Regulation Best Interest and Derivative Sales
intermediatePublished: 2026-01-01
Regulation Best Interest and Derivative Sales
SEC Regulation Best Interest (Reg BI) establishes a standard of conduct for broker-dealers when making recommendations to retail customers, including recommendations involving derivatives and structured products. The regulation requires broker-dealers to act in the best interest of customers without placing their own interests ahead of the customer's interest.
Definition and Key Concepts
Regulation Best Interest Overview
Regulation Best Interest: SEC rule requiring broker-dealers to act in the best interest of retail customers when making securities recommendations.
| Component | Requirement |
|---|---|
| Disclosure obligation | Provide Form CRS, disclose material facts |
| Care obligation | Reasonable basis, customer-specific, no excess trading |
| Conflict of interest | Identify, disclose, mitigate, eliminate conflicts |
| Compliance obligation | Policies and procedures to achieve compliance |
Scope for Derivatives
| Product | Covered by Reg BI |
|---|---|
| Listed options | Yes (if recommended) |
| Structured notes | Yes |
| OTC derivatives (retail) | Yes |
| Exchange-traded products | Yes |
| Institutional swaps | No (not retail) |
Retail Customer Definition
| Entity Type | Retail Customer? |
|---|---|
| Natural person | Yes |
| Trust for natural person | Yes |
| Corporation | No |
| ERISA plan | Depends on plan type |
| High net worth individual | Yes (no accredited exemption) |
How It Works in Practice
Disclosure Obligation
Form CRS requirements:
| Disclosure Item | Content |
|---|---|
| Services offered | Types of accounts, derivatives access |
| Fees and costs | Commission, spreads, margin interest |
| Conflicts of interest | Compensation structures, proprietary products |
| Disciplinary history | Any reportable events |
Point-of-sale disclosures:
| Disclosure | Timing |
|---|---|
| Product risks | Before recommendation |
| Costs and fees | Before recommendation |
| Conflicts | Before recommendation |
| Documentation | Contemporaneous |
Care Obligation
Three components:
| Component | Requirement |
|---|---|
| Reasonable basis | Understand the product and its risks |
| Customer-specific | Suitable for this customer's profile |
| Quantitative | No excessive trading or costs |
For derivatives:
| Factor | Consideration |
|---|---|
| Complexity | Does customer understand payoff? |
| Risk/reward | Appropriate for customer's risk tolerance? |
| Cost | Are costs reasonable for strategy? |
| Alternatives | Is there a less complex alternative? |
Conflict of Interest Obligation
| Conflict Type | Example | Required Action |
|---|---|---|
| Compensation-based | Higher commission on product | Disclose, mitigate |
| Proprietary product | Firm's structured note | Disclose, ensure suitability |
| Revenue sharing | Third-party payments | Disclose |
| Principal trading | Firm is counterparty | Disclose, best execution |
Worked Example
Recommending Covered Call Strategy
Scenario: Registered representative recommends covered call writing to a retail customer.
Customer profile:
| Attribute | Value |
|---|---|
| Age | 58 |
| Investment objective | Income, moderate growth |
| Risk tolerance | Moderate |
| Time horizon | 10 years |
| Options experience | None |
| Net worth | $1.2 million |
| Annual income | $150,000 |
Recommended strategy:
- Buy 500 shares XYZ at $100 ($50,000)
- Sell 5 XYZ covered calls, 30-day, $105 strike at $2.00 ($1,000 premium)
Disclosure obligation compliance:
| Item | Disclosure |
|---|---|
| Product description | Covered call mechanics, max gain capped |
| Risk factors | Stock can decline, upside limited |
| Costs | Commission: $50 stock + $10 options |
| Conflicts | Firm earns commission on both legs |
Care obligation analysis:
| Component | Analysis | Conclusion |
|---|---|---|
| Reasonable basis | Covered calls generate income, limit upside | Appropriate for income objective |
| Customer-specific | Moderate risk matches strategy | Suitable |
| Quantitative | One trade, not excessive | Compliant |
Documentation:
| Document | Content |
|---|---|
| Account application | Risk tolerance, objectives documented |
| Options agreement | Signed options disclosure, approval level |
| Trade confirmation | Strategy, costs, conflicts noted |
| Call recording | Conversation regarding recommendation |
Higher-Risk Derivative Recommendation
Scenario: Recommending a leveraged structured note linked to an index.
Product characteristics:
| Feature | Value |
|---|---|
| Underlying | S&P 500 |
| Leverage | 2x on first 15% gain |
| Downside | 1:1 participation |
| Maturity | 3 years |
| Issuer risk | Bank credit |
| Fee | 1.5% embedded |
Enhanced due diligence required:
| Factor | Consideration |
|---|---|
| Complexity | Can customer understand 2x leverage? |
| Issuer credit | Is customer aware of credit risk? |
| Liquidity | Secondary market may be limited |
| Alternatives | Could use options or ETF instead |
Suitability factors for approval:
| Customer Factor | Minimum Threshold |
|---|---|
| Net worth | $500,000+ |
| Investment experience | Moderate or higher |
| Risk tolerance | Moderate or higher |
| Time horizon | Match to maturity |
Risks, Limitations, and Tradeoffs
Compliance Risks
| Risk | Description | Consequence |
|---|---|---|
| Inadequate disclosure | Missing material facts | SEC/FINRA enforcement |
| Unsuitable recommendation | Not appropriate for customer | Customer complaint, liability |
| Undocumented rationale | No record of analysis | Examination findings |
| Conflict not addressed | Hidden compensation | Enhanced scrutiny |
Enforcement Actions
| Violation | Typical Penalty |
|---|---|
| Reg BI violation | Censure, fine ($5K - $250K) |
| Pattern of violations | Suspension, bar |
| Firm-wide failure | Undertaking, monitor |
| Customer harm | Restitution required |
Common Pitfalls
| Pitfall | Description | Prevention |
|---|---|---|
| Form over substance | Disclose but don't explain | Ensure customer understanding |
| Stale information | Outdated customer profile | Annual review |
| Generic suitability | Same recommendation for all | Customer-specific analysis |
| Compensation bias | Recommend higher-fee products | Mitigate through supervision |
| Documentation gaps | Verbal recommendations | Record keeping |
Supervision Requirements
Firm Obligations
| Requirement | Description |
|---|---|
| Written procedures | Document Reg BI policies |
| Training | Educate associated persons |
| Supervision | Review recommendations |
| Monitoring | Detect violations |
| Recordkeeping | Maintain for examination |
Review Process
| Review Type | Frequency | Focus |
|---|---|---|
| Pre-trade review | Complex products | Suitability, disclosure |
| Post-trade review | Sample or triggered | Compliance verification |
| Branch examination | Annual | Process adherence |
| Surveillance | Ongoing | Patterns, red flags |
Checklist and Next Steps
Pre-recommendation checklist:
- Verify customer profile is current
- Confirm options/derivatives approval level
- Analyze product suitability
- Identify applicable conflicts
- Prepare required disclosures
- Document recommendation rationale
Point-of-sale checklist:
- Deliver Form CRS (if not previously provided)
- Explain product mechanics and risks
- Disclose all costs and fees
- Describe conflicts of interest
- Confirm customer understanding
- Obtain necessary acknowledgments
Post-trade checklist:
- Verify trade executed as discussed
- Confirm disclosures were provided
- Document customer communications
- Complete supervision review
- Archive records per retention policy
- Monitor position performance
Firm compliance checklist:
- Maintain written Reg BI procedures
- Train all associated persons
- Implement supervision system
- Conduct periodic testing
- Address identified deficiencies
- Update for regulatory changes
Related articles:
- For collateral requirements, see Collateral Optimization Strategies
- For model controls, see Model Governance and Controls Requirements