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. Regulation BI applies specifically to recommendations made 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 known primarily for transaction execution (helping customers buy and sell securities). Many trades processed by broker-dealers are unsolicited, meaning the firm did not recommend the transaction. These trades are typically self-directed by the investor or recommended by a third party (for example, a customer’s investment adviser).
Historically, when recommendations were not a primary part of a firm’s business, broker-dealers largely avoided the rules that apply to investment advisers. Investment advisers must follow strict fiduciary* laws, which include extensive disclosures and thorough representative training 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 that client.
Why do rules around investment advice matter so much? The financial industry has a long history of unethical behavior. Here are a few examples:
For decades, investment adviser firms have been subject to recommendation-based regulations meant to prevent unethical activity. Broker-dealers largely avoided those regulations by arguing that their businesses focused on executing transactions, not making recommendations.
Over time, that distinction often didn’t match what was happening in practice. In the examples above, broker-dealer representatives earned large commissions after 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 for 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.” Broker-dealers and representatives who advise retail customers must follow specific rules and protocols, organized into 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 large commissions. If there are better alternatives they avoid because the payout is smaller, you can’t evaluate the recommendation fairly.
To help retail customers make informed decisions, Regulation BI requires broker-dealers and their representatives to disclose the following in writing at or prior to any retail customer recommendation:
Broker-dealers provide these disclosures in writing on Form CRS (customer relationship summary). You can see a real example here: 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 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.
As discussed above, a conflict of interest is any circumstance that jeopardizes prioritizing the client’s interests. In practice, these are situations where the financial professional has a financial incentive to put their own interests ahead of the client’s.
Common conflicts of interest in the industry 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. You’d reasonably question whether the recommendation is being made because it fits your needs, or because it benefits the representative’s family.
Recommending securities as part of a sales contest
Many securities firms run sales contests to motivate representatives. For example, a firm may pay a bonus to the representative who convinces the most clients to open discretionary accounts. Contests like this can create pressure to “sell” even when it isn’t in the client’s best interest.
While the conflicts of interest listed above can be problematic, they’re allowed with proper disclosures. 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, try to 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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