In June 2019, after considerable debate and discussion over the course of several years, the SEC adopted its new Regulation Best Interest ("BI") which governs the standard of conduct that must be observed by broker-dealers that transact with retail customers. The SEC also approved its Form CRS Relationship Summary provisions.
In this article, we focus on the impact of these regulatory actions on structured product offerings.
REGULATION BEST INTEREST
Regulation BI creates an enhanced standard of conduct for broker-dealers and their associated persons. It applies when they make any recommendation of a securities transaction or an investment strategy involving securities to a "retail customer." Notably, the SEC did not elect to impose a fiduciary standard of the type that is applicable to investment advisers. Instead, when making a recommendation that is covered by the rule, a broker-dealer must act in the customer's "best interest," and may not put its own interests ahead of those of its customer.
The term "retail customer" is defined to include any individual investor acting for its own account no matter what the sophistication or degree of wealth that the investor has. Of course, this is a broader definition than FINRA's historic definition, which excludes certain "ultra-high net worth" investors from its "retail investor" definition.
In addition, the regulation does not define the term "best interest." A broker-dealer's compliance will depend upon an assessment of the facts and circumstances at the time a relevant recommendation is made. Similarly, the term "recommendation" is not defined in the regulation, and it is subject to the relevant circumstances.
The best interest standard consists of four components, described as follows:
- The Disclosure Component -- the final rule requires full and fair written disclosure of all material facts relating to conflicts of interest associated with the recommendation. The term "conflict of interest" is defined as an interest that might incline a broker-dealer or an associated person, consciously or unconsciously, to make a recommendation that is not disinterested.
In the structured products sector, these conflicts are frequently subject to substantial prospectus disclosures; for example, these conflicts include, but are not limited to, broker-dealer compensation in connection with the relevant offering, and hedging profits that the broker-dealer may earn from the related transactions. These factors may materially increase a representative's incentive to recommend a structured note to a retail investor.
- The Care Component -- the broker-dealer must exercise reasonable diligence, care, skill and prudence to:
- understand the potential risks and rewards associated with the recommendation, and have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers4;
- have a reasonable basis to believe that the recommendation is in the best interest of the relevant retail customer to whom the recommendation is made, based on the retail customer's investment profile and the potential risks and rewards associated with the recommendation5; and
- have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer's best interest when viewed individually, is not excessive and is in the retail customer's best interest when considered in light of the retail customer's investment profile regulation.6
This prong of the rule contains an express requirement that broker-dealers consider the costs of a recommended transaction. However, in this regard, the SEC indicated that costs will not be the only relevant consideration, and the rule does not impose any requirement that broker-dealers recommend to their clients the least expensive product that is available. In its release, the SEC approvingly cited prior FINRA guidance, stating that when broker-dealers are recommending complex or costly products, including structured products, they should first consider whether less complex or costly products could achieve the same objectives for their retail customers.7 For example, in some cases, a structured note could be replicated through an investment in several related instruments.
- The Conflict of Interest Component -- the rule establishes an obligation for broker-dealers to establish written policies and procedures to comply with the regulation. Broker-dealers also must identify and, depending on the type of conflict, either disclose, mitigate or eliminate these conflicts of interest. Specifically, the rule requires broker-dealers to eliminate sales contests, sales quotas, bonuses, and non-cash compensation that are based on sales of specific securities or types of securities within a specified period of time. These types of activities create high-pressure situations for associated persons, and jeopardize their ability to act in the best interest of retail customers. In these cases, the relevant conflicts of interest cannot be reasonably mitigated. In contrast, the rule does not eliminate the ability of broker-dealers to receive transaction-based compensation, such as a brokerage commission.
This component requires broker-dealers to identify and disclose any material limitations placed on the securities or investment strategies involving securities that may be recommended to a retail customer and any conflicts of interest associated with these types of limitations. For example, if a broker-dealer offered only proprietary products, and not those of third parties, retail customers would need to be made aware of these limitations.
- The Compliance Component -- the regulation establishes a general compliance obligation that requires broker-dealers to establish policies and procedures to achieve compliance with Regulation BI.
Under the SEC's new rules and related amendments, both investment advisers and broker-dealers will be required to provide a brief "relationship summary" disclosure to "retail investors."8 This disclosure is known as Form CRS. This form uses a standardized Q&A format that designed to promote comparisons among firms by retail investors. The form requires the disclosure of summary information about a firm's services, fees, conflicts of interest, relevant legal standard of conduct, the disciplinary history of the firm and its financial professionals, and how investors may obtain additional information about the relevant firm. For each of broker-dealers and investment advisors, the length of the form is limited to two pages. Brokerdealers that specialize in structured products may be able to address issues relating to this product class in these documents. However, for full-service brokerage firms that have broader offerings, disclosures relating to individual product classes may not be discussed to a significant degree in these documents.
The SEC established the compliance date for both Regulation BI and Form CRS of June 30, 2019. At that time, broker-dealers that make the relevant recommendations must be in compliance with Regulation BI, and will need to file their updated Form CRS by that time.
A NOTE ABOUT STRUCTURED CERTIFICATES OF DEPOSIT
By its terms, Regulation BI applies to transactions in securities, as opposed to brokered bank deposits. In that sense, equity-linked certificates of deposit should be outside the scope of the regulation. That being said:
- it is possible under some circumstances for a "certificate of deposit" to be treated as a "security";
- especially in the case of complex instruments of this type, which are often sold to many of the same investors to whom structured notes are offered, broker-dealers may wish to consider applying similar procedures to the sale of these instruments, in order to comply with relevant "best practices," and to avoid the possibility of confusion among their representatives or investors.
Needless to say, broker-dealers will be working over the next year to adapt their policies and procedures to reflect the new rules. Compensation structures, and how they related to different types of products, will need to be carefully evaluated in light of the new conflict of interest rules. To the extent not already done in light of recent regulatory actions, sales competitions for structured products and other securities are likely to have seen their last days.
Broker-dealers who sell structured products through third-party dealers will want to update their "know-your-dealer" questionnaires and procedures to reflect the new rules. For example, broker-dealers will seek to know what changes their distributors are making in order to comply with the rules, and to what extent their product offerings will be changed to reflect these changes.