(Chief Investment Officer) - At the Financial Industry Regulatory Authority’s annual conference, enforcement leaders from the Securities and Exchange Commission and FINRA elaborated on some of the common problems they encounter during exams on compliance with both Reg BI and Reg BE.
Reg BI
On Reg BI, Gurbir Grewal, the director of the SEC’s division of enforcement, noted an SEC complaint from June 2022 in which the SEC charged Western International Securities with marketing a high-risk and illiquid debt security to retail and retirement investors when the issuer recommended it be marketed to wealthier investors due to its riskier nature. Because there was no reasonable basis to market the security in this way, it violated the care obligation as required under Reg BI.
Nicole McCafferty, vice president of examinations for FINRA, elaborated on the same point later in the conference. She said advisers must consider a range of alternatives when giving advice to clients, but it is especially important when recommending securities that are relatively risky or complicated. James Wrona, vice president and associate general counsel for FINRA, added that assets in this category could include investments such as: investments traded on margin, cryptocurrency, penny stocks, private placements and asset-backed securities. Wrona said advisers should have specific training and procedures related to these assets.
McCafferty said that merely having a client sign a statement acknowledging the risk involved with an investment, a practice McCafferty says she has noticed, is not adequate to meet the standard of Reg BI. The adviser must clearly explain the risks to the client and how those risks fit into their stated goals and existing portfolio. McCafferty said advisers should document such transactions to ensure an adviser can prove compliance with Reg BI, including when a client goes against an adviser’s advice and invests in something that the adviser believes is not in their best interest. The adviser could be asked to justify such an investment during a FINRA exam and having that documentation would be valuable.
She recommended that advisers begin with basic due diligence and knowledge of specific investments before even turning to the specific needs of a client. She finds advisers often know their customers well but are not as familiar with the products they are advising as they ought to be.
Another common refrain from SEC and FINRA officials during the conference was that merely disclosing conflicts of interest is not adequate; attempts to mitigate those conflicts must also be made. McCafferty said an advisory firm cannot disclose to clients that they hold regular sales contests and rely on that disclosure to satisfy their obligation under the regulation. A sales contest creates a conflict that must be eliminated because of the incentive structure it creates, putting the firms’ interests or its employees’ interests ahead of clients’ interests.
When FINRA conducts examinations, its officials also look for corrective action related to past failure notices, McCafferty explained. Such follow-up exams that look for changes are not limited to past FINRA exams. FINRA will also examine failures noted by the SEC and state-level authorities, and FINRA examiners expect to see corrective actions based on those observations.
Reg BE
On Reg BE, which addresses trade execution, Chris Kelly, senior vice president and acting head of enforcement at FINRA, noted two recent cases in which broker/dealers routed orders to affiliated trading systems without looking for better pricing in other trading systems. This behavior is a violation of Reg BE, because if an unaffiliated trading venue can offer a better price, the broker should execute the trade on that venue instead. Kelly explained that this is not a failure based on “technicality or nuance,” but instead is “a complete failure.”
Kelly warned of some of the risks associated with finance professionals who are registered simultaneously as both a financial adviser and as a broker/dealer. He highlighted a pattern of dual registrants moving securities back and forth between brokerage and advisory accounts to drive up fees. For example, Kelly said he has seen some dual registrants who charge clients to buy securities in their capacity as a broker, only to transfer those securities to an advisory account so they can also charge advisory fees on the same assets.
By Paul Mulholland
May 17, 2023
