This article was reprinted with permission from Business Law Today, May 12, 2020.
On June 30, 2020 registered securities broker-dealers must begin their compliance with new SEC Regulation Best Interest and Form CRS Relationship Summary/Form ADV Part 3, which were announced by the Securities and Exchange Commission on June 5, 2019. These new regulations were promulgated under authority given to the SEC by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Regulation Best Interest has four components: (1) the disclosure obligation; (2) the care obligation; (3) the conflict of interest obligation; and (4) the compliance obligation. The Form CRS Relationship Summary/Form ADV Part 3 imposes an obligation on both broker-dealers and investment advisers to provide a Customer Relationship Summary to retail investors. For broker-dealers this form is called Form CRS. For investment advisers this form is Form ADV Part 3. This article will provide some basic preliminary guidance on how broker-dealers and investment advisers can prepare for the June 30 compliance date.
Before getting into the weeds, we should note that according to the SEC, the purpose of its adoption of the rule package consisting of Regulation Best Interest and Form CRS is to enhance protections and preserve choice for retail investors in their relationship with their financial professionals by bringing the legal requirements and mandated disclosures for both broker-dealers and investment advisers in line with reasonable investor expectations. The intent is to preserve access and choice in: (1) the type of professional with whom they work (i.e. broker-dealer and/or investment adviser), (2) the services they receive (transaction based or ongoing monitoring), and (3) how they pay for these services (commissions or fees).
In order to accomplish this goal, the SEC adopted Regulation Best Interest to apply only to retail customers of broker-dealers and not to investment advisers, who are already subject to the fiduciary standard of the 1940 Investment Advisers Act. Reg. BI, as it is colloquially called, does not apply to institutional or other non-retail accounts, who will still be subject to FINRA’s Suitability Rule 2111. Regulation BI imposes a heightened standard of care at the time of a recommendation to a retail customer and does not impose an ongoing duty to monitor existing accounts, thereby contrasting it with the fiduciary duties of investment advisers. The new regulations require a broker-dealer to act in the retail customer’s best interest and not place its own interest ahead of the customer’s interest. This obligation is akin but not identical to the fiduciary obligations imposed upon investment advisers.
Duty of Disclosure
First and foremost, for broker-dealers scrambling to meet the June 30 deadline, is the duty of disclosure. Some helpful guidance in this regard is provided by the Financial Industry Regulatory Authority (“FINRA”) , which has published a Reg. BI and Form CRS firm checklist on its web page. While the SEC regulations have prescribed the overall contents and format of the new disclosures required by Form CRS, they have not prescribed the format of the written disclosures required by Reg. BI. Under the Reg. BI Disclosure Obligation, a broker-dealer and registered representative are required, prior to or at the time of the recommendation, to provide the retail customer, in writing, with a full and fair disclosure of all material facts related to the scope and terms of the firm-customer relationship, and all material facts relating to conflicts of interest that are associated with the recommendation. At a minimum, these disclosures are required: (1) All material facts relating to the scope and terms of the relationship with the retail customer, including; (a) that the broker-dealer and registered representative are acting as a broker, dealer or associated person of a broker-dealer with respect to the recommendation, (b) the material fees and costs that apply to the retail customer’s transactions, holdings, and accounts, (c) the type and scope of services provided to the retail customer, including any material limitations on the securities or investment strategies involving securities that may be recommended to the retail customer and (2) all material facts relating to conflicts of interest that are associated with the recommendation.
The regulations leave it to each individual firm to prepare its own Reg. BI written disclosure form and Form CRS/ADV Part 3. These forms, in other words, are do it yourself, with some guidance in the form of a prescribed format and “conversation starters” required for Form CRS/ADV Part 3. Form CRS/ADV Part 3 may be no more than two pages for broker-dealers and investment advisers, while dual registrants are encouraged to combine their disclosures in a four-page document. Helpful guidance is provided in the instructions to Form CRS/ADV Part 3 and the FINRA Reg. BI checklist. Among other things, Form CRS should have a basic introduction to the firm, a description of fees and costs generally, and must disclose any relevant disciplinary history of the firm and its principals. While Regulation Best Interest does not by its terms apply to investment advisers, registered investment advisers are required to prepare and provide to clients a Form ADV Part 3, which must have the same information as Form CRS.
When should customers receive their new Form CRS? According to the SEC, the form should be completed and delivered to the customer at the time a new customer account is opened, or at the time of recommendation for an existing customer. While the new Form CRS may be delivered in paper or electronic format, it should be done prominently, and must be the first document if provided with other materials.
In addition, it is incumbent upon the firm to explain to the customer the nature of the relationship, and whether it is advisory or that of a broker. Under the new regulations, the moniker “adviser” can only be used by investment advisers and may not be used by registered representatives who are not dually registered. Thus, firms should, prior to June 30, undertake to review their brokers’ business cards, office signage, websites and promotional material to ensure that the use of the word adviser is limited to registered investment advisors.
Some firms are undertaking firm-wide initiatives designed to encourage all brokers to become dually-registered, which will certainly help simplify determining the applicable standard of care.
Duty of Care
The duty of care imposed on broker-dealers is one of the central pillars of the new regulations, and imposes a heightened standard of care at the time of a recommendation akin to the fiduciary standard imposed on investment advisers under the 1940 Investment Advisers Act. Under the current FINRA suitability rule, a registered representative or broker-dealer must make a reasonable recommendation to buy or sell a security based upon the customer’s investment objectives, risk tolerance, investment time horizon and other securities holdings as disclosed to the firm. The care obligation of Reg. BI requires that when making a recommendation to a retail client, a registered representative must exercise reasonable diligence, care, and skill to: (1) understand the potential risks, rewards, and costs associated with the recommendation and to have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers; (2) have a reasonable basis to believe that the recommendation is in the best interest of a particular customer based on the retail customer’s investment profile and the potential risks, rewards, and costs associated with the recommendation and does not place the financial interests of the BD or RR ahead of the interests of the customer; and (3) have a reasonable basis to believe that a series of recommended transactions, even if in the customer’s best interest when viewed in isolation, is not excessive and is in the customer’s best interest when taken together in light of the customer’s investment profile and does not place the financial interests of the BD or RR ahead of the interests of the customer.
While the care obligation requires broker-dealers and registered representatives to consider and disclose to their customers the fees and costs involved, this is not the only criterion. The SEC recognizes that the cheapest product is not always the best product.
Also, Reg. BI specifically applies not only to the recommendation of an individual security, but to the selection of an account as well. As the SEC has announced, Reg. BI is relevant to “whether clients were put in the right kind of accounts—brokerage or advisory—and whether they received sound advice on rolling over retirement funds from a 401K to an individual retirement account.” Thus, a broker who recommends that a customer open an advisory account, as opposed to a brokerage account (or vice-versa), should be able to articulate how that choice of account benefits the customer. This is important for long-term buy and hold customers, who might not benefit from an advisory account, which would typically be charged an annual management fee of a percentage of assets under management. For example, imagine a hypothetical customer with a buy-and-hold investment strategy, who is charged an annual management fee of 1% in an account which has no transactions of any nature for a period of five years. In this example, charging a customer an annual fee for reviewing and monitoring an account which sees little or no activity might be tantamount to “reverse churning,” and might not pass muster under Reg. BI, or, for that matter, under the 1940 Act. The firm should be able to document and defend the reasonableness of its account selection recommendations.
Conflict of Interest
Under Reg. BI, conflicts of interest must be disclosed, and, if possible, mitigated. Thus, sales contests and quotas which are pegged to individual products or house products are unlikely to pass regulatory muster and could invite arbitration claims under the new regime. Of course, the whole purpose of Reg. BI is to place the customer’s interest above that of the broker, so registered representatives should be mindful of the obligation to place the customers’ interest above their own, and to document and mitigate any potential conflicts. This principle should apply, as mentioned, to sales quotas, sales contests, sales of proprietary products, and any consideration, such as bonuses or trips, offered by product issuers or underwriters.
Although disclosure of specific compensation amounts is not required, full and fair disclosure may require disclosure of the general magnitude of the compensation with respect to conflicts of interest. In this regard, a firm should consider whether or not to disclose its promissory notes to brokers, and whether those promissory notes contain performance standards or “bogeys” which could also contribute to conflicts of interest. In addition, the firm should be able to show that it considered reasonably available alternatives to the products that were actually recommended, and that it can document that these alternatives were considered.
FINRA member firms will be tested upon their compliance with the new regulations, especially in the first months. Of course, firms should promptly begin preparing their Reg. BI written disclosure document and Form CRS/ADV 3 and educating their brokers on how and when to make disclosures to customers. In addition, FINRA member firms should write and implement policies and procedures and sales practice and supervisory manuals designed to ensure compliance with the regulations, and to reach out to brokers in the field to educate them on the new requirements. Showing that their field brokers have been educated on the new regulations will help show the firms’ good faith compliance.
Roadmap for Claimant’s Counsel?
Will the new requirements of Regulation Best Interest and Form CRS serve as a roadmap for claimants’ lawyers looking to bring additional arbitration claims? The answer is probably yes. No individual or organization is perfect, and imposing additional regulatory requirements on broker-dealers simply increases the risk that the firm will make one or more mistakes. Under the current suitability rule, claimants’ lawyers are already looking for conflicts of interest and failures to disclose, which they are more than happy to bring to the attention of regulators or arbitrators. Under the new regulations, these arguments will have the force and weight of law.
In many of the securities arbitrations we have seen, the claimants’ lawyers spend a lot of time and energy arguing that the respondent broker should be subject to a fiduciary standard. Those fights will be largely but not entirely obviated by Reg. BI. Now, the existing regulations effectively place the burden upon the broker to articulate why the recommendation was in the customers’ best interest. Moreover, the regulations expressly require the firm to consider other reasonable alternative investments that were available at the time of the recommendation. This will also increase the burden on the firm to justify the reasonableness of its recommendations. While new Regulation Best Interest has increased the burden on registered broker-dealers, the new burden is not insurmountable. Rather, with thoughtfulness, compliance and adequate education of their brokers, broker-dealers can bring their registered representatives into compliance with the new regulation. Under Reg. BI, it is important for brokers to contemporaneously document the reasons for their recommendations, the alternatives they considered, and why their recommendations serve the customers’ best interests.
Barry R. Temkin is a partner at Mound Cotton Wollan & Greengrass LLP, with offices in New York, New Jersey, Florida, Texas, and California. He is also an adjunct professor of law at Fordham University School of Law, where he teaches courses on securities regulation and broker dealer regulation.
Cynthia L. King is a Principal of the Law Offices of the Cynthia L. King, and former Regional Counsel for NASD District 3 in Denver, a position she held for 10 years.
Mitchell Markarian is an Attorney-at-Law admitted to practice in New York, a graduate of New York Law School, and a claims professional at OneBeacon Insurance. The views expressed in this article are those of the authors alone, and not those of Mound Cotton, Fordham, OneBeacon or FINRA.
 See Regulation Best Interest: The Broker Dealer Standard of Conduct, 84 Federal Register 33, 318, 17 C.F.R. §240.
 15 U.S.C. § 80b.1 et seq (1990).
 See FINRA Reg. BI Form CRS Firm Checklist, www.finra.org.
 FINRA Reg. BI Informed CRS Firm Checklist, www.finra.org.
 See FINRA rule 2111, “Suitability,” www.finra.org/rules-guidance/rulebooks/finra-rukles/2111.