In light of recent discussions regarding the content and implications of Regulation Best Interest,1 Securities and Exchange Commission (“SEC”) Chairman Jay Clayton recently stated that broker dealers should be ready for the new regulation as of the compliance date next June.2 Commissioner Clayton has strongly supported Regulation Best Interest since its adoption in June 2019,3 despite statements from other lawmakers questioning the need and enforceability of the regulation and a recent suit by various states claiming that the regulation does not go far enough to protect investors.4
Broker-dealers and natural persons who are associated persons of a broker-dealer (collectively, “broker dealers”) that provide recommendations to retail customers of securities transactions or investment strategies involving securities (including account recommendations) (collectively, “recommendations”) and that are registered with the SEC will be required to comply with Regulation Best Interest by June 30, 2020 (the “Compliance Date”).5 Regulation Best Interest is intended to enhance the broker dealer standard of conduct beyond existing suitability obligations, and to align it with what the SEC considers retail customers reasonably should expect from a broker dealer.6 The adoption of Regulation Best Interest effectively means broker dealers will need to conduct the operational changes to their systems and establish internal processes that comply with Regulation Best Interest by the Compliance Date.7
Regulation Best Interest establishes a general best interest obligation: broker dealers making any recommendations shall act in the best interest of the retail customer at the time a recommendation is made, without placing the financial or other interest of the broker dealer making the recommendation ahead of the interest of the retail customer.8
It describes how broker dealers may satisfy such an obligation by complying with the following four additional specific obligations:
- Disclosure obligation: requires broker-dealers, prior to or at the time of the recommendations, to provide retail customers with full and fair disclosure in writing of (a) all material facts relating to the scope and terms of the relationship with the retail customer, including (i) that the broker dealer is acting as broker dealer with respect to the recommendations; (ii) the material fees and costs that apply to the retail customer’s transactions, holdings and accounts; and (iii) the type and scope of services provided to the retail customer, including any material limitations on the securities or investment strategies involving securities that may be recommended to the retail customer; and (b) all material facts relating to conflicts of interest that are associated with the recommendations.9
- Care obligation: requires broker dealers making any recommendation to exercise reasonable diligence, care and skill to: (a) understand the potential risks, rewards and costs associated with any recommendations, and have a reasonable basis to believe that any recommendations could be in the best interest of at least some retail customers; (b) have a reasonable basis to believe that any recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile10 and the potential risks, rewards and costs associated with any recommendations and does not place the financial or other interests of the broker dealer ahead of the interest of the retail customer; (c) have a reasonable basis to believe that a series of recommendations, even in the retail customer’s best interest when viewed in isolation, is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile and does not place the financial or other interest of the broker dealer making the series of recommendations ahead of the interest of the retail customer.11
- Conflict of interest obligation: requires broker dealers to establish, maintain and enforce written policies and procedures reasonably designed to: (a) identify and at a minimum disclose, in accordance with the disclosure obligation above, or eliminate, all conflicts of interest12 associated with such recommendations; (b) identify and mitigate any conflicts associated with such recommendations that create an incentive for a broker dealer to place its interest ahead of the interest of the retail customer; (c)(i) identify and disclose any material limitations placed on the securities or investment strategies involving securities that may be recommended to a retail customer and any conflicts of interest associated with such limitations, in accordance with the disclosure obligation above, and (ii) prevent such limitations and associated conflicts of interest from causing the broker dealer to make recommendations that place the interest of the broker dealer ahead of the interest of the retail customer; and (d) identify and eliminate any sale contests, sales quotas, bonuses and non-cash compensation that are based on the sales of specific securities or specific types of securities within a limited period of time.13
- Compliance obligation: requires broker dealers, in addition to the conflict of interest obligation above, to establish, maintain and enforce written policies and procedures reasonably designed to achieve compliance with Regulation Best Interest.14
Regulation Best Interest will require broker dealers to (i) act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker dealer ahead of the interests of the retail customer; (ii) address conflicts of interest by establishing, maintaining and enforcing policies and procedures reasonably designed to identify and fully and fairly disclose material facts about conflicts of interest; and (iii) in instances where the SEC has determined that disclosure is insufficient to reasonably address the conflict, mitigate or, in certain instances, eliminate the conflict.15 Additionally, Regulation Best Interest will require broker dealers to keep a record of all information collected from and provided to the retail customer pursuant to these new obligations for a period of at least six years after the earlier of the date the account was closed or the date on which the information was collected, provided, replaced or updated, as well as the identity of each natural person who is an associated person, if any, responsible for the account.16
While we expect that there will be additional statements regarding Regulation Best Interest, both by its supporters and detractors, it seems likely that it will be effective next June, and broker dealers should plan to make the operational changes and provide the disclosure as described in the Release.
1 Regulation Best Interest: The Broker Dealer Standard of Conduct (“Regulation Best Interest”) Release 34-86031 (June 5, 2019) (the “Release”), available here. Regulation Best Interest was adopted at the same time as Form CRS, which will require registered investment advisers and broker dealers to deliver disclosure about their relationships with other firms and the impact of those relationships on service, fees, costs and conflicts of interest. Form CRS Relationship Summary; Amendments to Form ADV, Release Nos. 34-86032; IA-5247 (June 5, 2019) here.
2 Chairman Clayton is reported to have made these remarks at the Securities Enforcement Forum on October 23, 2019 (see here).
3 Chairman Clayton gave a speech in connection to Regulation Best Interest in Boston, Massachusetts on July 8, 2019, available here.
4 The States of California, Connecticut, Delaware, Maine, New Mexico, New York, Oregon and the District of Columbia brought action to challenge the validity of Regulation Best Interest in the Southern District of New York, claiming that it does not meet Congress’s directives under the Dodd-Frank Act, and will harm both the plaintiff States and their residents (Case 1:19-cv-08365-VM), available here.
5 See Release 34-86031 (June 5, 2019) (the “Release”), at pp. 371-372.
6 Release, at p. 1.
7 Release, at p. 372-373.
8 Release, at p. 765; § 240.15l-1(a)(1).
9 Release, at p. 766; § 240.15l-1(a)(2)(i).
10 The Release defines “retail customer investment profile” as including, but not being limited to, the retail customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance and any other information the retail customer may disclose to the broker dealer in connection with a recommendation.
11 Release, at p. 766; § 240.15l-1(a)(2)(ii).
12 The Release defines “conflict of interest” as an interest that might incline a broker dealer –consciously or unconsciously— to make recommendation that is not disinterested.
13 Release, at p. 766; § 240.15l-1(a)(2)(iii).
14 Release, at p. 766; § 240.15l-1(a)(2)(iv).
15 Release, at p. 1.
16 Release, at p. 769; § 240.17a-3 and § 240.17a-4.
This publication is provided for your convenience and does not constitute legal advice. This publication is protected by copyright.
© 2019 White & Case LLP