Regulation Best Interest Education – due date June 2020 (ADV Part 3 Form CRS)

I. Regulation Best Interest (Reg BI) for broker-dealers includes:

• Vital enhancements to the standard conduct for brokers and their firms from the prior “suitability standard” to a more stringent fiduciary-like, or “best interest” standard
• Compliance deadline for broker/dealers is June 30, 2020
• “Regulation BI” rules apply solely to retail customers, not institutional investors
• Establishes a “Best Interest” obligation and four subordinate requirements for broker-dealers and their registered representatives (brokers) when providing investment advice to retail customers

1. Best Interest Obligation:

• Brokers shall act in the best interest of their customer at the time a recommendation is made regarding all investment products, strategies, or any account change (i.e. IRA rollover) and must not place interests of their firm ahead of the customer
• The “Best Interest” obligation is satisfied by meeting four specific obligations listed below (Sections A, B, C, D).

A: Disclosure Obligation

• Prior to or at time of recommendation the broker needs to provide “full and fair disclosure” of all material facts including; acting as a broker or broker/dealer; fees and/or costs that apply to customer’s transactions, holdings and accounts; type and scope of services provided (including limitations on strategies recommended); and material facts related to any potential conflicts of interest.

B. Care Obligation

• Broker exercises “reasonable diligence, care, and skill” in making a recommendation, including; understanding the potential risks, rewards and costs, and a reasonable basis to believe the investment recommendation is in the best interest of at least some customers; have a reasonable basis and believe the recommendation is in the best interest of the particular retail client based on their investment profile; have a reasonable basis and believe that a series of recommended transactions is not excessive and is in the investor’s “best interest” taking into account their investment profile; and does not place the firm or broker’s interest ahead of the customer.

C. Conflict of Interest Obligation

• Firm establishes, maintains and enforces policies and procedures that; Identify, disclose or eliminate all conflicts of interest related to the recommendation; Identify and mitigate conflicts that create an incentive for the broker to make recommendations that place the firm’s interests ahead of the customer; Identify and disclose material limitations placed on the investment product or strategy and any conflicts associated with such limitations; Prevent these limitations from causing the broker to make recommendations that place the firm’s interests ahead of the customer; Eliminate sales contests, sales quotas, bonuses, etc. that are based on a specific product or types of securities within a limited period of time.

D. Compliance Obligation

• Basically is a “catch-all” provision stating that the firm establishes, maintains and enforces written policies and procedures to ensure compliance with Reg BI.

Relevant Definitions:

• Retail Customer: A natural person, or legal representative who; receives a recommendation involving a securities transaction or investment strategy; and uses the recommendation primarily for personal, family, or household purposes.  A retail investors investment profile includes the following factors; age, other investments, financial situation, liquidity needs, tax status, investment objectives, investment experience, investment time horizon, risk tolerance, and all other information disclosed to the broker or firm.

• Conflict of Interest: An interest “that might incline a firm or broker “consciously or unconsciously” to make a recommendation that is not suitable.
  • Record-keeping requirements include all information collected from and provided to the retail client; broker/dealers are required to preserve all records for a period of at least six years.

II. Fiduciary Guidance for Investment Advisors

• Reaffirms proposed guidance from April 2018; Investment advisers have a duty of care and loyalty “fiduciary duty”; guidance is not all-inclusive; guidance applies to SEC and state-registered advisory firms; State securities regulators and the Department of Labor have additional requirements not addressed in this guidance.

i. Fiduciary duty “follows the contours of the relationship” between adviser and client

ii. Relationship is shaped by the agreement, provided there is “full and fair disclosure” and informed consent to the client

iii. Fiduciary duty may not be waived, although it will vary determined by the scope of the relationship

iv. Contract provisions generally waiving the fiduciary duty is inconsistent with the Investment Advisers Act of 1940, regardless of client’s sophistication

• Duty of Care

i. Adviser must provide advice in the best interest of the client; Advice must be suitable and at a minimum, an advisor must make a reasonable inquiry into client’s financial situation, level of financial sophistication, investment experience and overall financial goals

ii. An adviser formulating a financial plan should obtain a detailed range of financial information including: Current income, Current Investments, Assets and debts, Marital status, Tax status, Insurance policies and financial goals

iii. Advice includes rollovers and new proposed accounts – applies also to dually registered adviser/broker; must consider client’s best interests

iv. Monitoring scope and frequency turns ‘on the facts and circumstances’ including events that the advisor is aware of such as: Relevant tax law, Retirement plan, Change in marital status, and is generally shaped by specific details obtained from the client

v. Best interest is not based solely on cost “without further analysis of other factors in the context of the client’s portfolio” and client’s investment objectives

• Duty to Seek Best Execution

i. Adviser has duty to seek best execution and the responsibility to select broker/dealers (typically involving discretionary accounts)

ii. Adviser should consider full range and quality of brokerage services including: Research value, Execution capability, Commission rate, Financial responsibility, Responsiveness to advisor

iii. Lowest cost is not determinate factor, it is “whether the transaction represents the best qualitative execution.”

iv. Advisor should “periodically and systematically” evaluate execution

• Duty to Provide Advice and Monitoring

i. Depends upon scope of relationship; Asset-based fee compensation implies ongoing investment account monitoring services

ii. Limited projects, such as a one-time financial plan, and absent an express agreement covering monitoring, suggests advisor is unlikely to have a duty to monitor

• Duty of Loyalty

i. Advisor cannot subordinate clients’ interests to its own

ii. Advisor must make “full and fair disclosure” of all material facts related to the relationship. These include but are not limited to: Capacity in which the firm is acting with respect to advice provided (especially important for dual registrants); Disclosure and consent by client “does not satisfy the advisor’s duty to act in the client’s best interest.”

iii. Disclosure should be sufficient and specific so that a client is able to understand and make an informed decision whether to provide consent.

iv. No action was taken by the SEC on its request for comment on potential new rules for investment advisory firms that would require the following: 1) licensing of certain individuals and continuing education requirements; 2) net capital or bonding requirements for firms; and 3) periodic disclosures of the fees charged by advisory firms.

IV. Guidance on ‘Solely Incidental’ Advice Exemption for Brokerage Firms

a. Background

i. SEC asserts that brokers “commonly provided some investment advice” in the course of their work as broker/dealers, and that it would be inappropriate to require them to register as investment advisers because of this aspect of their business.

ii. Reg BI proposal asked additional question about the “solely incidental” prong of the exemption and its application to investment discretion.

1. Comments were mixed; some said broker/dealers should provide only limited advice.

iii. In 2005, the SEC adopted a rule that deemed investment discretion and financial planning services not ‘solely incidental’ to brokerage services. Other advice is solely incidental if “offered in connection with and reasonably related to the brokerage services.”

iv. In 2007, the Financial Planning Association v SEC, Court of Appeals for DC Circuit overturned a previous SEC rule defining solely incidental; however, the court focused on the second prong of the broker/dealer exemption, “special compensation,” finding the Commission exceeded its authority. Whole rule was vacated.

v. Following court decision, the SEC again proposed solely incidental interpretation along same lines in 2007 for investment discretion but never adopted.

b. Interpretation covers investment discretion and account monitoring.

i. Investment discretion

1. Not solely incidental if broker is responsible for customer’s trading decisions. “The totality of the facts and circumstances would be relevant to determining whether temporary or limited discretion is consistent with the solely incidental prong.”

2. Exceptions (not all-inclusive)

• Securities transactions for a specified amount or one that is only available for a limited period of time
• Exchanging money market fund for another or cash-equivalent
• To satisfy margin requirements
• Purchase a bond with a specific credit rating and maturity
• Tax planning purposes
• Other conditions specified by the customer

3. Note: A period of discretion of more than a few months “may be indicative” of an advisory relationship.

• Account monitoring

1. Certain activities deemed solely incidental advice include:  Providing monitoring on a periodic basis for purposes of providing buy, sell or hold recommendations; Broker voluntarily, and without customer agreement, reviews holdings and contacts customer to make a recommendation based on those holdings; Commission will consider other requests to determine application of the solely incidental exemption to brokerage monitoring services.

This information is not all-inclusive; it’s a limited educational summary of the rules provided by the SEC, click here to visit the SEC’s website for full content of Reg BI. Consult with your compliance professional for further details. This article is meant solely for educational purposes and should not be construed as legal or compliance advice.