On June 5, 2019, the SEC adopted Regulation Best Interest (“Reg BI”), which requires broker-dealers and associated persons to make recommendations regarding securities transactions (or investments involving securities) that are in the “best interest” of their retail clients. The SEC also adopted Form CRS, requiring broker-dealers and investment advisers to provide a brief relationship summary to retail investors, and issued two pieces of guidance regarding investment advisory activities. This Alert focuses largely on Reg BI. While the compliance deadline for Reg BI and Form CRS is not until June 30, 2020, firms should be prepared to shortly begin answering questions from regulators regarding their Reg BI implementation efforts.
Reg BI has four broad requirements or “Obligations:” (a) a Disclosure Obligation, which generally requires disclosure of relevant facts, (b) a Care Obligation, which generally requires the exercise of reasonable diligence and care, (c) a Conflict of Interest Obligation, which generally requires the implementation of policies and procedures to disclose and/or eliminate conflicts of interest and (d) a Compliance Obligation, which generally requires the implementation of Reg BI policies and procedures.
In order to comply with Reg BI, firms should review and update their procedures, update account information where necessary, evaluate current conflicts of interest, and train registered representatives, supervisors, and compliance personnel on the SEC’s new standard.
Potential Pitfalls – Watch Out
While we will not attempt here to capture all of the issues that firms must address in implementing Reg BI and Form CRS, we identify below certain potential pitfalls in Reg BI compliance. In particular, there are areas in Reg BI that may look very familiar to concepts with which firms are already familiar. Do not be fooled. There are critical differences.
- Recommendations: “Strategies,” “hold recommendations,” and “account recommendations” are all concepts that have existed, at a minimum, since FINRA Rule 2111 and the ensuing guidance was issued. Note, however, that in the Reg BI context, there can be an “implicit hold” recommendation when, for instance, the firm or associated person agrees to perform account monitoring services (i.e., silence can be a recommendation). Furthermore, if there is no agreement to perform account monitoring, but the associated person voluntarily undertakes such a review, that is not considered account monitoring but any recommendation arising from that review will be subject to the best interest standard.
- Dual Registrants: There are a number of nuances to consider when appropriately implementing Reg BI when the firm and/or the associated person is a dual investment adviser/broker-dealer registrant. Because Reg BI will only apply to the broker-dealer activities of a dual registrant firm, it will be important and potentially challenging for firms to clearly identify the activities that are subject to Reg BI.
- Disclosure: There are several questions that a firm/individual must consider when approaching the Reg BI disclosure obligations. For example, (a) how is the disclosure accomplished and when (i.e., at or before the recommendation)?, (b) to what extent will Form CRS disclosures satisfy the disclosure obligations?, (c) what is a material conflict of interest?, (d) are oral disclosures ever okay and if so, what are the requirements?, and (e) can the firm or individual refer to myself as an “advisor” or “adviser?”.
- Care Obligation: At first glance, the components of the Care Obligation look a lot like the three components of the Suitability Obligation in FINRA Rule 2111. However, while, like FINRA Rule 2111, there is a reasonable basis requirement, a customer specific requirement, and a quantitative (number of transactions) requirement, Reg BI requires much more than FINRA Rule 2111. In particular: (a) Firm must exercise reasonable diligence and skill to understand the potential risks, rewards, and costs (this includes assessing incentives, expected returns, and other factors), (b) With regard to the specific retail customer for whom the recommendation is made, the firm and associated person must have a reasonable basis to believe that the recommendation is in the customer’s best interest AND that it does not place the firm’s interest ahead of the customer, and (c) If a series of transactions is recommended, that strategy must be in the best interest of the customer and, with regard to this obligation, the biggest difference is that the series of transactions is evaluated without regard to whether the associated person exercises actual or de factor control over the account.
- Conflict of Interest Obligation: Under Reg BI, firms are required to have written policies and procedures that not only ensure disclosure conflicts of interest but that (a) Identify and disclose or eliminate conflicts, (b) Identify and mitigate conflicts creating an incentive to place interests ahead of the customer, (c) Identify and disclose if there is a limited product menu, and (d) Identify and eliminate certain sales contests, quotas, bonuses and non-cash compensation that are based on specific products or types to be sold within a specific time period.
- Compliance Obligation: This Obligation mandates that firms establish, maintain, and enforce written policies and procedures designed to achieve compliance with Reg BI. Because firms are very familiar with requirements to adopt compliance policies and procedures, particularly broker-dealer firms complying with FINRA Rule 3110, they may be inclined to not take this obligation as seriously as some of the others. However, the Compliance Obligation is a reminder that: (a) It is critical that this compliance program be reviewed periodically to assess whether changes are needed and (b) The SEC takes its policy and procedure requirements very seriously. In the past, in the broker-dealer context, FINRA has handled enforcement of policy and procedure deficiencies, because the SEC’s supervision cases were based on actual failures to supervise as opposed to procedural deficiencies. This Obligation provides a clear avenue for the examination and enforcement staff to take action if there a compliance program and procedural failures. Firms can expect that the SEC Staff will not be silent where compliance programs do not adequately address Reg BI.
- Firm Obligations vs. Individual Obligations: In the release adopting Reg BI, the SEC Staff emphasizes that the Conflict of Interest and Compliance Obligations apply only to firms, while the Care and the Disclosure Obligations apply to both the firms and the associated persons. With respect to the Conflict and Disclosure Obligations, a firm has responsibility for developing, maintain, and enforcement written policies and procedures, the firm must be vigilant in reasonably exercising those responsibilities. We have seen many cases in recent years where the regulators have brought enforcement actions against those with the same responsibilities when the program had material failures or gaps.
Early Examination Inquiry and Potential Enforcement Implications
As the primary regulator of broker-dealers, FINRA will be tasked with the leg work of Reg BI enforcement. FINRA will likely not wait until the effective date of Reg BI these requirements to begin asking firms about their Reg BI compliance efforts. Rather, FINRA will want to ensure that its member firms are prepared for this sea change in regulatory compliance obligations and requirements.
At a recent industry conference, senior FINRA officials indicated that FINRA will begin asking member firms about their Reg BI preparation efforts as part of its examination program as soon as early next year. While officials framed these examination inquiries as designed in part to identify areas where industry participants may need additional guidance, firms must nevertheless prepare for imminent questions regarding their Reg BI implementation efforts.
Many expect that it is unlikely that FINRA and the SEC will bring formal enforcement cases against firms and individuals in the first year or so following the compliance deadline. However, if firms fail to make an effort to comply with Reg BI or disregard issues a regulator identifies in a firm during an examination or otherwise, we would expect the SEC and FINRA will not hesitate to bring enforcement actions.
Firms will not only face scrutiny from the SEC and FINRA in connection with the subject matter of Reg BI. It is expected that the states, many of which have already passed, or are in the process of passing, their own more stringent fiduciary statutes and regulations, will be more proactive on the enforcement front in this space. Regardless of where a state may be with their own legislative action in this space, they could pursue actions when firms or individual registered representatives are not complying with Reg BI obligations. Furthermore, while the Department of Labor’s Fiduciary Rule, which sought to impose a fiduciary standard of conduct for registered representatives working with retirement accounts, was vacated by the U.S. Court of Appeals for the Fifth Circuit, the DOL has indicated that they expect to issue a revised rule later this year, with changes reflecting a similar approach to Reg BI.
Legal Challenge to Reg BI
On September 9, 2019, seven states and the District of Columbia filed suit against the SEC in the U.S. District Court for the Southern District of New York. The plaintiffs essentially claim that Reg BI is too weak, alleging that it undermines what they deem to be “critical consumer protections for retail investors” and allows registered representatives to continue to give conflicted advice. The plaintiffs seek to invalidate the SEC’s rule, alleging that the SEC exceeded its authority and that Reg BI is arbitrary and capricious under the Administrative Procedures Act.
Investment Adviser Guidance
Simultaneous with its adoption of Reg BI, the SEC approved two pieces of guidance in the investment advisory regulatory sphere.
First, the SEC issued guidance to clarify when a broker-dealer’s activities may qualify under the broker-dealer exclusion from investment adviser registration, which generally exempts a firm from investment adviser registration when such broker-dealer’s activities are “solely incidental” to its broker-dealer activities. In this guidance, the SEC Staff indicates that broker-dealers who have long-term investment discretion will unlikely be able to rely on the broker-dealer exclusion.
Second, the SEC issued guidance that generally expands upon prior SEC Staff guidance regarding an investment adviser’s fiduciary duty. In particular, this guidance provides more detail regarding an investment adviser’s duties of care and loyalty.
Form CRS and its related rules require SEC-registered investment advisers and broker-dealers to both file with the SEC and deliver to retail investors a customer or client relationship summary that meets certain requirements, which summary is intended to assist the customer or client in making decisions regarding its relationship with the adviser or broker-dealer.
If you have not started your Reg BI compliance preparation, Start Now.
This article was previously posted to McGuireWoods' blog, Subject to Inquiry.
Published November 1, 2019.