Regulation Best Interest (BI) is an amendment the Securities and Exchange Commission (SEC) added to the Securities Exchange Act of 1934 in 2019. The rule is designed to ensure broker-dealers and their registered representatives put the customer’s interests ahead of their own when making recommendations to retail investors*.
*A retail investor is an individual who invests for themselves or on behalf of their family or friends. Regulation BI does not apply to interactions with institutional customers (financial organizations investing on behalf of their clients).
Broker-dealers are best known for executing transactions (helping customers buy and sell securities). Most trades processed by broker-dealers are unsolicited, meaning the firm didn’t recommend the transaction. Instead, the investor directs the trade or a third party recommends it (for example, the customer’s investment adviser).
Historically, when recommendations weren’t a primary part of a firm’s business, broker-dealers could avoid many of the rules that apply to investment advisers. Investment advisers are held to strict fiduciary* standards, which include extensive disclosures and training requirements designed to protect clients.
*A fiduciary manages assets on behalf of another person. For example, an investment adviser managing a client’s assets is a fiduciary to their client.
Why do recommendation rules matter so much? The industry has a long history of unethical conduct tied to unsuitable recommendations. Here are a few examples:
For decades, investment adviser firms have been subject to recommendation-based regulations intended to prevent this kind of behavior. Broker-dealers often avoided those regulations by arguing that their business was primarily transaction execution, not advice. Over time, that distinction didn’t always match what was happening in practice.
In the examples above, broker-dealer representatives earned large commissions when clients accepted their (unsuitable) recommendations. In plain terms, some broker-dealers and their representatives were acting like investment advisers* without being regulated as such.
*To be considered an investment adviser, a client must make payment specifically for investment advice. Some broker-dealers and representatives providing advice were “skirting” the rules by claiming their commissions were payment for transaction execution, not the advice. As long as broker-dealers maintained that distinction, they were not regulated as investment advisers.
Regulation BI is the SEC’s attempt to close this “loophole.” When broker-dealers and their representatives recommend investments to retail customers, they must follow specific rules and protocols in four categories:
Transparency matters whenever a financial professional makes a recommendation. If important parts of a broker-dealer’s business are hidden, trust breaks down.
For example, imagine your representative recommends only securities that pay them high commissions. If there are better alternatives they avoid because the payout is smaller, the recommendation process isn’t really serving your interests.
To help retail customers make informed decisions, Regulation BI requires broker-dealers and their representatives to disclose the following in writing at or before any recommendation:
Broker-dealers typically provide these disclosures on Form CRS (customer relationship summary). Here’s an example from the real world: Charles Schwab’s Form CRS (the first two pages are Schwab’s broker-dealer portion). The form is divided into these sections:
To comply with Regulation BI, broker-dealers like Charles Schwab must deliver this customer relationship summary during or before making recommendations.
Before making a recommendation, broker-dealers and their representatives must determine the following:
*Even if a security or strategy is in a client’s best interest, it still shouldn’t be over-recommended. For example, a specific mutual fund may be suitable and in the client’s best interest, but recommending too much of it is unethical.
A conflict of interest is any circumstance that puts the client’s interests at risk. In practice, this usually means the financial professional has an incentive to put their own financial benefit ahead of the client’s needs.
Common conflicts of interest include:
Recommending proprietary products
A product created by the same institution that recommends it to clients is a proprietary product. For example, a Vanguard mutual fund recommended to clients by Vanguard advisers.
The firm (Vanguard in this example) can earn income in two ways:
*Firms that manage their clients’ assets typically charge assets under management (AUM) fees. For example, a firm charging a 1.5% AUM fee would collect $15,000 annually for managing a $1 million account.
Recommending securities the firm or representative is tied to
Assume you have an account at a broker-dealer and regularly discuss investment strategies with your assigned representative. Now suppose they recommend the stock of a company their spouse is the CEO of, without telling you. That missing disclosure makes it hard to judge whether the recommendation is based on suitability or personal benefit.
Recommending securities as part of a sales contest
Many firms run sales contests to motivate representatives. For example, a firm might pay a bonus to the representative who persuades the most clients to open discretionary accounts. Contests like this can create pressure to “sell,” even when the recommendation isn’t in the client’s best interest.
These conflicts can be allowed if they’re handled properly. Regulation BI requires the following:
The [broker-dealer] establishes, maintains, and enforces written policies and procedures reasonably designed to:
- Identify and at a minimum disclose … 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 a [representative] to place [their or their firm’s interests] ahead of the interest of the retail customer
- Identify and eliminate any sales contests, sales quotas, bonuses, and non-cash compensation* that are based on the sales of specific securities** or specific types of securities**
*Non-cash compensation is exactly what it sounds like. For example, a firm gives a representative a free all-paid vacation as a bonus.
**Sales contests are not prohibited as long as the firm discloses properly, but centering a contest around recommending one specific product or type of security creates a bad incentive structure. Firms should not engage in these types of competitions.
Bottom line: firms must identify conflicts of interest, eliminate them when possible, and disclose them when they can’t be eliminated.
This one is straightforward. Broker-dealers must:
Establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Regulation BI
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