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Compliance & Risk

Former FINRA enforcement chief says Reg BI brings new compliance liability

Richard Satran  Financial Journalist, Thomson Reuters Regulatory Intelligence

Richard Satran  Financial Journalist, Thomson Reuters Regulatory Intelligence

We speak to former FINRA enforcement chief Susan Schroeder about the new Reg BI and the challenges it poses for compliance professionals

Regulation Best Interest (Reg BI) has brought new challenges for compliance even though it looks a lot like the previous suitability rule, according to former Financial Industry Regulatory Authority (FINRA) enforcement chief Susan Schroeder. When combined with enhanced surveillance tools that are coming on line, however, “the door is wide open for data-driven approaches” in a wider range of suitability cases involving firms’ products and sales practices, she adds.

Schroeder now looks at the potential impact of Reg BI from the private side as vice chair of the Securities & Financial Services Department of law firm Wilmer Cutler Pickering Hale and Dorr. She held key positions at FINRA as the industry self-regulator worked with the U.S. Securities and Exchange Commission (SEC) in adopting Reg BI, which marked the first major change in brokerage industry sales practice rules in decades.

In an interview with Thomson Reuters Regulatory Intelligence (TRRI), Schroeder, who left FINRA in 2019, said that while Reg BI did not bring a dramatic change for brokers since it “borrowed pretty liberally from the FINRA suitability rule,” compliance professionals will likely face bigger challenges since the rule has “the potential for much more compliance liability.”

Schroeder also said she saw enforcement actions on the horizon that will require firms to show how they have mitigated conflicts of interest in areas such as volatility products, excessive trading, and even actions in which supervisory failures alone create violations — absent of other transgressions. The rule changes also raise the possibility that the SEC will take actions once handled largely by FINRA.

TRRI: Going forward, do you see compliance liability rising under Reg BI as judgment calls and interpretations are required? For example, the mitigation vs elimination of conflicts of interest? Is it all about documentation? Or is it a lot more than that?

Schroeder: Reg BI creates the potential for much more compliance liability because of the duty of compliance. Under Reg BI, it’s a violation to have faulty supervisory policies and procedures — even if there are no problematic customer trades or disclosures. If regulators look to hold individuals accountable (and they always do), the compliance professionals responsible for creating the firm’s supervisory structure could find themselves the subject of a lot of scrutiny.

Reg BI
Former FINRA enforcement chief Susan Schroeder

TRRI: The elimination of the control factor in determining excessive trading will make it easier to pursue actions. When you combine this with account- level surveillance and Consolidated Audit Trail (CAT) do you see this as a game changer?

Schroeder: Now that the SEC and FINRA no longer need to show that a broker “controlled” the customer’s account in order to prove that the broker excessively traded in that account, I think the door is wide open for data-driven approaches. The SEC experimented with that approach a few years ago in a case against two individual brokers in which the SEC alleged that the brokers controlled the accounts — but it also alleged that they recommended a quantitatively unsuitable strategy, and it relied on statistics in support of its claim. At the trial, the SEC did not even elicit testimony from all the victims. It relied on numbers, and it won.

TRRI: Do you see a Reg BI-type concern from the recent spate of volatility product actions? Have firms done enough to review products for Reg BI vulnerabilities?

Schroeder: Regulators are likely to use Reg BI as a powerful tool when investors are affected by performance issues in complex products. Brokers have to exercise due diligence to form a reasonable basis to believe that a security is suitable for at least some investors. Under Reg BI, regulators can use that due diligence obligation as the basis to charge firms with failures when they sell complex products that don’t perform.

Even if the features of a product are not unsuitable for a customer, the regulators can still take the position that the broker didn’t understand the product and therefore the firm violated Reg BI when it sold it. Firms selling complex products should document their initial due diligence process and make sure they refresh their diligence frequently.

TRRI: You’ve said previously that Reg BI in a sense is “not new” since it is built on the existing suitability standard. FINRA’s action to update regulations to conform with Reg BI amounted to tweaks. So, do you mean that its form or shape is the same even if there is a new standard of care with a fiduciary-style rule?

Schroeder: When the SEC adopted Reg BI, it borrowed pretty liberally from the FINRA suitability rule and acknowledged it was doing so. The three pillars of Reg BI’s “duty of care” correlate with the three types of suitability that FINRA identified in its rule. So, I think enforcement actions based on violations of the “duty of care” are likely to look an awful lot like FINRA suitability actions — except they’ll be brought by the SEC and FINRA.

TRRI: From a compliance point of view, how is Reg BI different from suitability?

Schroeder: Reg BI is more than just the duty of care, which echoes the suitability rule. There are aspects of Reg BI that are new for broker-dealers, such as the duty to identify and mitigate or eliminate conflicts of interest. And Reg BI is also one of a handful of SEC rules that imposes an affirmative obligation to establish, maintain, and enforce policies and procedures to achieve compliance with the regulations. That means that inadequate supervisory policies or procedures are enough for an enforcement action — no underlying suitability violation required.

TRRI: FINRA said that in the first six months of Reg BI exams, firms were largely compliant. Do you think they were just being nice? Or will Reg BI begin to have a larger impact going forward?

Schroeder: During the first six months after Reg BI’s implementation date, the SEC and FINRA were looking for “good faith efforts” to comply, and they generally found firms were, in fact, trying in good faith to comply. But the SEC has since made it clear that the “good faith” days are over.

I think we can expect significant Reg BI cases coming out of the SEC. We can expect “conflicts interest cases” similar to SEC cases we’ve seen against investment advisers in the past, and we can expect suitability cases where the SEC uses the legal frameworks FINRA has used in the past.

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