,
The last obligation is the compliance obligation and what that requires you to do is, specifically, have policies and procedures as to how you are, in fact, going to meet the obligations under Reg BI.
In a nutshell, those are the four obligations. But there is a lot of, as we say, devil in the details, in connection with all of those four regulations.
Buddy: Thank you. So, Polly is the practice lead for Oyster Solutions. What changes are coming to Oyster’s software platform?
Polly: We’re pretty excited about what we’re doing in the Solutions software. We’re kind of aligning our changes in the software with the four obligations of the rule. In the first thing, the disclosure obligation, we are touching on the disclosures that will mitigate the conflicts and the relationships in the firms that we have on our platform. And we’re doing that through a dashboard that we’ve built out for conflicts specifically. We have a huge survey to help firms identify their conflicts and then build those out into a dashboard that will compare the conflicts to the mitigation and let them know where their conflicts may be out of line with their mitigating process or procedures.
Then to the care obligation, we’re going to help them address anything that may be out of alignment from a best interest transaction perspective. And we’ll also have due diligence workflows in the system that will help them review their products and platforms and make sure those are in alignment with client care.
Back to the conflict of interest obligation that comes with the survey we’ve built out in inventory will help them identify every conflict, we hope, that’s out there. We’ve built a baseline and then we would, obviously, customize that. One of our big features is customization, so we would customize that for each firm to make sure that we are addressing everything that is particular to that firm.
And then, finally, to the compliance obligation. We would, especially in the implementation for any firm, we do a very thorough review of their policies and procedures. For all of our clients that have been implemented, we’ll be aligning their policies and procedures by helping them to recognize policies that may be affected by the new rule.
Buddy: Great! To me is seems like with Reg BI (BI standing for ‘Best Interests) which is a rule that governs how broker-dealers deal with their retail client base. Seems like it could, and really should, lead to a fundamental change in the suitability standard which is FINRA’s primary rule around helping retail customers and making recommendations to customers. But aside from a regulatory notice in August, which, you know, took a little while to get out, FINRA hasn’t give firms any real guidance on their websites, but I know that they’re really not talking at conferences, and Patrick, you’re out talking to regulators on a pretty routine basis, what are they saying and when can the industry expect to hear more?
Patrick: Well, a couple of things – I’ve been to 4 or 5 conferences since the rule was announced in April and it has been a hot topic at every single conference regardless of whether is was the FINRA Annual Conference that I attended in May or a couple of the regional Sifma Compliance and Legal conferences I’ve been. Reg BI has been a hot topic. It’s been on every agenda. One of the things I will tell you that’s going on is that a lot of folks are thinking that they are going to have to give an extension, they’re going to have to give us more time. You know, I think that’s what a lot of folks would like, but so far, I’m not hearing anything about that, and so June 30th of next year is the deadline. Commissioner Pierce from the SEC spoke at a conference I was at earlier this week, and I don’t think she has any inkling or any suggestions that there is going to be an extension. So, I think the timing is coming.
The other thing is, you know, the things that I’m hearing at conferences other than the concern about how long this is going to take and everything else is Commissioner Pierce and others have all sort of let folks know that there’s a lot more to this. This is not something that you’re going to be able to dash off in a couple of hours or a couple of weeks’ worth of work. I know a number of firms that are starting on it now and have devoted a lot of effort and resources to making sure they’re ready because it is a lot of work. One of the things I failed to mention when we went through the obligations, a part of one of those obligations is form CRS (or Customer Relationship Summary is what CRS stands for), it requires you as a broker-dealer to distill all of this down into plain English and describe it all in two pages or if you’re a dual registrant or RIA to do it in 4 pages. Either way it doesn’t give you a lot of space and a lot of time to get all of the information in that you need to have in that form, so it’s going to take a lot of time and effort, I think to come up with a concise, cogent, well-written piece that you’re going to need to deliver to your client. So, those are the kind of things that I’m hearing in the conference, but it is a hot topic and it is something that on everybody’s mind. It is that leader on the agenda for all of the conferences that I’ve been to or am planning on going to. So, keep that in mind that this is not going to be able to be taken care of with a minimal amount of effort.
Buddy: And we’re expecting to hear more out of FINRA. There are some conferences coming up for those of you that are interested in this, October 3rd, the FINRA Midwest Region Member Forum is taking place in St. Louis. There’s actually a FINRA small firm report on Reg BI that’s coming out and targeted for October 8th. The FINRA Small Firm conference is taking place later in October on the 23rd and 24th in Santa Monica, California. And then, I suspect they’ll be talking about this at the Advertising Review Conference as well in Washington, DC on the 24th and 25th.
Patrick: The Advertising Review Conference has gotten a lot of press and the new advertising rules. And, I guess, I would categorize it as modernizing the advertising rules to fit in with social media and all that is going on is getting a lot of attention at the conferences I’m attending as well. Not to mention a couple of them that Sifma is having. Compliance & Legal regional conferences, and if I have this right, I think that there’s one coming up in Minneapolis, certainly New York City is another one, and I think there’s a third one which I’m forgetting where it is right now. I believe it may be in Denver. Anyway, take a look at the website, and you can find out. I’m sure that Reg BI is going to be a topic at all of those conferences.
So, Buddy, why is this a bigger deal than most firms think, other than I mentioned it’s more complicated than I think meets the eye?
Buddy: Well, when I look at the rule, I see that this has tentacles into every corner of a broker-dealer from changing titles on business cards to how you disclose forgivable loans and things like that when you’re recruiting reps. When you’re prospecting clients and opening accounts, you kind of have to look at that and what you disclose and when. Or when you’re recommending investments, again, what’s going to happen with suitability? What’s going to happen with product reviews, your advertising, your marketing disclosures are certainly going to have to change. But one of the things that I look at when we’re talking about the urgency around making the changes in Reg BI or at least some decisions around Reg BI, this can impact comp plans, and this is a rule that’s coming to get implemented at the end of June, but most people change their comp plans on an annual calendar basis which means by December 31st, they’re defining what they’re going to do as far as a compensation plan that usually lasts all year long. So, anytime you’re touching compensation, it’s a pretty touchy subject, you want to communicate that well, you want to be very thoughtful about it. So when you talk about the fact that you’re serving retail customers, you’re changing comp plans, you’re changing processes , you’re changing procedures and you’re analyzing every conflict along the way, you know you’re going to have to change business cards and stationary and things like that because calling someone a financial advisor who is a registered rep of a broker-dealer, doesn’t work anymore. And so, there’s a lot of changes coming, and I don’t think people have really thought all the way through just how impactful this can be. It goes to the core of what you do as a broker-dealer if you’re serving retail customers. And so, I think that, that’s why I think that this is a bigger deal than what firms are thinking. When I talked with two compliance officers and asked them what they’re doing on this, they talked about states are suing, and things are going on and they’re waiting. But I look at this, and I think, wow, there’s going to be a really time where you’re going to wish you were working on your ADV at the end of March and, instead, this is going to be flooding you right at that time. So, don’t forget you have a day job, you have things that you have to get done, but in particular, you should be talking to your finance group right now, today, about comp plan changes that may be coming.
Patrick: One of the other things that’s coming out of the conferences, we now know I think it’s seven states and the District of Columbia that have filed suit. That doesn’t seem to be delaying things and it doesn’t seem to be holding it off. The other thing that’s being discussed is (and certainly something folks need to keep in mind) is states are passing legislation. Quite frankly, I think you can interpret that as the states don’t believe that Reg BI goes far enough in terms of making brokers a fiduciary and they’re not particularly happy about the fact that the SEC did not make putting a fiduciary standard for brokerage firms. So, we’ll see where those all go, but that’s another aspect of where this is all going, and things you need to keep in mind.
So, Buddy, why do you think it would be helpful for firms to consider having a third party helping them implement the changes that are required by Reg BI?
Buddy: Well, so don’t take this the wrong way, but there’s an old analogy that when you move in next to the big firm, sooner or later you get used to the smell. (Laughter) You can laugh. It’s OK, every once in a while, Compliance can have a little fun. But, in reality, conflicts can be hard to sniff out, right, when you work for a broker-dealer. And so, when you’re in the bubble and you’re working with a broker dealer and you’re looking at things, and you know, I live in a rural area so this applies more to me than to most, but I will say when you’re in the firm and you think about how you look at the world through your own perspective and there you are, it can be very difficult to find a conflict even when somebody else can see it. And, we’ve had conversations with firms before where we’re talking to someone about a real conflict of interest and they just don’t see it because they know that they’re good people and they’re going to take care of their clients. The standard of care obligation – you probably already feel like you’re fulfilling the standard of care to your customers because you care about them, you take care of them, and you talk to them during the tough times, you talk to them during the good times. But it’s really hard to look at a conflict the way a regulator would when you’re looking at yourself. When I look at myself in the mirror, I see the old me(?), the me that just looks the same, and when other people look at me that have never met me before, they see exactly what I am. So, it’s, to me, that’s a component that only an independent person can come in, look at a conflict and say, I truly see it. You may not be able to because you’re wired to take care of your customers. And so that’s one component that I think. And the other thing is, in working with third parties, I used to work at a firm that had a lot of different businesses. It was a pretty complex structure – there was an independent rep component. There was a retail component. There was an online, a discount component. There was a channel to deliver services to folks going into the retail bank system, and there was clearing, a back-office provider for 100 different broker dealers. When I was in there, I got to learn a lot; I got to see a lot, but working with 400 firms – 500 firms, I being able to see what happens from other people’s prospective as well. It something that you can get while dealing with a third party that you really can’t get when you’re inside your own organization and thinking about it. It’s really hard to think out of the box and in reality, there is no box. So, I think this is a brand new thing and so, it really helps to get, in my opinion, some independent help either in implementing it, all right, because you do have a day job and there is a lot to this, or, at least, come in back behind and say, ‘Well, hey, did you think about this?” And so, we put our grumpy regulator hat on with our clients sometimes and talk to them and challenge them on their ideas and the way they think about things, and it’s really hard to challenge yourself on your own ideas and how you think about things. And so, that’s why I think getting an independent third party, whether it’s Oyster or Deloitte or KP&G or EY, you know something to stick(?)
Patrick: Yeah, well, you know, I think to your point that a different set of eyes, a new set of eyes looking at things see things differently, obviously, and, you know, quite frankly, the analogy of “You don’t know what you don’t know”. That’s just the way life is. You work within your own sphere, with everything else, you really don’t know what you don’t know. And having a third consultant that sees a lot of different firms, a lot of different ways that this is being done and handled, I think can be helpful.
Buddy: OK, well, we’re going to wrap up today’s podcast. Again, this is a series of five on Reg BI. But, we’re going to be doing podcasts on a weekly basis at Oyster Consulting. We’re going to try to keep them to a time that’s meaningful. We want your time to be valuable. And if you’re struggling with a topic and you’d like us to do a podcast on it, feel free to reach out to us. You can call us at 804-965-5400 or you can visit us on the web at www.oysterllc.com. Thanks for your time.