All broker-dealers must be in compliance with Regulation Best Interest (Regulation BI) by June 30, 2020. Regulation BI, which was adopted by the Securities and Exchange Commission (SEC) in 2019, establishes a new standard of conduct under the Securities Exchange Act of 1934 (Exchange Act) for broker-dealers and natural persons who are associated persons of a broker-dealer (collectively referred to herein as broker-dealers unless noted otherwise) when making certain recommendations to a retail customer. Generally, Regulation BI can be broken down into a general obligation and four component obligations; however, broker-dealers must comply with all requirements under the Final Rule.
Under Regulation BI, broker-dealers must act in the best interests of the retail customer at the time a recommendation is made, without placing the broker-dealer’s interests ahead of the retail customer’s interests. This general obligation has three main points of discussion: (i) the application to broker-dealers; (ii) the definition of retail customers; and (iii) the identification of recommendations.
First, Regulation BI applies only to broker-dealers acting in the capacity of a broker-dealer at the time the recommendation is made. The duties imposed on broker-dealers under Regulation BI differ from the fiduciary standard imposed on investment advisors under the Investment Advisers Act of 1940 (Advisers Act). As described under Regulation BI, the Advisers Act fiduciary standard is principles-based and applies to the entire relationship between the investment advisor and the client. Regulation BI, although also principles-based, is more prescriptive and establishes minimum obligations for broker-dealers. These two standards reflect the differing roles that investment advisors and broker-dealers play in the financial industry. Therefore, Regulation BI does not apply to investment advice provided to retail customers by a dual registrant, i.e., a firm that is registered as a broker-dealer under Section 15 of the Exchange Act and as an investment advisor under Section 203 of the Advisers Act and that offers services to retail customers as both a broker-dealer and an investment advisor, when acting in the capacity of an investment advisor.
Second, Regulation BI applies only to recommendations made to retail customers. Under Regulation BI, a “retail customer” is defined as “any natural person who receives a recommendation from the broker-dealer for the natural person’s own account (but not an account for a business that he or she works for), including individual plan participants.” A retail customer can also include the “legal representative of such natural person,” which includes nonprofessional legal representatives. Regulation BI provides an example of a nonprofessional legal representative as a nonprofessional trustee who represents the assets of a natural person.
Third, Regulation BI applies only to communications that are recommendations. Whether or not a broker-dealer has provided a recommendation depends on the facts and circumstances of each individual situation. The SEC’s Small Entity Compliance Guide pulls from Regulation BI and references two factors that are considered when determining whether a recommendation has taken place: (i) whether the communication “reasonably could be viewed as a ‘call to action’”; and (ii) whether the communication “reasonably would influence an investor to trade a particular security or group of securities.” The SEC also notes that, “[t]he more individually tailored the communication to a specific customer or targeted group of customers about a security or group of securities, the greater the likelihood that the communication may be viewed as a ‘recommendation.’”
When an interaction involves a broker-dealer making a recommendation to a retail customer, four component obligations help broker-dealers conclude that such a recommendation is in the best interests of the retail customer or, in other words, satisfies the general obligation. The four component obligations include: (i) the Disclosure Obligation; (ii) the Care Obligation; (iii) the Conflict of Interest Obligation; and (iv) the Compliance Obligation.
The Disclosure Obligation requires a broker-dealer to disclose, in writing, all material facts about the scope and terms of its relationship with the retail customer before or at the time of the recommendation. Regulation BI states that the disclosure must include “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.” Additionally, the disclosure must include all material facts relating to conflicts of interest that the broker-dealer may have related to the recommendation. Regulation BI gives examples of such conflicts of interest to include “conflicts associated with proprietary products, payments from third parties, and compensation arrangements.” The Disclosure Obligation includes the requirement to disclose conflicts of interest under the Conflict of Interest Obligation, as discussed below.
The Care Obligation requires broker-dealers to “exercise reasonable diligence, care, and skill when making a recommendation to a retail customer.” The Care Obligation requires a broker-dealer to review the facts and circumstances of each individual recommendation made to each retail customer. In doing so, the broker-dealer must ultimately balance the risks and rewards of a particular recommendation, or a collection of transactions that make up the recommendation, in light of a retail customer’s investment profile and after considering reasonable alternatives to that recommendation. In choosing among the various alternatives, the broker-dealer should have a reasonable basis that such recommendation is in the retail customer’s best interests. If a broker-dealer is recommending a series of transactions, each individual transaction must be in the best interests of the retail customer and, collectively, the transactions taken as a whole should not be excessive.
Conflict of Interest Obligation
The Conflict of Interest Obligation requires broker-dealer entities to “establish, maintain, and enforce reasonably designed written policies and procedures addressing conflicts of interest associated with its recommendations to retail customers.” The Small Entity Compliance Guide, which tracks Regulation BI, states that written policies and procedures in compliance with the Conflict of Interest Obligation must be reasonably designed to:
(i) identify and at a minimum disclose or eliminate all conflicts of interest associated with recommendations;
(ii) identify and mitigate any conflicts of interest associated with recommendations that create an incentive for associated persons to place their interests or the interests of the broker-dealer entity ahead of the retail customer’s interests;
(iii) identify and disclose any material limitations and conflicts of interest associated with such material limitations placed on the securities or investment strategies involving securities that may be recommended to a retail customer, and prevent such material limitations and associated conflicts of interest from causing the broker-dealer to place the interests of the broker-dealer ahead of the retail customer’s interests; and
(iv) identify and eliminate sales contests, sales quotas, bonuses, and noncash compensation that are based on the sale of specific securities or types of securities within a limited period.
The Compliance Obligation requires broker-dealer entities to “establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Regulation Best Interest as a whole.” In other words, to comply with the Compliance Obligation, a firm’s policies and procedures should address the Disclosure Obligation, the Care Obligation, and the Conflicts of Interest Obligation. Regulation BI states that a reasonably designed compliance program includes controls, remediation of noncompliance, training, and periodic review and testing.
To comply with Regulation BI by June 30, 2020, broker-dealers should review Regulation BI in its entirety and, in particular, broker-dealer entities should take steps with those component obligations requiring certain policies and procedures to be in place so that broker-dealers act in the best interests of the retail customer at the time a recommendation is made, without placing the broker-dealer’s interests ahead of the retail customer’s interests.
Michael Best’s Securities & Capital Markets team has experts who advise broker-dealers on compliance with SEC rules and regulations, including compliance with Regulation Best Interest. Please do not hesitate to contact the authors of this article or your Michael Best attorney for additional guidance and information.