On Friday, June 26, 2020, the U.S. Court of Appeals for the 2^nd Circuit upheld Reg BI against a challenge brought by, among others, XY Planning Network and various U.S. states. 
 
The panel of three judges held that “Section 913(f) of the Dodd-Frank Act grants the SEC broad rulemaking authority, and Regulation Best Interest clearly falls within the discretion granted to the SEC by Congress.”  While it found that the states that petitioned the court to invalidate the regulation under the Administrative Procedures Act, the panel determined that XY Planning had standing, but rejected its attack on the legality of Reg BI as a matter of administrative process: “Although Regulation Best Interest may not be the policy that Petitioners would have preferred, it is what the SEC chose after a reasoned and lawful rulemaking process.”  Of note is the argument made by XY Planning, to the effect that Reg BI “will injure investment advisers by making it more difficult for them to differentiate their standard of care from that of broker-dealers in advertising to attract customers.”  The court took the argument at face value, but ultimately concluded that “Petitioners’ preference for a uniform fiduciary standard instead of a best-interest obligation is a policy quarrel dressed up as an APA claim.”
 
Unless the decision is reviewed by the 2^nd Circuit en banc or is successfully appealed to the U.S. Supreme Court, this decision marks the end of current procedural challenges to the Regulation.
 
1.         What is Reg BI again?
Regulation Best Interest (or Reg BI) was adopted by the SEC and creates an enhanced standard of conduct applicable to broker-dealers at the time they recommend to a retail customer a securities transaction or investment strategy involving securities.
            •          Retail Customer - Any individual who receives a recommendation from the broker-dealer for the individual’s own account (but not an account for a business that he or she works for), including individual plan participants. 
            •          Securities Transaction or Investment Strategy Involving Securities – The term includes recommendations of account types and rollovers or transfers of assets and also covers implicit hold recommendations resulting from agreed-upon account monitoring.
2.         What do I have to do to Comply? 
The Regulation sets forth a number of important requirements applicable to broker-dealers when making a recommendation to retail customers. In particular, when making a recommendation, a broker-dealer must act in the retail customer’s best interest and cannot place its own interests ahead of the customer’s interests. To satisfy this requirement, a broker-dealer must comply with the following four obligations.
            A.         Disclosure Obligation:  Before or at the time of making a recommendation, a broker-dealer must disclose, in writing, material facts about the scope and terms of its relationship with the customer.  This includes:
                        i.          disclosure that the broker-dealer or associated person is acting in a broker-dealer capacity;
                        ii.         the material fees and costs the customer will incur;
                        iii.        the type and scope of the services to be provided, including any material limitations on the recommendations that could be made to the retail customer; and
                        iv.        all material facts relating to conflicts of interest associated with the recommendation that might incline a broker-dealer to make a recommendation that is not disinterested, including, for example: (a) proprietary products; (b) payments from third parties; and (c) compensation arrangements.
            B.         Care Obligation:  A broker-dealer must exercise reasonable diligence, care, and skill when making a recommendation to a retail customer.  The broker-dealer must understand potential risks, rewards, and costs associated with the recommendation.
                        i.          The broker-dealer must consider those risks, rewards, and costs in light of the retail customer’s investment profile and have a reasonable basis to believe that the recommendation is in the customer’s best interest and does not place the broker-dealer’s interest ahead of the retail customer’s interest.
                        ii.         When recommending a series of transactions, the broker-dealer must have a reasonable basis to believe that the transactions taken together are not excessive, even if each is in the retail customer’s best interest when viewed in isolation.
            C.         Conflict of Interest Obligation:  A broker-dealer must establish, maintain, and enforce reasonably designed written policies and procedures addressing conflicts of interest associated with its recommendations to retail customers.
                        i.          These policies and procedures must be reasonably designed to identify all such conflicts and at a minimum disclose or eliminate them.
                        ii.         The policies and procedures must be reasonably designed to mitigate conflicts of interests that create an incentive for an associated person of the broker-dealer to place its interests or the interest of the firm ahead of the retail customer’s interest.
                        iii.        When a broker-dealer places material limitations on recommendations that may be made to a retail customer (e.g., offering only proprietary or other limited ranges of products), the policies and procedures must be reasonably designed to disclose the limitations and associated conflicts and to prevent the limitations from causing the associated person or broker-dealer to place the associated person’s or broker-dealer’s interests ahead of the customer’s interest.
                        iv.        The policies and procedures must be reasonably designed to identify 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.
            D.         Compliance Obligation:  A broker-dealer must establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Regulation Best Interest as a whole.  This includes compliance with its Disclosure and Care Obligations under Regulation Best Interest. 
3.            What is Form CRS?
In addition to adopting Reg BI, the SE also adopted requirements for broker-dealers and investment advisers to create and disseminate a new form – Form CRS.  The Form is a relationship summary of not more than 2 pages for investment advisers or broker-dealers (4 pages for dual registrants) to provide to retail investors.  A “Retail investor” is an individual, or the legal representative of the individual, who seeks to receive or receives services primarily for personal, family or household purposes.
 
A.         Delivery Obligation
 
            i.          An Investment Adviser must deliver an electronic or paper version of the relationship summary to each retail investor before or at the time the adviser enters into an investment advisory contract with the retail investor.
            ii.          A Broker-Dealer must deliver an electronic or paper version of the relationship summary, with respect to a retail investor that is a new or prospective customer, before or at the earliest of: (a) A recommendation of an account type, a securities transaction or an investment strategy involving securities; (b) placing an order for the retail investor; or (c) the opening of a brokerage account for the retail investor.
            B.         Content of Relationship Summary.  Every investment adviser and broker-dealer must use the same headings and present the information in the same order. 
            i.          Introduction
            ii.         Relationship and Services 
            iii.        Fees and Costs, Standard of Conduct, and Conflicts of Interest       
            iv.        Disciplinary History
            v.         Additional Information
            vi.        Conversation Starters
 
4.            What about Investment Advisers?
In the course of adopting Reg BI, the SEC issued a release setting forth its views on how investment advisers can satisfy their fiduciary duties.  An investment adviser’s fiduciary duty comprises a duty of care and a duty of loyalty.  It applies to the entire adviser-client relationship, and reflects Congressional intent to “eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser — consciously or unconsciously — to render advice which was not disinterested.”
               A.         Scope of Fiduciary Duty Determined by Scope of Relationship: 
                        i.          The specific obligations that flow from the adviser’s fiduciary duty depend upon what functions the adviser, as agent, has agreed to assume for the client, its principal.
                        ii.         An adviser’s federal fiduciary duty may not be waived, though its application may be shaped by agreement.
            B.         Duty of Care:
                        i.          Duty to Provide Advice That Is in the Best Interest of the Client:
                                    (a)        An adviser must have a reasonable understanding of the client’s objectives.
                                    (b)       An adviser must have a reasonable belief that the advice it provides is in the best interest of the client based on the client’s objectives.
                        ii.         Duty to Seek Best Execution: 
                                    (a)        The “determinative factor” is not the lowest possible commission cost, “but whether the transaction represents the best qualitative execution.”
                                    (b)       An adviser should “periodically and systematically” evaluate the execution it is receiving for clients.
                        iii.        Duty to Provide Advice and Monitoring Over the Course of the Relationship: 
                                    (a)        An adviser’s duty to monitor extends to all personalized advice it provides to the client, including, for example, in an ongoing relationship, an evaluation of whether a client’s account or program type (for example, a wrap account) continues to be in the client’s best interest.
                                    (b)       In the absence of any agreed limitation or expansion, the scope of the duty to monitor will depend upon the duration and nature of the agreed advisory arrangement.
            C.         Duty of Loyalty:
            An adviser must not subordinate its clients’ interests to its own.
                        i.          An adviser must eliminate – or at least expose through full and fair disclosure – all conflicts of interest which might incline an investment adviser – consciously or unconsciously – to render advice which was not disinterested.
                        ii.         Whenever an adviser cannot fully and fairly disclose a conflict of interest to a client such that the client can provide informed consent (typically, a scenario involving a retail client), the adviser should either eliminate the conflict or adequately mitigate (i.e., modify practices to reduce) the conflict such that full and fair disclosure and informed consent are possible.
5.         What Other Points Should I Know?
            A.         The implementation date for Reg BI and Form CRS is June30, 2020.
            B.         FINRA has revised its suitability rule to fit it into the Reg BI framework
            C.         The SEC staff has published FAQs regarding Reg BI: https://www.sec.gov/tm/faq-regulation-best-interest
            D.         The SEC staff has published FAQs regarding Form CRS: https://www.sec.gov/investment/form-crs-faq
            E.         Both the SEC and FINRA examination staff will be looking at firms’ Reg BI and Form CRS compliance efforts.