It has been 391 days since the Securities and Exchange Commission introduced a new set of standards for broker-dealers, registered investment advisors (RIAs), and dual registrants. On June 30, the Regulation Best Interest (Reg BI) rule went into effect, ensuring brokers are acting in the best interests of their clients.
The rule was created as a way to help close the regulatory gap between broker-dealers and RIAs, who have long been held to stricter guidelines with the fiduciary standard. Prior to Reg BI’s implementation, brokers were held to a looser suitability standard, which has also been slightly updated by FINRA to account for the SEC’s new regulation.
You may recall that Reg BI has been a topic of debate amongst the financial services industry since being introduced last year and was even challenged by several states and advisor member platform XY Planning Network. In this article, we will give an update on how that challenge played out, and everything brokers need to know as Reg BI is made effective.
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Opposition to Reg BI
In September 2019, several attorneys general from the states of California, Connecticut, Delaware, the District of Columbia, Maine, New Mexico, New York, and Oregon combined to file a suit against the SEC and its chairman Jay Clayton claiming that Reg BI’s standards were too weak to properly protect clients when compared to the fiduciary rule. The next day, XY Planning Network also filed a suit, which was consolidated into one on September 12, 2019.
Just under one month after the suits were consolidated, the Southern District of New York dismissed the lawsuit due to a self-declared lack of subject matter jurisdiction – meaning that they felt the case would be better handled by the U.S. Court of Appeals for the Second Circuit.
The outbreak of COVID-19 led to some uncertainty on whether the case would be heard by the 2nd Circuit, but oral arguments were scheduled and made virtually on June 2, 2020. Ultimately, the court ruled in favor of the SEC on June 26, citing that “Regulation Best Interest clearly falls within the discretion granted to the SEC by Congress.” Time will tell whether further opposition will be formed, however, Reg BI went into effect as planned on June 30.
Suitable vs best interest advice
The suitability rule that previously applied to broker-dealers permitted them to recommend investments that were simply suitable based on the client’s demographics, characteristics, goals, and level of acceptable risk. The issue was that broker-dealers were not necessarily required to present the very best option based on the client’s situation, and instead just one that fits their needs in some way.
As an example, consider that two investment options with similar risk were presented to a client: option A that historically returned six percent and option B that historically returned four percent. Say that option A carried a lower commission for a broker than option B did. If both options A and B were suitable for a client, the broker was not required to present option A over option B and could have leaned towards the one that paid them a higher commission.
In addition to preventing broker-dealers from favoring their own interests over that of their clients, the rule bans from offering certain sales incentives such as free vacations or bonuses for selling specific products. Further, Reg BI restricts broker-dealers from using the title of ‘advisor’ or ‘adviser’ if they are not dually registered as an investment advisor.
While we recommend that all brokers visit the SEC’s Reg BI page to gain a full understanding of the new rule, it can be broken down simply into these four main components:
- Disclosure Obligation: Broker-dealers must disclose material facts about the relationship and recommendations, including specific disclosures about the capacity in which the broker is acting, fees, the type and scope of services provided, conflicts, limitations on services and products, and whether the broker-dealer provides monitoring services.
- Care Obligation: A broker-dealer must exercise reasonable diligence, care and skill when making a recommendation to a retail customer. The broker-dealer must understand potential risks, rewards, and costs associated with the recommendation. The broker-dealer must then consider these factors in light of the retail customer’s investment profile and make a recommendation is in the retail customer’s best interest. The final regulation, which is an enhancement from the proposal, explicitly requires the broker-dealer to consider the costs of the recommendation.
- Conflict of Interest Obligation: The broker-dealer must establish, maintain, and enforce written policies and procedures reasonably designed to identify and at a minimum disclose or eliminate conflicts of interest. This obligation, which is an enhancement from the proposal, specifically requires policies and procedures to:
- Mitigate conflicts that create an incentive for the firm’s financial professionals to place their interest or the interests of the firm ahead of the retail customer’s interest;
- Prevent material limitations on offerings, such as a limited product menu or offering only proprietary products, from causing the firm or its financial professional to place his or her interest or the interests of the firm ahead of the retail customer’s interest; and
- Eliminate sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sale of specific securities or specific types of securities within a limited period of time.
- Compliance Obligation: In an enhancement from the proposal, broker-dealers must establish, maintain and enforce policies and procedures reasonably designed to achieve compliance with Regulation Best Interest as a whole.
In wake of Reg BI’s implementation, FINRA also updated its suitability rule to clarify that it does not apply to recommendations that are now subject to Reg BI. More information can be found in this regulatory notice from FINRA.
To ensure that the relationship between a client and a broker-dealer, RIA, or dual registrant is clear from day one, Reg BI requires the use of a new document titled “Form CRS.” This document is meant to summarize information about a firm’s services, fees and costs, conflicts of interest, legal standard of conduct, and whether or not the firm and its financial professionals have a disciplinary history.
Form CRS applies to all broker-dealers, RIAs, and dual registrants that do business with retail investors.
Achieving compliance through FinTech
Though we at Advicent do not believe any singular software or process can completely ensure that a broker-dealer will not be subject to investigation, there are several key functionalities that modern financial planning software can deliver to help achieve compliance with Reg BI.
To learn how NaviPlan can help broker-dealers provide best interest advice, click here.