Reg. BI – The Conflict of Interest Obligation, Part 1
The third aspect of Reg. BI is the Conflict of Interest Obligation. It applies solely to the broker- dealer entity, and not to associated persons. Under the Conflict of Interest Obligation, a broker-dealer must establish, maintain, and enforce written policies and procedures reasonably designed to address conflicts of interest associated with its recommendations to retail customers. In this post we’re going to discuss the four main points the SEC is conveying with this obligation of Reg. BI. Remember, “customer” = retail customer.
Specifically, these written policies and procedures must be reasonably designed to identify and . . .
. . . disclose or eliminate all conflicts of interest associated with the B-D’s recommendations. [This one is pretty straightforward. Eliminate the conflicts, or explain what they are.]
. . . mitigate any conflicts of interest associated with recommendations that create an incentive for the B-D’s associated persons to place their interest or the interest of the broker-dealer ahead of the customer’s interest. [We’ll get into mitigation of conflicts in later posts.]
. . . disclose any material limitations – such as a limited product menu or offering only proprietary products – placed on the securities or investment strategies that may be recommended to a customer. [If you’re presenting a slate of investment options that uniformly skews toward higher commissions and fees for you, you have to explain that to your customer.] The SEC also says that in this situation you have to prevent those limitations and associated conflicts of interest from causing the B-D or associated person to place their interests ahead of the retail customer’s interest. [This one is a bit of a puzzle. If a broker-dealer offers only proprietary products and explains that clearly, what does it have to do to prevent that limited menu from placing its interests ahead of its customers? What could it do?]
. . . eliminate sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sale of specific securities or specific types of securities within a limited period of time. [Time-based sales contests and quotas are so inherently pressure-filled, the SEC has come out squarely against them. There’s no disclosing your way around this prohibition, and it’s hard to see how they fit in the Reg. BI universe.]
As we suggested above, we’ll dig deeper into conflict mitigation and material limitations in later posts.
How should you develop policies and procedures to mitigate certain incentives to associated persons?
Your policies and procedures must be reasonably designed to reduce the potential effect such conflicts may have on a recommendation given to a retail customer.
You have flexibility to develop and tailor reasonably designed policies and procedures that include conflict mitigation measures, based on your circumstances, such as your size, retail customer base (for example, the diversity of investment experience and financial needs), and the complexity of the security or investment strategy involving securities that is being recommended, some of which may be weighed more heavily than others.
Policies and procedures may be reasonably designed at the outset, but may later cease to be reasonably designed based on subsequent events or information obtained, for example, through supervision (e.g., exception testing) of associated person recommendations. Your actual experience should be used to revise your measures as appropriate.
Do different incentives require different mitigation measures?
There are a number of different kinds of incentives and, depending on the specific characteristics of an incentive, different levels and types of mitigation measures may be necessary.
For example, incentives tied to asset accumulation generally would present a different risk and require a different level or kind of mitigation, than variable compensation for similar securities, which in turn may present a different level or kind of risk and may require different mitigation methods than differential or variable compensation or financial incentives tied to broker-dealer revenues.
In certain instances, compliance with existing supervisory requirements and disclosure may be sufficient, for example, where a broker-dealer may develop a surveillance program to monitor sales activity near compensation thresholds.
What are some potential mitigation measures?
The following non-exhaustive list of practices could be used as potential mitigation methods for broker-dealers to comply with the mitigation requirement:
avoiding compensation thresholds that disproportionately increase compensation through incremental increases in sales;
minimizing compensation incentives for employees to favor one type of account over another; or to favor one type of product over another, proprietary or preferred provider products, or comparable products sold on a principal basis, for example, by establishing differential compensation based on neutral factors;
eliminating compensation incentives within comparable product lines by, for example, capping the credit that an associated person may receive across mutual funds or other comparable products across providers;
implementing supervisory procedures to monitor recommendations that are:
near compensation thresholds;
near thresholds for broker-dealer recognition;
involve higher compensating products, proprietary products or transactions in a principal capacity; or,
involve the roll over or transfer of assets from one type of account to another (such as recommendations to roll over or transfer assets in an ERISA account to an IRA) or from one product class to another;
adjusting compensation for associated persons who fail to adequately manage conflicts of interest; and
limiting the types of retail customer to whom a product, transaction or strategy may be recommended.
What are “material limitations” on recommendations?
A “material limitation” placed on the securities or investment strategies involving securities that may be recommended would include, for example, recommending only:
proprietary products, that is, any product that is managed, issued, or sponsored by the financial institution or any of its affiliates;
a specific asset class;
or products with third-party arrangements, that is, revenue sharing.
In addition, the fact that you recommend only products from a select group of issuers could also be a material limitation.
We recognize that, as a practical matter, almost all broker-dealers limit their offerings of securities and investment strategies to some degree. We do not believe that disclosing the fact that a broker-dealer does not offer the entire possible range of securities and investment strategies would convey useful information to a retail customer, and therefore we would not consider this fact, standing alone, to constitute a material limitation. Rather, consistent with the examples of a “material limitation” provided above, whether the limitation is material will depend on the facts and circumstances of the extent of the limitation.
How should you mitigate material limitations on recommendations to retail customers?
You have flexibility to develop and tailor reasonably designed policies and procedures to prevent such limitations and the associated conflicts from causing the broker-dealer or an associated person from placing their interest ahead of the retail customer’s interest.
In developing such policies and procedures, you should, for example, consider establishing product review processes for products that may be recommended, including establishing procedures for identifying and mitigating the conflicts of interests associated with the product, or declining to recommend a product where you cannot effectively mitigate the conflict, and identifying which retail customers would qualify for recommendations from this product menu.
As part of this process, you may consider:
evaluating the use of “preferred lists;”
restricting the retail customers to whom a product may be sold;
prescribing minimum knowledge requirements for associated persons who may recommend certain products; and
conducting periodic product reviews to identify potential conflicts of interest, whether the measures addressing conflicts are working as intended, and to modify the mitigation measures or product selection accordingly.
Are certain conflicts of interest required to be eliminated?
You must develop written policies and procedures reasonably designed to eliminate sales contests, sales quotas, bonuses and non-cash compensation that are based on the sales of specific securities and specific types of securities within a limited period of time. These practices, when coupled with a time limitation, create high-pressure situations for associated persons to engage in sales conduct contrary to the best interest of retail customers.
This requirement does not apply to compensation practices based on, for example, total products sold, or asset growth or accumulation, and customer satisfaction.
This elimination requirement would not prevent a broker-dealer from offering only proprietary products, placing material limitations on the menu of products, or incentivizing the sale of such products through its compensation practices, so long as the incentive is not based on the sale of specific securities or types of securities within a limited period of time.
The elimination requirement is not intended to prohibit:
Training or education meetings, provided that these meetings are not based on the sale of specific securities or types of securities within a limited period of time;
Receipt of certain employee benefits by statutory employees, as we do not consider these benefits to be non-cash compensation for purposes of Regulation Best Interest.