The Securities and Exchange Commission (“SEC”) recently adopted a new rule which established a standard of conduct for brokers and their firms when making recommendations to retail customers. This includes recommending both a securities transaction or recommending any investment strategy which involves securities. This new rule is called “Regulation Best Interest”. The Regulation Best Interest rule was established to align the broker’s standard of conduct with their retail customer’s reasonable expectations by requiring that they “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 broker-dealer ahead of the interests of the retail customer.” The Regulation Best Interest rule also addresses conflicts of interest by requiring brokerage firms to establish, maintain, and enforce policies and procedures that are reasonably designed to both identify as well as to and fully and fairly disclose material facts about conflicts of interest. In cases where disclosure is deemed insufficient to reasonably address any conflicts of interest, the rule requires that steps must be taken to mitigate or eliminate the conflict. Importantly, the standards of conduct established by Regulation Best Interest rule cannot be satisfied simply through disclosure alone.
In enacting this standard of conduct, the SEC borrowed from key principles underlying two fiduciary obligations, including those that applied to investment advisers under the Investment Advisers Act of 1940 (“Advisers Act”). To align the duties owed to retail customers of both broker-dealers and investment advisers, the SEC mandates that retail investors are entitled to a recommendation (from a broker-dealer) or advice (from an investment adviser) that is in the clients’ best interest. This means that the advice or recommendation does not place the interests of the firm or the financial professional ahead of the interests of the retail investor.
Under the Regulation Best Interest rule, a conflict of interest is defined as “an interest that might incline a broker, dealer, or a natural person who is an associated person of a broker or dealer—consciously or unconsciously—to make a recommendation that is not disinterested.”
Regulation Best Interest Applies to All Recommendations
- What is a recommendation? Deciding whether a broker-dealer has made a recommendation triggering Regulation Best Interest turns on the specific facts and circumstances of each case. Factors that are considered in determining whether in fact a recommendation has been made include whether the communication “reasonably could be viewed as a ‘call to action’” and “reasonably would influence an investor to trade a particular security or group of securities.” The more tailored to the customer or targeted group of customers the communication about a security or group of securities is, the greater the likelihood is that it may be viewed as a “recommendation.”
- Type of Account recommendations Regulation Best Interest expressly applies to account recommendations including recommendations of securities account types generally (e.g., to open an IRA or other brokerage account, or an advisory account), as well as recommendations to roll over or transfer assets from one type of account to another (e.g., from a workplace retirement plan account to an IRA). There are many different account types within brokerage firms. Choices can include education accounts (such as 529 Plans and tax-free Coverdell accounts); retirement accounts ( accounts such as IRA, Roth IRA, or SEP accounts); and specialty accounts ( margin accounts, and accounts with access to options trading). Different brokerage accounts can also offer different types and levels of services, such as online trading. The SEC has used these as examples of the type of brokerage accounts that could be recommended to a retail customer, and to which Regulation Best Interest would apply.
The specific type of securities account recommended is an “investment strategy” that can significantly affect a retail customers’ costs and investment returns. Thus, different types of securities accounts offering different features, products, or services, may—or may not—be deemed to be in the best interest of certain retail customers.
- Recommendations to Hold are Recommendations for Purposes of Regulation Best Interest
The SEC has stated that any securities transaction or investment strategy involving securities includes both
- explicit hold recommendations; and
- implicit hold recommendations that are the result of agreed-upon account monitoring between the broker-dealer and retail customer.
Brokerage Firms Must Have Written Policies to Address Conflicts of Interest
The Regulation Best Interest rule requires that a broker-dealer establish, maintain, and enforce reasonably designed written policies and procedures addressing conflicts of interest associated with recommendations to retail customers. The firm’s policies and procedures must be reasonably designed to identify all conflicts and to either disclose or eliminate them. Specifically, these policies and procedures must be reasonably designed to mitigate any conflicts of interests that create an incentive for a broker or financial advisor to place their own interest (or the interest of the firm) ahead of the retail customer’s interest. Even when a brokerage firm creates limitations on recommendations that may be made to a retail customer, such as offering only proprietary or a very limited range of securities, the policies and procedures must also be reasonably designed to disclose these limitations and associated conflicts as well as to prevent these limitations from also causing the broker or firm from placing the their own interests ahead of the customer’s.
Importantly, the policies and procedures should be reasonably designed to both identify and eliminate things such as sales contests, quotas, bonuses, and all non-cash compensation (like trips or gifts) that are based on selling specific securities or types of securities within a limited period of time.
Are Forgivable Loans to Brokers a Conflict of Interest?
Another area ripe for conflicts of interest are broker forgivable loans. Firms routinely offer upfront loans as an incentive to entice a broker to leave another firm and bring clients to the new firm. The loans are then “burned off” by a broker reaching certain sales thresholds during a specific time interval. In describing the conflict that such loans create, the SEC answered this in the context of Regulation Best Interest as follows:
Q: Are forgivable loans conflicts of interest under Regulation Best Interest?
A: Typically, yes. Staff understands that firms may offer “forgivable loans” as an incentive to induce associated persons to move from one firm to another and that typically these loans are forgiven based upon the performance of future services by the individuals and based upon the achievement of specified performance goals related to asset accumulation, revenue benchmarks, client transfer, or client retention. Under Regulation Best Interest, a conflict of interest is defined as “an interest that might incline a broker, dealer, or a natural person who is an associated person of a broker or dealer—consciously or unconsciously—to make a recommendation that is not disinterested.”
Thus, under the SEC’s view, a forgivable loan that is based on specified performance goals could very well constitute a conflict of interest. And, pursuant to the firm’s Conflict of Interest Obligation, the brokerage firm would need to establish, maintain, and enforce written policies and procedures reasonably designed to identify and address such forgivable loans. And, at a minimum, the firm would also be required to identify, disclose or eliminate all conflicts of interest related to the forgivable loan.
Is a High Commission a Sign of Investor Fraud or Misconduct?
Many products such as annuities, insurance, structured products and REITs are high commission investments. Brokers and Financial Advisors may be incentivized to sell them just based upon the high commission that is paid to them. Before you invest, make certain that you understand the commission or incentive which your broker is receiving in connection with selling the product to you.
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If you or your loved one has suffered investment losses as a result of investment fraud or broker negligence, contact the offices of Investment Fraud lawyer Melanie Cherdack for a free consultation. Because she has been in the trenches as a former Wall Street attorney, Melanie Cherdack and her team of experienced attorneys have seen just about every type of investment fraud or investment scam. While almost every investment carries a degree of uncertainty and risk, you may have been unnecessarily exposed to such risk. Former Wall Street securities attorney Melanie S. Cherdack and her team of lawyers represent individual and institutional investors who are unwitting victims of investment fraud and broker negligence. She heads up a group of attorneys who represent investors across the United States and the Americas. Contact us by filling out our online contact form, or calling 844-635-1609.