Regulation Best Interest: Higher Standards for Broker-Dealers, Strengthened Protections for Clients
November 12, 2019
In June, the Securities and Exchange Commission (“SEC”) adopted a new regulation, Regulation Best Interest (“Reg BI”) to address a long-standing concern among consumer advocates and some financial professionals that existing regulations do not impose requirements on broker-dealers to make recommendations that are in a client’s best interest. Reg BI is designed to strengthen investor protections by raising the standards of conduct for broker-dealers when making recommendations on a securities transaction or investment strategy involving securities, and to move those standards closer to the standards that investment advisors must abide by when providing investment advice to clients. By raising the standards, Reg BI is intended to enhance the quality of broker-dealer recommendations and reduce the potential harm caused by conflicts of interest.
In conjunction with adopting Reg BI, the SEC also developed a Customer Relationship Summary (“Form CRS”) that broker-dealers and investment advisers will be required to complete and provide to each client to give the client basic information about the nature of the client’s relationship with their financial professional. Form CRS is designed to provide a client with sufficient information about a firm to enable the client to understand his/her relationship firm (broker-dealer or investment advisory), the specific services to be provided, the fees and costs of those services, and whether the financial advisor has any conflicts of interest, and any disciplinary history.
The SEC also clarified its views of the fiduciary standard of care that an investment advisor owes to a client pursuant to the Investment Advisers Act of 1940.
Firms have until June 30, 2020 to comply with Reg BI, which will require changes to a firm’s compliance processes, policies and procedures, disclosures, and marketing materials.
This article provides an overview of the significant provisions of Reg BI, and what a broker-dealer firm must do to comply with Reg BI.
BEST INTEREST STANDARD
Reg BI requires that when making a recommendation of a securities transaction or investment strategy involving securities to a client, a broker-dealer must: (1) act in the best interest of the client at the time the recommendation is made; and (2) not place the financial or other interest of the broker-dealer ahead of the interest of the client.
A broker-dealer must comply with each of the following four obligations to comply with Reg BI:
(1) Provide certain prescribed disclosures before or at the time of the recommendation about the recommendation and the relationship between the client and the broker-dealer (“Disclosure Obligation”);
(2) Exercise reasonable diligence, care, and skill in making the recommendation (“Care Obligation”);
(3) Establish, maintain, and enforce policies and procedures reasonably designed to address conflicts of interest (“Conflict of Interest Obligation”); and
(4) Establish, maintain, and enforce policies and procedure reasonably designed to achieve compliance with Reg BI (“Compliance Obligation”).
See Section II.A, General Obligations
Disclosure Obligation
Before or at the time of the recommendation, a must disclose, in writing, all material facts about the scope and terms of its relationship with the client, including:
(1) that the Firm is acting in a broker-dealer capacity with respect to the recommendation;
(2) the material fees and costs that apply to the client’s transactions, holdings, and accounts; and
(3) the type and scope of services to be provided, including any material limitations on the securities or investment strategies that may be recommended to the client.
Additionally, broker-dealers must disclose all material facts relating to conflicts of interest associated with the recommendation that could benefit the broker-dealer, such as conflicts associated with proprietary products, payments from third parties, and compensation arrangements.
See Section II.C.1, Disclosure Obligation
Care Obligation
A broker-dealer must exercise reasonable diligence, care, and skill when making a recommendation to a client. This requires the broker-dealer to understand potential risks, rewards, and costs associated with the recommendation, then consider those risks, rewards, and costs in view of the client’s investment profile, and have a reasonable basis to believe that the recommendation is in the client’s best interest and does not place the broker-dealer’s interest ahead of the client’s interest. A broker-dealer must consider reasonable alternatives, if any, offered by the broker-dealer in determining whether it has a reasonable basis for making the recommendation.
See Section II.C.2, Care Obligation
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 clients. These policies and procedures must be reasonably designed to: (1) identify all such conflicts and, at a minimum, disclose or eliminate them; or (2) mitigate them, particularly conflicts that create an incentive for an associated person to place the interest of the broker-dealer ahead of the client’s interest. Additionally, when a broker-dealer places material limitations on recommendations that my be made to a client, such as offering only proprietary 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 his/her or the broker-dealer’s interests ahead of the client’s. 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 time period.
See Section II.C.3, Conflict of Interest Obligation
Compliance Obligation
A broker-dealer must establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with each of the obligations under Reg BI -- Disclosure, Care and Conflict of Interest.
See Section II.C.4, Compliance Obligation
Michael P. Shaw is a Partner in the Corporate Department of Niles, Barton & Wilmer, LLP, with over 25 years of experience as an in-house corporate and regulatory attorney in the securities and insurance industries. He serves the legal, compliance and enforcement defense needs of registered investment advisers, broker-dealers, hedge funds, private equity firms, and insurance agencies.
