Regulation Best Interest: Understanding and Compliance

The promulgation of the SEC’s Regulation Best Interest (Reg BI) marked a significant moment in the broker-dealer industry, reflecting a transformative shift in how brokers are expected to interact with retail investors. Before Reg BI, broker-dealers operated under a suitability standard, which required them to ensure that any investment recommendation was appropriate for the client's financial situation and goals. However, critics argued that this standard allowed brokers to recommend products that, while technically suitable, might not have been the best option for the client. Many argued that this opened the door to conflicts of interest, such as recommending products that offered higher commissions to the broker, even if other lower-cost alternatives might have better served the investor's needs.

With the introduction of Reg BI, the regulatory landscape changed substantially. The new rule requires broker-dealers to act in the best interest of their clients, elevating the standard of conduct and pushing the industry closer to a fiduciary-like model when making recommendations to retail customers. This represents a significant shift in how broker-dealers have to approach their client relationships, as it places a higher expectation on them to prioritize client outcomes over their own financial incentives. This upward shift in standards was intended to address the potential harm that sales-driven practices had caused, where brokers could push high-commission products that weren’t necessarily in the client’s best interest.

General Obligation

According to the General Obligation under Reg BI, broker-dealers are required to “act in the best interest of the retail customer . . . without placing the financial or other interest of the [broker-dealer] ahead of the retail customer”, ensuring that their customer’s interests are prioritized above their own. While the SEC chose not to define the term “best interest,” it issued extensive guidance and interpretations regarding the application of the rule.

As noted in the rule’s final release, Reg BI draws on principles similar to those underpinning the fiduciary duty that applies to investment advisers under the Advisers Act. Indeed, the SEC acknowledged that “key elements of the standard of conduct that applies to broker-dealers under Regulation Best Interest will be substantially similar to key elements of the standard of conduct that applies to investment advisers pursuant to their fiduciary duty under the Advisers Ac at the time that a recommendation is made.” Still, while there are extensive similarities, the Commission was careful to point out that it has chosen not to apply the existing fiduciary standard under the Advisers Act to broker-dealers in its entirety and retained some key differences tailored to the broker-dealer business model.

For example, the fiduciary duty of an investment adviser generally applies to the entire adviser-client relationship and includes an ongoing duty to monitor the client's account. In contrast, the obligations under Reg BI apply specifically when a recommendation is made, reflecting the transactional and episodic nature of broker-dealer relationships with retail customers.

Reg BI is designed to protect investors and enhance transparency in the financial markets and is centered around four main obligations that broker-dealers must meet: Disclosure Obligation, Care Obligation, Conflict of Interest Obligations, and Compliance Obligation. These specific component obligations detail what it actually means to “act in the best interest” of the retail customer. The General Obligation to act in the customer’s “best interest” is satisfied only if the broker-dealer complies with all these four specified component obligations.

Disclosure Obligation 

Broker-dealers must provide retail customers with full and fair disclosure of all material facts concerning the scope and terms of their relationship, as well as conflicts of interest that are associated with the recommendation prior to or at the time of the recommendation. This includes disclosing fees, the broker’s capacity, any material limitations on the services offered, and any potential conflicts of interest. It applies to a broker, dealer, or natural person who is an associated person of a broker or dealer. Financial professionals have an independent duty to ensure that all material disclosures are made and, while they can rely on the materials prepared by their firms, if those are insufficient, they are required to supplement them to ensure the required level of transparency. The standard of materiality under Reg BI was determined to be that articulated by the Supreme Court in Basic v. Levinson where information was found to be material if there was “a substantial likelihood that a reasonable shareholder would consider it important.”

While the discussion of all the specific guidance issued and rule provisions is beyond the scope of this essay, a few of the newly issued interpretations are notable. For example, through their interpretation of Reg BI, the SEC explicitly prohibited financial professionals associated with broker-dealers and not registered as investment advisers from using the titles “adviser” and “advisor” because those terms were found too closely related to the statutory term “investment adviser” and their use by broker-dealers could inaccurately communicate to investors that they are regulated as investment advisers.

In addition, consistent with the requirement that “any material limitations on the securities or investment strategies involving securities that may be recommended to the retail customer” be disclosed, the SEC interpreted Reg BI to require disclosures where, for example, a broker-dealer or their associated person is limited to recommending only proprietary products or products from a select group of issuers, a specific asset class, or products with third-party arrangements involving revenue sharing or mutual fund service fees, or limits availability to participate in IPOs to select clients.

The SEC also noted that whether the broker-dealer will monitor the retail customer’s account and the scope and frequency of any account monitoring services that a broker-dealer agrees to provide are material facts under Reg BI and must be disclosed. But, as the interpretive guidance makes clear, broker-dealers are not obligated to provide account monitoring services.

Defining “conflict of interest” “as an interest that might incline a broker to either consciously or unconsciously make a recommendation that is not disinterested,” the SEC stated the compensation arrangements or how the broker is compensated must be disclosed but that no specific or individual numerical compensation disclosure is required.

Finally, Reg BI requires broker-dealers to deliver to retail investors a Relationship Summary, “provid[ing] succinct information about the relationships and services the firm offers to retail investors, fees and costs that retail investors will pay, specified conflicts of interest and standards of conduct, and disciplinary history, among other things.” In the Relationship Summary, the broker-dealer must also address whether they offer monitoring of investments.

The primary objective of the Disclosure Obligation is to ensure customers are fully informed about the nature of their relationship with the broker-dealer and any conflicts that might influence the advice they receive.

Care Obligation 

The Care Obligation has three main components. First, a broker must understand the potential risks, rewards, and costs related to a product, investment strategy, or account type. This is a threshold requirement that every broker must meet. To comply with this requirement, a broker needs to “undertake reasonable diligence, care, and skill to understand the nature of the recommended security or investment strategy.” This is especially important for complex investment products such as inverse and leverage or volatility-linked exchange-traded products that reset daily and present unique and sometimes large investment risks.

Second, and akin to the FINRA’s “customer-specific suitability requirement,” a broker must reasonably understand the retail investor’s investment profile, including their financial situation, assets, liabilities, income, investment goals, time horizon, risk tolerance, and any relevant personal details they provide. In order to develop such a reasonable understanding of the customer’s investment profile, broker-dealers must collect sufficient information to allow them to properly evaluate and determine what the customer’s investment profile is.

And, finally, after having a reasonable understanding of the investment and the investor’s profile, and after considering reasonable alternatives, a broker must have a reasonable basis to conclude that their recommendation to the retail investor is in the investor’s best interest. Not every single alternative product must be evaluated, but the financial professional is required to conduct a reasonable review of reasonably available alternatives. What’s reasonable is dependent on the facts and circumstances of each individual case.

The “reasonable basis” component of the Care Obligation is an objective standard and is evaluated on the facts and circumstances specific to the recommendation. And financial professionals have an independent duty to understand the investment or investment strategies before recommending them to their customers and cannot simply rely on their firms’ reviews and approved investment lists to satisfy their duty of care obligation.

The SEC placed considerable emphasis on the fact that cost must always be considered by a financial professional, including any upfront costs as well as deferred charges, when making recommendations. Still, while it is important and must always be considered, cost is not solely determinative of suitability and, the Reg BI standard does not necessarily require that the lowest-cost investment be always recommended. Instead, other qualitative factors might favor other, even more costly, investments.

The Care Obligation does not require broker-dealers to document their basis for recommendations. However, the guidance strongly suggests that in certain circumstances such documentation be made. For example, in cases where the recommendation appears to be in conflict with the customer’s investment profile, risk tolerance, or investment objective, or where complex investment products were recommended, documenting the rationale for the recommendation is highly advisable.

The goal of the Care Obligation is to ensure brokers provide well-founded advice and prioritize customer interests over their own.

Conflict of Interest Obligation

Reg BI defined broadly what constitutes a “conflict of interest” under the rule. It is “an interest that might incline a broker-dealer—consciously or unconsciously—to make a recommendation that is not disinterested.” The Conflict of Interest Obligation requires broker-dealers to establish, maintain, and enforce written policies and procedures reasonably designed to identify, and at a minimum, disclose, or in certain circumstances eliminate all conflicts of interest associated with the recommendation.

The Commission highlighted the importance of having a structured process for identifying and categorizing conflicts of interest as a foundation for broker-dealers to develop effective policies that meet the Conflict of Interest Obligation. These policies should clearly define conflicts in a way that aligns with the broker-dealer's operations, outline procedures for identifying current and potential conflicts, and incorporate regular reviews to adapt to changes in the business or its compensation and product offerings. Training programs should be implemented to equip employees to recognize conflicts and understand their responsibilities in managing them.

One of the most significant requirements is to both identify and eliminate any conflicts of interest associated with “sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sale of specific securities or specific types of securities within a limited period of time.” However, transaction-based compensation does not need to be eliminated.

The Commission recognized that there is no one-size-fits-all approach to designing policies and procedures that comply with the Conflict of Interest Obligation, and Reg BI allows for flexibility and customization of the policies and procedures to fit different business models.

Compliance Obligation

Broker-dealers must establish, maintain, and enforce policies and procedures reasonably designed to achieve compliance with Reg BI. While firms need robust compliance frameworks to ensure all aspects of the regulation are followed, including regular monitoring, training, and supervision, the are no specific requirements enumerated in the rule that broker-dealers must include in their policies and procedures, allowing for flexibility in their design to meet specific needs and business models of the broker-dealers. This obligation underscores the importance of building a culture of compliance to protect retail investors and ensure adherence to the regulation's requirements.

Regulation Best Interest represents a significant step forward in enhancing investor protection and fostering greater accountability in the broker-dealer industry. By establishing a clear framework that prioritizes the best interests of retail customers, Reg BI has addressed longstanding concerns about conflicts of interest and sales-driven practices that often undermined client outcomes. Its four core obligations—Disclosure, Care, Conflict of Interest, and Compliance—set a higher standard for broker-dealers, balancing flexibility for diverse business models with strict expectations for transparency and ethical conduct.

While challenges remain in implementation and oversight, Reg BI has laid a strong foundation for a more investor-focused approach, ultimately fostering trust and confidence in the financial markets. As the industry continues to adapt, the regulation serves as a reminder that the financial professional’s responsibility to act in the best interest of their clients is not just a regulatory requirement but an essential element of ethical practice.