Coren Stern, Partner, Leon Cosgrove, Coral Gables

Regulation Best Interest (Reg BI) is a new Securities Exchange Commission rule that enhances the broker-dealer standard of conduct beyond the existing suitability obligations. This new rule, which calls for compliance by June 30, 2020, requires broker-dealers to only recommend financial products that are in the customers' best interests, and to clearly identify any potential conflicts of interest and financial incentives the broker-dealer may have with those products. Reg BI is, in part, designed to eliminate, or at least minimize, financial conflicts of interest inherent in broker-dealers' recommendations to customers. In doing so, Reg BI attempts to address the concept of a transaction-based compensation system for financial advisers, wherein financial advisers are paid for recommending to and placing trades for their customers. Accordingly, it is interesting that the SEC also addressed the issue of “implicit” hold recommendations, as such a recommendation is, by its very nature, the lack of a recommendation at all, and in fact, comes at no cost to customers in commission-based accounts.

With this in mind, it is worth noting that in approving this new rule, the SEC took great pains to define what constitutes a “recommendation.”  This new definition is important, in that it departs from certain aspects of FINRA Rule 2111, which previously defined broker-dealer's suitability obligations. Previously, Rule 2111 used a facts and circumstances analysis to determine if a recommendation had been made. See FINRA Regulatory Notice 11-02 at 2. According to FINRA Notice to Members 11-02, in determining whether a recommendation was made under Rule 2111, a communication's content, context, and presentation would be important aspects of the inquiry. With respect to hold recommendations, however, FINRA very clearly stated that, under Rule 2111, while the term “investment strategy” should be interpreted broadly, it would only encompass hold recommendations in the event there was an explicit recommendation to do so. Under Reg BI, by contrast, the SEC has stated that while it remains a facts and circumstances inquiry, hold recommendations do not always have to be explicit in order to fall within the purview of Reg BI.

Specifically, Reg BI is broadening the circumstances where a hold recommendation is to be evaluated as a recommendation or strategy. While explicit hold recommendations continue to be recommendations for the purposes of the new rule, the SEC has clearly stated that Reg BI does not impose a duty on broker-dealers to continually monitor customers' accounts. See ”Regulation Best Interest: The Broker-Dealer Standard of Conduct,” Release No. 34-86031, File No. S7-07-18 at 102 (June 5, 2019). With this in mind, however, if broker-dealers agree to monitor customers' accounts on a periodic basis, a lack of a recommendation by such broker-dealers will be viewed by the SEC as “implicit” recommendations to hold, and thus, be covered by Reg BI. This is a significant departure from a broker-dealer's obligations under the prior suitability standard, which did not recognize “implicit” hold recommendations. In discussing this particular scenario, the SEC stated,

We believe that “implicit” hold recommendations in this context, where the broker-dealer agrees to provide specified account monitoring services, are similar to explicit hold recommendations that are considered “investment strategies” because they would constitute the type of recommendations that retail customers would be expected to rely upon and would be a “call to action” in the sense of a recommendation that the customer stay the course. We believe that, in this context, silence is tantamount to an explicit recommendation to hold, and should be viewed as a recommendation to hold the securities for purposes of Regulation Best Interest.

It is notable, however, that the SEC has specifically indicated that this context is unique, i.e. there is no implicit hold recommendation where the broker-dealer has not agreed to provide account monitoring services. In that case, only an explicit hold recommendation would be considered a recommendation or investment strategy such that Reg BI would impose a duty to make a recommendation in the customer's best interest. Furthermore, it is also important to consider that even in the absence of an agreement to monitor customers' accounts, under Reg BI, broker-dealers may voluntarily review the holdings in their customers' accounts for the purpose of determining whether to provide recommendations. Under these circumstances, the SEC would not consider this review to be “account monitoring,” nor would it create some sort of implied agreement to monitor the customer's account that would activate the best interests standard.

The long and short of this is that broker-dealers need to seriously consider whether or not they wish to offer account monitoring services to their clients. If they do, they need to make sure they have policies and procedures in place to ensure that a reasonable basis exists for their customers' investments and account allocations, as a sudden market downturn that results in the devaluation of a customer's portfolio could result in liability if a broker-dealer agreed to monitor their clients' accounts, even if they made no recommendation at all.

Coren Stern is a partner with Leon Cosgrove in Coral Gables. He chairs its securities litigation and regulatory practice.