Regulation Best Interest: An Overview of the Requirements

The SEC has issued its final Regulation Best Interest (Reg BI), Form CRS Regulation, RIA Interpretation and Solely Incidental Interpretation. I am discussing the SEC’s guidance in a series of articles entitled “Best Interest Standard of Care for Advisors.”

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The SEC’s Reg BI establishes a best interest standard of care for investment recommendations to retail customers by broker-dealers and their registered representatives. In addition, Reg BI requires new disclosures and mitigation of advisor’s financial conflicts of interest. The SEC also issued an Interpretation of the Standard of Conduct for Investment Advisers, which clarified the SEC’s position on a number of issues related to the fiduciary standard and conflicts of interest for RIAs. There were two other pieces of guidance: the Form CRS Regulation (which requires a simplified front-end disclosure by broker-dealers and investment advisers); and the Solely Incidental Interpretation for limited discretion and monitoring of accounts by broker-dealers.

My last two posts, Best Interest for Advisors #9 and #10, focused on the requirement in Reg BI that a recommendation to a retail customer must include consideration of the cost of the investment or strategy. I started with that issue because I believe that it will be highly impactful over the long run. However, this article starts at the beginning . . . an overview of the changes made by Reg BI. In the release to the final regulation, the SEC explained Reg BI’s requirements (applicable on June 30, 2020):

“When making a recommendation, a broker-dealer must act in the retail customer’s best interest and cannot place its own interests ahead of the customer’s interests (hereinafter, ‘‘General Obligation’’). The General Obligation is satisfied only if the broker-dealer complies with four specified component obligations. The obligations are:

1. Providing certain prescribed disclosure 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. Exercising reasonable diligence, care, and skill in making the recommendation (‘‘Care Obligation’’);
3. Establishing, maintaining, and enforcing policies and procedures reasonably designed to address conflicts of interest (‘‘Conflict of Interest Obligation’’), and
4. Establishing, maintaining, and enforcing policies and procedures reasonably designed to achieve compliance with Regulation Best Interest (‘‘Compliance Obligation’’).

In each of those four areas the SEC has imposed heightened requirements on broker-dealers, which will in turn impact advisors. This article now looks at one of those “Obligations”—the duty of care. The Care Obligation is described, in part, as:

Care obligation. The broker, dealer, or natural person who is an associated person of a broker or dealer, in making the recommendation, exercises reasonable diligence, care, and skill to: . . . Have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks, rewards, and costs associated with the recommendation and does not place the financial or other interest of the broker, dealer, or such natural person ahead of the interest of the retail customer; . . .

I highlighted four parts of the regulatory section for emphasis and discussion.

First, the broker-dealer and advisor must act with “reasonable diligence, care, and skill” to develop the recommendation. That is similar to the DOL’s prudent man rule for fiduciaries, which requires care, skill, diligence and prudence. The SEC dropped the word “prudence,” but then went on to say that “diligence, care, and skill” has the same meaning as if the word “prudence” was included. In other words, from the SEC’s perspective, the standard is similar to the prudent man rule applied on a transactional basis (that is, applied at the time of the recommendation of covered transactions). This standard—which the SEC says is based on fiduciary principles-would require a process of gathering information about the investor, and consideration the available account-types and investments (including factors such as costs and risk), appears to be very much like the prudent process required by ERISA for retirement plan recommendations. For this part of the Obligations, the focus should be on the process used by the advisor and the broker-dealer.

The second part is that the recommendation must be in the “best interest” of the retail customer. However, it’s not possible to determine what is “best”, and unfortunately the SEC didn’t define that standard (other than to say that it didn’t require selection of the single best investment). Based on my review of the full Reg BI rule and release, I believe that its meaning is similar to “prudent”, in the sense that, if a rigorous process is followed to identify the superior alternatives and reasonable costs, a number of qualifying options (e.g., mutual funds) can be identified as being “prudent,” that is, in the best interest of the customer. However, if the number of alternatives examined for this purpose is limited, it may be that the process will reveal than none of the limited group can be recommended under the best interest standard, even though some of the limited group are better than the others.

The third part is about the “retail customer’s investment profile and the potential risks, rewards and costs”.  While the process requires a diligent, careful and skillful analysis of the relevant information, the retail customer’s profile is starting point for the information that needs to be considered in the process. Once the needs and circumstances of the retail customer have been identified based on the profile, the advisor needs to consider the account-types and investments that are reasonably available for that customer, and factors such as costs, risk and rewards of the alternatives based on the particular customer’s needs and circumstances.

The last part is that the broker-dealer and the advisor cannot put their interests ahead of the retail customer’s. This is, unfortunately, something that can be easily identified after the fact, but hard to describe before the fact. A violation could result from recommending mediocre proprietary mutual funds or recommending higher compensating alternatives when comparable options are available to the investor at a lower cost.

Concluding Thoughts

The Care Obligation will increase the legal standard for recommendations to retail customers by broker-dealers and advisors. But, for those advisors who have focused on providing good advice to their customers, and used high quality and reasonably priced investments, there will be little change in how they do business. In that case, the burden will fall primarily on the broker-dealer to develop best interest processes, policies and procedures, and supervisory practices.

The material contained in this communication is informational, general in nature and does not constitute legal advice. The material contained in this communication should not be relied upon or used without consulting a lawyer to consider your specific circumstances. This communication was published on the date specified and may not include any changes in the topics, laws, rules or regulations covered. Receipt of this communication does not establish an attorney-client relationship. In some jurisdictions, this communication may be considered attorney advertising.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Faegre Drinker.