The Fiduciary Governance Group has been closely tracking the standard of conduct rulemaking developments out of the Securities and Exchange Commission (“Commission”), Department of Labor (“DOL”), Office of the Comptroller of the Currency, and the states. This new client alert, A Guide to Regulation Best Interest, complements our prior analysis of the SEC rulemaking, particularly our overview of the rulemaking, our analysis of the practical implications of the Investment Adviser Interpretive Release, and our discussion of Form CRS. On July 9 at 2 p.m. (EDT), the Fiduciary Governance Group will host a one-hour webcast where we will examine the SEC rulemaking in its entirety.

On June 5, 2019, the Commission adopted a package of rulemakings and interpretations designed to “enhance and clarify the standards of conduct applicable to broker-dealers and investment advisers, help retail investors better understand and compare the services offered and make an informed choice of the relationship best suited to their needs and circumstances, and foster greater consistency in the level of protections provided by each regime, particularly at the point in time that a recommendation is made.”¹ Arguably, the most potentially impactful element of this package is the new Regulation Best Interest, which the Commission adopted as Rule 15l-1 under the Securities Exchange Act of 1934 (“Exchange Act”).

Regulation Best Interest imposes a new federal conduct standard on registered broker-dealers and their associated persons who are natural persons (“Representatives”) when making securities transaction or related investment strategy recommendations to their retail customers. Specifically, it requires that a broker-dealer or Representative, when making a covered recommendation, act in the retail customer’s best interest and not place its own interests ahead of the customer’s interests (“General Conduct Obligation”). To satisfy this General Conduct Obligation, a broker-dealer must satisfy each and every one of the following four core component obligations: (1) provide certain prescribed material disclosures before or at the time of the recommendation about the recommendation and the relationship between the retail customer and the broker-dealer (“Disclosure Obligation”); (2) exercise reasonable diligence, care, and skill in making the recommendation (“Care Obligation”); (3) establish, maintain, and enforce policies and procedures reasonably designed to address conflicts of interest (“Conflict of Interest Obligation”); and (4) establish, maintain, and enforce policies and procedures reasonably designed to achieve compliance with Regulation Best Interest (“Compliance Obligation”) (collectively, “Component Obligations”). Thus, a failure to satisfy any single one of the Component Obligations constitutes a violation of Regulation Best Interest.

In adopting Regulation Best Interest, the Commission ultimately “declined to subject broker-dealers to a wholesale and complete application of the existing fiduciary standard under the Adviser Act because it is not appropriately tailored to the structure and characteristics of the broker-dealer business model (i.e., transaction-specific recommendations and compensation), and would not properly take into account, and build upon, existing obligations that apply to broker-dealers . . . . ”² Moreover, in the Commission’s view, “this approach would significantly reduce retail investor access to differing types of investment services and products, reduce retail investor choice in how to pay for those products and services, and increase costs for retail investors of obtaining investment recommendations.”³ Instead, the enhancements contained in Regulation Best Interest “are designed to improve investor protection by enhancing the quality of broker-dealer recommendations to retail customers and reducing the potential harm to retail customers that may be caused by conflicts of interest.”⁴ Together with the other elements of the rulemaking and interpretive package, Regulation Best Interest also was designed to help retail customers better understand and compare the services offered by broker-dealers and investment advisers and make an informed choice of the relationship best suited to their needs and circumstances, provide clarity with respect to the standards of conduct applicable to investment advisers and broker-dealers, and foster greater consistency in the level of protections provided by each regime, particularly at the point in time that a recommendation is made.

This Client Alert provides an overview of Regulation Best Interest. The Alert is divided into five sections. Section I discusses Regulation Best Interest generally. Section II discusses at some length each of the four Component Obligations that must be satisfied to demonstrate compliance with Regulation Best Interest. Section III examines a number of other important collateral issues under and related to Regulation Best Interest. Section IV discusses required records and recordkeeping related to Regulation Best Interest. Finally, Section V provides a suggested framework for ensuring that registered broker-dealers are fully compliant with Regulation Best Interest on or before the fast-approaching compliance date of June 30, 2020.

Key Takeaways

• Regulation Best Interest requires that a broker-dealer or its Representative, when making a recommendation, act in the retail customer’s best interest and not place its own interests ahead of the customer’s interests, which is satisfied only if the broker-dealer or Representative complies with the four specified component obligations, referred to as the Disclosure Obligation, the Care Obligation, the Conflict of Interest Obligation, and the Compliance Obligation.
• Regulation Best Interest applies to broker-dealers and Representatives that make recommendations of securities transactions and investment strategies to retail customers. Recommendations include recommendations of account types and rollovers or transfers of assets (e.g., to roll over or transfer assets in a workplace retirement plan to an individual retirement account). Recommendations also include implicit hold recommendations resulting from agreed-upon account monitoring.
• A retail customer is a natural person (or legal representative) who receives a recommendation and uses it primarily for personal, family or household purposes. There is no carve-out for wealthy individuals, so Warren Buffett is a retail customer, assuming his brokerage services are not for commercial or business purposes.
• With limited exceptions (e.g., for commodity trading advisors), a broker-dealer or Representative cannot use the title “adviser” or “advisor” unless that person is also an investment adviser or a supervised person of an investment adviser. The rationale is that the title would be inconsistent with the disclosure of the capacity in which the person acts.
• Before or at the time of the recommendation, a broker-dealer or Representative must disclose, in writing, all material facts about the scope and terms of its relationship with the customer and all material facts relating to conflicts of interest that are associated with the recommendation.
• A broker-dealer or Representative must exercise reasonable diligence, care, and skill when making a recommendation to a retail customer. The broker-dealer or Representative must understand potential risks, rewards, and costs associated with the recommendation. While costs must always be considered in making a recommendation, they should be considered in light of other factors and the retail customer’s investment profile; there is no requirement to recommend only the lowest cost option.
• When recommending a series of transactions, the broker-dealer or Representative 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.
• A broker-dealer must establish, maintain, and enforce reasonably designed written policies and procedures addressing conflicts of interest associated with 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.
• The policies and procedures must be reasonably designed to mitigate conflicts of interests that create an incentive for an associated person to place his or her interests or the interest of the firm ahead of the retail customer’s interest.
• Where a broker-dealer places material limitations on recommendations (e.g., offering only proprietary or other limited range of products), the policies and procedures must be reasonably designed to disclose the limitations and associated conflicts and to prevent the limitations from causing the associated person or broker-dealer to place the person’s or the firm’s interests ahead of the customer’s interest.
• Sales contests, sales quotas, bonuses, and non-cash compensation are prohibited if they are based on (1) the sale of specific securities or specific types of securities (2) within a limited period of time. Other incentives and practices that are not explicitly prohibited are permitted, provided that the broker-dealer establishes reasonably designed policies and procedures to disclose and mitigate the incentive created to the Representative, and the Care and Disclosure Obligations are complied with.
• A broker-dealer must establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Regulation Best Interest as a whole. Thus, a broker-dealer’s policies and procedures must address not only conflicts of interest but also compliance with its Disclosure and Care Obligations.
• Compliance with Regulation Best Interest will not alter a broker-dealer’s obligations under the general antifraud provisions of the federal securities laws. Regulation Best Interest applies in addition to any applicable securities laws and regulations. Read more...

Information contained in this publication should not be construed as legal advice or opinion or as a substitute for the advice of counsel. The articles by these authors may have first appeared in other publications. The content provided is for educational and informational purposes for the use of clients and others who may be interested in the subject matter. We recommend that readers seek specific advice from counsel about particular matters of interest.

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