[CS&M Draft—01/28/2020]

SIFMA Compliance & Legal 2020 Annual Seminar March 16, 2020

Compliance Issues in Investment Banking

Gary Distell Guggenheim Securities, LLC Darian Futrell Goldman Sachs & Co. LLC Jodi Huckabee Barclays Capital Inc. Andrew Pitts Cravath, Swaine & Moore LLP C.B. Richardson Citigroup Global Markets Inc.

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Direct Listings

I. What Is a Direct Listing?

A. A direct listing is a type of SEC-registered offering completed under the Securities Act of 1933 (the “Securities Act”). While there are many similarities between a traditional underwritten initial public offering (“IPO”) and a direct listing, there are also significant differences in the key processes, structure and registration statement disclosure of the two types of offerings.

B. A direct listing takes place when a company’s outstanding stock is listed on a stock exchange without the occurrence of an underwritten offering. A notable difference between a traditional IPO and a direct listing is that in the former, a company issues new shares for sale to the public, whereas direct listings are structured as the resale of securities held by existing shareholders rather than as primary offerings.

1. As the securities are not being underwritten, the involvement of underwriters (and by extension, features intended to stabilize stock price such as overallotment options and syndicate short positions) is eliminated; instead, investment banks are included as financial advisors in the offering process.

2. Lock-up agreements are also excluded from direct listings; all shareholders are eligible to sell their shares on the first day of trading.

C. In a direct listing, a company’s existing shareholders are able to sell their shares immediately after listing through the normal auction mechanisms of the stock exchanges, and prospective purchasers are able to purchase shares from any willing seller. Unlike with a traditional IPO, in a direct listing there is no fixed, pre-determined number of shares available for sale and there is no IPO price. The placing of orders through broker- dealers drives share demand and price-setting.

II. Why Go Public at All?

A. A private company may decide to “go public” for several reasons. Chief among them are to:

1. generate equity capital through the sale of stock to the public. To achieve this goal, a company must engage in a traditional IPO. Currently, direct listings do not result in influxes of cash for the

[[DMS:5276894v2:1/28/2020 1:34:58 PM company, as the U.S. Securities and Exchange Commission (the “SEC”) disallows the generation of new capital via direct listings;1

2. respond to liquidity demands of existing investors. Going public allows shareholders (such as early investors and employees) to “cash out” by selling shares into a liquid market with certainty around pricing and quick execution of trades;

3. gain the ability to use publicly traded stock as currency for acquisitions and for employee compensation; and

4. increase public awareness about the company. Market exposure, branding and credibility afforded to companies listed on a stock exchange can provide a form of advertising, attract institutional investors and funds and aid in raising debt financing, and in fulfilling other business objectives.

1 A December 2019 New York Stock Exchange proposal (amended after the rejection of a similar proposal) to allow companies to sell shares, and thereby raise capital, in the opening auction on the first day of trading on the Exchange is currently under review by the SEC. The proposal is discussed in further detail below.

2

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Key Considerations When Choosing a Direct Listing

Why pursue a traditional IPO? Why pursue a direct listing?

Capital . Company needs to raise money . Company has no need to raise money, but wants Requirements to provide liquidity to existing shareholders and employees

Control Over . Opportunity for Company and underwriters to . Comfortable with buyers/sellers setting valuation Process drive the valuation/pricing dynamic and more without a traditional roadshow and limited ability tightly control messaging to investors and who is of investment banks to help market allocated stock (i.e., pension funds, hedge funds, retail, etc.)

Marketing . Potential to benefit from actively marketing the . Company has a highly visible, well known and Company’s story to top investors in a highly easily understood business model that requires coordinated and directed manner less investor/equity research analyst education

Size of Company . Company is not large enough to attract sufficient . Company has a meaningful equity value, has seen investor attention several rounds of financing and is big enough to attract investor attention without targeted and lengthy marketing efforts

Shareholder . Opportunity to transition concentrated private . Company has well-diversified private shareholder Considerations ownership structure to broadly dispersed public base and history of multiple financing rounds shareholder base . Company expects existing shareholders will be willing to sell enough shares to create a liquid trading market

Research . Ability for company to actively drive the equity . Company has high profile that will naturally research analyst selection and education process attract broad equity research coverage without extensive analyst education process

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Pros and Cons of a Direct Listing

Pros Cons

. Provides for immediate shareholder liquidity . Company cannot raise money • No lock-ups for significant shareholders, which would . May be subject to a more unpredictable market open be required in traditional IPO • No offering by which stabilization can take place (e.g., no • Lock-up period for a traditional IPO is typically overallotment mechanism) 180 days for directors, officers and shareholders • Dependent on existing shareholders to provide liquidity that hold a meaningful amount of stock • May not attract traditional IPO investors, who are often • All existing shareholders can sell without any legal institutional investors who buy large initial blocks restrictions on first day of trading • Requires willing buyers and sellers to create an orderly . Gives shareholders and potential buyers equal access and liquid trading market to the market • Can’t terminate the IPO/listing if Company and . Market-driven price discovery process shareholders don’t like opening price • Rather than rely on investment bank’s pricing • No ability to direct shares to friendly holders recommendation, initial trading price is entirely . dependent upon market forces Non-traditional marketing • • Because selling shareholders sell directly into the Substantial limitations on role of investment bank market, in theory no risk of losing out on potential advisors to assist with marketing process and price “pop” from an “underpriced” IPO discovery • . May result in lower transaction fees than a traditional The Company has less time with potential significant IPO investors than in a traditional roadshow process • Target buyers may be less sophisticated and not well- versed in Company . Less engagement with equity research analysts as compared to traditional IPO

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III. Practical Considerations of SEC Filings

A. Prior to Spotify and Slack, generally, a company engaging in a direct listing filed a registration statement on Form 10 to become a reporting company under the Securities Exchange Act of 1934 (the “Exchange Act”) and simultaneously listed its shares on a stock exchange.

1. Form 10 does not carry Securities Act liability and there are no “gun-jumping” issues, but there is still liability for material misstatements or omissions.

B. Why use the Securities Act Form S-1?

1. As with the traditional IPO, the SEC requires Form S-1 or, in cases of foreign issuers, Form F-1, for use of the new NYSE direct listings rule used by Spotify and Slack. A direct listing’s Form S-1 receives the same SEC staff review as that of a traditional IPO. Form S-1 was required in connection with Watford Holdings’ March 2019 direct listing on NASDAQ.

2. Because the issuer is participating in the facilitation and development of a trading market, even though issuer itself is not offering shares for sale, the SEC requires a Securities Act registration statement because the SEC considers these activities as a “distribution”.

3. In addition, an active registration statement ensures that all shareholders are able to sell shares on the first day of trading.

a) Form S-1/Form F-1 registers the resale of all shares that are not otherwise already freely tradeable under Rule 144.

o Without Form S-1/Form F-1 registration, under Rule 144, affiliates and other holders of restricted stock could be subject to delay before they may sell.

o A Form S-1/Form F-1 is deregistered after 90 days (the relevant length of time for a company to be deemed a reporting company under Rule 144).

5 [[DMS:5276894v2:1/28/2020 1:34:58 PM IV. Disclosure Specific to a Direct Listing

Direct listing resale registration statement is substantially similar to that of an underwritten IPO, with a few key differences. They are as follows:

A. Shares registered

1. In a direct listing, there is no pre-determined committed number of shares to be sold and specified to be registered.

2. Generally, a direct listing registers existing shares that are not otherwise already freely tradeable under Rule 144, whereas in an IPO, an issuer creates new shares for sale to the public.

B. Pricing

1. In a direct listing, pricing is not pre-determined and there is no price range on the cover of the “red herring” preliminary prospectus. The cover page of the preliminary prospectus instead outlines how the opening public price will be determined. The cover page pricing explanations include:

a) disclosure that the opening price will be determined by buy-and-sell orders collected by the stock exchange from broker-dealers;

b) how the market for the sales will open;

c) recent high and low private transaction sales prices of individual stock units; and

d) risk factor disclosure stating that the opening price may have little correlation to the historical sales prices.

2. The stock exchange reference price and opening price are not determined until after the S-1/F-1 is declared effective.

a) NYSE declared a reference price for each of Spotify and Slack the day before trading; the reference prices were not presented in the registration statement. The reference prices were tied to recent private secondary trades and served only as a guidepost to the public.

6 [[DMS:5276894v2:1/28/2020 1:34:58 PM C. Plan of distribution

1. The registration for a traditional IPO includes an underwriting section. Because a direct offering is not underwritten, the underwriting section is generally replaced with a plan of distribution, as characteristically seen in resale registration statements.

2. The plan of distribution states that shareholders may sell their shares, rather than listing bank syndicates and the number of shares to be sold.

3. The SEC has commented that the procedures that apply to determining the opening trading price on the stock exchange and how buy-and-sell orders are assessed without a traditional pricing range should be detailed in the plan of distribution section.

D. Registered holders

1. A section of the prospectus must list either the registered holders or categories of registered holders of existing stock.

E. Financial advisors

1. Financial advisor names, arrangements with the company and compensation are generally required to be disclosed in the prospectus.

2. In the event that financial advisors are involved in advising existing shareholders, such relationships must be disclosed.

F. Fee for financial advisors

1. In a traditional IPO, underwriting compensation must be disclosed. Underwriting discounts and commissions are listed on the cover of the prospectus, and additional underwriting compensation is listed in the “Underwriting” section.

2. In a direct listing, a financial advisory fee may be listed in a separate section covering other expenses of the listing. For example, the Spotify F-1 included an “Expenses of the Registration” section that, aside from various administrative fees, listed legal, auditors, transfer agent, registrar and “other advisers” fees. It did not specify the exact financial advisory fees.

7 [[DMS:5276894v2:1/28/2020 1:34:58 PM G. Risk factors

1. Risk factors cover the various unique features of a direct listing. For example, in a January 17, 2018 comment letter to Spotify, the SEC required that Spotify highlight, among other things, the differences between a traditional IPO and a direct listing, as well adequately discuss topics such as the potential impact of the absence of safeguards, such as book-building and lock-up agreements, on trade price and volume, risk of fluctuations in trading prices following initial listing and uncertainties with the listing process.

V. Gone Are the Gatekeepers?

A. In addition to providing important services such as marketing, book- building and market stabilization activities, underwriters have also traditionally been viewed as “gatekeepers” of companies seeking to go public.

1. Sections 11 and 12(a)(2) of the Securities Act subject underwriters to liability for material misstatements or omissions contained in a registration statement or prospectus.

2. In addition to legal liability under the U.S. securities laws, underwriters take on reputational risk when selling IPO shares to clients and the market as a whole.

B. Banks serve as financial advisors in a direct listing, since there is no underwritten offering.

1. It remains to be seen whether the lack of underwriters will limit the universe of companies pursuing direct listings. Analysis on the outcome is split—while some industry players believe that direct listings may weaken investor protections, thereby eventually resulting in adverse effects on the overall market, according to Reuters, on January 14, 2020, SEC Commissioner Rob Jackson backed direct listing, stating that underwriting fees act as an impediment to listing for middle-market companies.

2. Because financial advisors are not selling shares into the market, the reputational risk associated with a direct listing may be less than in a traditional IPO.

a) However, the market may associate financial advisors, especially the lead financial advisors, with a particular

8 [[DMS:5276894v2:1/28/2020 1:34:58 PM direct listing and as a result there may be meaningful reputational risk by association.

b) As there is no obligation to provide market stabilization, financial advisors do not face the same risk of losing money from initial listings that face immediate downward pressure.

VI. Underwriter vs. Financial Advisor

A. Banks play an important role in assisting and advising on direct listings, and therefore are still key actors in the process.

B. The disclosure in the registration statement highlights the role of financial advisors. The disclosure clearly delineates the banks’ role as not underwriting the offering, and the plan of distribution section contrasts the role of financial advisors in a direct listing against the role investment banks play in a traditional underwritten IPO.

C. Whether an investment bank is acting as a statutory underwriter is based on the applicable facts and circumstances and has not been tested in the context of direct listings.

1. The Securities Act defines “underwriter” to mean “any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking, or participates or has a participation in the direct or indirect underwriting of any such undertaking...”.

2. The direct listing process is designed so that the banks are not construed as underwriters.

D. Banks generally seek to conduct a due diligence process in a direct listing that is similar to that in a traditional IPO. They also commission “10b-5” letters from legal counsel, as well as auditor comfort letters.

VII. Pre-Listing Period Public Financial Guidance in a Direct Listing

A. The direct listing company issues public guidance and financial outlook information to potential investors during the period between the effectiveness of registration statement and pricing/trading.

1. Such guidance was issued in both Spotify’s and Slack’s direct listings. Each of the companies filed a press release covering

9 [[DMS:5276894v2:1/28/2020 1:34:58 PM quarterly earnings and outlook after the registration statement went effective but prior to opening for trading.

2. In both cases, outlook was not filed on a free writing prospectus and was not incorporated into Form S-1/Form F-1.

3. Resale registration statement became effective 10 days prior to trading in Slack’s direct listing and eight days prior to trading in Spotify’s direct listing.

4. Similar guidance is unusual in traditional IPOs due to liability concerns.

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First Day of Trading

Pre-Trading Day Before Trading . Marketing to investors directly (e.g., “Investor . Stock exchange (in consultation with the Day”) at least 15 days after first public SEC filing Company’s financial advisor) declares a reference . Resale registration statement declared effective price . Existing shareholders and prospective investors • Serves as a guidepost only, and disclosure in assess forward-looking financial guidance during preliminary prospectus cautions that trading this period to zero in on price for sale/purchase price may have no correlation to pricing range indications or reference price . Shareholders deposit shares to be sold through DTC • Calculated based on recent high and low sales prices in recent transactions in private placement market

Morning of Trading Opening of Trading . Auction commences . Once an equilibrium is reached, the market maker . Demand size and price start to emerge (either the company’s financial advisor or the NYSE designated market maker in consultation with the . Buyers and sellers adjust orders for several hours company’s financial advisor) will open the stock for throughout morning as the market begins to reach trading an equilibrium . Price discovery may be aided by private secondary trading activity prior to direct listing

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VIII. Stock Exchange Listing Rules

A. Listing of Private Companies

1. Prior to the February 2018, the ability to list private companies not previously registered with the SEC was limited. A prospective company had to demonstrate $100 million aggregate market value of publicly held shares based on both:

a) an independent third-party valuation; and

b) the most recent trading price for its shares in a private placement market.

o Such trading price requires continued trading history over multiple-month period.

B. New NYSE Rule - February 2018

1. In March 2017, the NYSE began the formal rule filing process with the SEC to permit the direct listing of Spotify, which lacked sustained trading activity in a private placement market.

2. The SEC approved the new NYSE rule in February 2018.

3. The rule provides an exception to the trading requirement for companies looking to list on the NYSE that:

a) have an independent third-party valuation of at least $250 million aggregate market value of publicly held shares; and

b) use a financial advisor for consultation with the NYSE’s designated market maker in determining the opening trading price.

4. Amended Section 102.01B of the Listed Company Manual and NYSE Rules 15, 104 and 123D.2

2Section 102 of the Listed Company Manual sets forth the minimum numerical standards for issuers to list equity securities on NYSE.

NYSE Rule 15 sets forth the requirements for a pre-opening indication.

NYSE Rule 104 sets forth the responsibilities and duties of a designated market maker.

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5. The requirement that a company must have at least 400 round lot shareholders (i.e., holders of at least 100 shares of company stock) in order to be listed on NYSE remained unchanged.

C. New NASDAQ Rule - February 2018

1. The new NASDAQ rule mimics the NYSE rule incorporating the $250 million valuation threshold, and amended NASDAQ Rule 5315 (Initial Listing Requirements for Primary Equity Securities).

2. NASDAQ requires that a company has 300 round lot holders in order to initially list.3

3. On December 3, 2019, the SEC approved NASDAQ rule changes to allow direct listings on the NASDAQ Global and Capital Markets exchange. Previously, direct listings were permitted only on the NASDAQ Global Select Market.

IX. New NYSE Proposal Rejected by SEC

A. On November 26, 2019, the NYSE proposed a rule that would allow companies conducting a direct listing to also raise capital through the public markets. Currently, the direct listing process only permits the resale of existing shares, not the offering of new shares. The SEC rejected this proposal on December 6, 2019.

B. The SEC did not provide details on rejecting the proposal, but there are a few potential reasons, including:

1. Investors may be unaware of price and dilutive effect of offerings as described in the NYSE proposal.

a) In a traditional IPO, the price and amount of shares for sale are fixed and there is limited ability to price above/below range or upsize/downsize.

b) In the NYSE proposal-style open auction, the company can opportunistically increase or decrease shares at the

NYSE Rule 123D addresses openings and halts in trading. NYSE Rule 15, 104, and 123D Rule Changes Relating to NYSE Direct Listings. NYSE Information Memo (March 28, 2018).

3 Effective August 2019, NASDAQ revised its listing criteria to exclude securities subject to any resale restrictions from the calculation of round lot shareholders, publicly held shares and market value of publicly held shares. In addition, at least half of the minimum required number of round lot holders must each hold unrestricted securities with a minimum value of $2,500.

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opening price with limited disclosure or advance warning to investors.

2. Limiting the types of companies to which direct listing is available.

a) The SEC may want to limit availability of direct listings to mature, larger companies seeking to provide shareholders’ liquidity, rather than companies that need to raise capital, which may use a traditional public offering to achieve that goal.

C. Amended NYSE Proposal

1. The NYSE amended its proposal on December 11, 2019.

2. Under the proposed change, companies which meet the requirements for a direct listing would have to sell at least $100 million worth of stock instead of $250 million presented in the initial proposal.

3. The amended proposal also suggests delaying the 400 round lot shareholder requirement until 90 days after the listing date.

X. Equity Awards and Other Considerations

A. Restricted stock may vest upon public listing. This is an increasingly common market practice for technology companies.

B. Settlement is a taxable event. To cover withholding taxes incurred, it is advisable that holders trade on day one to cover the tax liability. In addition, withholding tax liability is based on opening price, and payments may be made by the company on holders’ behalf.

C. Unlike in a traditional IPO, there is no offer price to which to refer in order to determine the value of the equity award settlement, the resulting tax liability and the number of shares to be traded to cover the liability.

1. One focus of the disclosure in the Slack Form S-1 was how the acceleration of equity awards and desire to cover the withholding tax by selling shares into the market would impact trading on the first day.

a) In the Slack Form S-1, the estimated number of shares to be sold at the opening of trading was based on an estimated opening price using a recent independent

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common stock valuation report. Additional disclosure detailed that the estimate would be revised the day prior to the opening of trading (after the Form S-1 went effective).

D. Definition of “initial public offering” in fund or other documents.

1. A direct listing may not be considered an “underwritten initial public offering”.

2. Shareholder agreements, registration rights agreements and the terms of preferred stock may use the term “initial public offering”.

3. It is necessary to consider implications of a direct listing versus underwritten IPO in this context.

XI. Regulation M

A. Regulation M under the Exchange Act is designed to regulate market manipulation by underwriters, issuers, selling shareholders and other participants in an offering.

B. Its rules regulate bids and purchases by distribution participants (which include underwriters), issuers, selling shareholders and certain of their respective affiliates in connection with a securities distribution during the “restricted period”.

1. The “restricted period” generally begins five business days before the pricing date, but may begin one business day prior to pricing if the security being distributed has an average daily trading volume of $100,000 and the issuing company’s equity securities have a public float of $25 million.

2. The “restricted period” ends when a participant’s participation in the offering is complete (when the offered securities have been distributed or a participant has sold its allotment).

C. Regulation M rules also regulate passive market making, stabilization activities and short sales.

D. Regulation M prohibits trading that could artificially inflate the price of a security or generate a false impression of active trading.

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E. The new type of direct listing used by Spotify and Slack generated questions about applicability of Regulation M under the Exchange Act to this type of direct listing. Key questions included:

1. whether the registration of shares for resale under Form S-1/F-1 constitutes an offering, and if so, in combination with investor outreach and education, whether such activity constitutes a “distribution” for purposes of Regulation M; and

2. since unlike in a traditional IPO, there is no underwriting process to set the offering price or the number of shares to be sold and no clear-cut pre- and post-pricing times, whether or how participants should observe the restricted period under Regulation M.

F. In advance of its direct listing, Spotify submitted a no-action request letter to the SEC, requesting clarification of the applicability of Regulation M to the listing.

1. Spotify represented to the SEC that the company, financial advisors, registered shareholders and their respective affiliates would observe a restricted period commencing on the fifth business day prior to the designated market maker’s determination of the opening trading price and that such period would end with the commencement of secondary market trading in the shares on the NYSE.

2. Based on the fact pattern set forth in the no-action request:

a) Spotify would not offer any new shares under the registration statement for at least 90 days after declared effective;

b) Spotify would not receive any proceeds from sale of shares by shareholders;

c) resales during the effective period would be made solely through ordinary brokerage transactions into an independent market not controlled by the company, financial advisors, registered shareholders or their respective affiliates;

d) financial advisors would only be engaged to provide advice and assistance with respect to the filing of the registration statement and the listing of shares;

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e) financial advisors would not further assist Spotify in the planning of, or participate in, investor meetings;

f) financial advisors would not engage in any special selling efforts or stabilization/price support activities;

g) timing of resales would be at the sole discretion of the registered shareholders; and

h) financial advisors would have no discretionary authority to transact in the shares held in brokerage accounts and no fees or expenses could be paid by the company or any financial advisors in connection with the brokerage accounts.

G. The SEC responded that they would not recommend enforcement.

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Conflict of Interests and Regulation Best Interest

A. Conflict of Interest

1. Overview

a) Given the potential negative repercussions of unrestrained conflicts of interest on the financial market and the dynamic ways in which conflicts of interest may arise, lawmakers continually enact new laws designed to mitigate or eliminate instances of it. One such recent law is Regulation Best Interest (“Reg. BI”).

2. Definition

a) In the context of Reg. BI, a conflict of interest is defined as “an interest that might incline a broker, dealer, or a natural person who is an associated person of a broker or dealer—consciously or unconsciously—to make a recommendation that is not disinterested”. Exchange Act, Rule 15l‐1(b)(3).

B. Regulation Best Interest

1. Overview of Reg. BI

a) On June 5, 2019, the SEC adopted rule 15 l-1, Regulation Best Interest (“Reg. BI”) under the Exchange Act. Reg. BI establishes a new standard of conduct for broker-dealers and associated persons of a broker-dealer4 (together, “broker-dealers”) for the recommendation5 of any securities transaction or investment strategy involving

4 An “associated person of a broker or dealer” is “any partner, officer, director, or branch manager of such broker or dealer (or any person occupying a similar status or performing similar functions), any person directly or indirectly controlling, controlled by, or under common control with such broker or dealer, or any employee of such broker or dealer”, generally excluding, for the purpose of certain registration processes, persons whose functions are solely clerical or ministerial. Exchange Act, § 3(a)(18).

5 The SEC takes a principles-based approach based on existing SEC precedent and guidance on what constitutes a recommendation. Whether a broker-dealer has made a recommendation depends is a factual inquiry, considering factors such as “whether the communication reasonably could be viewed as a call to action and reasonably would influence an investor to trade a particular security or group of securities”. Regulation Best Interest: The Broker‐Dealer Standard of Conduct, 84 Fed. Reg. 33336 (July 12, 2019).

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securities6 to retail customers.7 Regulation Best Interest: The Broker‐Dealer Standard of Conduct, 84 Fed. Reg. 33318 (July 12, 2019), available at https://www.federalregister.gov/documents/2019/07/12/ 2019-12164/regulation-best-interest-the-broker-dealer- standard-of-conduct.

b) Prior to the adoption of Reg. BI, broker-dealers abided by the “suitability” standard of conduct under which brokers, in advising their customers, needed only to recommend investments suitable for their customers; such investments were not required to be in the best interest of their customers, and could ultimately offer greater financial or other benefits to the broker-dealer than the customer. Reg. BI enhances the broker-dealer suitability standard to emphasize that a retail customer’s financial interests should be the primary driver to a broker-dealer making recommendations. SEC Adopts Rules and Interpretations to Enhance Protections and Preserve Choice for Retail Investors in Their Relationships With Financial Professionals, SEC Press Release (June 5, 2019), available at https://www.sec.gov/news/press-release/2019-89.

2. Broker-Dealer General Obligation to Act in Customers’ Best Interest

a) Reg. BI Rule 15l‐1(a)(1) (hereinafter, the “General Obligation”) states that “[a] broker, dealer, or a natural person who is an associated person of a broker or dealer, when making a recommendation of any securities transaction or investment strategy involving securities (including account recommendations)8 to a retail

6 Under Reg. BI, the term “any securities transactions” includes the purchase, sale or exchange of securities, and “investment strategy involving securities” includes account type recommendations, explicit recommendations to hold a security, implicit hold recommendations resulting from agreed-upon account monitoring by a broker-dealer, and instructions regarding selling or purchasing a security. Id. at 33336.

7 A retail customer is a natural person, or the legal representative of such natural person, who: (i) receives a recommendation of any securities transaction or investment strategy involving securities from a broker, dealer, or a natural person who is an associated person of a broker or dealer; and (ii) uses the recommendation primarily for personal, family, or household purposes. Exchange Act, Rule 15l-1(b)(1).

8 The SEC defines “account recommendations” under Reg. BI as including “recommendations of securities account types generally (e.g., to open an IRA or other brokerage account), as well as

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customer, shall 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, or natural person who is an associated person of a broker or dealer making the recommendation ahead of the interest of the retail customer.”

b) The General Obligation is fulfilled through broker-dealer compliance with four component obligations, namely (1) Disclosure Obligation, (2) Care Obligation, (3) Conflict of Interest Obligation and (4) Compliance Obligation. Regulation Best Interest: The Broker‐Dealer Standard of Conduct, 84 Fed. Reg. 33320 (July 12, 2019). See also Exchange Act, Rule 15l‐1(a)(2).

c) Reg. BI became effective on September 10, 2019, and has a compliance date of June 30, 2020.

3. Further Discussion of the Four Component Obligations of the General Obligation

a) Disclosure obligation. The broker-dealer, prior to or at the time of the recommendation, must provide the retail customer full and fair written disclosure of:

o Any material facts relating to the scope and terms of the broker-dealer/retail customer relationship with the retail customer, including:

i. that the broker-dealer is acting within a broker-dealer capacity in making the recommendation;

ii. any material fees and costs applicable to the transaction; and

iii. The type and scope of services the broker- dealer will provide to the retail customer, including any material limitations on the securities or investment strategies involving

recommendations to roll over or transfer assets from one type of account to another (e.g., a workplace retirement plan account to an IRA)”. Id. at 33336.

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securities that the broker-dealer may recommend.

o All material facts relating to conflicts of interest associated with the recommendation, such as conflicts stemming from third-party payments, proprietary products and compensation arrangements.

b) Care obligation. In making a recommendation or series of recommendations to a retail customer, a broker-dealer must ensure that the recommendation does not place the financial or other interest of broker-dealer ahead of the interest of the retail customer. In addition, the broker- dealer must employ reasonable diligence, skill and care to:

o understand the recommendation’s potential risks, rewards and costs, and have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers;

o have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks, rewards and costs associated with the recommendation; and

o have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer’s best interest when viewed in isolation, is not excessive and is in the retail customer’s best interest when assessed with the retail customer’s investment profile. Exchange Act, Rule 15l‐ 1(a)(2)(ii).

c) Conflict of Interest Obligation. The broker-dealer must establish, maintain and enforce written policies and procedures reasonably designed to:

o identify and at a minimum disclose in accordance with the Disclosure Obligation, or eliminate, all

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conflicts of interest associated with recommendations to retail customers;9

o identify and mitigate conflicts of interests that create an incentive for a broker-dealer to place the interest of the broker-dealer ahead of the interest of the retail customer in making recommendations;10

o in accordance with the Disclosure Obligation, identify and disclose material limitations11 placed on recommendations that may be made to a retail customer and any associated conflicts of interest, and prevent such limitations and associated conflicts of interest from causing the broker-dealer to make recommendations that place the broker- dealer’s interest ahead of the interest of the retail customer; and

o identify and eliminate sales contests, sales quotas, bonuses and non-cash compensation12 that are based on the sales of specific securities or specific types of securities within a limited period of time.

d) Compliance Obligation. A broker-dealer must establish, maintain and enforce written policies and procedures

9 The SEC notes that it would be sufficient for broker-dealers to use a risk-based compliance and supervisory system rather than require a detailed review of each recommendation. Regulation Best Interest: The Broker‐Dealer Standard of Conduct, 84 Fed. Reg. 33385 (July 12, 2019).

10 The applicability of this requirement to associated persons extends only to incentives provided to the associated person by the firm or a third-party within the control of or associated with the broker- dealer’s business. It does not include the associated person’s external interests not within the control of or associated with the broker-dealer’s business. Id. at 33391.

11 While recognizing that for purposes of practicality all broker-dealers limit offerings, the SEC states that in this context, “a material limitation placed on the securities or investment strategies involving securities could include, for example, recommending only proprietary products (e.g., any product that is managed, issued, or sponsored by the broker-dealer or any of its affiliates), a specific asset class, or products with third-party arrangements (e.g., revenue sharing, mutual fund service fees).” Id. at 33393.

12 The SEC cautions that in specifying these incentives, it does not give implicit approval of other types incentives not mentioned here. It lists these incentives to exemplify those that create high-pressure environments to sell specific securities or types of securities within a limited period of time, creating conflict of interest situations which the SEC does not believe can be reasonably mitigated. The SEC explains that instances in which incentives do not create high-pressure situations to sell a specifically identified type of security do not generally fall afoul of this requirement. Id. at 33396.

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reasonably designed to achieve compliance with Reg. BI in its entirety. Exchange Act, Rule 15l‐1(a)(2)(iv).

The Compliance Obligation is designed to ensure that broker-dealers have internal controls in place to prevent Reg. BI violations. The required policies and procedures heighten the chances of early SEC recognition of insufficiencies or failures in compliance, thereby decreasing the chance of harm to retail customers.13

Given the variety in broker-dealer operations, the Compliance Obligation does not outline specific elements to be included in a broker-dealer’s policies and procedures. Whether policies and procedures are reasonably designed to be Reg. BI-compliant will be a fact- based inquiry.14

13 Id. at 33455.

14 Id. at 33397.

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