Authors: Jay Kasting and Chris Payne

What is Regulation Best Interest

On June 5th, 2019, the Securities & Exchange Commission (SEC) finally unveiled the much talked about Regulation Best Interest, also known as “Reg BI.” The new rule comes on the heels of the vacated “Fiduciary Rule” issued by the Department of Labor, which would have imposed a fiduciary standard on broker-dealers in the same fashion as registered investment advisors (RIAs). That rule was ultimately struck down by a federal court and came to its final resting place when the Trump Administration expressed its intention not to pursue further action.

At the most basic level, Regulation Best Interest is the SEC’s attempt to narrow the gap between the standards of conduct between broker-dealers and investment advisers. The regulation requires broker-dealers to only recommend financial products that are in their customers’ “best interests.” The “best interests” requirement is intended to hold broker-dealers to a higher ethical standard than the status quo “suitability” requirement, but does not rise to the level of fiduciary duties imposed on investment advisors.

As one might expect, the rule has caused considerable confusion given that the SEC has not yet provided a clear definition of what constitutes “best interests” and how it differs from a fiduciary standard of conduct. There is, however, more clarity surrounding the reporting and disclosure requirements imposed on broker-dealers and, to some extent, investment advisors. More on that later.

How Should Advisers Prepare For Compliance?

Even though most of the changes under Reg BI affect broker-dealers, investment advisors will feel the impact of the new regulation as well. By June 30, 2020, SEC-registered investment advisers will need to create a new disclosure (four-page max) brochure named the Form CRS Relationship Summary (Form CRS), which is intended to reduce investors’ confusion related to their relationship with investment professionals.

Assuming Reg BI is implemented as planned, Form CRS will constitute Part 3 of an advisory firm’s Form ADV. In a similar fashion to Parts 1 & 2, RIAs will file Form CRS online and must include a short, concise summary of adviser’s business. The summary should be written in plain English and cover specified topics such as advisory services, fees, conflicts of interest, standards of conduct, and disciplinary history. Once an advisor files the Form CRS, it must begin distributing the form to all retail investors which are defined as “natural persons who seek to receive or receive services primarily for personal, family, or household purposes.”

Much of the disclosure info mandated by Form CRS should mostly be covered by Form ADV Part 2. In preparing Form CRS, advisors may borrow material from the Firm Brochure (Part 2A) and Supplements (Part 2B). Further guidance may be obtained by reviewing the Instructions on Form CRS as well as the examples prepared by the SEC staff for standalone broker-dealer firms, standalone investment advisor firms, and dually registered firms.

Why are States Suing to Kill the Rule?

The impetus for Reg BI comes from the legislative mandate in Dodd-Frank which instructs the SEC to harmonize requirements for broker-dealers and investment advisors offering services to retail customers. The evident goal being increased consumer protection in the financial services industry.

Earlier this month, seven states and the District of Columbia filed suit against the SEC to overturn the rule’s implementation next year. The central themes of the plaintiffs’ case are 1) the SEC exceeded its statutory authority by issuing the final rule, and 2) Reg BI will actually undermine consumer protection for retail investors in contravention to the rule’s purpose. Plaintiffs fear the rule will cause investors to perceive broker-dealers as equally trustworthy even though they give conflicted advice. In essence, plaintiffs would have the SEC implement a uniform fiduciary standard or take no action at all.

On the flip side, proponents of Reg BI contend that an enhanced duty of care/standard of conduct for broker-dealers is better than nothing at all. The plaintiffs have a number of legal hurdles to overcome before any changes take place. In the meantime, it is prudent for RIAs to plan on Reg BI rolling out as expected.

While it is difficult to frame an increase of compliance reporting in a positive light, many investment advisers have long complained the length of the Form ADV Part 2A prevented it from being a particularly useful document with clients. The length and nature of the Form CRS will lead to increased transparency and investor awareness. Furthermore, the materials and knowledge necessary to produce Form CRS should not be unduly burdensome for investment advisors given fiduciary disclosure requirements already in place and the form will ultimately be one additional delivery document for advisors serving retail clients.

Given the confusion surrounding the shifting standards of conduct for financial advisors, RIAs should take the opportunity to speak with their clients about the differences between “fiduciary” and “best interest” standards of conduct. Firm advisors can emphasize the benefits of engaging investments advisors as fiduciaries such as the reduced conflicts of interest, superior decision-making ability, and a higher standard for advisors to meet.

In preparation for the June 30th, 2020 deadline, we will begin reaching out to all Key Bridge Compliance clients by the end of the year. If you have any questions in the meantime, please don’t hesitate to contact the Key Bridge team.