Since 2010 and the passing of Dodd-Frank, the SEC and the industry have wrestled with how to minimize the inherent conflict between commission sales and a client’s right to obtain “disinterested” advice. Now, nearly a decade later, Regulation Best Interest is here and will fundamentally impact our industry in its attempt to mitigate that conflict. The question of whether a cross-border broker-dealer has acted in a client’s “best interest” will no longer be a matter of individual subjective discretion. Instead, that determination will be made subject to strict, disciplined guidelines by the SEC.
Reg BI will now require significant review of both broker-dealer and advisory offerings for an expanded level of conflict disclosure, and, in certain SEC-urged circumstances, mitigation or elimination of those conflicts. In addition, it will require a fundamentally new, disciplined and documented methodology for individual recommendations that has led some to openly question whether the commission model can survive under it.
Regulation Best Interest Generally
Under Reg BI, broker-dealers and investment advisers must provide layered disclosures and diligence at the firm, broker and product levels. Each of those obligations arise for broker- dealers at the time they “recommend” to a “retail customer” a securities transaction or investment strategy involving securities. Recommendations also extend to what type of account to open.
On its face, Reg BI’s mandate is not remarkable. It simply requires broker-dealers to act in the “best interest” of their retail customers when making recommendations about particular securities or investment strategies. The context of this “best interest” determination centers almost exclusively on prohibiting the broker-dealer from placing its financial interest ahead of the customer’s, and disclosing any information which may lead the customer to believe that the broker-dealer is not consciously or unconsciously “disinterested.” The difference is that now the SEC is requiring specific measures to document and confirm the methodology of reaching that determination.
Cross-Border Application
Because of the way the cross-border private wealth business delivers many of its services, satisfying those obligations could have a uniquely disadvantageous impact on our industry. Unlike the domestic investor, non-U.S. resident investment into U.S. accounts is often driven by non-economic factors including dollarization of currency risk, family security and risk, geographic diversification, and the international tax considerations tied to those. Further, non- U.S. resident investors often operate in languages other than English. Also, brokers who service non-U.S. resident clients often travel to meet their clients in countries that present additional layers of law and regulation and may legally constrain the in-country performance of certain service activities.
Smaller Shops
Many cross-border service providers are smaller broker-dealers or advisers that have limited offerings and platforms. In its mandate to fully disclose the scope and terms of the relationship with its customer, the SEC newly emphasizes the disclosure of any material limitations a broker-dealer may operate under, including limited licensing consequences, proprietary or limited product range, and limited strategy availability. Smaller firms may well bear a disproportionate amount of the compliance burden and cost in implementation. It is clear,
however, that the availability of only a limited range of product will not protect a firm or broker from Reg BI non-compliance.
An Expanded Duty of Care
While many cross-border brokers operate under FINRA Rule 2111 (suitability), Reg BI’s enhanced suitability requirements will force greater and deeper knowledge of a client’s investment profile —specifically, tax status — in order to formulate a compliant recommendation. The obligation not only requires “diligence, care and skill” in making disinterested recommendations, but will now require that the methodology used in considering alternatives, costs, and consequences of the recommendation be thoroughly documented. Those variables must then be analyzed in application to a particular customer’s investment profile before a compliant recommendation can be made. Importantly, a customer’s investment profile must include a documented analysis of the customer’s tax status and the impact of any recommendation under that status. Under this “show your work” methodology, the ability to minimize the importance of client tax status will be largely lost.
Broker Compensation
Because the SEC views certain bonuses as too pernicious to be merely disclosed or mitigated, benchmark and target-laden packages under which many now work, may need to be revised or eliminated. In a marked departure from its disclosure-oriented philosophy, the SEC has now determined that certain types of conflict are so harmful that only eliminating them will suffice. While some, like sales contests, and sales quotas, have largely been abandoned by a self-policing industry, the application of that elimination strategy to other modes of
compensation remains unclear. Accordingly, the viability of benchmark-laden revenue goals is now in substantial question.
Non-Economic Investment Considerations
At its core, Reg BI is heavily premised on “objectively verifiable” performance indicators that disregard some of the main drivers to cross-border investment—such as geographic diversity, dollarization of assets, privacy and security, and complex structures for tax and succession planning. While the SEC has also noted that these “highly personalized non-economic” drivers may also factor into the best interests inquiry, how those factors will be weighed remains unclear.
Document Delivery and Prospects
Reg BI is triggered when a recommendation is made. That trigger could well create obligations upon a broker regardless of whether the recipient has an account that may actually execute the trade. While much uncertainty remains as to when Reg BI applies, it is important to note that the SEC is urging heightened consideration in making recommendations to prospects.
“[A] broker-dealer should carefully consider the extent to which it can make a recommendation to prospective retail customers, including having gathered sufficient information that would enable them to comply with Regulation Best Interest… should the prospective retail customer use the recommendation.”
Conclusion
At first blush, Reg BI appears to be the SEC’s innocuous response to the mandates of Dodd-Frank. But when applied to the cross-border banking industry, Reg BI will significantly impact the ways that broker-dealers interact with their international customers. Many are questioning the viability of the brokerage model given the increased compliance costs. Others are advocating a limiting of recommended stocks or clients eligible for recommendations. All these options themselves would require conflict disclosure under Reg BI!
We will all look expectantly to how the industry responds.
Column by Sergio Alvarez-Mena, Partner, Financial Institutions Litigation and Regulation Practice, Jones Day Miami, and Lance Maynard, University of Miami School of Law (JD/MBA 2020)
