Enforcement News: SEC Settles Charges Against Registered Broker-Dealer for Violating Reg BI

• Posted on: Feb 21 2024

By: Jeffrey M. Haber

It’s been some time since this Blog has written about Regulation Best Interest (“BI”).¹ See here.² As a general matter, Reg BI requires a broker, dealer, or associated person to act in the best interest of a retail customer when making a recommendation of a securities transaction (the “Best Interest Obligation”). 

Today, we examine an enforcement action and settlement of charges against TIAA-CREF Individual & Institutional Services LLC (“TC Services” or “Respondent”), a subsidiary of Teachers Insurance and Annuity Association of America (TIAA), for allegedly failing to comply with Reg BI in connection with recommendations to retail customers to open a TIAA Individual Retirement Account (“TIAA IRA”). As discussed below, TC Services agreed to pay more than $2.2 million to settle the charges.

A Primer on Reg BI

Reg BI established a standard of conduct for broker-dealers and associated persons who recommend securities transactions to retail customers. Reg BI is intended to enhance the broker-dealer standard of conduct beyond existing suitability obligations, by requiring broker-dealers to, among other things: act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker-dealer ahead of the interests of the retail customer; and address conflicts of interest by establishing, maintaining, and enforcing policies and procedures reasonably designed to identify and fully and fairly disclose material facts about conflicts of interest.

There are four components to Reg BI: (1) Disclosure Obligation, (2) Care Obligation, (3) Conflict of Interest Obligation, and (4) Compliance Obligation. All four components must be met in order to satisfy the regulation.

Under the Disclosure Obligation, before or at the time of the recommendation, a broker-dealer must disclose, in writing, all material facts about the scope and terms of its relationship with the customer. This includes a disclosure that the firm or representative is acting in a broker-dealer capacity; the material fees and costs the customer will incur; and the type and scope of the services to be provided, including any material limitations on the recommendations that could be made to the retail customer. Moreover, the broker-dealer must disclose all material facts relating to conflicts of interest associated with the recommendation that might incline a broker-dealer to make a recommendation that is not disinterested, including, for example, conflicts associated with proprietary products, payments from third parties, and compensation arrangements. 

The Care Obligation requires a broker, dealer, or associated person to exercise reasonable diligence, care, and skill to understand the potential risks, rewards, and costs associated with a recommendation of a securities transaction to a retail customer. According to the SEC, whether a broker, dealer, or associated person exercises reasonable diligence depends on, among other things, the complexity of, and risks associated with, the recommended security.

The Care Obligation also requires a broker, dealer, or associated person to have a reasonable basis to believe that the recommendation is in the best interest of the particular retail customer, based on that customer’s investment profile and the potential risks, rewards, and costs associated with the recommendation. Whether the recommendation is in the best interest of the customer depends on the facts and circumstances of the recommendation, including “matching” the recommended security to the retail customer’s investment profile. Where the “match” between the retail customer profile and the recommendation appears less reasonable, it is incumbent upon the broker to establish that it had a reasonable belief that the recommendation was in the best interest of the retail customer. In addition to “matching” the recommendation to the customer’s suitability profile, a registered representative should also exercise reasonable diligence, care, and skill to consider reasonably available alternatives.

Under the Conflict of Interest Obligation, a broker-dealer must establish, maintain, and enforce reasonably designed written policies and procedures addressing conflicts of interest associated with its recommendations to retail customers. These policies and procedures must be reasonably designed to identify all such conflicts and at a minimum disclose or eliminate them. Importantly, the policies and procedures must be reasonably designed to mitigate conflicts of interests that create an incentive for an associated person of the broker-dealer to place its interests or the interest of the firm ahead of the retail customer’s interest.

Moreover, when a broker-dealer places material limitations on recommendations that may be made to a retail customer (e.g., offering only proprietary or other limited range of products), the policies and procedures must be reasonably designed to disclose the limitations and associated conflicts and to prevent the limitations from causing the associated person or broker-dealer from placing the associated person’s or broker-dealer’s interests ahead of the customer’s interest. Finally, the policies and procedures must be reasonably designed to identify and eliminate sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sale of specific securities or specific types of securities within a limited period of time.

The Compliance Obligation requires a broker-dealer to establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Reg BI. According to the SEC, a broker “should consider the nature of that firm’s operations and how to design such policies and procedures to prevent violations from occurring, detect violations that have occurred, and to correct promptly any violations that have occurred.”

[Eds. Note: for the most part, the foregoing discussion was reprinted from our June 2022 article (here).]

Reg BI After the Compliance Date

On April 20, 2023, the SEC released a Staff Bulletin (“Bulletin”) on the care obligation for broker-dealers and investment advisors.³ As noted in the Bulletin, the Bulletin and other staff documents (including those cited therein) represent the views of the SEC staff. They do not carry the force of a rule, regulation, or statement of the Commission. In fact, the Commission neither approved nor disapproved of the content of the Bulletin. 

According to the Staff, the Bulletin was designed to assist firms and their financial professionals with meeting their care obligations under Reg BI. Some commentators have argued that the Staff’s views appear to go beyond the requirements of Reg BI (here). 

In addition to SEC enforcement of Reg BI, the Financial Industry Regulatory Authority (“FINRA”) has brought enforcement actions involving Reg BI. In October 2022, for example, FINRA charged a representative (here) with “recommending a series of transactions in the account of one retail customer that was excessive in light of the customer’s investment profile and therefore was not in that customer’s best interest.” FINRA noted that “[n]o single test defines when trading is excessive, but factors such as the turnover rate, the cost-to-equity ratio, and the use of in-and-out trading in a customer’s account are relevant to determining whether a member firm or associated person has excessively traded a customer’s account in violation of Reg BI.” To settle the charges, the respondent consented to the imposition of a six-month suspension from associating with any FINRA member in all capacities, and a $5,000 fine.

Customers are also bringing arbitrations that include claims that the representative violated Reg BI. In 2023, there were 408 cases on FINRA’s docket in which the claimant alleged a violation of Reg BI, up from 216 in 2022 (here). 

In the Matter of TIAA-CREF Individual & Institutional Services, LLC

On February 16, 2024, the SEC announced (here) that TC Services agreed to pay more than $2.2 million to settle charges that it failed to comply with Reg BI in connection with recommendations to retail customers to open a TIAA IRA.

The enforcement proceedings arose out of Respondent’s alleged failure to comply with Reg BI between June 30, 2020, the compliance date for Reg BI, and approximately November 1, 2021. 

During the Relevant Period, Respondent offered a variety of investment alternatives to retail brokerage customers, including the TIAA IRA, an investment strategy involving securities. The TIAA IRA enabled customers to invest in a pre-selected core menu of affiliated investments, including TIAA mutual funds, Nuveen mutual funds, and TIAA retirement annuities.⁴ In the core menu, customers could opt to receive certain benefits like third-party allocation advice on core menu investments and the ability to establish automatic contributions. Affiliated funds in the core menu typically had higher expenses than the lowest-cost share classes offered by those funds and required no minimum initial investment.

In addition to the core menu, the TIAA IRA also enabled customers to invest in a broader array of affiliated and non-affiliated investments through the TIAA IRA brokerage window. Specifically, through the TIAA IRA brokerage window, customers could invest in TIAA mutual funds and Nuveen mutual funds, as well as a variety of third-party mutual funds, ETFs, stocks, and bonds. The brokerage window included the lowest-cost share classes of core menu funds where available. These share classes were generally subject to investment minimums. 

The SEC’s order (here) found that Respondent violated Reg BI by, among other things, failing to disclose both that substantially equivalent, lower-cost share classes of affiliated funds were available in the brokerage window and the conflicts that it created.

In particular, according to the SEC, Respondent did not disclose to its retail customers prior to or at the time of the recommendation to open a TIAA IRA account that substantially equivalent, lower-cost share classes of select affiliated funds were available in the brokerage window. The SEC also said that Respondent did not disclose the conflicts associated therewith – that is, that Respondent allegedly earned higher fees when customers invested in more expensive share classes of core menu funds. 

The SEC further alleged that Respondent failed to comply with Reg BI’s Care Obligation because Respondent and its associated persons did not exercise reasonable diligence, care, and skill to understand the potential risks, rewards, and costs associated with its recommendations to open a TIAA IRA. In particular, alleged the SEC, the firm failed to understand the costs associated with their recommendations of that product.

Finally, the SEC alleged that Respondent failed to comply with the Compliance Obligation of Reg BI because it failed to establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Reg BI’s Care Obligation. According to the SEC, Respondent had no policies and procedures in place to detect investment minimum waivers. In addition, said the SEC, Respondent did not enforce its written policies and procedures because the third-party tool Respondent provided to associated persons to consider costs did not consider costs associated with other share classes of core menu funds available within the TIAA IRA brokerage window.

As a result of Respondent’s alleged violations of Reg BI, between June 30, 2020 and October 27, 2021, approximately 5,894 retail customer accounts allegedly purchased higher cost share classes of affiliated mutual funds without being informed by Respondent or its associated persons that substantially equivalent, lower cost offerings were also available within the TIAA IRA. In total, said the SEC, these customers paid about $936,714 more in expenses for substantially equivalent funds than they otherwise could have paid if these funds were purchased through the brokerage window.

Without admitting or denying the SEC’s findings, Respondent consented to the entry of an order that requires it to cease-and-desist from violating Reg BI, censures the firm, and orders it to pay disgorgement of $936,714, together with prejudgment interest of $103,424.91, as well as a civil monetary penalty of $1,250,000.

Footnotes

1. On June 5, 2019, the Securities and Exchange Commission (“SEC” or the “Commission”) adopted “Regulation Best Interest” or “Reg BI”. The SEC set June 30, 2020, as the compliance date in order to give broker-dealers sufficient time to comply with Reg BI. On and after the compliance date, broker-dealers that provide recommendations of securities transactions or investment strategies that register with the Commission were required to comply with Reg BI. In connection with adoption of the regulation, the SEC issued a 175-page release in which it offered guidance on how the Commission interprets Reg BI. See Regulation Best Interest: The Broker-Dealer Standard of Conduct, Exchange Act Release No. 34-86031, 84 Fed. Reg. 33318 (July 12, 2019) (here).
2. The case examined in the article remains ongoing. 
3. See SEC Staff Bulletin: Standards of Conduct for Broker-Dealers and Investment Advisers Care Obligations (Apr. 20, 2023) (here).
4. Nuveen, LLC is a wholly owned subsidiary of TIAA.