REGULATION BEST INTEREST: THE BROKER-DEALER STANDARD OF CONDUCT
On June 5, 2019, the SEC voted to adapt a new rule under the Securities Exchange Act of 1923 titled Regulation Best Interest. Thus, it became the broker-dealer standard of conduct. Regulation Best Interest establishes a standard of conduct for broker-dealers and associated persons when making a recommendation to a retail customer or any securities transaction or investment strategy involving securities. The package of rulemakings and interpretations implemented by the SEC included Regulation Best Interest, the new Form CRS Relationship Summary, and two separate interpretations under the Investment Advisers Act of 1940. The stated intention of the SEC in implementing the new rules was to tighten the obligation of broker-dealers and representatives when making a recommendation to a retail customer and to reduce the potential ham to retail customers from conflicts of interest that may affect the recommendation. Registered broker-dealers must be in compliance with Regulation Best Interest by June 30, 2020.,
Regulation Best Interest was intended to improve investor protection by requiring (1) that broker-dealers and representatives act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interests of the broker-dealer ahead of the interests of the retail customer; and (2) address conflicts of interest by establishing, maintaining, and enforcing policies and procedures reasonably designed to identify and fully and fairly disclose material facts about conflicts of interest, and in instances where it has been determined that disclosure is insufficient to reasonably address the conflict, to mitigate or eliminate the conflict.
Regulation Best Interest imposes a new standard of conduct specifically for broker-dealers and associated persons that is intended to regulate the standard of conduct for them “beyond” the suitability standard. Regulation Best Interest includes disclosure provisions along with specific requirements imposed on the broker-dealer, rep. and client relationship.
One of the pillars of Regulation Best Interest is that when making a recommendation of a securities transaction (buy, sell or hold) or an investment strategy involving securities, a broker-dealer and its rep. must act in the retail customer’s best interest and cannot place their own interests ahead of the customer’s interests. Regulation Best Interest applies to broker-dealers and registered representatives at the point the securities transaction or investment strategy involving securities is made to the customer. Regulation Best Interest sets forth the following four (4) obligations on broker-dealers and their representatives:
Disclosure Obligation: Broker-dealers must disclose material facts about the relationship and recommendations, including specific disclosures about the capacity in which the broker is acting, fees, costs, the type and scope of services provided, conflicts, limitations on services and products, and whether the broker-dealer provides monitoring services. A broker-dealer must disclose in writing, all material facts about the scope and terms of the relationship with the customer prior to or at the time the recommendation is made. The requirement includes disclosure that the firm representative is acting in a broker-dealer capacity; the material fees and costs the client will be charged; and the type and scope of services to be offered, including any material restrictions on the recommendations that could be made to the retail customer. Additionally, the broker-dealer must disclose all material facts relating to conflicts of interest associated with the recommendation that might incline a broker dealer or rep to make an impartial recommendation, such as conflicts inherent to proprietary products, third party compensation, and payment arrangements.
Care Obligation: A broker-dealer and its representative are obligated to use reasonable diligence, care and skill when making a recommendation to a retail customer. The broker-dealer is required to consider potential risks, rewards, and costs associated with t e recommendation offered. The broker-dealer and rep. must have a reasonable basis to believe that the recommendation is in the customer’s best interest and does not place the broker-dealer or reps. Interest before the interests of the retail customer. When recommending multiple transactions, the broker-dealer or rep. must have a reasonable basis to believe that the sum of the transactions is not excessive, even if each is in the customer’s best interest when viewed singularly. The point of evaluation of whether or not a broker-dealer or rep has fulfilled their duties under the Care Obligation is determined at the time of the recommendation ( and not in retrospect).
Conflict of Interest Obligation: Broker-dealers are obligated to establish, maintain and enforce reasonably created written policies and procedures to prevent violations by addressing conflicts of interest related to its recommendations to retail customers. These policies and procedures must be reasonably designed to identify all such conflicts and at a minimum, disclose or eliminate them. Essentially, conflicts of interest that generate an incentive for an associated person of the firm, to place its interests or the interest of the firm ahead of the retail customer’s best interest must be mitigated by the firm’s policies and procedures. Importantly, appropriate disclosures must be made to the retail client when a broker-dealer places material restrictions on recommendations that may be made to a retail customer to avoid the associated person’s or broker-dealer’s interests being put ahead of the customer’s interest. Lastly, the firm’s policies and procedures must be reasonably designed to identify and remove sales contests, sales quotas, bonuses, and non-cash compensation that are premised on the sale of specific securities or specific types of securities within a certain time frame.
Compliance Obligation: Broker-dealers are obligated to establish, maintain, and enforce policies and procedures reasonably designed to attain compliance with Regulation Best Interest in its entirety. A broker-dealers’ policies and procedures must address conflicts of interest as well as compliance with its Disclosure and Care Obligations under Regulation Best Interest. In addition to Regulation Best Interest, the SEC also implemented a requirement that the broker-dealers and investment advisers utilize a Form CRS Relationship Summary. Under the regulation, advisors and broker-dealers are required to provide retail investors a relationship summary at the outset of their relationship. In the relationship summary, firms are required to summarize information about services, fees and costs, conflicts of interest, legal standards of conduct, and whether or not the firm and its financial professionals have a disciplinary history. The relationship summary will highlight the Commission’s investor education website, investor.gov, which offers the investing public educational information.
Lastly, as part of the SEC’s package of new rules, the SEC provided two (2) interpretations. The first is the Investment Adviser Interpretation which clarifies that an investment adviser owes a fiduciary duty to its clients under the Advisers Act. This duty is principles-based and applies to the entire relationship between an investment adviser and its client. The second is the Solely Incidental Interpretation which confirms and clarifies the Commission’s interpretation of the “solely Incidental” prong of the broker-dealer exclusion of the Advisers Act. Specifically, the interpretation states that a broker-dealers’ advice as to the value and characteristics of securities or as to the advisability of transacting in securities falls within the “solely Incidental” part of this exclusion if the advice is provided in connection with and is reasonably related to the broker-dealers’ primary business of effecting securities transactions.