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What You Need to Know

  • The SEC is now looking for more than good-faith compliance efforts.
  • Complex products are a focus now in Reg BI exams.
  • Look to FINRA's playbook regarding potential Reg BI enforcement actions.

Regulation Best Interest exams have moved beyond a “good faith” compliance assessment, John Polise, associate director of the Securities and Exchange Commission’s National Broker-Dealer and Exchange Program within the exam division, warned Thursday.

While the agency has moved beyond the Phase 1 “good faith effort” Reg BI exam cycle, the agency is “not looking to do gotcha exams or make enforcement referrals per se,” Polise said during a webcast held by the Securities Industry and Financial Markets Association. “I think we’re still understanding that the rule is complicated, that there are myriad ways for individual firms to address the four core obligations” in Reg BI.

The SEC released a statement on Dec. 21 detailing its plans to ramp up Reg BI exams.

The SEC, Polise added, also still has “not identified ideal or best practices and can do quite a bit more in helping the industry comply with that.”

That said, Reg BI “is a serious obligation,” Polise added. “In our good-faith exams we saw very good efforts and attempts by people to comply with the rule but there were some areas that could certainly be improved. Would they rise to the level of enforcement referrals? Probably not— more like deficiency letters to encourage people to take a more aggressive approach towards some of those requirements.”

What’s a Complex Product Under Reg BI?

Kevin Carroll, SIFMA’s associate general counsel, stated that complex products will be probed under Reg BI Phase 2 exams, but noted such products are not defined. He queried Polise on what products fall under that definition.

Polise responded: Inverse or leveraged exchange products, penny stocks, variable annuities, derivatives, as well as securities with low liquidity “that may not be consistent with what a customer’s needs are” — asset-backed securities or investments tied to market volatility.

“While there’s no set definition” of a complex product, Polise explained, “I think we often look to … whether the rep can explain it in the first instance and whether there are higher costs associated with it.”

Potential Enforcement Actions

Susan Schroeder, former enforcement chief at the Financial Industry Regulatory Authority who’s now partner and vice-chair of the Securities Department at WilmerHale, stated on the webcast that Reg BI was “predicated in a lot of ways on FINRA concepts, [so] we can kind of look to FINRA enforcement and their playbook” regarding potential enforcement actions.

The first area is a focus on policies, procedures and systems, Schroeder said.

“Reg BI is unusual in that it’s one of the few SEC rules that affirmatively requires reasonably designed systems to achieve compliance,” Schroeder said. “Most of the time, an SEC failure to supervise charge … requires an underlying violation before you can charge failure to supervise, then a reasonably designed supervisory system is a defense to that charge, but the failure to have a reasonably designed supervisory system is not, in and of itself, a violation.”

Reg BI changes that, she said.

“Reg BI makes it an affirmative violation just to have a deficient supervisory system, even if there’s not a single unsuitable recommendation made. That’s similar to FINRA’s Rule 3110. FINRA, for a long time, has been able to bring enforcement cases based purely on what FINRA terms ‘deficient’ supervisory processes.”

FINRA cases have included things like “alleged deficiencies in training, documentation — such as failures to point out specific risks of a given product,” Schroeder said.

Even in the adopting release for Reg BI, Schroeder said, the SEC “was pretty straightforward about the fact that it would not necessarily wait for underlying violations, that the compliance obligation, this affirmative supervisory system obligation, was something that the SEC would be willing bring charges on, in and of itself.”

Another potential enforcement action could be brought regarding Reg BI’s “care obligation,” Schroeder said, “which incorporates, very expressly, the FINRA suitability rule, with some tweaks.”


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