On June 5, 2019, the Securities and Exchange Commission (SEC) adopted a new rule defining a standard of conduct for broker-dealers when recommending a securities transaction or investment strategy involving securities to a retail customer. Regulation Best Interest, Rule 15l-1 under the Securities Exchange Act of 1934 (Exchange Act), creates an enhanced standard of conduct for broker-dealers and is intended to align broker-dealers' obligations with retail customers’ expectations. The SEC also adopted new rules and forms that will require broker-dealers and registered investment advisers to deliver to retail customers a new relationship summary, Rule 17a-14 under the Exchange Act and Form CRS.
Regulation Best Interest differs from the fiduciary standard governing registered investment advisers and does not require a broker-dealer to deliver conflict-free recommendations.
Broker-dealers should begin the process of evaluating their policies, procedures, and disclosure mechanisms to meet the June 30, 2020 deadline for compliance with Regulation Best Interest.
Summary of Regulation Best Interest
Regulation Best Interest creates a general obligation for brokers, dealers, and associated persons of a broker or dealer to act in the best interest of a retail customer at the time a recommendation is made, without placing their financial or other interest ahead of the interests of their customer. This general obligation is satisfied by complying with all of the following four specific obligations.
Prior to or at the time of a recommendation, the retail customer must be provided with a full and fair written disclosure of all material facts relating to the scope and terms of the relationship, including (1) the fact that the broker, dealer or natural person of a broker or dealer is acting in that capacity with respect to the recommendation, (2) the material fees and costs that apply to the retail customer's transactions, holdings, and accounts, and (3) the type and scope of services provided, including any material limitations on the securities or investment strategies that may be recommended. The written disclosure must also include a full and fair disclosure of all material facts relating to conflicts of interest associated with the recommendation.
A broker, dealer, or associated person of a broker or dealer must exercise reasonable diligence, care and skill to:
- Understand the potential risks, rewards, and costs associated with a recommendation and have a reasonable basis to believe it could be in the best interest of at least some retail customers; and
- Have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that customer's investment profile and the recommendation’s potential risks, rewards, and costs and that the recommendation does not place the financial or other interest of the person making the recommendation ahead of the interest of the customer.
In the case of a series of recommended transactions, there must also be a reasonable basis to believe the series of recommended transactions is not excessive.
Conflict of Interest
A broker or dealer must establish, maintain and enforce written policies and procedures reasonably designed to:
- Identify and, at a minimum, disclose or eliminate conflicts of interest;
- Identify and mitigate conflicts that create an incentive for the firm’s financial professionals to place their interest or the interests of the firm ahead of the retail customer’s interest;
- Identify and disclose material limitations on offerings, such as a limited product menu offering only proprietary products, and prevent those limitations from causing the firm or its financial professionals to place their interests or the interests of the firm ahead of the retail customer’s interest; and
- Identify and eliminate sales contests, sales quotas, bonuses and non-cash compensation that are based on the sale of specific securities or specific types of securities within a limited period of time.
In addition to the policies and procedures for conflicts of interest described above, a broker or dealer must establish, maintain and enforce written policies and procedures reasonably designed to achieve compliance with Regulation Best Interest.
Application of Regulation Best Interest
Regulation Best Interest applies to recommendations made to retail customers for a securities transaction or investment strategy involving securities.
A retail customer is a natural person who receives a recommendation for a securities transaction or an investment strategy and uses the recommendation for personal, family, or household purposes.
Effect on State Law
Several states, notably Massachusetts, Nevada, and New Jersey, have proposed to impose fiduciary standards on broker-dealers. The SEC release accompanying Regulation Best Interest noted that its pre-emptive effect on any such state regulation will need to be determined by future judicial proceedings based on the specific language and effect of that state regulation.
Broker-dealers and registered investment advisers will be required to deliver to retail customers a new relationship summary containing information about: (1) the types of client relationships and services the firm offers; (2) the fees, costs, conflicts of interest, and required standard of conduct associated with those relationships and services; (3) whether the firm and its financial professionals currently have reportable legal or disciplinary history; and (4) how to obtain additional information about the firm. It requires the use of a Q&A format and is subject to page limitations (two pages for broker-dealers and registered investment advisers and four pages for dual registrants) and other requirements.
Regulation Best Interest, Form CRS, and Rule 17a-14 will become effective 60 days after they are published in the Federal Register. The compliance date for these new requirements is June 30, 2020.