Some key areas for brokers to assess in determining whether they’re subject to the new rules as implementation date approaches.

The June 30, 2020 implementation date of the U.S. Securities and Exchange Commission's Regulation Best Interest is a few weeks away. While firms starting to prepare now are behind the curve, the SEC has provided some comfort stating that it won’t initially conduct “gotcha” exams and will only require “good faith efforts” for Day 1 compliance with Reg BI.

Reg BI will fundamentally alter how brokers interact with and provide recommendations to their retail customers. The SEC’s goal of heightened care and disclosure under Reg BI requires brokers to update their compliance procedures and training programs and put retail customers’ interests before their own. Reg BI will replace and expand current suitability requirements for retail customers. It doesn’t apply to investment advisors, who maintain fiduciary duties that brokers don’t.

Here are areas for brokers to assess in determining whether they’re subject to Reg BI. Specifically, brokers that service family offices, offer private placements, run self-directed platforms or solicit customers through direct outreach must be acutely aware of how they operate as they now may be within the broad scope of Reg BI.

Scope of Reg BI

Reg BI’s scope is broader than many believe, specifically with respect to the two triggering elements: (1) retail customers; and (2) recommendations. Brokers must review to whom and how they provide services to determine whether they’re subject to Reg BI. If a broker has even one retail customer and provides one recommendation, he must comply with Reg BI.

Who’s a Retail Customer?

Reg BI defines “retail customer” more expansively than current FINRA rules. Specifically, all natural persons and people legally representing them, regardless of sophistication or net worth, are considered retail customers. Brokers should apply a “two-legged” test (that is, do their customers have two legs) to determine whether they have retail customers. This two-legged test is easy to apply, however, as interpreted, it’s inexplicably extended the scope of Reg BI to family offices, as discussed further below.

Family Offices

The one-size-fits-all retail customer definition that includes family offices is overly broad and requires clarification from the SEC. Over the past year, there’s been a push for the SEC to exclude family offices from the definition of “retail customer.” The SEC has demurred saying consensus on the issue hasn’t been reached. Family offices are typically much different than other retail customers, due to their heightened sophistication and resources. Requiring brokers to treat family offices identically to everyday individuals isn’t rational and unnecessarily expands the scope of Reg BI. This increases the burden of compliance on brokers and the burden on customers who now must wade through unnecessary disclosure. Family offices haven’t historically been subject to heightened standards of review and disclosure and, furthermore, have the resources, infrastructure and sophistication to take care of themselves. Given these strong legal and policy arguments, we’re hopeful that in the near future, more guidance will be provided to carve out family offices from the retail customer definition. Until then, however, whether a broker’s customer is a billionaire, a billionaire’s family office or a teacher, he’ll be required to uphold the same degree of heightened disclosure and care for each.

What’s a Recommendation?

Reg BI broadens the types of broker communications that have historically been considered recommendations. Whether a communication is a recommendation under Reg BI is a fact-specific inquiry guided by asking whether it could reasonably be viewed as a “call to action” or it’s individually tailored to the retail customer. Traditionally, this analysis centered on recommendations of securities transactions or investment strategies. Reg BI broadens this definition by also considering account types and account monitoring activity as recommendations. This broadened definition will affect all broker-dealers that provide recommendations to retail customers including private placement brokers, self-directed brokers or options brokers. As such, all brokers should conduct a holistic review of their interactions with retail customers to confirm the applicability of Reg BI. 

“Hire-Me” Scenario

The “hire-me” scenario is the most challenging Reg BI compliance consideration. Here, a prospective retail customer is solicited and encouraged to either open an account or to transact in securities. If the retail customer uses this recommendation, the broker would have all Reg BI obligations, even if the person isn’t yet a customer. Account type recommendations are a new requirement for brokers subject to Reg BI. Accordingly, brokers will need to gather information regarding the customer’s investment objectives and investment profile prior to being able to determine whether any recommendation is in their best interest.

Practically speaking, there are only two ways to conduct this activity. The first is when a broker, while discussing services, stops short of a call to action or tailoring the communication to the retail customer, so that a recommendation isn’t provided. The broker would need to follow up and gather all necessary information from the retail customer prior to being able to provide a recommendation. The second requires a broker to gather all necessary information from a retail customer and determine based on this information whether recommending the account type, security or strategy is in the retail customer’s best interest. Neither of these options is ideal, but a broker in this scenario must be mindful of the scope and triggering elements of Reg BI.

Impact on Self-directed Brokers

Self-directed brokers aren’t likely subject to Reg BI because they typically don’t provide recommendations to their retail customers. However, recent guidance by the SEC explicitly states that self-directed brokers could be within the scope of Reg BI if they provide a “recommendation” at account opening, even if no subsequent recommendations are provided. What this means is very unclear and requires more clarification from the SEC. Is the one-time recommendation standard met by a broker’s marketing approach or individualized outreach through networks? If so, many self-directed fintech brokers are swept into Reg BI’s scope, while their entrenched brokerage competitors, with their established customer base, will avoid the onerous disclosure because they don’t need to employ similar tactics to grow. This moat creating interpretation will stifle innovative services while limiting choices for the same retail customers that Reg BI is intended to protect. In light of this vague guidance, self-directed brokers must closely review how they acquire and open accounts for retail customers to determine whether they’re subject to Reg BI.

Action Steps

In light of Reg BI’s broad definitions of retail customer and recommendation, brokers need to review their services and customers. If you’re in scope of Reg BI, you must take action fast. This requires you to consider Reg BI and its impact on your business activities and to take reasonable steps to adopt policies and procedures to address its various obligations. SEC officials have noted that documenting efforts to come into compliance will be viewed favorably during an exam, along with the expectation that compliance with the new obligations will be iterative.

Practical steps a broker must take include: drafting, filing, distributing and posting (if applicable) a Form CRS, as well as creating supplemental disclosure(s), detailing a broker’s capacity, fees, services and conflicts of interest. You must also update your compliance procedures and implement a corresponding training program.

Reprinted with permission from the June 17, 2020, issue of © 2020 Informa USA, Inc. All Rights Reserved. Further duplication without permission is prohibited.

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