On June 5th of this year, the Securities and Exchange Commission (SEC) adopted a new package of rules and interpretations that broker-dealers, investment advisors, and others associated with these professionals need to review. These new rules govern the standards of conduct and disclosure requirements, including the new Regulation Best Interest (Regulation BI), that creates a best interest code of conduct for broker-dealers when interacting with and making recommendations to retail customers. The package also includes a standardized form for broker-dealers to use when disclosing their relationship to retail customers.
Regulation Best Interest
Regulation BI is also known as Rule 151-1 of the Securities Exchange Act of 1934. While it only contains a single rule, the regulation applies to the code of conduct for broker-dealers and their staff when they make recommendations to retail customers. These recommendations include securities transactions, investment strategies, asset roll-overs, and other related business. It also includes hold recommendations that are implicit when coming from mutually arranged investment account monitoring.
The new Regulation BI requires that recommendations should be made that are in the customer’s best interest. The broker-dealer cannot place his or her own interests above the customer’s. While “best interest” is not defined, it is broken down into a series of obligations placed on the broker-dealer and his or her team when interacting with retail customers. This includes an obligation to disclose, to act with care, to avoid conflicts of interest, and a compliance obligation. While this new best interest rule is not considered a fiduciary standard, it is similar in nature so that retail consumers are getting advice that is in their best interests, regardless of whether they’re working with a broker-dealer or an investment advisor.
Disclosure Obligation: Before broker-dealers can begin making recommendations to a retail customer, they must give a written disclosure detailing their relationship with the customer. This disclosure covers the fees and costs the customer will incur, the types of services the broker-dealer provides, limitations on recommendations, any conflicts of interest, and any other important details regarding the terms of the arrangement and the scope of services offered.
Care Obligation: A broker-dealer is required to exercise diligence, care, and skill when making recommendations to customers. This means understanding the risks, rewards, and costs of different investments or actions and how those would apply to the specific customer’s situation. Broker-dealers must consider the investment as a part of the customer’s whole investment profile and believe that their recommendation is truly in the customer’s best interests. It’s important to note that this doesn’t necessarily mean always selecting the lowest cost option, but rather selecting the option that will work best for a customer.
The care obligation may mean considering reasonable alternatives, when necessary. If a broker-dealer’s firm chooses to limit their offerings to a certain selection, they still have a requirement to comply with their care obligation. Having a limited range of products to choose from does not exempt the broker-dealer from the care obligation.
Conflict of Interest Obligation: Broker-dealers are now required to create and enforce written conflict of interest policies and procedures regarding customer recommendations. These policies must be designed to identify any potential conflicts and either eliminate them or disclose them to customers. The goal is to incentivize the broker-dealer to place their customer’s best interests ahead of their own. When a broker-dealer firm chooses to limit their product offerings as mentioned above, then their conflict of interest policy must disclose this limitation.
Further, to eliminate a broker-dealer’s incentive to make certain recommendations, the conflict of interest policy must identify and eliminate any sales quotas, bonuses, contests, or non-cash compensation. These behaviors are generally designed to encourage broker-dealers to sell a certain security quickly, thus incentivizing them to make recommendations to customers that may not be in the customer’s best interest.
Compliance Obligation: This obligation requires broker-dealers to have written policies and procedures in place that ensure compliance with the new Regulation BI. This means putting in place policies that not only address conflicts of interest, but otherwise ensure that the disclosure obligation and the care obligation are being met in every interaction with a retail customer.
Standardized Customer Relationship Summary (CRS): Form CRS
Simultaneous to the adoption of the new Regulation BI, the SEC also adopted Form CRS, which requires registered investment advisors (RIAs) and broker-dealers to provide a relationship summary to retail customers. The Form CRS is aimed to help broker-dealers comply with the Regulation BI and their disclosure obligation by providing a clear summary to customers regarding the relationship. This includes information on the types of clients and relationships available from the firm, fees and costs, any disciplinary history, and how to obtain more information. This was all created with the goal of increasing transparency between financial firms and the customers who use them. Firms must file Form CRS by June 30, 2020.