LOUD AND CLEAR

Broker-Dealer Regulation in 2022: Bold New Action or Just Fine-Tuning?

Regulators are poised to take bold new actions impacting broker-dealers in 2022. Is this likely to bring just challenges or will there also be opportunities?

The heavily regulated broker-dealer industry often bears the brunt of political transitions, and the current situation in the US and UK is no exception.

The Biden Administration has pledged to overhaul US financial markets to enhance investor protections and promote his agenda. In the UK, numerous regulatory issues could confront the broker-dealer community this year, some merely “deregulatory” in nature but others increasing the regulatory burden on an already heavily regulated sector. Here, we highlight several regulatory changes that pose significant and perhaps the most immediate challenges for broker-dealers during 2022.

US Perspective

Digital Engagement Practices in the Crosshairs

The rise in retail stock trading on electronic platforms has triggered intense scrutiny of digital engagement practices (“DEPs”). Last summer, the US Securities and Exchange Commission (“SEC”) issued a 70+ page Request for Information and Comments concerning broker-dealers’ use of DEPs and other technology tools, such as artificial intelligence and machine-learning, to influence customer behaviour and provide investment advice.

As 2022 unfolds, watch for proposed rule-making, particularly around policies, procedures and controls, and vigorous debate concerning what, if anything, should be done to regulate DEPs.

To reinforce the issue, the SEC also issued a Risk Alert highlighting critical compliance failures among firms offering electronic investment platforms, including failures to act in clients’ best interests (see here for more detail). One SEC proposal reportedly being considered treats all DEPs as “recommendations” subject to Reg BI – an approach we believe would be unworkable and impose significant, unnecessary costs. As 2022 unfolds, watch for proposed rule-making, particularly around policies, procedures and controls, and vigorous debate concerning what, if anything, should be done to regulate DEPs.

FINRA’s Bad Broker Initiative Kicks Off

In 2021, the Financial Industry Regulatory Authority (“FINRA”) created new rules aimed at policing “high risk” brokers and the firms that hire them. Perhaps the most far-reaching is Rule 4111, effective January 1, 2022, outlining a process whereby a firm may be designated as “Restricted” and the penalties to be imposed as a result. Briefly, FINRA will calculate a “score” for each firm based on the number of risk-related disclosures relative to its peers. Firms with outlier scores – deemed “Restricted Firms” – must deposit a pre-determined amount in cash or qualified securities into a restricted account to cover arbitration awards. Firms may improve their scores by terminating bad brokers or challenging FINRA’s designation at a hearing. Although other regulators have “bad broker” rules, this initiative presents unique challenges. We foresee a host of employment, due process, and other challenges in the year ahead. For more detail, see our Client Alert.

We foresee a host of employment, due process, and other challenges in the year ahead.

AML: New Rules and Rigorous Enforcement

Regulators have sent strong signals that firms are not doing enough to comply with anti-money laundering (AML) requirements (see January 2021 and June 2021 Client Alerts). AML enforcement is a Biden Administration priority and new regulations addressing Financial Crimes Enforcement Network’s (“FinCEN”) AML “Priorities” are expected in early 2022. Firms were advised months ago to begin modifying their AML programs to address these Priorities. FINRA advised firms to focus on red flags and surveillance technology, routinely check news sources for signs of bad actors and listen carefully to internal fraud watchdogs. Of the highest risk: foreign customers and penny stock trading. FINRA also stressed that firms make technology changes to improve their ability to monitor and investigate suspicious activity.

UK Perspective

The real impact of Brexit on the UK financial services sector was unlikely to be felt for some time following the UK’s formal departure. This is the year in which we expect clarity. The EU has indicated it will seek supervisory convergence across EU member states over how UK regulated banking and broker-dealer firms continue to provide services within the EU and use EU-based establishments. It has expressed concern that too many UK firms continue to access the EU market without appropriate substance in the EU itself. The EU is likely to tighten restrictions on third country firms which may trigger a response from UK regulators, who want to ensure appropriate UK based supervision. The stage is set for this most recent instalment in the Brexit saga, with the costs and regulatory burden on broker-dealers only likely to increase as a result.

During the first quarter of 2022, UK broker-dealers will need to begin implementing in earnest the FCA’s new rules on operational resilience. The level of firm wide coordination and cost required to comply with these new requirements should not be underestimated.

The stage is set for this most recent installment in the Brexit saga, with the costs and regulatory burden on broker-dealers only likely to increase as a result.

Likewise the FCA’s proposed consumer duty will require broker-dealers to assess the way in which they provide services through a very different lens to that which they have been accustomed. While this proposed duty should most affect brokers that deal directly with retail customers, those operating in wholesale markets will also be required to consider the downstream impact of their products and services on end retail customers.

It’s not all bad news. Using its new found post-Brexit legislative freedom, the UK Treasury, through the Wholesale Markets Review, is likely to roll back many of the MiFID II requirements that were seen as pointless, unworkable or otherwise undermined the proper functioning of markets – particularly in the non-equities space. The precise nature and scope of this will become clearer this spring. We strongly recommend that the broker-dealer community actively engage with law makers and regulators to help shape the UK specific regime.

CONCLUSION

Overall, the message is loud and clear: new regulations are coming and there will be little tolerance for transgressions. In the US, expect rigorous enforcement and high fines to follow. The landscape for broker-dealers in the UK poses both opportunities and challenges. The UK’s freedom from EU rules means that it can take a more deregulatory path with respect to certain areas of regulation. It is also clear, however, that UK regulators are prepared to implement their own bespoke measures to protect UK markets and consumers. Where this balance ultimately ends up remains to be seen.

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MEET THE AUTHORS

LORI VAN AUKEN

Partner, New York

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DAN CSEFALVAY

Partner, London

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This document provides a general summary and is for information/educational purposes only. It is not intended to be comprehensive, nor does it constitute legal advice. Specific legal advice should always be sought before taking or refraining from taking any action.

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