Financial Planning (May 16, 2024) - By Dan Shaw

It has been nearly five years since the SEC's adoption of Regulation Best Interest and four since the conduct standard started being enforced.

What have been the resultsAccording to data posted by the Financial Industry Regulatory Authority, the broker-dealer industry's self-regulator, there have been 42 cases brought under Reg BI's provisions since 2021, the first full year the rule was in effect. Of those, seven involved firms' alleged compliance failures in their customer relationship summaries — documents used mainly to disclose conflicts of interest.

That leaves 35 cases centered on Reg BI's central tenet, which, at its most basic interpretation, tells brokers to simply do what's in their clients' best interests. To Joe Peiffer, the president of the Public Investors Advocate Bar Association, it's "bananas" that the number of cases is so low.

"That they would have only that number in the whole country is just not that impressive to me," said Peiffer, also the founder of the New Orleans-based firm Peiffer Wolf Carr Kane Conway & Wise.

More on the way

Although some may view the Reg BI numbers as low, the increase in cases citing the conduct standard is undeniable. Of the 42 total cases so far, only one was brought in 2021, four in 2022 and 31 in 2023. Only six have been filed in 2024, but it's still fairly early.

FINRA and the SEC have long warned the industry that enforcement of the new conduct standard would become steadily stricter with time.

Speaking at his agency's national conference in Washington, D.C. this week, Jeff Fauci, the chief counsel for FINRA's department of enforcement, said regulators have clearly moved beyond the sorts of low-lying cases made against firms for not having proper disclosures in a customer relationship summary, or Form CRS, or not properly revising their written supervisory procedures.

"There's been nontraditional ETF cases, excessive-trading cases … and I think there's been a lot of subtle cases," Fauci said. "There's been a couple of complaints that have been charged against individual supervisors and against firms, as well."

A short history of Reg BI

Regulation Best Interest was approved by the SEC in June 2019 and put into effect a year later following much debate over how strict a conduct standard for broker-dealers should be. The rule it replaced — the so-called suitability standard — merely called on brokers to make sure any investments they were considering recommending were in fact a good fit for their clients.

The drafters of Reg BI sought to go beyond suitability by insisting that broker-dealers should always prioritize clients' best interests. They also introduced a "duty of care," requiring brokers to consider alternatives to any risky or pricey investment they might consider recommending.

If, in the end, brokers go with the riskier, pricier option, they have to provide justifications for their decision. 

To Mark Quinn, the director of regulatory affairs at the independent broker-dealer network Cetera, the duty to consider alternatives to favored investment recommendations is probably the biggest practical change brought about by Reg BI.

Most firms, Cetera included, have had to make use of technology to track not only what investments they put clients into but also what other options they considered and their reasons for their final choice. Quinn said Cetera relies on an automated system called RightBRIDGE, developed by the fintech firm CapitalROCK, for that purpose.

"But there are a number of other really good systems out there," Quinn said.

Quinn said it's true Reg BI doesn't specify the best way to make comparisons.

"If there are 100 firms out there now, then there are 100 ways to do it," he said. "But eventually a consensus will emerge on what's reasonable and what will be reasonably expected."

One way standardization is likely to come back is through enforcement. Firms often learn what they can do by being told what they can't.

Notable cases

Regulators have already let the industry know they're serious about the duty to consider alternatives and disclose conflicts of interest. 

In February, for instance, the SEC reached a $2.2 million settlement with a broker-dealer subsidiary of Teachers Insurance and Annuity of America, or TIAA, for alleged failures to let its customers select cheaper alternatives to mutual funds it was recommending. Other cases, like one resulting in a more than $6 million settlement with the independent broker-dealer LPL Financial, have been brought over accusations that firms weren't doing enough to supervise and monitor trades made on clients' behalf.

Industry lawyers often point out that many of the recent legal actions could have been brought just as easily under the old suitability standard. The law firm Eversheds Sutherland found in a recent look at FINRA enforcement in 2023 that the agency brought a full 33 cases last year citing unsuitable investments.

Meanwhile, some of the biggest Reg BI cases to fetch headlines were so egregious that they could have been brought under virtually any industry regulation. In July of last year, for instance, the SEC cited Reg BI in accusing a former U.S. Army Reserve financial counselor of defrauding bereaved military "Gold Star" families of millions.

Looking to regulators

Joe Wojciechowski, an investment fraud lawyer at Chicago-based Stoltmann Law, said he's waiting for regulators to sketch out more details of just what they expect from broker-dealers falling under Reg BI. Wojciechowski said he's particularly eager to see how the SEC and FINRA will respond to the large number of firms that are promoting private markets to clients.

Many of the investment opportunities in these markets — private equity, credit and real estate funds — are advertised as having potential for high returns. But they are also often more expensive and harder to pull money out of than similar vehicles traded on public exchanges.

Wojciechowski said he's looking forward to seeing how firms that recommend private investments explain their choices over public options that haven't got "6% commissions." The real test for Reg BI then, he said, will be to see how regulators respond when firms' justifications fall flat.

"How a private and speculative and risky and illiquid investment could be more in the client's best interest versus the public option — given the same level of potential return — I don't know," he said.

What do with conflicts

To some, the real question is over what brokers are required to do with conflicts of interest under Reg BI. 

In adopting the standard, the SEC insisted that merely disclosing conflicts is not enough for staying in compliance. Depending on how avoidable a given conflict might be, a broker may need to find a way to eliminate it, or at least mitigate it.

Reg BI's treatment of conflicts of interest is often contrasted with the way that the conduct standard for investment advisors, the fiduciary rule, treats similar situations. Fiduciaries are called on to always put their clients' interests first and eliminate conflicts as much as possible.

Knut Rostad, the president of the Institute for the Fiduciary Standard, said Reg BI is often touted for being flexible with conflicts. What it really is, he said, is ambiguous about which conflicts have to be mitigated or eliminated, rather than simply disclosed.

"Attorneys [for broker-dealers] basically decide if an incentive requires mitigation — or cannot be mitigated and must be eliminated," Rostad said.

To Peiffer, the way out of these puzzling questions is easy. It's stated right in Reg BI's name, he said.

"Act in the client's best interest," he said. "That's all you have to do."