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by InnReg

Reg BI and the Fiduciary Standard: Compliance Guide for RIAs and Broker-Dealers

Categories: RIA Compliance


Regulation Best Interest (Reg BI) became a hot topic across the investment landscape when the SEC adopted new rulemaking guidance in June 2019. Digital broker-dealers and robo-advisers had many questions about how Reg BI and other rules apply to self-service or automation-driven investment platforms. Those questions are still widespread.

The SEC ‘s Reg BI has defined clear standards of care:

  • The Commission’s June 2019 adoption of Regulation Best Interest, the Interpretation Regarding Standard of Conduct for Investment Advisers, and the Form CRS Relationship Summary will have a direct impact on the retail investor experience with broker-dealers and RIAs.
  • Regulation Best Interest requires broker-dealers or a natural person who is an associated person of a broker or dealer, among other things, to act in the best interest of their retail customers when making a recommendation of any securities transaction or investment strategy involving securities, without placing their financial or other interests ahead of the interests of the retail customer.
  • The standard of conduct draws from key fiduciary principles and cannot be satisfied through disclosure alone. The Interpretation Regarding Standard of Conduct for Investment Advisers reaffirms, and in some cases clarifies, aspects of an RIA’s fiduciary duty that comprises duties of care and loyalty to their clients.

In other words, Reg BI has aligned regulations for broker-dealers more closely to standards of conduct that already applied for RIAs.

In this guide to RIA compliance, we will cover the difference between the standards and how they apply. We will also cover mandated disclosure requirements, including Form CRS, and the nuances of Reg BI, and the fiduciary standard for digital broker-dealers and robo-advisers.


Reg BI: The History Behind RIA and Broker-Dealer Compliance Questions

Investment platforms from today’s digital era can benefit from a brief history lesson. The story behind the regulations explains why these questions are so confusing. It also helps clarify how to interpret both the SEC’s Reg BI and the fiduciary standard (whose most current definition is the SEC’s Interpretation Regarding Standard of Conduct for Investment Advisers).

Broker-dealers (BDs) and RIAs have coexisted for most of a century. BDs have traditionally focused on transactions and particular investments, whereas advisers generally offered more comprehensive account management. However, over subsequent years, the line between BDs and RIAs blurred as brokers increasingly provided advice.


SEC Regulations and Fiduciary Standards

After the 1929 stock market crash, the United States established both the Securities Act of 1933 and the Investment Adviser Act of 1940. Many people refer to these as simply the “1933 Act” and the “1940 Act.” The latter requires that advisers register and become monitored by regulators. The Act itself never explicitly spells out a fiduciary duty, which only emerged later in a 1963 Supreme Court ruling.

Both BDs and RIAs have adhered to standards that guide their relationships with clients. While RIAs’ primary responsibility was to put their clients’ interests ahead of their own, known as a fiduciary standard, BDs followed a somewhat less stringent approach, known as the suitability rule. Their requirement was to believe an investment decision would benefit a client before making a recommendation.


How Reg BI Came to Be

After years of confusing messages from regulators, the Securities and Exchange Commission finally took a firm stance and issued a long-anticipated release on June 5, 2019. The rulemaking package has helped to explain and demystify some of the nuances.

While creating no new duties, the Commission wished to “reaffirm and clarify” the obligations of the adviser-client relationship, which had hitherto only existed in cases and SEC statements. On the BD side, a central measure, Regulation Best Interest (Reg BI), updates descriptions of their responsibilities and strengthens the old suitability rules.

New BD obligations now extend beyond suitability and in many ways resemble the advisers’ fiduciary standard. Nevertheless, there are some clear revisions. For instance, Reg BI covers more of the advice spectrum, such as account types, and BD must offer customers more information about their services. It is no longer enough to suggest an appropriate investment; today’s BD must also be familiar with the alternatives.


Reg BI Summary

The rest of this article summarizes the overhauled requirements and provides a Reg BI checklist for compliance.


What are “Best Interest,” “Fiduciary Standards,” and Other Duties?

Fiduciary standards are relevant because clients entrust their investments to a third party, whether it be an RIA or a BD. These broad standards apply to the entire client relationship and include both a “duty of care” and a “duty of loyalty.”

The duty of care calls for an adviser to provide advice in their clients’ best interest, seek the best execution for clients’ transactions, and make reasonable inquiries into clients’ objectives. The duty of loyalty means an adviser must disclose to clients all material facts and eliminate or expose any conflicts of interest. The degree of disclosure for a retail client may differ from that appropriate for an institution.

Providing suitable investment advice for each client means understanding a retail client’s investment profile or an institutional client’s investment mandate. For its retail clients, the adviser must investigate a client’s financial situation, level of financial knowledge, investment experience, and financial goals to provide a multidimensional picture.


What Reg BI Does

The 2019 SEC rulemaking package includes three additional sections that elevate standards of conduct and clarify applicable behavior and requirements for BDs who engage with a retail clientele.

As with the onus placed on investment advisers, the BD must act in the best interest of the customer at the time it makes a recommendation, without putting its financial or other interest ahead of the customer’s. Note a critical distinction. An RIA’s duty covers the entire period of the relationship, whereas a BD is only responsible for the precise time it is suggesting and executing a transaction.

In executing its care obligations, the BD will need to learn the client’s profile, such as investment objectives, liquidity needs, or age. The BD must discharge its duties in the following fields:

  • disclosure
  • care (diligence and skill)
  • avoiding conflicts of interest (with written policies)
  • compliance (also in written form)
  • record-keeping requirements.

BDs should be prepared to disclose all material facts related to the scope and terms of the client relationship. Typical details may include costs, services, minimum account sizes, investment approaches, risks, or conflicts of interest.

However, the definition of “recommendation” is ambiguous and can depend on the circumstances. These circumstances cover a range of transaction advice, such as implicit or explicit hold recommendations, with special considerations for providing pre-agreed account monitoring. Such considerations vary by account types and securities.

The nuances can be especially challenging for digital providers whose clients engage in high volumes of self-service information seeking and trading.


Form CRS

“CRS” stands for customer or client relationship summary. It is a new relationship summary document that both RIAs and BDs must provide to retail investors starting June 30, 2020. It aims to help investors better understand what they are getting. The SEC set out requirements at the same time as Reg BI. Many investment professionals lump them together, but they are, in fact, distinct. They apply to both BDs and RIAs. Much of the confusion over whether Reg BI applies to RIAs comes from this overlap.

This disclosure includes key information such as:

  • the name of the provider and whether it is registered;
  • an explanation for investors that brokerage and advisory services differ;
  • a summary of the relationship and services offered;
  • fees and costs; and
  • other account elements, such as whether services include monitoring, discretionary authority, or account minimums.

The form itself is intentionally simple, but it does create customer disclosure and documentation requirements that can become compliance challenges.

On July 26, 2021, the SEC announced charges against 27 separate firms for Form CRS violations, with fines in the tens of thousands of dollars even for small firms. We explore how to avoid Reg BI lawsuits and fines below.


“Solely Incidental” Interpretation

Gray areas for digital platforms can emerge in what regulations refer to as “solely incidental” activity. The phrase refers to situations where a BD provides advisory services. Does that mean the 1940 Act applies to them, or no? The 1940 Act contained many exclusions, in particular, one for “any broker or dealer whose performance of such [i.e., advisory] services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefore.”

At the time of the Act, compensation functioned clearly as a distinction between advisors and brokers. But, over the years, the line became fuzzier with industry deregulation.

Now, in a digital world, it can be very unclear whether information that an end-user finds on a trading app counts as advisory. The ambiguity becomes even more complicated when considering the source of information. Is the app maker liable, or only the individual end-users who may make advisory comments? If the app itself offers advisory features, could monthly fees be interpreted as compensation for advice, or would regulators accept them as simple account access fees?

These nuanced questions are exactly why digital platforms and even traditional advisers should seek the counsel of digitally-adept compliance experts and even consider outsourcing elements of the compliance function.


When Reg BI and Digital Platforms Collide

The framers of the Investment Act of 1940 could not have imagined today’s fintech offerings and digital platforms. New financial services offered via digital platforms require reinterpretation of fiduciary duties and related components, including Reg BI, Form CRS, and solely incidental activity.

Robo-advisors have been delivering automated financial advice through web-based or mobile platforms for over ten years, most notably when Betterment launched in 2010. These investment vehicles rely on questionnaires and algorithms rather than human judgment and perception to tailor portfolios to clients’ needs. Portfolios typically comprise exchange-traded funds. They often rely on passive indexing and diversification and may work well for rebalancing or tax-loss harvesting.

The automatic features raise a host of questions:

  • Can providers meet the traditional duty of care standards?
  • Is an electronic questionnaire sufficient for extracting a fully informative client profile?
  • How would these mechanisms perform for dealing with unusual market failures (e.g., flash crashes)?

Self-directed online discount brokerage trading apps have also raised questions. Companies like Robinhood are challenging concepts of fiduciary duty, which also pertain at the state level. In December 2020, The Massachusetts Securities Division filed a complaint against Robinhood for violating the state’s fiduciary duty rules. It raised three allegations:

  • That Robinhood failed to supervise and respond to technological outages
  • That Robinhood approved unqualified customers to engage in options trading
  • That Robinhood uses gamification attractions to promote unwarranted trading risks.

The state court must now address several issues around a definition of recommendation and investment discretion. These actions in Massachusetts help illustrate just how challenging matters become when fiduciary questions and digital platforms collide. More may follow at the federal level as the SEC begins examinations of companies’ compliance programs. While the SEC is currently using these examinations as just a means to help BDs comply, they may become more hard-edged over time.


Highlights: A Reg BI FAQ

What is Reg BI?

Reg BI states that broker-dealers must act in the best interest of the customer at the time they make an investment recommendation, without placing their financial or other interest ahead of the customer’s.

Does Reg BI apply to RIAs?

Technically, it does not. However, Reg BI is part of a broader rulemaking package that includes Form CRS and clarifies some (but not all) open questions about the concept of “solely incidental” advice.

What is Form CRS?

Form CRS is a new relationship summary document that both RIAs and BDs must provide to retail investors from June 30, 2020.
How can my digital broker-dealer or robo-adviser comply with fiduciary, disclosure, and other requirements?

We’ve provided a checklist to help!


Reg BI Checklist

 

Reg BI

You must establish procedures and documentation protocols that cover all of the following:

  • Client investment profile, including age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance
  • Costs of recommended securities, including deferred sales charges and liquidation costs
  • Reasonably available alternatives
  • Disclosure of broker’s fees and charges
  • Compensation methods
  • Retail account monitoring
  • Limits on account types and services available
  • Creating, updating, filing, delivering client disclosures like the Relationship Summary (Form CRS)
  • Documented versions of oral disclosures
  • Potential conflicts of interest and protocols for identifying and addressing them
  • Prohibitions on sales contests, sales quotas, bonuses, non-cash compensation

Form CRS

You must disclose all material facts relating to the scope and terms of the relationship with the retail customer and all material facts relating to conflicts of interest that are associated with the recommendation, including:

  • Capacity in which the BD or associated person is acting
  • Material fees and costs for transactions, holdings, and accounts
  • The scope of the services, including material limitations on recommended securities or investment strategies
  • Whether the BD or RIA will monitor the account and the frequency of monitoring
  • The requirements to maintain an account
  • The investment approach or strategy
  • Associated risks

Conclusion

Reg BI and related components have created confusion for digital and traditional advisers alike. Especially in the digital world, many open questions remain, including how best to implement a process that ensures and documents compliance with Reg BI, Form CRS, and solely incidental activity provisions.

If you have further questions about what applies to your traditional firm, digital broker-dealer, or robo-adviser, we will be happy to discuss. Please be in touch at info@innreg.com.