Pathway to Reg BI Compliance: Have You Started Your Conflict of Interest Assessment?

Pathway to Reg BI Compliance: Have You Started Your Conflict of Interest Assessment?

As the June 30, 2020 compliance date for the SEC’s Regulation Best Interest (“Reg BI”) draws near, broker-dealers are scrambling to design and implement a comprehensive solution to ensure compliance with Reg BI. In short, Reg BI requires that broker-dealer recommendations be in the retail client’s best interest, creates a broad disclosure obligation, and compels broker-dealers to mitigate certain conflicts of interest. Clearly, identifying and mitigating conflicts of interest is a key part of ensuring your firm’s compliance with Reg BI.

Identifying Conflicts of Interest

So how do you identify and mitigate conflicts of interest? For starters, it’s always prudent to take a “follow the revenue” approach, as conflicts of interest typically result from financial incentives related to transactions that benefit the firm and/or its registered persons. As pointed out in FINRA’s “Report on Conflicts of Interest” issued in October 2013; “Conflicts of interest can arise in any relationship where a duty of care or trust exists between two or more parties, and, as a result, are widespread across the financial services industry.” As part of your firm’s exercise to identify conflicts, it’s critical to establish a framework to identify, assess, monitor and control conflicts. Some guidance in this regard can be gleaned from the SEC’s adopting release for its investment adviser compliance program rule, where the SEC provides conflict of interest guidance for advisers that is also applicable to broker-dealers:

“Each adviser, in designing its policies and procedures, should first identify conflicts and other compliance factors creating risk exposure for the firm and its clients in light of the firm’s particular operations, and then design policies and procedures that address those risks.”

Conflicts of Interest Examples

First, some high-level guidance from FINRA, as reflected in its conflicts of interest report, where FINRA noted that the objective of the report “… is to focus on firms’ approaches to identifying and managing conflicts in three critical areas:

• Enterprise-level frameworks to identify and manage conflicts of interest
• Approaches to handling conflicts of interest in manufacturing and distributing new financial products
• Approaches to compensating their associated persons, particularly those acting as brokers for private clients.

More recently, FINRA’s Reg BI checklist provides some examples of business practices that create material conflicts of interest, including:

• Offering proprietary products
• Payments from third parties, revenue sharing
• Compensation arrangements
• Principal trading
• Payment for order flow

The SEC’s enforcement action against Commonwealth Equity Services, LLC, a registered investment adviser and broker-dealer also provides an illustration of a conflict of interest. In this case, the SEC  charged the firm with failing to disclose material conflicts of interest related to revenue sharing Commonwealth received for certain client mutual fund investments.

The SEC’s Complaint alleges that Commonwealth breached its fiduciary duty to its clients by failing to disclose the conflicts of interest created by its receipt of compensation through the revenue sharing agreement.

Action Items

So, as firms prepare for Reg BI, what are some practical steps that a broker-dealer can take to address conflict of interest concerns?

• Conduct an enterprise-wide, conflict assessment as a key first step in identifying conflicts of interest
• Determine the scope of the conflict assessment focus with a view to ensuring that it encompasses all business units/products
• Interview key business stakeholders as part of this assessment
• Gather, analyze and document conflict assessment findings
• Out of this exercise, develop a conflicts checklist that ties to procedures to reflect how risks are mitigated
• Based upon the findings, implement changes to written policies and procedures, disclosures and surveillance systems designed to identify, eliminate, mitigate or manage conflicts
• Utilize technology to assist with monitoring of client and employee transactions to identify and mange conflicts
• Perform an annual review of internal controls for identifying and mitigating conflicts;
• Cover conflicts of interest in training programs