Nearly Time to Comply with Reg BI

Some see the SEC’s Regulation Best Interest as “nothing new,” while others say it will be a game changer when it takes effect June 30. Likely the biggest impacts will be felt by dual registered firms and broker/dealers.

Art by Julie Benbassat

The reason why the U.S. Securities and Exchange Commission (SEC) decided to come out with Regulation Best Interest (Reg BI) is because the Dodd-Frank Act required a study be conducted on whether investors could tell the difference between a brokerage account and an advisory account, and, of course, they could not, says Bao Nguyen, a principal in the risk advisory department of Kaufman Rossin.

“To harmonize that, the SEC came up with Reg BI, to bring it closer in line with the fiduciary rule of the Investment Advisers Act,” Nguyen says. “They also came up with Form Customer Relationship Summary (CRS), which requires a broker/dealer [B/D] and adviser to provide a two-page summary of their investment recommendation.”

The criteria on which Reg BI is based is built on four building blocks, says Thomas Gorman, a partner with Dorsey & Whitney.

“These are the disclosure obligation, the conflict of interest obligation, the care obligation and the compliance obligation,” Gorman says. “It is designed to ensure the broker makes reasonable efforts to put the interests of the client ahead of the firm and the individual broker.”

With the disclosure obligation, the broker must disclose all fees, Gorman says. The conflict of interest obligation requires the broker to either mitigate all conflicts or to disclose them clearly, he says. The care obligation means that the broker must explore all investment options available to meet the customer’s investment objectives.

“The broker has to do his homework,” Gorman says. “He needs to investigate all options. And the compliance obligation means he is taking care of all of these things.” Like other sources, Gorman says the compliance obligation will likely require material changes to firms’ processes and procedures.

With the regulation taking effect June 30, inspectors from the SEC’s Office of Compliance Inspections and Examinations (OCIE) will start to visit broker/dealers to see if they are compliant beginning on that date, Gorman says.

While Gorman says that Reg BI is really nothing new, just essentially the SEC repackaging existing rules, Nguyen sees it as more of a real “game changer.”

“For so many years now, the SEC only applied a ‘suitability’ principle to broker/dealer sales,” he says. “Now, broker/dealers will truly have to act in the best interest of their customers.”

To apply the four principles of Reg BI to their practices, Kaufman Rossin is advising its clients to think objectively and exhaustively about their business models.

“We are telling clients to think carefully about all of the ways they are paid,” Nguyen says. “Look at the conflicts of interest associated with your business model and do a conflict of interest inventory. You then need to do mitigation mapping—mapping specific conflicts to detailed policies, procedures or disclosures that will mitigate those conflicts.”

While it is not expressly required by Reg BI, Kaufman Rossin is encouraging its clients to keep a record of the recommendation they make as to why they think a certain investment is in a client’s best interest.

Rich Kerr, a partner at K&L Gates, says he is telling clients to make Reg BI policy part of their regular supervisory procedures. “That may mean migrating a number of procedures they already have in place to the Reg BI policy,” Kerr explains. “Very likely they will need to enhance their conflict of interest procedures.”

As for the care component of Reg BI, rather than examining product suitability over and over again for clients, K&L Gates is recommending that brokers create a “product inventory documenting the basis on which they have determined that each product is in the best interest of retail customers,” Kerr says.

Brokerages may be surprised to learn that they have contact with retail customers, he adds.

“If you asked them a year ago if they have not just institutional but also retail customers, they would have said no,” Kerr says. “Many firms have discovered that this is not, in fact, the case. So, they need to inventory each of their business lines to see if there are touch points with retail customers.”

Once they have identified the businesses that are impacted by Reg BI, brokerages will need to train all client-facing personnel on the new regulation, Kerr says. With the coronavirus keeping so many people working from home, it will be challenging to meet the June 30 deadline, he says. They will have to replace those in-person training sessions with webinars and video training, he says.