Reg. BI – The Disclosure Obligation, Part I (Scope and Terms of the Relationship with the Retail Customer)

As we’ve discussed previously, Regulation Best Interest imposes four obligations on broker-dealers that make recommendations to retail customers: a Disclosure Obligation, a Care Obligation, a Conflict of Interest Obligation, and a Compliance Obligation. We’ll talk about each of these, but let’s get into the Disclosure Obligation first.[1]

So what does the Reg. BI Disclosure Obligation require?

At the time of a recommendation, a broker-dealer must provide the retail customer “full and fair” written disclosure of all material facts relating to: (1) the scope and terms of the relationship with the retail customer; and (2) conflicts of interest associated with the recommendation.

You can imagine what material facts are here. The SEC basically interprets those the same way it interprets materiality in other aspects of the federal securities laws – that is, consistent with the standard laid out in Basic v. Levinson, 485 U.S. 224 (1988). Essentially, information is material if there is a “substantial likelihood that a reasonable shareholder [or retail customer] would consider it important.”

The Scope and Terms of the Relationship with the Retail Customer

Anyway, let’s talk about No. 1 first. If you’re a B-D or an associated person, you have to disclose these material facts on the scope and terms of your relationship to your retail customers:

• the role the B-D is playing in making the recommendation (that is, as a B-D or an associated person)

• the fees and other costs that apply to the retail customer’s transactions, holdings, and accounts;

• the general basis for your recommendations (your investment approach or strategy);

• the general risks associated with your recommendation; and

• the type and scope of the services you’ll be providing to the retail customer, including any material limitations on the securities or investment strategies you might recommend. When discussing the services you’re providing, you also have to include:

  • whether you’ll monitor the retail customer’s account and, if so, how; and

  • any requirements to open or maintain an account, such as a minimum account size.

And if you have any other material facts the SEC didn’t mention explicitly that the retail customer should know, you have to disclose those, too. We’ll break more of this down – including material limitations on your recommendations – in later posts.

[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.