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 registered representatives put their customers’ 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**.
*The Securities Exchange Act of 1934 is a securities legislation that primarily regulates the secondary market and its participants.
**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). Most trades processed by broker-dealers are unsolicited, meaning the firm did not recommend the transaction. Instead, the investor typically directs the trade themselves, or a third party recommends it (for example, a customer’s investment adviser).
When recommendations aren’t a primary part of a firm’s business, the firm can largely avoid the rules that apply to investment advisers. Investment advisers must follow strict fiduciary* laws, including 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 their client.
Why do recommendation rules matter so much? The financial industry has a history of unethical recommendation practices. Here are a few examples:
For decades, investment adviser firms have been subject to recommendation-based regulations intended to prevent this kind of misconduct. Broker-dealers often avoided those rules by arguing that their business was primarily transaction execution, not recommendations.
Over time, that distinction didn’t always match reality. 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, the firm’s clients 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 representatives make recommendations 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 products that pay them large commissions. If there are better alternatives they avoid because the payout is smaller, the recommendation process is no longer focused on 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 recommendation to a retail customer:
Broker-dealers provide Regulation BI disclosures in writing 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. If Form CRS is updated, member firms must file the updates with FINRA’s Central Registration Depository (CRD) within 30 days. Then, the firm must forward the updated form to customers within 60 days*.
*The entire process of updating Form CRS can take up to 90 days. The first 30 days can be dedicated to filing the updates with FINRA’s CRD. The following 60 days are reserved for sending the updated form to customers.
Before making a recommendation, broker-dealers and their representatives 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, an options contract may be suitable and in the client’s best interest, but recommending more contracts than a customer’s risk tolerance can handle is unethical.
As discussed above, a conflict of interest is any circumstance that jeopardizes prioritizing the client’s interests. In other words, it’s a situation where the financial professional has an incentive to put their own interests ahead of the customer’s.
Common conflicts of interest in the industry include:
Recommending proprietary products
A product created by the same institution that recommends it to its clients is a proprietary product. For example, a financial firm recommends an options-based fiduciary account. While the account may be suitable for some customers, the firm makes additional compensation* for every customer placed in these accounts. As a result, a representative (whose compensation may be tied to selling these accounts) could be incentivized to recommend the proprietary product even when the customer might be better off placing unsolicited trades.
*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 stock and options strategies with your assigned representative. Now assume they recommend the stock of a company their spouse is the CEO of, without telling you. That missing disclosure makes it hard to evaluate whether the recommendation is based on your needs or the representative’s personal connection.
Recommending securities as part of a sales contest
Many securities firms run sales contests to encourage representatives to produce. For example, a firm may pay a bonus to the representative who opens the most discretionary accounts. These contests can create pressure to “sell sell sell,” even when doing so isn’t in the client’s best interest.
While all 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, 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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