What broker-dealers need to know about the Regulation Best Interest rule

June 12, 2019 by Kelton Corcoran

about the author:

Kelton Corcoran

Senior content marketing specialist

Kelton Corcoran is a senior content marketing specialist at Advicent, the financial planning technology provider of choice for nearly 100,000 financial professionals.

On June 5, 2019, the Securities and Exchange Commission (SEC) officially voted in the Regulation Best Interest (Reg BI) rule to bring a new set of standards to broker-dealers. The rule – which will go into effect June of 2020 – aims to strengthen the guidelines previously outlined by the suitability rule.

The new rule is also an attempt at closing the regulatory gap between broker-dealers and Registered Investment Advisors (RIAs), who have long been held to a higher measure of client care with the fiduciary standard. Rather than recommending investments that are simply “suitable” for a client, RIAs are beholden to recommend the best possible option for the client’s situation regardless of their own interests (commissions or other incentives).

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While the official SEC document comes in at a hefty 771 pages, here are some of the highlights that broker-dealers need to know about the new Reg BI rule.

Suitable vs best interest

The suitability rule under which broker-dealers currently operate requires that recommended investments are suitable for a client based on their demographics, characteristics, goals, and level of acceptable risk. The issue is that broker-dealers are not necessarily required to present the very best option for the client’s situation, instead just one that fits their needs in some way.

For example, consider that two investment options with similar risk are presented to a client: option A that has historically returned six percent and option B that has historically returned four percent. Say that option A carries a commission of one percent, but option B carries a commission of two percent. If both options A and B are suitable for a client, the broker is not required to present option A over option B and can lean towards the one that pays them a higher commission.

In addition to preventing broker-dealers from presenting options that favor their interests over that of their clients, the rule will ban firms from offering sales incentives such as free vacations or bonuses for selling certain 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.

The SEC breaks down the Regulation Best Interest rule into the following 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 an interview on CNBC’s “Squawk Box,” SEC Chairman Jay Clayton said that “We’re raising the standard of conduct for broker-dealers – the obligations that they owe to their clients.” When asked about the previous suitability standard, Clayton said: “It wasn’t clear enough.”

Form CRS

To make the relationship between a client and RIA or broker-dealer clear from the jump, the Reg BI rule calls for the required 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 disciplinary history. Both RIAs and broker-dealers will need to deliver this document to their clients at the start of the relationship.

In comparison to the former DOL fiduciary rule

Critics of the new rule say that although it is a step in the right direction, Reg BI is weak in comparison to the now-defunct DOL fiduciary rule that was rescinded on July 20, 2018. One area of contrast was the fiduciary rule’s requirement of a signed best interest contract with clients that could allow for litigation and class action lawsuits. This contract would have seriously bolstered the enforcement of the new standards but is not included in Reg BI.

Another is that there are now two sets of rules: a fiduciary rule for RIAs and Reg BI for broker-dealers. The fiduciary standard aimed to make a much larger portion of financial professionals – including financial advisors – legally obligated to always act in the best interest of the client. Not only did this hope to clarify the rules that govern financial professionals but also make it easier for clients to understand. Many believe that even with the improvements made with Reg BI, the regulations have only become more complicated for consumers.

Though Reg BI has already been voted through, expect more news surrounding the ruling to appear before it goes into effect next June.

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