Regulation Best Interest (BI) is an amendment the Securities and Exchange Commission (SEC) recently added to the Securities Exchange Act of 1934. This rule is designed to ensure broker-dealers and their agents put the customer’s interests ahead of their own when making recommendations. In particular, Regulation BI sets standards that apply when these professionals recommend securities transactions or investment strategies to retail investors*.
*Regulation BI does not apply to interactions with institutional investors (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 did not recommend the transaction. Instead, the investor directs the trade or a third party recommends it (for example, the customer’s investment adviser).
When recommendations aren’t a primary part of a firm’s business, the firm has historically avoided many of the rules that apply to investment advisers, who must follow strict fiduciary* laws. Investment adviser-specific regulations require extensive disclosures and thorough investment adviser representative (IAR) training 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 financial 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 reduce this kind of misconduct. Broker-dealers largely avoided those rules by arguing that their business was primarily transaction execution, not recommendations.
Over time, that distinction often didn’t match what was happening in practice. Many of the examples above involve broker-dealer representatives earning large commissions after clients accepted unsuitable recommendations. In effect, 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 pay specifically for investment advice. Some broker-dealers and representatives providing advice were “skirting” the rules by claiming their commissions were payment for the transaction execution, not the advice. As long as broker-dealers implied that distinction, they were not regulated as investment advisers.
Regulation BI is the SEC’s attempt to close this “loophole.” When broker-dealers and agents recommend securities or strategies to retail customers, they must follow specific rules and protocols in four categories:
Transparency matters whenever a financial professional makes a recommendation. If key parts of a broker-dealer’s business are hidden, trust breaks down.
For example, imagine your representative recommends only products that pay them high commissions. If there are better alternatives they avoid because the payout is smaller, the recommendation isn’t really about your needs.
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 retail customer recommendation:
Broker-dealers provide these disclosures on Form CRS (customer relationship summary). To see a real example, here’s 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 to customers during or prior to making recommendations.
Before making a recommendation, broker-dealers and agents must determine the following:
*Although a security or strategy may be in a client’s best interest, it 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.
As discussed above, a conflict of interest is any circumstance that puts the client’s interests at risk because the financial professional has an incentive to put their own interests first. 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) can earn income in two ways. First, it collects investment advisory fees, especially when managing client assets on a discretionary basis. Second, the proprietary product generates additional revenue for the firm. In the Vanguard example, the fund collects fees through its expense ratio.
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. Is the recommendation being made because it fits your needs, or because it benefits the representative’s family?
Recommending securities as part of a sales contest
Many firms run sales contests to motivate representatives. For example, a firm may pay a bonus to the representative who persuades the most clients to open discretionary accounts. In that situation, the representative has an incentive to “sell” the firm’s goal, even when it isn’t in the client’s best interest.
These conflicts can be harmful, but they’re generally permitted if 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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