Written by a human
In November 2023, the SEC had no qualms in enforcing Regulation Best Interest when brokers were found to have been trading in client accounts without regard to risk tolerance or personal profiles. The company at fault, Laidlaw and Co, were fined $800,000.
Without having implemented a detection and prevention strategy for excessive trading, two of their representatives were also fined and suspended. And with the potential for more investigations to come, it’s time for broker-dealer firms to start taking Regulation Best Interest seriously.
What is Regulation Best Interest?
Regulation Best Interest (Reg BI) establishes a standard of conduct for compliant broker-dealers. When making a financial recommendation, it must clearly be in the best interest of the customer and not the advisor.
Recommendations under this rule are defined as communications that “could reasonably be viewed as a call to action”, or “reasonably would influence an investor to trade a particular security or group of securities”. In fact, the more personalised or specific communications are, the more likely they are considered to be a recommendation.
The Regulation BI rule was brought in by the SEC in 2019 for investor protection, to prevent mis-selling due to kickbacks, affiliate rewards or commission.
Who does Regulation Best Interest apply to?
Reg BI applies to broker-dealers who make recommendations to retail customers.
Broker-dealers include the likes of an investment adviser, and a dually-registered financial professional. They are responsible for making account recommendations to customers. They must consider all types of accounts offered, such as brokerage and advisory accounts, before making their recommendations.
Retail investors are simply defined as individuals who receive financial recommendations for personal, family or household purposes. Therefore, this rule doesn’t apply to business or institutional investor recommendations.
What are the requirements of Reg BI?
There are four key obligations under Regulation Best Interest:
- Disclosure: before or at the time of making a recommendation, inform the customer about the relationship between you and the retailer
- Care: use skill, due diligence and care when making a product recommendation
- Conflict of Interest: create and maintain policies to prevent a conflict of interest
- Compliance: create and maintain policies to comply with regulation best interest
Disclosure Obligation
Advisors must provide information about the scope and terms of their relationship with the retail customer, and any conflicts of interests associated with the recommendation.
For example, one conflict of interest might be minimum account requirements that you hold for customers to establish a relationship with you.
As part of the disclosure, you must provide a basis for your recommendation and detail the risks. Data on the fees and costs, as well as services that you agree to provide (such as account monitoring), should be disclosed
Care Obligation
The Care obligation has three key components:
1. Exercising reasonable due diligence and skill to understand possible risks and rewards of any recommendation. This includes the consideration of factors like volatility, liquidity, investment goals and expected returns, for example.
2. Determine the risks and rewards through the lens of the specific profile of your retail customer. This includes considering factors like the customers:
- Age and investment time horizon
- Previous experiences
- Financial situation and needs
- Risk tolerance and liquidity requirements
- Tax status
3. Consider whether recommendations taken together are excessive, even if each is in the customer’s best interests in isolation.
Conflict of Interest Obligation
The written policies designed to prevent conflicts of interests should firstly identify potential conflicts, such as material limitations, and later mitigate the idea of incentives or sales quotas, bonuses and other commissions.
Examples of mitigation strategies given by the SEC include:
- Avoiding compensation incentives that favour one type of account over another (eliminating compensation differences for comparable product lines)
- Limiting the types of customer for which certain products are recommended
- Monitoring recommendations that are near compensation or recognition thresholds
Compliance Obligation
Finally, the compliance obligation provides broker-dealers with some flexibility in how they establish and maintain Reg BI compliance. Ongoing work in this area means continuously checking that policies are well-designed as products and circumstances evolve.
The SEC recommends including the likes of controls, remediation of non-compliance, training and periodic reviews in your compliance policies.
More enforcements are coming
With the number of Reg BI enforcements increasing in 2024, many broker-dealer firms feel like there’s a surge of pressure. In fact, FINRA recently hired 10% more staff, with its rationale behind this being to complete more investigations into firms and investment advisors.
With recent cases of fines for individual contributors as well as overall firms, broker-dealers need to get their compliance under control.
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