SEC Regulation Best Interest – How Does It Impact Broker-Dealers and Investment Advisors?

September 01, 2021 | Financial Industry

The Securities and Exchange Commission (SEC) drafted the Regulation Best Interest (Reg BI) rule in 2019. Regulation BI provides additional safeguards for investors by setting new standards of conduct for financial advisors and broker-dealers.

The implementation of Regulation BI may lead to operational changes for broker-dealers and investment advisers. Under Regulation BI, these individuals have obligations related to disclosure, care, conflicts of interest, and delivery.

What Is Regulation Best Interest (BI)?

The Regulation BI rule regulates the behavior of investment advisors and broker-dealers. Reg BI falls under the Securities Exchange Act of 1934 and comes into effect as a code of conduct when financial advisors or broker-dealers make a recommendation to retail customers regarding:

• Investment strategies that involve securities
• Securities transactions

Under Regulation BI, broker-dealers and financial advisors must also give retail investors a relationship summary using Form CRS. Broker-dealers and financial advisors must also provide advice that represents a client’s best interest. They can no longer provide advice that is merely “suitable.”

What Is Suitable Investment Advice?

“Suitable” investments are ones that may benefit the investor or, at least, not cost an investor money. However, that does not mean they are the best of all possible investing options available. For example, a broker-dealer could suggest a slightly subpar investment opportunity to acquire a benefit for themselves, like a bonus for selling a certain kind of stock.

Under these new regulations, the government no longer legally allows broker-dealers to make these “suitable” advisements unless they inform their client about the possible conflict of interest. Instead, they must attempt to find investments that will work for the best interest of their clients, not choices that serve the advisor’s best interest primarily.

Regulation BI represents another step towards providing increased protections for consumers. In many ways, Reg BI builds on the standards established by the Dodd-Frank Act (or the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010).

The Dodd-Frank Act focused on improvements for accountability in financial sectors throughout the U.S. The Dodd-Frank Act aimed to improve the stability of the U.S. financial system in the aftermath of the 2008 recession by focusing on responsible financial gain.

An Enhanced Standard of Conduct for Broker-Dealers

The SEC established Reg Best Interest with the intention of setting a higher standard for brokers and financial advisors. The SEC felt a sense of concern that the previous suitability obligations did not require brokers to prioritize the best interest of a particular retail customer.

Note that retail customers may refer to any natural person or a legal representative of this person. Legal representatives can make financial decisions in certain situations, especially for household purposes.

Before Reg BI went into effect, several states were already moving to establish similar regulatory laws. For example, New York, New Jersey, and Nevada were working to impose fiduciary requirements on brokers in 2019. However, not all states approve of the Reg BI rules. Areas like the District of Columbia, California, and Oregon have argued in the courts to have Reg BI vacated.

The Department of Labor Fiduciary Rule

The Department of Labor (DOL) attempted to pass a fiduciary rule in 2017. The DOL fiduciary rule would have added new regulations for financial professionals who dispense advice on retirement planning. Investment advisors would have had a conflict-of-interest obligation. They would have also had to disclose any:

• Fees
• Bonuses
• Commissions

The Trump Administration opposed Regulation FD, which eventually killed the rulemaking effort that would have impacted an investment adviser’s fiduciary duty.

Regulation Best Interest Obligations

Regulation BI provides a series of recommendations and rules that govern the fiduciary standard for any securities transaction. Reviewing each of these obligations in greater detail can help you understand how Regulation BI impacts investment advisors and brokers.

Disclosure Obligation

Under Regulation BI, brokers need to provide disclosures in writing relating to all:

• Material facts associated with their relationship
• Material facts tied to conflicts of interest

The broker must provide this information either at the time of the recommendation or before making a recommendation.

Care Obligation

Also called the “duty of care” obligation, this obligation requires brokers to display:

• Reasonable diligence
• Care
• Skill

Brokers must look at all potential risks before making a suggestion. They also need to consider rewards for investors. The broker assesses risks and rewards as they’ll impact a retail customer’s investment profile and should only then make a suggestion.

Conflict of Interest Obligation

Finally, Regulation BI comes with extensive regulations on conflicts of interest. Broker-dealers must set up, maintain, and enforce policies to share material facts regarding any conflicting interests on a reasonable basis.

Conflicts of interest can commonly occur when giving investment advice. We see a conflict of interest when the best interests of an entity–such as a broker-dealer–do not align with the best interests of the retail investors the broker serves.

For instance, brokers may attempt to secure additional compensation by making suggestions that are not in the retail customer’s best interest. Regulation BI requires broker-dealers to develop procedures that limit this conflict and inform investors of possible conflicts when they occur.

Disclosure Items

Under the standard of care set forth through Regulation BI, broker-dealers have a duty to disclose certain information before providing advisory services. In the spirit of fair disclosure, these brokers must disclose—in writing—any material facts about their relationship with the retail customer. Generally, this means they must state:

• That they are registered and planning to act as a dealer, broker, or broker-dealer
• Any material fees or costs associated with accounts, holding, or transactions
• The scope of the services they offer retail customers
• Material limitations on investment strategies
• Material facts tied to a conflict of interest

Broker-dealers have a compliance obligation to disclose information about all of the above items.

Delivery Requirements

The SEC uses specific requirements for the delivery of disclosure items. Broker-dealers must provide all disclosures before making a recommendation on any securities transaction. Brokers may give customers information about disclosures either when making such recommendations or in the days before they make the recommendations.

The SEC requires broker-dealers to use a written disclosure form and Form CRS/ADV Part 3. Generally, Form CRS/ADV Part 3 represents a two-page form for broker-dealers. Investment advisors also have a two-page document to fill out.

Individuals with dual registries as investment advisors and broker-dealers may combine their forms into a single four-page document. Broker-dealers should provide all disclosures as a written document. However, brokers can deliver the document electronically or as a hard copy.

Key Differences Between the DOL Fiduciary and Regulation Best Interest

The DOL fiduciary requirements and Regulation BI share several things in common. These regulations focused on establishing a new standard for financial responsibility concerning brokers, dealers, and financial advisors.

However, there are several key differences between these rules. First and foremost, Regulation BI is a current rule as established by the Exchange Commission. Regulation FD effectively ended in 2018. However, recent comments by members of the DOL imply this rule may return in the future.

The DOL’s rule expanded the definition of professionals considered “fiduciaries.” Fiduciaries are financial professionals required to act in the best interest of their clients, not just in an acceptable way. In the past, only advisors who charged a fee to handle retirement plans were considered fiduciaries.

Under Regulation FD, anyone providing professional advice regarding retirement investments would have a fiduciary responsibility. On the other hand, Regulation BI deals specifically with rules for broker-dealers and financial advisors providing investment advice for the sale of specific securities.

Based on Regulation FD, advisors who continued to work under commission could still handle accounts with a possible conflict of interest. However, they would have to provide a Best Interest Contract Exemption (BICE) document, informing their client that the conflict existed.

For example, an advisor could have filled out a BICE form if they received an incentive to sell a particular product or meet specific sales quotas, even if the incentive did not involve cash compensation. Currently, Regulation FD does not apply, so financial advisors are not subject to its care obligation.

How Does Reg BI Impact Investors?

Investors should experience few direct impacts from Regulation BI. However, this rule does change the responsibilities of those who handle the investment experience for customers. Before the implementation of Reg BI, only certain professionals had a fiduciary duty.

Registered investment advisors (RIAs) had a fiduciary responsibility before the adoption of Reg BI. The government expected these professionals to put the best interest of their clients first when building an investment strategy based on the Investment Advisers Act of 1940.

Brokers, on the other hand, were seen as intermediaries in this system. They registered with the Financial Industry Regulation Authority (FINRA), which is a private corporation. According to FINRA rules, they were allowed to take client orders for the market and provide some financial advisor services. However, they were required to only make “suitable” choices for clients, not necessarily the best choice.

Reg BI requires brokers to look beyond suitability. The component obligations associated with Regulation BI mean that brokers must put the needs of their clients first, while:

• Disclosing why they are making a recommendation
• Making recommendations with all their care and skill
• Following policies to avoid a conflict of interest
• Complying with all legal procedures and policies

Investors should receive a document dictating the terms of the relationship with their broker or financial advisor. Under Regulation BI, investors should also receive information about any financial incentives brokers may receive if they make certain investments.

Reg BI aims to provide investors with more information about their financial situation while promising increased investor protection.

How Does Reg BI Impact Financial Advisors and Broker-Dealers?

Regulation BI adds some increased responsibilities for broker-dealers. Registered investor advisors already had worked under fiduciary requirements. Reg BI only added these same requirements to broker-dealers.

Brokers-dealers must act in accordance with the uniform regulations handed down by Reg BI. They must provide information about any conflicts of interest when handling transactions in the securities industry. Such limitations require them to inform clients if they receive extra payments or commissions for specific transactions.

Reg BI means that these professionals can no longer put the interest of the broker-deal first. Instead, the client’s interest must take precedence when making account recommendations. Broker-dealers and their affiliates are no longer permitted to make financial suggestions that are merely “suitable.”

Additionally, brokers and financial professionals must provide information about the scope of services they offer before handling a retail customer’s transactions or brokerage account. Brokers have a limited period to provide this information, as they must give it to their clients before sharing any financial recommendations.

The Securities Industry and Financial Markets Association (SIFMA), a trade group representing brokers and other financial professionals, supported the adoption of Regulation BI.

Common Questions About Regulation Best Interest

Regulation BI represents a reasonably recent adjustment to the rules on working with a broker or an associated person of a broker. You can review some questions about Reg BI to learn more about this rule and how it affects the sale of specific types of securities.

How Will Regulation Best Interest Impact My Investments?

Reg BI may have several impacts on your investments. This rule should help you meet your investment objectives by requiring broker-dealers to place your best interests first. You may open an advisory account under these new regulations, where you get ongoing advice about your investments. These accounts also require financial professionals to inform you of any conflict of interests as quickly as possible.

You should receive information if your broker received extra funds if you make certain purchases, perhaps as a result of sales contests. Instead of making financial decisions in relative isolation and without complete information, you should be aware of the possible conflicts faced by your broker.

Who Does Regulation Best Interest Apply To?

Regulation BI primarily impacts broker-dealers who were not previously subject to fiduciary responsibility. Unlike many financial advisors, brokers were allowed to make “suitable” suggestions for their clients.

Regulation BI requires broker-dealers to make financial suggestions that are in the best interests of their clients. The broker may need to consider the client’s risk tolerance and liquidity needs to make the best choice. The broker may also need to focus on the investment time horizon before making a recommendation.

Based on the new rules established by Reg BI, there is no “minimum” acceptable amount of conflict of interest, as previously existed. Instead, brokers and other financial professionals must inform their clients of any potential conflict of interest.

Conflicts of interest can refer to relatively minor factors, such as getting a bonus for selling a specific stock. As long as clients know these conflicts exist, they may continue to work with the broker-dealer or financial advisor.

When Does Regulation Best Interest Start?

Reg BI requirements went into effect on June 30, 2020. Broker-dealers had more than a year to prepare to comply with this new rule. Currently, the government expects all broker-dealers to adhere to the SEC’s regulations.

Broker-dealers have a responsibility to prepare a relationship summary to deliver to any of their retail investors. They may include any potential conflicts of interest in this document. Additionally, broker-dealers must include information about whether or not they have any disciplinary history with the SEC.

Generally, they must present this form in a question-and-answer format. Keep in mind that broker-dealers must provide these details before offering financial advice or making recommendations about sales to their clients.

Solving Compliance Issues With Wealth Manager

One of the biggest impacts that regulation BI has had on wealth managers, TAMPs, and broker-dealers involves how they invoice their clients. Where they could once send clients an invoice with a single “bundled” or “wrapped” fee for simplified billing, this invoicing does not meet the transparency requirements set forth by reg BI.

With Redi2 Wealth Manager, broker-dealers, wealth managers, and TAMPs can easily break out each underlying fee that is passed to the client with the click of a button. Wealth Manager calculates and tracks all client fees separately allowing you to accurately and efficiently provide fee calculations to your clients.

If you’d like to find out more about how Wealth Manager can help streamline your wealth management firm and improve your compliance oversight, contact us today to schedule a demo.