The SEC’s Long-Awaited Regulation Best Interest is Here: What Producers Need to Know About “Reg BI”

June 12, 2019
WRN 19.06.12

The SEC’s Long-Awaited Regulation Best Interest is Here: 

What Producers Need to Know About “Reg BI”

On June 5th, the Securities and Exchange Commission (“SEC”) approved and released its much-anticipated final package of rules and guidance on new standards of conduct and new disclosure requirements, completing the work it began last April.  Passed by a three to one vote, the new rules include Regulation Best Interest (“Reg BI”), the new Form CRS Relationship Summary (“Form CRS”) and new guidance for Registered Investment Advisers.

The new rules go into effect on June 30, 2020.

Overview:

Reg BI provides a new “best interest” standard for broker-dealers that replaces the previous “suitability” standard, requiring an enhanced process for developing recommendations and requiring the mitigation or elimination of conflicts of interest.  Of particular importance to producers, Reg BI preserves the commission-based compensation model.  However, Reg BI also provides some new restrictions, most notably in prohibiting product-specific “sales contests” and certain other types of incentive compensation.  Both Reg BI and the Form CRS rules have new disclosure requirements regarding compensation and conflicts.

These new rules are not window dressing—they make significant changes for broker-dealers and their registered representatives, and these changes will affect producers.  While it is too early to have analyzed fully these final regulations (as released, Reg BI alone is 771 pages with 1,671 footnotes—the total package is roughly 1,500 pages of text), this alert provides a summary of the major provisions affecting producers.

AALU will provide more detail on specific issues of interest to producers as we further study the rule package.  We also anticipate working with the SEC to request guidance as we begin implementing the new rules.

How Does Reg BI Apply to Producers?

Reg BI applies to producers who are acting as registered representatives for a broker-dealer when recommending securities to a “retail customer.”  For example, Reg BI would apply when recommending variable annuities or variable life insurance products that are classified as securities.  Typically, the new rules would not apply to traditional insurance product sales that do not involve securities.

Who is a Retail Customer?

A “retail customer” is a natural person or her “non-professional” legal representative who will use the recommendation primarily for personal, family, or household purposes.  The SEC explained that its intent is to ensure Reg BI applies to recommendations to people and to those non-financial professionals acting on their behalf—such as executors, conservators, and those with power of attorney—who directly rely on the recommendations to make decisions, but not to interactions between financial professionals.  For purposes of retirement plans, the SEC explains that retail customer includes plan participants receiving recommendations about how to invest their retirement accounts (because they are natural persons), but generally would exclude the plan fiduciaries making decisions for the plan as a whole (because the plan is not a natural person).  However, it is important to note that these distinctions described by the SEC are not precisely defined, and likely will raise a number of questions going forward.

What Types of Recommendations Are Covered By Reg BI?

Reg BI applies when the producer (or other registered representative) is recommending:

  • a security;
  • an investment strategy; or
  • a type of account.

The type of account recommendation is a new feature in the final rule.  It includes recommendations to roll over or transfer assets in a workplace retirement plan account to an IRA, recommendations to open a particular securities account (such as a brokerage account or an advisory account), and recommendations to take a plan distribution for the purpose of opening a securities account.  For example, if a producer is acting as a representative of a broker-dealer and recommending a rollover from a 401(k) plan to a variable annuity in an IRA, Reg BI would apply to the rollover recommendation.

What Are the Basic Requirements of the New Reg BI?

Reg BI requires the broker-dealer and producer to 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 producer, broker-dealer, or its affiliates ahead of the interests of the retail customer.  The rule does this through four specific obligations on broker-dealers, all of which must be met to comply with the rule.

The four general obligations are:

  • Disclosure Obligation—Requires “full and fair” written disclosure to the retail customer before or at the time of the recommendation of all material facts about the relationship, the fees, and the basis for the recommendation, including the capacity in which the financial professional is acting. This obligation applies to the broker-dealer and to the producer acting as its registered representative.
  • Care Obligation—Requires the broker-dealer to exercise reasonable diligence, care, and skill when making a recommendation to a retail customer. This obligation applies to the broker-dealer and to the producer acting as its registered representative.
  • Conflict of Interest Obligation—Requires the broker-dealer to establish, maintain, and enforce written policies and procedures reasonably designed to disclose or mitigate conflicts of interest; and to eliminate certain conflicts the SEC determined cannot be mitigated, such as certain sales contests.
  • Compliance Obligation—Requires the broker-dealer to establish, maintain, and enforce policies and procedures reasonably designed to achieve compliance with Regulation Best Interest as a whole.

While the disclosure and care obligations apply to producers directly, as well as to their broker-dealers, the conflict and compliance obligations apply to broker-dealers.  However, all four obligations will directly affect producers as broker-dealers must develop policies and procedures to comply with the rule’s various requirements.  Producers, when acting as registered representatives for their broker-dealers, are required to follow these policies and procedures.      Accordingly, here is a more detailed look at these general obligations to understand key issued that will affect producers.

How will the Disclosure Obligation Affect Producers?

There are several disclosures that will be of particular interest to producers, including fees; product, service, and other limits on recommendations; conflicts of interest; and limitations on the use of the titles “adviser” or “advisor.”  While disclosures generally must be in writing and made in advance or along with the recommendation, Reg BI makes provision for supplemental oral disclosures where written disclosures cannot reasonably be provided at the time the recommendation is made.  The producer will need to document that it made the oral disclosure in such a circumstance, and follow up with written disclosures.  These disclosures cover a fairly broad range of issues:

  • Fees—All material fees and costs that apply to the customer’s transactions, holdings, and accounts must be disclosed. However, this does not necessarily require that the specific commission received by a producer in connection with a specific product must be disclosed.  While a range for costs or fees may be provided in cases where it is not clear in advance what those expenses will actually be, the range must accurately reflect the likely amount.
  • Limitations—All material limitations on the products or services that may be recommended must also be disclosed. Thus, for example, where a broker-dealer or producer has an agreement with only a limited set of carriers, or can recommend only proprietary products, the recommendation will have to include a disclosure explaining those limits.  While the new rule does not impose an ongoing monitoring obligation on broker-dealers or producers, it does permit broker-dealers to agree to do so for retail customers.  Where a monitoring obligation has been agreed to, its scope and any limits on the obligation should be clearly identified (especially as the SEC notes that not communicating a new recommendation can be interpreted as a “hold” recommendation).
  • Conflicts of Interest—The final rule expands the disclosure requirements related to conflicts of interest. The broker-dealer must disclose “all material facts” regarding a conflict.  Conflict is defined as “an interest that might incline a [producer or other representative of the broker-dealer]—consciously or unconsciously—to make a recommendation that is not disinterested.”  Compensation that differs between products or carriers is such a conflict.  As above, the broker-dealer likely does not have to disclose the specific commission that a producer would receive from each product, but it will have to provide enough facts about the differences in commissions between product types or carriers to allow the retail customer to understand the conflict.  It is quite likely that this standard will be a source of confusion and requests for additional guidance.
  • Titles—The final rule states that the use of titles such as “advisor” or “adviser” by a producer who is not also registered as an investment adviser, or who is not a supervised person of an investment adviser, would be presumed to violate the requirement to disclose that the producer is acting in its capacity as a broker-dealer. The rationale for this presumption is that the term “adviser” is closely linked with the legal term “registered investment adviser,” and its use by a broker-dealer or producer that is not such an adviser or supervised by such an adviser would undermine the clarity of the disclosure regarding the capacity in which the producer is acting.

How Will the Care Obligation Affect Producers?

The care obligation expands the existing suitability requirements in several ways, and will likely result in broker-dealers adopting detailed policies and procedurs requiring producers to gather customer information and document the basis for their recommendations.  The broker-dealer and producer must understand potential risks, rewards, and costs associated with the recommendation.  The broker-dealer and producer must then consider these factors in light of the retail customer’s investment profile and make a recommendation that is in the retail customer’s best interest.  The final regulation explicitly requires the broker-dealer and producer to consider the costs of the recommended product to the customer.

Importantly, while the rule specifically states that broker-dealers and producers must consider costs in the recommendations, they are not obligated to recommend the lowest cost product.  The SEC provides an example in which the broker-dealer recommends a higher-cost product where its features and benefits are in the best interest of the retail customer based on her investment profile and objectives.  However, it is very clear from the SEC’s description that a robust consideration of costs to the retail customer is required, and that there is a “thumb on the scale” in favor of a lower-cost investments that meets the retail customer’s needs.

How Will the Conflict of Interest Obligation Affect Producers?

This is one of the more significant new requirements in the rule.  While the SEC specifically preserves the transaction-based business model of broker-dealers, the rule establishes a broad policy of disclosure, as well as specifically identifying certain practices that must either be mitigated or eliminated.  The broker-dealer must establish, maintain, and enforce written policies and procedures reasonably designed to identify, and at a minimum disclose or eliminate, conflicts of interest.  This obligation specifically requires policies and procedures to:

  • Mitigate conflicts that create an incentive for producers and other representatives to place their interest or the interests of the firm ahead of the retail customer’s interest;
  • Prevent material limitations on offerings, such as a limited product menu or offering only proprietary products, from causing the firm or its financial professional to place her interest or the interests of the firm ahead of the retail customer’s interest; and
  • Eliminate sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sale of specific securities or specific types of securities within a limited period of time.

The relatively vague language regarding prohibited sales contests and similar activities raises a number of questions.  In general, it appears that “firm level” conflicts of broker-dealers can be addressed with disclosure, while mitigation or elimination of a conflict is more likely to be required at the producer/representative level.

Possible Mitigation Strategies at the Producer Level

The SEC cites as examples of these producer/representative-level conflicts “commissions or sales charges, or other fees or financial incentives, or differential or variable compensation…[with a] focus on compensation that varies based on the advice given, such as commissions, markups/markdowns, loads, revenue sharing, and Rule 12b-1 fees.”  The SEC reiterates that the mitigation requirement is principles-based, and that there is no one-size-fits-all requirement regarding how such conflicts may be mitigated.  The SEC provided some examples of mitigation strategies, but indicated that these were not requirements.  As a result, producers likely will see a wide-array of implementation approaches from different broker-dealers.  Some of the strategies suggested by the SEC are reminiscent of those related to the DOL Fiduciary Rule, and include:

  • Avoiding compensation thresholds that disproportionately increase compensation through incremental increases in sales;
  • Minimizing compensation incentives favoring one type of account or product over another, or to favor proprietary or preferred provider products, such as by establishing differential compensation based on neutral factors;
  • Eliminating compensation incentives within comparable product lines such as by capping the credit that an associated person may receive across providers;
  • Implementing supervisory procedures to monitor recommendations that are near compensation thresholds; involve higher compensating products, proprietary products, or transactions in a principal capacity; or involve the roll over or transfer of assets from one type of account to another;
  • Adjusting compensation for associated persons who fail to adequately manage conflicts of interest; and
  • Limiting the types of retail customer to whom a product, transaction, or strategy may be recommended.

While not directly affecting producers, the broker-dealer will have to review its menu of offerings to determine whether those limitations negatively affect retail customers.  This may indirectly affect producers if it ends up resulting in changes to existing product offerings, but it is too soon to see if such a response is likely.

Elimination of Sales Contests and Similar Types of Compensation 

Reg BI requires the elimination of what it describes as “high-pressure” situations where producers and other representatives will receive additional money, gifts, trips, and similar types of compensation for recommending specific products or types of products in a “limited period of time.”  These situations present a degree of conflict that cannot be addressed through disclosure and mitigation alone.

These high-pressure situations do not include incentives based on broad measures like total products sold or assets accumulated—they are focused on what the SEC perceives as a “push” to sell certain products or types of products.  Importantly for some producers, the SEC notes that it does not consider sales of proprietary products that make producers eligible for employee benefits (as in the case of a statutory employee) to be prohibited incentives.  It also states that qualifying for educational meetings and other types of gatherings are not prohibited provided they are not earned based on the sale of a product or product type in a limited period of time.

Unfortunately, the SEC did not explain what it considered a limited period of time to be.  As a result, we believe there will be a need for additional guidance, especially for those distribution channels in which producers are accustomed to commissions and incentives common in insurance transactions.

What Does the Form CRS Disclosure Require?

While Reg BI contains disclosure requirements as discussed above, broker-dealers (and by extension, producers) will also be subject to disclosures required by the new Form CRS relationship summary.  It will require investment advisors and broker-dealers to deliver a relationship summary to retail investors at the beginning of their relationship. Firms will summarize information about services, fees and costs, conflicts of interest, the respective legal standard of conduct, and whether or not the firm and its financial professionals have any disciplinary history. The relationship summary will have a standardized question-and-answer format to promote comparison by retail investors in a way that is distinct from existing disclosures. The relationship summary will permit the use of layered disclosure so that investors can more easily access additional information from the firm about these topics. It also will highlight the Commission’s investor education website (Investor.gov), which offers the investing public educational information, including a series of educational videos designed to provide ordinary investors with some basic information about broker-dealers and investment advisors.

What Happens Next?

The SEC is establishing an inter-Divisional Standards of Conduct Implementation Committee, comprised of representatives from the Division of Investment Management, Division of Trading and Markets, Division of Economic and Risk Analysis, Office of Compliance Inspections and Examinations, and Office of the General Counsel to assist firms with planning for compliance. The SEC is encouraging firms to engage with this committee as questions arise in planning for implementation.

Separately, the Department of Labor (“DOL”) will be revising its fiduciary regulation that was vacated by a Federal appeals court to comport with the new SEC regulations.  DOL has not provided much detail on its new proposed regulatory proposal, and AALU will monitor their activities closely.

Conclusion

After much debate and controversy, the SEC rules and interpretations are now final.  Setting aside whether they may be subject to legal challenges, firms need to complete their implementation efforts by June 30, 2020.  Producers will need to discuss these rules with their broker-dealers as implementation proceeds, as there may well be significant differences from one broker-dealer to the next.  AALU will be working closely with our members and partners to seek useful guidance from the SEC as this process continues.

©2019, Association of Advanced Life Underwriting. Reprinted with permission from the Association of Advanced Life Underwriting, which does not endorse any particular uses of this document.

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