Recently, the Securities and Exchange Commission’s Division of Trading and Markets published responses to frequently asked questions that it has received on Regulation Best Interest (the “Reg. BI FAQ”).
Regulation Best Interest (Securities Exchange Act Rule 15l-1) becomes effective June 30, 2020, and imposes a number of obligations on broker-dealers and natural persons associated with a broker-dealer if they make recommendations to retail customers. Our blog post on the issuance of the regulation may be found here.
These requirements include a disclosure obligation that generally must be met prior to or at the time of each recommendation, a care obligation that requires the representative to understand the potential risks, rewards, and costs associated with a recommended transaction or series of recommended transactions, and an obligation, when making a recommendation, to act in the customer’s best interest. Regulation Best Interest also requires broker-dealers who make recommendations to retail customers to establish, maintain and enforce written policies and procedures related to the identification, disclosure and mitigation of conflicts of interests and, more generally, to implement, maintain and enforce policies and procedures that are reasonably designed to achieve compliance with Regulation Best Interest.
For most brokerage firms, compliance with Regulation Best Interest will require significant time and effort and will depend upon input and involvement of numerous people and functions across the firm. Firms that have not already begun their Regulation Best efforts are encouraged to begin these efforts as soon as possible, notwithstanding that the rule’s effective date is still more than five months away.
The Reg. BI FAQ covers the following topics:
- Disclosure Obligation
- Care Obligation
- Conflict of Interest Obligation
Recommendation. The Reg. BI FAQ reminds readers that the term “recommendation” applies not only to recommendations of securities, i.e., to buy or sale or continue to hold a particular security position, but also applies to account recommendations. The Reg. BI FAQ also provides a non-exclusive, but useful, list of account types.
The Reg. BI FAQ also states that dually registered financial professionals, i.e., natural persons who are both associated with a broker-dealer and a supervised person of an investment adviser, must consider both brokerage and advisory accounts when making an account recommendation. By contrast, an associated person of a broker-dealer that is not also a supervised person of an investment adviser need only take into consideration available brokerage accounts. This is true even though the associated person’s brokerage firm may be dually registered as both a broker-dealer and an investment adviser.
The Reg. BI FAQ also provides analysis of whether several fact patterns might constitute a recommendation, though, for the most part, this analysis does not improve upon the more in-depth discussion of the term “recommendation” that is set forth in the Regulation Best Interest Approving Release.
An interesting point, however, is raised by the fact pattern involving an associated person moving from Firm A to Firm B who also contacts existing retail customers in an attempt to persuade them to move their accounts to Firm B. Specifically, it seems difficult to imagine how a departing representative who recommends that existing customers move their accounts From Firm A to Firm B would be able to comply with Regulation BI – at least absent the full engagement of Firm B. This follows from the fact that since the departing representative’s recommendation is being made on behalf of Firm B, the recommendation would seem to trigger obligations on the part of Firm B to comply with the disclosure and other obligations of Regulation Best Interest. Firm B’s engagement, however, is problematic as it is unclear how Firm B would be in a position to supervise the departing representative’s compliance with Firm B’s Regulation Best Interest requirements. Perhaps this could be worked out satisfactorily with the involvement and cooperation of both Firm A and Firm B. Absent such an approach, however, it seems the best advice is that departing representatives should be careful to not recommend that customers move their accounts to the representative’s new firm until such time as the representative is actually associated with the new firm and to then make such recommendation only in compliance with the full requirements of Regulation Best Interest.
Disclosure Obligation. The Reg. BI FAQ discusses when the disclosure obligation may be satisfied after a recommendation is made, whether the Relationship Summary Form (Form CRS) can be used to satisfy the disclosure obligation, and electronic delivery obligations.
Care Obligation. The care obligation must be met each time a recommendation is made and also in the context of “a series of recommended transactions.” Unhelpfully, without providing any citations, the Reg. BI FAQ states that the concept of a “series” of recommended transactions “is an established term under the federal securities laws and SRO rules that is evaluated in concert with existing guideposts, such as turnover rate, cost-to equity ratio, and use of in-and-out trading.” In other words, this is a facts and circumstances determination that is likely to be construed broadly in a manner that favors retail customers.
Conflict of Interest Obligation. The Reg. BI FAQ states that conflicts that are not explicitly prohibited are permitted provided they are properly disclosed and mitigated. The FAQ also provides a non-exhaustive list of potential mitigation practices.