Brokerages make progress, but still fall short on Reg BI compliance: State regulators

Brokerages are doing a better job of complying with Regulation Best Interest but they have more work to do before they get it right, state securities regulators said Tuesday.

Under Reg BI, the broker standard of conduct implemented in 2020 by the Securities and Exchange Commission, brokers are prohibited from putting their revenue interests ahead of their customers’ interests in investment returns.

The latest iteration of a Reg BI study by the North American Securities Administrators Association shows brokers are enhancing their policies and procedures to meet Reg BI obligations but they’re also falling short on key aspects of compliance, such as offering customers reasonably available alternatives to recommendations and mitigating conflicts of interest.

Brokers selling complex products — leveraged and inverse exchange-traded funds, nontraded real estate investment trusts, private placements and variable annuities — are imposing restrictions based on the age, net worth and risk profiles of customers, the NASAA study said. They’re also using tools to compare the costs of those investments with reasonably available alternatives.

But brokers are still giving incentives to their registered representatives to sell complex products and not putting in place measures to curb potential conflicts of interest, the NASAA study found. Firms also are ignoring lower-cost and lower-risk investments when recommending complex products.

Brokers have put time and energy into disclosures contained in their customer relationship summaries, or Form CRS, but they have not enhanced point-of-sale disclosures, NASAA found.

The state regulators released their most recent conclusions — known as Phase II (b) — of their Reg BI study. The first two parts were unveiled in 2020 and November 2021. The previous studies have drawn strong industry criticism. The latest iteration is based on 200 on-site or remote examinations of Finra-registered brokerages conducted by 25 states.

State regulators were less critical of brokerages in the current report but said they still are not moving much beyond their previous suitability standard, which Reg BI was supposed to elevate.

“While the Phase II (B) exams reveal helpful and steady implementation progress by the firms examined, firms are still relying heavily on suitability policies and strategies that predated Reg BI,” the NASAA study states. “Efforts to address the standard of care concepts established by Reg BI remain perfunctory. In short, more work needs to be done to truly elevate the standard of care for retail customers.”

On Tuesday, NASAA also released a request for comment on proposed revisions to its model rule on broker conduct, which it is updating now that Reg BI is in force. Public input is due in early December.

Some states are trying to go beyond Reg BI on investor protection. The highest court in Massachusetts recently upheld that state's fiduciary rule for all advisors in the state, including brokers.

The SEC promulgated Reg BI as a way to strengthen the broker standard of conduct and make it similar to the fiduciary standard that governs investment advisors.

The NASAA report shows that it will take brokers a while to move from a product-sales mindset to working with customers to find the best investment approach for their needs, said Jeffery Schaff, vice president of Ardor Fiduciary Services, a fiduciary consulting firm.

“They do have a long way to go in every regard, based on my initial read,” Schaff said. Reg BI represents “a different culture. It will take them time to evolve.”

The NASAA report provided a list of best practices state regulators found on Reg BI compliance. They included forming conflicts committees to review a firm’s business lines and practices, clearly identifying third-party compensation arrangements and looking more holistically at customer characteristics — beyond net worth — to determine if they should invest in complex products.

“It will hopefully help the industry understand the path they need to take to fully comply with Reg BI,” Schaff said.