On February 21, 2020, the Massachusetts Securities Division (the “MSD”) announced the finalization of its fiduciary rule.1Part I summarized the evolution of Massachusetts Fiduciary Rule (“Fiduciary Rule”) and the modifications from prior versions of the proposed rule released on June 14, 2019 and, as amended on December 3, 2019. This Part II summarizes the requirements of the Fiduciary Rule and compares the implementation requirements beyond what is required for compliance with the Securities and Exchange Commission’s (the “Commission”) Regulation Best Interest (“RegBI”).
1. Implementation and Enforcement
The Fiduciary Rule’s effective date is March 6, 2020; enforcement will begin on September 1, 2020.
Last September, at the annual meeting of the North American Securities Administrators Association (“NASAA”), Rick Fleming, the Investor Advocate for the Commission, acknowledged that in many ways Reg BI codified FINRA’s existing suitability requirements (rather that imposing the fiduciary standard for which he and many in the audience had advocated). In doing so, he cast Reg BI as a second chance for regulators to do what, in his view, many had not done with suitability: use their enforcement programs to illustrate the full extent of the requirements and, in certain instances, to expand the requirements beyond a plain reading of the rule.
It is prudent for the industry to expect that MSD will follow a similar roadmap in implementing its Fiduciary Rule. While the final Fiduciary Rule may be very similar to Reg BI on its face, it uses the term “fiduciary” and will be enforced by one of the most active, and often aggressive, enforcement divisions within the industry.
Broker-dealers (“BDs”) and their agents (“RRs”) impacted by the Fiduciary Rule should expect a broad interpretation of the Fiduciary Rule and an active enforcement program beginning in about 6 months.
2. To whom does the Fiduciary Rule apply?
The Fiduciary Rule applies to all BDs and RRs conducting securities business into and/or from Massachusetts. This means that any BD or RR with an office in Massachusetts and any BD or RR who does business with a client located in Massachusetts will be subject to the Fiduciary Rule, so long as the customer meets the Fiduciary Rule’s definition of customer (discussed in further detail below).
3. To whom do to the standards of the Fiduciary Rule and Reg BI apply?
The definition of a customer is broader under the Fiduciary Rule than Reg BI because it covers both entities and persons.
The Fiduciary Rule applies to current and prospective customers unless the customer is:2
- A bank, savings and loan association, insurance company, trust company, or registered investment company;
- A registered BD;
- A registered investment adviser; or
- Certain institutional buyers, like a:
- Qualified institutional buyer (“QIB”);
- Corporation with more than $5 million in assets, if the corporation is not formed for the purposes of investing and its investment decisions are made by persons who are reasonably believed by the seller to have such knowledge and experience in financial and business matters as to be capable of evaluating the merits and risks of investment; or
- Non-profit, if it has a securities portfolio of more than $25 million.3
Reg BI applies to natural persons, or their legal representative, who receive a recommendation of any securities transaction or investment strategy involving securities from a BD or RR and uses the recommendation primarily for personal, family, or household purposes.4
4. When do the Fiduciary Rule, Reg BI, and Suitability standards apply?
The “best interest” standard imposed by Reg BI is limited to the recommendation period, while the fiduciary duty imposed by the Fiduciary Rule applies during the recommendation period and will extend beyond the recommendation period when the circumstances described below are present.
Under the Fiduciary Rule, a BD and RR have a fiduciary duty when providing incidental advice in connection with a recommendation.5 The fiduciary duty extends beyond this recommendation period when the BD or RR has:6
- discretionary authority over a customer’s account;
- a contractual obligation that imposes a fiduciary duty; or
- a contractual obligation to monitor the customer’s account on a regular or periodic basis and then only during the term of that period (e.g., a duty to monitor once per quarter means the fiduciary duty applies during the course of the quarterly review).
When a BD or RR recommendation is excluded from the fiduciary standard, the BD and RR must comply with both FINRA’s and MSD’s suitability standard.7
Under Reg BI, a BD and RR must act in the best interest of a retail customer (i.e., a natural person) when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer and the suitability standards imposed by FINRA continue to apply to all recommended transactions or investment strategies involving securities.8
5. What are the duties imposed by the Fiduciary Rule and Reg BI?
Care Obligation: The Fiduciary Rule’s duty of care standard and Reg BI’s care obligations are substantially similar. Both rules require a BD and RR to use care, skill, and diligence when making recommendations and require the BD and RR to have a reasonable basis for the recommendation after considering certain factors, like risks, costs, rewards, and conflicts, and the client’s individual circumstances.
Disclosure Obligation: The Fiduciary Rule focuses solely on the disclosure of material conflicts. In addition to disclosure of material conflicts, Reg BI also requires disclosure of other material facts like the scope and terms of service and limitations on service.
Conflicts Obligation. The Fiduciary Rule imposes a more onerous standard than Reg BI. The Fiduciary Rule imposes an obligation to avoid conflicts to the extent reasonably practical and eliminate or mitigate conflicts that cannot be reasonably avoided. Further, disclosure alone is not sufficient.
Under Reg BI, the minimum standard is to identify and disclose or eliminate the conflict. Reg BI does not require a BD or RR to disclose and mitigate all conflicts. However, the Commission has “indicated that there may be situations in which disclosure alone is not sufficient and a [BD] may need to …eliminate the conflict or both disclose and mitigate it.” A few of these situations are addressed in Reg BI itself and requires a BD to have procedures reasonably designed to mitigate or eliminate that conflict.
While the standards of the Fiduciary Rule and Reg BI are slightly different, best practice would be to mitigate or eliminate conflicts to the extent practicable.
Fiduciary Duty. The Fiduciary Rule expressly applies a “fiduciary” obligation to BDs and RRs. As at common law, and in state and federal standards for investment advisers and their representatives, the duty prescribed under the Fiduciary Rule has two prongs: the duty of care and the duty of loyalty.
Duty of Care. In order to satisfy the duty of care, a BD or RR must “use the care, skill, prudence, and diligence that a person acting in a similar capacity and familiar with such matters would use, taking into consideration the relevant facts and circumstances.”9 A BD or RR must make a reasonable inquiry into the risks, costs, and conflicts of interest related to their recommendations and advice, the customer’s investment objectives, risk tolerance, financial situation, and needs, and any other relevant information.10
Duty of Loyalty. In order to satisfy the duty of loyalty, a BD and RR must:11
- disclose all material conflicts;
- make all reasonably practicable efforts to avoid conflicts of interest, eliminate conflicts that cannot reasonably be avoided, and mitigate conflicts that cannot reasonably be avoided or eliminated; and
- make recommendations and provide investment advice without regard to the financial or any other interest of any party other than the customer.12
To be clear, disclosure of material conflicts of interest without more is not enough to meet the duty of loyalty.13 Depending on the circumstances, the BD or RR will need to avoid or eliminate the conflict and if it cannot reasonably do so, then at least disclose and mitigate the conflict.14
Regulation Best Interest. Reg BI imposes a “best interest” obligation, which requires a BD and RR to act in the best interest of its customer at the time of a recommendation.15 This “best interest” obligation is satisfied when a BD or RR complies with certain disclosure, care, conflicts of interest, and compliance obligations.
Care Obligation. In order to satisfy the care obligation, a BD or RR must exercise reasonable diligence, care, and skill when making a recommendation.16 This means the BD or RR needs to understand the potential risks, rewards, and costs of a recommendation and have a reasonable basis to believe that (i) the recommendation is in the best interest of the client based on these factors and the customer’s investment profile and (ii) the recommendation does not place the interest of the BD or RR ahead of the clients.17 Note, that this does not require the customer’s interests to be placed ahead of the BD or RR, only that the customer’s interests cannot be subordinate to the BD and RR’s interests.
Disclosure Obligation. In order to satisfy the disclosure obligation, a BD or RR must make a full and fair disclosure of all material facts on the scope and terms of the relationship (e.g., capacity, material fees and costs that apply, the type and scope of services provided, and material limitations on securities that may be recommended) and all material facts relating to conflicts of interest associated with the recommendation.18
Conflicts of Interest Obligation. Reg BI requires a BD to establish and enforce written policies and procedures reasonably designed19 to: (i) identify and at a minimum disclose or eliminate conflicts of interest; (ii) identify and mitigate conflicts that incentivize a RR to place the interests of the BD or RR ahead of the customer; (iii) identify and disclose any material limitations on securities that may be recommended and conflicts associated with the limitation, prevent such limitations from causing the BD or RR to place interests of the BD or RR ahead of the client’s interests; and (iv) identify and eliminate sales contests, sales quotas, bonuses, and non-cash competition based on the sales of specific securities or specific types of securities within a limited period of time.20
Compliance Obligation. A BD must establish and enforce written policies and procedures reasonably designed to comply with Reg BI.21
6. How does suitability fit in?
Under the Fiduciary Rule, BDs and RRs must, at all times, continue to comply with the suitability standard. To comply with the suitability standard, BD’s and RR’s must have “reasonable grounds to believe that such transaction or recommendation is suitable for the customer based upon reasonable inquiry concerning the customer’s investment objectives, financial situation and needs, and any other relevant information known by the broker-dealer.”22
Reg BI enhances the BD standard of conduct beyond existing suitability obligations, but the suitability standard continues to apply at all times.23 To comply with FINRA’s suitability standard, BD’s and RR’s must have “a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer's investment profile.”24
Suitability has both a qualitative and quantitative prong. Qualitative suitability requires that the recommender possess a thorough understanding of the product, the customer’s investment objectives, and whether the product/transaction as utilized in the customer’s account is suitable in light of the customer’s objectives.25 Quantitative suitability relates to a series of transactions rather than a single transaction. A BD or RR violates the quantitative suitability standard when excessively trading customer accounts they control without a reasonable basis.26 Quantitative suitability generally requires that the return on investment exceed the costs associated with the transactions recommended.
7. Sales Contests
Unlike Reg BI, the Fiduciary Rule does not place the sales contests restriction within the context of an obligation to create and implement policies and procedures reasonably designed to eliminate sales contests. Thereby arguably enhancing BD’s accountability for their RR’s conduct.
The Fiduciary Rule’s sales contest prohibition is broader than Reg BI. Reg BI’s restriction is limited to sales of specific securities or types of securities within a limited period of time. The Fiduciary Rule has no similar limitation.
Both Reg BI and the Fiduciary Rule address the inherent conflicts of sales contests. However, the Fiduciary Rule is more pointed and broader in scope as compared to Reg BI.
Under the Fiduciary Rule, a BD or RR will be presumed to have breached the duty of loyalty, and thus their fiduciary duty, if the BD or RR makes a recommendation in connection with a sales contest regarding an investment strategy, the opening or transferring of assets to a specific type of account, or the purchase, sale, or exchange of any security.27
Reg BI requires BDs to create and implement policies and procedures to identify and eliminate sales contests based on the sale of specific securities or types of securities within a limited period of time.28
8. When does the Fiduciary Rule not apply?
The final Fiduciary Rule excludes municipal securities, commodities, and insurance products.
Importantly, as noted in Part I, the final Fiduciary Rule excludes municipal securities, commodities, and insurance products. In the Adopting Release, MSD explained that: “Multiple commenters wrote that variable annuities and insurance products are excluded from the definition of ‘security,’ as defined in M.G.L. c. 110A, § 401(k) and that the Proposal should be limited only to securities. In response, the [MSD] has removed the express language regarding advice on commodities and insurance products from the Final Regulations.”29
We strongly caution registrants in Massachusetts to be careful in taking too much comfort in the apparent exclusion of variable annuities from the scope of the Fiduciary Rule.
The MSD has a long history of asserting its enforcement authority relative to the sale of annuities, particularly variable annuities, in Massachusetts.30 MSD has argued, for example, that the recommendation to Massachusetts customers to sell securities and purchase annuities with the proceeds of the sale gives MSD jurisdiction over the entire course of conduct.31
9. What are the risks of non-compliance with Fiduciary Rule?
A final order finding a violation of the Fiduciary Rule could result in an administrative fine, the suspension or revocation of the BD’s or RR’s registration in Massachusetts, and collateral consequences including statutory disqualification in other states, or by FINRA and/or the Commission.
The Fiduciary Rule makes it a dishonest and unethical practice for a BD or RR to fail to act in accordance with its fiduciary duty (when applicable) and/or to make an unsuitable recommendation to a customer regarding an investment strategy, opening of any type of account, transferring assets to any type of account, and/or purchasing, selling, or exchanging any security.32 A finding that a BD or RR has engaged in a dishonest and unethical practice can result in the revocation or suspension of their license to conduct securities business in Massachusetts, an administrative fine, and, sometimes most impactful of all, collateral consequences including statutory disqualification in other states, or by FINRA and the Commission.33
Footnotes
