Securities brokers are on official notice from their Wall Street watchdog: Either understand the nuances of every investment you recommend and follow Reg BI, or face penalties.
The Financial Industry Regulatory Authority, the self-regulating overseer of more than 600,000 brokers, issued that warning about the client-care standard in its latest annual report on its regulatory and examination priorities, a document that touches on two dozen topics ranging from cybersecurity and electronic communications to money laundering and market manipulation.
Promulgated by the Securities and Exchange Commission, Regulation Best Interest, known as Reg BI, took effect in June 2020 and requires brokers to put their clients' interests first. Unlike the fiduciary standard — a higher standard of client care that applies to independent financial advisors — Reg BI only requires brokers to disclose conflicts of interest to clients, not eliminate them altogether. Conflicts of interest often arise for brokers because they earn commissions on the products they sell. By contrast, independent advisors have no financial incentive to trade in individual funds and securities.
Carlo di Florio, the global advisory leader at ACA Group, which advises financial services companies on regulatory compliance, said that regulators often give firms a grace period to make "good faith" efforts to fully abide by new rules. If FINRA's
"The training wheels are off now," di Florio said. "This rule has been out there, and you've had lots of opportunities for guidance and to build your programs. So now we are going to do deeper exams to see how well you are complying with the critical elements of the rule."
Enforcement of Reg BI so far has been rare. Last October, FINRA brought its
Bill St. Louis, the vice president of FINRA's
St. Louis said the first question FINRA officials ask when testing to see if brokers understand a particular investment they've recommended is: "How does this product work?"
The report calls attention to several new areas that FINRA wants brokers to keep in mind when trying to stay on the right side of Reg BI. For example, if a broker recommends rolling over a 401(k) plan into an individual retirement account, it's no longer acceptable to assume that just any IRA will do. Brokers now must take into account a variety of factors including the costs of the transfer, the number of investment options the new account will provide and the client's ability to make penalty-free withdrawals. The same criteria apply to almost any type of investment a broker might put forward, including variable annuities and private funds. Before recommending those products, says FINRA, brokers must first consider cheaper and safer alternatives.
"We'll look more into
Brokers will also have to monitor their communications about cryptocurrencies to make sure they are distinguishing between regulated and unregulated digital assets.
Just as brokers are required to have a thorough understanding of any investment opportunities they recommend, so are they expected to know their clients as investors. FINRA requires that brokers maintain customer profiles listing such details as their likely retirement age, assets on hand and tolerance for risk.
Solomon said on the podcast that FINRA officials have "seen some simply wrong interpretations on what is a recommendation."
"And so that's an area that we're going to try to bore into a little bit in terms of how firms decide on what is a recommendation, whether they're accurately doing that," he added. "So, that's just a couple of the areas that I think firms will likely see a change and pivot in what we've been looking at over the last year or two."
FINRA scrutinizes the more than 3,000 brokerage firms under its jurisdiction at least once every four years. Firms that are deemed riskier are subject to more frequent examinations, sometimes annually. FINRA also conducts investigations following customer complaints or similar reports.
Di Florio said FINRA officials will also want to see that brokers have properly reported any conflicts of interest using
Di Florio said it wasn't uncommon in the days before Reg BI for FINRA and the SEC, Wall Street's regulator and FINRA's overseer, to bring cases alleging violations of the previous standard of conduct for broker-dealers. That so-called suitability standard, considered weaker than Reg BI, called on brokers to make sure that they genuinely believed their recommendations would be appropriate for clients.
"I think what we're going to see now is a steady flow of Reg BI cases just like we used to have with the old suitability cases," di Florio said. "But these will be brought to bear with a higher standard."
For brokers who are overwhelmed by the myriad of topics in the latest FINRA report, there's good news, di Florio said. The document is drawn up like an index that can be scanned to find topics that are of the most interest to them. FINRA even bolded language describing new policies or developments.
Among the report's other highlights are reminders that:
Brokers are responsible for being on the lookout for
manipulative trading schemes. A particular type of scam that has come into regulators' sights in recent years involves so-called meme stocks. These are stocks that can be easily bought in large numbers because they are cheap. Fraudsters use social media to misleadingly promote them as long-term investments, all the while planning to dump them once their price hits a certain point. FINRA's report warns that cheap initial public offerings — sales of shares in a company for the first time — are now being used for similar purposes.Di Florio said brokers might be approached by clients who have been convinced by social media that they should put their money into something sketchy. In such cases, it's a broker's responsibility to warn clients of all the risks and to do their best to persuade them to consider alternative investments.
- Brokers are responsible for abiding by anti-money laundering laws and sanctions against foreign countries. With the U.S. having placed restrictions on Russian transactions in response to Moscow's invasion of Ukraine, brokers need to be doubly sure of the origin of any money they're asked to handle.
- Brokers need to make sure that they're not only recommending the best possible investments to clients but are are executing those investments in the best possible way. FINRA's Regulation Best Execution rule is generally meant to ensure that brokers are looking at more than one place where, say, a given stock might be sold and choosing the platform that offers the lowest price.
The SEC has proposed its own Regulation Best Execution as part of a plan to overhaul U.S. securities markets. - Brokers need to have strong cybersecurity systems and procedures to protect client and business information.
