SEC Regulation Best Interest Disclosures

Regulation Best Interest Overview

SEC Regulation Best Interest (Reg BI) fundamentally changed the standard of conduct for broker-dealers when making recommendations to retail customers. Effective June 30, 2020, Reg BI establishes a new "best interest" standard that goes beyond the prior suitability standard but is distinct from the fiduciary duty applicable to investment advisers.

In my practice advising broker-dealers, I see firms struggle with the practical implementation of Reg BI. The regulation is principles-based rather than prescriptive, which means compliance requires judgment, documentation, and a genuine commitment to putting customer interests first.

The "Best Interest" Standard

Reg BI requires that when I make a recommendation to a retail customer, I must act in the best interest of the retail customer at the time the recommendation is made, without placing my financial or other interest ahead of the retail customer's interest. This involves:

• Disclosure Obligation - Provide certain disclosures before or at the time of the recommendation
• Care Obligation - Exercise reasonable diligence, care, and skill in making the recommendation
• Conflict of Interest Obligation - Establish, maintain, and enforce policies to identify and mitigate conflicts of interest
• Compliance Obligation - Establish, maintain, and enforce written policies and procedures

What Constitutes a "Recommendation"?

A recommendation includes any communication that, based on its content, context, and presentation, would reasonably be viewed as a suggestion to:

• Engage in or refrain from taking a securities transaction
• Engage in or refrain from adopting an investment strategy involving securities
• Open, hold, or maintain a type of account (e.g., brokerage vs. advisory)
• Roll over assets from a retirement account

Disclosure Obligation

The Disclosure Obligation requires that before or at the time of the recommendation, I must provide retail customers with full and fair disclosure of all material facts relating to conflicts of interest associated with the recommendation.

Required Disclosures

At a minimum, disclosures must include:

• Material Facts About the Relationship - The scope and terms of the relationship with the retail customer, including whether the recommendation is in the customer's best interest
• Material Facts About Conflicts - Material conflicts of interest associated with the recommendation
• Compensation - Information about the fees and costs that apply to the retail customer's transactions, holdings, and accounts
• Type and Scope of Services - Material limitations on securities or investment strategies that may be recommended
• Account Monitoring - Whether the firm or representative will monitor the account and provide ongoing recommendations

Form and Timing

Disclosures must be provided:

• In Writing - Generally must be in writing, though oral disclosure followed by written confirmation may be permitted in some circumstances
• Before or At Recommendation - Prior to or at the time of the recommendation, or at the earliest practical opportunity if circumstances make earlier disclosure impossible
• Clear and Conspicuous - Disclosures must be in plain English and presented in a manner that is reasonably designed to be understood by retail customers
• Updated as Needed - Must be updated when material changes occur

Practical Disclosure Implementation

In my practice, I recommend a layered disclosure approach:

1. Form CRS - Provides a high-level overview of the relationship (discussed in detail below)
2. Account Opening Disclosures - Detailed disclosure of conflicts, compensation, and account features
3. Transaction-Specific Disclosures - Point-of-sale disclosures for specific recommendations highlighting relevant conflicts
4. Periodic Disclosures - Annual or quarterly updates on account costs, conflicts, and relationship terms

Care Obligation

The Care Obligation is the substantive core of Reg BI. It requires that when I make a recommendation to a retail customer, I must exercise reasonable diligence, care, and skill to:

Understand the Investment

I must understand the potential risks, rewards, and costs associated with the recommendation, and have a reasonable basis to believe the recommendation could be in the best interest of at least some retail customers. This includes:

• Understanding the investment's features, liquidity, costs, fees, and risks
• Analyzing how the investment performs in different market conditions
• Evaluating the investment compared to available alternatives
• Understanding complex or structured products before recommending them
• Conducting ongoing due diligence as market conditions change

Understand the Customer

I must have a reasonable understanding of the retail customer's investment profile, including:

• Age - Relevant for time horizon and risk capacity
• Investment Experience - Sophistication level and familiarity with different products
• Time Horizon - Short-term vs. long-term investment objectives
• Liquidity Needs - When the customer may need access to funds
• Risk Tolerance - Willingness and ability to accept investment risk
• Tax Status - Tax considerations relevant to the recommendation
• Investment Objectives - Growth, income, preservation, speculation
• Financial Situation - Income, net worth, existing investments, and liabilities

Reasonable Basis for the Recommendation

Based on my understanding of the investment and the customer, I must have a reasonable basis to believe the recommendation is in the best interest of the particular customer. This means:

• The recommendation must be suitable for the customer's investment profile
• The costs and complexity must be justified by the customer's needs
• The recommendation must align with the customer's stated objectives
• Available alternatives must be considered
• Conflicts of interest must not drive the recommendation

Cost Consideration

A critical component of the Care Obligation is the requirement to consider costs. I must:

• Understand all costs associated with the recommendation (commissions, fees, loads, spreads, markups)
• Consider whether less costly alternatives would equally or better serve the customer's interest
• Evaluate costs in light of the customer's investment profile and objectives
• Document the cost analysis and why the recommended approach is justified

Conflict of Interest Obligation

The Conflict of Interest Obligation requires that I establish, maintain, and enforce written policies and procedures reasonably designed to identify and at a minimum disclose, or eliminate, all conflicts of interest associated with recommendations to retail customers.

Material Conflicts Requiring Mitigation

Certain conflicts of interest create such significant incentives that disclosure alone is insufficient. I must establish policies to mitigate or eliminate:

• Material Financial Incentives - Sales contests, bonuses, or non-cash compensation that could incentivize recommendations not in customer interest
• Differential Compensation - Significantly higher compensation for recommending certain products or account types
• Third-Party Payments - Revenue sharing, marketing support, or other payments from product sponsors
• Principal Trading - Recommendations to purchase securities from the firm's inventory
• Proprietary Products - Recommendations of the firm's own products or affiliated products

Mitigation Strategies

Effective conflict mitigation includes:

• Compensation Structure Changes - Eliminate or reduce differential compensation based on product type
• Product Rationalization - Limit product shelf to reduce conflicts in product selection
• Supervisory Review - Enhanced review of recommendations involving conflicts
• Training and Guidance - Educate representatives on identifying and managing conflicts
• Disclosure - Clear disclosure of conflicts that cannot be eliminated
• Documentation - Require documentation of why conflicted recommendation is in customer best interest

Identifying Conflicts of Interest

I advise broker-dealers to conduct a comprehensive conflict inventory:

1. Revenue Sources - Identify all sources of firm revenue (commissions, fees, revenue sharing, marketing support, principal markups)
2. Compensation Structures - Analyze representative compensation arrangements and incentives
3. Affiliated Products - Identify proprietary or affiliated products
4. Third-Party Relationships - Document relationships with product sponsors, clearing firms, and service providers
5. Material Limitations - Identify limitations on available products or strategies
6. Financial Incentives - Document sales contests, bonuses, and non-cash compensation

Compliance Obligation

The Compliance Obligation requires that I establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Reg BI. This includes:

Written Policies and Procedures

Policies must address:

• Disclosure Requirements - How and when required disclosures will be provided to customers
• Care Standards - Procedures for product due diligence, customer profiling, and recommendation analysis
• Conflict Identification and Mitigation - Process for identifying conflicts and implementing mitigation measures
• Supervision - Supervisory procedures to monitor compliance with Reg BI
• Training - Training programs for representatives and supervisors
• Documentation - Recordkeeping requirements to demonstrate compliance

Supervision and Oversight

Effective supervision includes:

• Pre-approval of certain recommendations involving conflicts or complex products
• Post-trade surveillance for patterns suggesting unsuitable recommendations
• Exception reporting for high-cost products, concentrated positions, or frequent trading
• Regular review of customer complaints and regulatory inquiries
• Testing and monitoring of compliance with policies

Training Requirements

Training should cover:

• Overview of Reg BI obligations and how they differ from prior standards
• Firm-specific policies and procedures
• How to identify and mitigate conflicts of interest
• Product due diligence requirements and resources
• Documentation expectations
• Case studies and examples of compliant vs. non-compliant recommendations

Documentation and Recordkeeping

To demonstrate compliance, maintain records of:

• Policies and procedures (current and historical versions)
• Product due diligence analyses
• Customer investment profiles and account opening documentation
• Recommendation rationale and best interest analysis
• Conflict identification and mitigation documentation
• Disclosures provided to customers
• Supervisory reviews and exception reports
• Training materials and attendance records

Form CRS Requirements

Form CRS (Customer or Client Relationship Summary) is a brief disclosure document required under Reg BI and related rules. It provides retail investors with key information about the firm's services, fees, conflicts of interest, legal standard of conduct, and disciplinary history.

Who Must Prepare Form CRS?

• Broker-dealers registered with the SEC
• Investment advisers registered with the SEC
• Dual registrants (firms registered as both) must prepare a single combined Form CRS

Form CRS Content Requirements

Form CRS must be no more than two pages and include:

1. Introduction

Brief description of the firm and its services, including whether it is a broker-dealer, investment adviser, or both.

2. What investment services and advice can you provide me?

• Description of services offered (brokerage, advisory, or both)
• Monitoring practices (whether accounts are monitored and frequency)
• Investment authority (discretionary vs. non-discretionary)
• Limited investment offerings (material limitations on products or strategies)
• Account minimums and other requirements

3. What fees will I pay?

• Principal fees and costs (commissions, advisory fees, account fees)
• Explanation of how fees are charged (transaction-based vs. asset-based)
• Description of other fees and costs (mutual fund fees, custodian fees, etc.)
• Explanation that customer will pay fees whether or not money is made

4. What are your legal obligations to me when providing recommendations? How else does your firm make money and what conflicts of interest do you have?

• For broker-dealers: Explanation of Reg BI best interest standard
• For investment advisers: Explanation of fiduciary duty
• Material conflicts of interest
• How the firm makes money (revenue sharing, principal trading, proprietary products)

5. How do your financial professionals make money?

• Description of how representatives are compensated
• Conflicts created by compensation structure
• Differential compensation for different products or services

6. Do you or your financial professionals have legal or disciplinary history?

• Yes or No answer
• Reference to BrokerCheck or IAPD for detailed information

7. Additional Information

• Where to find additional information
• How to contact the firm with questions
• How to report problems

Form CRS Delivery Requirements

Form CRS must be delivered:

• Before or at the time an investment account is opened or an investment advisory agreement is entered
• Before or at the time of a recommendation of an account type (e.g., brokerage vs. advisory)
• Within 30 days of any material changes
• Annually even if no changes (with notice that Form CRS is available and how to request it)

Conversation Starters

Form CRS must include specific "conversation starter" questions in each section to encourage retail investors to engage with their financial professionals:

• "Given my financial situation, should I choose an investment advisory service? Should I choose a brokerage service? Should I choose both types of services? Why or why not?"
• "How will you choose investments to recommend to me?"
• "What is your relevant experience, including your licenses, education and other qualifications? What do these qualifications mean?"
• "Help me understand how these fees and costs might affect my investments. If I give you $10,000 to invest, how much will go to fees and costs, and how much will be invested for me?"
• "How might your conflicts of interest affect me, and how will you address them?"
• "As a financial professional, do you have any disciplinary history? For what type of conduct?"
• "Who is my primary contact person? Is he or she a representative of an investment adviser or a broker-dealer? Who can I talk to if I have concerns about how this person is treating me?"

Conflict Disclosure Examples

Effective conflict disclosure requires specificity. Generic statements that conflicts exist are insufficient. Here are examples of specific conflict disclosures:

Revenue Sharing

Weak Disclosure: "We may receive payments from product sponsors."

Strong Disclosure: "We receive revenue sharing payments from mutual fund companies when you invest in their funds. These payments can range from 0.10% to 0.40% of assets annually. This creates an incentive to recommend funds that pay us higher revenue sharing amounts. To mitigate this conflict, we limit our approved product list to funds where revenue sharing does not exceed 0.25%, and our representatives receive the same compensation regardless of which approved fund you select."

Proprietary Products

Weak Disclosure: "We may recommend our own products."

Strong Disclosure: "We offer proprietary mutual funds managed by our affiliate, [Affiliate Name]. When you invest in these funds, we earn the management fees charged by the funds, which range from 0.75% to 1.50% annually. This is in addition to any commissions or sales loads you pay. This creates a significant financial incentive to recommend our proprietary funds over third-party alternatives. To address this conflict, we require that recommendations of proprietary funds be reviewed and approved by a supervisor who does not benefit from the sale."

Differential Compensation

Weak Disclosure: "Our representatives earn different compensation based on the products they sell."

Strong Disclosure: "Our representatives earn higher commissions on the sale of annuities (typically 5-7% of the amount invested) compared to mutual funds (typically 1-5%) or stocks (typically 0.5-2%). This creates an incentive to recommend annuities even when other products may be more appropriate. To mitigate this conflict, all annuity recommendations require supervisory pre-approval and documentation of why an annuity is appropriate for your specific situation."

Principal Trading

Weak Disclosure: "We may trade from our own inventory."

Strong Disclosure: "When we recommend that you purchase a security, we may sell it to you from our own inventory rather than purchasing it in the open market. When we do this, we earn a markup (typically 1-3%) in addition to any commission charged. This creates an incentive to recommend securities we hold in inventory and to apply a higher markup. You will receive trade confirmation identifying principal trades, and you have the right to request that securities be purchased from the market instead."

Sales Contests and Non-Cash Compensation

Weak Disclosure: "Our representatives may receive incentive compensation."

Strong Disclosure: "Our representatives may participate in sales contests where they can win prizes (such as trips, electronics, or cash bonuses) for achieving certain sales targets. Product sponsors may also provide non-cash compensation such as meals, entertainment, or trips for representatives who sell their products. These incentives create a conflict because they may motivate recommendations based on the representative's financial interest rather than your best interest. We mitigate this conflict by requiring supervisory review of recommendations made during contest periods and prohibiting representatives from receiving non-cash compensation exceeding $100 per year from any single product sponsor."

Material Limitations Disclosure

Many broker-dealers limit the universe of products they offer or recommend. These limitations must be disclosed because they affect the recommendations customers receive.

Common Material Limitations

1. Limited Product Shelf

"Our approved product list includes only [X] mutual fund families out of thousands available in the market. This means we do not offer or recommend many mutual funds that may be available at other firms, including potentially lower-cost alternatives. We selected our approved products based on [criteria], but you should understand that our recommendations are limited to these pre-selected options."

2. Proprietary Product Focus

"Our investment recommendations primarily focus on proprietary products managed by our affiliates. While we have a limited selection of third-party products available, [X]% of assets under management are invested in proprietary products. This limitation means you may not receive recommendations for the full range of products available in the marketplace."

3. No Advisory Services

"We offer only brokerage services and do not provide ongoing investment advisory services or account monitoring. This means we will not regularly review your account, proactively rebalance your portfolio, or provide ongoing advice unless you contact us. If you desire ongoing monitoring and advice, you should consider an investment advisory relationship."

4. Limited Asset Classes

"We offer recommendations only for publicly traded stocks, bonds, mutual funds, and exchange-traded funds. We do not offer or recommend alternative investments, private placements, options, futures, or other derivatives. This limitation means our recommendations do not consider the full spectrum of investment opportunities."

5. Clearing Firm Limitations

"We clear transactions through [Clearing Firm Name], which determines the products available for purchase. Some products available at other firms may not be available through our clearing firm. Additionally, our clearing firm receives payment for order flow from market makers, which may affect execution quality."

Comparison: Reg BI vs. Fiduciary Duty

One of the most common questions I receive is how Reg BI's best interest standard compares to the fiduciary duty applicable to investment advisers. While both require acting in the client's best interest, there are important differences.

Key Conceptual Differences

Point-in-Time vs. Ongoing

Reg BI applies at the time a recommendation is made. I must ensure the recommendation is in the customer's best interest at that moment, but I have no ongoing obligation to monitor or update the recommendation unless I make a new recommendation.

In contrast, an investment adviser's fiduciary duty is continuous. I must regularly review client accounts, update recommendations as circumstances change, and proactively address issues.

Conflicts of Interest

Under Reg BI, conflicts of interest are inherent and expected in the broker-dealer model (transaction-based compensation, principal trading, limited product shelf). These conflicts must be disclosed and mitigated but not necessarily eliminated.

Under the fiduciary standard, conflicts must be eliminated where possible. Where elimination is not possible, I must obtain informed consent after full disclosure. The threshold for acceptable conflicts is higher.

Scope of Services

Broker-dealers provide episodic recommendations when requested by the customer or initiated by the representative. There is no obligation to provide comprehensive financial planning or ongoing monitoring.

Investment advisers typically provide ongoing investment advice, portfolio management, and holistic financial planning. The relationship is continuous rather than transactional.

Enforcement Actions

The SEC has been actively enforcing Reg BI since it became effective. Understanding enforcement priorities helps identify compliance risks.

Common Violations in Enforcement Actions

1. Share Class Selection Failures

The Violation: Recommending mutual fund share classes with higher fees when lower-cost share classes were available to the customer.

Example: A firm recommended Class A shares with a front-end load when customers qualified for lower-cost institutional share classes with no load.

Penalty Range: $5 million to $15 million in recent cases

Prevention: Implement automated share class analysis; require documentation of share class selection rationale; conduct surveillance for patterns of higher-cost share class recommendations.

2. Undisclosed or Inadequately Mitigated Conflicts

The Violation: Failing to disclose material conflicts of interest or failing to implement adequate mitigation measures.

Example: Representatives received higher compensation for selling certain products but this conflict was not disclosed to customers and no mitigation measures were in place.

Penalty Range: $3 million to $20 million

Prevention: Conduct comprehensive conflict inventory; implement specific mitigation for each material conflict; provide clear disclosure of conflicts and how they are managed.

3. Excessive Trading and Churning

The Violation: Recommending frequent trading that generated commissions but was not in the customer's best interest.

Example: Representatives recommended frequent purchases and sales of securities to generate commissions, resulting in high costs that eroded customer returns.

Penalty Range: $1 million to $10 million

Prevention: Implement surveillance for excessive turnover; require justification for frequent trading; consider cost-to-equity ratios in suitability analysis.

4. Unsuitable Recommendations

The Violation: Recommending products that were not suitable for the customer's investment profile, even if they met prior suitability standards.

Example: Recommending complex, high-cost variable annuities to elderly customers with limited liquidity needs or recommending concentrated positions creating excessive risk.

Penalty Range: $2 million to $12 million

Prevention: Enhanced customer profiling; product-specific suitability review; supervisory review of complex product recommendations; heightened scrutiny for vulnerable customers.

5. Inadequate Policies and Procedures

The Violation: Failing to establish, maintain, or enforce written policies and procedures reasonably designed to achieve Reg BI compliance.

Example: Firms had Reg BI policies on paper but failed to implement them, train staff, or supervise for compliance.

Penalty Range: $500,000 to $5 million

Prevention: Comprehensive written policies; mandatory training; supervisory procedures; testing and monitoring; documentation of compliance efforts.

Self-Reporting and Cooperation

In several enforcement actions, firms that self-reported violations and remediated affected customers received reduced penalties. If you identify potential Reg BI violations, consider:

• Immediately suspending the problematic practice
• Conducting a comprehensive review to identify affected customers
• Remediating customers (refunding excess fees or making customers whole)
• Self-reporting to the SEC
• Implementing enhanced policies to prevent recurrence

Practical Implementation Roadmap

Implementing Reg BI compliance requires a systematic approach. Here is the roadmap I recommend to broker-dealer clients:

Phase 1: Assessment and Planning (Weeks 1-4)

• Gap Analysis - Compare current practices against Reg BI requirements; identify gaps
• Conflict Inventory - Document all conflicts of interest (compensation, revenue sharing, proprietary products, etc.)
• Business Model Review - Assess whether current business model is compatible with Reg BI or requires changes
• Stakeholder Education - Brief senior management and board on Reg BI requirements and implementation needs
• Budget and Resources - Determine budget for technology, compliance staff, training, and legal counsel
• Project Plan - Create detailed implementation timeline with milestones and accountability

Phase 2: Policy Development (Weeks 5-8)

• Draft Reg BI Policies - Comprehensive written policies addressing all four obligations
• Conflict Mitigation Strategies - Design specific mitigation measures for each material conflict
• Product Due Diligence Procedures - Establish product review committee and approval process
• Supervisory Procedures - Update supervisory procedures for Reg BI compliance
• Documentation Standards - Define what must be documented and how
• Disclosure Development - Draft Form CRS and other required disclosures

Phase 3: Business Practice Changes (Weeks 9-16)

• Compensation Structure Review - Evaluate and modify compensation to reduce conflicts
• Product Shelf Rationalization - Review approved products; eliminate problematic products
• Revenue Sharing Negotiations - Renegotiate or eliminate revenue sharing arrangements
• Form CRS Finalization - Finalize and file Form CRS with SEC
• Account Opening Updates - Update new account forms and disclosures
• Customer Profiling Enhancement - Expand customer information gathering to support care obligation

Phase 4: Technology and Systems (Weeks 12-20)

• Surveillance Systems - Implement or enhance surveillance for unsuitable recommendations, excessive trading, high-cost products
• Share Class Analysis Tools - Implement automated share class comparison tools
• Documentation Systems - Create systems to capture and maintain required documentation
• Reporting and Dashboards - Build management dashboards for Reg BI compliance monitoring
• Form CRS Delivery - Implement systems for Form CRS delivery and tracking

Phase 5: Training and Communication (Weeks 18-24)

• Management Training - Comprehensive training for senior management and supervisors
• Representative Training - Mandatory training for all registered representatives
• Specialized Training - Product-specific training for complex products
• Testing and Certification - Comprehension testing to ensure understanding
• Ongoing Education - Establish annual training program
• Customer Communication - Communicate changes to existing customers

Phase 6: Testing and Refinement (Weeks 24-28)

• Policy Testing - Test policies and procedures with sample scenarios
• System Testing - Validate surveillance and documentation systems
• Mock Examination - Conduct internal mock examination
• Issue Remediation - Address issues identified in testing
• Final Approval - Obtain final management approval for implementation

Ongoing Compliance Program

Conclusion

Regulation Best Interest represents a fundamental shift in the standard of conduct for broker-dealers. While it is not a full fiduciary standard, it significantly raises the bar beyond prior suitability requirements and requires meaningful changes to business practices.

The key takeaways from my work implementing Reg BI compliance:

1. Conflicts Must Be Managed - Disclosure alone is insufficient; material conflicts require mitigation through business practice changes, compensation adjustments, or enhanced supervision
2. Costs Matter - Reg BI requires affirmative consideration of costs and available alternatives; cannot simply recommend what is suitable without evaluating whether lower-cost options would serve customer interests
3. Documentation Is Critical - Must be able to demonstrate why a recommendation is in the customer's best interest; document product analysis, customer profile, and recommendation rationale
4. Form CRS Is Not Sufficient - Form CRS is the starting point, not the complete disclosure; need transaction-specific disclosures highlighting relevant conflicts
5. Enforcement Is Active - SEC has brought significant enforcement actions; assume compliance will be examined and build accordingly
6. Training Is Essential - Representatives must understand Reg BI requirements and how to apply them; annual training is necessary
7. Culture Matters - Compliance requires cultural shift toward customer-centric recommendations, not just policy changes

For broker-dealers, Reg BI is not optional and cannot be satisfied with minimal effort. It requires genuine commitment to acting in customers' best interests, which may require difficult business model changes. However, firms that embrace this standard can differentiate themselves in the marketplace and build stronger, more sustainable customer relationships.