iSEC Commissioner Allison Herren Lee addressed questions on the scope and application of Regulation Best Interest, speaking to (i) what constitutes a “recommendation” under Reg BI, and (ii) firms’ conflicts of interest in light of developments in the securities markets.
In a speech at the 2021 ALI CLE Conference on Life Insurance Company Products, Ms. Lee emphasized the importance of a regulatory focus on retail investors due to the “substantial influx” of inexperienced investors and “an increasingly high tech brokerage community.” Ms. Lee stated that as Reg BI is “largely principles-based,” it is able to adapt to market developments and the evolving needs of investors. She added that both the concept of a “recommendation” under Reg BI and the circumstances in which broker-dealers must mitigate conflicts of interest are also subject to the evolution of the broker-dealer community as new technologies are introduced and markets face increasing modernization.
Recommendations
Ms. Lee noted that the determination of whether a recommendation exists acts as the trigger for Reg BI’s best interest standard. She emphasized that broker-dealers should examine “the extent to which nascent practices in the industry may in fact, constitute recommendations,” and highlighted new uses of technology as requiring special focus from the SEC. She said that algorithms and machine-learning are increasingly utilized for communications between broker-dealers and retail investors. Many of these communications, she said, can be characterized as “reasonably likely” to influence such investors’ trading behavior, even in subtle ways.
Furthermore, Ms. Lee said that the SEC and FINRA may take into account (i) the nature of a broker-dealer’s customer base, and (ii) whether a firm’s communications are more likely to influence a customer’s trading decisions when determining whether a recommendation has been made by a broker-dealer. She called on broker-dealers to “think broadly” about their communications with customers, and to reevaluate existing practices - including around opening customer accounts, default account options, and the presentation of selected investment options - in determining whether such practices constitute a recommendation under Reg BI.
Conflicts of Interest
Ms. Lee argued that continued emphasis should be placed on the importance of mitigating broker-dealers’ conflicts of interest both at the entity-level and for associated persons. She noted that Reg BI’s best interest obligation is “not satisfied through disclosure alone.” She went on to say that a broker-dealer’s failure to mitigate certain conflicts of interest, particularly in situations where mitigation is not strictly required, may raise the risk of a recommendation violating Reg BI’s best interest standard. Ms. Lee said that this is especially the case where, due to increasing use of technology for communications to retail investors, the recommendations are coming from broker-dealers themselves instead of just associated persons.
Commissioner Lee called on the SEC’s Division of Examinations to focus on firms’ conflict of interest mitigation efforts to ensure that such efforts are both “reasonably designed and effective” in achieving protection of retail investors. Ms. Lee suggested the Division staff make public its findings about conflict mitigation practices to help identify and distinguish effective mitigation practices.
Finally, noting differences between Reg BI and the National Association of Insurance Commissioners’ model regulation, Ms. Lee encouraged firms in both the securities and insurance industries to ensure that policies and procedures are in compliance with both standards.
"It would be prudent for firms to pay particular attention to Commissioner Lee’s remarks as they represent further evidence of the SEC’s growing emphasis on the investor protection implications of broker-dealers’ use of new technologies and digital engagement practices (“DEPs”). Commissioner Lee’s speech can be seen as building off of (i) the SEC’s August 2021 request for comment on the use of DEPs by broker-dealers and investment advisers, (ii) SEC Chair Gary Gensler’s September 2021 speech highlighting, in part, the SEC’s focus on DEPs as part of a “broader examination of predictive data analytics,” and (iii) SEC Investor Advocate Rick Fleming’s October 2021 speech on the broad implications of DEPs for Reg BI’s ability to effectively protect retail investors. Whereas such prior comments and actions appeared to be geared more towards inquiry and fact-finding, Commissioner Lee’s specific recommendations to market participants and the Division of Examinations—particularly in light of her highlighting the upcoming examination cycle—appear to indicate the importance and high priority of this issue for the SEC’s regulatory and enforcement agenda under Chair Gensler. Firms should broadly review their communications and account opening practices with respect to retail investors—particularly those practices involving the use of new technologies and DEPs (e.g., social networking tools and digital notification services; games with points, badges, or prizes; chatbots, etc.)—to ensure that such activities receive sufficient scrutiny for compliance with Reg BI as well as other applicable securities laws.
"As a policy matter, Commissioner Lee’s remarks serve to highlight continuing questions regarding how the SEC will strike the appropriate regulatory balance between facilitating retail investors’ access to the capital markets and ensuring effective investor protection. The increasing prevalence of “gamification” in securities trading—i.e., the use of game-like features such as contests, points, badges, prizes, and other technological design elements to engage with retail investors on digital trading platforms—as well as the reduction in broker-dealer commissions, has been credited with giving rise, in significant part, to a new generation of investors. However, as Commissioner Lee notes, the new wave of investors is, on balance, younger and less financially sophisticated, and has fewer assets. Because the concept of a “recommendation” is not static and depends on both (i) existing precedent and the historical practice of the SEC and FINRA, and (ii) the facts and circumstances of the particular situation in which a communication is made (including the nature of a broker-dealer’s customer base), how do such characteristics of the new investor generation alter the threshold for determining whether a recommendation has occurred? What effect, if any, do investor education efforts by the SEC, FINRA, and broker-dealers themselves have on whether a “recommendation” is determined to have been made with respect to such investors? What standards or factors will the SEC use to evaluate whether a DEP of a broker-dealer has influenced an investor to trade, such that a recommendation can be said to have occurred? What impact will Chair Gensler’s “technology neutral” regulatory approach have on the SEC’s regulation of DEPs? These are just some of the questions that should be addressed by the SEC as it continues to focus on the role played by new technologies and DEPs with respect to the broker-dealer business model and the capital markets overall," said Sebastian Souchet and Steven Lofchie.
