PRIMER: Regulation Best Interest
IFLR’s latest free-to-read primer looks at Securities and Exchange Commission’s Regulation Best Interest, addressing what it is, what it does and related retail investor protection issues
Regulation Best Interest (Reg BI) is a Securities and Exchange Commission (SEC) package of rules aimed at improving the quality and transparency of retail investors’ interactions with investment advisers and broker-dealers.
IFLR’s latest free-to-read primer looks at the rule, addressing what it is, what it does and related retail investor protection issues.
What is Regulation Best Interest?
The rule, adopted in 2019, requires that investment recommendations by advisers and broker-dealers are made in the customers’ best interest, and clearly identify any potential conflicts of interest and financial incentives that the broker-dealer may have for the sale of those products.
“These actions are designed to enhance and clarify the standards of conduct applicable to broker-dealers and investment advisers, help retail investors better understand and compare the services offered and make an informed choice of the relationship best suited to their needs and circumstances, and foster greater consistency in the level of protections provided by each regime, particularly at the point in time that a recommendation is made,” reads the official SEC website.
Reg BI became effective 30 June 2020, following a period of good faith compliance last year. The SEC allowed firm’s time where good faith efforts to comply would not result in enforcement actions. Under a new SEC chair, nominee Gary Gensler, enforcement will be a priority, with agency actions expected to increase alongside testing as the rule is cemented.
Reg BI rewind: history of the rule
Following the 2008 financial crisis, when several legacy banks and financial services companies shuttered, including the investment bank Lehman Brothers, lawmakers and regulatory agencies were prompted to act and tightened myriad aspects of the financial system in an attempt to tighten screws on the activities and actors responsible. The efforts looked to limit damage of future crises and negate the next one. In 2010, Congress passed the sweeping Dodd-Frank Act, a broad package of reforms to stifle the riskiest activities that added hazards to the financial system.
Although the concept of heightened standards for broker-dealers and advisers for investment recommendations to retail investors has been studied and argued over for decades prior, the push to promulgate new regulations gained new energy at this time.
In this environment, then-president Obama urged the DoL to ensure greater protections for retail investors, particularly from costly retirement investments with hidden fees that earned high commissions for brokers but low returns for retirement investors.
In response, the DoL promulgated the now-vacated fiduciary rule for retirement advisers and others working with retirement plans and investors savings.
Following financial industry lobby opposition and court challenges to the rule, which held retirement advisers to a fiduciary standard requiring that they always act in the best interest of their clients and put their clients’ interests before their own, the rule was struck down in 2018 and ordered vacated by the US Fifth Circuit of Appeals.
After the fiduciary rule was kiboshed, the agency worked on a new, less restrictive rule in its stead. Consumer protection advocates were not impressed by the finalised replacement rule that was a lower bar than the fiduciary standard.
“We felt like the 2016 rule was really meaningful and the investment advice rule that occurred last year missed the mark,” Geoffrey Brown, CEO, National Association of Personal Advisors, said. “It allowed some of the things that were potentially harmful to consumers to continue in the fact that advisers do earn transaction-based compensation inside retirement plans and things of that nature. It just wasn't in the same vein of what we saw in the original rule analysis.”
In contrast to the vacated fiduciary rule, the DoL’s Investment Advice rule allows retirement advisers to be paid for 401(k) advice from mutual fund companies, with certain restrictions.
What did the new rule do?
During this period, the SEC was working on a new rule to heighten standards for financial advisers and broker-dealers, which became Regulation Best Interest. The SEC established the new standard whereby investment advisers and broker-dealers must meet a four-legged set of general obligations when making recommendations to customers. The rule requires that recommendations to a retail customer must be in their best interest at the time when the recommendation is made and that the obligation is only satisfied when four component obligations are met: disclosure, care, conflict of interest, and compliance.
The rule also created and adopted the Form Client Relationship Summary (CRS). This required investment advisers and broker-dealers working with customers to deliver a brief customer or client relationship summary that provides information about the firm.
Among other items, the Form CRS must disclose fees, costs, conflicts and standard of conduct and any disciplinary history.
The state vs federal issue
As the now-sunk fiduciary rule faced legal challenges and an uncertain fate, US states including Maryland, Massachusetts, Nevada, New Jersey and New York, announced, mulled or blared their intention towards creating their own fiduciary rules. The possible “patchwork of rules” that could result was critiqued as unworkable across borders, raising costs and limiting access by the Securities Industry and Financial Markets Authority (Sifma), a powerful financial industry lobby group.
These moves by states didn’t end with the fiduciary rule’s fate, Brown said. Lawmakers still intend to pursue fiduciary standards, but state officials were busy dealing with the Covid-19 pandemic, he explained.
“We saw a bit of a slowdown, probably because of Covid, government officials having to pay attention to more pressing matters,” he said. “Right now there's probably some hope that the Biden administration will tune up the DoL’s investment advice rule and offer some potential changes to Reg BI, and once states see what happens with the SEC and the DoL, then you might see a return to some of the state based fiduciary rules that we saw.”
Despite these states leading the way, many feel that a state by state approach is not ideal.
“These are states that are liberal bellwethers that have the potential to move the needle across the country but for all of us that watch this world, we would feel better about it coming from the federal government as opposed to a state by state patchwork,” Brown added.
Has the good faith period ended?
In the words of famed American singer and songwriter, Billy Joel, life may be a series of hello’s and goodbye’s but for investment advisers and broker-dealers the honeymoon is over for complying with Regulation Best Interest.
Following the good faith period, enforcement actions are expected to spike this year as part of the SEC’s 2021 exam priorities, under chair Gensler.
“[Firms] took a great deal of comfort in the staff statement that the assessment would consider good faith compliance,” said Stephanie Nicolas, partner at Wilmer Hale, during a Sifma webinar in March 2021. “For phase two we are unfortunately past the good faith compliance window and now the staff has said that it will conduct more focused examinations.”
For enforcement priorities, Nicolas explained that based on staff statements at the end of 2020, the SEC will be examining firm’s compliance through focused examinations in a number of areas.
The staff will continue to evaluate policies and procedures for establishing that investment recommendations are being made in the customer’s best interest with special attention to alterations to product offerings including the removal of higher cost products.
“And if you haven’t evaluated your product offerings in light of Reg BI, you should consider doing so,” she said.
John Polise, associate director for broker-dealer and exchange oversight in the SEC’s enforcement division, explained that while the honeymoon may have ended, the agency won’t be breaking down doors and doing sudden enforcement blitzes.
“It’s something beyond good faith,” he said. “Understand we’re not looking to gotcha exams or make enforcement referrals. We’re still understanding that the rule is complicated.”
With incoming chair Gensler enforcement actions are expected to increase from predecessor Jay Clayton, when standalone enforcement actions dipped, Marlon Paz, partner, with Mayer Brown said.
Kyle DeYoung, partner with Cadwalader, explained that “an increased focus or maybe a more aggressive approach would be the focus on Reg BI and the nitty-gritty of firms’ compliance with its specific requirements.”
Best Interest wish list and criticisms
Consumer protection advocates argue Regulation Best Interest falls short in several areas. Advocates want to see changes to the rule to bolster protections for retail investors.
Barbara Roper, director of investor protection for the Consumer Federation of America, faults the SEC for not defining best interest, adding that without clear guidance recommendations may be based on the suitability standard used by the Financial Industry Regulatory Authority (Finra).
“The problem with regulation best interest is that its best interest obligation is undefined,” Roper said. “And the limited guidance that the SEC has provided to date, suggests that it is essentially the same as the suitability standard under Finra rules.”
The suitability standard, put forth in Finra Rule 2111, is a lower bar than the SEC’s Best Interest, requiring that a firm or recommending person “have a reasonable basis to believe a recommended transaction or investment strategy” is suitable for the customer.
Finra, a self-regulatory organisation is responsible for regulating exchange markets and brokerage firms outside of the SEC’s remit.
“The SEC has never said that you meet your best interest obligation by recommending the investments or investment strategies or accounts or services that you reasonably believe are the best option for the investor from among those you have reasonably available to recommend,” Roper explained.
“Instead, the rule has this sort of tautology; you meet your best interest obligations by making recommendations in the best interest of the investor and nobody knows what that means because the term best interest hasn't been given any real meaning by the SEC.”
Brown agrees best interest must be clearly defined, wants to SEC to address the issue of conflicts of interest and added that he sees “a lot of potential” in Form CRS for greater transparency “to give a consumer a really good idea of the nature of the relationship that they're engaging in.”
Although Brown does see potential for Reg BI to be strengthened under new chair Gensler and the Biden administration ̶ viewed as more favourable to financial regulation ̶ the rule as it stands falls short.
“We felt like the SEC had an opportunity to really highlight the distinction between broker dealers and investment advisory professionals and the rule that came out and was approved has woefully missed the mark,” he said.
Steve Hall, legal director and securities specialist for Better Markets, agreed the SEC rule is inadequate and favours the stronger fiduciary standard.
“The bottom line is it's a weak rule, it's based on ridiculous mythologies peddled by the industry to the effect that if you make the standard a real fiduciary standard, it'll deprive investors of product choice,” he said. “That’s a fiction, and in the end, it is misleading.”
Hall favours the SEC returning to rulemaking and guidance because Congress, through Dodd-Frank, gave the authority to establish a “real fiduciary standard for all advisers, a uniform standard that really had teeth,” he added.
“It's a missed opportunity,” he said. “There's a sort of tragic element to it. In an ideal world, the SEC would invoke the authority that it has under Dodd Frank to establish a uniform fiduciary standard and get it right, as Congress envisioned.”