Last month, despite the market disruption caused by the global pandemic, the SEC announced they had no plans to extend the June 30, 2020 compliance deadline for Regulation Best Interest. This decision may present challenges for firms who have had to divert resources from Reg BI readiness towards addressing the impact of Covid-19 on business operations.
For firms who are still preparing for the implementation of these new requirements, here is a summary of the components of the rule and the necessary requirements in order to comply.
What is Reg BI?
BI stands for best interest. You can find the full text of the rule at 17 CFR Part 240.15l-1. There are also minor changes in other parts of the 1934 Act to match the new rule. Regulation BI has several parts.
Best Interest Obligation
A broker or dealer must act in the best interest of a retail customer. This means without placing the broker or dealer’s financial interest ahead of the interest of the customer.
Broker or dealer includes any person working for or associated with a broker or dealer. Most wealth and retail managers will fit into this category for at least some of their work. Retail customer means an individual who is investing for their own household purposes (generally retirement savings or general investing).
As a broker or dealer, you must make several written disclosures to each customer. You must provide the disclosure in writing at or before the time you make the recommendation. You may not provide oral disclosures and send a written copy later.
You must include the following disclosures.
- You are acting as a broker or dealer with respect to the recommendation.
- All material fees and costs that apply to each transaction, the customer’s overall holdings, and the customer’s accounts.
- The type and scope of services you’re providing. This includes any limitations on the securities or investment strategies that you’re recommending.
- All material facts regarding any conflict of interest you have with what you’re recommending.
An important update: On April 20th, 2020, the SEC issued an update to its FAQ for Reg BI which clarified that, except in certain cases, broker-dealers who use the terms “advisor” or “adviser” in their titles or their firms’ names without being registered as investment advisors will be in violation of the rule’s Disclosure Obligation.
When acting as a broker or dealer, you must exercise reasonable diligence, care, and skill when making a recommendation. You must also ensure that anyone working for you or associated with you does the same.
The care obligation includes three parts.
- Having a reasonable basis to believe the recommendation could be in the best interest of at least some retail customers. This includes understanding the potential risks, rewards, and costs associated with the recommendation.
- Having a reasonable basis to believe the recommendation is in the best interest of each particular customer you make the recommendation to. This includes having an understanding of the customer’s investment profile and the potential risks, rewards, and costs.
- Having a reasonable basis to believe that a series of recommended transactions is in the best interests of the customer not just at each individual transaction but as a whole. This includes not making excessive transactions and considering the customer’s investment profile.
In each part, you must continue to place the interest of the customer over the financial or other interest of your firm.
Conflict of Interest Obligation
You also have several obligations with regard to conflicts of interest.
- Identify and disclose all conflicts of interest.
- Mitigate any conflicts of interest that create an incentive for you or anyone working with or associated with you to place the interest of the broker, dealer, or any individual over the interests of the customer.
- Identify and disclose any material limitations placed on the securities and investment strategies you’ve recommended. You also must prevent these limitations from causing anyone to place other interests ahead of the customer’s.
- Eliminate quotas, contests, and other incentives that are based on the sales of specific securities or types of securities within a limited period of time.
You have a general duty to take reasonable steps to achieve compliance with your obligations under Regulation BI. This includes establishing, maintaining, and enforcing written policies towards that end.
Why Was Reg BI Passed
Federal regulators sought Regulation BI for a number of reasons. The overarching theme is that brokers and dealers and those working for them had sometimes put their own profits ahead of the customer’s best interests.
The suitability rule didn’t adequately address this because it only required that an investment meet an investor’s minimum needs. For example, a client saving for retirement might need 60% in equities based on their risk profile. A broker or dealer could recommend a high-fee, actively-managed equities fund that generates a large commission over an index fund with similar expected returns and lower costs to the customer but a lower commission. Other targeted behaviors included excessive trading to generate additional commissions and recommending rollovers from workplace plans solely to generate additional fees.
Regulation BI also covers more account types than the Department of Labor Fiduciary Rule was intended to cover. The Department of Labor generally only has authority over ERISA accounts, while the SEC rules can also include individual retirement accounts and brokerage accounts.
What Do Firms Need to Do to Comply With Reg BI
The regulation itself spells out the basics of what you need to do to comply. One of the most important first steps is understanding what Regulation BI is not asking you to do. Then, there are a few practical steps you should take.
What Reg BI is Not
Reg BI does not mean that you can never recommend funds with higher fees or commissions. However, the reason for recommending a product that nets you a higher fee must be in the client’s best interest. For example, both you and your client may not believe in only using a passive index fund approach, so you may recommend that part of their portfolio go into higher-cost active funds.
The key is that you’ll need to be able to document what you recommended and why. You’ll also need to disclose that you’re earning a higher fee due to your recommendation in your disclosures.
Can Customers Waive Reg BI?
Once you start digging into Reg BI, you may think about asking customers to waive it. This is not an unreasonable thought since many professional obligations in many settings can be waived with a client’s informed consent. When it comes to Regulation BI, the SEC doesn’t allow waivers. If the person you’re dealing with classifies as a retail customer, they have no ability to waive the regulation in any circumstance.
What Steps You Should Take to Comply with Reg BI
Here’s what you should be doing to comply with Regulation BI.
- Know the deadline. All firms must be in compliance by June 30, 2020.
- Identify whether your clients are retail customers. Business entities are likely not covered by Reg BI. For trusts, family companies, and similar entities, you should seek legal guidance as the SEC hasn’t clarified this issue.
- Evaluate your compensation packages. Some compensation structures are now illegal. Others may require disclosure. In addition to avoiding compensation packages that break the regulation, you’ll also need to find new ways of ensuring that members of your firm don’t see their compensation go down but still retain an incentive for high performance.
- Review your client intake procedures. You now have a high burden to understand each customer’s objectives and risk tolerance. This may require a more thorough intake than you’ve done in the past. You may also need to follow up on a quarterly or annual basis to ensure their needs haven’t changed. Document all of this information in your files to demonstrate how you understand your clients’ needs.
- Create a disclosure form. You must make your written disclosures on a standardized form. This is a similar process to how the disclosures you receive from your own banks all look the same. FINRA has a checklist that you can follow.
- Understand how to deliver your disclosures. You must deliver your disclosures at the time of the recommendation. A general disclosure when starting the client relationship won’t be enough in most situations. For in-person meetings, you should use physical copies of your disclosure forms. You can’t direct a client to look at your website at a later time, since you must make the disclosure when you present the recommendation. If you conduct business online, you must clearly present your disclosures in a prominent place — you can’t bury them in fine print or use links to other parts of your site.
- Consider all of your services. If you offer multiple covered services, you can’t treat them in isolation. Brokers who are also advisors must consider what they could offer as an advisor when making recommendations as a broker. Brokers who are not registered as investment advisors, cannot use the term “advisor” or “adviser” in their titles or their firm names under Reg BI. However, broker-dealers may use the terms when performing “a role specifically defined by federal statute that does not entail providing investment advisor services to retail customers, for example, as a municipal advisor, commodity trading advisor, or advisor to a special entity,” says the SEC.
- Document everything. The SEC requirement of having a documented compliance plan is an opportunity not a hurdle. There is always the chance of a customer disgruntled over their losses filing an SEC complaint. If your plan only covers the legal minimum requirements, it may leave you open to liability. If you thoroughly document each procedure you follow and also make it your policy to maintain all of the information you collect from your customers, you can more easily demonstrate your compliance.
If you act as a broker or dealer, you should be taking final steps to ensure your compliance with Regulation BI. The regulation adds additional burdens, but most boil down to disclose everything and don’t do anything against your client’s interests. These are common themes with the SEC, but the regulation was passed to curtail abuses at some firms. If you haven’t already, begin implementing steps to maintain and demonstrate compliance with your obligations.
If your firm is unable to meet the requirements of Reg BI or make certain filings before the June 30th, 2020 deadline because of the disruptions caused by the pandemic, your firm should engage with SEC. To the extent that compliance efforts are being made in good faith, the regulator has vowed to work with firms on a case-by-case basis to find a solution.
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