Minimizing Liability Under the SEC’s Reg-BI

By looking beyond Reg-BI’s June 30, 2020 compliance date to some of the litigation risks posed by Reg-BI, this article addresses:

• The possible litigation risks Reg-BI poses to broker-dealers and their associated persons;
• whether new damages are available to customers under Reg-BI; and
• strategies to mitigate the litigation risks.

Overview of Reg-BI

Reg-BI imposes a general obligation that is only satisfied when each of four component obligations are met: (1) the disclosure obligation, (2) the care obligation; (3) the conflict of interest obligation and (4) the compliance obligation.[1]

The General Best Interest Obligation

The general or “best interest” obligation states:

(1) A broker, dealer or a natural person who is an associated person of a broker or dealer, when making a recommendation of any securities transaction or investment strategy involving securities (including account recommendations) to a retail customer, shall 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 or natural person who is an associated person of a broker or dealer making the recommendation ahead of the interest of the retail customer.

(2) The best interest obligation in paragraph (a)(1) of this section shall be satisfied if [the (i) the disclosure obligation; (ii) the care obligation; (iii) the conflict of interest obligation and (iv) the compliance obligation are met]” (BI-Standards at 765-768).

The Disclosure Obligation

The disclosure obligation requires broker-dealers and their associated persons:

“prior to or at the time of the recommendation, [to] provide the retail customer, in writing, full and fair disclosure of:

all material facts relating to the scope and terms of the relationship with the retail customer; and all material facts relating to conflicts of interest that are associated with the recommendation.”

According to the Small Entity Guide, “material facts relating to the scope and terms of the relationship” include:

• the capacity in which the broker-dealer or associated person is acting;
• material fees and costs for transactions, holdings and accounts;
• the scope of the services, including material limitations on securities or investment strategies that can be recommended;
• whether the account will be monitored and the frequency of monitoring;
• the requirements to maintain an account;
• the investment approach or strategy; and
• the associated risks in standardized terms (See Id).

A “conflict of interest” is “an interest that might incline” a broker-dealer, or associated person “– consciously or unconsciously – to make a recommendation that is not disinterested.” Id. Examples include “conflicts associated with proprietary products, payments from third parties and compensation arrangements.” Id. Material facts will be interpreted consistent with the Basic v. Levinson standard — a fact will be material if there is a “substantial likelihood that a reasonable [retail customer] would consider it important.” Id.

The Care Obligation

Regarding the care obligation, which is applicable to firms and associated person, the Small Entity Guide states:

Under the care obligation, you must exercise reasonable diligence, care and skill when making a recommendation to a retail customer to:

• Understand potential risks, rewards and costs associated with recommendation, and have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers;
• Have a reasonable basis to believe the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks, rewards and costs associated with the recommendation and does not place the interest of the broker-dealer ahead of the interest of the retail customer; and
• Have a reasonable basis to believe that a series of recommended transactions … is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile.

Whether you have complied with the care obligation will be evaluated as of the time of the recommendation (and not in hindsight).

The Conflict of Interest Obligation

Under the conflict of interest obligation, a broker-dealer must establish, maintain and enforce written policies and procedures reasonably designed to address conflicts of interest associated with its recommendations to retail customers.” Id. And they must be reasonably designed to:

• disclose or eliminate all conflicts of interest associated with such recommendations;
• mitigate conflicts of interest that incentivize associated persons to place their interest or the broker-dealer’s interest above the retail customer’s;
• disclose material limitations (g., a limited product menu) on recommendations and any associated conflicts of interest and to prevent these limitations from causing the broker-dealer or the associated person to place their interest over the retail customer’s interest; and
• “eliminate sales contests, sales quotas, bonuses and non-cash compensation” for sales of specific securities or types of securities in a limited time period (Id).

The Compliance Obligation

The compliance obligation requires broker-dealers to “establish, maintain and enforce written policies and procedures reasonably designed to achieve compliance with” Reg-BI, which  should take into account the nature of their operations, be designed to prevent violations, detect violations, promptly correct violations and include “controls, remediation of noncompliance, training and periodic review and testing” (Id).

What litigation risks will Reg-BI pose to broker-dealers and their associated persons?

While there will likely be disputes with retail customers regarding whether they received timely “full and fair” written disclosures concerning all material facts relating to (1) the “scope and terms of the relationship” and (2) the “conflicts of interest that are associated with the recommendation” under the disclosure obligation, the care and compliance obligations pose greater risks of increased litigation.

Even though the SEC has stated that it does not believe that Reg-BI “creates any new private right of action or right of rescission, nor do we intend such a result,” (BI-Standards at 43), the care and compliance obligations will likely increase litigation risks for two reasons:

1. Most retail customer claims are brought as FINRA arbitrations. While the law is clear that there is no private right of action for violation of self-regulatory organization rules, like FINRA (see e.g., Liskey v. Oppenheimer & Co., 717 F.2d 314, 321 (6th Cir. 1983) (noting that district court had dismissed claims based on NYSE and NASD rules because there was no private right of action for violation of those rules)), customer claims in FINRA arbitrations routinely allege violations of FINRA rules as causes of action.
2. Reg-BI’s obligations will likely be considered industry standards of care that are relevant to negligence and other claims. (See, e.g., Scott v. Dime Savings Bank, 886 F. Supp. 1073, 1080-81 (S.D. N.Y. 1995) (violation of NASD “suitability rules” could be viewed as evidence of whether broker-dealer acted reasonably under negligence claim)).

The Reg-BI care obligation imposes duties on broker-dealers and associated persons that exceed the current suitability requirements:

“The care obligation significantly enhances the investor protection provided as compared to current suitability obligations by:

• explicitly requiring in regulation best interest that recommendations be in the best interest of the retail customer and do not place the broker-dealer’s interests ahead of the retail customer’s interests;
• explicitly requiring by rule the consideration of costs when making the recommendation; and
• applying the obligations relating to a series of recommended transactions (currently referred to as “quantitative suitability”) irrespective of whether a broker-dealer exercises actual or de facto control over a customer’s account. In addition, it is our view that a broker-dealer should consider “reasonably available alternatives” as part of having a reasonable basis to believe” that the recommendation is in the best interest of the retail customer, which we also believe is an enhancement beyond existing suitability expectations (BI-Standards at 253-254).

The care obligation “enhancements” over existing suitability requirements are areas of additional litigation risk, which include whether:

• the broker-dealer or associated person exercised the required “reasonable diligence, care and skill” to meet the care obligation (see BI-Standards at 247);
• the recommendation was in the best interest of the retail customer;
• the broker-dealer or associated person put their interests ahead of the retail customer’s interests;[2] and
• the firm had reasonable policies and procedures to ensure compliance with this requirement.

Litigation is also likely concerning whether a broker-dealer or associated person adequately considered the potential costs associated with a particular recommendation. These costs include “both costs associated with the purchase of the security, as well as any costs that may apply to the future sale or exchange of the security, such as deferred sales charges or liquidation costs” (BI-Standard s at 249.) Although the potential cost is not a dispositive factor, it must always be considered when making a recommendation (See Id).

Reg-BI’s requirement that “when making a recommendation to a particular retail customer, broker-dealers must weigh the potential risks, rewards and costs of a particular security or investment strategy in light of the particular retail customer’s investment profile” (see Id. at 270) adds another dimension of potential litigation risk. The investment profile must include “the retail customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance and any other information the retail customer may disclose” to the broker-dealer or associated person (BI-Standards at 768). “Broker-dealers must obtain and analyze enough customer information to have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer” (Id. at 276).

The SEC’s position that a “broker-dealer should consider ‘reasonably available alternatives’ as part of having a ‘reasonable basis to believe’ that the recommendation is in the best interest of the retail customer” (Id. at 254) is another area for potential litigation risk. Even though Reg-BI does not require an “evaluation of every possible alternative” or the recommendation of “the single ‘best’ of all possible alternatives that might exist” (Id. at 284-285), disputes may still arise over whether there was an appropriate comparative assessment of reasonably available alternatives, as well as over the adequacy of the policies and procedures concerning compliance with this obligation. There may also be an issue over whether the broker-dealer had “a reasonable process for establishing and understanding the scope of such ‘reasonably available alternatives’ that would be considered by particular associated persons or groups of associated persons (e.g., groups that specialize in particular product lines)” to fulfill the “reasonable diligence, care and skill requirements under the care obligation” (Id. at 287).

Are there new damages under Reg-BI?

Nothing in Reg-BI expressly creates different damages from those now commonly sought by retail customers, and only time will tell if claimants are able to develop viable claims for different damages.

Strategies to Mitigate Litigation Risk

Good contemporaneous documentation, which is important today, will be a key strategy for avoiding increased liability under Reg-BI. Whether the recommendation is in the best interest of the retail customer and did not place the interests of the broker-dealer ahead of those of the retail customer “must be based on information reasonably known to the associated person (based on her reasonable diligence, care and skill) at the time the recommendation is made” (See Id at 286).

However, litigation over the recommendation will likely occur years later when circumstances may have changed, and memories have faded. Comprehensive contemporaneous documentation of the information known at the time of the recommendation as well as the analyses conducted by the firm or associated person prior to the recommendation of costs, reasonably available alternatives and other best interest factors will be key to defending the claim and mitigating potential exposure.

As the SEC notes, although Reg-BI does not require such documentation, “broker-dealers may wish to consider documenting the basis for determining that the recommendation is in the best interest of the retail customer when it is not evident from the recommendation itself” (Id. at 278). This is particularly important if the recommended security costs more than other alternative investments or results in greater remuneration to the firm or associated person.

Firms will also need to implement, test and enforce written policies and procedures reasonably designed to achieve compliance with Reg-BI to meet their compliance obligation. These policies and procedures need to address the Reg-BI’s enhancements to existing suitability obligations. The steps that the firm uses to determine if costs are appropriately being taken into account, if reasonably available alternatives are required to be considered and if the customer’s interests are given priority will all be at issue in Reg-BI cases.

Robust policies and procedures that are utilized and enforced will help mitigate litigation exposure to Reg-BI’s enhanced obligations and will be key to the defense of customer claims.

[1] The SEC’s Small Entity Compliance Guide for Reg-BI (the “Small Entity Guide”) provides a good general overview of the obligations that Reg-BI imposes. It can be found at: https://www.sec.gov/info/smallbus/secg/regulation-best-interest. A more detailed granular level discussion of Regulation Best Interest can be can be found at https://www.sec.gov/rules/final/2019/34-86031.pdf (“BI-Standards”). Another helpful source is FINRA’s Reg BI and Form CRS Firm Checklist, at: https://www.finra.org/sites/default/files/2019-10/reg-bi-checklist.pdf.

[2] While broker-dealers and associated persons “can and will have some financial interest in a recommendation …  the care obligation makes clear that these interests cannot be placed ahead of the retail customer’s interests when making a recommendation” (BI-Standards at 252).