Insights into the States' 2021 BD Examination, Enforcement Priorities
Putting Teeth on Reg BI (to take a bite out of complex products sales), Protecting Seniors (from romance scams, affinity frauds, and rogue POAs), Scrutinizing Bank-Based Reps, DBAs, and Remote Supervision, and the beginning of the end of COVID-Regulatory Relief
The implementation date for Regulation Best Interest (“BI”) has come and gone, and as the leaders of the U.S. Securities and Exchange Commission (“SEC”) have been installed by the new Biden administration, the new SEC's priorities have emerged: ESG, SPACs and crypto, plus trading and market integrity (speedier settlement, more transparency in swaps and short selling, parsing where free speech ends and manipulation begins in an AI- and social-media driven world, etc.).
Meanwhile, the seasoned staffs of the state securities departments around the country – many continuing long tenures in their roles – remain steadfastly focused on their evergreen priority: protecting the “mom and pop” and the “tik tock” retail investors.1 For many, their tools for examinations and enforcement have been sharpened, their methods honed and increasingly automated and coordinated, but their mandate remains the same as it's always been.
The goal of this alert is to provide information and areas of consideration for compliance and legal personnel (generally referred to herein as “practitioners”) who are tasked with ensuring that a broker-dealer (“BD”) and its registered representatives (“RRs”) comply with the laws, rules and regulations in each state where they do business,2 in light of emerging regulatory interpretations by those states.3
The offer and sale of securities by BDs and RRs are regulated by, among others, the SEC, the Financial Industry Regulatory Authority (“FINRA”), and state securities administrators (and their staffs) in each of the 50 U.S. states, the District of Columbia, Puerto Rico and the Virgin Islands (collectively referred to herein as the “States”). Among these three, only the States are singularly focused upon sales practices impacting Main Street retail investors.
BDs (of all shapes and sizes) ignore the States' regulatory priorities at their peril. Over the years, individual states, and States acting in concert with each other, have brought significant enforcement actions, levied large fines, imposed costly remediations, and regularly make enforcement referrals or queue up enforcement actions to FINRA, the SEC, and private litigants.
The North American Securities Administrators Association (“NASAA”) enables the States (a.k.a. its members) to coordinate on investor protection initiatives by: promulgating model rules, lobbying Congress and federal administrative agencies (e.g., the SEC and Department of Labor), offering investor and industry education, and by detecting, deterring, and punishing fraud and abuse.
While NASAA does not have any legal authority – each member jurisdiction must take action consistent with that state's laws and regulations – NASAA has proven a powerful and useful mechanism for aggregating and leveraging the limited resources available within any single jurisdiction. These efforts are effected through NASAA standing sections, project groups, and task forces.4
This alert describes certain current (2021) areas of focus for the States based upon various publications (as referenced in the endnotes) and conversations with the States, including members of the NASAA BD Section and the NASAA Regulation Best Interest Implementation Committee (hereafter, the “Committee”). Nothing herein is intended to suggest that the States are monolithic; references to the States collectively (including positions or opinions attributed to “the States”) are made in that manner for editorial and reader ease. The priorities and programs in any state almost certainly vary from those of another state. Notwithstanding, the issues outlined below are known priorities in a number of states with active, engaged securities regulatory regimes. These are recurring, common themes that we believe warrant serious consideration by practitioners, some with 2021 twists.
A. Putting Teeth on Reg BI and Taking a Bite out of Complex Products Sales
In the Reg BI rulemaking process, NASAA advocated for the application of a new BD standard of conduct akin to a fiduciary duty.5 The final rule, as well as Form CRS, lacked many of the elements NASAA recommended in its comment letters. While SEC Chairman Gensler has directed SEC staff to seek comment and provide guidance as to Reg BI's application to bespoke issues (such as trading apps),6 there is no indication that a broad overhaul of Reg BI will be undertaken. Accordingly, the States have been left to do what some discussed in September 2019 at the NASAA Annual Conference: build an examination and enforcement regime around Reg BI that is intended to ensure the most stringent interpretation of its requirements. Early indications suggest that the States' expectations for BDs are higher than the SEC's expectations (as articulated in Reg BI's adopting release, subsequent FAQs, and alerts and priorities published by the Division of Examinations).7
1. Reg BI Survey, Phase One, 2020
In Q1 2020, the Committee conducted Phase One of its Reg BI national examination initiative (the “Reg BI Survey”). To identify a baseline of pre-Reg BI policies, procedures and sales practices, Phase One surveyed8 516 BDs (15 percent of FINRA member firms)9 in 34 States.10 Phase One also surveyed 1,522, mostly state-registered, investment advisers (“IAs”), to identify practical differences between those subject to a fiduciary duty (the IAs) versus those subject to a suitability standard (the BDs pre-Reg BI). Among other things, we expect that when the States conduct Phase Two of the survey this summer, they will look to see whether the BDs have moved closer to where IAs were in the Phase One survey results. (IAs will not be included in Phase Two.)
In September 2020, the Committee released a report of its Phase One findings11 and described or alluded to other ways that BD practices will (per the Committee) likely need to change to comply with Reg BI, including:
2. Reg BI Survey, Phase Two & Examinations, 2021
The Committee plans to conduct Phase Two of the Reg BI Survey this summer, and also expects that the States will begin to conduct Reg BI examinations (both remotely, and onsite); those exams may include the Reg BI Survey or occur independent of the Reg BI Survey. It appears that originally, the Committee planned to gather the Phase Two survey results and then roll-out the Reg BI examination modules to the States – more on modules below – but as we all know by now, the pandemic often wreaks havoc on the best-laid plans.
Phase Two will largely seek to identify what changes, if any, BDs have made in their sales practices, especially with respect to four product types: (1) private placements, (2) variable annuities (“VAs”), (3) non-traded REITs and other direct participation programs (“DPPs”) and (4) leveraged- or inverse exchange traded funds (“ETFs”) (collectively, “Complex Products”). Notably, 64 percent of firms surveyed (both BDs and IAs) did not make any of these products available to their customers.17 The Committee found that in 2020, 26 percent of BDs surveyed offered private placements, 49 percent offered VAs, 27 percent offered non-traded DPPs, and 25 percent offered leveraged- or inverse-ETFs.18
a. Modules Designed to Provide for Consistent, Uniform, Scalable Reg BI Examinations
In November 2019, NASAA launched its significantly enhanced electronic examinations module interface (“NEMO”), which is a web-based software application designed to assist the States in conducting examinations of BDs (and state-registered IAs) in a secure, digital environment.19 NEMO allows NASAA to more quickly identify trends and plan policy initiatives, or enforcement task forces based upon statistical reporting of data aggregated across all participating jurisdictions.20
It is our understanding that: The Committee and NASAA have designed four NEMO modules, one specific to each of the Complex Products.21 In crafting these modules, NASAA sought to design thorough, detailed exam materials that can be scaled (i.e., downsized or right-sized) by a state, so that one or more Complex Products' exam(s) can be integrated into a broader exam or stand alone. This approach will hopefully ease the burden on BDs operating in numerous jurisdictions by ensuring consistency and uniformity in questions and setting clear expectations. We understand that NASAA will also make available to its members additional Regulation BI examination materials (beyond the Complex Product-specific modules). While these materials may be updated from time to time, the expectation is that these will generally form the basis for the States' Reg BI examinations going forward.22
b. The States' Perspective on Reg BI Compliance in the Sale of Complex Products
When the States describe what compliance with Reg BI should look like, in the context of BDs/RRs offering and selling Complex Products, it is often presented from the perspective of a hypothetical, unsophisticated (perhaps: busy, distracted, or overly trusting) retail investor. (i.e., what might he or she focus on, expect, understand, or presume in a conversation with the RR assigned to handle his or her brokerage account?). In contrast, when practitioners set out to design a supervisory system to ensure compliance with a rule (like Reg BI) they tend to consider whether compliance measures are operationally-feasible (i.e., can the measure be standardized, and is it scalable and surveillable by an automated system?).
Given their respective experiences, roles, responsibilities, and vantage points, each approach is reasonable but sometimes difficult to reconcile. This difficulty is perhaps most stark when it comes to the Complex Products; it is fair to say that many regulators, including many in the States, tend to be dubious that a solicited brokerage sale of a Complex Product to a retail investor is ever in that customer's best interest. Obviously, many industry participants would strongly disagree.
The following describes our understanding of some of the States' expectations and concerns, as well as some worthwhile considerations for practitioners relative to the offer and sale of Complex Products by BDs to retail investors under the best interest standard:
1) Private Placements
2) Variable Annuities
3) Non-Traded REITs (and other DPPs)
Given the steps involved in ensuring adherence to state-specific heightened suitability standards included in the prospectus as offering restrictions, some RRs may be surprised (or frustrated) to learn that Reg BI requires additional diligence and analysis relative to the product's cost and alternatives.
Fulsome consideration of alternatives likely includes considering other types of the same product (i.e., non-traded REITs offered by a range of sponsors), and other products that might offer the same type of industry exposure without the costs, valuation challenges, or illiquidity of a non-traded REIT (e.g., a publically-traded REIT or an ETF with exposure to a certain real estate segment).
4) Leveraged, Inverse ETFs
As a risk mitigation measure, practitioners may consider whether it would be helpful to provide conspicuous, point of sale disclosure relative to unsolicited trades placed by BD customers for their own account in leveraged or inverse ETFs, or whether it may be prudent to remove leveraged or inverse ETFs entirely from the available products on their platforms.
B. Protecting Seniors and other Vulnerable Adults
In 2014, NASAA formed a Board-level committee and launched a website (serveourseniors.org) dedicated to senior issues. It also reported in that year that at least one-third of the States' enforcement actions involved senior investors. In February 2016, NASAA distributed to its members a model act entitled, “An Act to Protect Vulnerable Adults from Financial Exploitation” (the “Model Act”). In September 2016, the BD Section released a report describing coordinated examination findings on issues related to seniors.31 Senior investor protection has remained a top priority for the States ever since.
The Model Act sought to coordinate efforts by securities regulators, investment advisers, BDs and state adult protective services (“APS”) agencies to detect and prevent financial exploitation of vulnerable adults.
The Model Act generally has the following provisions:
Model Act States. According to the NASAA website, as of 2021, the following jurisdictions have enacted legislation or regulations based upon the Model Act: Alabama, Alaska, Arizona, Arkansas, California, Colorado, Delaware, Florida, Indiana, Kentucky, Louisiana, Maine, Maryland, Minnesota, Mississippi, Montana, New Hampshire, New Jersey, New Mexico, North Dakota, Oregon, Rhode Island, Tennessee, Texas, Utah, Vermont, Virginia, and West Virginia. Notably, while these states' legislation and regulations are based on the Model Act, they do not all perfectly mirror the Model Act.
Non-Model Act States. According to the NASAA website, as of 2021, the following jurisdictions have enacted legislation or regulation relating to senior financial exploitation that is not based upon the Model Act (often because these states' laws preceded the Model Act): Connecticut, DC, Georgia, Hawaii, Idaho, Illinois, Iowa, Kansas, Massachusetts, Michigan, Missouri, Nebraska, Nevada, Nebraska, Nevada, New York, North Carolina, Ohio, Oklahoma, Pennsylvania, Puerto Rico, South Carolina, South Dakota, Washington, Wisconsin, and Wyoming.
Generally speaking, the non-Model Act states tend to address only reporting to APS and sometimes training requirements, whereas the Model Act states typically also include asset hold safe harbors and requirements to report asset holds to state securities regulators. Importantly, each jurisdiction's requirements vary. For example, Washington is a non-Model Act state that nonetheless has an asset hold provision In addition, the definitions that define the scope of each state's act, such as who is a vulnerable adult or whether a hold can be placed on a securities transaction (versus a disbursement), often differ from one state to another, regardless of whether the state is a Model Act state or a non-Model Act state.
1. What's New in Senior Investor Protection?
In 2019 (the last year for which summary data is available), the States fielded 709 reports, opened 233 investigations and brought 15 enforcement actions relating to reports made under the Model Act.32 More broadly, the States conducted 486 investigations, and brought 208 enforcement actions, relative to 857 senior investor victims.33 Of those, 22 of the investigations related to variable annuities, 160 related to traditional securities, and 51 involved “affinity fraud.” Affinity frauds target particular communities or groups, often a religious or ethnic group of which the fraudster is also a member, and operate by exploiting a sense of communal trust.
Anecdotally, in 2021, as society begins to emerge from the pandemic, several States have described a noticeable, and somewhat unexpected uptick in complaints (as compared to 2020). This is unusual insofar as an increase in customer complaints is rarely seen when the stock market is performing well. It may be that the isolation so many people have endured over the last year during the pandemic – especially seniors – has left them particularly vulnerable to various scams and frauds (including romance and precious metals scams) and now that families are getting back together, exploitation that took root during the pandemic is coming to light.
Practitioners should consider whether any of the following would enhance their firm's senior investor protection regime:
C. Bank-Based RRs and RRs Doing Business Under a Name Different than their BD
1. Doing Business As (“DBAs”)
Many RRs conduct their securities business using a name that is different than the name of the BD that holds their securities licenses and is responsible for their supervision. The States and practitioners often use the short-hand of “DBAs” to discuss these arrangements. DBAs are an area of concern for regulators because they can create supervisory challenges for BDs and confusion for customers.
Shakespeare's Juliet famously wondered “What is in a name? A rose by any other name would smell as sweet.” The sentiment holds true here insofar as what a person (or business) is called does not alter its fundamental, intrinsic characteristics for better or worse. But, just as Romeo's sur name was a label that distinguished his family from their rivals and conjured innumerable presumptions and expectations among the people of Verona, the name under which a business operates can have real implications for its customers. Switching metaphors: A wolf in sheep's clothing, is indeed still a wolf, but its clothing can cause tremendous confusion and may be a predicate to great harm for any bamboozled sheep.
To be clear, most DBAs are not wolves (nor sheep). Many RRs are actively involved in their communities, and operate dynamic small businesses that offer a range of important services aimed at ensuring the financial well-being of their clients and fellow community members. These small businesses often have names that are meaningful to the business owner and to the community it serves. The good will inherent in that business's name was earned and is a valuable asset.
As is true in so many things, the answer to reconciling business interests and regulatory concerns about investor confusion likely lies in clear communication (i.e., disclosure) that respects an RR's interest in leveraging their business's name and sustaining their client relationships, without concealing, disguising (e.g., in very small print on the bottom of a business card or webpage) or diminishing the identity and critical role of the registered BD that carries the RR's license and the customer's accounts.
The States bottom-line appears to be this: BD customers need to know the name of their BD, and understand the role the BD plays in executing their securities transactions, valuing and custodying their assets, supervising the conduct of their RR, and handling their concerns and complaints, should any arise. States describe it as a red flag when a customer has never heard of and cannot identify the name of the BD that holds their RR's brokerage license.
FINRA and the States have long scrutinized and expressed concerns about customer confusion that can result from DBAs.35 There seems to be some discussion of whether a model rule, or at least specific guidance from NASAA or the BD Section aimed at defining disclosure requirements or best practices for DBAs, might prove useful.
2. Bank-Based RRs
DBA concerns are closely linked to another persistent regulatory concern: the sales practices of RRs that are (or soon will be, when everyone goes back into “the office”) physically located within bank and credit union branches (“bank-based RRs”). The concerns are two-fold: (1) that a customer may transfer their feelings of good will and trust for their bank or credit union (where they may have been a customer for decades) to an RR who is not employed by the bank, and is trying to sell securities in the hope of earning a selling commission;36 and (2) given the now-prolonged low interest rates offered on savings accounts, customers are increasingly likely to use funds derived from a maturing FDIC-insured product or an FDIC-insured bank account to purchase securities.37
In the bank-based context, certain States have specific rules relating to bank-based RRs, including the degree of disclosure required.38 FINRA's more generalized guidance on communications with the public, and Reg BI's requirements relative to conflicts and disclosure, are also instructive in this space.
3. Bank-Based and DBA-related Considerations
Practitioners may find it helpful to offer (or require) training for RRs that are operating in an environment that may create confusion for customers about the responsibilities and/or affiliation of their RR and the BD that carries their RR's license/holds their accounts. Practitioners may be able to help RRs understand the importance of clear communications – whether verbal or non-verbal (e.g., wearing a polo shirt embroidered with the bank's logo or placing SIPC signage next to FDIC signage) – and the relative ease of having plain English conversations with their customers about the BD's role. These conversations need not be overly technical or in any way diminish the strength of the relationship and role of the RR in the provision of financial services to the customer.
D. Remote Supervision
BDs have extraordinary responsibility for supervising the conduct of their RRs. These obligations are set out in FINRA Rule 3110 and also in the States' laws, rules, and regulations.
Even before the pandemic, many RRs were supervised by a person that was not physically located in the same location as the RR. Then, as a result of the pandemic, many (perhaps most) RRs began to work from home. Throughout the pandemic, FINRA and other regulators offered guidance and directives regarding remote supervision.39 It now appears that the pandemic may have permanently altered many RRs' working arrangements such that, going forward, a large segment of RRs may primarily work from home, physically removed from their supervisor(s).
We expect that States may conduct examinations regarding remote supervision, either as a part of a firm's permanent business model or during the pandemic, and may focus on:
A similar review could be conducted on customer complaints.40
E. Repealing COVID-Related Regulatory Accommodations
A number of States provided BDs with temporary regulatory relief from examination and fingerprinting requirements; mandatory, on-site branch office inspections; and flexibility in the timeline for compliance with, and/or outright relief from, RR registration requirements for RRs working remotely. The States have begun to repeal, allow to expire, or issue superseding versions of those prior orders. NASAA has endeavored to track the States COVID-related orders on its website at: https://www.nasaa.org/industry-resources/covid-19-updates/.
F. Miscellaneous Observations
1) RRs must (a) have a general understanding of the full range of securities products that are available in the market, (b) a specific understanding of the mechanics and details of any product the RR is selling, (c) know the customer41 to whom the RR is selling, and (d) take reasonable steps to ensure the customer understands that the RR is trying to sell them something (and if they buy it, the RR will make money).
2) If the RR is concerned that if the client knows X, then the client will not buy the product, that probably means that X is material information that should be fully and conspicuously disclosed to the customer at point of sale.
If you have any questions about States' examinations and enforcement priorities for BDs, or about the regulation of the investment management and broker-dealer industries generally, please feel free to contact us.
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Alexandra M. Fenno
Jeffrey T. Skinner
Regan K. Adamson
F. Daniel Bell, III
Thomas W. Steed, III
Katherine A. McCurry
Thomas B. Cain
Lauren B. Henderson