Broker-Dealers are no strangers to the volume of complex rules and standards that regulate the wealth management industry. Maintaining an understanding of and abiding by these rules to ensure compliance requires time and money but is often misunderstood as simply the cost of doing business. However, one recently introduced piece of legislation is turning out to be the most significant and overarching change to hit the industry in a very long time.
The SEC’s updated standard of conduct for investment professionals rulemaking package entered into its compliance period on June 30, 2020. Regulation Best Interest, or “Reg BI” raises the level of responsibility that Broker-Dealers and their registered representatives have to demonstrate that they’re acting in their client’s best interest; similar to the DOL’s Fiduciary Rule of 2016, only Reg BI stops short of naming Brokers as fiduciaries. And maintaining compliance by this nebulous rule is necessary to avoid fines and penalties. So, what exactly does Reg BI entail?
What is Reg BI?
Officially, Reg BI requires Broker-Dealers and their representatives to, “Act in the best interest of the retail customer at the time a recommendation is made, without placing the financial or other interest of the broker, dealer or natural person who is an associated person of a broker or dealer making the recommendation ahead of the interest of the retail customer.”
It is important to note that Reg BI only applies to individuals when they are acting as a Broker. As it pertains to the rulemaking package, financial professionals acting as an Investment Adviser have complied with the new standard of conduct once they have provided the Form CRS, a brief document that summarizes the relationship between the adviser and the customer. The adviser becomes a fiduciary at that point and is subject to the Investment Adviser Act of 1940’s jurisdiction. However, when acting as a Broker, Reg BI is triggered and requires that financial professionals and their representatives meet four obligations: Disclosure, Care, Conflicts of Interest and Compliance.
So, what do these obligations mean exactly? And how can Brokers and advisors assure that they meet each one?
This exact requirement is that “Prior to or at the time of a recommendation, a Broker-Dealer or rep must provide the retail customer with a written disclosure of all material facts relating to the scope and terms of the relationship.” Therefore, in addition to providing the retail investor with Form CRS, if Reg BI is triggered, additional disclosures covering the scope of services, fees, conflict of interest, and title must also be provided. These must be provided at the time of the recommendation and on an ongoing basis with each recommendation. This detail is very important. Just because the Reg BI disclosures are provided when the account is opened does not mean the Broker has met this obligation. Brokers must make ongoing material facts disclosures with every single recommendation.
This requires that the Broker-Dealer or associated person use reasonable diligence, care, and skill to meet three obligations:
The SEC states that while cost is important, other factors to consider include characteristics and unique or unusual features, liquidity, risks and potential benefits, volatility, expected return of the security or investment strategy, any financial incentives to recommend the security or investment strategy, and other reasonably available alternatives.
This is essentially the same obligation covered by FINRA’s suitability rule 2111, except the Broker must believe the transaction is in the client’s best interest, instead of merely suitable for the client. This obligation assumes the Broker has obtained all material facts about the client including suitability information, age, financial situation, risk tolerance, etc.
So, where previously an expensive high commission product may have been suitable for the client and thus covered by FINRA’s suitability rule, now the Broker must prove that a more expensive security is in the client’s best interest, given other readily available options. This is certainly possible but requires thorough documentation. Additionally, this obligation must be met for any recommendation throughout the relationship with the customer. Not just upon initial portfolio construction or at the time an account is opened.
This obligation essentially prohibits churning in an account to increase a representative’s fees. Recommendations on transactions must be reasonable and not excessive. Again, documentation will be necessary to prove why a series of trades was made, and why these trades are not excessive in nature.
Conflicts of Interest
This obligation applies only to the Broker-Dealer at the firm level, and requires Broker-Dealers to take steps to disclose, reduce the effect of, and in some cases, eliminate conflicts that would create an incentive to put the Broker-Dealer’s interest ahead of those of the customer when making a recommendation that falls under Reg BI’s Disclosure obligation.
Essentially, this eliminates any sales contests, quotas, paying more for specific products to incentivize sales of those products, etc.
Also only applying to the Broker-Dealer at the firm level, this obligation requires that the Broker-Dealer must establish, maintain, and enforce written policies and procedures designed to achieve compliance with Reg BI as a whole.
This obligation is a catch-all for regulators if they feel that firms aren’t implementing the appropriate procedures to follow these rules.
Reg BI is a significant change to the way financial professionals must operate, and it merits every Broker’s careful consideration in order to update processes accordingly and maintain compliance. Yet, while it is a lot to understand, Reg BI is only one of four parts to the SEC’s standard of conduct rulemaking package.
If you have questions about Reg BI, or any other part of the SEC rulemaking package, L.M. Kohn can help. Please feel free to contact us today.