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Investment Funds, Compass

Feb 19, 2020

SEC Publishes Frequently Asked Questions on Regulation Best Interest

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On June 5, 2019, the U.S. Securities and Exchange Commission (the “SEC”) adopted Regulation Best Interest (“Regulation BI”) to improve investor protection by establishing a standard of conduct for broker-dealers making recommendations to retail customers.[1] Firms must bring their operations into compliance by June 30, 2020. On January 10, 2020 and February 11, 2020, the SEC Staff published and then supplemented responses to a series of Frequently Asked Questions (“FAQs”) it has received regarding Regulation BI.[2]

Retail Customer 

Regulation BI defines a retail customer as “a natural person, or the legal representative of such natural person, who: (A) receives a recommendation of any securities transaction or investment strategy involving securities from a broker-dealer; and (B) uses the recommendation primarily for personal, family, or household purposes.”[3]

In the FAQs, the SEC Staff clarified what it means to “use” a recommendation. A retail customer “uses” a recommendation when, as a result of the recommendation: (1) the retail customer opens a brokerage account with the broker-dealer, regardless of whether the broker-dealer receives compensation; (2) the retail customer has an existing account with the broker-dealer and receives a recommendation from the broker-dealer, regardless of whether the broker-dealer receives or will receive compensation; or (3) the broker-dealer receives or will receive compensation, directly or indirectly, as a result of that recommendation, even if the retail customer did not have an account at the firm. The SEC Staff further noted that a retail customer is in a position to “use” the recommendation when they open an account or have an existing account with the broker-dealer.[4]

 The SEC Staff also clarified whom they would consider a “legal representative” of a natural person.[5] The SEC Staff states that the phrase “legal representative” is intended to cover non-professional legal representatives who are not themselves already regulated. If a legal representative is currently a regulated financial services industry professional, such as a registered investment adviser, broker, corporate fiduciary, insurance company or an employee of such entity, they would not be a legal representative for purposes of Regulation BI, but rather would be an entity in and of themselves.

The SEC Staff also addressed in the FAQs whether Regulation BI applies to limited purpose broker-dealers, such as a broker-dealer that makes recommendations of private offerings to accredited investors.[6] Whether a broker-dealer engages in limited activity does not determine when Regulation BI applies. If an accredited investor is a retail customer, then Regulation BI would apply despite the limited scope of this scenario.

The FAQs also remind firms that retail customers, no matter how wealthy or sophisticated, may not waive or agree to waive the protections of Regulation BI. This stands in contrast with FINRA suitability Rule 2111, which permits an institutional investor (which can include a natural person) to waive the customer-specific suitability obligation of a broker-dealer making a recommendation.[7]

Recommendation

The SEC Staff provided guidance regarding what account recommendations are covered by Regulation BI and highlighted considerations for dually registered individuals making account recommendations.[8]

 Regulation BI applies to account recommendations that include recommendations of securities account types, including recommendations to open a self-directed brokerage account, as these recommendations are investment strategies that could affect retail customers’ investment returns. The FAQs further remind broker-dealers that “investment strategy” should be interpreted broadly. The SEC Staff notes that account recommendations would likely be subject to Regulation BI in any event, as they will usually involve a securities transaction.

Dually registered individuals making account recommendations must take into consideration the range of accounts they can offer, and not just brokerage accounts. However, if an individual is only registered with a broker-dealer, but that broker-dealer is affiliated with an investment adviser, the individual would only need to consider the brokerage accounts in making a recommendation.

The SEC Staff also addressed the applicability of Regulation BI to informal settings, such as meeting with a retail customer on the golf course. The SEC Staff emphasized that the setting of the communication is not indicative of whether Regulation BI applies to a communication, and noted that the more individually tailored the communication to a specific customer is, the greater the likelihood that it is a recommendation. The same analysis applies to scenarios where an individual is changing firms and calls existing customers to inform them of the move. While not all communications with a retail customer would rise to the level of a recommendation, broker-dealers should consider whether a communication could reasonably be viewed as a “call to action.”[9] This guidance is important as it speaks directly to those wealth managers who deal with high-net-worth individuals.

Disclosure Obligation

The SEC Staff clarified that, typically, Form CRS by itself will not satisfy the Disclosure Obligation.[10] With respect to electronic delivery of Regulation BI disclosures or Form CRS, the FAQs remind firms that neither Regulation BI nor Form CRS permit a “notice plus access” or “access equals delivery” method of electronic delivery, including in the context of hyperlinking Regulation BI disclosures to Form CRS. Regulation BI requires broker-dealers to disclose the scope and terms of its relationship with a retail customer, including that it is acting in a broker-dealer capacity.[11] This capacity disclosure can generally be satisfied by Form CRS for standalone broker-dealers. Dually registered associated persons and associated persons who solely offer broker-dealer services through a dually registered firm must disclose whether they are acting as a broker-dealer. 

Regulation Best Interest requires written disclosures prior to or at the time of a recommendation, but oral disclosures are allowed in very limited circumstances. For example, a broker-dealer may update written disclosures orally to reflect information not reasonably known at the time the written disclosure was provided. The broker-dealer must maintain a record of that oral disclosure.[12]

Broker-dealers may seek to satisfy their Disclosure Obligation by delivering disclosure alongside a retail customer’s June 2020 quarterly account statement. The SEC Staff provided that while firms may include these disclosures in a quarterly mailing after June 30, 2020, they will not satisfy the obligation for any recommendations made between June 30, 2020 and the time the disclosures were provided.

Conflict of Interest Obligation

Regulation BI requires the elimination of sales contests, sales quotas, bonuses and non-cash compensation based on the sale of specific securities or types of securities within a limited timeframe.[13] However, this does not mean that all other incentives are compliant with Regulation BI. The FAQs declined to give examples of other specific conflicts that should be eliminated, but re-emphasized that firms should have policies and procedures in place to disclose and mitigate the incentives created by any other practices. 

The SEC Staff declined to mandate any particular mitigation method, instead reiterating that firms have flexibility to design policies and procedures based on each firm’s circumstances. Broker-dealers need not establish differential compensation based on neutral factors, but may choose to do so for practical reasons, presumably including the efficiency of such structures in relation to record keeping, and in connection with demonstrating compliance.

The FAQs also addressed forgivable loans.[14] Forgivable loans are a common form of compensation that is provided in the wealth management and retail brokerage industry. A forgivable loan is provided to individual brokers at a particular time, which can include at the time the individual associates with a firm, and the loan is forgiven if the associated person meets specified benchmarks, which can include length-of-service or other metrics. It is the SEC Staff’s view that a forgivable loan based on specified performance goals related to asset accumulation, revenue benchmarks, or client transfers or retention would constitute a conflict of interest. Firms would need to identify, and either disclose or eliminate all conflicts associated with forgivable loans. The SEC Staff continues to emphasize that just because certain compensation practices are not required to be eliminated does not mean they necessarily comply with Regulation BI. 

Compliance Obligation

The Compliance Obligation requires firms to establish, maintain and enforce written policies and procedures reasonably designed to achieve compliance with Regulation BI.[15] The FAQs provide that firms are not required to build out new systems of control in order to satisfy this obligation. As broker-dealers are already subject to federal laws and regulations and self-regulatory rules, broker-dealers can leverage their existing systems of supervision and compliance to comply with Regulation BI.[16]

Conclusion

Regulation BI enhances the applicable standard of conduct for broker-dealers beyond existing obligations under FINRA’s suitability rules.[17] As the June 30, 2020 compliance date draws near, firms will continue to look to the SEC and its Staff for guidance as they build out their compliance systems and revised written policies and procedures.

Footnotes

[1]  Regulation Best Interest: The Broker-Dealer Standard of Conduct, 84 Fed. Reg. 33,318 (July 12, 2019) (the “Regulation BI Adopting Release”) (codified at 17 C.F.R. 240.15l–1). For a comprehensive summary of Regulation BI, you may wish to refer to our client publications: “Raising the Bar? SEC Proposes Broker-Dealer Standard of Care and Guidance on Investment Advisers’ Fiduciary Standard”, available at https://www.shearman.com/perspectives/2018/04/sec-proposes-broker-dealer-standard-of-care-and-guidance and “Raising the Bar: SEC Adopts Broker-Dealer Standard of Care and Guidance on Investment Advisers’ Fiduciary Duty”, available at https://www.shearman.com/perspectives/2019/06/sec-adopts-broker-dealer-standard-of-care-and-guidance-on-investment-advisers-fiduciary-standard.

[2]  SEC, Frequently Asked Questions on Regulation Best Interest, (Feb. 11, 2020) (the “FAQs on Regulation BI”), available at https://www.sec.gov/tm/faq-regulation-best-interest.

[3]  Regulation BI Adopting Release at 33,442.

[4]  FAQs on Regulation BI.

[5]  FAQs on Regulation BI.

[6]  FAQs on Regulation BI.

[7]  For a comparison of Regulation BI and FINRA’s suitability rules, you may wish to refer to our client publication: “Navigating the Co-existence of Regulation Best Interest and FINRA Rule 2111”, available at https://www.shearman.com/perspectives/2019/12/navigating-the-coexistence-of-regulation-best-interest-and-finra-rule-2111.

[8]  FAQs on Regulation BI.

[9]  FAQs on Regulation BI.

[10]  FAQs on Regulation BI.

[11]  Regulation BI Adopting Release at 33,446.

[12]  FAQs on Regulation BI.

[13]  Regulation BI Adopting Release at 33,327.

[14]  FAQs on Regulation BI.

[15]  Regulation BI Adopting Release at 33,327.

[16]  FAQs on Regulation BI.

[17]  For a comparison of Regulation BI and FINRA’s suitability rules, you may wish to refer to our client publication: “Navigating the Co-existence of Regulation Best Interest and FINRA Rule 2111”, available at https://www.shearman.com/perspectives/2019/12/navigating-the-coexistence-of-regulation-best-interest-and-finra-rule-2111.

Authors and Contributors

Russell Sacks

Partner

Financial Institutions Advisory & Financial Regulatory

+1 212 848 7585

+1 212 848 7585

New York

Jennifer D. Morton

Partner

Financial Institutions Advisory & Financial Regulatory

+1 212 848 5187

+1 212 848 5187

New York

P. Sean Kelly

Associate

Financial Institutions Advisory & Financial Regulatory

+1 212 848 7312

+1 212 848 7312

New York

Taylor Pugliese

Associate

Financial Institutions Advisory & Financial Regulatory

+1 212 848 7294

+1 212 848 7294

New York