RIA
Reg BI and the Fiduciary Standard: Compliance Guide for RIAs and Broker-Dealers
Dec 19, 2023
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InnReg
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10 min read
Contents
Regulation Best Interest (Reg BI) emerged as a pivotal topic within the investment landscape following the SEC's adoption of new rulemaking guidance in June 2019. This regulation stirred many questions, particularly from digital broker-dealers and robo-advisers, regarding applying Reg BI and related rules to self-service or automation-driven investment platforms.
Broker-dealers (BDs) and Registered Investment Advisers (RIAs) have coexisted for decades. BDs have traditionally focused on transactions and particular investments, whereas advisers generally offered more comprehensive account management services. However, in recent years, the distinction between BDs and RIAs has become less clear, with brokers increasingly offering advisory services.
InnReg has deep experience in supporting clients with Reg BI and Fiduciary Standard interpretation and implementation. Here, we unpack Reg BI definitions and requirements and offer practical advice around differentiating Reg BI and Fiduciary Standard applications.
In this comprehensive guide, we will navigate through the intricacies of Reg BI, mandated Reg BI disclosure requirements, including Form CRS, and the fiduciary standard for digital broker-dealers and robo-advisers.
See also:
What does Reg BI mean?
Reg BI (Regulation Best Interest), established by the SEC under the Securities Exchange Act of 1934, sets forth a "best interest" standard of conduct for broker-dealers and their associates. This standard is relevant when the financial services providers make recommendations to retail customers, including securities transactions and investment strategies, related to various types of accounts.
Notably, Reg BI is closely linked to the U.S. Department of Labor's (DOL) fiduciary rule, collectively reinforcing the commitment to safeguarding investor interests and promoting transparency within the financial services industry.
As part of this regulatory initiative, the SEC has also put forth fresh regulations and forms. These mandate that both broker-dealers and investment advisers furnish retail investors with a concise relationship summary, known as Form CRS.
How Did Reg BI Come to Be?
After years of regulatory ambiguity, the Securities and Exchange Commission (SEC) released long-awaited guidance on June 5, 2019.
While this release did not introduce new obligations, it aimed to “reaffirm and clarify” the obligations inherent in the adviser-client relationship, which had previously existed primarily in cases and SEC statements. A key component on the broker-dealer side, Regulation Best Interest (Reg BI), updated their responsibilities and bolstered the existing rules on recommendations.
Who Does Reg BI Apply to?
Reg BI applies to broker-dealers when recommending a transaction or investment strategy involving securities (i.e., account types) to a retail customer. Reg BI requires a comprehensive disclosure (Form CRS) from broker-dealers and RIAs about their products and services (in addition to fees & conflicts).
Reg BI obligation for broker-dealers surpasses “suitability;” it mandates a Standard of Conduct similar to RIA’s fiduciary standard. Merely suggesting suitable investments is no longer sufficient, as today's broker-dealers must also show a duty of care and possess a thorough understanding of available alternatives.
Reg BI has aligned broker-dealer regulations more closely to existing RIA standards.
In this guide to compliance with Reg BI, we differentiate between the standards and explain their applications. We also discuss mandated disclosure requirements, including Form CRS, and the nuances of this new regulation, including the fiduciary standard for digital broker-dealers and robo-advisers.
The SEC's Reg BI and Fiduciary Standards
In the aftermath of the 1929 stock market crash, the United States introduced three pivotal pieces of legislation: the Securities Act of 1933, The Securities Exchange Act of 1934, and the Investment Adviser Act of 1940, often referred to simply as the "33 Act," “34 Act,” and "40 Act."
While the latter compelled advisers to register and submit to regulatory oversight, it didn't explicitly articulate a fiduciary duty. This duty only came into sharper focus with the 1963 Supreme Court ruling in 1963 SEC v. Capital Gains Research Bureau, Inc..
Both broker-dealers and registered investment advisers have long been guided by standards governing their client interactions.
RIAs have upheld a fiduciary standard, placing their clients' interests above their own.
In contrast, BDs adhered to a somewhat less rigorous suitability rule, requiring them to believe that an investment decision suits a client before recommending it.
The introduction of Regulation Best Interest (Reg BI) added a new dimension to these standards, emphasizing the paramount importance of the client's best interest, extending its reach, and promoting transparency in the financial advisory landscape.
Reg BI vs. Fiduciary Standard - Who Does Reg BI Apply To?
When comparing Reg BI and Fiduciary Standards, what are the key similarities and differences? We asked our experienced consultants to draw a high-level comparison:
Broker-Dealers
Regulation: Securities Act of 1933 & Securities Exchange Act of 1934
Sec - Reg BI: Yes
Form CRS: Yes
Standard of Care: Suitability: act in the client’s Best Interest
Similarities: Form CRS, comply with anti-fraud rules
Differences: Sell securities, no ongoing portfolio management, human representatives
Investment Advisers
Regulation: Investment Advisers Act of 1940
Sec - Reg BI: No
Form CRS: Yes
Standard of Care: Fiduciary Standard
Similarities: Form CRS, comply with anti-fraud rules
Differences: Recommend advisers, manage portfolios on an ongoing basis, financial planning, non-human (robo-advisers)
Reg BI Effective Date
The compliance date for the SEC Regulation “BI” and Form CRS was June 30, 2020.
What Are the Key Requirements of Reg BI?
Regulation Best Interest (Reg BI) is comprised of four specific obligations:
Disclosure
Care
Conflict of Interest
Compliance
These components must ensure that broker-dealers interact responsibly and ethically with retail customers. A written disclosure, Form CRS (see guidance below), is also required.
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Reg BI Disclosure Obligation
Broker-dealers are required to provide comprehensive, clear written disclosures of all "material facts" about the scope and terms of their relationship with the retail customer before or when making recommendations. This disclosure is provided to assist investors in deciding what type of firm and/or service is best for their investment decisions. This includes:
The representative is acting in a broker-dealer capacity concerning the recommendation.
Fees and costs that would apply to the retail customer’s transactions, holdings, and accounts.
The type and scope of services provided by the broker-dealer and any material limitations, including, for example, monitoring the performance of the retail customer’s account.
All “material facts” relating to conflicts of interest associated with a recommendation.
Form CRS is a part of disclosure obligations
What is Form CRS?
“CRS” stands for customer or client relationship summary. As a part of their disclosure obligations within Reg BI, both broker-dealers and financial advisers must now provide retail investors with copies of Form CRS.
Form CRS is essentially a new addition (Part 3) to Form ADV, mainly pulling from information already included in the Part 2A brochure. This makes it relatively easy to integrate with an RIA's existing ADV requirements.
Practically, the biggest challenge for RIAs may not be adapting to Regulation Best Interest (Reg BI) itself but rather the challenge of distinguishing themselves in a landscape where broker-dealers can also claim to follow a “best interest” standard when advising clients.
What is the Purpose of Form CRS?
According to the SEC, the primary objective of Form CRS is to offer “simple, easy-to-understand information about the nature of their relationship with their financial professional.” The goal is to assist investors in comparing services between firms and making well-informed decisions.
What is the Rule for Form CRS?
Under Rule 17a-14 under the Securities Exchange Act of 1934 and Rule 204-5 under the Investment Advisers Act of 1940, broker-dealers registered under Section 15 of the Exchange Act and investment advisers registered under Section 203 of the Advisers Act are required to deliver to retail investors a relationship summary (i.e., Form CRS) disclosing certain information about the firm.
What Must be Included in Form CRS?
The content of Form CRS depends on the firm’s services, but must include:
Details about the firm's registration (broker-dealer, investment adviser, or both).
An explanation of all the services provided.
Information about fees and expenses (including principal fees, custodian fees, account maintenance fees, and more).Information about conflicts of interest.
A brief overview of the firm and adviser's past disciplinary actions.
"Conversation starters" for customers to initiate discussions with their advisor.
When do Firms Have to Send Form CRS?
Firms are required to provide Form CRS to customers and potential clients before or at the earliest when:
Entering into a new investment advisory agreement.
A brokerage account is opened.
Recommending an account type, a securities transaction, or an investment strategy involving securities.
Care Obligation
A broker-dealer must exercise due diligence, care, and expertise when making recommendations to a retail customer. This responsibility involves a comprehensive understanding of the potential risks, rewards, and associated costs related to the recommendation, along with a reasonable understanding of the investor's investment profile and consideration of reasonably available alternatives, all in the customer’s best interest.
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Conflicts of Interest Obligation
The broker-dealer is obligated to establish, maintain, and rigorously enforce written policies and procedures. These policies and procedures should be thoughtfully designed to not only identify but also mitigate or eliminate conflicts of interest. These measures include:
Addressing conflicts that may incentivize the firm's financial professionals to prioritize their interests or the firm's interests over those of the retail customer.
Preventing substantial limitations on offerings, such as offering a restricted product selection or solely promoting proprietary products, from leading the firm or its financial professionals to place their interests above the retail customer's interests.
Eliminating practices like sales contests, sales quotas, bonuses, and non-cash compensation tied to the sale of specific securities or particular types of securities within a limited timeframe.
Compliance Obligation
As a notable improvement over the initial proposal, broker-dealers are now required to institute, uphold, and enforce policies and procedures that are thoughtfully crafted to ensure full compliance with Regulation Best Interest in its entirety. This regulatory obligation extends to all registered broker-dealers, mandating their adherence to Regulation BI.
Recordkeeping
In its final form, Reg BI introduces amendments to Rules 17a-3 and 17a-4. These amendments mandate that every retail customer who receives or will receive a recommendation related to any securities transaction or investment strategy involving securities is or will be provided:
A comprehensive record of all information gathered from and furnished to the retail customer per Reg BI.
The identity of the broker or dealer accountable for the account.
Retention of all record-related data acquired or provided to the retail customer pursuant to Reg BI. This data should be retained for a minimum of six years, commencing from either the account's closure date or the date of initial data collection, provision, replacement, or update, whichever occurs first.
Interpretations
Alongside the implementation of Reg BI, the SEC issued two interpretations:
The first interpretation aims to reaffirm and clarify the SEC's stance on the standard of conduct for investment advisers as defined by the Advisers Act.
The second interpretation seeks to confirm and elucidate the SEC's position concerning the "solely incidental" prong of the broker-dealer exclusion under the Advisers Act. This exclusion permits broker-dealers to provide certain advisory services without becoming an investment adviser.
Reg BI Example
InnReg recently worked with a mid-sized dual-registered firm (Broker-Dealer & RIA) to develop procedures to comply with the new regulation and create a new disclosure (Form CRS). The scope of compliance procedures and deliverables covered the following key elements:
Recommendations,
Acting in the investor's best interest,
Form CRS,
Supervision of recommendations and the timing of the disclosure form.
The client’s most challenging obligation was meeting the timeframe for Care Obligation, which requires reasonable diligence, care, and skill when making recommendations from all client-facing professionals involved in advisory services.
Navigating Challenges of Reg BI in the Digital Platform Era
The creators of the Investment Act of 1940 could hardly anticipate the complex landscape of today's fintech offerings and digital financial platforms. The emergence of new financial services delivered via digital channels demands a fresh interpretation of fiduciary duties, especially concerning regulatory components like Reg BI, Form CRS, and solely incidental activities.
For over a decade, robo-advisors revolutionized the financial advisory industry. Notably, Betterment pioneered this field in 2010, introducing web-based and mobile platforms that provide automated financial advice. These platforms utilize algorithms and client questionnaires to craft personalized investment portfolios, reducing reliance on human judgment.
Typically, such portfolios consist of exchange-traded funds (ETFs) and prioritize passive indexing and diversification. While these platforms excel at tasks like rebalancing and tax-loss harvesting, they also raise critical questions:
Can these automated providers meet traditional duty of care standards?
Is an electronic questionnaire sufficient for creating a comprehensive client profile?
How would these mechanisms perform during extraordinary market events, such as flash crashes?
In addition to robo-advisors, self-directed online discount brokerage trading apps have garnered attention and raised fiduciary duty concerns. Companies like Robinhood have disrupted the status quo and triggered legal action. In December 2020, the Massachusetts Securities Division filed a complaint against Robinhood for violating the state's fiduciary duty regulations. The complaint revolved around three key allegations:
Robinhood's failure to supervise and respond to technological outages.
Approval of unqualified customers for options trading.
Using gamification tactics to promote risky trading behavior.
This case underscores the importance of defining terms like "recommendation" and "investment discretion" within the context of digital platforms. The collision of fiduciary questions and digital financial services presents significant challenges, not limited to Massachusetts. The federal level may witness similar developments as the SEC intensifies examinations of companies' compliance programs. While these examinations currently serve as a means to assist broker-dealers in compliance, they may adopt a more stringent approach in the future.
Reg BI Checklist
Here's a summary checklist to ensure your brokerage or advisory firm meets SEC's Reg BI requirements.
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Final Takeaways
In summary, the SEC introduced Reg BI to elevate the standard of conduct for broker-dealers in their interactions with retail investors. Unlike existing suitability standards governed by FINRA, Reg BI seeks to provide enhanced protection for investors. Importantly, this regulation was issued alongside the Standards of Conduct for Investment Advisers, demonstrating a comprehensive approach to investor safeguarding. Notably, while Reg BI does not establish a fiduciary standard equivalent to that of the Advisers Act, it is crucial to understand that it does not supersede state fiduciary regulations. Additionally, Reg BI maintains a clear distinction between the responsibilities of broker-dealers and investment advisers, with the regulation directly impacting broker-dealers.
In the era of digital finance, new challenges arise as robo-advisors and online trading apps redefine conventional fiduciary duties. There are growing concerns about their capacity to fulfill duty of care standards and how best to implement a process that ensures and documents compliance with Reg BI, Form CRS, and solely incidental activity provisions.
If you have more questions about how these regulations affect your firm, whether it's traditional or digital, email us at info@innreg.com
