November 19, 2019

November 19, 2019

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November 18, 2019

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An Overview of the SEC’s “Regulation Best Interest” and Form CRS

Broker-dealers (“BDs”) should be aware that, on June 5, 2019, the SEC adopted “Regulation Best Interest” (“Reg BI”), which requires BDs and their registered representatives (“RRs”) to “act in the best interest of the retail customer,” when “making a recommendation” regarding “a securities transaction or investment strategy.”  In addition, the SEC’s new rules require BDs to deliver Form CRS relationship summaries (“Form CRS”) to retail customers.  BDs will need to be in compliance with Reg BI and Form CRS, which were accompanied by more than 1,000 pages of explanation, by June 30, 2020.   On August 7, 2019, FINRA issued Notice 19-26, which informed BDs and RRs of the need to comply, but offered no guidance on compliance.  This post summarizes some of the key aspects of Reg BI and Form CRS.

The Obligations Required by Reg BI

Reg BI does not impose a general fiduciary duty.  Rather, Reg BI requires BDs and RRs to comply with four obligations: (i) a disclosure obligation; (ii) a care obligation; (iii) a conflict of interest obligation; and (iv) a compliance obligation.  Reg BI’s obligations of care and compliance resemble obligations already set forth in FINRA Rules 2111 and 3110, respectively.   In contrast, Reg BI’s disclosure and conflict management obligations create new duties, and require BDs to update their written supervisory procedures, internal and external procedures, and certain compensation practices.

The Obligation of Care Largely Mirrors FINRA’s “Suitability” Rule

Reg BI’s obligation of care closely resembles the suitability standard of FINRA Rule 2111.  Under Reg BI, BDs and their RRs must have a reasonable basis to believe that a recommendation:  (1) would be in the best interest of at least someretail customers (Rule 2111’s reasonable basis suitability test); (2) is in the specificcustomer’s best interest (Rule 2111’s customer-specific suitability test); and, (3) if the recommendation involves a series of transactions, the transactions should not be excessive or place the BD’s financial interests ahead of the customer’s interests (Rule 2111’s quantitative suitability rest).

In addition, Reg BI expressly requires BDs and RRs to consider “the costs associated with the recommendation,” and to refrain from placing their own financial interests ahead of the customer.  Although Reg BI does not require a BD to recommend the lowest cost option, the SEC “elevated” cost consideration to the text of Reg BI to emphasize that the cost of a product, transaction, or account type (asset-based fees versus transaction-based fees) is “always relevant” to—though not always dispositive of—whether a recommendation is in the customer’s best interest.  Thus, to ensure compliance, BDs should train their RRs to: (1) evaluate and discuss the costs of both products and account types with retail clients at the time of a recommendation, and (2) document those discussions.  These discussions will be critical to satisfying not only the care obligation, but, as explained below, the disclosure obligation as well.  BDs also should confirm that their written supervisory policies reflect these procedures.

New Burdens Associated with the Obligation of Disclosure and Form CRS

Reg BI expressly requires BDs and RRs to make “full and fair” written disclosures at the time of any recommendation, concerning (i) the material fees and costs associated with the transaction, holdings, and accounts; (ii) the type and scope of services; (iii) any limitation on services offered; and (v) any conflict of interest.  Although account-opening documents and confirmations may contain some of these disclosures, Reg BI requires disclosures that are more detailed than those required by current law.   For example, Reg BI requires firms to disclose: (1) whether they are acting as a BD, a registered investment advisor (“RIA”), or a dual registrant; (2) the duty of care to which the firm is held, including whether the firm will make recommendations or engage in ongoing account monitoring; (3) the variance in fees associated with brokerage accounts and advisory accounts; (4) the existence of any conflicts of interest; and (5) any disciplinary and legal history.  These disclosures are largely intended to ensure that retail customers understand whether they are working with a BD, who must act in their interest, or an RIA, who must act as a fiduciary.  The disclosures are also designed to assist customers in determining whether they should choose a brokerage account, where fees are charged for transactions, or an advisory account, where fees are based on a percentage of assets.  The SEC’s explanatory comments about the disclosure obligation endorsed restrictions regarding the use of the titles “advisor” and “adviser” and stated it would “presume” that BDs who are not also registered as RIAs violate the disclosure obligation when they refer to themselves or their RRs as  “advisors” or “advisers.”

Firms will make many, but not all, of these disclosures via the new Form CRS.  The SEC has published templates of Forms CRS for BDs, RIAs, and dual registrants, which include language that firms must include in their Form CRS disclosures.  Notably, Form CRS requires firms to compare the fees associated with transaction-based brokerage accounts with the fees associated with fee-based advisory accounts.  Form CRS also requires the BD to state that it has “a legal or disciplinary history” if either the BD or any of its RRs has made disclosures concerning criminal proceedings, regulatory proceedings, judicial proceedings, or unsatisfied judgments on their Forms BD, U-4 or U-5, or if an RR has reported a customer complaint or a specified termination on a Form U-4 or Form U-5.   Finally, all firms must include “conversation starters” on Form CRS to help investors ask questions that will assist them in choosing between firms and between brokerage and advisory accounts.

BDs must submit their initial Form CRS to FINRA via the Central Registration Depository (“CRD”) no later than June 30, 2020, and must update the Form CRS within 30 days if there are any “material changes.”  BDs must begin to deliver Form CS to their retail customers once the Form CRS becomes effective, and must post the form on their websites, if they have one, in a readily accessible format.   BDs will be required to deliver the Form CRS to new customers at the earliest of: making a recommendation, opening an account, or executing a transaction.

BDs should begin preparing their Form CRS and additional disclosures early, in light of the scope of these obligations.  This will ensure the timely completion of Form CRS and any additional disclosure documents and updates to written supervisory procedures, and afford time for BDs to provide training to RRs about how to respond to customer questions concerning the Form CRS.  In addition, BDs that are not dually registered as RIAs should evaluate the risks of referring to themselves and their RRs as “advisors” or “advisers” in their communications with the public and with customers.  Finally, BDs may consider whether to support RRs in seeking expungements of inaccurate or meritless information regarding customer complaints.

The New Burdens Associated with the Conflict of Interest Obligation

Regulation BI also requires BDs to “establish, maintain, and enforce policies” designed to:  (1) identify and disclose conflicts of interest, and (2) eliminate conflicts that cannot be ameliorated by disclosure.

The SEC has opined that BDs and RRs act under a remediable conflict of interest when:  (1) selling proprietary products; (2) offering a limited range of products; and (3) offering products with substantial variations in compensation to the BD and RR.  Reg BI permits firms to remediate these conflicts with appropriate disclosures—which are in addition to the disclosures included in Form CRS.

However, the SEC has concluded that sales contests, quotas, and bonuses based on the sale of specific securities within a limited time period undermine one’s ability to make recommendations that serve the customer’s best interest, and thus, the conflicts created by such practices cannot be remediated by disclosure.  Therefore, Reg BI requires BDs to eliminate these compensation practices.  Note, however, that Reg BI does not require BDs to eliminate compensation tied to total production or asset accumulation.

In sum, BDs should review their product offerings to identify any conflicts that must be disclosed, and to develop procedures for disclosure and documentation thereof.  Further, despite the June 2020 deadline for compliance, firms should consider eliminating sales contests and quotas as soon as possible, particularly to avoid state-level regulatory action and customer-generated litigation.

The Compliance Obligation

Finally, Reg BI requires firms to establish and enforce written policies “designed to achieve compliance with” Reg BI.  The SEC adopted a flexible approach, which, like FINRA Rule 3110, allows firms to adopt procedures that reflect the firm’s scope, size, and business lines.  The SEC has suggested that a reasonable compliance program would include: “controls; remediation of non-compliance; training; and periodic review and testing.”   In addition, the SEC amended SEA Rules 17a-3 and 17a-4 to require BDs to keep records concerning recommendations and the delivery of Form CRS to customers for a period of six years.

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About this Author

Janene Marasciullo, Epstein Becker Law Firm, New York, Labor and Employment, Litigation Attorney
Member

Janene Marasciullo is a Member of the Firm in the Employment, Labor & Workforce Management and Litigation & Business Disputes practices, in the New York office of Epstein Becker Green. Ms. Marasciullo has extensive first-chair experience litigating complex commercial, fraud, regulatory, and employment disputes, with an emphasis on disputes arising within the financial industry. In addition, she represents corporations and individuals during regulatory investigations and grand jury investigations...

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