All things come to those who wait … even Regulation Best Interest (colloquially known as Reg BI). In what now feels like a lifetime since the Securities and Exchange Commission (SEC) adopted it (believe it or not, it was only adopted on June 5, 2019), Reg BI has now passed its compliance date of June 30, 2020. This article aims to provide a brief overview of Reg BI and decipher its implications for brokers and broker-dealers. It will also provide an overview of a recent Risk Alert drafted by the SEC’s Office of Compliance Inspections and Examinations (OCIE), and examine the SEC’s and the Financial Industry Regulatory Authority’s (FINRA’s) review of Reg BI compliance.

The Question You Might Have Been Afraid to Ask: So, What Is Reg BI?

Reg BI is the SEC’s new standard of care for broker-dealers. It displaces the suitability standard and governs investment recommendations broker-dealers and their registered representatives make to retail customers. Namely, the broker-dealer must act in the best interest of the retail customer, without placing his or her financial interests ahead of the customer.

That Sounds Amorphous…

Like any general standard, it certainly does. Luckily, the SEC has provided some guidance. There are four general obligations a broker-dealer must satisfy to meet Reg BI’s requirements: (1) the disclosure obligation, (2) the care obligation, (3) the conflict of interest obligation and (4) the compliance obligation.¹ The broker-dealer also must comply with new record-making and record-keeping requirements.

The Disclosure Obligation: Sunlight Is the Best Disinfectant

The broker must — prior to or at the time of the recommendation — provide a written disclosure of (1) all material facts relating to the scope and terms of his or her relationship with the customer and (2) all material facts concerning conflicts of interest relating to the recommendation.

Let’s break that down.

“Scope and Terms of the Relationship”: 

A proper disclosure should include:

• All material fees and costs

• The type and scope of services to be provided, including any material limitations

• A general basis for any recommendations

• Risks concerning the recommendation

• Whether there are any special account requirements (e.g., a minimum account balance)

• Any other unique material facts associated with that particular customer’s investment.

“Conflicts of Interest”: 

A conflict of interest is “an interest that might incline a broker, a dealer, or a natural person who is an associated person of a broker or dealer — consciously or unconsciously — to make a recommendation that is not disinterested.”² Conflicts of interest include receiving payments from third parties. Brokers should actively examine their individual situations to make such a determination.

The Care Obligation

A broker needs to use reasonable diligence, care and skill when making a recommendation. The care requirement has three essential features, as outlined below. As is evident, none of these features is particularly groundbreaking, and most brokers likely already consider them.

• Understand potential risks, rewards and costs associated with the recommendation. Among other things, the broker must consider the investment strategy’s objectives, characteristics, liquidity, volatility, likely performance and expected return.

• Have a reasonable basis to believe the recommendation is in the customer’s best interest based on their investment profile and the potential risks, rewards and costs. The broker must consider the customer’s investment profile, which includes a litany of considerations. Age, other investments, liquidity needs, tax status, risk tolerance, experience, investment experience and time horizon all should be considered. This standard seems familiar because it is similar to FINRA’s present Customer Suitability Rule.³

• Have a reasonable basis to believe that a series of recommended transactions is not excessive. While this rule appears similar to the existing FINRA Quantitative Suitability Rule,⁴ it differs because it does not require a broker to have “actual or de facto control over a customer’s account” at issue. To satisfy this rule, brokers should consider the particular recommended trade in light of other trades the customer has been making. The recommendation cannot be viewed in isolation. This is especially true if a broker is recommending a riskier product. The idea here is that brokers should — but not only — view the recommended product within the series of proposed investments. In other words, the broker should examine each investment in isolation and as a whole.

The Conflict of Interest Obligation

A broker-dealer must create and enforce a series of written policies to address conflicts of interest. This is solely the responsibility of the broker-dealer. To this end, the written policies must (1) identify and disclose all conflicts of interest; (2) identify and mitigate conflicts of interest where a broker-dealer has incentive to place its interest before the client’s; (3) identify any material limitations a broker-dealer has, such as a limited products menu; (4) identify and eliminate certain sales practices — such as quotas or bonuses — that are predicated on a broker’s sale of specific securities.

There are a number of pitfalls that a broker-dealer should avoid. These include setting compensation thresholds that “disproportionately increase compensation through incremental increases in sales” and “minimizing compensation incentives for employees to favor one type of account over another.”⁵ The broker-dealer also should consider limiting the types of customers to whom a specific type of product is sold. Similarly, the broker-dealer might prefer to limit the number of brokers who sell certain types of products. While the broker-dealer is responsible for written supervisory procedures and their enforcement, the broker is responsible for managing his personal conflicts of interest. Therefore, a broker-dealer could consider penalizing brokers who fail to properly manage conflicts of interest.

The Compliance Obligation

Broker-dealers must keep and enforce written policies and procedures to comply with Reg BI as a whole. Like the conflict of interest obligation, this requirement applies only to broker-dealers. The SEC has been vague on exactly what is required, but firms should consider creating policies that “prevent violations from occurring, detect violations that have occurred, and correct promptly any violations that have occurred.”⁶ As part of this obligation, firms should develop controls, training and periodic reviews of the effectiveness of their policies.

Record-Making and Recordkeeping

Firms also must develop certain new record practices (if not already in place). For example, firms must keep records of all customers to whom any securities recommendation is made. Firms also would have to keep a record of the individuals responsible for each account. These records need to be kept for at least six (6) years from the date the account is closed or information within the account is updated, whichever is earliest.

Don’t Forget about Form CRS

Form Client Relationship Summary (Form CRS) also has a scheduled compliance date of June 30.⁷ SEC registered investment advisers and broker-dealers will have to provide to retail customers certain information about their firm, and a firm’s Form CRS must be filed with the SEC. Form CRS must contain information about, among other things, its (1) relationships and services; (2) fees, costs, conflicts and standard of conduct; and (3) disciplinary history. Form CRS must be delivered to new clients and existing clients. Broker-dealers must file their initial relationship history with the SEC no later than June 30, 2020.

Exam Time: The OCIE Weighs in on Broker-Dealer Compliance

 On April 7, 2020, the OCIE issued a Risk Alert⁸ providing guidance for the SEC’s post–June 30, 2020, examinations of firms’ compliance with Reg BI. The Risk Alert advised that “OCIE is providing transparency into its plans regarding Regulation Best Interest examinations to empower broker-dealers to assess their level of preparedness as the compliance date nears.” OCIE’s alert and guidance aligns with Reg BI’s four obligations. OCIE advised that it may assess specific disclosures regarding (1) the capacity in which the recommendation is being made; (2) the material fees and costs that apply to transactions, holdings and accounts; and (3) material limitations on the securities or investment strategies.

OCIE specifically advised that it may review the following types of firm documents:

• Schedules of fees and charges assessed against retail customers and disclosures regarding such fees and charges, including disclosures regarding the fees and costs related to services and investments that retail customers will pay or incur directly and indirectly

• The broker-dealer’s compensation methods for registered personnel, including (1) compensation associated with recommendations to retail customers, (2) sources and types of compensation, and (3) related conflicts of interest (e.g., conflicts associated with recommending proprietary products or with receiving payments for inclusion on a product menu)

• Disclosures related to monitoring of retail customers’ accounts

• Disclosures on material limitations on accounts or services recommended to retail customers

• Lists of proprietary products sold to retail customers.

The OCIE also specifically addressed its efforts to assess compliance with the care obligation. Namely, the OCIE may review, among other things:

• Information collected from retail customers to develop their investment profiles

• How the broker-dealer makes recommendations related to significant investment decisions

• The broker-dealer’s process for having a reasonable basis to believe that the recommendations are in the best interest of the retail customer:

• The factors the broker-dealer considers to assess the potential risks, rewards and costs of the recommendations in light of the retail customer’s investment profile

• The broker-dealer’s process for having a reasonable basis to believe that it does not place the financial or other interest of the broker-dealer ahead of the interest of the retail customer.

Overall, OCIE stated that “initial examinations will focus on assessing whether firms have made a good faith effort to implement policies and procedures reasonably designed to comply with Regulation Best Interest, including the operational effectiveness of broker-dealers’ policies and procedures.⁹” This “good faith” assessment is important; it allows firms a reasonable explanation for any work impacted by the pandemic or perhaps other resource constraints to present proactively to OCIE staff or in response to a finding or a significant deficiency.

So, what is the status of Reg BI?

On Friday, June 25, 2010, the Second Circuit Court of Appeals upheld Reg BI.¹⁰ Living up to the quip that “marriages make strange bedfellows,” challengers to Reg BI were investment advisers who were joined by several states attorneys’ general. The investment advisers argued that Congress required the SEC to “harmonize” the investment adviser and broker-dealer regulatory regimes. The attorneys’ general argued that Reg BI is contrary to law and exceeds the SEC’s authority. The petitioners articulated the view that Reg BI provides less protection than the suitability rule. The SEC countered by arguing that the Dodd-Frank Act provided them with discretionary authority to develop their own set of standards and rules.

In denying the challenge to Reg BI, the Second Circuit held:

Petitioners — an organization of investment advisers, an individual investment adviser, seven states, and the District of Columbia — now challenge Regulation Best Interest as unlawful under the Administrative Procedure Act (APA), 5 U.S.C. § 706(2). They argue that the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) requires the SEC to adopt a rule holding broker-dealers to the same fiduciary standard as investment advisers. But Section 913(f) of the Dodd-Frank Act grants the SEC broad rulemaking authority, and Regulation Best Interest clearly falls within the discretion granted to the SEC by Congress. Although Regulation Best Interest may not be the policy that Petitioners would have preferred, it is what the SEC chose after a reasoned and lawful rulemaking process.

We thus hold that: (1) the individual investment-adviser petitioner has Article III standing to bring its petition for review, but the state petitioners do not; (2) Section 913(f) of the Dodd-Frank Act authorizes the SEC to promulgate Regulation Best Interest; and (3) Regulation Best Interest is not arbitrary and capricious under the APA. [Footnote omitted].¹¹

The SEC Commissioner publicly stated that he did not intend to change the June 30 date. Nothing in the Second Circuit Court’s opinion indicated a change would be necessary. And in fact, June 30 has come and gone and the Reg BI enforcement date stayed firm.

True to its word, the SEC has begun examining for Reg BI compliance. The SEC and FINRA are looking into efforts made by broker-dealers to comply with Reg BI and are comparing what is being done today with what was done historically. They are reviewing written supervisory procedures and training programs and, of course, the disclosures made to the public. It also is likely that over the next several months they will continue to look at compliance efforts and at efforts by broker-dealers to tweak their disclosure and training to better inform and service their clients.

1. https://www.sec.gov/info/smallbus/secg/form-crs-relationship-summary. As it must, this article draws extensively from the SEC’s guidance.

2. Id.

3. See FINRA Rules 2111 Supplemental Material .05, which can be found at www.finra.org/rules-guidance/rulebooks/finra-rules/2111#the-ruleand FINRA Rules & Guideline: Key Topics, which can be found at www.finra.org/rules-guidance/key-topics/suitability.

4. Id.

5. Id.

6. Id.

7. See https://www.sec.gov/info/smallbus/secg/form-crs-relationship-summary.

8. https://www.sec.gov/files/Risk%20Alert-%20Regulation%20Best%20Interest%20Exams.pdf.

9. Id.

10. XY Planning Network, LLC, Ford Financial Solutions, LLC, State of New York, State of California, State of Connecticut, State of Delaware, State of Maine, District of Columbia, State of New Mexico And State of Oregon, v. United States Securities and Exchange Commission, Walter Clayton, In His Official Capacity As Chairman of the United States Securities and Exchange Commission, Case 19-2886 (argued June 2, 2020, and decided June 26, 2020). The Decision can be found at https://assets.documentcloud.org/documents/6958594/Xy-Main-Op.pdf..

11. Id.