With Reg BI, 'Think Broadly' About Recommendations: SEC's Lee

SEC Commissioner Allison Herren Lee called on broker-dealers to “think broadly” about how their communications with clients might be recommendations under Regulation Best Interest.

In a recent speech, Lee also stressed that “where mitigation is specifically called for by the rule text, the requirement necessarily demands steps beyond mere disclosure.”

Lee, a Democrat, stressed to broker-dealers that when “evaluating the ways in which Reg BI applies to your business, think broadly about your communications with customers — no matter the form — to evaluate whether they might be recommendations.”

She stated that the securities regulator “was clear that disclosure alone will not sufficiently reduce the potential effect that certain conflicts may have on recommendations. Broker-dealers must take steps to affirmatively reduce the potential effect of conflicts so they do not taint recommendations.”

Tech Warning

Broker-dealers, Lee warned, “should be thinking critically and carefully about the extent to which nascent practices in the industry may in fact, constitute recommendations. Emerging uses of technology present a clear example of an area that warrants close scrutiny, especially when such technologies are used to engage and communicate with retail customers in a way that is reasonably likely or designed to influence investment or trading behavior, even if such influence is subtle.”

SEC Chairman Gary Gensler also questioned recently when design elements and psychological nudges associated with digital engagement platforms, or DEPs, “cross the line” and become recommendations.

“The answer to that question is important, because that might change the nature of the platform’s obligations under the securities laws,” Gensler said at the Practising Law Institute’s SEC Speaks event.

Gensler said he’s asked SEC staff to take a close look at the feedback the agency received on the use of new and emerging technologies by financial industry firms as they make recommendations for the commission’s consideration, both related to brokers and to investment advisors.

Lee echoed in her remarks that it’s “also evident that, in an increasingly commission-free trading environment where broker-dealers generate substantial revenue from payment for order flow, incentives are shifting more and more from recommending particular securities to recommending day trading more broadly, irrespective of the securities traded.”

As the Commission stated in adopting Reg BI, the broad scope of what constitutes a recommendation, Lee stated, “appropriately recognizes that customers may rely on firms’ and associated persons’ investment expertise and knowledge, and therefore the broker-dealer should be responsible for recommendations, regardless of whether [they] result in transactions or generate transaction-based compensation.”

Mitigating Conflicts

As to mitigating conflicts, Lee advised that conflicts can arise in “various contexts,” with some “not affirmatively created by the firm, but rather are built into the products that a firm permits its representatives to recommend (e.g. some products pay higher commissions than others, or make revenue sharing payments when others do not).”

Conflicts can also originate with the firms themselves, she continued, with firms setting quotas, offering bonuses or other rewards, certain hiring incentives and payout grids.

“Firms must mitigate all of these conflicts, and have various options for doing so,” Lee warned.

“However, a threshold question to ask about an incentive is whether it should be created or permitted at all,” she said. “Sometimes the best mitigation is simply to avoid from the outset an inducement that might cause representatives to put their own interests ahead of their customers.”

Evaluate Longstanding Practices

Broker-dealers should also reevaluate “longstanding practices,” Lee advised, such as those related to account opening, to determine whether Reg BI may apply.

The commission’s “recent experience with the Share Class Selection Disclosure Initiative and other similar cases may be instructive in this respect,” Lee stated. “In those cases, investment advisers were causing clients to purchase and/or hold mutual fund share classes that were more expensive (but usually more lucrative for the adviser or its affiliates) than otherwise available share classes, including in the context of money market funds used as cash sweep vehicles.”

What lessons might be learned from this in the broker-dealer context?

“Compliance personnel should closely evaluate account opening procedures, to consider whether practices for selecting default account options or presenting or otherwise highlighting a subset of investment options might implicate Reg BI,” Lee said. “Depending on the facts and circumstances, the use of a default investment or the presentation of a small subset of investment options on an account opening form may well constitute a recommendation under existing interpretations of that term.”