SEC Approves Regulation Best Interest
On June 5, 2019, the Securities and Exchange Commission (the “SEC”) adopted Rule 15l-1 (“Regulation Best Interest” or the “Rule) under the Securities Exchange Act of 1934 (the “Exchange Act”), a new rule that establishes a heightened “best interest” standard for broker-dealers and replaces the longstanding “suitability” standard.
Under the Rule, brokers will now be held to a higher standard of care when making a recommendation of any securities transaction or investment strategy to retail customers, including with respect to investments in private funds. The Rule also applies to recommendations given regarding account related matters, such as rollovers, transfers of assets among accounts (e.g. as a workplace retirement plan to an IRA) or decisions whether to take a plan distribution.
The compliance date for Regulation Best Interest is June 30, 2020.
Summary of the final rule
The Rule was adopted pursuant to Section 913(f) of the Dodd Frank Act and requires that broker-dealers and their associated persons “act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker-dealer or an associated person making the recommendation ahead of the interest of the retail customer.” The “best interest” standard replaces the “suitability standard” and is intended to align the brokers’ standard of conduct with retail customers’ reasonable expectations. Recognizing that a broker-dealer’s relationship with a customer is transactional and intermittent in nature, the Rule does not impose a duty to monitor a customer’s account after a recommendation is made.
For purposes of the Rule, the definition of “retail customer” is intended to capture any natural person who receives a recommendation from a broker-dealer with respect to any transaction or investment strategy involving securities and who uses such recommendation primarily for personal, family or household purposes, irrespective of the person’s net worth, financial literacy, sophistication, or experience in investment related matters.
To ensure compliance with the Rule, broker-dealers and their associated persons must satisfy the following four obligations when providing securities-related recommendations to customers:
1. The Disclosure Obligation
Before or at the time of any recommendation, a broker-dealer or its associated person must provide the retail customer with written, full and fair disclosure of all material facts related to the nature of the broker-dealer/customer relationship and all material facts necessary for the customer to evaluate the merits of the recommendation.
As a matter of best practice, such disclosure should identify to the retail customer (1) that the broker-dealer’s recommendation is being given by a broker-dealer, (2) all material fees and costs the customer will incur if the recommendation is acted upon, (3) the type and scope of the broker-dealer/customer relationship, and (4) all material facts relating to conflicts of interest related to the recommendation sufficient to indicate to the customer that such recommendation was not made by a disinterested party.
2. The Care Obligation
When making a recommendation to a retail customer, a broker-dealer must exercise reasonable due diligence, care, and skill to understand the customer’s profile so that the broker-dealer possesses sufficient knowledge to allow it to properly consider the potential risks, rewards, and costs associated with the recommendation. The broker-dealer must assess these considerations, including evaluating reasonable alternatives, in the context of the customer’s investment profile, such that the broker-dealer is in a position to make a reasonable basis determination that the recommendation is in the customer’s best interest and does not place the broker-dealer’s interests ahead of the customer’s.
Where the broker-dealer is advising the customer as to more than one transaction, each transaction is treated as a distinct recommendation and the broker-dealer must determine that the series of recommendations is not excessive given the potential benefits of the recommendation(s) to the customer and the customer’s profile and circumstances. Accordingly, the broker-dealer must arrive at a reasonable basis determination that (1) each transaction serves the customer’s best interest, and (2) the cumulative result of the series of transactions is in the best interest of the customer and does not does not place the broker-dealer’s interests ahead of the customer’s.
3. Conflict of Interest Obligation
Regulation Best Interest imposes an overarching obligation for broker-dealers to establish, maintain, and enforce reasonably designed written policies and procedures to address conflicts of interest associated with its recommendations to retail customers. Such policies and procedures must (1) identify and at a minimum disclose or eliminate all conflicts of interest associated with their recommendations and (2) mitigate or eliminate certain identified conflicts of interest. The policies and procedures must be reasonably designed to mitigate conflicts of interest which create an incentive for an associated person of the broker-dealer making the recommendation to place their or the firm’s interests ahead of the interests of the retail customer.
In addition, the broker-dealer’s policies must specifically identify and disclose to the retail customer any material limitations placed on the securities or investment strategies recommended and any conflicts of interest associated with such limitations. For example, if a broker-dealer recommends securities transactions which are materially limited in scope, such as offering proprietary products only, or otherwise does not provide its customer with a representative range of options, the broker-dealer’s policies and procedures must include controls that prevent such limitations from resulting in a recommendation that places the broker-dealer’s interests ahead of the customer’s.
Policies and procedures should prohibit organizationally sanctioned competitive driven incentives, such as sales competitions, quotas, and other non-cash compensation that is based on the sale of specific securities or types of securities at a given time. The Rule provides broker-dealers and associated persons with wide latitude to adopt tailored solutions for their particular firm or organization, such as size, customer base, and product offerings.
4. Compliance Obligation
Broker-dealers must establish, maintain and enforce written policies and procedures reasonably designed to achieve compliance with the Rule. In its adopting release, the SEC acknowledges that the nature and content of policies and procedures sufficient to satisfy the compliance obligation is a facts and circumstances determination based on the particular business model of the broker-dealer. However a reasonably designed compliance program should, in all cases, provide for adequate controls and quality checkpoints, periodic review and testing, and remediation action plans, as well as require training for all appropriate personnel.
Considerations for Private Fund Managers
Despite industry advocacy that the Rule exclude recommendations with respect to interests in private funds, the definition of “securities transaction” is broad and captures recommendations involving securities transactions not generally considered to be “retail.” Accordingly, while the sale of interests in private funds by placement agents and other registered broker-dealers to institutional investors are not covered by the Rule, private fund managers should be cognizant of its requirements, as recommendations of such investments to high-net worth individuals and their estate planning and related vehicles are subject to the Rule. Private fund sponsors who establish an affiliated broker-dealer to market their fund interests should consult with counsel to develop appropriate policies and procedures in order to comply with the Rule.
As a general matter, private fund managers need to ensure that their fundraising and marketing efforts remain compliant with applicable law, or otherwise risk operating as an unregistered broker-dealer and in a manner violative of the Rule. For example, funds relying on the Issuer’s Exemption safe harbor pursuant to Rule 3a4-1, must frequently review the duties and activities of those fund employees or agents who regularly market the fund and solicit investors, as such persons may be deemed to be acting as unregistered brokers or dealers -- particularly those persons receiving commissions or other transaction-based compensation.
Private funds or investment advisers who engage unaffiliated “finders” to identify and introduce potential investors must take care that such persons are operating in compliance with applicable law, as the costs to a fund and/or its managers of working with an unregistered broker-dealer are severe. Risks to the fund and/or manager include (i) investors later found to have been solicited by an unregistered broker-dealer invoking their right to rescind their investment under Section 29(b) of the Exchange Act, (ii) the inability for the fund manager or sponsor to rely on exemptions from registration in future offerings, and/or (iii) SEC examination or investigation potentially resulting in accounting and disgorgement of profits, civil penalties, or other fines. In order to prevent such consequences and avoid reputational harm, fund managers should conduct appropriate due diligence with respect to the selection and operation of their affiliated as well as unaffiliated broker-dealers and consult with counsel.
 Section 913(f) of the Dodd Frank Act grants considerable rulemaking authority to SEC: “The Commission may commence a rulemaking, as necessary or appropriate in the public interest and for the protection of retail customers (and such other customers as the Commission may by rule provide), to address the legal or regulatory standards of care for brokers, dealers, investment advisers, persons associated with brokers or dealers, and persons associated with investment advisers for providing personalized investment advice about securities to such retail customers.”
 Unlike the Disclosure and Care Obligations discussed herein, which apply to a broker or dealer and to natural persons who are associated persons of a broker dealer, the Conflict of Interest Obligation (and Compliance Obligation) applies solely to the broker or dealer entity, and not to natural persons who are associated persons of a broker or dealer. The Conflict of Interest Obligation requires the entity to analyze conflicts among (i) the broker-dealer entity and the retail customer; (ii) the natural persons who are associated persons and the retail customer, and (iii) the broker-dealer entity and the natural persons who are associated persons.
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