United States: Regulation Best Interest

On June 5, 2019, the Securities and Exchange Commission (SEC) adopted Regulation Best Interest (Rule 15l-1 under the Securities Exchange Act of 1934 (Exchange Act)), which requires broker-dealers and their associated persons who are natural persons to act in the best interest of their retail customers when making a recommendation.1 The SEC also adopted Form CRS Relationship Summary, which requires registered investment advisers (RIAs) and broker-dealers to deliver to retail investors a succinct, plain English summary about the relationship and services provided by the firm and the required standard of conduct associated with the relationship and services. (Rule 17a-14 and Form CRS under the Exchange Act.)2, 3

Regulation Best Interest (Regulation BI), Form CRS and the related rule will become effective 60 days after their publication in the Federal Register. The compliance date for both rules is June 30, 2020.

This Legal Update necessarily summarizes the principal aspects of Regulation Best Interest, as the Release runs to 771 pages.

Regulation Best Interest – the General Obligation

Regulation BI has a "general obligation," which requires that the broker or dealer (BD) comply with four component obligations: the disclosure obligation, the care obligation, the conflict of interest obligation and the compliance obligation (the compliance obligation having been added since the proposing release).

The general obligation requires that BDs and their associated persons who are natural persons, when making a recommendation of any securities transaction or investment strategy involving securities (including account recommendations) to a retail customer, 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, or natural person who is an associated person of a broker or dealer making the recommendation ahead of the interest of the retail customer.4

The general obligation remains fundamentally unchanged since the proposing release, without defining "best interest." It does not apply the existing RIA fiduciary standard to BDs, and is not a separate fiduciary standard. The general obligation is not intended to require a BD to make conflict-free recommendations. BDs must take steps to reduce the effect of (and, in some cases, eliminate) conflicts that would create an incentive to place the BD's interests ahead of those of the retail customer when making a recommendation, and to make a recommendation in the customer's best interest even where conflicts continue to exist. A BD may recommend products that involve higher risks or costs to the retail customer, or that result in greater compensation to the BD, provided that each component obligation is satisfied.

Whether the BD complied with each of the four component obligations will be determined on a principles basis — an evaluation of the facts and circumstances of the particular recommendation and the particular retail customer, at the time that the recommendation was made (not in hindsight). The general obligation contains a number of defined terms, some of which are defined in Regulation BI, while others are explained in the Release.

A "retail customer" is defined as a natural person, or the legal representative of such natural person, who (A) receives a recommendation of any securities transaction or investment strategy involving securities from a broker, dealer, or a natural person who is an associated person of a broker or dealer; and (B) uses the recommendation primarily for personal, family, or household purposes.5

The SEC added the word "natural" to the definition since the proposing release, and the Release explains that the term "legal representatives" is interpreted to mean non-professional legal representatives of a natural person. An example of a non-professional legal representative would be a non-professional trustee that represents the assets of a natural person, and similar representatives such as executors, conservators and persons holding a power of attorney for a natural person.

Regulated financial services industry professionals retained by natural persons to exercise independent professional judgment, such as RIAs and BDs, corporate fiduciaries (e.g., banks, trust companies and similar financial institutions) and insurance companies, and the employees or other regulated representatives of such RIAs, BDs, corporate fiduciaries and insurance companies are not within the scope of a "legal representative of such natural person." 6

"Personal, family or household purposes" includes retirement accounts; accordingly, a retirement plan participant receiving a recommendation about whether to take a distribution from a 401(k) plan and how to invest that distribution would be a "retail customer" for purposes of Regulation BI.

A recommendation is not defined but is interpreted in a manner consistent with current BD regulation under the federal securities laws and FINRA rules.

The adopting release includes a list of activities that fall outside the scope of a "recommendation":

  • General financial and investment information;
  • Descriptive information about an employer-sponsored retirement or benefit plan;
  • Certain asset allocation models; and
  • Interactive investment materials that incorporate the exclusions above.7

"Account recommendations" include recommendations by BDs of securities account types generally, as well as recommendations to roll over or transfer assets from one type of account to another (e.g., workplace retirement plan account to an IRA).8

"Any securities transaction or investment strategy involving securities" not only includes explicit hold recommendations, but also includes implicit hold recommendations that are the result of agreed-upon account monitoring between the BD and its retail customer. Consequently, account recommendations are subject to Regulation BI even if there is not a recommendation of a securities transaction.

Regulation BI does not impose a duty to monitor a retail account; however, if the BD agrees to provide account monitoring services, Regulation BI will apply to any recommendations resulting from the account monitoring services. By agreeing to account monitoring services, the BD takes on an obligation to review and make recommendations for the account on a specified, periodic basis. If the BD makes no recommendation on a periodic review, it is an implicit "hold" recommendation, subject to Regulation BI, just as would an explicit "hold" recommendation.

This result is different from the FINRA Rule 2111 interpretation that the suitability rule does not cover an implicit hold recommendation. Absent a BD's agreement to monitor an account, Regulation BI does not apply to implicit hold recommendations, only explicit.9

Footnote

1 Release 34-86031 (June 5, 2019) (the "Release"), available at: http://bit.ly/2KbhJE8.

2 Release 34-86032 (June 5, 2019) (the "CRS Release"), available at: http://bit.ly/2XIK1Jl.

3 The SEC also issued an interpretation reaffirming and clarifying the fiduciary duty that RIAs owe to their clients under the Investment Advisers Act of 1940 (Advisers Act) and an interpretation of the "solely incidental" prong of the broker-dealer exclusion under the Advisers Act, both of which are addressed in a separate Client Alert.

4 Rule 15l-1(a)(1) under the Exchange Act.

5 Rule 15l-1(b)(1) under the Exchange Act.

6 See the Release at pp. 112-115.

7 See the Release at pp. 89-91.

8 See the Release at p. 96.

9 See the Release at pp. 103-106.

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© Copyright 2019. The Mayer Brown Practices. All rights reserved.

This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

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