SEC to advisors: Marketing rule, Reg BI will be on the exam

February 8, 2023 6:38 PM

Every advisor or broker-dealer knows that feeling of dread that usually precedes a coming regulatory examination.

But when it's Securities and Exchange Commission regulators who are conducting the exams, they at least offer a courtesy familiar to many a college student: They tell you what will be on the test.

The SEC, which oversees more than 15,000 registered investment advisors and 3,500 brokerages, released its list of 2023 Examination Priorities on Feb. 7. Among the topics regulators are calling on advisors and brokerages to pay particular attention to are a new marketing rule governing how firms can advertise their services to the public and a nearly 3-year-old regulation calling on brokers to put clients' interests ahead of their own.

"Our examination program continues moving forward and remains committed to furthering investor protection through high-quality examinations and staying abreast of the latest industry trends and emerging risks to investors and the markets," said Richard Best, the director of the SEC's division of examinations, in an official statement.

The SEC's latest fiscal year — from Oct. 1, 2021, to Sept. 30, 2022 — saw regulators conduct examinations at roughly 15% of the more than 15,000 RIAs under their jurisdiction. That figure has been more or less consistent over the years; in the SEC's 2020 fiscal year, it was 16% of the roughly 14,800 RIAs then in existence.

That steady pace of work means a firm's chances of being up for inspection could come every six years or so. Based on the SEC's guidance, here are some compliance developments to think about if regulators may soon be knocking on your door.

To market, to market

For years, advisors had looked on with envy as bankers, insurance providers and workers in nearly every other industry were able to use testimonials from satisfied clients and customers to advertise their services. Worried about messages that might mislead the public, regulators had long banned wealth managers from doing the same.

That all changed on May 4, 2021, with the adoption of the SEC's new marketing rule. Now advisors are explicitly allowed to include not only clients' testimonials in their advertising but also endorsements from celebrities or other third parties.

Of course, though, they can't do so without abiding by a slew of new requirements. For instance, they will have to disclose if the person giving the statement is a current client, was paid for the testimony or endorsement, or has any relationship to the advisor that might constitute a conflict of interest.

They also have a duty to make sure whatever is being said is true. That, contends John Gebauer, chief regulatory officer at the compliance consultant and technology firm Comply, is where some firms might be falling down.

Gebauer said he thinks most advisors are going to the trouble of recording who exactly is providing them with testimonials and endorsements and any conflicts of interest they may have in doing so. He worries, though, that they aren't taking the extra step of providing documentation showing that everything being said is true.

"Simply stating you reviewed it isn't enough," Gebauer said. "You need to do a little more documenting to show you delved into the testimonials or endorsements so you can say you have a reasonable basis for believing they are true and accurate."

Tim Nagy, a securities and enforcement lawyer at Morgan, Lewis & Bockius, recommended firm's conduct their own internal compliance reviews now before the SEC or other regulators show up at their doors.

Reg BI vs. fiduciary

Of the more than 600,000 registered financial advisors in the U.S., roughly half are hybrids — meaning they sometimes act as investment advisors and sometimes as broker-dealers. That also means they operate under two different standards of care with their clients.

When they're serving as investment advisors, they have a fiduciary responsibility to always put their clients first and to avoid conflicts of interest as much as possible. When they're acting as broker-dealers, they're under Regulation Best Interest, a slightly less restrictive rule that stresses the need to recommend investments that are in their clients' best interests and disclose conflicts of interest.

The SEC's exam priorities, Gebauer said, clearly show regulators are concerned advisors aren't doing enough to let clients know when they're acting in one capacity or the other. The distinction is particularly important when it comes to compensation.

Investment advisors typically earn fees that give them little personal incentive for favoring one type of investment over another. Brokers, by contrast, charge commissions from trading in individual stocks and bonds, making them much more likely to have conflicts.

The SEC has no objection to advisors working in both capacities as long as they're upfront with clients about how they're making money at any time.

"Advisors are going to have to tighten up their disclosures so clients understand what compensation they're receiving for advisory services and what for brokerage services," Gebauer said. "That's especially true if you have the same individual who is providing both and is getting paid in both ways."

Reg BI is not yet quite 3 years old and remains somewhat new territory for brokerages. But recent investors warnings and enforcement cases show regulators are starting to insist on strict compliance.

"In the first year, regulators took it light," said Carlo di Florio, the global advisory leader at the compliance consultant ACA Group. "They were just checking to make sure you were making good-faith efforts to comply with the rule. Now, though, they are saying, 'You had better be compliant with the substance of the rule when we come do our exams.'"

Crypto and ESG

The SEC is also warning that it's not enough for advisors to inform clients how they're charging them. They also have to make sure that the sorts of investments they're recommending are appropriate for clients depending on their age, total assets, tolerance for risk and myriad other factors.

That's especially true with so-called alternative investments that go beyond the stocks and bonds that make up traditional portfolios. Cryptocurrencies like bitcoin became popular with many investors when their values shot sky high during the pandemic. Now that those have fallen, advisors who recommended digital assets to clients will be under a heavy obligation to provide documentation explaining their actions.

The same, Gebauer said, goes for other sorts of alternative investments like private funds, real estate trusts or derivatives. In trying to prove that they've recommended the best investments for a client, advisors will have to provide documentation showing they considered other options and then provide reasons for why those weren't chosen.

"This all ties back to the fiduciary duty and Reg BI," Gebauer said. "There is concern that these more complex products are being offered to the wrong sorts of investors."

Regulators have similar concerns about advisors who are touting investment plans that are made according to environmental, social and governance principles. The general idea with ESG is to allow clients to invest their money in companies that align with goals that go beyond producing good returns. A client who's interested in ESG investing might, say, favor investing in businesses that promise to reduce their carbon emissions.

The important thing for advisors who recommend ESG strategies, the SEC said, is to make sure the companies that are being invested in are actually doing what they promise. One of the biggest complaints about ESG investing is that too many beneficiaries of it engage in "greenwashing" — claiming to do something good for the environment without taking any real action.

The SEC's exam priorities, di Florio said, suggest it's now part of advisors' responsibilities to be on the lookout for this unscrupulous practice.

"They want you digging in deeper to avoid greenwashing and really ask, 'Are you really doing what you say you're doing?'" he said.