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It’s the Final Countdown: Being Prepared for Regulation Best Interest

Last year the U.S. Securities and Exchange Commission (“SEC”) approved Regulation Best Interest (“Reg BI”).[1] Reg BI requires broker-dealers and their associated persons to act in “the best interest” of a retail customer when recommending a securities transaction or investment strategy. Reg BI applies not only to broker-dealers but also to investment advisors.[2] It will take effect in June of 2020.[3]

According to the SEC’s Final Rule release, Reg BI enhances a BD’s standard of conduct beyond the existing “reasonable basis” suitability obligation[4] by requiring a BD to act in the best interest of its retail customer at the time of making a recommendation, and proscribes placing the BD’s financial interests ahead of that of its customer.[5]  Satisfying this enhanced obligation requires the BD to address conflicts of interest by establishing, maintaining, and enforcing policies and procedures reasonably designed to identify and fully and fairly disclose material facts about conflicts of interest.  The SEC made clear the best interest standard cannot be satisfied through disclosure alone.[6]  Thus, when mere disclosure of conflicts is insufficient, BDs may need to mitigate or eliminate the conflict of interest altogether.[7]

The SEC divided the Reg BI standard into four obligations: (1) disclosure, (2) care, (3) conflict of interest, and (4) compliance.

  1. Disclosure Obligation: BDs must deliver certain prescribed disclosures before or at the time of the recommendation.  Disclosures must be in writing and include all material facts associated with the recommendation. For example, a disclosure obligation would include the following:

  • That the firm or representative is acting in a BD capacity;

  • The material fees and costs that apply to the retail holdings and accounts, including when and why a fee will be imposed;

  • The type and scope of the services to be provided, including material limitations on the securities or investment strategies (g., limited product menu, proprietary products only, payments from third parties, compensation arrangements, etc.); and

  • The material facts relating to conflicts of interest associated with the recommendation that might sway a BD to make an interested recommendation.

  1. Care Obligation: The BD must exercise reasonable diligence, care, and skill in making a recommendation to a retail investor.[8] Thus, the BD must understand the potential risks, rewards, and costs associated with the recommendation and hold a reasonable belief the recommendation is in the customer’s best interest.   Satisfaction of the care obligation is evaluated as of the time it is made, not in hindsight.[9]  In addition, a series of transactions is viewed as a whole, rather than evaluating each transaction in isolation.

Following the SEC’s adoption, industry advocate SIFMA acknowledged the enhanced nature of the Care Obligation, noting it is:

stronger than the existing suitability standard because it: (1) explicitly requires that the recommendation be in the customer’s best interest and that the BD does not place its interests ahead of the customer; (2) explicitly requires that cost be a consideration; (3) applies the quantitative suitability requirement irrespective of whether the BD has actual or de facto control over the customer’s account; and (4) requires the BD to consider “reasonably available alternatives” as part of having a “reasonable basis to believe” that the recommendation is in best interests of the customer.[10

  1. Conflict of Interest Obligation: This obligation goes further than standard measures such as simply establishing, maintaining, and enforcing policies and procedures reasonably designed to address conflicts of interest. Now, the BD must eliminate certain compensation incentives altogether. For instance, a BD must identify and eliminate sales contests, sales quotas, bonuses, and non-cash compensation based on the sale of specific securities or types of securities within a limited period of time.[11]

  1. Compliance Obligation: This obligation requires the BD to establish, maintain, and enforce policies and procedures reasonably designed to achieve compliance with Reg BI as a whole. Thus, a BD’s policies and procedures must address conflicts of interest as well as the firm’s compliance with the BI disclosure and care obligations.[12]

Along with Reg BI, the SEC concurrently adopted Form CRS under both the Exchange Act and the Advisers Act.[13]  Form CRS requires BDs and investment advisers to deliver to retail investors a concise relationship summary.  The CRS must be written in a standardized question and answer format and describe the nature and scope of services the firm provides, the types of fees a customer will incur, the conflicts of interest faced by the firm, and the firm’s (and its associated person’s/IARs) disciplinary history.[14]  The CRS will include principal fees and costs the investor will pay directly or indirectly, the applicable standard of conduct and associated conflicts.

With the effective date fast approaching, FINRA and the SEC are providing a variety of support and information to help firms ensure compliance.  In October, FINRA announced that it will be conducting “preparedness reviews” of broker dealers to help firms comply with Reg BI.[15]  FINRA also has posted a Reg BI and Form CRS Firm Checklist that includes questions to help firms assess their obligations under Reg BI and Form CRS.[16]  The checklist also explains key differences between FINRA rules and Reg BI and Form CRS. In addition, the SEC has provided compliance guides, commission interpretations, and recent guidance on complying with Reg BI and Form CRS. [17]

Firms should be well on their way in analyzing and implementing Reg BI given its June 2020 “very ambitious” compliance period.[18]  Enacting and enforcing appropriate policies and procedures will significantly mitigate regulatory and litigation risk arising from this new regulation.

[1] Regulation Best Interest: The Broker-Dealer Standard of Conduct, SEC Release No. 34-86031, File No. S7-07-18 (June 5, 2019) (“Final Rule”), available at https://www.sec.gov/rules/final/2019/34-86031.pdf.

[2] Final Rule, p. 2.

[3] Final Rule, p. 371.

[4] See FINRA Suitability Rule 2111, available at https://www.finra.org/industry/suitability.

[5] See Final Rule, p. 1.

[6] See Final Rule, pp. 1, 5, and 280.

[7] See Final Rule, pp. 317 and 326.

[8] See Final Rule, p. 14.

[9] See Final Rule, p. 15. In this regard, evaluation of the care obligation at the time of the recommendation is a carry-over of the suitability analysis.  Compare generally, Reg BI with FINRA Rule 2111.

[10] SIFMA, Reg BI Final Rules and Guidance: Preliminary Summary (Jun. 10, 2019), available athttps://www.sifma.org/wp-content/uploads/2019/06/Preliminary-Summary-Reg-BI-Final-Rules-Guidance-06-10-2019.pdf.

[11] Id.

[12] Id. In this regard, a firm should consider how or by what actions it will undertake to meet the new obligations.

[13] See Final Rule, p. 16. See also Form CRS Relationship Summary; Amendments to Form ADV, Exchange Act Release No. 86032, Advisers Act Release No. 5247, File No. S7-08-18 (June 5, 2019) (“Relationship Summary Adopting Release”), available at https://www.sec.gov/rules/final/2019/34-86032.pdf.

[14] Relationship Summary Adopting Release, fn. 6.  A new Form ADV part 3 will describe the requirements for the relationship summary and will be required by amended Advisers Act Rule 203-1.

[15] FINRA Provides New Reg BI and Form CRS Resources to Assist Member Firms in Complying with SEC Rules by June 30, 2020, FINRA News Release (Oct. 8, 2019), available at https://www.finra.org/media-center/newsreleases/2019/finra-provides-new-reg-bi-and-form-crs-resources.

[16] FINRA, Reg BI and Form CRS Firm Checklistavailable at https://www.finra.org/sites/default/files/2019-10/reg-bi-checklist.pdf.

[17] See e.g., the Final Rule; Regulation Best Interest: A Small Entity Compliance Guide (modified Sept. 23, 2019), available at https://www.sec.gov/info/smallbus/secg/regulation-best-interestFrequently Asked Questions on Form CRS (modified Nov. 26, 2019), available at https://www.sec.gov/investment/form-crs-faq.

[18] See Statement at the Open Meeting on Regulation Best Interest and Related Actions, Commissioner Hester M. Peirce (June 5, 2019), available at https://www.sec.gov/news/public-statement/peirce-statement-open-meeting-regulation-best-interest.

© 2020 Winstead PC.

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About this Author

John Kincade, Winstead, Shareholder; Co-Chair, Securities Litigation & Enforcement
Shareholder

John Kincade is Co-Chair of Winstead’s Securities Litigation & Enforcement Practice Group. He practices at all levels of federal and state securities litigation, arbitration and regulatory enforcement disputes. He represents a wide range of financial services clients including brokers/dealers, investment advisers, banks, and their registered persons in complex, high stakes FINRA arbitrations, FINRA Enforcement proceedings and investigations, and SEC and State enforcement matters. He also advises privately held and publicly traded companies and their officers and directors in federal...

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Jamie Lacy Associate Winstead Securities Litigation & Enforcement Business Litigation Governmental & Internal Investigations White-Collar Defense
Associate

Jamie Lacy is an associate in Winstead’s Securities Litigation & Enforcement, White-Collar Defense, and Business Litigation Practice Groups.  Jamie represents public and private companies, hedge funds, private equity funds, asset managers, broker-dealers, registered investment advisers, officers and directors, registered persons, and other institutions in government investigations, securities law enforcement and litigation, and FINRA arbitrations.  In addition, she counsels clients in regulatory and enforcement matters before the SEC, FINRA, Texas State Securities Board and other state securities regulators, as well as other regulatory and law enforcement agencies.  

Prior to joining Winstead, Jamie represented commercial sureties in complex litigation involving bond disputes.  Jamie also served as an extern for the SEC where she worked on various investigations and enforcement matters, including insider trading, EB-5 fraud, municipal bond fraud, and violations of the FCPA.  Additionally, Jamie twice served as an extern for FINRA in their Member Regulation and Enforcement Departments.

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