The Disclosure Obligation under Regulation Best Interest

While this blog is typically focused on issues pertinent to investment advisers and their associated persons, Regulation Best Interest also extends to “associated persons of a broker dealer”. Many clients that I represent have relationships with broker-dealers and are responsible for supervising persons who are “associated persons of a broker dealer”. I often refer to these investment advisers as “hybrid advisers”.

One aspect that broker-dealers and their associated persons must adhere to in order to comply with Regulation Best Interest is the Disclosure Obligation. This post begins by providing the exact language of the Disclosure Obligation, provides broker-dealers with a high level checklist to comply with the Disclosure Obligation, and then provides more detailed tips for broker-dealers and associated persons in order to meet the requirements under the Disclosure Obligation.

Below is the precise language of the Disclosure Obligation under Regulation Best Interest:

(i) Disclosure obligation. The broker, dealer, or natural person who is an associated person of a broker or dealer, prior to or at the time of the recommendation, provides the retail customer, in writing, full and fair disclosure of:

(A) All material facts relating to the scope and terms of the relationship with the retail customer, including:

(1) That the broker, dealer, or such natural person is acting as a broker, dealer, or an associated person of a broker or dealer with respect to the recommendation;

(2) The material fees and costs that apply to the retail customer’s transactions, holdings, and accounts; and

(3) The type and scope of services provided to the retail customer, including any material limitations on the securities or investment strategies involving securities that may be recommended to the retail customer; and

(B) All material facts relating to conflicts of interest that are associated with the recommendation.

Initial Steps to Comply with the Disclosure Obligation under Regulation Best Interest

1. Understand the specific requirements imposed by Regulation Best Interest.
2. Identify existing disclosures already made to retail customers, when they are made during the customer relationship, and where they are made.
   • Consider brokerage agreements
   • Confirmation enclosures with account statements and other regular communications
   • Prospectuses
   • Pending Form CRS Draft
3. Identify gaps between existing disclosures and disclosures required under Regulation Best Interest, which are stated above in the section (i)(A)-(B). There is also added commentary on these requirements following this checklist.
4. Identify how these gaps will be cured prior to the effective date of Regulation Best Interest.  Consider:
   • Whether new disclosure will be generic or customized for the specific customer or transaction.
   • The timing of these new disclosures.
   • Whether the disclosure will be made initially (or upon the effective date of Regulation Best Interest), or must be made at the time of recommendation, or orally.
     • Oral disclosure may be made when facts not reasonably known at the time the written disclosure is provided are being supplemented. Personally, I would avoid relying on oral disclosures where possible.
     • Trade confirmation and prospectus delivery can continue to be used following recommendations to layer disclosure. Generic disclosure can be provided in a disclosure document and the confirmation or prospectus can be relied on to solidify those disclosures. For example, an disclosure might inform the customer that mutual funds typically have internal expenses between x-y%, of which the broker-dealer typically retains between 0-0.25% in rule 12b-1 fees. Customers should refer to the prospectus and their confirmation they receive to see the specific expense ratio and rule 12b-1 fees the broker-dealer receives.
     • When relying on oral or post-recommendation supplemental disclosure, firms should describe in writing how these supplements will be made[1]
   • How will the firm document oral disclosures?
5. Consider the delivery of Form CRS and documenting its delivery
   • Initial Delivery – Before or at the earliest of:
     • a recommendation of an account type, a securities transaction, or an investment strategy involving securities;
     • placing an order for the retail investor; or
     • the opening of a brokerage account for the retail investor.
   • Continued Delivery Obligations – A firm must deliver the most recent Form CRS to a retail investor who is an existing client or customer before or at the time it:
     • opens a new account that is different from the retail investor’s existing account(s);
     • recommend that the retail investor roll over assets from a retirement account into a new or existing account or investment; or
     • recommend or provide a new brokerage or investment advisory service or investment that does not necessarily involve the opening of a new account and would not be held in an existing account, for example, the first-time purchase of a direct-sold mutual fund or insurance product that is a security through a “check and application” process, i.e., not held directly within an account.
   • CLIENT NOTE: Ensure that electronic delivery is able to be relied upon, if that is the intended delivery method.
6. Ensure that the firm has procedures to continue its review of disclosures and insure that it continues to comply with the Disclosure Obligation.

Tips for Identifying Disclosure Obligations under Regulation Best Interest

• (1) Capacity in which the broker, dealer, or such natural person is acting as a broker, dealer, or an associated person of a broker or dealer

• Dually registered associated persons and associated persons who are not dually registered but only offer broker-dealer services through a firm that is dually registered as an investment adviser with the Commission or with a state, must disclose whether they are acting (or, in the case of the latter, that they are only acting) as an associated person of a broker-dealer in order to satisfy the Disclosure Obligation.
• An associated person of a dual-registrant who does not offer investment advisory services must disclose that fact as a material limitation in order to satisfy the Disclosure Obligation.
• Use of term “adviser” and “advisor” by (1) a broker-dealer that is not also registered as an investment adviser or (2) a financial professional that is not also a supervised person of an investment adviser would be a violation of the Disclosure Obligation under Regulation Best Interest.
• A broker-dealer may disclose that: “All recommendations will be made in a broker-dealer capacity unless otherwise expressly stated at the time of the recommendation; any such statement will be made orally.” In this case, no further oral or written disclosure would be required until a recommendation is made in a capacity other than as a broker-dealer.
• Note – The adopting rule release does not state that an associated person who renders services through a hybrid investment adviser could disclose that all recommendations will be made in an investment advisory capacity unless otherwise expressly stated at the time of the recommendation, and that any such statement will be made orally. I believe that this is a reasonable approach and consistent with the regulatory framework, but I am seeking further assurances from the staff of the SEC.
• Similarly, a broker-dealer may disclose that: “All recommendations regarding your brokerage account will be made in a broker-dealer capacity, and all recommendations regarding your advisory account will be in an advisory capacity. When we make a recommendation to you, we will expressly tell you orally which account we are discussing”). In this instance, no further disclosure of capacity is necessary.

(A)(2) The material fees and costs that apply to the retail customer’s transactions, holdings, and accounts

• Should generally build upon disclosure in the Form CRS.
• Does not mandate individualized fee disclosure particular to each retail customer
• Broker-dealers may disclose “material facts” about material fees and costs in terms of more standardized numerical and narrative disclosures, such as standardized or hypothetical amounts, dollar or percentage ranges, and explanatory text where appropriate. The disclosure should accurately convey why a fee is being imposed and when the fee is to be charged.
• A broker-dealer might initially disclose a range of product fees, and later supplement that information with more particularized information by delivering the product prospectus.
• Broker-dealers may refer the customer to any issuer disclosure of the security being recommended, such as a prospectus, private placement memorandum, or offering circular, where more particular information may be found.
• Ranges may be used and designed to reasonably reflect the actual fee to be charged. For example, a statement that a charge may be “between 5 and 100 basis points” would not be accurate if the fee is in almost all instances between 85 and 100 basis points.

(A)(3) The type and scope of services provided to the retail customer, including any material limitations on the securities or investment strategies involving securities that may be recommended to the retail customer

• Only requires disclosure of material facts relating to the type of services provided (e.g., the fact that the broker-dealer monitors securities transactions and investment strategies) and the scope of services (e.g., information about the frequency and duration of the services).
• Should disclose whether the broker-dealer has account minimums or similar requirements.
• May be able to rely on existing disclosures in account opening agreement or other account opening related documentation.
• If the firm places material limitations on securities or investment strategies, the firm would need to describe the material facts relating to those limitations. Examples of these material limitation include, but are not limited to:
  • Recommending only proprietary products (e.g., any product that is managed, issued, or sponsored by the broker-dealer or any of its affiliates), a specific asset class, or products with third-party arrangements (e.g., revenue sharing, mutual fund service fees).
  • Recommending only products from a select group of issuers, or making IPOs available only to certain clients, could also be considered a material limitation.
  • If an associated person of a dually registered broker-dealer only offers brokerage services, and is not able to offer advisory services, the fact that the associated person’s services are materially narrower than those offered by the broker-dealer would constitute a material limitation.
• Disclosing that the firm uses the entire universe of securities is not acceptable. Firms may want to disclose the processes for the selection of a “menu” of products that are available for recommendations to retail customers.
• If an associated person has a distinct investment approach, as may be the case with persons associated with an independent contractor broker dealer, the broker-dealer’s standardized disclosure should indicate how its associated persons will notify retail customers of their own investment approach. While oral disclosure could be relied upon, I would personally recommend a much more formal approach.

(B) All material facts relating to conflicts of interest that are associated with the recommendation.

• Start with conflicts referenced in Form CRS.
• Build upon those disclosures.
  • Would include material conflicts associated with recommending: proprietary products, products of affiliates, or a limited range of products, or one share class versus another share class of a mutual fund; securities underwritten by the broker-dealer or an affiliate; the rollover or transfer of assets from one type of account to another (such as a recommendation to roll over or transfer assets in an ERISA account to an IRA); and allocation of investment opportunities among retail customers (e.g., IPO allocation).
  • Also includes how a broker-dealer’s investment professionals are compensated, and the conflicts associated with those arrangements.
  • Where fees and compensation vary depending on what securities transaction or investment strategy involving securities is being recommended.
  • Disclose how sources of compensation may vary, for example being paid directly by the investor, or by a product sponsor, or a combination of both.
  • Discuss how the firm pays its associated persons different rates of compensation depending on the type of security they sell.
  •  Describe if the firm receives different payments from different product providers (e.g., mutual funds) for a variety of reasons, such as payments for inclusion on a broker-dealer’s menu of products offered (sometimes referred to as shelf space).
• Be certain to discuss the arrangement and the conflict that it presents.
• Does not require that information regarding conflicts be disclosed on a recommendation-by-recommendation basis. May be initial disclosures.
• Does not require specific written disclosure of the amounts of compensation received by the broker-dealer or the financial representative.
• May continue to receive higher compensation for recommending some products rather than others, whether received by the broker-dealer, the associated person, or both, as long as the firm establishes policies and procedures reasonably designed to mitigate the conflicts of interest that create an incentive for financial professionals to place the interest of the professional or broker-dealer ahead of the interest of the retail customer.  In this case, the firm must make full and fair disclosure of the material facts concerning conflicts raised by this practice.

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[1] For example, with regard to product-level fees, a broker-dealer could provide an initial standardized disclosure of product-level fees generally (e.g., reasonable dollar or percentage ranges), noting that further specifics for particular products appear in the product prospectus, which will be delivered after a transaction in accordance with the delivery method the retail customer has selected, such as by mail or electronically. Similarly, with regard to the disclosure of a broker-dealer’s capacity, a dual-registrant could disclose that recommendations will be made in a broker-dealer capacity unless otherwise expressly stated at the time of the recommendation, and that any such statement will be made orally. Or, a broker-dealer could disclose that its associated persons may have conflicts of interest beyond than those disclosed by the broker-dealer, and that associated persons will disclose, where appropriate, any additional material conflicts of interest not later than the time of a recommendation, and that any such disclosure will be made orally.