Introduction to New SEC Regulation BI

On June 5, 2019, the United States Securities and Exchange Commission adopted the Regulation Best Interest (“Reg BI”) in Rule 15l-1 of the Securities Exchange Act of 1934, which increases the existing standard for broker-dealers from the current suitability standard in FINRA Rule 2111. Reg BI does not impose a fiduciary duty on broker-dealers like registered investment advisers (RIAs) that would have occurred with the United States Department of Labor’s fiduciary rule that was proposed under the Obama administration but then voided in 2018 by the Fifth Circuit Court of Appeals, which the Trump administration did not contest, thereby effectively ending the fiduciary rule. U.S. Chamber of Commerce v. U.S. Dept. of Labor, 885 F.3d 360 (5th Cir. 2018).

Reg BI imposes the following best interest obligation on a broker, dealer, and natural person who is an associated person of a broker or dealer (hereinafter “associated natural person”):

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.

17 C.F.R. § 240.15l-1(a)(1). Reg BI is not a separate fiduciary standard and does not apply the existing fiduciary standard for RIAs to broker-dealers.

A “broker” is any person engaged in the business of effecting transactions in securities for the account of others except for certain bank activities. 15 U.S.C. § 78c(a)(4).

A “dealer” is any person engaged in the business of buying and selling securities (not including security-based swaps, other than security-based swaps with or for persons that are not eligible participants) for such person’s own account through a broker or otherwise, except for a person not engaged in the business of dealing and certain bank activities. 15 U.S.C. § 78c(a)(5).

An “associated person of a broker or dealer” is any partner, officer, director, or branch manager of such broker or dealer (or any person occupying a similar status or performing similar functions), any person directly or indirectly controlling, controlled by, or under common control with such broker or dealer, or any employee of such broker or dealer. 15 U.S.C. § 78c(a)(18).

A “retail customer” is a natural person, or the legal representative of such natural person like a non-professional trustee representing the natural person’s assets or similar representative like an executor, conservator, or person holding a power of attorney for a natural person, who: (1) receives a recommendation of any securities transaction or investment strategy involving securities from a broker, dealer, or associated natural person; and (2) uses the recommendation primarily for personal, family, or household purposes (including retirement accounts) rather than for commercial or business purposes such as seeking services for an employer, small business or non-natural person entity like a charitable trust. 17 C.F.R. § 240.15l-1(b)(1); SEC Reg BI: A Small Entity Compliance Guide. There is no cap defining a “retail customer” based on assets or income.

A retail customer “uses” a recommendation if the retail customer opens a brokerage account with the broker-dealer (regardless of whether the broker-dealer receives compensation), the retail customer has an existing account with the broker-dealer and receives a recommendation from the broker-dealer (regardless of whether the broker-dealer receives or will receive compensation directly or indirectly from the recommendation), or the broker-dealer receives or will receive direct or indirect compensation as a result of the recommendation, even if the retail customer has no account with the broker-dealer. SEC Reg BI: A Small Entity Compliance Guide. 

A “recommendation” has no bright-line definition and turns on the facts and circumstances of a particular situation, including whether the communication reasonably could be viewed as a call to action and reasonably would influence an investor to trade a specific security or group of securities. Id. “The more individually tailored the communication to a specific customer or targeted group of customers about a security or group of securities, the greater the likelihood that the communication may be reviewed as a ‘recommendation.’” Id.  

Whether a “recommendation” has been made to a retail customer such that it triggers Reg BI is interpreted consistent with precedent under the anti-fraud provisions of the federal securities laws and rules of self-regulatory organizations like FINRA. Id. However, Reg BI “does not apply to investment advice provided to a retail customer by a dual-registrant when acting in the capacity of an investment adviser, even if the retail customer has a brokerage relationship with the dual-registrant or the dual-registrant executes the transaction in a brokerage capacity.” Id.

Activities falling outside the scope of a “recommendation” include general financial and investment information, descriptive information about an employer-sponsored retirement or benefit plan, certain asset allocation models, and interactive investment materials that incorporate the foregoing. SEC Release No. 34-86031.

A “recommendation of any securities transaction or investment strategy involving securities” includes explicit hold recommendations and implicit hold recommendations resulting from agreed-on monitoring between the broker-dealer and retail customer (Reg BI does not impose a duty to monitor a retail customer’s account). SEC Reg BI: A Small Entity Compliance Guide. A voluntary review of the holdings in a retail customer’s account to decide whether to provide a recommendation to the customer is not account monitoring and does not create an implied agreement to conduct such monitoring, but any explicit recommendation made to a retail customer as a result of any such voluntary review of a retail customer’s account is subject to Reg BI. Id.

“Account recommendations” include recommendations of types of securities accounts, such as an IRA account, recommendations to roll over or transfer assets from one type of account to another, such as rolling over a 401K account to an IRA account, and recommendations to take a plan distribution to open up an investment account with the proceeds. Id.

Reg BI does not define “best interest.” Rather, the overarching best interest obligation in Reg BI is satisfied by complying with four specified underlying component obligations of (1) disclosure, (2) care, (3) conflict of interest, and (4) compliance. 17 C.F.R. § 240.15l-1(a)(2). 

Reg BI allows a broker-dealer to recommend securities or investment strategies with greater risk or cost to the retail customer, or higher compensation for the broker-dealer, and where conflicts of interest continue to exist, if each obligation discussed in detail below is met. This is not a safe harbor, each obligation must be fulfilled and the failure to comply with one violates Reg BI, which does not require a showing of scienter or intent. Reg BI also does not override any antifraud provisions in securities laws and does not expressly preempt any state fiduciary laws.

Reg BI’s disclosure obligation requires the broker, dealer, or associated natural person, before or at the time of the recommendation, to provide full and fair written disclosure of all material facts relating to: (1) the scope and terms of the relationship with the retail customer; and (2) conflicts of interest associated with the recommendation. Id. § 240.15l-1(a)(2)(i). “Full and fair” disclosure is sufficient information to allow a retail customer to make an informed decision with respect to the recommendation. SEC Reg BI: A Small Entity Compliance Guide. 

The first disclosure of all material facts relating to the scope and terms of the relationship with the retail customer includes disclosing the: (1) capacity in which the broker, dealer, or associated natural person is acting with respect to the recommendation, keeping in mind that a broker-dealer that is not also registered as an investment adviser and associated person that is not also a supervised person of an investment adviser cannot use the term “adviser” or “advisor;” (2) material fees and costs that apply to the customer’s transactions, holdings, and accounts, which can use a standardized numerical or other non-individualized disclosure like reasonable dollar or percentage ranges rather than individualized disclosure for each retail customer; and (3) type and scope of services provided to the retail customer, including any material limitations on the securities or investment strategies involving securities that may be recommended to the retail customer, the existence, scope and frequency of any agreed account monitoring services, and requirements to open or maintain an account or establish a relationship like a minimum account size. Id.; 17 C.F.R. § 240.15l-1(a)(2)(i)(A). Other material facts relating to the scope and terms of the relationship with the retail customer that should be disclosed include the general basis for recommendations like investment approach, philosophy or strategy, and risks associated with the recommendations in standardized terms. SEC Reg BI: A Small Entity Compliance Guide. 

With the second disclosure of all material facts relating to conflicts of interest that are associated with the recommendation, a conflict of interest is an interest that might incline a broker, dealer, or associated natural person to make a recommendation that is not disinterested, whether consciously or subconsciously. 17 C.F.R. § 240.15l-1(a)(2)(i)(B), (b)(3). This may include conflicts associated with proprietary products, third-party payments, and compensation arrangements. SEC Reg BI: A Small Entity Compliance Guide. 

A fact is “material” if there is a substantial likelihood that a reasonable retail customer would consider it important. Id.; Basic v. Levinson, 485 U.S. 224, 231-32 (1988).

A written disclosure may be subsequently supplemented, clarified or updated by way of a recorded supplemental oral disclosure made at the time of the recommendation or a permitted disclosure after the recommendation is made (e.g., trade confirmation or prospectus) if the initial written disclosures identifies the material fact and describes the process through which such fact may be supplemented, clarified, or updated. SEC Reg BI: A Small Entity Compliance Guide. 

The Form CRS (Relationship Summary) or other standardized disclosure about products and services may help satisfy the disclosure obligation, but alone may not be sufficient, and additional information may be required depending on the facts and circumstances of each case. Id.

Reg BI’s care obligation requires the broker, dealer, or their associated natural person, in making the recommendation, to exercise reasonable diligence, care, and skill to: (1) understand the potential risks, rewards, and costs associated with the recommendation, and have a reasonable basis to believe the recommendation could be in the best interest of at least some retail customers; (2) 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 associated natural person ahead of the retail customer’s interest; and (3) 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 and does not place the financial or other interest of the broker, dealer, or associated natural person making the series of recommendations ahead of the retail customer’s interest. 17 C.F.R. § 240.15l-1(a)(2)(ii).

Compliance with this care obligation is evaluated at the time of the recommendation and not in hindsight. SEC Reg BI: A Small Entity Compliance Guide. What constitutes “reasonable diligence, care, and skill” depends on, among other factors, the complexity of, associated risks and broker-dealer’s familiarity with the recommended security or investment strategy. Id.

With respect to the first part of the care obligation and whether one has a sufficient understanding of the security or investment strategy and reasonable belief that it could be in the best interest of at least some retail customers, one must consider the security or investment strategy’s investment objectives, characteristics including any special or unusual features, liquidity, volatility, anticipated performance in varied market and economic conditions, expected return, and financial incentives to recommend it. Id.

Regarding the second and third part of the care obligation and whether one has a reasonable belief that a recommendation is in the retail customer’s best interest, it is based in part on a “retail customer’s investment profile,” which includes, but is not limited to, the retail customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the retail customer discloses to the broker, dealer, or associated natural person in connection with a recommendation. 17 C.F.R. § 240.15l-1(b)(2).

Further, in connection with the third part of the care obligation, it applies regardless of whether exercising actual or de facto control over a retail customer’s account and what amounts to a series of recommended transactions depends on the facts and circumstances of each case that must be evaluated for a particular retail customer. SEC Reg BI: A Small Entity Compliance Guide. 

To satisfy the care obligations, reasonably available alternatives, if any, offered by the broker-dealer should be reviewed under the facts and circumstances at the time of the recommendation should be done. SEC Reg BI: A Small Entity Compliance Guide. This does not require a broker-dealer to investigate every possible alternative offered on or outside its platform, and does not require associated persons to be familiar with every product on a broker-dealer’s platform, especially if the broker-dealer’s platform has a large number of products. A broker-dealer must also take particular care to understand the terms, features and risks of complex or risky securities or investment strategies. Id. However, a broker-dealer is not required to recommend the cheapest security or investment strategy as cost is only one of a variety of factors to weigh. Id.

When making account type recommendations, the types of specific factors a broker-dealer should consider include, among others: (1) the services and products provided in the account; (2) the projected cost to the retail customer of the account; (3) alternative account types available; (4) the services requested by the retail customer; and (5) the retail customer’s investment profile. Id.

When making recommendations to open, or roll over assets to, an IRA, specific factors a broker-dealer should consider include, but are not limited to: (1) fees and expenses; (2) level of services available; (3) available investment options; (4) ability to take penalty-free withdrawals; (5) application of required minimum distributions; (6) protections from creditors and legal judgments; (7) holdings of employer stock; and (8) special features of the existing account. Id.

The first disclosure of all material facts relating to the scope and terms of the relationship with the retail customer includes disclosing the: (1) capacity in which the broker, dealer, or associated natural person is acting with respect to the recommendation, keeping in mind that a broker-dealer that is not also registered as an investment adviser and associated person that is not also a supervised person of an investment adviser cannot use the term “adviser” or “advisor;” (2) material fees and costs that apply to the customer’s transactions, holdings, and accounts, which can use a standardized numerical or other non-individualized disclosure like reasonable dollar or percentage ranges rather than individualized disclosure for each retail customer; and (3) type and scope of services provided to the retail customer, including any material limitations on the securities or investment strategies involving securities that may be recommended to the retail customer, the existence, scope and frequency of any agreed account monitoring services, and requirements to open or maintain an account or establish a relationship like a minimum account size. Id. ; 17 C.F.R. § 240.15l-1(a)(2)(i)(A). Other material facts relating to the scope and terms of the relationship with the retail customer that should be disclosed include the general basis for recommendations like investment approach, philosophy or strategy, and risks associated with the recommendations in standardized terms. SEC Reg BI: A Small Entity Compliance Guide. 

With the second disclosure of all material facts relating to conflicts of interest that are associated with the recommendation, a conflict of interest is an interest that might incline a broker, dealer, or associated natural person to make a recommendation that is not disinterested, whether consciously or subconsciously. 17 C.F.R. § 240.15l-1(a)(2)(i)(B), (b)(3). This may include conflicts associated with proprietary products, third-party payments, and compensation arrangements. SEC Reg BI: A Small Entity Compliance Guide. 

A fact is “material” if there is a substantial likelihood that a reasonable retail customer would consider it important. Id. ; Basic v. Levinson, 485 U.S. 224, 231-32 (1988).

A written disclosure may be subsequently supplemented, clarified or updated by way of a recorded supplemental oral disclosure made at the time of the recommendation or a permitted disclosure after the recommendation is made (e.g., trade confirmation or prospectus) if the initial written disclosures identifies the material fact and describes the process through which such fact may be supplemented, clarified, or updated. SEC Reg BI: A Small Entity Compliance Guide. 

The Form CRS (Relationship Summary) or other standardized disclosure about products and services may help satisfy the disclosure obligation, but alone may not be sufficient, and additional information may be required depending on the facts and circumstances of each case. Id.

Reg BI’s compliance obligation requires the broker or dealer (but not its associated persons) to establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Reg BI. 17 C.F.R. § 240.15l-1(a)(iv). 

This affirmative obligation is flexible such that it allows a broker-dealer to establish compliance policies and procedures that accommodate its business model. SEC Reg BI: A Small Entity Compliance Guide. Whether a broker-dealer’s policies and procedures are reasonably designed to comply with Reg BI depends on the facts and circumstances of each case, but they should address and be proportionate to the scope, size, and risks associated with the types of business being engaged and nature of operations, and be designed to prevent, detect and promptly correct any violations of the Reg BI. Id. A reasonably designed compliance program would also include controls, remediation of non-compliance, training, and periodic review and testing. Id.

Record must be kept of all information collected from or provided to a retail customer who is recommended any securities or investment strategy (unless the retail customer neglects, refuses or is unable to provide or update such information) and the identity of each associated natural person responsible for the account, if any, which must be retained for at least six years after the earlier of the date the account was closed or the date on which the information was replaced or updated. Id.; 17 C.F.R. § 240.17a-3(a)(35); 17 C.F.R. § 240.17a-4(e)(5).

The effective date for Reg BI is September 10, 2019, and the compliance date is June 30, 2020, when the SEC will start enforcing Reg BI. SEC Reg BI: A Small Entity Compliance Guide. 

Just days prior to the start of compliance, on June 26, 2020, the Second Circuit Court of Appeals upheld Reg BI, finding Reg BI is authorized by Section 913(f) of the Dodd-Frank Act and Reg BI is not arbitrary and capricious. See XY Planning Network, LLC v. SEC, Docket Nos. 19-2886-ag(L) and 19-2893ag(CON) (2d Cir. June 26, 2020).