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Regulation Best Interest Sets a New Bar for Broker Dealers

by | Sep 22, 2020 | Securities

The COVID-19 pandemic may have put a damper on business activity this summer, but it didn’t motivate the U.S. Securities and Exchange Commission to delay the June 30th compliance deadline for Regulation Best Interest.

SEC Regulation Best Interest, which became effective September 10, 2019, establishes a new standard of conduct for broker-dealers and their registered representatives to act in the best interest of a retail customer when they make recommendations about any securities transaction or investment strategy, without placing the broker-dealer’s financial or other interest ahead of the retail customer’s interest.

In general, broker-dealers take orders from clients and buy and sell securities for them for a commission. Though they are required by the Financial Industry Regulatory Authority (FINRA) to recommend “suitable” transactions to customers, they are not required to always act in a client’s best interests. This is a distinct difference from registered investment advisers (RIAs), who are obligated under the Investment Advisers Act of 1940 to always act in the best interest of their clients. Their fiduciary duty requires disclosure of conflicts of interest and fees that might influence their decision-making.  Such disclosure was not affirmatively required for broker-dealers prior to Regulation Best Interest, a perceived deficiency that helped stoke the adoption of new rules.

NEW OBLIGATIONS

Regulation Best Interest creates a series of four new obligations for broker-dealers to comply with in order to adhere to the ‘best interest’ conduct standard. Briefly, the new obligations include:

1) Disclosure Obligation. At the time of a recommendation, brokers must now inform clients in writing “all material facts about the scope and terms of its relationship with the customer.” This includes disclosing: the fact that the firm or representative is acting in a broker-dealer capacity; any material fees and costs the costumer will incur; and the type and scope of services to be provided. The broker-dealer must also disclose all material facts relating to conflicts of interest associated with a recommendation, including, for example, compensation arrangements and payments from third parties.  Notably, broker-dealers may not refer to themselves “financial advisors” if they are not bound by a fiduciary standard, like those governing registered investment advisors. (A number of broker-dealers also are registered as investment advisers, and will be able to continue calling themselves financial advisers provided they adhere to other aspects of the Disclosure Obligation.)

2) Care Obligation. A broker-dealer must “exercise reasonable diligence, care, and skill when making a recommendation to a retail customer.” The broker-dealer must understand potential risks, rewards, and costs associated with the recommendation and consider those risks, rewards, and costs in light of the customer’s investment profile. The broker-dealer must also have a reasonable basis to believe that the recommendation is in the customer’s best interest and does not place the broker-dealer’s interest ahead of the retail customer’s interest. Further, “whether a broker-dealer has complied with the Care Obligation will be evaluated as of the time of the recommendation (and not in hindsight). When recommending a series of transactions, the broker-dealer must have a reasonable basis to believe that the transactions taken together are not excessive, even if each is in the customer’s best interest when viewed in isolation.”

3)  Conflict of Interest Obligation. A broker-dealer must establish, maintain and enforce written policies and procedures addressing conflicts of interest associated with its recommendations to retail customers. These must be reasonably designed to identify all such conflicts and at a minimum disclose or eliminate them. “Importantly, the policies and procedures must be reasonably designed to mitigate conflicts of interests that create an incentive for an associated person of the broker-dealer to place its interests or the interest of the firm ahead of the retail customer’s interest,” the SEC said. Conflict policies must be reasonably designed to disclose the limitations and associated conflicts and to prevent the limitations from causing the associated person or broker-dealer from placing the associated person’s or broker-dealer’s interests ahead of the customer’s interest. They also should identify and eliminate sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sale of specific securities or specific types of securities within a limited period of time.

4) Compliance Obligation. A broker-dealer must also establish, maintain and enforce policies and procedures established to meet the obligations of Regulation Best Interest. A broker-dealer’s policies and procedures must address not only conflicts of interest but also compliance with its disclosure and care obligations.

FORM CRS REQUIRED

The new regulation also requires that broker-dealers and registered investment advisers disclose information about their firms in a Form CRS  (Client Relationship Summary) and provide that document to clients.

A Form CRS includes information about:

  • the types of services a firm offers;
  • the fees and costs related to services;
  • conflicts of interest a broker-dealer or RIA may have;
  • the required standard of conduct associated with the services a firm offers
  • whether a firm and its financial professionals have reportable legal or disciplinary history;
  • key questions a customer might ask of a financial professional.

The CRS Form requirement and the other new standards established by the SEC are designed, the agency said, to “align the standard of (broker-dealer) conduct with retail customers’ reasonable expectations.” They are the product of a two-year process that included input from the securities industry and investors.

Not all are happy with Regulation Best Interest.  Democrats in Congress have said they want tougher standards, and if the Senate and White House change hands in November, standards and obligations for broker-dealer conduct with retail customers may be revisited.

For now, however, broker-dealers and financial advisors should be aware of the changes and act accordingly to meet their new obligations. To learn more about how Kaplan Voekler Cunningham & Frank can assist your firm, contact us.