What Is Best Interest?
The "Best Interest" standard, particularly as embodied in Regulation Best Interest (Reg BI), is a regulatory requirement that mandates broker-dealers and their associated persons act in the best interest of their retail customers when making investment recommendations. This standard, falling under the broader category of Financial Regulation, aims to enhance investor protection by requiring financial professionals to prioritize their clients' interests over their own or their firm's financial incentives. It specifically addresses issues related to conflicts of interest in the financial advisory space.
History and Origin
Prior to June 30, 2020, broker-dealers were primarily governed by a "suitability" standard, largely enforced by the Financial Industry Regulatory Authority (FINRA). This suitability standard required that recommended investments be appropriate for a client's financial situation and objectives, but it did not explicitly mandate that the recommendation be the best available option for the client or that the broker's interests be subordinate.
The landscape began to shift with growing concerns about conflicts of interest in the financial industry, especially as the lines between traditional brokerage services and investment advice blurred. While registered investment advisors were already held to a fiduciary duty under the Investment Advisers Act of 1940, broker-dealers operated under a different standard.24 This disparity led to calls for greater investor protection. In response, the U.S. Securities and Exchange Commission (SEC) adopted Regulation Best Interest in 2019, with a compliance date of June 30, 2020.23 The SEC's intent was to raise the standard of conduct for broker-dealers beyond mere suitability, requiring them to act in the best interest of their retail customers without placing their own financial or other interests ahead of the customer's.21, 22
Key Takeaways
- The Best Interest standard requires broker-dealers to prioritize their retail customers' interests when making investment recommendations.
- It was implemented by the SEC through Regulation Best Interest (Reg BI) and became effective on June 30, 2020.
- Reg BI mandates that firms address potential conflicts of interest and provide transparent disclosures to clients.
- This standard aims to bridge the gap between the former suitability rule and the more stringent fiduciary duty.
- Compliance involves meeting four core obligations: Disclosure, Care, Conflict of Interest, and Compliance.
Formula and Calculation
The concept of "Best Interest" is a regulatory standard of conduct, not a mathematical formula or calculation. It does not involve a specific quantitative output or a direct equation. Instead, adherence to the Best Interest standard is assessed based on qualitative factors and the processes a financial professional follows to ensure recommendations are in a client's best interest, considering their specific circumstances.
Interpreting the Best Interest
Interpreting the Best Interest standard involves an objective assessment of whether a broker-dealer's recommendation aligns with the retail customer's overall financial situation and objectives. It goes beyond simply being "suitable" and requires a deeper consideration of the recommendation's potential risks, rewards, and costs.20
A core aspect of interpreting "Best Interest" is ensuring that the recommendation does not prioritize the financial professional's or firm's interests, such as higher commissions or incentives for selling proprietary products, over the client's. Firms must undertake due diligence to understand the recommended product or strategy and have a reasonable basis to believe it is in the client's best interest based on their unique investment profile, including their risk tolerance.19
Hypothetical Example
Consider a retail customer, Sarah, who has a moderate risk tolerance and is saving for retirement in 15 years. Her broker, John, is considering recommending two exchange-traded funds (ETFs) that track the same broad market index.
- ETF A: Has an expense ratio of 0.10% and is offered by a third-party provider. John's firm receives no additional compensation for recommending this ETF.
- ETF B: Has an expense ratio of 0.25% and is a proprietary product of John's firm, which provides John a higher internal bonus for its sale.
Under the Best Interest standard, John would need to assess both ETFs based on Sarah's investment profile. While both might be "suitable" for a moderate-risk retirement saver, recommending ETF B solely due to the higher bonus would violate the Best Interest standard because it places John's financial interest ahead of Sarah's by recommending a higher-cost alternative for the same exposure. To act in Sarah's best interest, John would likely recommend ETF A due to its lower cost, even if it means less compensation for him.
Practical Applications
The Best Interest standard finds its primary application in the regulation of investment advice provided by broker-dealers to retail investors. It impacts how financial firms:
- Develop and Review Products: Firms must ensure that the financial products and investment strategies they offer can be recommended in a retail customer's best interest.
- Train Financial Professionals: Broker-dealers must educate their registered representatives on identifying and mitigating conflicts of interest and understanding the client's investment profile thoroughly.
- Disclose Information: Firms are required to provide clear and concise disclosures regarding the nature of their relationship with the customer and any material conflicts of interest. The SEC requires broker-dealers and investment advisers to provide a brief relationship summary, Form CRS, to retail investors.18
- Compliance Monitoring: Broker-dealers implement policies and procedures to ensure ongoing compliance with the Best Interest standard across all recommendations.17 The Financial Industry Regulatory Authority (FINRA) provides resources and guidance to assist broker-dealers with these compliance efforts.15, 16
The standard aims to ensure that interactions with retail customers prioritize the customer's financial well-being.
Limitations and Criticisms
Despite its aim to enhance investor protection, the Best Interest standard has faced several limitations and criticisms. One common critique is that it does not go far enough to establish a full fiduciary duty for broker-dealers, unlike the standard applied to registered investment advisers. Critics argue that this leaves room for certain conflicts of interest to persist, even with disclosure and mitigation requirements.14
Another area of concern is the standard's principles-based approach rather than a rigid set of rules. While intended to offer flexibility, this approach can lead to inconsistencies in how different firms interpret and implement the regulation, potentially resulting in varying levels of investor protection. Some have voiced concern that the lack of a precise definition of "best interest" could lead to ambiguity and potential litigation.12, 13 Additionally, some critics suggest that the emphasis on disclosure might not fully protect investors who do not thoroughly understand complex financial disclosures.11
Best Interest vs. Fiduciary Duty
While both the "Best Interest" standard (under Reg BI) and fiduciary duty aim to protect investors, they represent different levels of legal obligation and apply to different types of financial professionals.
| Feature | Best Interest (Reg BI) | Fiduciary Duty |
|---|---|---|
| Applies To | Broker-dealers when making recommendations to retail customers. | Registered Investment Advisers (RIAs) when providing investment advice to clients. Also applies to trustees and other positions of trust. |
| Core Principle | Act in the best interest of the retail customer without placing the financial or other interest of the broker-dealer ahead of the customer's interest.10 | Act with utmost good faith, loyalty, and care, always putting the client's interests above their own. This includes an affirmative duty of full and fair disclosure of all material facts and a duty to avoid conflicts of interest, or at least disclose and manage them.9 |
| Conflicts | Requires identification and mitigation of conflicts; in some cases, elimination. Disclosure alone is not sufficient.8 | Requires avoidance of conflicts of interest where possible; otherwise, full and fair disclosure and informed consent from the client. Disclosure alone is not sufficient to satisfy the duty of care.7 |
| Compensation | Can be compensated by commissions or other product-based payments, but must manage associated conflicts. | Typically compensated by fees (e.g., assets under management, hourly), which generally minimizes product-based conflicts of interest. |
The primary distinction lies in the historical regulatory frameworks and the comprehensiveness of the duty owed. Fiduciary duty is generally considered a higher standard, demanding a more proactive and unwavering commitment to the client's interests, often requiring the avoidance of certain conflicts entirely.
FAQs
Q: Does the Best Interest standard apply to all financial professionals?
A: No, the Best Interest standard under Regulation Best Interest (Reg BI) primarily applies to broker-dealers and their associated persons when they make investment recommendations to retail customers. Registered investment advisers are subject to a fiduciary duty, which is generally considered a higher standard of care.6
Q: How does Best Interest differ from the old suitability standard?
A: The "Best Interest" standard is stricter than the previous suitability standard. Suitability only required that an investment recommendation be appropriate for a client's profile. Best Interest goes further by requiring that the recommendation must be in the customer's best interest, explicitly preventing the financial professional from prioritizing their own financial gain or their firm's interests over the client's.4, 5
Q: What should I expect from a financial professional under the Best Interest standard?
A: You should expect your financial professional to understand your financial situation, goals, and risk tolerance. They are required to recommend investments that are in your best interest and to disclose any material conflicts of interest they may have. The firm should also provide you with a Form CRS, a summary of their relationship and services.2, 3
Q: Can a recommendation still be in my best interest if the advisor earns a commission?
A: Yes, a recommendation can still be in your best interest even if the financial professional earns a commission. However, under the Best Interest standard, the firm must have policies and procedures in place to identify and mitigate conflicts of interest that arise from such compensation, ensuring that the commission does not improperly influence the recommendation away from your best interest.1