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Regulation Best Interest and Broker Dealers

The U.S. Securities and Exchange Commission (“SEC”) passed Regulation Best Interest (“Reg BI”) which becomes effective 60 days after it is posted in the federal register.  Broker-Dealers (“BDs”) will have until June 30, 2020 to comply.

BDs will be required to act in the best interest of their retail customers when recommending any securities transaction or investment strategy. As part of Reg BI, BDs and Registered Investment Advisers (“RIAs”) will be required to provide retail investors with a Form CRS Relationship Summary which discloses the nature of the relationship between the entities and their customers.

Going forward, whenever making a recommendation, a BD must act in the retail customer’s best interest and cannot place its own interests ahead of the customer’s interests. The general obligation is satisfied only if the BD complies with four specified component obligations.

The specified component obligations are:

1.  Providing certain prescribed disclosures before or at the time of the recommendation, about the recommendation and the relationship between the retail customer and the BD (“Disclosure Obligation”);

BDs are required to disclose the following:
Material facts about the relationship:

  • Scope of services offered
  • Limitations of offerings
  • Conflicts
  • Whether the BD provides ongoing monitoring

Material facts about recommendations:

  • Fees
  • Risks

2. Exercising reasonable diligence, care, and skill in making the recommendation (“Care Obligation”);

BDs are required to understand the following:

  • Potential risk, reward and costs of recommendation
  • Reasonable basis that recommendation is in the customers best interest
  • Reasonable alternatives that exist

3. Establishing, maintaining, and enforcing written policies and procedures reasonably designed to address conflicts of interest (“Conflict of Interest Obligation”),

BDs are required to design policies, around sales of specific securities or type of security, that:

  • Disclose or eliminate all conflicts
  • Mitigate conflicts that incentivize financial professionals to place their own interests ahead of the retail customer
  • Prevent material limitations on offerings
  • Identify and eliminate
    • Sales contests
    • Sales quotas
    • Bonuses and non-cash compensation

4. Establishing, maintaining, and enforcing policies and procedures reasonably designed to achieve compliance with Reg BI (“Compliance Obligation”).

The Compliance Obligation requirement adds recommendations of account types to its scope of coverage, as well as recommendations to roll over retirement plan assets or to take a distribution from a retirement plan and to consider all costs when a BD recommends a certain product or strategy.

RIAs and BDs will be required to deliver a relationship summary to retail investors at the beginning of their relationship.  Firms will summarize information about services, fees and costs, conflicts of interest, legal standard of conduct, and whether or not the firm and its financial professionals have disciplinary history.  The relationship summary will have a standardized question-and-answer format to promote comparison by retail investors in a way that is distinct from existing disclosures.  The relationship summary will permit the use of layered disclosure so that investors can more easily access additional information from the firm about these topics.  It also will highlight the SEC’s investor education website, Investor.gov, which offers the investing public educational information, including a series of educational videos designed to provide ordinary investors with some basic information about RIAs and BDs.

Impact

As of December 31, 2018, 3,764 BDs were registered with the SEC, either as standalone BDs or as dually registered entities. The SEC believes that approximately 2,766 BDs have retail customers and therefore would be subject to Reg BI and the amendments under Rules 17a-3(a)(35) and 17a-4(e)(5). Further, based on FOCUS Report data, the SEC estimates that as of December 31, 2018, approximately 985 BDs may be deemed small entities under the Regulatory Flexibility Act, and would therefore be exempt from Reg BI. Of these, approximately 756 have retail business. Therefore, it is estimated that 2,010 BDs would qualify as large BDs with retail customers.

As with BDs, Reg BI imposes a best interest obligation on natural persons who are associated persons of BDs when making recommendations of any securities transaction or investment strategy involving securities to retail customers. The SEC believes that approximately 428,404 associates would account for registered retail representatives, and would therefore be subject to Reg BI.

Further, rule 17a-3 requires a BD to make and keep current certain records, which the SEC now plans to amend by adding a new paragraph (a)(35) to implement new record making obligations on BDs subject to Reg BI. Rule 17a-4 requires a BD to preserve certain records if it makes or receives them. The SEC is amending Rule 17a-4(e)(5) to impose new record retention obligations on BDs subject to Reg BI.

The obligations under Reg BI combined with the amendments under Rule 17a-3(a)(35) and Rule 17a-4(e)(5) will create increased costs to obtain and secure this additional information for BDs subject to these new rules. Depending on the size and structure of the BD, the amount of costs could vary greatly.

The overall purpose of Reg BI is to protect investors and provide them with some level of comfort that RIAs, BDs and all associated persons have their best interest in mind at all times. Still, critics who feel the regulation does not go far enough to protect investors are threatening lawsuits and are claiming that it is simply a relaxed version of the Department of Labor (“DOL”) planned fiduciary rule. They note that it doesn’t define what “best interests” or “conflicts of interest” really mean or offer guidance on measures brokers need to take to fulfill the rule’s requirements.  Further, the SEC didn’t vote on a proposed provision that would have prohibited brokers from calling themselves “financial advisors,” which causes more confusion among investors. Several states, including Nevada and New Jersey, have proposed regulations which would require BDs and their registered representatives to act as fiduciaries. In order to assist firms with planning for compliance with these new rules, the SEC is establishing an Inter-Divisional Standards of Conduct Implementation Committee, comprised of representatives from the Division of Investment Management, Division of Trading and Markets, Division of Economic and Risk Analysis, Office of Compliance Inspections and Examinations, and Office of the General Counsel.  Regardless of what becomes of these efforts, firms only have a little over a year to comply with Reg BI. While it looks to be burdensome and costly, especially for smaller BDs, it is important that firms begin developing the processes and procedures necessary to address these new regulations.

Author: Joseph Fede, CPA  |  jfede@withum.com

Broker-Dealers Services
 

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