Effective from June 30th 2020, the US Securities and Exchange Commission’s (SEC) Regulation Best Interest (Reg BI) rules mean that broker-dealers will be bound by law to put their customers’ interests first. Billed as the biggest regulatory change in decades, Reg BI is a new stricter standard for broker-dealers, governing how they provide investment advice to retail clients.
Some people have dubbed the new regulations ‘suitability on steroids’, as they bolster existing FINRA rules that already stipulate that broker-dealers should only recommend investments they believe are suitable for their clients.
Many firms will say they are already putting their clients’ interests first—after all, clients are hardly going to continue doing business with a broker who they consider to be acting against their interests. But the new rules go a step further by requiring broker-dealers to formally comply with three basic principles: disclosure, customer care, and addressing conflicts of interest.
As part of the Reg BI rules, brokers must fill out Form CRS, a customer relationship summary form that clearly outlines those disclosures and conflicts, so that clients can more easily compare what different firms are offering.
So from the outset, broker-dealers must now disclose to clients how they are being compensated, and what conflicts they might have, while ensuring the client understands exactly what they are investing in, what the risks are, and how much it is going to cost them.
Broker-dealers also have to maintain a duty of care for their clients. That means brokers need to understand everything about a client’s financial situation so that any investment recommendations—relating to both products and strategies—are appropriate to those circumstances. For instance, advising an 80-year-old retiree to invest in a leveraged ETF, where returns are based on short-term stock market volatility, would be unlikely to meet the standard.
Lastly, firms must ensure that any conflicts of interest that could deter broker-dealers from acting in the best interests of clients are properly mitigated.
So, what are the implications for firms? To start with, incentive programs such as sales contests, bonuses or non-cash compensation linked to specific investments within a limited time period, are no longer allowed.
Firms must also develop policies and procedures to mitigate other potential conflicts. Those could be anything from recommending proprietary products or investments that pay brokers higher commission fees, to holding board positions or trading ahead of customer orders.
Another requirement is for firms to have policies and procedures in place that will enable them to justify their product recommendations. This means carrying out periodic product reviews to assess if the investments a firm is selling should remain on their product list. For instance, has a particular investment become so risky that it would now be unsuitable for any retail customer to purchase, or have the fees and pricing associated with a product increased to the point where it is now significantly more expensive compared to other similar investments?
Firms are also required to maintain ongoing monitoring and surveillance of these processes to ensure compliance with Reg BI. Increasingly, firms are putting technology in place to monitor and archive client communications involving registered investment advisers, because these communications often include vital evidence that the adviser has acted in the client’s best interests. The new rules widen the net to include broker-dealers, and as a result the volume and variety of communications that must be recorded has increased.
What Reg BI underscores is the importance for firms to continuously monitor the interactions they have with clients, and to ensure they have the right technology and tools in place to capture and flag potential rule violations. In doing so, compliance teams can focus on proactively reviewing suspect communications, rather than wasting time managing infringements and paying costly enforcement fines.
Want to learn more? Watch our webinar “Understanding Regulation Best Interest” on demand to learn:
Why Reg BI came into force
- How the obligations of regulated firms are affected
- What the Regulator expects from firms to ensure compliance
- How Reg BI impacts product sales
- More about conflicts, compensation, and disclosure