Quick Answer
Regulation Best Interest requires broker-dealers to act in a retail customer's best interest through four obligations: disclosure, care, conflict of interest, and compliance. FINRA suitability, with its reasonable-basis, customer-specific, and quantitative types, still governs where Reg BI does not reach, such as institutional accounts. Know Your Customer applies to everyone.
With an understanding of how firms communicate with the public, you can now examine the standards that govern what firms actually recommend. This is the most complex and frequently tested topic in this unit.
Regulation Best Interest (Reg BI)
Regulation Best Interest establishes the SEC's standard of conduct for broker-dealers when making recommendations to retail customers.
Core requirement: The broker-dealer must act in the customer's best interest at the time of the recommendation.
The Four Component Obligations
Reg BI is satisfied by complying with four component obligations:
| Obligation | What It Requires |
|---|---|
| 1. Disclosure | Provide the customer with Form CRS and make full and fair disclosure of all material facts, including conflicts of interest |
| 2. Care | Exercise reasonable diligence, care, and skill in making the recommendation |
| 3. Conflict of Interest | Establish written policies to identify, disclose, and mitigate or eliminate conflicts of interest |
| 4. Compliance | Establish written policies and procedures to achieve compliance with Reg BI |
Exam Tip: Gotchas
- Reg BI has four obligations, not just "act in the best interest." The exam tests all four: Disclosure, Care, Conflict of Interest, and Compliance. Knowing the standard exists is not enough; know what each obligation requires.
Form CRS (Customer Relationship Summary)
Form CRS is a brief, plain-language summary required by the SEC that helps retail investors understand the firm:
- Length: capped at 2 pages for a standalone broker-dealer or investment adviser, or up to 4 pages for a dual registrant (a firm registered as both) combining both sides into one summary
- Content: Services offered, fees and costs, conflicts of interest, disciplinary history, and how to get more information
- Delivery: Must be provided at the beginning of the relationship or before/at the time of a recommendation
Exam Tip: Gotchas
- Form CRS is capped at 2 pages, or 4 pages for a dual registrant. It is a brief summary, not a comprehensive disclosure document. The cap is a maximum, not a required or fixed length.
FINRA Suitability Obligations
While Reg BI governs recommendations to retail customers, FINRA's suitability rule still governs recommendations that Reg BI does not reach (for example, recommendations to institutional customers). Suitability has three obligations:
| Suitability Type | What It Requires |
|---|---|
| Reasonable-basis | The recommendation is suitable for at least some investors - the product makes sense generally |
| Customer-specific | The recommendation is suitable for the specific customer based on their individual investment profile |
| Quantitative | The series of recommended transactions, taken together, are not excessive for the customer (anti-churning) |
Exam Tip: Gotchas
- Reg BI applies to broker-dealer recommendations to retail customers only. It does not apply to institutional customers or self-directed trades.
- FINRA suitability does NOT apply where Reg BI applies. For a retail-customer recommendation, Reg BI's "best interest" standard governs. FINRA suitability remains the operative standard only where Reg BI does not reach, such as recommendations to institutional accounts. The two rules cover different customers, not the same customer at different strengths.
- Quantitative suitability targets churning. Churning is excessive trading that generates commissions but not returns for the customer.
Know Your Customer (KYC)
FINRA's Know Your Customer obligation requires firms to use reasonable diligence to know the essential facts about every customer.
A firm must know enough to:
- Effectively service the account
- Identify the person with authority to act on the account
- Comply with applicable laws and regulations
Customer information collected includes:
- Investment objectives
- Risk tolerance
- Financial situation (income, net worth)
- Tax status
- Time horizon
- Liquidity needs
- Other holdings
Exam Tip: Gotchas
- KYC applies to every customer, not just those receiving recommendations. Even self-directed accounts require the firm to know essential facts about the customer.
What Constitutes a "Recommendation"?
Not every communication is a recommendation. Understanding the line matters:
| IS a Recommendation | Is NOT a Recommendation |
|---|---|
| Suggesting a specific security to buy | Providing general financial education |
| Recommending an investment strategy | Responding to an unsolicited inquiry about a specific security |
| Suggesting an account type | Providing research reports without a call to action |
A recommendation is a communication that, based on its content, context, and manner of presentation, could reasonably be viewed as a suggestion to take action.
Think of it this way: If the firm is nudging the customer toward a specific action, it is a recommendation. If the customer came up with the idea on their own, it is unsolicited and neither Reg BI nor suitability applies.
Exam Tip: Gotchas
- An unsolicited trade does not trigger Reg BI or suitability. The customer initiated the idea, not the firm. The firm must still execute the trade, but the best interest and suitability standards only apply to firm-initiated recommendations.
What Should You Check on Exam Day?
- Can you name the four component obligations of Regulation Best Interest?
- Do you know the page limits for Form CRS for a standalone firm versus a dual registrant?
- Can you explain the three types of FINRA suitability and when each applies?
- Do you know when FINRA suitability governs instead of Reg BI?
- Can you explain why an unsolicited trade does not trigger Reg BI or suitability?