Regulation Best Interest

Financial Advisers Must Act in the Best Interest of the Customer

The Securities and Exchange Commission and FINRA have made changes to the standard of conduct between a brokerage firm and its customer. Regulation Best Interest or “Reg BI” goes into effect on Tuesday, June 30.

The SEC adopted Reg BI under the Securities Exchange Act of 1934 (Exchange Act). Reg BI establishes a “best interest” standard of conduct for broker-dealers and associated persons when they make a recommendation to a retail customer of any securities transaction or investment strategy involving securities, including recommendations of types of accounts.

Among other things, Reg BI incorporates and enhances principles that are also found in the Suitability Rule under FINRA Rule 2111. Reg BI requires brokers making investment recommendations to put the financial or other interests of their customers ahead of their own, to comply with the firm’s four obligations – Care, Disclosure, Conflict of Interest and Compliance.

FINRA’s Suitability rule provided that that a broker-dealer or associated person “have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the firm or associated person to ascertain the customer’s investment profile.” The rule identified the three main suitability obligations: reasonable-basis, customer-specific and quantitative suitability.

Care Obligation

The care obligation requires that the BD, or an associated person of the BD, in making the recommendation, exercises reasonable diligence, care and skill to:

• 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;

• 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 BD or such natural person ahead of the interest of the retail customer; and

• 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 BD or such natural person making the series of recommendations ahead of the interest of the retail customer.

Disclosure Obligation

The disclosure obligation requires a BD or associated person, prior to or at the time of the recommendation, to provide the retail customer, in writing, full and fair disclosure of:

• All material facts relating to the scope and terms of the relationship with the retail customer, including:
  • That the BD or associated person is acting as a BD or an associated person with respect to the recommendation;
  • The material fees and costs that apply to the retail customer’s transactions, holdings, and accounts; and
  • The 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; and
• All material facts relating to conflicts of interest that are associated with the recommendation.

Conflict of Interest Obligation

To satisfy the conflict of interest obligation, the BD must establish, maintain and enforce written policies and procedures reasonably designed to:

• Identify and, at a minimum, disclose, in accordance with the disclosure obligation, or eliminate, all conflicts of interest associated with such recommendations;

• Identify and mitigate any conflicts of interest associated with such recommendations that create an incentive for an associated person of a BD to place the interest of the BD or such natural person ahead of the interest of the retail customer;

• Identify and disclose any material limitations placed on the securities or investment strategies involving securities that may be recommended to a retail customer and any conflicts of interest associated with such limitations, in accordance with the disclosure obligation;

• Prevent such limitations and associated conflicts of interest from causing the BD or an associated person of the BD to make recommendations that place the interest of the BD or such associated person ahead of the interest of the retail customer; and

• Identify and eliminate any sales contests, sales quotas, bonuses and non-cash compensation that are based on the sales of specific securities or of specific types of securities within a limited period of time.

Compliance Obligation

In a new part of the general obligation, and in addition to the procedures required by the conflict of interest obligation, a BD must also establish, maintain and enforce written policies and procedures designed to achieve compliance with Regulation BI as a whole. These procedures must not only address conflicts of interest, but also compliance with the disclosure and care obligations. The SEC believes that, while creating an affirmative obligation with respect to Regulation BI as a whole, the compliance obligation provides sufficient flexibility to establish compliance procedures across a broad range of business models. A reasonably designed compliance program generally would also include controls, remediation of noncompliance, training, and periodic review and testing.