Reg. BI – The Disclosure Obligation, Part 2: Conflicts of Interest (and Fees!)

Under Regulation Best Interest, the second major topic broker-dealers have to make disclosures about is conflicts of interest it might have with their retail customers.[1] Because fees and costs will often be the source of potential conflicts, we’ll address those in this post as well. So what are the material facts on conflicts associated with a recommendation that must be disclosed?

For purposes of Reg. BI, a “conflict of interest” is an interest that might incline a B-D or an associated person – consciously or unconsciously – to make a recommendation that is not disinterested. Proprietary products, payments from third parties, compensation arrangements – these all could make a recommendation “not disinterested”. A broker-dealer has to disclose all material facts relating to those.

And that makes sense! If:

1. you’re a retail customer, and

2. a B-D is recommending that you invest in a particular mutual fund, and

3. that mutual fund is proprietary to the B-D, and

4. the B-D will therefore receive compensation based on the investment in that proprietary fund . . .

. . . you would be interested in knowing that!

What fees and costs must be disclosed?

The Disclosure Obligation requires disclosure of material fees and costs relating to a retail customer’s transactions, holding, and accounts. Materiality here is the same kind of materiality you see in other securities contexts. Fees and costs are material if there’s a “substantial likelihood that a reasonable [retail customer] would consider it important.”

This obligation does not require individualized disclosure for each retail customer. Using standardized numerical disclosures (including reasonable dollar or percentage ranges) is permissible. So a B-D can give retail customers, say, a sheet explaining the management fees associated with different levels of investment for different funds, and let the customers figure out which percentages will apply to them. That sheet should not be a Byzantine, incomprehensible hodgepodge of numbers that makes it difficult for the customer to figure out the answer.

The SEC says that generally a B-D can build on the material fees and costs identified in the Form CRS (Relationship Summary), and then provide additional detail as appropriate.

[1] In Cady’s Regulation Best Interest series, we’ll largely be breaking down the SEC’s Small Entity Compliance Guide into smaller chunks and, we think, easier language.