As the new year rings in, broker-dealers and their associated persons should not lose sight of the momentous rule change that is expected before yearend. On April 18, 2018, the SEC proposed a new “best interest” standard of conduct for broker-dealers and their associated persons when making recommendations to retail customers concerning securities transactions or investment strategies involving securities.
For the many practitioners who may not be following this issue closely, we explain below what the best interest standard requires, how it differs from the current suitability standard, some of the proposal’s pros and cons and the expected time frame for the SEC to take action.
WHAT IS REGULATION BEST INTEREST?
The proposal, Regulation Best Interest (“Reg BI”), would require broker-dealers and their associated persons to “act in the best interest of the retail customer at the time a 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.”
Under proposed Reg BI, broker-dealers and their associated persons would satisfy their duty by complying with three specific obligations: a disclosure obligation (requiring written notification of any material facts relating to the relationship with the customer and any material conflicts of interest relating to the recommendation), a care obligation (requiring reasonable diligence, care, skill, and prudence in making recommendations) and a conflict of interest obligation (requiring written policies and procedures designed to identify, disclose, mitigate, and eliminate conflicts of interest).
The proposed rule has no scienter or intent-based requirement; violations may be found in cases where the broker-dealer or associated person was negligent. Further, the rule would be enforced by the SEC and FINRA; it does not provide for a private right of action.
HOW DOES REG BI DIFFER FROM THE CURRENT SUITABILITY STANDARD?
If adopted, proposed Reg BI would increase the standard applicable to brokerdealers and their associated persons beyond what is required by the current suitability standard, which only requires that they make recommendations that are “suitable” for a customer and that they receive fair and reasonable compensation. In contrast to the proposed best interest standard, the suitability standard does not require brokers-dealers or their associated persons to put their customers’ best interests before their own. Nor must they avoid conflicts of interest when they make recommendations to retail customers.
But while proposed Reg BI appears to call for a higher standard than suitability, it falls short of creating a fiduciary duty, like the one applicable to registered investment advisers under the Investment Advisers Act.
WHY IS REG BI NEEDED?
Proposed Reg BI is intended to address longstanding concerns regarding the potential conflicts of interest that may arise when broker-dealers and their associated persons make recommendations to retail customers. According to the SEC, many retail customers do not understand the broker-dealer relationship, and in particular the conflicts of interest presented by brokerdealer compensation arrangements and practices when making a recommendation. Further, the broker-dealer regulatory requirements do not require recommendations by a broker-dealer or its associated persons to be in a customer’s best interest. In addition, these requirements demand only limited disclosure that may not appropriately address the conflicts of interest presented. In proposing Reg BI, the SEC aims to enhance investor protection by increasing disclosure obligations, establishing higher minimum professional standards of diligence and care, and requiring mitigation of certain conflicts of interest.
PROS AND CONS OF REG BI
Between April 18 and August 7, 2018, when the 90-day public comment and hearing period officially ended, the SEC received more than 3,000 comment letters regarding proposed Reg BI. While some comment letters simply endorse or object to the proposal, many of them praise the SEC’s attempt to enhance the applicable standard while offering nuanced views and suggestions on how to improve the proposed rule.
Many of those who have acknowledged proposed Reg BI’s benefits have focused on the fact that the rule:
- Prioritizes customers’ interests. Proposed Reg BI explicitly places the interests of customers above those of firms and advisers and requires individualized and thorough analysis of the appropriateness of a recommendation to a particular customer.
- Contains clear disclosure obligations. Proposed Reg BI requires written disclosure to retail customers at or before the time of a recommendation about services, fees, the applicable standard of conduct, conflicts of interest and whether the firm and its financial professionals have reportable legal or disciplinary events.
- Requires firm-wide policies and procedures. Proposed Reg BI requires all brokers to establish, maintain and enforce firm-wide written policies and procedures to identify and disclose conflicts of interest.
- Preserves commissions. By preserving a variety of payment models for customers, including pay-asyou-go or commission-based models, proposed Reg BI preserves retail customer choice regarding the level and type of advice provided and the products available.
On the other hand, proposed Reg BI has been the subject of much criticism. Among the key areas of criticism are the fact that the rule:
- Fails to define “best interest.” Rather than defining “best interest,” the proposed standard requires an analysis of the facts and circumstances surrounding the particular recommendation to the particular customer. Many believe that introducing yet another standard will merely confuse customers, and it would be preferable to adopt a single fiduciary duty standard for all personalized investment advice to retail customers.
- Fails to define what is “material.” In the SEC’s proposing release, it defines a material conflict of interest as a conflict that “a reasonable person would expect might incline a broker-dealer— consciously or unconsciously—to make a recommendation that is not disinterested.” Some have argued that the SEC should revise the interpretation of “materiality” to align with the Supreme Court’s long-standing definition in the context of Section 10(b) of the Securities Exchange Act as set forth in Basic, Inc. v. Levinson, 485 U.S. 224 (1988), which is well understood by broker-dealers and would promote consistency and legal certainty.
- Proposes an overbroad definition of “retail customer.” Proposed Reg BI defines “retail customer” as “a person, or the legal representative of such person, who (1) 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 (2) Uses the recommendation primarily for personal, family, or household purposes.” Some critics state that this definition is overbroad in that it potentially captures registered investment advisers or regulated market professionals who have authority to enter into transactions on behalf of persons who transact “primarily for personal, family, or household purposes.” Instead, they propose that the definition of “retail customer” should be modified to be consistent with FINRA Rules 2210(a)(6) and 4512(c).
- Relies on disclosure to protect customers. Proposed Reg BI’s disclosure obligation requires broker-dealers and their associated persons to make certain disclosures to customers, but it does not obligate them to eliminate conflicts. Critics assert that there is no evidence suggesting that these disclosures will be effective, and in fact they may confuse customers or lead to a false sense of security.
WHAT IS THE CURRENT STATUS?
Now that the comment period has concluded, the SEC will debate the rule and consider any proposed modifications. According to the SEC’s regulatory agenda, it will take final action by September 2019. While it is hard to predict what the final version will be, it seems clear that by year-end, broker-dealers and their associated persons will soon have to alter significantly the ways in which they advise and interact with their customers.