May 29, 2018
Regulation Best Interest ("Reg BI") is a significant improvement over the original rule proposed by the Department of Labor. However, it is still a one size fits all proposal. The Commission has stated that when a person associated with a broker-dealer makes a recommendation of a security transaction or an investment strategy to a retail customer, the broker should act in the best interest of the customer. Best Interest is not defined. We are instructed that this obligation can be satisfied by providing (1) adequate disclosure (2) exercising reasonable due diligence, care, skill and prudence and (3) by identifying and mitigating all conflicts of interest. The specifics of how one satisfies these three obligations is left to the broker-dealer.
It is unlikely that a broker-dealer will allow the individual broker to decide if they have satisfied Reg BI. To ensure compliance, each broker-dealer will establish their own rules and guidelines that can be monitored by the firm. In larger firms, compliance staffs will be available to assist in achieving compliance. Several of the largest broker-dealers have already confirmed that they will be able to comply. But is this feasible for all broker-dealers?
In April 2018 there were approximately 642,200 persons registered with the Financial Industry Regulatory Authority (FINRA), collectively Associated Persons or APs. All Associated Persons are registered by at least one of the 3,700 FINRA member firms. The largest 368 broker-dealers, less than 10% of FINRAs membership, accounted for more than 574,800 Associated Persons or 90% of all APs.
More significantly, 1,775 broker dealers employed 10 or fewer Associated Persons. I will refer to these firms as MicroBDs. MicroBDs employ a total of 8,800 APs. MicroBDs are almost fifty percent of FINRA's member firms, but they represent less than one and one-half percent of all Associated Persons.(1)
A MicroBD is not likely to have a full-time compliance officer, much less a compliance department. Compliance duties are shared by the firms principals, often with support from one of many compliance support firms. MicroBDs already comply with FINRAs Know your Customer and suitability requirements. Over one thousand small broker-dealers have gone out of business over the past 10 years while the number of Associated Persons has remained relatively constant. While there are several reasons for this decline, the increasing cost of compliance has been a major factor. The added burden of compliance with Reg BI will likely cause many more small firms to close their doors.
If these small firms go out of business, who will be harmed other than the firms principals? Many of the accounts handled by the MicroBD are small accounts. Larger firms often establish minimum production targets for its Associated Persons, goals that cannot be readily achieved if the AP has a large number of clients with small accounts. A retail clients best interest can only be served if there is an Associated Person available and willing to provide assistance. A small account can often only be serviced by the small broker-dealer.
I would propose offering an exemption from Reg BI for those broker-dealer firms that have ten or fewer Associated Persons. In effect, by exempting the smallest firms, one would still capture over 98% of the Associated Persons.(2)
If a MicroBD wanted to avail itself of this exemption the retail client would acknowledge the fact that the broker-dealer had an exemption from Reg BI. The client would be asked to sign an agreement that, in plain and simple language, explains the difference between the current FINRA rules and Reg BI. This document would make it clear that the client could move the account to a larger firm. MicroBDs would have the option not to avail themselves of this exemption.
(1) Only 71% of the MicroBD APs hold a Series 7 license (General Securities License).
(2) If we exclude an additional 630 broker-dealers that employ 11-20 Associated Persons, Reg BI would cover an estimated 1300 Broker-dealers employing 97% of all Associate Persons.