Best Interest Standard of Care for Advisors #12

Regulation Best Interest: An Overview of the Changes.

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.”

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.

A starting point for understanding the requirements of Reg BI (which are applicable on June 30, 2020) is to compare it to existing standards, e.g., the suitability rule. In its release for the final regulation, the SEC did just that. Here it is in the SEC’s words (with my comments added):

“Regulation Best Interest is designed to improve investor protection by:

  • Requiring broker-dealers to have a reasonable basis to believe that recommendations are in the retail customer’s best interest, which enhances existing suitability obligations by:
    • requiring compliance not only with the explicit Care Obligation, but also with Disclosure, Conflict of Interest, and Compliance Obligations; 
    • expressly requiring consideration of cost in evaluating a recommendation as part of the Care Obligation; 
    • expressing our views regarding the consideration of reasonably available alternatives when making a recommendation as part of the Care Obligation; 
    • applying Regulation Best Interest to recommendations of account types and rollovers and to any recommendations resulting from agreed-upon account monitoring services (including implicit hold recommendations); and, 
    • applying the Care Obligation to a series of recommended transactions (currently referred to as ‘‘quantitative suitability’’) irrespective of whether a broker-dealer exercises actual or de facto control over a customer’s account;”

Comment: These enhancements will be discussed in more detail in other articles. However, several major points are:

  • the Best Interest standard is higher than suitability, for example, it requires a careful, skillful and diligent process to develop a recommendation;
  • the Care Obligation requires that costs be considered in all recommendations;
  • the Care Obligation applies to the recommendation of the appropriate account type to retail customers (in addition to applying to the recommendations of investments and investment strategies).

The cumulative effect of those changes, if implemented as intended, will add to the quality and lower the costs of recommendations to retail customers.

  • requiring broker-dealers to establish, maintain, and enforce written policies and procedures reasonably designed to mitigate (and in some cases, eliminate) certain identified conflicts of interest that create incentives to make recommendations that are not in the retail customer’s best interest; these new requirements are a significant and critical enhancement as existing requirements under the federal securities laws largely center upon conflict disclosure rather than conflict mitigation;

Comment:  The requirement to eliminate the types of sales contests that could materially affect the quality of the recommendations to retail customers is a significant change from some existing practices. Even more significant is the requirement to “mitigate” the incentives for individual advisors. However, mitigation is in the eye of the beholder. The ultimate impact will depend on how the SEC enforces the rule. If the mitigation practices of broker-dealers actually dampen the incentive to give advice that favors the advisor over the retail customer, this could be one of the most significant changes in the new rules. Since there is flexibility for broker-dealers to develop their mitigation measures, there is both opportunity and risk. The opportunity is that broker-dealers can design mitigation strategies that reflect their business models and cultures; the risk is that the SEC or FINRA may, upon examination, determine that the strategies are inadequate to properly mitigate the incentives. There is at least a chance that the SEC will try to set examples through their examination and enforcement activities after the rules apply.

  • requiring disclosure under the Disclosure Obligation of the material facts relating to the scope of terms of a broker-dealer’s relationship with the retail customer and the conflicts of interest associated with a broker-dealer’s recommendations, which will foster retail customers’ understanding of their relationship with the broker-dealer and help them to evaluate the recommendations received; and 

Comment: Unfortunately, the guidance on disclosures is not entirely clear. As a result, broker-dealers will need to decide whether to take a conservative approach and possibly “over disclose”. These disclosure issues will be discussed in future articles.

  • requiring broker-dealers to establish, maintain and enforce written policies and procedures reasonably designed to achieve compliance with Regulation as a whole, which will further promote broker-dealer compliance with Regulation Best Interest.”

Comment:  This provision is a “catch-all” in the sense that it requires that broker-dealers have written policies and procedures to support compliance with the first three obligations. It doesn’t impose a separate obligation.

After explaining the four obligations, the SEC concludes:

“Through these new requirements, we believe that Regulation Best Interest will 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 conflicted brokerage recommendations.”

Comment and Conclusion: The Care and Conflict Obligations will likely have a significant impact. However, the Disclosure Obligation may be less helpful.

The focus on cost, risk and process in the Care Obligation should elevate the “ground floor” for compliant recommendations. The requirement in the Conflict Obligation for broker-dealers to mitigate the effect of incentives on advisors should reduce the incidence of recommendations of higher-priced, higher-compensating account-types, investments and strategies that could benefit the advisor (and the broker-dealer) at the expense of the retail customer. In most cases, though, where broker-dealers and their advisors have focused on the interests of their customers, the changes should be at the margins.

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.