SEC Approves Regulation Best Interest for Broker-Dealers, Form CRS

Emily HayesBest Practices, Market Rules & Responsibilities, Operations

sec-approves-regulation-best-interest-for-broker-dealers-form-crs

The U.S. Securities and Exchange Commission (“SEC”) adopted “Regulation Best Interest” (“Reg BI”) on June 5, 2019, requiring broker-dealers to act in the best interest of their retail customers when recommending securities or a particular investment strategy. Additionally, the SEC adopted a new Exchange Act Rule 17a-14, 17 CFR § 240.17a-14, that requires broker-dealers to prepare, file with the SEC, and send to their retail customers the Form CRS Relationship Summary.  This summary must describe the broker-dealers’ services, fees, conflicts of interest, disciplinary history, and legal standard of conduct. Broker-dealers have until June 30, 2020, to comply with these new regulations.

Summary of Regulation Best Interest

Reg BI prohibits broker-dealers from placing their own financial or other interests ahead of the interests of their retail customers. When broker-dealers and associated persons of a broker-dealer recommend any securities transaction or investment strategies to retail customers, the broker-dealer or associated person must act in the best interest of the retail customer at the time the recommendation is made. Under the regulation, a broker-dealer will meet the “best interest” standard if it complies with the following four obligations:

1. Disclosure Obligation

A broker-dealer must provide its retail customers with a written disclosure before or at the time the broker dealer makes a recommendation to a retail customer. This disclosure must describe all material facts relating to the broker-dealer’s relationship with the retail customer and all material facts relating to conflicts of interest associated with the recommendation. The broker-dealer must include the material fees and costs that apply to the retail customer’s transactions, holdings, and accounts and must state the type and scope of services provided to the retail customer. The broker-dealer must deliver this disclosure to the retail customer prior to or at the time it makes the recommendation.

2. Care Obligation

When the broker-dealer makes the recommendation, it must exercise reasonable diligence, care, and skill to: (a) understand the recommendation’s potential risks, rewards, and costs; (b) have a reasonable basis to believe the recommendation is in the best interest of the retail customer based on the retail customer’s investment profile; and, (c) have a reasonable basis to believe that a series of recommended transactions is not excessive and is in the retail customer’s best interest based on the retail customer’s investment profile. Reg BI defines “retail customer investment profile” to include the retail customer’s age, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other factors that the retail customer may disclose to a broker-dealer. This obligation also requires broker-dealers to have a reasonable belief that the recommendation does not place the broker-dealers’ interest ahead of their retail customers’.

3. Conflict of Interest Obligation

Broker-dealers must now establish, maintain, and enforce written policies and procedures to identify and either eliminate or disclose and mitigate conflicts of interest. A “conflict of interest” is an interest that might incline a broker-dealer “consciously or unconsciously, to make a recommendation that is not disinterested.” Broker-dealers must identify and mitigate any conflicts of interest that would create an incentive for them to place their interest ahead of their retail customers’. This obligation also, requires broker-dealers to eliminate any sales contests, sales quotas, bonuses, and non-cash compensation that a broker-dealer’s associated persons may receive based on their sale of specific securities within a limited period of time.

4. Compliance Obligation

Lastly, broker-dealers must establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Reg BI.

Reg BI replaces the “suitability standard” that currently governs broker-dealer recommendations. The suitability standard requires broker-dealers to have a reasonable basis to believe a recommended transaction or investment strategy involving a security or securities is suitable for the customer based on the customer’s investment profile.

The Pros and Cons of Reg BI

The SEC maintains that Reg BI “will enhance the broker-dealer standard of conduct beyond existing suitability obligations and make it clear that a broker-dealer may not put its financial interests ahead of the interests of a retail customer when making recommendations.” The SEC’s Investor Advocate stated that Reg BI is an improvement upon the suitability standard and will provide customers will more disclosures about conflicts of interest and costs. And SIMFA President and CEO Kenneth E. Bentsen, Jr. claimed the rule will “directly enhance investor protection and contribute to increased professionalism among financial service providers.”

However, not everyone is convinced that Reg BI will protect broker-dealers’ retail customers. SEC Commissioner Robert J. Jackson Jr. decried Reg BI as relying “on a weak mix of measures that are unlikely to make much difference in improving the advice ordinary Americans receive from brokers.” Commissioner Jackson criticized Reg BI’s failure to define “best interest” and its reliance on disclosure alone to mitigate conflicts of interest. He was the lone dissenting vote on the Commission because, in his opinion, Reg BI fails to require Wall Street to put investors first.

Commissioner Jackson is not the only critic of Reg BI. The SEC’s Investor Advocate tempered his enthusiasm by stating his concern that Reg BI will allow broker-dealers to market themselves as acting in the best interest of their customers and, without rigorous enforcement demanding that broker-dealers’ behavior match their customers’ expectations, this marketing could harm retail customers. Several investor advocates and consumer organizations also opined on Reg BI’s deficiencies. For example, Barbara Roper, the Consumer Federation of America’s Director of Investor Protection, argued that Reg BI fails to require broker-dealers to completely eliminate incentives that encourage and reward advice that is not in the retail customer’s best interest. Roper also believes that Reg BI will be vulnerable to a court challenge due to problems with its legal standard and economic analysis.

Compliance Deadline

Broker-dealers have until June 30, 2020 to comply with Reg BI and Exchange Act Rule 17a-14. This gives broker-dealers a little over a year to comply with the new rule and to provide all current and future clients with Form CRS. In order to meet their compliance obligations, broker-dealers should start drafting written policies and procedures that identify and mitigate their conflicts of interest. If you have any questions or desire guidance on how to comply with Reg BI, please contact the Financial Industry team at Ziliak Law at finserv@ziliak.com.

Emily Hayes

Emily Hayes

Emily Hayes first began at Ziliak Law in the fall of 2016 as a law clerk and, after graduating from Law School, passing the Bar exam, and being sworn in to the Illinois Bar Association, joined us as an Associate.Read more...
Emily Hayes