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60 Days And Counting: “Regulation Best Interest” Is Nearly Here. Are Independent Broker-Dealers Ready? What They Need to Know and Do

On June 5, 2019, the United States Securities and Exchange Commission (“Commission”) adopted Rule 15l-1 (“Regulation Best Interest”) under the Securities Exchange Act of 1934 (“Exchange Act”), which has a compliance date of June 30, 2020.[1]  Regulation Best Interest became effective September 10, 2019.  Notwithstanding the host of issues arising from the global pandemic, an economic recession and significant market volatility across essentially every sector, the Commission has made clear that the deadline for compliance with Regulation Best Interest and the related Form CRS requirements will not be delayed or extended.

In broadest terms, Regulation Best Interest provides that when recommending a securities transaction or investment strategy to a retail customer[2], including a mere account recommendation by an associated person of a broker-dealer to open an IRA or to roll over to an IRA (in other words, even in the absence of a specific securities recommendation), a broker-dealer, including its associated person, must act in the customer’s best interest by not putting its financial interests ahead of the interests of the customer when making a recommendation.  Regulation Best Interest has four (4) component parts with which a broker-dealer must comply in order to satisfy this “best interest” standard: a (i) Disclosure Obligation; (ii) Care Obligation; (iii) Conflict of Interest Obligation; and (iv) Compliance Obligation.

Furthermore, broker-dealers and Commission-registered investment advisers are now obligated to prepare and deliver a two-page, “question-and-answer” format relationship summary to potential, new retail customers as well as existing retail customers that, in one place, describes for the retail customer: “(i)the types of client and customer relationships and services the firm offers; (ii) the fees, costs, conflicts of interest, and required standard of conduct associated with those relationships and services; (iii) whether the firm and its professionals currently have reportable legal or disciplinary history; and (iv) how to obtain additional information about the firm.”  Like the effective date of Regulation Best Interest, June 30, 2020 is also the compliance date by which broker-dealers must file their initial Forms CRS with the Commission.[3]   Broker-dealers have an additional thirty (30) days from that filing deadline to provide all existing retail customers with a copy of the initial Form CRS.[4]  Thereafter, broker-dealers must post a current copy of their relationship summary on their firms’ websites, provide updates to existing customers within thirty (30) days of receiving a request from a retail customer and otherwise provide an updated Form CRS to all existing customers within sixty (60) days of any future update deadlines.  In so doing, the Regulation places a continuing burden on broker-dealers to regularly provide their existing retail customers with sufficient information that the customers may require to determine, at any time, if they wish to continue their relationships with their broker-dealers.[5]

For many small and independent broker-dealers with limited time and resources, implementing and testing their supervisory policies and procedures remains a priority and a challenge despite the looming deadline.  While broker-dealers must comply with all aspects of Regulation Best Interest, particular emphasis on broker-dealers’ duty of care to their customers; to recommend investments and strategies that are in the customers’ best interest and to consider reasonable alternatives and costs as part of that determination, remains at the core of supervisory procedures and practices.  Furthermore, broker-dealers’ ability to demonstrate compliance with the new standard of conduct will be a priority for the Commission’s Office of Compliance Inspections and Examination (“OCIE”).[6]

On April 7, 2020, OCIE issued a “Risk Alert” “to provide broker-dealers with information about the scope and content of initial examinations after the compliance date for Regulation Best Interest.”[7]  OCIE anticipates commencing examinations of broker-dealers throughout year one (1) to assess whether broker-dealers have developed and implemented supervisory policies and procedures designed to achieve compliance with Regulation Best Interest.  We strongly expect that OCIE will also examine the efficacy of such supervisory policies and procedures.

With that in mind, this article discusses the elements of the new standard and proposes some considerations for written supervisory procedures (“WSPs”) that establish practices and procedures reasonably designed to ensure compliance with Regulation Best Interest and training tips to demonstrate the efficacy of those policies and procedures.

Who Is Covered

Regulation Best Interest applies to associated persons registered with a broker-dealer (even if the broker-dealer itself is a dual-registrant or affiliated with an investment adviser) and may apply to a dually-registered person, i.e., an associated person of a broker-dealer  who also is a supervised adviser of an investment adviser, if the person was acting as a broker at the time of the recommendation and in connection with any securities transactions in a brokerage (as distinguished from an advisory) account.[8]

Disclosure Obligation

Under Regulation Best Interest, prior to or at the time of making a “recommendation” to a retail customer, broker-dealers and their associated persons must provide (in writing) the retail customers with the “all material facts relating to the scope and terms of the relationship with the retail customers; and all material facts relating to conflicts of interest that are associated with the recommendation.”  To some broker-dealers and associated persons, these disclosure obligations may not appear to impose significant, new requirements, but the quality and scope of the additional disclosures is significant for independent broker-dealers with limited back office, operations and supervisory staff.  The resource commitment of these new obligations effectively scales up for broker-dealers (typically independent broker-dealers) with business model platforms that are decentralized and rely on offices of supervisory jurisdiction (“OSJ”) to carry out supervisory responsibilities over a network of geographically dispersed, single-person and multi-person branch offices that engage in retail sales and where the securities activities at such discrete locations may be diverse and complex.

Importantly, although the “Best Interest” standard is not a per se fiduciary standard, Regulation Best Interest does employ fiduciary concepts applicable to registered investment advisers.  Thus, with respect to the “scope and terms of the relationship,” Regulation Best Interest requires broker-dealers to expressly advise the retail customer if the firm and associated person will monitor customer accounts and the frequency of such activities.

Broker-dealers must disclose the capacity in which they are making recommendations to their retail customers – as a broker, dealer or an associated person of a broker-dealer.  Firms must disclose their material fees and costs that apply to the retail customer’s transactions and account.  Firms must disclose the type and scope of services to be provided to the retail customer, including any material limitations on the securities or investment strategies that may be recommended to the retail customer, such as, by way of illustration only, the requirement that an associated person recommend only proprietary products of his broker-dealer or products of a specific sponsor to the retail customer.

The Disclosure Obligation also requires broker-dealers and associated persons to disclose all material facts relating to conflicts of interest associated with the recommendation.  As every broker-dealer knows, there is no single, “bright line” test for an alleged conflict of interest, but, generally, one should consider it anything that “might incline a broker, dealer, or a natural person who is an associated person of a broker or dealer – consciously or unconsciously – to make a recommendation that is not disinterested.”  Again, examples could include proprietary products, high commission products, sellers’ agreement incentives and other forms of cash and in-kind incentives common to alternative investment asset classes and their issuers and sponsors.  This is not an exhaustive list.  Regulation Best Interest makes clear that precise disclosure of these conflicts, together with WSPs that identify and map these conflicts, are critical tools for broker-dealers to manage and mitigate such conflicts of interest.[9]

Finally, for Regulation Best Interest disclosure purposes, broker-dealers and their associated persons should regard information to be “material” if there is a substantial likelihood that a reasonable retail customer would consider it important.

OCIE guidance makes clear that its examining staff may assess how each broker-dealer endeavors to comply with the Regulation’s Disclosure Obligation element.  In particular, OCIE may review the content of the disclosures for materiality and clarity and review documents such as:

  • Schedules of fees and charges assessed against retail customers and disclosures regarding such fees and charges, including disclosures regarding the fees and costs related to services and investments that retail customers will pay or incur directly and indirectly (g., custodian fees, account maintenance fees, fees related to mutual funds and variable annuities, and other transactional fees and product-level fees);
  • The broker-dealer’s compensation methods for registered personnel, including (i) compensation associated with recommendations to retail customers, (ii) sources and types of compensation (g., direct payments by an investor, payments by a product sponsor), and (iii) related conflicts of interest (e.g., conflicts associated with recommending proprietary products or with receiving payments for inclusion on a product menu);
  • Disclosures related to monitoring of retail customers’ accounts;
  • Disclosures on material limitations on accounts or services recommended to retail customers; and
  • Lists of proprietary products sold to retail customers.[10]

Care Obligation

The Care Obligation requires broker-dealers, when making recommendations (not in hindsight) of any securities transactions or investment strategies involving securities to retail customers to exercise reasonable diligence, care, and skill to: “(i) understand potential risks, rewards, and costs associated with recommendation, and have a reasonable basis to believe that the recommendations could be in the best interest of at least some retail customers; (ii) have a reasonable basis to believe 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 interest of the broker-dealer ahead of the interest of the retail customer; and (iii) have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer’s best interest when viewed in isolation, is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile.”  Although the element is multi-pronged and reads as cumbersome, broker-dealers will recognize that the Care Obligation follows existing FINRA Rule 2111’s suitability standard: (i) reasonable basis suitability; (ii) customer-specific suitability; and (iii) quantitative suitability.

Importantly, the Care Obligation requires broker-dealers to consider costs associated with recommendations – both costs incurred to purchase a security and costs arising from a future sale or exchange of the security.  Given the holistic analysis demanded by the new standard of conduct,[11] broker-dealers should not interpret cost to mean that a recommendation of the lowest cost product satisfies this element.  Meaning, a more expensive product may still be the best product for a client.

Regulation Best Interest does not define what constitutes “reasonable diligence, care, and skill”, but, in addition to the complexity of the security or investment strategy, factors that broker-dealers should consider in order to reasonably concluded that the security or strategy could be in the best interest of some of the broker-dealers’ retail customers include: (i) investment objectives; (ii) liquidity; (iii) volatility; (iv) the expected return of the security or investment strategy; and (v) financial incentives to recommend the security or investment strategy.

In addition, the new standard requires that broker-dealers compile a complete investor profile to determine if it is suitable for the specific customer: age, financial situation, investment objectives, investment experience, investment time horizons, liquidity needs, risk tolerance, etc.

Broker-dealers should consider reasonably available alternatives, if any, offered and document the reasonable basis for making the securities transaction or investment strategy recommendation.  Consistent with OCIE guidance, broker-dealers should be prepared to document and present to examining staff the following:

  • Information collected from retail customers to develop their investment profiles (including any new account forms, correspondence, and any agreements the customer has with the broker-dealer).
  • The broker-dealer’s process for having a reasonable basis to believe that the recommendations are in the best interest of the retail customer (which may include, g., any process for establishing, understanding, and implementing the scope of reasonably available alternatives when making a recommendation).
  • The factors the broker-dealer considers to assess the potential risks, rewards, and costs of the recommendations in light of the retail customer’s investment profile.
  • The broker-dealer’s process for having a reasonable basis to believe that it does not place the financial or other interest of the broker-dealer ahead of the interest of the retail customer.
  • How the broker-dealer makes recommendations related to significant investment decisions, such as rollovers and account recommendations, and how the broker-dealer has a reasonable basis to believe that such investment strategies are in a retail customer’s best interest.
  • How the broker-dealer makes recommendations related to more complex, risky or expensive products and how the broker-dealer has a reasonable basis to believe that such investments are in a retail customer’s best interest.[12]

Conflict of Interest Obligation

The Conflict of Interest Obligation, which applies only to broker-dealers, requires that firms establish, maintain and enforce written policies and procedures reasonably designed to address conflicts of interest associated with its recommendations to retail customers.

OCIE guidance indicates that examining staff may review broker-dealers’ policies and procedures to assess:

  • Conflicts that create an incentive for an associated person to place its interest or the interest of a broker-dealer ahead of the interest of the retail customer;
  • Conflicts associated with material limitations (g., a limited product menu, offering only proprietary products, or products with third-party arrangements) on the securities or investment strategies involving securities that may be recommended to a retail customer; and
  • The elimination of the following conflicts: sales contests, sales quotas, bonuses, and non-cash compensation based on the sale of specific securities or specific types of securities within a limited period of time.[13]
  • If they establish a structure for identifying the conflicts that the broker-dealer or its associated person may face. Staff may request documentation identifying all conflicts associated with the broker-dealer’s recommendations.
  • If they establish a structure to identify and assess conflicts in the broker-dealer’s business as it evolves. Staff may request to see all policies and procedures in place during the scope period of the examination.
  • If they provide for disclosure of conflicts and what conflicts are disclosed.
  • If they provide for mitigation or elimination of conflicts and what conflicts are mitigated or eliminated.[14]

Of course, the types of potential conflicts of interest and the corresponding changes to WSPs and other policies and procedures will vary by broker-dealer.  The Conflict of Interest Obligation element, however, does emphasize that each broker-dealer should determine the types of compensation and incentives that are available to its business that may incent them or their associated persons to recommend a particular security or strategy that may not be in their retail customers’ best interest and implement changes to mitigate such a conflict.  Broker-dealers should consider the following mitigation tools:

  • Limiting the retail customers to whom a product, transaction or strategy may be recommended.
  • Harmonizing compensation for similar product types;
  • Harmonizing compensation and incentives for promoting and selling proprietary products versus all other products of third parties.
  • Adjusting compensation for associated persons who do not effectively manage conflicts of interest;
  • Restricting or eliminating certain share classes for mutual funds;
  • Eliminating or modifying sales contests that emphasize certain product or service sales during specified time periods; and
  • Amplifying surveillance programs that monitor sales activity subject to certain compensation thresholds.[15]

Compliance Obligation

Finally, as to broker-dealers only (not their associated persons), Regulation Best Interest requires broker-dealers to establish, maintain and enforce policies and procedures reasonably designed to achieve compliance with Regulation Best Interest.  This language structurally mirrors existing FINRA Rule 3110, which requires broker-dealers to establish and maintain a system to supervise the activities of each associated person that is reasonably designed to achieve compliance with applicable securities laws and regulations, and with applicable FINRA rules.

We expect that OCIE examining staff will look for evidence of broker-dealers developing, implementing and maintaining new training programs that would cover compliance with Regulation Best Interest.  The Compliance Obligation element also imposes new record making and record keeping obligations on all broker-dealers.[16]  Broker-dealers must now record all information collected from, and provided to, their retail customers pursuant to Regulation Best Interest, as well as record the identity of each natural person who is an associated person of a broker-dealer, if any, responsible for the retail customer’s account, for a period of at least six (6) years after the earlier of the date the account was closed or the date on which the information as last replaced or updated.

Conclusion

Regulation Best Interest will significantly influence how broker-dealers and their associated persons engage with retail customers, drive the development, maintenance and testing of broker-dealers’ WSPs and other policies and procedures; and require substantial staffing and resource commitments on a going-forward basis of independent broker-dealers.

If you have any questions about the issues addressed in this Broker-Dealer Regulation Alert, if you would like a copy of any of the materials mentioned in it or if you would like to continue to receive Broker-Dealer Regulation Alerts, please do not hesitate to call or email Securities and Commercial Litigation and Securities Regulatory Practice Partner Daniel Scott Furst at (646) 810-2185 or sfurst@srf.law.[17]

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    [1] See Exchange Act Release No. 86031 (June 5, 2019) (“Regulation Best Interest Adopting Release”).

    [2] A “retail customer” is “a natural person, or the legal representative of such natural person, who: (A) receives a recommendation of any securities transaction or investment strategy involving securities from a broker, dealer, or a natural person who is an associated person of a broker or dealer; and (B) uses the recommendation primarily for personal, family, or household purposes.” Exchange Act Rule 15l-1(b)(1).

    [3] Broker-dealers must file their relationship summary as Form CRS electronically through the Central Registration Depository (Web CRD).  Commission-registered investment advisers must file their relationship summary as Form ADV Part 3 (Form CRS) electronically through the Investment Adviser Registration Depository (IARD).  Finally, dual registrants are required to deliver a relationship summary to retail customers of the broker-dealer as well as to investment advisory clients using both Web CRD and IARD.

    [4] Broker-dealers must deliver a relationship summary to each retail investor, before or at the earliest of (i) a recommendation of an account type, a securities transaction, or an investment strategy involving securities; (ii) placing an order for the retail investor; or (iii) the opening of a brokerage account for the retail investor.  The Commission’s guidance also provides that Commission-registered investment advisers must deliver a relationship summary to each retail investor before or at the time the firm enters into an investment advisory contract with the retail investor, even if the agreement is oral.  Finally, dual registrants must deliver the relationship summary at the earlier of the delivery requirements for the broker-dealer or investment adviser.

    [5] For a complete discussion of the amendments to Form CRS in “question-and-answer” format with related guidance links, see https://www.sec.gov/info/smallbus/secg/form-crs-relationship-summary.

    [6] See the Commission’s “Small Entity Compliance Guide” at https://www.sec.gov/info/smallbus/secg/regulation-best-interest.

    [7] See https://www.sec.gov/ocie/announcement/risk-alert-regulation-best-interest.

    [8] Consequently, dual-registrants should identify the circumstances and protocols that should be followed when its associated persons who are also investment advisers are communicating with customers of the broker-dealer versus the registered investment adviser and the protocols for reasonable supervision over same.  Indeed, we strongly recommend that broker-dealers’ WSPs map the protocol for dual-registrants.

    [9] See Exchange Act Rule 15l-1(a)(2)(iii)(B).

    [10] See fn. 4.

    [11] See Exchange Act Rule 15l-1(a)(2)(iv) (“In addition to the policies and procedures required by paragraph (a)(2)(iii) of this section, the broker or dealer establishes, maintains, and enforces written policies and procedures reasonably designed to achieve compliance with Regulation Best Interest.”).

    [12] See fn. 4.

    [13] Through Regulation Best Interest, the Commission takes the position that broker-dealers’ written policies must be reasonably designed to eliminate sales contests, sales quotas, bonuses and non-cash compensation that are based on the sales of specific securities and specific types of securities within a limited period of time.

    [14] See fn, 4.

    [15] This list is not exhaustive and broker-dealers should first examine their own policies and procedures to identify gaps between same and the new requirements of Regulation Best Interest and update their supervisory tools and protocols designed to mitigate conflicts accordingly.

    [16] The Compliance Obligation element of Regulation Best Interest amends Rules 17a-3 and 17a-4 of the Exchange Act, which set forth minimum requirements with respect to the records that broker-dealers must make, and how long those records and other documents must be kept, respectively.

    [17] This Broker-Dealer Regulation Alert is for general information purposes and is not intended to advertise our services, solicit clients or represent our legal advice.