FINRA, SEC Detail Enforcement Priorities in Reg BI, BE Exams

Officials from the two regulatory groups outlined common missteps discovered while enforcing regulations covering conflicts of interest and trade execution.

At the Financial Industry Regulatory Authority’s annual conference, enforcement leaders from the Securities and Exchange Commission and FINRA elaborated on some of the common problems they encounter during exams on compliance with both Reg BI and Reg BE.

Reg BI

On Reg BI, Gurbir Grewal, the director of the SEC’s division of enforcement, noted an SEC complaint from June 2022 in which the SEC charged Western International Securities with marketing a high-risk and illiquid debt security to retail and retirement investors when the issuer recommended it be marketed to wealthier investors due to its riskier nature. Because there was no reasonable basis to market the security in this way, it violated the care obligation as required under Reg BI.

Nicole McCafferty, vice president of examinations for FINRA, elaborated on the same point later in the conference. She said advisers must consider a range of alternatives when giving advice to clients, but it is especially important when recommending securities that are relatively risky or complicated. James Wrona, vice president and associate general counsel for FINRA, added that assets in this category could include investments such as: investments traded on margin, cryptocurrency, penny stocks, private placements and asset-backed securities. Wrona said advisers should have specific training and procedures related to these assets.

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McCafferty said that merely having a client sign a statement acknowledging the risk involved with an investment, a practice McCafferty says she has noticed, is not adequate to meet the standard of Reg BI. The adviser must clearly explain the risks to the client and how those risks fit into their stated goals and existing portfolio. McCafferty said advisers should document such transactions to ensure an adviser can prove compliance with Reg BI, including when a client goes against an adviser’s advice and invests in something that the adviser believes is not in their best interest. The adviser could be asked to justify such an investment during a FINRA exam and having that documentation would be valuable.

She recommended that advisers begin with basic due diligence and knowledge of specific investments before even turning to the specific needs of a client. She finds advisers often know their customers well but are not as familiar with the products they are advising as they ought to be.

Another common refrain from SEC and FINRA officials during the conference was that merely disclosing conflicts of interest is not adequate; attempts to mitigate those conflicts must also be made. McCafferty said an advisory firm cannot disclose to clients that they hold regular sales contests and rely on that disclosure to satisfy their obligation under the regulation. A sales contest creates a conflict that must be eliminated because of the incentive structure it creates, putting the firms’ interests or its employees’ interests ahead of clients’ interests.

When FINRA conducts examinations, its officials also look for corrective action related to past failure notices, McCafferty explained. Such follow-up exams that look for changes are not limited to past FINRA exams. FINRA will also examine failures noted by the SEC and state-level authorities, and FINRA examiners expect to see corrective actions based on those observations.

Reg BE

On Reg BE, which addresses trade execution, Chris Kelly, senior vice president and acting head of enforcement at FINRA, noted two recent cases in which broker/dealers routed orders to affiliated trading systems without looking for better pricing in other trading systems. This behavior is a violation of Reg BE, because if an unaffiliated trading venue can offer a better price, the broker should execute the trade on that venue instead. Kelly explained that this is not a failure based on “technicality or nuance,” but instead is “a complete failure.”

Kelly warned of some of the risks associated with finance professionals who are registered simultaneously as both a financial adviser and as a broker/dealer. He highlighted a pattern of dual registrants moving securities back and forth between brokerage and advisory accounts to drive up fees. For example, Kelly said he has seen some dual registrants who charge clients to buy securities in their capacity as a broker, only to transfer those securities to an advisory account so they can also charge advisory fees on the same assets.

Tags: FINRA, Reg BE, Reg BI, SEC

With the X-date looming for when the U.S. government could default on its bonds and welch on paying other obligations due to the standoff over raising the federal debt ceiling, there is scant panic among pension plans.

While they have little to say publicly about the prospect of a default, one CIO said, “We have enough liquidity to get through this, and we think [the impasse in Washington] will be resolved quickly.”

Typically, plans exude an outward calm. A spokeswoman for the California Public Employees’ Retirement System said the CalPERS investment team is “closely monitoring and considering responses, but it is too soon to say what those responses might be.”

The worst-case scenario is that if the GOP-controlled House of Representatives and the Democrat-held White House cannot agree to a solution, then capital markets will crater, investments will plummet and a recession will erupt.

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But to Chris Ailman, CIO of the California State Teachers’ Retirement System, little cause for alarm exists. In a May 5 appearance before his plan’s investment committee, Ailman said a default “would not portend a huge crash.” He noted that the U.S. dollar remains the world’s reserve currency and is still strong: Over the past month, it has gained 0.13% against a basket of other denominations.

Certainly, Ailman cautioned, a default risks further deterioration of the U.S. credit rating. After the last battle over the debt limit in 2011, when the government came within hours of defaulting before an agreement was struck, Standard & Poor’s stripped the nation of its top rating. S&P was unsettled that Congress would come so close to defaulting.

In 2023, the two other major rating agencies could follow suit, even if another last-minute resolution appears. “This time there would be some serious downgrades,” said Ailman, who did not elaborate on what CalSTRS was doing to prepare for a default.

There is talk of allocators boosting their hedges against a cataclysmic outcome to this controversy. But no concern has appeared that pension programs would be unable to pay their retirees.

Celia Dallas, chief investment strategist at Cambridge Associates, which advises many plans, indicated plans are confident they “can meet their needs.” The plans, she said, “have adequate liquidity and not just cash.” U.S. pension programs have $2.8 trillion in Treasurys, according to the St. Louis Federal Reserve Bank. And right now, U.S. bonds have lost little in price, meaning investors are hardly dumping them in a panic.

Among public pension plans (assets: $5.6 trillion), equities are almost 43%, fixed income (the bulk of that in Treasury bonds) 21% and cash 2%. All of these asset classes are extremely liquid.

To Jay Love, U.S. chief investment strategist at Mercer Investments, the prospect of a default is “a low probability,” because such deadlocks “almost always get resolved.” If a default happens, it should be over in short order, “and things will drift back to normal.”

Meanwhile, he advises clients to increase their cash holdings to 4% or 5% to be ready for any future problems. Clients “have been resistant” in the past to his notion, he said, “but now we have better yields.”