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Regulation and Compliance > State Regulation > NASAA

Reg BI Report Zooms in on BDs' Lack of Compliance

By Melanie Waddell

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What You Need to Know

  • While there has been incremental progress in Reg BI compliance, broker-dealers still are not abiding by the Reg BI rule now in effect, Lubin said.
  • The report focuses on the progress made by 225 firms.
  • It's time for the SEC to clarify its expectation by issuing supplemental guidance, Seidt said.

Broker-dealer compliance with the Securities and Exchange Commission Regulation Best Interest is falling short, according to state securities regulators.

The North American Securities Administrators Association’s 2021 Reg BI Phase Two Report, released Thursday, follows the group’s 2020 Reg BI Phase One Report, which analyzed financial services industry policies and practices prior to the implementation of Reg BI.

Melanie Lubin, NASAA president and Maryland securities commissioner, said Wednesday on a call with reporters that NASAA’s latest report shows that “while there has been incremental progress [in Reg BI compliance],  broker-dealer firms still are not abiding by the Reg BI rule now in effect.”

State securities regulators, Lubin said, “did not see the tide-turning reforms they had expected to see in the broker-dealer industry” after Reg BI took effect.

The 2021 report “reveals that while there were some improvements, most firms are operating in the same manner as they were under the suitability rule, especially when it comes to harmful compensation conflicts,” she explained.

Andrea Seidt, chair of NASAA’s Regulation Best Interest Implementation Committee and Ohio securities commissioner, added that “some firms are headed in the right direction, but Reg BI has a long way to go to close the investor protection gap separating broker-dealers from investment advisors when it comes to conflicted advice.”

Notable Findings

State examiners from 35 jurisdictions examined 443 broker-dealer firms in the 2021 report.

The report focuses on the progress made by 225 firms that were examined in both phases of the initiative — phase one and two — and have transitioned from the suitability standard to the new, best interest standard of care, NASAA explained.

These 225 firms serve more than 77.5 million retail accounts and employ over 316,000 registered reps, NASAA said.

Some notable findings from the 2021 Phase Two report include:

  • The percentage of BDs surveyed that were offering complex, costly and risky products increased by 11% after Reg BI took effect.
  • Sixty-five percent of BDs surveyed are not discussing lower-cost or lower-risk products with their customers when they recommend these types of products.
  • No more than 4% of BDs surveyed had enhanced their investor profile forms (in any key metric measured) to more carefully match investors with products after Reg BI took effect.
  • Three percent of BDs surveyed took a step backward from their prior suitability procedures by dropping customer education, longevity risk and tolerance for alternative products from their investor profile forms.
  • From 24% to 30% of BDs surveyed were still utilizing product-agnostic sales contests, differential compensation and extra forms of compensation. These compensation conflicts are rarely seen in fiduciary firms, observed in only 0.5%-3% of investment advisors examined in Phase I.

Compensation conflicts were concentrated in firms that recommended complex, costly and risky products after Reg BI took effect.

  • Forty percent of BDs surveyed that recommended leveraged or inverse exchange-traded funds had compensation conflicts, as did 41% of firms that recommended private securities, 44% of firms that recommended variable annuities, and 52% of firms that recommended non-traded real estate investment trusts.
  • Only 35% of BDs surveyed that recommended complex, costly and risky products after Reg BI took effect reduced the financial reward associated with these products by capping agent sales credits.

How Should the SEC Respond?

“It is early, and I think [broker-dealers have] done what they thought they needed to do. But now the ball is back in the regulators’ court,” Seidt said on the call. “I think Reg BI sinks or swims based on what securities regulators do, now that we are aware of that firm inaction. We need to help the firms move the needle and close the gaps that remain between Reg BI and fiduciary firms.”

The SEC, Seidt continued, needs to issue “supplemental interpretive guidance. I don’t think it’s really necessary to reform or revise or amend the [Reg BI] rule. It really is time for the SEC to clarify its expectation by issuing supplemental guidance.”

The regulator, she said, received an advance copy of the Phase Two report, and NASAA wants to coordinate with the securities regulator in the coming year on a response.

When asked whether the deficiencies cited in the Phase Two report warrant enforcement action, Seidt responded: “On the state side, we don’t anticipate the states to take early enforcement actions. There needs to be stronger and clearer guidance. A lot of it now is coaching and a redirection at the examination stage.”

PIABA, SIFMA Weigh In

Michael Edmiston, the new president of the Public Investors Advocate Bar Association, or PIABA, said NASAA’s report shows that Reg BI “has not improved the standards of conduct. The very set of rules the brokerage industry supported are now being ignored.”

PIABA is an association of lawyers who represent investors in disputes with the securities industry.

NASAA’s report, Edmiston said, “demonstrates that many firms have not changed their policies, procedures and practices in the areas of due diligence and care, disclosure, or conflict management.”

It “concludes that firms are not providing ‘fair and balanced point-of-sale disclosures regarding fees, costs, and risk to retail investors,’” Edmiston said.

He maintained that enforcement actions are warranted. “It is incumbent upon the SEC to offer clearer guidance as to what is expected of firms and what conduct is unacceptable. It is also time for the SEC, the states and FINRA to bring enforcement actions against those firms which, a year in, have not yet implemented any changes to their policies, procedures and practices.”

Ken Bentsen, president and CEO of the Securities Industry and Financial Markets Association, said that SIFMA appreciates “that the NASAA report and NASAA leadership recognize that firms have adjusted their policies and procedures to be compliant with the federal law that Reg Best interest is and that the vast majority of firms are headed in the right direction.”

He added, however, that “the report misses the mark in terms of the numerous and substantial changes that firms have made to enhance investor protection and satisfy the best interests of their retail investors.”

Firms began making those beneficial changes in 2015 and 2016, when the now-vacated Department of Labor fiduciary rule came out.

“In mid-2019 when Reg BI was finalized, firms maintained those material changes because they would also help the firm comply with Reg BI,” Bentsen said. “The report fails to recognize these significant changes made in response to Reg BI, thereby discounting the true benefits delivered by Reg BI in terms of the positive changes it inspired and requires.”

Reg BI, Bentsen said, “is the law, and it has meaningfully raised the bar for financial professionals, and includes many important investor protections while preserving investors’ choices.”

He argued that “the public record is replete with tangible examples of the SEC’s and FINRA’s robust efforts to implement Reg BI, including their extensive compliance and examination efforts, and their publication of additional regulatory guidance and resources.  We continue to support the organic development and growth of Reg BI in that thoughtful and incremental manner.”

SEC Reg BI Deficiency Letters, Enforcement Actions

Issa Hanna, counsel at Eversheds Sutherland, told me in a recent interview that SEC deficiency letters regarding Reg BI “are starting to come out.”

The two areas the SEC has been hitting on consistently in the letters, Hanna said, are “reasonably available alternatives and policies and procedures around conflicts.”

Jim Lundy, a partner at Faegre Drinker’s Chicago office, said that the SEC’s Division of Examinations “issuing substantive Reg BI deficiency letters around this time is not a surprise.” Rather, Lundy said, “this is part of the ongoing evolution of the SEC continuing to assess firms’ implementation of and compliance with Reg BI.”

Lundy said to expect the SEC’s Division of Enforcement to start bringing enforcement actions against firms for Reg BI violations in 2022.

“At the end of June 2022, we will be two years out from the implementation date” of Reg BI, Lundy continued. “That timing is about right for the Division of Examinations to complete examination cycles for Reg BI, determine which fact patterns and firms warrant enforcement referral consideration, and for the Division of Enforcement to conduct investigations.”

Due to the resources involved and the high-profile nature “of the first Reg BI cases,” Lundy added,  “we may not see them being issued until the second half of next year.”

In comparison with the customer relationship summary, or Form CRS settlements, that the SEC has issued, “which have primarily been technical in nature, I expect the first Reg BI cases to be more substantive and to also be ‘message’ cases,” Lundy said.

Melanie Waddell

@Think_MelanieW

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