T&M Issues Regulation Best Interest FAQs

Ethan CoreyLegal Insights

ethan corey

On January 10, 2020, the SEC’s Division of Trading and Markets (T&M) issued responses to Frequently Asked Questions (FAQs) concerning Regulation Best Interest (Reg BI).1  T&M issued further FAQs on February 11, 2020.  The FAQs address retail customers, recommendations, the Disclosure Obligation, the Care Obligation and the Conflict of Interest Obligation.  

OVERVIEW

TL;DR:  Key takeaways of the FAQs, including the new FAQs, are set forth below.  We review the FAQs in more depth below the key takeaways.

FAQ TopicSub-topicKey Takeaway(s)
Retail CustomerWhat Constitutes a Retail Customer “Using” a Recommendation?– Opening a brokerage account with the broker-dealer as a result of the recommendation regardless of whether the broker-dealer receives compensation;

– With respect to a retail customer with an existing account with the broker-dealer, simply receiving the recommendation; or

– The result of the recommendation is that the broker-dealer will receive compensation, even if the retail customer does not have an account with the broker-dealer.
Retail CustomerLegal Representatives of Retail Customers – Professional RepresentativesIf a retail customer has a professional (regulated) legal representative – a registered investment adviser or broker-dealer, a corporate fiduciary (e.g., a bank, trust company or and similar financial institution) or an insurance company, as well as the employees or other regulated representatives of those institutions – a recommendation would not be viewed as a recommendation to a retail customer.
Retail CustomerLegal Representatives of Retail Customers – Nonprofessional RepresentativesIf the legal representative is not regulated, such as an executor, conservator, person holding a power of attorney for the retail customer or a formerly registered/licensed professional, a recommendation to the legal representative would be viewed as a recommendation to a retail customer.
RecommendationsAccount Recommendations Encompassed by Reg BIThe term “investment strategy” (which includes account recommendations) must be interpreted broadly.
RecommendationsDually-Registered Financial Professionals Making Account RecommendationsA dually registered financial professional must consider the spectrum of accounts that can be offered (i.e., both brokerage and advisory taking into account any eligibility requirements such as account minimums), and not just brokerage accounts, when making an account recommendation.
RecommendationsRegistered Broker-Dealer Associated Person of a Dual RegistrantA registered broker-dealer representative of a dual registrant must consider only the available brokerage accounts, when making an account recommendation, but must have a reasonable basis to believe that the brokerage account is in the best interest of the retail customer. If the representative instead elects to advise the customer to consider an advisory account with the dual registrant or an affiliated investment adviser, that advice must be in the best interest of the customer.
RecommendationsCalls to Action– Soliciting new clients or soliciting existing clients to move accounts to a new firm in instances where the representative has joined the new firm, without more, does not constitute a call to action.

– Educational communications do not constitute recommendations as long as they do not involve calls to action regarding specific securities to be sold or a recommendation regarding specific securities to be purchased with the proceeds of any sale.
Disclosure ObligationForm CRST&M believes that in most instances, the Relationship Summary does not contain all of the information necessary to satisfy the disclosure obligation.
Disclosure ObligationElectronic Delivery – Permissible MethodsNeither Reg BI nor Form CRS permits a “notice plus access” or “access plus delivery” method of electronic delivery.
Conflict of Interest ObligationMethods to Mitigate Conflicts– Avoiding compensation thresholds that disproportionately increase compensation through incremental increases in sales;

– implementing supervisory procedures to monitor recommendations that are: near compensation thresholds; near thresholds for firm recognition; involve higher compensating products, proprietary products or transactions in a principal capacity; and

– Limiting the types of retail customer to whom a product, transaction, or strategy may be recommended.

ANALYSIS

Retail Customers

Reg BI by its terms applies only to broker-dealers when making recommendations to retail customers.  The most recent set of FAQs posted address questions relating to retail customers.

“Using” a Recommendation.  

A “retail customer” is an individual, or the individual’s legal representative, who:  (i) 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.  The FAQ states that “using” a recommendation means:  (i) opening a brokerage account with the broker-dealer as a result of the recommendation regardless of whether the broker-dealer receives compensation; (ii) with respect to an a retail customer with an existing account with the broker-dealer, simply receiving the recommendation; or (iii) the result of the recommendation is that the broker-dealer will receive compensation, even if the retail customer does not have an account with the broker-dealer.  

Recommendations to Accredited Investors; Ability to Waive Reg BI Protections.  

Reg BI applies to recommendations to all retail customers, regardless of whether they are accredited investors.  A retail customer cannot waive the protections of Reg BI.

Legal Representatives of Retail Customers.  

  • If a retail customer has a professional (regulated) legal representative – a registered investment adviser or broker-dealer, corporate fiduciary (e.g., bank, trust company or similar financial institution) or insurance company, as well as the employees or other regulated representatives of those institutions – a recommendation would not be viewed as a recommendation to a retail customer.
  • However, if the legal representative is not regulated, such as an executor, conservator, person holding a power of attorney for the retail customer or a formerly registered/licensed professional, a recommendation to the legal representative would be viewed as a recommendation to a retail customer.

Recommendations

Account Recommendations Encompassed by Regulation Best Interest.  

T&M notes that different types of securities accounts can offer different features, products, or services, some of which may—or may not—be in the best interest of certain retail customers.  Consequently, T&M reminds broker-dealers that the term “investment strategy” (which includes account recommendations) must be interpreted broadly. 

Dually-Registered Financial Professionals Making Account Recommendations.  

A dually registered financial professional must consider the spectrum of accounts that can be offered (i.e., both brokerage and advisory taking into account any eligibility requirements such as account minimums), and not just brokerage accounts, when making an account recommendation.

Registered Broker-Dealer Associated Person of a Dual Registrant.  

If an individual is registered only as an associated person of a broker-dealer and works for a dual registrant, that individual:

  • would need to take into consideration only the brokerage accounts available at the firm; but
  • would need to have a reasonable basis to believe that the recommended brokerage account is in the best interest of the retail customer.

If a financial professional who is only a registered representative chooses to advise a client to consider an advisory account (or to speak with other personnel at a dual registrant or affiliate about an advisory account), that advice should be in the best interest of the client.

Communications Constituting Calls to Action.  

A communication is a recommendation for purposes of Regulation BI if it could be reasonably be viewed as a “call to action” to:

  • open an account; 
  • engage in a securities transaction; or
  • act on an investment strategy.

Soliciting new clients or soliciting existing clients to move accounts to a new firm in instances where the representative has joined the new firm, without more, does not constitute a call to action.  Moreover, educational communications do not constitute recommendations as long as they do not involve calls to action  regarding specific securities to be sold or a recommendation regarding specific securities to be purchased with the proceeds of any sale.

Self-Directed Brokerage Accounts.  

Reg BI applies to recommendations to a retail customer to open a self-directed brokerage account even in situations where the broker-dealer will not provide subsequent recommendations.

Disclosure Obligation

Timing of Disclosures.  

  • General Rule:   full and fair disclosure of all material facts relating to the scope and terms of the relationship with the retail customer and all material facts relating to conflicts of interest that are associated with the recommendation must be provided in writing to the retail customer before or at the time of the recommendation.
  • Facts Not Reasonably Known At the Time Disclosure Is Provided:  the written disclosure may be supplemented orally.  In addition, when making any supplemental oral disclosure not later than the time of the recommendation, the broker-dealer must maintain a record of the fact that oral disclosure was provided to the retail customer.
  • Regulations Specifically Permit Post-Recommendation Disclosures:  Reg BI does not supersede regulations such as those governing the timing of trade confirmations or prospectus delivery.  However, the written disclosure document must identify the material fact and describe the process through which the fact may be supplemented, clarified or updated. 

Form CRS and Disclosure Obligation. 

T&M is skeptical of a broker-dealer’s ability to satisfy the Disclosure Obligation solely by providing retail customers with the Form CRS-Relationship Summary, as it believes that the Form does not contain all of the information necessary to satisfy the Disclosure Obligation in most circumstances.

Electronic Delivery. 

T&M notes that neither Reg BI nor Form CRS permits a “notice plus access” or “access plus delivery” method of electronic delivery.  Instead, consent to electronic delivery must be evidenced through : 

  • notice to the retail customer that information is available electronically; 
  • access to information comparable to that which would have been provided in paper form and that is not so burdensome that the intended recipients cannot effectively access it; and 
  • evidence to show delivery (i.e., reason to believe that electronically delivered information will result in the satisfaction of the delivery requirements under the federal securities laws).

Form CRS and Disclosure – Acting as Broker-Dealer or Investment Adviser.  

For broker-dealers who are dually registered, and for associated persons who are either dually registered or, who are not dually registered but only offer broker-dealer services through a firm that is dually registered, T&M believes that information contained in the Relationship Summary will not be sufficient to disclose they are acting as broker-dealer or investment adviser in making a recommendation. Therefore, a separate disclosure is required whether they are acting (or only acting) as an associated person of a broker-dealer.

Similarly, for standalone broker-dealers who prepare a combined Relationship Summary with an investment adviser affiliate, or whose associated persons deliver both the broker-dealer’s Relationship Summary and an affiliated investment adviser’s Relationship Summary, T&M believes the information contained in the broker-dealer’s Relationship Summary will not be sufficient to disclose that they are acting as a broker-dealer in making a recommendation. Accordingly, T&M believes that associated persons must separately disclose that they are acting on behalf of the broker-dealer when making a recommendation.

Care Obligation – “series of transactions”

The staff stated that it intends to interpret a “series” of recommended transactions consistently with how the term is used under the federal securities laws and SRO rules – it will look at factors such as turnover rate, cost-to-equity ratio, and use of in-and-out trading. 

Conflict of Interest Obligation

Conflicts to Be Eliminated In Addition to Sales Contests, Sales Quotas, Bonuses, and Non-cash Compensation, Based on the Sales of Specific Securities or Types of Security Within a Limited Period of Time.  

T&M notes that a broker needs to eliminate or disclose and mitigate conflicts other than those listed.  T&M notes that a broker-dealer could choose to:

  • Disclose and Mitigate:  establish policies and procedures to reasonably designed disclose and mitigate the incentives created by the conflict; or
  • Eliminate address the conflict by eliminating it.

Methods to Mitigate Conflicts. 

T&M notes that the SEC did not mandate particular mitigation methods.  Instead, broker-dealers should tailor procedures relevant to their own circumstances.  The SEC did offer a laundry list of mitigation practices, including:

  • avoiding compensation thresholds that disproportionately increase compensation through incremental increases in sales;
  • implementing supervisory procedures to monitor recommendations that are: near compensation thresholds; near thresholds for firm recognition; involve higher compensating products, proprietary products or transactions in a principal capacity; and
  • limiting the types of retail customer to whom a product, transaction, or strategy may be recommended.

Compliance Obligation  

Because broker-dealers are currently subject to supervisory obligations under federal securities laws and regulations, as well as applicable self-regulatory organization rules, broker-dealers could choose to satisfy the Compliance Obligation by adjusting/building upon their current systems of supervision and compliance.  Reg BI does not require a broker-dealer to create entirely new supervision and compliance systems. 

Conclusion 

As noted above, Reg BI applies only to broker-dealers, and only when they make recommendations to retail customers.  Therefore, at first blush, the FAQs would seem not to be relevant to investment advisers.  However, an investment adviser’s fiduciary duty to clients requires, among other things, that an adviser:  (a) fully and fairly disclose all facts material to the client’s engagement of the adviser to its clients, and avoid misleading them; (b) provide clients only suitable advice; and (c) have a reasonable basis for recommendations.  The responses provided by T&M to the Reg BI FAQs – in particular, with respect to the Disclosure Obligation, Care Obligation and Conflict of Interest Obligation – can also assist investment advisers in satisfying their fiduciary duties to clients.  Moreover, the guidance serves as useful reminder that unless the SEC specifically authorizes a notice plus access or access plus delivery method of electronic delivery with respect to a particular disclosure, the SEC will continue to apply its prior guidance with respect to what constitutes valid consent to electronic delivery.  

1 Frequently Asked Questions on Regulation Best Interest, Division of Trading and Markets, U.S. Securities and Exchange Commission (Jan. 10, 2020; updated February 11, 2020) (https://www.sec.gov/tm/faq-regulation-best-interest) (visited February 27, 2020).