As regulators get more aggressive about enforcing investor-friendly regulations, such as Reg Best Interest, financial services firms may need to revamp their controls
Top U.S. securities regulators have warned financial services firms that any failure to revamp sales-practice controls for new fiduciary-style standards will draw questions from examiners in the year ahead. However, firms are encountering unexpected difficulties in translating the rules’ risk-based principles into the “hard coded” metrics and algorithms that automated controls require.
Firms that have used digital surveillance tools for decades are finding unique challenges supervising retail sales under standards that regulators embodied under the 2020 rule package known as Regulation Best Interest (Reg BI). The Securities and Exchange Commission (SEC), whose recently issued exam priorities included Reg BI as a key concern, had its own problems meeting the Dodd-Frank Act’s mandate to protect investors from self-serving investment professionals.
The Reg BI rules require firms to recommend transactions with impartial advice, to explain investment alternatives to clients, including those that other firms could offer, to detail relative costs and risks, and to tell clients of any conflicts of interest the firm may have in the products and services sold to the client. The Financial Industry Regulatory Authority, the self-regulator directly overseeing the brokerage industry, also included Reg BI as a top concern in its annual priorities and recently settled an enforcement action against brokerage Long Island Financial Group that focused on inadequate controls.
Reg BI adds new factors to monitor
In a risk alert on Reg BI compliance issued in January, the SEC said it had found that some firms lacked adequate automated systems to monitor transactions and said compliance processes would probably be incapable of providing brokers the tools needed to document that they were offering advice in clients’ best interest.
“Putting the risk assessments into a surveillance system for Reg BI compliance involves significantly more challenges than the kind of monitoring that systems have done in the past,” says Parham Nasseri, vice president in product and regulatory strategy at compliance software developer InvestorCOM, Inc.
The routine transaction surveillance systems used prior to Reg BI were programmed for simple patterns, such as high-volume trading, and could flag account churning or risks of concentrated account positions. The Reg BI rules would add conflicts of interest, customer profiles, costs, alternate investments, and other client-specific factors brokers must consider in advising clients.
The SEC’s guidance points to the need for brokers to have a “dashboard” that displays and documents the factors used in giving impartial advice. In its recent risk alert, the SEC focused on areas in which compliance failures had emerged and in which deficiencies were linked mostly to systems that lacked tools to assure compliance.
Jay Gould, special counsel at Baker Botts, says the SEC risk alert was too broad to give clients clear guidance to set up procedures on how systems should be managed. “The SEC alert was vague about what firms should do,” explains Gould. “It could have used more detail on what they want. There could be unexpected challenges for firms setting this kind of system up. They could have done more to explain it.”
In the report, the SEC exam unit said it would look into whether firms had updated their monitoring systems with specific Best Interest factors, adding that compliance deficiencies were often found in firms that had not made such changes
SEC looks at investor protection controls
The agency has increasingly taken action in situations in which inadequate controls have failed to protect investors from harm. This was seen in the SEC’s civil case against the now-bankrupt FTX crypto exchange, which allegedly lacked an internal process to prevent self-dealing practices.
The SEC said some firms have undermined their controls by allowing brokers to decide whether their transactions were tracked by the firms’ monitoring systems. Reg BI includes rules that some see requiring judgment calls by brokers who base their decisions on long-term relationships with clients. The SEC has pushed firms to create a more ordered process, with a firm-wide system of automated surveillance to eliminate subjective or self-interest when brokers advises clients
“Where firms did not mandate use of such systems, the firm could not enforce its policies and procedures that required financial professionals to consider costs and reasonably available alternatives when making recommendations,” the SEC stated.
The SEC comment was seen as all but banning brokers from working without the automated tools. The implication “could not be made more clear” that examiners would ask early on whether a system allows discretionary overrides, says InvestorCOM’s Nasseri. Such inconsistency inside a firm would probably lead examiners to look more broadly at the sales operation to learn why some brokers would opt-out of using a tool that, if properly designed, would simplify their practices, he adds.
The SEC also has cited other factors such as inadequate training or failure to review factors that could make systems less applicable for some brokers’ practices.
Yet, Nasseri says, the purely technical elements have been a relatively small part of the work that needs to be done to update transaction monitoring to include Reg BI practice factors that could red-flag potential violations. “The technology itself is available, and that part is relatively simple to set up and can handle all of this stuff,” he explains, adding that most of the challenge is in the due diligence and supervision which now firms have to make operational and work effectively. “When that’s done, the technology makes compliance easier.”
While Reg BI, and the related sales practice rules for investment advisers and new client disclosure requirements took effect in 2020, regulators had held off on rigorous examinations for compliance with the new rules due to the COVID-19 pandemic. Exam priority letters this year show they are now set to fully review how firms are complying with the sales practice rules, which sprawled over 1,500 pages.
Compliance experts say that even those financial services firms with long histories of deploying technology to meet compliance challenges are finding difficulties. Indeed, some firms are finding that proven solutions of the past are facing a stress test as they perform more complex tasks over a wider footprint.
A focus on broker training and the process of information-gathering for account actions will play a critical role in fulfilling monitoring expectations, Nasseri says.
Further, monitoring must consider any material changes in overall portfolio holdings that can shift in volatile times, for client history to other factors that have in the past been expected of investment advisers but not brokers.
“Income levels, asset levels, age appropriateness, all appear to be relevant,” says Gould, of Baker Botts. “There will be some challenges ahead.”
