A New National Investor Protections Standard

The establishment of Regulation Best Interest (Reg BI) marked a major milestone for the U.S. Securities and Exchange Commission (SEC) in their efforts to raise the standard of conduct for broker-dealers. Reg BI was adopted by the SEC on June 5, 2019 (going into effect starting on June 30, 2020) and will significantly enhance protection for U.S. retail customers, or “two-legged individuals”, who receive recommendations from broker-dealers for the purposes of managing personal, family, or household wealth. Impacted firms have been working diligently to implement a framework that upholds this new normal for broker-dealer conduct in the marketplace. Reg BI was designed to place investor interests ahead of the profit motivation of broker dealers and registered investment advisers. As simple as that principle may sound, there is ample evidence to suggest that broker-dealers and those in investment advisory roles are not fully aware of the obligations they owe retail investors. At the same time, many retail investors are not sufficiently familiar with the standards, conduct, and fiduciary responsibilities their investment advisors are required to follow to protect their interests. Reg BI is centered on fairness and transparency for individual investors, which continues to be an ongoing priority for the SEC.

Understanding the Impact of Reg BI

Prior to Reg BI, the Department of Labor issued a fiduciary rule in 2017, which required professionals offering retirement account advice to put their clients' interests above their own. This was a good start but the fiduciary rule only applied to a small portion of retail brokerage accounts. By contrast, Reg BI is far more expansive in scope and applies to all retail brokerage accounts. In line with the SEC’s jurisdiction, Reg BI only applies to security products and related recommendations; financial assets such as foreign exchange, commodities, or non-security related derivatives are not subject to Reg BI. Once firms understand how Reg BI impacts their business, focus naturally turns to interpretation of the rule and the most practical path to implementation and ongoing compliance.

The New Obligations for Broker-Dealers

General Obligation: Broker-dealers must act in a retail customer’s best interest when making a security recommendation or investment strategy recommendation. This must be done without placing their interest ahead of the retail customer’s interest. In order to ensure the best interest obligation can be satisfied, the broker-dealer must comply with this overarching General Obligation and its four component parts:

1. Disclosure Obligation

Prior to or at the time of a recommendation, the broker-dealer must provide the retail customer, in writing, a full and fair disclosure of the scope and terms of the relationship, the capacity in which the broker dealer is acting, the fees and costs associated with the services provided, as well as all material facts relating to conflicts of interest associated with the recommendation.

2. Duty of Care Obligation

The broker-dealer must understand the risks, rewards, and costs associated with the recommendation and exercise reasonable diligence, care, and skill when making the recommendation. In an enhancement to FINRA’s Suitability Rule, which only considers the ‘suitability’ of a given recommendation, the care obligation goes further and ensures that the recommendation is made in the customer’s best interest and the broker-dealer does not place their own interests ahead of the retail investor. If the implementation of this obligation proves successful, FINRA’s Suitability Rule may soon become redundant.

3. Conflict of Interest Obligation

A conflict of interest is defined as an interest that might incline a broker-dealer, consciously or unconsciously, to make a recommendation that is not disinterested. The Conflict of Interest Obligation requires the establishment of policies and procedures designed to mitigate, prevent, or eliminate conflicts of interest that may create an incentive for a broker-dealer to place their interest above that of the retail customer.

4. Compliance Obligation

Tackling Reg BI as a whole, the broker-dealer has an obligation to establish, maintain, and enforce policies and procedures that address all components of the regulation and aid compliance with the rule.

The Form CRS (Customer Relationship Summary)

Separate from the four obligations above, the regulation also requires a two-page Form CRS (Customer Relationship Summary) disclosure be provided to a retail investor and filed with the SEC. The Form CRS includes basic information about the broker-dealer, how it conducts its business, its registration status, and where to find its disciplinary history, etc. The user-friendly and digestible format of the form is intentional, increasing the likelihood of consumption and enabling the retail customer to make an informed decision when deliberating over which broker-dealer to conduct business with. Such transparency is valuable and just part of the SEC’s wider effort to raise the standard of conduct for broker-dealers in the financial services industry.

COVID-19 and the Road Ahead

Continuing the theme of transparency, the SEC has promoted an open dialogue between itself and impacted broker-dealers throughout the implementation phase. As 2019 drew to a close, the SEC was asked to approve exemption requests and to provide clarity on the ‘best interest’ definition. In addition, several lawsuits were initiated to block the rule from going into effect. Despite these challenges and the outbreak of COVID-19 in the spring of 2020, extension requests were swiftly denied by SEC Chairman, Jay Clayton, on April 2, 2020. Jay Clayton reiterated his focus on retail investor protection as a top priority, especially in light of prevailing market volatility. As a result, firms are moving full steam ahead to implement Reg BI by June 30th and adopt a more stringent standard of market conduct. With two months to go, the race is on!

About Monticello

Monticello consultants have extensive experience in the implementation of large-scale regulatory initiatives. Our firm understands the importance of diligent analysis, program management, and collaboration across teams within major financial institutions and across the industry. Our current work on LIBOR Transition, Uncleared Margin Rules (UMR), SEC SBS, and Reg BI demonstrates the deep regulatory expertise our consultants bring to our clients. By leveraging our core practice areas covering Financial Services Advisory, Digital Transformation, and Change Management, our firm continues to successfully deliver on critical regulatory and change initiatives.

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