Reg BI - Conflicts of Interest Obligation

In this episode, Oyster CEO Buddy Doyle, and Consultants Bob Tuch and Bill Reilly discuss the Regulation Best Interest (Reg BI) Conflicts of Interest Obligation, including: 

• Identifying and assessing conflicts
• Disclosure, mitigation, elimination and monitoring
• New product review around conflicts
• Escalating conflicts 
• Conflict surveillance
• Disclosure reviews
• Training 

Reg BI requirements touch on many, many aspects of Broker-Dealer and RIA businesses.  Oyster can help your firm navigate the rule and make sure your firm is compliant and ready for the implementation deadline. 

CRC-Oyster: Compliance Risk Concepts / Oyster Consulting

Transcript

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Oyster Host 0:06

Welcome to this week's serving of Oyster Stew, a mix of financial services, commentary and insight . Each week we'll discuss what is happening in the industry based on what we see as we work with regulators and clients. We hope you come away with the knowledge and tools to help you make the best decisions for your firm's future. You can learn more about oyster consulting and the value we can add to your firm by going to our website, www.oysterllc.com.

Buddy Doyle 0:33

Hi everybody. This is Buddy Doyle of Oyster Consulting. Welcome to our Reg BI podcast. Today we're going to be talking about Conflicts of Interest Obligation under the new Reg BI rule as it relates to Conflicts of Interest. Joining me today are Bob Tuch and Bill Reilly. Bob Tuch is a former general counsel for a broker-dealer. He's also got experience with the Securities and Exchange Commission. Bill Reilly is a former regulator from the state of Florida. Both have been consultants at Oyster Consulting for awhile, and we're really excited to have you guys on to help our listeners understand the obligations that are required under Reg BI. So with that , Bob, maybe you could give us a little bit of a summary of the rule requirements as it relates to Conflicts of Interest.

Bob Tuch 1:26

Sure. I'd be happy to. Reg BI contains a general requirement that applies to broker-dealer personnel when they make recommendations to retail customers. This general requirement imposes a standard of care when there's a recommendation of any securities, transaction or investment strategy involving securities. When broker-dealer personnel make these recommendations, they must act in the best interest of the retail customer at the time of the recommendation without placing the financial or other interests to the firm or the firm's representatives ahead of the interests of the customer. This standard of care must also be met when broker-dealer personnel make account recommendations, including recommendations to roll over or transfer assets in a workplace retirement plan to an IRA, and recommendations to take a plan distribution. And finally, the standard of care must also be adhered to in connection with implicit hold recommendations that result from agreed upon account monitoring to settlement at this general standard of care requirement. Reg BI imposes additional obligations in the form of a Disclosure Obligation, a Care Obligation that provides details regarding how the standard of care must be met, the Conflict of Interest Obligation that we will be addressing in some detail today, and a Compliance Obligation that requires written policies and procedures designed to achieve compliance with Reg BI. With that general overview in mind, let's focus on the Conflict of Interest Obligation. The Conflict of Interest Obligation requires that reasonably designed written policies and procedures be established, maintained, and enforced and that they address these four things: 1) identify conflicts associated with firm recommendations and at a minimum disclose or eliminate those conflicts; 2) identify and mitigate any conflicts associated with firm recommendations. They create an incentive for personnel to place, firm interests or firm representative interests ahead of customer interests; 3) identify and disclose material limitations placed on the transactions or strategies that may be recommended , and any conflicts associated with those limitations. In addition, prevent those limitations and associated conflicts from causing from personnel to make recommendations that plays from related interests ahead of customer interests ;and 4) identify and eliminate sales contests , sales quotas, bonuses and non-cash compensation that are based on the sales of specific securities or specific types of securities within a limited period of time. With these requirements in mind, I would like to touch on some important things that you should be thinking about when addressing the conflict of interest. First, identify conflicts and have a process for assessing the nature and severity of the conflicts, as we'll cover later. Oyster can help firms create a conflicts inventory by using a matrix. Next, conduct periodic reviews of the firm's conflicts inventory. Be prepared to assess how conflicts should be disclosed, monitored, mitigated, and where appropriate, Eliminated. Review new product offerings with a view toward addressing potential conflicts. Create a process for escalating conflicts of interest. Establish a n enhanced surveillance program to monitor associated persons' recommendations under specified circumstances. Conduct periodic reviews of disclosures and d etermine whether disclosures must be updated, and create a conflicts of interest training program for your associates.

Buddy Doyle 5:53

So Bill, Bob talked about outlining how firms identify conflicts and the nature and severity of those things. Can you give us a little bit of a hint as to how firms should go about identifying their conflicts?

Bill Reilly 6:10

Yes, thank you Buddy. As Bob just discussed , the firm should create a process to identify conflicts and prepare conflicts inventory. The one thing that's important to remember is that this Risk Inventory list is not a onetime creation, but it's what I would call a living, breathing document, which must be updated as new conflicts are identified or previously identified. Conflicts need to be amended. The review of conflicts should occur on an ongoing basis. But one exception to this might be if a small firm has small number of registered reps and a limited number of products offered. That review could be conducted on a quarterly, semi-annual, or annual basis. But also an important note is that all reviews for conflicts should be documented in writing. Let's talk for a minute now about the firm's business practice, which could give rise to a conflict of interest. As usual, we need to remember that no two firms operate the same, and as a result of the conflicts, identifying the means by which a firm addresses those conflicts may not be the same. And so we thought the one thing that we would do is go through a list. This is not an exhaustive list, but it is a list of the more common type of conflicts that may be encountered by most firms. The first one we are talking about is compensation structure: compensation received by the firm and ultimately provided to the registered representatives. The next one is revenue sharing arrangements. And what we're talking about here are 12b-1 fees. We're also talking about revenue sharing fees from direct participation firms , and product sponsors for the broker-dealer engaging in items such as marketing support and or due diligence. The next area that we want to talk about is gifts and entertainment. What we're talking about here are gifts that are provided to or provided by registered representatives, and these gifts should be placed on the firm's gifts and entertainment logs . These logs should be reviewed by an appropriate principal and on an ongoing basis. One other area that is a major concern to a lot of firms is outside of business activities. An example of an outside business activity would include the sale of a product to a client which may or may not be a security , which is not on the approved sales list by their broker-dealer. So it's very important to make sure that all outside business activities are disclosed and approved by the company. Another area that we're looking at as far as the conflict inventory is transactions involving proprietary products. Proprietary products are those products that can only be bought and sold through that broker-dealer, and what are the concerns that there could be a different compensation structure for payouts. And one other concern is a lack of portability of their proprietary product when the account is closed and moved to a new company, that a proprietary product may or may not be eligible to be transferred to the new firm when they know when the account is opened there. Another area is personal trading, and the concern in this area is as to whether or not the firm is approving the opening of accounts that are held at other firms or financial institutions and, more importantly, are the firms reviewing the trading activity in those accounts on an ongoing basis. So it's very important to determine where outside accounts are and to review that activity. The next area is vendor and service provider relationships. The concern in this area is, is there undisclosed compensation or services being provided and not being disclosed. It is important to make sure that all those areas are disclosed and known to clients. One other area of importance is the new and existing products, and Bob kind of touched on this in the opening part of the presentation. Is there a process in place? Is there a group or a committee to review new products and services that may be offered by the firm and its registered representatives? Are those products approved in total or are there certain restrictions and so forth? Well , one thing to also remember as we're going through these inventories is to make sure that in the process under which the inventory item was discussed that there's written documentation that actually describes the process , their review and the approval process. And one of the last item. The last item we want to talk about is what is the process for obtaining the initial and, or continuing approval for securities offered by the firm? Now, very similar to what we have on the new and existing products, is that, do we have a procedure? Is there a group or a committee that has been formed that can talk about these new products, these new securities or existing securities being continued to be allowed to be traded by the registered representatives? So is there a review process? Is a documented in writing? If approved, are the sales restricted to certain classes of investors with a certain level of experience? Net worth a nd age? One of the big areas that we're talking about here, since i t's been a large focus since the very start of t he retirement of the baby boomers, a re sales of certain products with or without restrictions for sales to retired clients over the age of 65. One other area we want to talk about are transactions and relationships with affiliates. And one of the more common types of issues in this area would include a firm sharing undisclosed fees and services with an affiliated investment advisor. So w e've seen a whole lot of concerns in this general area.

Buddy Doyle 12:27

So Bill, thank you for sharing that. It sounds like this is a really big deal when you're talking about looking at the compensation structure. You know how you get money as a broker-dealer , where that money goes, what products you're trading. This seems to have tentacles into every section of an organization. So it seems to me like as you're sitting down and you start putting together a list of conflicts, you're almost putting together a list of everything that you do and looking for conflicts. And that's a pretty big a review. How are firms supposed to manage through their conflicts inventory, Bill? What are some of the things that firms should be looking to do?

Bill Reilly 13:12

Yeah, thank you Buddy. Let me talk a bit about that. Once the firm has identified its conflicts inventory, the firm will need to develop a plan. One of the conflicts that Bob mentioned earlier were things like sales contests which were no longer permitted by the provisions of Reg BI, and to the means by which the firm can mitigate and manage the conflict. As part of the process for our clients, Oyster has developed a matrix which, among other categories, includes the name of the conflict, the identification as to whether the conflict is between the firm and the registered representative, the firm and the client, or registered representative and the client. Or, in some instances, the firm and a vendor. Other categories we have on our matrix include how will the conflict be mitigated? And the name of the title , name and tag of the person responsible for the management of the conflict. So we have this broad matrix that allows us to monitor activity, identify who's in charge of it, and eventually, when we get to the point of testing, which will come after this is established and implemented, we can actually have some testing going on and determine what the degree of the testing was, who the testing was completed by and what the results of the testing was.

Buddy Doyle 14:34

Now , Bob, I'm listening to Bill talk about making the list of conflicts and thinking about the things that you've said. Now , I don't recall working with registered reps, and I noticed Bill use the term "registered reps" to describe folks that work at broker-dealers, but I don't recall any registered reps sort of ever saying they're trying to put their own interest ahead of their clients. It seems to me like generally in the industry, people want to do right by their clients. And I know that the term financial advisor is now supposedly out of favor; if you work for a broker-dealer, you're not allowed to use the term financial advisor . Is it fair to say though that most of those folks that are out giving advice related to finances, are they going to see any real change in how they operate or do you think that we're g oing t o see a major impact on how retail customers get served?

Bob Tuch 15:51

I would say that many of these registered reps have been operating in a very appropriate and acceptable way. However, I'm operating under a suitability standard of care. It was something that was believed by many to be an inadequate level of protection for investors. And one of the best examples that comes to mind would be variable annuity exchanges. I've assisted some firms where some reps get the idea that there's this new shiny object that should be offered to a customer and have that person do an exchange out of their current holdings. And, in some instances, it's really not in the best interest of the customer when you take into account all the bells and whistles of the existing product and all the bells and whistles of the proposed product. So I guess what I'm seeing here is that Reg BI is hopefully going to be a better safeguard in terms of firms and their reps paying close attention to everything that needs to be looked at to really feel comfortable that they're acting in the best interest of the customer. And I guess that's the way I see it at this point.

Buddy Doyle 17:34

So, thank you for that. So it sounds to me like firms are going to have to take some extra steps, that registered reps are going to have to go through maybe some additional hoops to get a more thorough analysis before recommending a client move from one product to another. Bill, maybe you could share with us some other measures that firms potentially may take to try to help identify and avoid some conflicts as they move forward.

Bill Reilly 18:11

I think it's important, Buddy, because what we've talked about at this time, complex inventory, documenting and processing the writing to obtain the conflicts, and possible creation of a matrix for monitoring t he conflicts. I think it is time now to take a look at some examples of conflict mitigation measures that firms may consider. And we've actually got a couple that are pretty common across the board when w e're talking about most firms. We're talking about avoiding compensation thresholds that disproportionately increased compensation through incremental increases in sales. And to go along with that, we're talking about minimizing compensation o f incentives for RRs (Registered Reps) who f avor one type of account over another ,or those that favor one type of product over another, by establishing differential compensation based on neutral factors, eliminating c ompensations incentives with comparable product lines. So I think one of the things that we're talking about here as looking at compensation levels, compensation needs, and also looking at activity where people may be looking at moving from a threshold of a certain payout to another payout, and also favoring certain types of accounts or products over other accounts. I think that's a very vital part of this role. Another part of the measures that you would maybe want to implement are procedures to monitor recommendations that are made near these compensation thresholds. So again, when you're talking about moving from one payout threshold to another, are there people out there that may push the envelope, that may engage in certain activity that may not be in the best interest of their clients because again, they're moving from one payout threshold to another. So, supervisors should be aware when people are on the cusp of these levels to make sure that the activity engaged in is in fact in the best interest of the client. Recommendations involving higher compensation products or other recommendations that may be more likely than others t o cause an RR to place his or her i nterest ahead of the c ustomer's i nterest. And again, this is a situation where supervisors, branch managers and compliance people should be aware and actively reviewing activity where compensation levels are are ratcheting up, and just to make sure that in fact the RR has the best i nterests of the clients, and not his or her best interest, in mind. Another one w e're talking about are limiting types of retail customers who have a product transaction or strategy may be recommended. We talked about this a little bit in the previous category and a good example of this would be limits or restrictions on the sale of certain products. And maybe we're talking high-risk products, or products that may not have tremendous transparency, may not be actively traded. Firms may decide to limit or restrict the sales of those products to certain classes, including retired investors here, only because of the fact that, again, the interest of the client should be at the forefront of any and all of these recommendations.

Buddy Doyle 21:45

Okay. Well, thanks Bill. And so it seems to me listening through this, to your perspective and Bob's perspective on building the conflicts inventory, what the rule requires, there is a lot of focus on compensation, and I think it's going to require firms to operate a little bit differently than they have in the past. Again, my belief, knowing what I know and talking to what used to be called financial advisors for so long and kind of listening to how they serve their clients and help them grow, I think there's some things to keep in mind for the compliance folks that might be listening, for the payroll folks in broker-dealers that are listening here. Most compensation plans go January 1 to December 31. Remember, this is a rule that the implementation date is June 30th. So if you're going to be making changes to your comp structure in the middle of the year, you should be thinking about how that's going to work mechanically. Otherwise, you need to be making some pretty tough decisions right now on what you're going to do to govern the compensation that registered reps are achieving, and to look at how you can make a more product-neutral approach to your compensation structure. A lot of firms who have supervisors monitoring trade blotters and looking at activity of reps don't consider the next hurdle on the payout grid. So generally speaking, the industry is operated that as you become a more successful registered rep , and as your production goes up , the firm's profitability goes up and you share that with the registered rep. So they may have some challenges proving to regulators that they're not just chasing a bonus. They're really sitting across from their clients and trying to understand their goals and objectives and doing their best to meet them. So compensation is a really big deal. Incentives across product lines is a really big deal, and listening to Bill talk about limiting the products that you can offer to your retail customers in order to keep yourself safe from regulators, I think, is something else to keep in mind as you're going through this decision and thinking about risk to your firm. Keep in mind what Bill said about transparency, about liquidity and these complex products in particular. And ask yourself, even if you think it's appropriate for a customer to get one , is that going to be okay or not? Am I overthinking this, Bill and Bob, or is that probably something that firms really need to be doing right now?

Bob Tuch 24:55

No, I think that's good. I mean, a couple of things come to mind that you might want to throw in. As a reminder for listeners, and one of which is there are a lot of incentives and other compensation packages for registered reps that are entirely acceptable, and we can help firms kind of sift through what's acceptable and what isn't. And finally , on a lot of these recommendations, it's really important to document all the thinking behind it including consideration of conflicts of interests.

Buddy Doyle 25:30

And that's not really been a natural way that I've seen registered reps think in terms of documentation and making sure that things are always, the I's are dotted and the T's are crossed. You're going to have to take these entrepreneurial registered reps , and the independent rep firms, and really the entrepreneurial ones in wirehouses even, and sort of try to make sure that you're checking behind them often to make sure they're documenting things in a way that makes sense to us compliance types. So with that, we would love to help you if you need help implementing your conflicts inventory and your Reg BI compliance programs. It's often hard to see a conflict when you're looking at it because , as I've said, that typically no one's out trying to take advantage of customers. That's not something that people in the industry , the vast majority of people in the industry, do. And so as you're going through this, if you want to have an independent look, a set of eyes that can think like a regulator to point out things to make sure that you've got yourself prepared , we'd love to be able to help you. Feel free to reach out to us at (804) 965-5400 or visit us on the web at www.oysterllc.com. And Bill, Bob, thank you so much for sharing your wisdom with our listeners today.