Written by: Arthur J. Flynn
Global regulations are converging at a greater degree than ever—but the manner in which these regulations are implemented varies greatly across international lines. The regulatory regime in the United Kingdom operates on a principles-basis, while the United States’ regime is rules-based. Many companies adhering to the rules in the U.S. believe that the British system is vague and doesn’t give a clear set of rules and standards. On the other side, many companies in the British regulatory landscape think the stringent regulations in the U.S. allow for loopholes, and encourage over-complex, over-engineered controls.
Wanting to stick to the status quo of rigid regulations, U.S. firms became concerned when the Securities and Exchange Commission (SEC) recently announced that Regulation Best Interest (Reg BI) would be governed on a principles-basis. The law took effect on June 30, 2020, and investment professionals in the U.S. are expected to give recommendations and advice that are in the ‘best interest’ of the customer. This means that U.S. firms must manage customer conflict holistically by implementing a compliance program and controls to promote fair customer outcomes.
Firms must now have the infrastructure, supervision, control structure, and sufficient documentation in place to evidence compliance with this important new rule. Concerns about what constitutes sufficient documentation persist (even though the rule is now in-force), and there’s a lack of clarity on what’s required in this principles-based environment.
Principles-Based vs. Rules-Based
Principles-based supervision and rules-based supervision aren’t polar opposites. They both employ guidance and supervisory techniques, but principles-based utilizes a broad set of principles of conduct that allow for more flexibility. In this system, regulated parties are able to decide how to best interpret and implement these guidelines in various situations. Rules-based supervision rarely allows for interpretation, and requires a regulator to assign a far more specific rule book.
The SEC’s principles-based guidance is reasonably prescriptive for companies, and appears aligned with the core obligations of Reg BI.
Regulation Best Interest Obligations
A firm must comply with the four component obligations discussed below. In the past, there were different iterations of a ‘prudent expert’ rule, where the financial professional was expected to act as a prudent expert on behalf of their client and in pursuit of an entirely suitable investment. When interacting with the investing public, these general expectations for behavior now fall under this obligation—where transparency and an effort to fully understand your client should be considered table stakes.
- Disclosure Obligation: Requires a firm to disclose all pertinent material facts about the relationship between the firm and the client, and all material conflicts of interest related to the recommendation.
Though these obligations are stated at a high level in the rule, disclosure pertains to advertisements, reports, SEC submissions, compliance manuals, and other policies and procedures. Anywhere there’s contact with the investing public or the existing client base, transparent disclosure of relevant information is required. Relevant information includes remuneration and reciprocal arrangements with other firms.
- Care Obligation: Requires a firm to exercise reasonable diligence, care, skill, and prudence, and to have a reasonable basis to believe that the recommendation or series of recommended transactions could be in the client’s best interest, even if viewed in isolation.
Evidence of adherence to the care obligation could include documentation of certification and licensing for the firm’s professionals, and will include retained records of training provided with appropriate content.
- Conflict of Interest Obligation: Requires a firm to establish, maintain, and enforce written policies and procedures designed to identify, disclose, mitigate, or eliminate material conflicts of interest.
At its core, the Regulation Best Interest rule is a means to control a central conflict of interest in the industry, so the conflict of interest obligation should receive the most attention. It may be necessary in some circumstances to change a product offering, realign compensation schemes, or even cease a business practice which can’t be fully supported by reasonable documentation. At a minimum, the policies and procedures should include requirements for identification and management of conflicts of interest. Firms operating under European accountability regimes have had an established requirement in this area for some time.
- Compliance Obligation: Requires firms to establish, maintain, and enforce policies and procedures reasonably designed to achieve compliance with Reg BI.
Early reports found that the examiners aren’t looking to indict firms for noncompliance if it’s clear that a good faith effort has been made. However, inattention to compliance issues and factors may lead to negative outcomes.
To prepare for the Reg BI implementation, many organizations conducted gap analyses to ensure adequate preparation. Even if gaps were identified but not fully remediated before an exam, having made the effort in good faith could positively impact the exam result. If your firm hasn’t been examined yet, but still has concerns around your Reg BI protocols, engaging a third party to conduct a gap analysis or a post-implementation assessment could be highly beneficial to ensure compliance.