As an investor, your broker-dealer should have your best interests in mind—right? While the answer to these questions might seem obvious, until very recently, broker-dealers were not required to make investment recommendations based on what they believed was best for their customers.
Fortunately, this changed when the SEC’s Regulation Best Interest took effect on June 30, 2020.
Regulation Best Interest (Reg BI) establishes a fiduciary duty for broker-dealers who work with individual investors. While investment advisors have long owed a fiduciary duty to their clients, broker-dealers have not historically owed their customers a corresponding duty. This disparity was based, in theory, on the distinction between the role of an investment advisor and that of a broker-dealer: While an investment advisor’s job is to help his or her clients invest wisely, a broker-dealers’ job is to sell investments. Just as someone who sells you a car is not required to help you choose the best car for your needs and budget, a broker-dealer is not (or was not) needed to help you make a sound investment decision.
Of course, investing in securities is not the same as buying a car—or just about anything else. If you are not careful (and even if you are careful), you can potentially lose your investment in its entirety. The complexity and exclusivity of the investment industry lend themselves to fraudulent activities. This, combined with the inherent risks of investing, means that individual investors need to be able to make informed decisions based on reliable and unbiased advice.
It is these concerns that led the U.S. Securities and Exchange Commission (SEC) to adopt Regulation Best Interest last year.
Regulation Best Interest is a federal regulation that protects individual investors who purchase securities through broker-dealers. As the SEC explains, under Reg BI, broker-dealers now must act in the best interests of their customers when making investment recommendations, “without placing [their] financial or other interest[s] ahead of the retail customer’s interests.” This is referred to as broker-dealers’ “general obligation” under Reg BI, and this general obligation is further broken down into four “component obligations,” as discussed below.
The purpose of Regulation Best Interest is singular: to protect individual investors who work with broker-dealers. The SEC refers to these individual investors as “retail customers.” A retail customer is anyone 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.” In other words, if you invest on your own with the assistance of a broker-dealer, then you are protected by Reg BI.
To avoid running afoul of Regulation Best Interest, broker-dealers must comply with the SEC’s four-component obligations. Broker-dealers are subject to new documentation and recordkeeping requirements under Reg BI as well. The four-component obligations under Reg BI are:
● Disclosure Obligation – When making investment recommendations to retail customers, Reg BI requires broker-dealers to disclose certain information about the recommended investment as well as the relationship between the broker-dealer and the customer. More specifically, broker-dealers must provide, “in writing, 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.”
● Care Obligation – Regulation Best Interest requires broker-dealers to “exercise reasonable diligence, care, and skill,” in making investment recommendations to retail customers. Thus, no longer is it enough for broker-dealers to merely determine that an investment is “suitable” to a particular customer—as was largely the extent of broker-dealers’ obligations before the effective date of Reg BI. Now, broker-dealers must take affirmative steps to arrive at an informed opinion about whether a particular investment makes sense for a particular customer based upon their personal investment profile.
● Conflict of Interest Obligation – Under Regulation Best Interest, broker-dealers must “establish, maintain, and enforce written policies and procedures reasonably designed to address conflicts of interest.” Notably, this does not mean that broker-dealers have an obligation to avoid conflicts of interest entirely—and this is one of the most significant limitations of Reg BI of which individual investors need to be aware. While broker-dealers are prohibited from accepting certain types of incentives for making investment recommendations, they can accept other types of incentives upon providing adequate disclosure to their customers. This makes it extremely important for individual investors to read their broker-dealers’ disclosures carefully and not rely solely on the existence of Reg BI.
● Compliance Obligation – In addition to establishing, maintaining, and enforcing written policies and procedures designed to “address” conflicts of interest, broker-dealers must undertake similar measures to “achieve compliance with Regulation Best Interest.” What is required depends on the size of the broker-dealer’s firm and the specific types of securities it sells. Generally speaking, however, broker-dealers must adopt policies and procedures that are adequate to ensure compliance with Reg BI for the benefit of their retail customers.
Importantly, the obligations established under Regulation Best Interest do not apply to all interactions between broker-dealers and their retail customers. Instead, Reg BI only applies when a broker-dealer is providing an investment “recommendation.” In determining whether a communication constitutes a recommendation, the SEC advises that:
“Factors [to be] considered in determining whether a recommendation has taken place include whether the communication ‘reasonably could be viewed as a “call to action”’ and ‘reasonably would influence an investor to trade a particular security or group of securities.’ The more individually tailored the communication to a specific customer or targeted group of customers about a security or group of securities, the greater the likelihood that the communication may be viewed as a ‘recommendation.’”
What if a broker-dealer also serves as a retail customer’s investment advisor? This is where things get particularly murky. According to the SEC’s guidance, Regulation Best Interest does not apply when an individual is acting in his or her capacity as an investment advisor—even if the individual subsequently executes a securities transaction on behalf of a retail customer in a brokerage capacity. Of course, if Reg BI does not apply based on the fact that a broker-dealer is serving as an investment advisor at a particular point in time, then the rules and regulations that apply to investment advisors would apply and provide protection to the individual investor.
Now that Regulation Best Interest is in effect, what happens if a broker-dealer violates any of its component obligations? Just like other claims against their broker-dealers, individual investors who have claims based on violations of Reg BI will be able to seek relief through arbitration with the Financial Industry Regulatory Authority (FINRA).
FINRA is a quasi-governmental entity tasked with enforcing broker-dealers’ and brokerage firms’ obligations to their retail customers. Broker-dealers and brokerage firms are required to register with FINRA, and, as a condition of registration, they are required to submit to arbitration when their retail customers file claims. There are various grounds on which individual investors can pursue claims against their broker-dealers in FINRA arbitration, which now includes violations of Regulation Best Interest. Some examples of specific claims that individual investors may be able to pursue against their broker-dealers in FINRA arbitration under Reg BI include:
● Failure to adequately disclose the risks associated with a particular investment recommendation;
● Failure to consider reasonable alternatives to potential investments before making specific investment recommendations;
● Failure to provide investment recommendations that are sufficiently tailored to the retail customer’s investment profile; and,
● Failure to adequately disclose a conflict of interest, such as a financial incentive that the broker-dealer receives for selling a particular security.
While FINRA arbitration is a unique process that is subject to its own unique set of substantive and procedural requirements, it offers many benefits compared to traditional courtroom litigation. FINRA arbitration is generally faster with fewer formalities involved. FINRA arbitrators are usually experts in the area of broker-dealer compliance, and, when a retail investor has a valid claim against his or her broker-dealer, there is a clear path toward recovering his or her fraudulent investment losses.
Given its limitations – most notably its limited protections regarding conflicts of interest – is Regulation Best Interest a good thing for investors? Ultimately, the answer is a resounding yes. Anything that provides more protection to investors is a win; and, while the SEC could possibly have gone further in restricting broker-dealers’ activities, Reg BI allows investors to make informed investment decisions when relying on broker-dealers’ recommendations—and it affords new opportunities for investors to seek relief when their broker-dealers’ recommendations do not adequately reflect their personal investment objectives and needs.