Four Tips for Broker-Dealers to Effectively Navigate the Enhanced Standard of Conduct Under Reg. BI

The SRO and States Subcommittee of the Section of Litigation’s Securities Litigation Committee recently hosted a State Securities Regulators Roundtable to discuss Reg. BI and its implications for the financial services industry and regulators. The following professionals participated in the Roundtable:

• Moderator: Andrew W. Sidman, Principal, Bressler, Amery & Ross, P.C.
• Joseph P. Borg, Director, Alabama Securities Commission; NASAA President 2007, 2018
• Christopher W. Gerold, Bureau Chief, New Jersey Bureau of Securities; Chair, NASAA Enforcement Section 2019
• Katherine C. Milgram, Vice President & Counsel, Head of Regulatory Affairs, Chief of Staff to the General Counsel, The Guardian Life Insurance Company
• Michael S. Pieciak, Commissioner, Vermont Department of Financial Regulation; NASAA President 2019

The Roundtable participants provided valuable insights into the various stakeholders’ viewpoints on Reg. BI, all of which can be distilled into the following tips for broker-dealers as they prepare for the evolving regulatory framework under Reg. BI.

Educate Financial Advisors on the Nuances of the Enhanced Standard of Conduct

Under Reg. BI, broker-dealers are required to satisfy four core obligations:

1. Disclosure. Prior to or at the time of the recommendation, the firm must disclose in writing all material facts to the customer regarding the terms and scope of the relationship (e.g., capacity, fees, and charges) and all conflicts of interest associated with the recommendation. If it is impossible or impractical to make the disclosure in writing, then it must be made orally and documented in the firm’s records.
2. Care. The firm must exercise reasonable diligence, care, skill, and prudence to understand the potential risks and rewards of a recommendation to form a reasonable belief that it is in the best interest of the client. A financial advisor must also consider reasonable alternatives and the potential costs of the recommendation.
3. Conflict of interest. The firm must maintain and enforce policies and procedures reasonably designed to identify, disclose, eliminate, and mitigate conflicts of interest. The policies and procedures must eliminate sales contests and any other incentives for financial advisors to put their interests before their clients’ interests.
4. Compliance. The firm must maintain and enforce policies and procedures reasonably designed to achieve compliance with Reg. BI.

Given the enhanced standard of conduct for evaluating financial advisors’ recommendations to their retail customers, it is important to educate financial advisors on their enhanced obligations. Firms should emphasize to their financial advisors that: (1) the disclosure of the terms and scope of the relationship must be made in writing, (2) the determination that a transaction is in the best interest of a client must consider reasonable alternatives and costs, and (3) recommendations must be viewed in terms of merit to the customer.

Broker-dealers should emphasize to their financial advisors that regulators will view recommendations in terms of merit to the customer, and that the costs associated with a recommended transaction must be a factor considered in the determination that the transaction is in the client’s best interest. To meet their care obligation, financial advisors must document the presentation of reasonable alternatives and the discussion of the varying costs of each alternative.

Develop Compliance Functions Centered on the Focuses of Reg. BI

In addition to educating financial advisors, firms should also develop compliance functions that highlight the primary concerns of Reg. BI, including written disclosure of conflicts of interest, consideration of reasonable alternatives and costs of a transaction, and identification of incentives to financial advisors to make certain recommendations. A few compliance functions that firms can consider:

• Requiring financial advisors to keep copies of written disclosure of conflicts of interest.
• Requiring clients to sign these written disclosures.
• Developing a form note for financial advisors to fill out in connection with each recommendation that includes sections for reasonable alternatives considered and costs.
• Implementing mandatory second-level review for any transactions involving traditionally high cost investments.
• Mandating client contact from a manager following transactions involving traditionally high cost investments.

Prepare for Even More Stringent Standards of Conduct from State Regulators

While firms must prepare for the enhanced standard of conduct under Reg. BI, they should also be mindful of state regulators seeking to impose a more stringent standard of conduct on financial advisors. The North American Securities Administrators Association (NASAA) views Reg. BI as a good first step that will still require final rules with significant improvements to serve the best interests of investors. NASAA recommends expanding the scope of Reg. BI beyond retail customers to encompass all investors and securities products, requiring financial advisors to consider products beyond those offered by the firm when making recommendations, and clarifying investor remedies in the event the regulation is violated. To date, Nevada, New Jersey, and New York have already taken concrete steps toward imposing a fiduciary standard for all financial advisors operating in those states. These efforts are likely to face pushback from the industry and legal challenges, but firms should be prepared for the potential for differing federal and state regulatory frameworks.

Stay Up-to-Date on Legal Challenges to Reg. BI

Several state attorneys general and XY Planning Network LLC, a group of fee-only financial planners, have also mounted a legal challenge to Reg. BI in the Second Circuit Court of Appeals. The complaints allege that the SEC violated its requirement to promulgate a rule that harmonized the standard of conduct for broker-dealers and investment advisers. The lawsuits rely on the assertion that the SEC’s own study found robust evidence that investors are confused by the different standards. While the Department of Labor’s Fiduciary Rule was struck down by the Fifth Circuit Court of Appeals, Reg. BI has several distinctions from the Fiduciary Rule that make it more likely to withstand judicial scrutiny. First, Reg. BI was enacted pursuant to a recent act of Congress, Dodd-Frank, rather than the 40-year-old statute relied on by the Department of Labor (DOL) for the Fiduciary Rule. Second, unlike the DOL, the financial services industry is with little question within the SEC’s regulatory purview. Finally, although the Fifth Circuit determined that the requirements of the Fiduciary Rule are overly burdensome, Reg. BI appears to be less onerous on the industry. Nevertheless, it is important that broker-dealers closely monitor legal developments affecting Reg. BI and make any necessary adjustments to the firms’ policies and procedures.

Reg. BI will alter the regulatory framework for review of broker-dealers and their financial advisors’ recommendations to their retail customers. In addition, while there is no express private right of action for alleged violations of Reg. BI, FINRA arbitration panels will also likely evaluate broker-dealers and their financial advisors’ actions based on this enhanced standard of conduct. Thus, broker-dealers must take concrete steps now to prepare for the enhanced standard of conduct under Reg. BI.

Louis Mendez is an associate with Bressler Amery Ross in Birmingham, Alabama.

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