On June 5, 2019, the SEC voted 3 to 1 to approve Regulation Best Interest, the most significant rulemaking and guidance impacting the standards of conduct applicable to broker-dealer and registered investment advisers since the Investment Advisers Act of 1940. The SEC noted that firms “need to start implementation right away” to meet the a one-year compliance deadline of June 30, 2020.
The SEC approved two new or amended rules and two Commission interpretations:
- Regulation Best Interest – New rule imposing an enhanced standard of conduct upon Broker-Dealer recommendations.
- Form “CRS” – New/amended rules requiring the development of Client Relationship Summaries for Broker-Dealers and Investment Advisers.
- Interpretation of the standard of conduct applicable to Investment Advisers.
- Interpretation of the “Solely Incidental” prong of the Investment Advisers Act of 1940.
Regulation Best Interest
In 2018, in the wake of the failed Department of Labor “Fiduciary Rule” proposal, the SEC proposed Regulation Best Interest, which establishes a new standard of conduct for broker-dealers when making a recommendation of a specific security or investment strategy to clients.
Regulation Best Interest expands the current “suitability” standard by requiring that the broker-dealer act in the best interest of the customer, which can be achieved by demonstrating compliance with four explicit obligations:
- Disclosure Obligation: Prior to or at the time of the recommendation, the broker-dealer must disclose all material facts to the customer regarding the terms and scope of the relationship (e.g., capacity, fees and charges) with the broker-dealer and all conflicts of interest associated with the recommendation. The disclosure must be made in writing, unless it is impossible or impractical to do so, in which case the disclosure must be made orally and documented in the firm’s records.
- Care Obligation: When recommending a securities transaction or investment strategy, the broker-dealer must exercise reasonable diligence, care, skill and prudence to understand the potential risks and rewards of the recommendation to believe that it is in the best interest of the client. The broker must consider reasonable alternatives and potential costs of the recommendation. In particular, when recommending a series of transactions, the broker-dealer must consider whether the transactions taken together are not excessive, even if each transaction in isolation is in the customer’s best interest.
- Conflict of Interest Obligation: Broker-dealers must maintain and enforce policies and procedures reasonably designed to identify, disclose, eliminate and mitigate conflicts of interest. The policies and procedures must eliminate incentives for brokers to put their interests in front of the client (e.g., sales contests / bonuses focused on a specific type of security within a limited period of time).
- Compliance Obligation: Broker-dealers must maintain and enforce policies and procedures reasonably designed to achieve compliance with Regulation Best Interest.
This significant overhaul to the standard applicable to broker-dealers was met with equal parts of acceptance and skepticism by consumer and industry groups. Commissioner Jackson echoed the disappointment that many investor advocacy groups expressed that the SEC did not go far enough to increase the standard of care applicable to broker-dealers to a “uniform fiduciary standard” more in line with the Department of Labor’s now-defunct fiduciary rule proposal. In light of that criticism, the SEC emphasized that it was important to account for the important differences between broker-dealer and investment adviser models, and by establishing different standards of care, investors can continue to avail themselves of different cost and advice models consistent with their individual goals.
New and amended disclosure rules will require that broker-dealers and investment advisers provide clients with a standardized set of information that investors can use to evaluate and compare the services they receive across various financial professionals. In particular, Form CRS will require disclosure of (i) fees, costs and the standard of conduct associated with a relationship; (ii) the services offered by a financial professional; (iii) relevant legal or disciplinary history; and (iv) links to investor education resources, as well as “conversation starter” questions that investors are encouraged to discuss with their brokers.
Standard of Conduct for RIAs
The SEC will publish a new interpretation of the standard of conduct applicable to investment advisers, seeking to clarify and reaffirm the duty of care and loyalty that an adviser has for its clients. In addition, the interpretation will discuss steps an investment adviser can take to appropriately tailor, through an agreement and informed consent, the nature of its relationship with a client. The guidance will also describe how the duty of care considerations differ for institutional clients compared to retail clients, and the “reasonable client” standard for assessing whether a client can understand and agree to firm disclosures.
“Solely Incidental” Exclusion for Broker-Dealers
Under the Investment Advisers Act of 1940, broker-dealers who advise clients are excluded from registering as investment advisers so long as the advice is given without “special compensation” and is “solely incidental” to the broker-dealer business. Under the new interpretation, the SEC will clarify that broker-dealers who exercise investment discretion in client accounts may not fall under the “solely incidental” exclusion of investment adviser registration. The interpretation also describes instances where broker-dealer account monitoring could trigger the enhance duties required under the Investment Advisers Act.
The SEC recognized that these new regulations come with a significant cost for compliance and implementation over the coming year, and encouraged firms to start implementing right away. During the one-year implementation period, the SEC will offer “significant assistance” to firms, who will need to dedicate substantial resources to reviewing and enhancing their policies, procedures, training and disclosures to comply these substantial rule changes.