Regulation BI

Regulation Best Interest (BI) is an amendment the Securities and Exchange Commission (SEC) added to the Securities Exchange Act of 1934* recently (in 2019). This new rule aims to ensure broker-dealers and registered representatives prioritize the interests of their customers over their own. In particular, Regulation BI imposes rules to follow when these financial professionals make recommendations 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 their transaction execution services (helping customers buy and sell securities). Most trades processed by broker-dealers are unsolicited (meaning the firm did not recommend the transaction) and are typically self-directed by the investor or recommended by a third party (e.g., a customer’s investment adviser). When recommendations are not a primary part of a financial firm’s business, they largely avoid rules and regulations imposed on investment advisers. Investment advisers must follow strict fiduciary* laws, which involve numerous disclosures and thorough representative training to protect their 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 are rules related to investment advice so important? Unfortunately, the financial industry has a checkered past riddled with unethical behavior. Here are a few examples:

• Firm executive recommends nearly $3 million of unsuitable securities to an athlete with no investment experience, resulting in nearly $1 million in losses
• Broker suspended one year for recommending illiquid BDC investments to elderly clients with conservative investment objectives, resulting in significant losses
• Elderly investor awarded $2.6 million through arbitration after unsuitable recommendations made by a now-imprisoned former broker

For decades, investment adviser firms have been subject to recommendation-based regulations meant to prevent unethical activity. Broker-dealers largely avoided them by claiming their businesses focused primarily on executing transactions, not recommendations. But, over the years, it seemed like this was not reality. All the examples above involve broker-dealer representatives who were paid hefty commissions once their clients agreed to their (unsuitable) recommendations. In plain terms, some broker-dealers and their representatives acted as investment advisers* without being regulated accordingly.

*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.” Broker-dealers and representatives advising retail customers must follow specific rules and protocols, which are outlined in these four categories:

• Disclosure obligation
• Care obligation
• Conflict of interest obligation
• Compliance obligation

Disclosure obligation

Transparency is vital when financial professionals interact with customers. When aspects of a broker-dealer’s business are hidden, it can erode trust. For example, how would you feel if your assigned representative only recommended securities that made them large commissions? What if there were better securities they avoided recommending because their paycheck would be smaller? You would likely lose faith in the firm, representative, and maybe even the financial industry.

To ensure clients are capable of making informed decisions, Regulation BI requires broker-dealers and their representatives to disclose the following in writing at or prior to any retail customer recommendation:

• All material facts related to the relationship with the customer
• Any conflicts of interest associated with the recommendation
• The capacity the broker-dealer and/or representative(s) are acting in (e.g., agency or principal)
• All associated fees and costs
• The type and scope of services provided

Broker-dealers provide Regulation BI disclosures in writing on Form CRS (customer relationship summary). You can explore what this looks like in the real world - here’s a link to Charles Schwab’s Form CRS (the first two pages are Schwab’s broker-dealer portion). The form is divided into these sections:

1. What investors should consider when choosing Schwab
2. Investment services and advice Schwab provides
3. Fees their customers pay
4. Existing legal obligations and conflicts of interest
5. How Schwab’s representatives make money
6. Legal and disciplinary history of Schwab representatives (links to BrokerCheck)

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.

Care obligation

Broker-dealers and their representatives must determine the following prior to making a recommendation:

• Potential risks, benefits, and costs related to the recommendation
• The recommendation is in the client’s best interest and does not prioritize the broker-dealer or representative’s interests
• The recommendation is not excessive*

*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.

Conflict of interest obligation

As we discussed above, a conflict of interest is any circumstance that jeopardizes the prioritization of the client’s interests. Essentially, these are scenarios where the financial professional is incentivized to disregard their client’s needs. 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. Therefore, a firm representative (whose compensation is likely tied to selling these accounts) may recommend the proprietary product to customers who may 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 discuss stock and options strategies regularly with your assigned representative. Let’s say they recommend the stock of a company their spouse is the CEO of without telling you. How would you feel? Are they making the recommendation because it’s suitable? Or because it benefits their spouse?

Recommending securities as part of a sales contest
Many securities firms run sales contests to encourage their representatives to perform. For example, a firm may pay a bonus to the representative who opens the most discretionary accounts. Financial professionals taking part in these contests have an underlying incentive to “sell sell sell,” even if not 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, attempt to eliminate them if possible, and disclose them if they can’t be eliminated.

Compliance obligation

This one is simple - broker-dealers must:

Establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Regulation BI