SEC’s New Rule 15l-1 – Regulation Best Interest – Standard of Conduct Requiring Broker-Dealers to Act in the “Best Interest” of Retail Customers
September 19, 2019
On June 5, 2019, the Securities and Exchange Commission (SEC) adopted Regulation Best Interest: The Broker-Dealer Standard of Conduct (Reg. BI) – codified as Rule 15l-1 under the Securities Exchange Act of 1934 (Exchange Act) setting the standard of conduct applicable to a broker, dealer, or a natural person who is an associated person of a broker or dealer (together referred to as a broker-dealer) when making recommendations to retail customers of any securities transaction or investment strategy involving securities.1 Reg. BI includes obligations with respect to disclosure, duty of care, conflicts of interest and compliance. The regulation became effective on September 10, 2019. The compliance date is June 30, 2020.2 This memorandum provides a summary of the principal aspects of Reg. BI.
I. General Obligation and Component Obligations of Reg. BI
Reg. BI imposes a general obligation (General Obligation) that requires a broker-dealer, when making a recommendation of any securities transaction or investment strategy to a retail customer, to 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 interest of the retail customer.
The General Obligation is satisfied only if a broker-dealer complies with four specified component obligations (collectively, the Components):
1. Disclosure Obligation.
Broker-dealers must provide full and fair written disclosure, before or at the time of the recommendation, of all material facts about the scope and terms of its relationship with the customer.
The Disclosure Obligation requires that, prior to or at the time of a recommendation, a broker-dealer must provide “full and fair”3 disclosure, in writing, of all material facts about the scope and terms of its relationship with the customer. The written disclosure must provide notice to the customer of certain material facts that govern its relationship with the customer and any material conflicts of interest, including: (i) indication that the broker-dealer was acting as a broker-dealer (rather than an adviser) with respect to a recommendation, (ii) fees and charges applicable to a customer and (iii) the type and scope of services provided by the broker-dealer.4 A broker-dealer must disclose material facts5 related to conflicts of interest such as conflicts associated with proprietary products, payments from third parties, and compensation arrangements. The written disclosures must be updated to reflect material changes or inaccuracies as soon as practicable, generally not be later than 30 days after the material change occurred.
2. Care Obligation.
Broker-dealers must exercise reasonable diligence, care, and skill when making a recommendation to a retail customer.
Under the Care Obligation, a broker-dealer must exercise reasonable diligence, care, and skill when making a recommendation to a retail customer. The broker-dealer must have a reasonable basis to believe that the recommendation is in the customer’s best interest and does not place the broker-dealer’s interest ahead of the retail customer’s interest. The SEC confirmed that the Care Obligation goes beyond suitability requirements.6
Whether a broker-dealer has complied with the Care Obligation will be evaluated as of the time of the recommendation (and not in hindsight). When recommending a series of transactions, the broker-dealer must have a reasonable basis to believe that the transactions taken together are not excessive, even if each is in the customer’s best interest when viewed in isolation.
The Care Obligation goes beyond suitability requirements by requiring that the recommendations be in the best interest of a retail customer, and that reasonably available alternatives7 be considered, not just that the recommendation be consistent with the customer’s best interest.
3. Conflict of Interest Obligation.
Broker-dealers must establish, maintain, and enforce reasonably designed written policies and procedures addressing conflicts of interest associated with its recommendations to retail customers.
The Conflict of Interest Obligation requires that a broker-dealer establish, maintain, and enforce reasonably designed written policies and procedures addressing conflicts of interest associated with its recommendations to retail customers. Conflicts of interest must be disclosed and mitigated or eliminated. When disclosed, the policies and procedures must be reasonably designed to mitigate conflicts of interests that create an incentive for an associated person of the broker-dealer to place its interests or the interest of the broker-dealer ahead of the retail customer’s interest.
When a broker-dealer places material limitations on recommendations that may be made to a retail customer (e.g., offering only proprietary or other limited range of products), the policies and procedures must be reasonably designed to disclose the limitations and associated conflicts and to prevent the limitations from causing the broker-dealer from placing its interests ahead of the interest of the customer.
Broker-dealers must eliminate certain conflicts of interest, such as sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sale of specific securities or specific types of securities within a limited period.
4. Compliance Obligation.
Broker-dealers must establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Reg. BI.
In addition to policies and procedures that address conflicts of interest, Reg. BI requires policies and procedures for compliance with the disclosure and care obligations. The SEC notes that a firm’s compliance policies and procedures should be proportionate to the scope, size, and risks associated with the operations of the firm and the types of business in which the firm engages but makes no further specific mandates as to the compliance obligations of broker-dealers.8 The compliance obligation requires that policies and procedures include remediation of non-compliance and implement controls, training, and periodic review and testing.
II. Certain Key Defined Terms
Certain defined terms are key to understanding the requirements of Reg. BI.
1. Retail customer
A “retail customer” is any natural person, or the legal representative9 of such natural person, who (i) receives a recommendation of any securities transaction or investment strategy involving securities from a broker-dealer and (ii) uses the recommendation primarily for personal, family, or household purposes.10
2. Conflict of Interest
Reg. BI defines a “conflict of interest” as “an interest that might incline a broker, dealer, or natural person who is an associated person of a broker or dealer-consciously or unconsciously-to make a recommendation that is not disinterested.”11
As with FINRA’s suitability rule, Rule 2111 and related guidance, “recommendation” is a key trigger to the application of the General Obligation under Reg. BI. The determination of what communication constitutes a “recommendation” is a facts and circumstances analysis. The SEC listed the following factors to assist in the analysis of what constitutes a recommendation: (1) whether the communication reasonably could be viewed as a call to action; (2) whether the communication would influence an investor to trade a particular security or group of securities; and (3) whether the communication is more individually tailored to a specific customer or targeted group of customers.12
While broker-dealers will not be required to monitor accounts, in instances where a broker-dealer agrees to provide the retail customer with specified account monitoring services, such agreed-upon monitoring will result in buy, sell or hold recommendations subject to Reg. BI, even when the recommendation to hold is implicit.
The SEC provided the following list of communications that would not be considered recommendations: (i) general financial and investment information, including basic investment concepts, historic differences in the return of asset classes, effects of inflation, estimates of future retirement income needs, and assessment of a customer’s investment profile; (ii) descriptive information about an employer-sponsored retirement or benefit plan, participation in the plan, benefits of plan participation, and investment options available under the plan; (iii) certain asset allocation models; and (iv) interactive investment materials that incorporate these items.
III. Recordkeeping Requirements
The SEC also adopted certain record-making and recordkeeping requirements largely as proposed. Under new paragraph (a)(35) to Rule 17a-3 under the Exchange Act, as amended, broker-dealers must record, for each retail customer to whom a recommendation is made, all information collected from and provided to the retail customer pursuant to Reg. BI, as well as the identity of each associated person responsible for the account.13 Neglect, refusal, or inability of a retail customer to provide or update any such information would excuse the broker-dealer from obtaining that information.
The requirements of Rule 17a-3 are not designed to create additional, standalone burdens for broker-dealers; rather, the new requirement provides a means by which broker-dealers can demonstrate, and SEC examiners can confirm, compliance with the new substantive requirements of Reg. BI. Note that the new record-making requirements would not require the duplication of existing records.
IV. S&K Observations
We recommend a broker-dealer to consider the following steps to comply with the requirements of Reg. BI:
- Conduct a “gap” analysis to ensure compliance with the General Obligation, each of the Components, and the books and records requirements adopted under Reg. BI.
- Update written supervisory procedures to include policies and procedures that identify and mitigate conflicts of interest and specifically to identify and eliminate sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sale of specific securities or the sale of specific types of securities within a limited period.
- Update written supervisory procedures to include policies and procedures reasonably designed to: (1) identify and disclose any material limitations placed on the securities or investment strategies involving securities that may be recommended and any associated conflicts of interest; and (2) prevent the limitations and associated conflicts of interest from causing you and your registered representatives to make recommendations that place your and their interest ahead of the interest of the retail customer.
- Draft disclosure to provide, prior to or at the time of a recommendation, all material facts relating to the scope and terms of the relationship with the retail customer (e.g., stating that all recommendations will be made in a broker-dealer capacity unless otherwise expressly stated at the time of the recommendation) and relating to conflicts of interest that are associated with recommendations.
- Review your procedures for marketing communications based on the Disclosure Obligation especially if you state that you provide “advice.” Be sure those statements are made in a way that does not contradict the disclosures made pursuant to Reg. BI.
- Review titles given to registered representatives and, if necessary, remove “adviser” and/or “advisor” titles.
Please contact your Seward & Kissel attorneys if you’d like more information on Reg. BI.
1 Regulation Best Interest: The Broker-Dealer Standard of Conduct, Securities Exchange Act Release No. 86031 (June 5, 2019), 84 Fed. Reg. 33318 (July 12, 2019), available at https://www.sec.gov/rules/final/2019/34-86031.pdf. Reg. BI does not create a fiduciary standard for broker-dealers and their registered representatives. Rather, Reg. BI reflects FINRA Rule 2111 and related Notices To Members and other prior guidance provided by FINRA and the SEC.
2 84 Fed. Reg. at 33318, 33400.
3 Note that the Proposing Release required that a broker-dealer “reasonably disclose” material facts to retail customers.
4 84 Fed. Reg. at 33349.
5 The Release provides that a fact is material if there is “a substantial likelihood that a reasonable [retail customer] would consider it important.”
6 84 Fed. Reg. at 33374.
7 The SEC clarified that an evaluation of reasonably available alternatives does not require an evaluation of every possible alternative nor require broker-dealers to recommend one “best” product.
8 84 Fed. Reg. at 33397.
9 According to the SEC, 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.
10 84 Fed. Reg. at 33325, 33342. The inclusion of “personal, family, or household purposes” is designed to exclude natural persons seeking services for commercial or business purposes. The “personal, family, or household purposes” language also covers retirement accounts and recommendations to plan participants; however, it would not include recommendations made to plan representatives of workplace retirement plans.
11 84 Fed. Reg. at 33325.
12 84 Fed. Reg. at 33325.
13 Records must include information for written and oral information provided to comply with Reg. BI.