Digitizing the Best Product Alternative Mandate: How to Comply with Reg BI and Add Value to the Advisory Business
In early April, Securities and Exchange Commission Chairman Jay Clayton informed the financial services industry that the June 30th compliance date for Regulation Best Interest ("Reg BI") and Form CRS will remain unchanged. Although this pronouncement caught many by surprise, the action is consistent with the Clayton Commission’s focus on enhancing investor protections for Main Street. As a result of the constrained timeframe and additional challenges posed by COVID-19 protocols, many firms seemingly have placed the majority of their effort into procedural changes surrounding proper disclosure, including incorporating Form CRS.
Shortly after the Chairman’s statement affirming the date, the Office of Compliance Inspections and Examinations ("OCIE") released a risk alert outlining the expectations of firms in initial examinations. "These initial examinations, which will likely occur during the first year after the compliance date, are designed primarily to evaluate whether firms have established policies and procedures reasonably designed to achieve compliance with Regulation Best Interest." OCIE specifically highlights evaluating if a firm made "reasonable progress in implementing those policies and procedures, including making such modifications demonstrating care obligation."
Whereas disclosure enhancements are necessary, they are insufficient to prove compliance with Reg BI in initial audits. "Reg BI is specifically designed to improve investor protection by enhancing the quality of broker-dealer recommendations to retail customers," which "cannot be satisfied through disclosure alone."
In order to fulfil the obligations of Reg BI in totality, firms need to think differently about their Reg BI approach. What initially seems like a daunting task is, in actuality, an opportunity for Compliance to add value, enhance the advisor experience, and demonstrate increased compliance over the previous suitability standard. That secret lies in the digital transformation of the best product alternative analysis.
Enhancing the Advisor Experience
In order to demonstrate the ’care’ aspect of Reg BI, a broker-dealer should consider reasonably available alternatives in determining whether a reasonable basis for making the recommendation is established – the "best product alternative." Some firms have concluded this task can be accomplished with a procedural change. In an attempt to govern by policy alone, these firms plan to require registered representatives to manually identify and analyze available alternatives to a recommended product, including potentially hundreds of products, and subsequently attest to the sufficiency of their findings. In practice, this will likely lead to nothing more than increased paperwork for the registered rep, nearly zero quantitative compliance oversight, and minimal confidence of a regulator during an audit.
As the SEC stated numerous times, a best product alternative analysis would require a review of such reasonably available alternatives depending on the facts and circumstances at the time of the recommendation. A registered rep would not satisfy the Care Obligation by simply recommending the least expensive or least remunerative security (without any further analysis of the other factors and of the retail customer’s investment profile). A recent study of over 1,000 advisors found less than 20% of a typical advisor’s time is spent meeting with current clients. Given how much time broker-dealers spend on back office related activities, it is ludicrous to believe that advisors will be able to successfully complete an additional, manual analysis for every recommendation, for every client, and for every available product the firm offers.
Conversely, firms that digitize this effort to comply with the Care Obligation will gain substantial strategic benefits. Presenting registered reps with a fast and efficient method to analyze product recommendations will arguably lead to increased productivity, improved overall recommendations, and superior service to retail clients. In the event a product is identified as potentially a better fit for the client, a rep can proactively note why their ultimate decision was made, thus decreasing the need for follow up conversations with a compliance officer in benign cases. A digital transformation of the Care Obligation allows for effective compliance procedures that actually increase value to clients, instead of simply disrupting an advisor’s business.
Evidencing the Care Obligation
COVID-19 restrictions will no doubt influence how SEC investigations are carried out, but likely will not cause any loss in their effectiveness. In 2018, the SEC reported to Congress that 80% of its employees were teleworking on a frequent, or at a minimum an infrequent routine basis. Despite the adaptability of the regulator, the nature of their investigations shall undoubtedly change for the foreseeable future. The market will likely experience a shift toward data-driven investigations, thus maintaining market oversight and preserving the health of the Commission’s staff. In the past, similar audits typically lasted longer, requiring registrants to provide greater volumes of documents and respond to more frequent information requests. Although lacking the benefit of face-to-face interviews, these distance audits are no less effective and typically focus on behaviors detectible through data analytics.
The Compliance Obligation of Regulation Best Interest requires a broker-dealer to establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Regulation Best Interest as a whole. As OCIE noted in their risk alert, to assess compliance with this obligation the staff may review the broker-dealer’s policies and procedures and evaluate any controls in place. Given the importance of the Care Obligation, and the nature of audits for the foreseeable future, implementing a manual process to define the best product alternative is unlikely to convince a regulator that an acceptable control is in place – particularly considering that examiners tend to focus on objective data points during audits.
This is an area where digital transformation can help too. If a compliance officer can provide an automatically generated report consisting of pre and post trade analyses involving every recommendation and trade firm-wide, imagine the impact that would have on the individual inspecting the firm. Often lost is the idea that regulators are people too, more often than not with tremendous industry knowledge and experience. Impressions matter. The idea of ’reasonableness’ is not a bright line in the sand and can move with the impression a firm makes. If a firm provides a tool that can objectively showcase consistent, repeatable, and measurable compliance with the best product alternative analysis that will create an impression immeasurable in value.
Digitizing the best product alternative analysis will not only demonstrate a high level of compliance with the Care Obligation of Reg BI, but ultimately add value to the client experience by providing advisors a powerful yet simple tool to proactively ensure they are meeting the needs of their retail customers. Additionally, automatically auditing this process provides data-based proof of adherence to policies and procedures, and evidences a demonstratable improvement over and above the previous suitability standard. Early adopters of this digital first mindset will reap the benefits long after Reg BI’s June 30th deadline.