Regulation Best Interest: Significant Changes from Proposal (Part 2)

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.”

In my last post, Best Interest for Advisors #13, I commented on the SEC’s discussion of the major changes in Reg BI from the proposal to the final regulation. This article continues that commentary, with a focus on what it means to act in the “best interest” of a retail customer. To quote from the adopting release of the final regulation:

We are also clarifying the relationship between the General Obligation and the specific component obligations, and in particular, what it means to ‘‘act in the best interest’’ of the retail customer.

As is the case with the fiduciary duty applicable to investment advisers under the Advisers Act, we are not expressly defining in the rule text the term ‘‘best interest,’’ and instead are providing in Regulation Best Interest and through interpretations, what ‘‘acting in the best interest’’ means. Whether a broker-dealer has acted in the retail customer’s best interest in compliance with Regulation Best Interest will turn on an objective assessment of the facts and circumstances of how the specific components of Regulation Best Interest—including its Disclosure, Care, Conflict of Interest, and Compliance Obligations—are satisfied at the time that the recommendation is made (and not in hindsight).

Comment: Unfortunately, we are left with little guidance on what best interest means. The actual regulation says:

A broker, dealer, or a natural person who is an associated person of a broker or dealer, when making a recommendation of any securities transaction or investment strategy involving securities (including account recommendations) to a retail customer, shall act in the best interest of the retail customer at the time the 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.

The regulation then goes on to explain how the Care Obligation is satisfied (in relevant part):

The best interest obligation . . . shall be satisfied if:

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, . . .

At one level, that could be read to be circular, that is, a recommendation is in the best interest of a retail customer if it is in the retail investor’s best interest. But perhaps a closer reading would be that a recommendation is in the best interest of the retail customer if the broker-dealer and/or the advisor engages in a diligent, careful and skillful process to develop a recommendation, focusing on the customer’s investment profile and the potential costs, risks and rewards to the retail customer. As that suggests, the investment profile, and the costs, risks and rewards, must be a part of the process for developing every recommendation of a securities transaction or a strategy involving securities. That also applies to recommendations of types of accounts. (The need to consider costs was discussed in some of my earlier articles in this series, #9 and #10.)

The keys, then, are the process that the broker-dealer and/or the advisor uses to develop the recommendation, and the factors that are considered in the process.

The SEC’s statement that compliance will be based on an “objective assessments of the facts and circumstances” strikes me as a reasonable man standard. In other words, it doesn’t matter what was intended, but instead compliance will be measured by how the recommendation (and the process) would be viewed by a reasonable third party.

The adopting release then explains that the SEC will be providing examples of the application of the Care Obligation (which future articles will discuss):

In response to commenters, we are addressing, among other things, what the General Obligation does and does not require (for example, that it does not impose a continuing duty beyond a particular recommendation), providing specific examples of what would violate Regulation Best Interest, and its application to certain scenarios, particularly in the context of satisfying the Care Obligation.

Comment: The SEC’s discussion of the Care Obligation provides a number of examples of the considerations for recommendations that are in the best interest of retail customers. For example, and regarding recommendation of account types, a retail customer who indicates that he wants to buy and hold an investment will likely be better served by paying a commission and avoiding an annual advisory fee. On the other hand, if a retail customer wants ongoing oversight and investment management, then she may be better served by a discretionary advisory account.

As another example, the SEC discusses the factors to be considered in making a rollover recommendation from a “workplace retirement plan” to an IRA. The SEC says that is an account-type recommendation subject to the best interest standard of care. The SEC’s position is that a rollover analysis must include a comparison of, e.g., the participant’s actual 401(k) account (as well as other plan factors) and the IRA. As with all best interest recommendations, the process must include a comparison of costs incurred by the retail customer under the alternatives.

I will go into more detail on the SEC examples in future posts.

Conclusion

While the impact of Reg BI will be partially dependent on future SEC and FINRA examinations and enforcement, it is clear that it will have a significant impact on broker-dealer practices, including the processes they use to develop recommendations. All of those changes need to be made and in place by June 30, 2020.

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.