The U.S. Securities and Exchange Commission, on June 5, 2019, voted 3-1 in favor of adopting a package of rules, amendments and interpretations (Final Rules)1 intended to improve the retail investor experience and to provide greater clarity for investors regarding the differences in the roles played by, and standards of conduct applicable to, broker-dealers and investment advisers.2 The Final Rules consist of two rulemakings (Regulation Best Interest and Form CRS) and two interpretive releases (pertaining to the “solely incidental” prong of the broker-dealer exclusion from registration as an investment adviser, and the standard of conduct for investment advisers).
SEC Chairman Jay Clayton stated that “[t]his rulemaking package will bring the legal requirements and mandated disclosures for broker-dealers and investment advisers in line with reasonable investor expectations, while simultaneously preserving retail investors’ access to a range of products and services at a reasonable cost.”3
In the end, and consistent with the initial proposals from April 18, 2018 (Proposed Rules), the SEC decided not to create a uniform standard of conduct for broker-dealers and investment advisers, but instead “adopt[ed] an enhanced investor-protection standard for broker-dealers that maintains the availability of both the broker-dealer model and the investment adviser model.”4 The SEC reasoned that adopting a uniform standard “would not appropriately reflect the fact that broker-dealers and investment advisers play distinct roles in providing recommendations or advice and services to investors, and may ultimately harm retail investors.” Rather, the set of actions taken by the SEC on June 5 clarify that the fiduciary responsibilities of investment advisers apply to their entire relationship with clients, whereas the duties of broker-dealers are generally “transactional and episodic,” unless otherwise agreed to by contract.
The SEC’s interpretation of the standard of conduct for investment advisers and the “solely incidental” prong of Section 202(a)(11)(C) of the Investment Advisers Act of 1940 will become effective upon publication in the Federal Register. Regulation Best Interest and the Form CRS Relationship Summary will become effective 60 days after their publication in the Federal Register. As discussed below, the compliance date for Regulation Best Interest and Form CRS is June 30, 2020.
This Newsflash provides a brief overview of the Final Rules. Dechert will provide a more in-depth analysis in an upcoming OnPoint as to the Final Rules and the issues broker-dealers and investment advisers are likely to face.
Regulation Best Interest
The SEC adopted Regulation Best Interest largely as proposed, including choosing not to include a definition of “best interest;”5 however, the final Regulation Best Interest rules reflect certain meaningful modifications. Regulation Best Interest requires broker-dealers to act in the best interest of retail customerswhen making recommendations to them regarding any “securities transaction or investment strategy involving securities (including account recommendations)” and to place the interests of the retail customer ahead of the financial or other interests of the broker-dealer (General Obligation). The SEC stated that scienter is not needed to show a violation of Regulation Best Interest; however, the SEC further stated that it does not intend to provide for a private cause of action or rescission rights in the event of a violation.
The General Obligation is triggered when a recommendation is made to a retail customer. The definition of “retail customer” remains substantially unchanged from the proposed rule, and covers persons, or legal representatives of such persons, who receive a recommendation of a securities transaction or investment strategy involving securities and use the recommendation “primarily for personal, family or household purposes,” including ERISA retirement accounts. Consistent with long-standing FINRA interpretations, the SEC did not adopt a specific definition or bright-line test for when a “recommendation” is made, instead choosing to retain the principles-based approach outlined in the proposed rule. Accordingly, determining if a recommendation has been made (and therefore the General Obligation is triggered) is based on traditional factors such as “whether the communication ‘reasonably could be viewed as a call to action’ and ‘reasonably would influence an investor to trade a particular security or group of securities’” and whether the communication was tailored to a specific customer or group of customers.
As adopted, the General Obligation explicitly applies to recommendations as to the type of account a retail customer might consider, including recommendations to open accounts generally and recommendations to roll over assets from one type of account to another. These recommendations are viewed by the SEC as “investment strategies.” The SEC also clarified that broker-dealers are not required to monitor their retail clients’ accounts on an ongoing basis. However, if a broker-dealer agrees to provide ongoing monitoring, the General Obligation is triggered and, even if a broker-dealer does not expressly recommend a change, the broker-dealer will be viewed as having made an implicit hold recommendation.6
Further, the SEC clarified that, with respect to ERISA retirement accounts, the General Obligation is triggered when a recommendation is made to a retail client about taking distributions “from proceeds of specific securities or to take in-service loans from an employer-sponsored plan,” because these transactions involve the sale of a security. The General Obligation will not be triggered, however, by a broker-dealer’s communications relating to required minimum distributions, or education regarding a plan’s options.
The General Obligation will be satisfied if the broker-dealer complies with the four component obligations of care, disclosure, conflicts of interest and compliance.
- Care Obligation. The key component of the best interest standard is the Care Obligation, which incorporates and enhances the current suitability standards applied by the SEC and FINRA. The Care Obligation requires that, in making a recommendation, a broker-dealer exercise “reasonable diligence, care, and skill” in satisfying the following three requirements:
Reasonable Basis Requirement: The broker-dealer must have a reasonable basis to believe that its recommendation with respect to a particular security or investment strategy could be in the best interest of “at least some” retail customers, taking into account the “potential risks, rewards, and costs associated with the recommendation.”
Customer-Specific Requirement: The broker-dealer must have a reasonable basis to believe that the recommendation is in the best interests of the specific retail customer, “based on that retail customer’s investment profile and the potential risks, rewards and costs associated with the recommendation and does not place the financial or other interest of the [broker-dealer or the associated person of the broker-dealer] ahead of the interest of the retail customer.” The broker-dealer must take into consideration: the retail customer’s investment profile;7 risks; and the fees and costs associated with the recommendation or series of recommendations.
Quantitative Requirement: With respect to a series of transactions, the broker-dealer must have a reasonable basis to believe that the series, viewed as a whole, is in the best interests of the retail customer and is not excessive, even if each transaction would be in the retail customer’s best interests when viewed individually. Further, the recommendation cannot place the “financial or other interest of the [broker-dealer or the associated person of the broker-dealer] ahead of the interest of the retail customer,” and the broker-dealer must take into consideration the same factors as with respect to the customer-specific requirement.
Notably, Regulation Best Interest does not require a broker-dealer to exercise prudence in meeting its duty of care, as originally proposed. While the SEC linked this determination to concerns about legal uncertainty and confusion, it also noted that inclusion of “prudence” would have been redundant in light of the requirement that a broker-dealer exercise “diligence, care, and skill.”
Regulation Best Interest includes a requirement that broker-dealers “must always” consider the cost of the recommendation (including upfront costs and “any costs that may apply to the future sale or exchange of the security, such as deferred sales charges or liquidation costs”) and whether there are other alternative products that may be better for the retail client. The SEC noted that this standard should not be construed as requiring the broker-dealer to always recommend the lowest cost product, but rather that cost should be a factor.8 The Care Obligation will be “evaluated at the time of the recommendation (and not in hindsight) and will focus on whether the broker-dealer had a reasonable basis to believe that the recommendation is in the best interest of the retail customer.” (Emphasis in original).
- Disclosure Obligation. The retail customer must be provided with full and fair written disclosure of “all material facts relating to the scope and terms of the relationship,” including: the capacity in which the broker, dealer or associated person of a broker or dealer is acting; all material fees and expenses associated with the transactions, holdings and accounts; the type of and scope of services being provided; and “all material conflicts of interest associated with the recommendation.”9 The Disclosure Obligation, which is in addition to Form CRS, requires that disclosure be provided prior to or at the time of the recommendation; however, in response to comments, the SEC provided a roadmap for providing oral disclosure or disclosure after a recommendation.
- Conflicts of Interest Obligation. The broker-dealer must have in place and enforce written policies and procedures that are reasonably designed to identify, disclose and/or mitigate, as applicable, all conflicts of interest associated with a recommendation; these might include: conflicts that could incentivize a broker-dealer (or its associated person) to place its interests ahead of the retail customer’s interests; any material limitations placed on the investment strategy or security; and any conflicts associated with such limitations. All sales contests, sales quotas, bonuses and non-cash compensation that are based on the sales of specific securities or types of securities within a limited period of time also must be identified and eliminated.
- Compliance Obligation. In addition to the policies and procedures required by the Conflicts of Interest Obligation, broker-dealers must have in place written policies and procedures reasonably designed to ensure compliance with Regulation Best Interest generally.
With respect to dual-registrants, the SEC clarified that the General Obligation will apply only when a dual-registrant is acting in its capacity as a broker-dealer, and not as an investment adviser. In determining the capacity in which a dual-registrant is acting, the dual-registrant should consider, among other factors: “the type of account, how the account is described, the type of compensation and the extent to which the dual-registrant made clear to the customer or client the capacity in which it was acting.”10
The SEC declined to address any effect Regulation Best Interest could have on state law prescribing a standard of conduct for investment professionals, stating that any effect on state law “would be determined in future judicial proceedings based on the specific language and effect of that state law.”11
“Solely Incidental” Prong of Broker-Dealer Exclusion from the Definition of Investment Adviser
The SEC, after receiving and reviewing comments submitted in connection with the Regulation Best Interest rule proposal, published an interpretation of the “solely incidental” prong of the broker-dealer exclusion from the definition of investment adviser under the Advisers Act (BD Exclusion). Under the BD Exclusion, a broker-dealer that provides investment advisory services is excluded from the definition of investment adviser if: the broker-dealer does not receive special compensation for the advisory services; and the advisory services provided are “solely incidental” to its business as a broker or dealer. The SEC’s interpretation sets forth its general standard for assessing when a broker-dealer’s provision of investment advice is solely incidental to its broker-dealer business and applies that standard in two specific contexts: exercising discretion over customer accounts; and account monitoring.
According to the SEC, a broker-dealer’s advisory activities are within the “solely incidental” prong of the BD Exclusion if “the advice is provided in connection with and is reasonably related to the broker-dealer’s primary business of effecting securities transactions.”12 In application, the standard is a facts-and-circumstances analysis involving, among other factors: the broker-dealer’s business; the specific services offered; and the relationship between the broker-dealer and the customer.
With respect to investment discretion, the SEC stated its view that it would be “inconsistent” with the BD Exclusion for broker-dealers to exercise investment discretion over customer accounts, unless the investment discretion is granted by a customer on a “temporary or limited basis.”13 Similarly, the SEC stated that it does not view an agreement for a broker-dealer to monitor a customer’s account on a periodic basis “for purposes of providing buy, sell, or hold recommendations” to the customer to be the type of activity that would be inconsistent with the “solely incidental” prong.14
The SEC indicated that it will consider further comment on its interpretation of the “solely incidental” prong to determine whether it would be appropriate to publish additional guidance in the future.
Interpretation Regarding Investment Adviser Fiduciary Duties
The framework of the SEC’s final interpretive guidance relating to investment advisers’ fiduciary duties (Fiduciary Interpretation) is substantially similar to that of the proposed interpretation.15 The Fiduciary Interpretation addresses many commenters’ concerns regarding the proposed interpretation’s failure to consider the various differences in business models and types of clients.16 Accordingly, in contrast to the proposal, the Fiduciary Interpretation provides a clearer distinction between its application to institutional and retail clients, among others.
The Fiduciary Interpretation provides that an investment adviser’s fiduciary duties consist of a duty of care and a duty of loyalty, which, taken together, require an adviser to act in the best interest of its client at all times. The duty of care consists of three components: the duty to provide advice that is in the client’s best interest (which includes suitability obligations); the duty to seek best execution; and the duty to provide advice and monitoring over the course of the adviser/client relationship. The duty of loyalty requires an adviser to eliminate, or to fully and fairly disclose, all conflicts of interest for the purpose of obtaining informed consent. Although the Fiduciary Interpretation contains much detail that had not been included in prior SEC statements, the SEC explained that the Fiduciary Interpretation reflects its views as to the nature and scope of an investment adviser’s existing fiduciary duties.
Duty of Care
The Final Interpretation includes an additional section in which the SEC recognized that how an adviser satisfies its fiduciary duties is determined by the scope of the adviser/client relationship and that advisers serve a variety of clients. The discussion of an adviser’s duty of care – specifically, the duty to provide advice that is in a client’s best interest – has been enhanced since the proposed interpretation to detail how the components of an adviser’s fiduciary duties apply to retail as opposed to institutional clients. For example, according to the SEC, in order to provide advice that is in a client’s best interest, the adviser must have a reasonable understanding of the client’s objectives. The Fiduciary Interpretation also explains how an adviser can form a reasonable understanding of a client’s investment objective by making a reasonable inquiry when advising retail and institutional clients.17 In forming a reasonable belief that advice is in a retail client’s best interest, an adviser must consider, in connection with the retail client’s investment objectives, whether the retail client is willing to tolerate the risks associated with the investments or overall strategy and whether the potential benefits justify the associated risks.
The Fiduciary Interpretation specifically discusses how advisers to registered investment companies and private funds can satisfy their fiduciary responsibilities to these types of institutional clients through understanding their mandates. Fund advisers must have a reasonable understanding of the fund’s investment guidelines and objectives, and the SEC clarified that fund advisers would not be obligated to update a client’s investment objectives, except to the extent that the advisory agreement includes such an obligation.
Duty of Loyalty
The SEC recognized that, in principle, an adviser’s fiduciary obligations under the Advisers Act are satisfied when the adviser makes full and fair disclosure of a conflict of interest and obtains the client’s informed consent. According to the SEC, informed consent is a broad and flexible concept that encompasses not just a client’s signature on an agreement at the start of a relationship, but also disclosure and acceptance through the receipt of continued advisory services. The Fiduciary Interpretation sets forth the SEC’s views as to what constitutes informed consent, noting that a client must be made aware of all conflicts of interest that could prevent an adviser from providing disinterested advice. The Fiduciary Interpretation provides examples and analysis illustrating when clients were, or could not have been, given enough information to allow for consent to be informed.
The SEC acknowledged that full and fair disclosure (including the specificity, level of detail and explanation of terminology used in such disclosure) can differ in the retail and institutional contexts. The SEC helpfully recognized that institutional clients have greater capacity and resources to analyze and understand complex conflicts and their implications, as compared to retail clients. In this respect, advisers to retail clients may find it difficult to sufficiently disclose complex or extensive conflicts in a manner that is understandable. Regardless of whether a client falls into the retail or institutional category, in scenarios where an adviser cannot fully and fairly disclose a conflict, the adviser must eliminate or mitigate the conflict. An adviser can mitigate conflicts by modifying its practices.
The SEC recognized that an adviser’s suitability obligations and duty to monitor are linked to the “contours” of the adviser’s relationship with the client. An adviser’s duty to monitor is shaped through the contract and disclosures provided, which set the client’s expectations as to the services that the adviser will provide. At the same time, the SEC’s view remained that clients cannot waive an adviser’s fiduciary duties generally, and that contractual provisions that purport to do so (including so-called “hedge clauses”) are inconsistent with the Advisers Act to the extent such provisions are misleading.18
The Fiduciary Interpretation also discusses how dual-registrants can satisfy their duty of loyalty by disclosing when they intend to act in their brokerage capacity and when they intend to act in their advisory capacity.
Form CRS
The Final Rules include the adoption of new Form CRS (Client Relationship Summary), a disclosure document intended to reduce retail investor confusion regarding brokerage and investment advisory services, and to assist retail investors in determining which type of investment professional they should engage, if any, for their investment needs; for advisers, this becomes Part 3 of Form ADV. Form CRS is intended to provide clarity and assist investors in comparing firms, by informing investors about: “(i) the types of client and customer relationships and services the firm offers; (ii) the fees, costs, conflicts of interest, and required standard of conduct associated with those relationships and services; (iii) whether the firm and its financial professionals currently have reportable legal or disciplinary history; and (iv) how to obtain additional information about the firm.”19 Dual-registrants are encouraged by the SEC to use a combined Form CRS relationship summary to discuss brokerage and advisory services; however, they are permitted to provide separate summaries.20
The adopted version of the Client Relationship Summary differs substantially from the proposed Form CRS. Specifically, the adopted version of Form CRS: uses standardized question-and-answer style headings; affords firms greater flexibility in how they can respond to each question; and integrates “the proposed fees and costs section with the sections discussing conflicts of interest and standards of conduct.” Notably, the adopted Form CRS eliminates the proposed section that would have required investment advisers to explain, using prescribed language, how their services differ from, or are similar to, those of broker-dealers and vice versa.21
As adopted, the delivery requirement under Form CRS differs from the proposal by mandating that broker-dealers deliver the Client Relationship Summary “to each new or prospective customer who is a retail investor before or at the earliest of: (i) a recommendation of an account type, a securities transaction, or an investment strategy involving securities; (ii) placing an order for the retail investor; or (iii) the opening of a brokerage account for the retail investor.”
Compliance Deadlines
The compliance date for Regulation Best Interest and Form CRS is June 30, 2020.
For Form CRS, registered broker-dealers and investment advisers, as well as investment advisers with pending registration applications, will be able to file their initial relationship summaries with the SEC between May 1, 2020 and June 30, 2020. After June 30, 2020, newly registered broker-dealers will be required to file Form CRS before the effective date of their registration with the SEC, and investment advisers will be required to submit a Form CRS on Form ADV Part 3 with any initial application for registration. In addition, broker-dealers and investment advisers must deliver their relationship summaries to all existing retail investor clients and customers on an initial one-time basis within 30 days after the date the firm is required to file its relationship summary with the SEC.
This relatively short compliance period will require diligent efforts by firms to timely implement the Final Rules. In recognition of the potential difficulty in complying with the Final Rules, the SEC is establishing an inter-divisional Standard of Conduct Implementation Committee to offer firms significant assistance and support with such compliance. The Standard of Conduct Implementation Committee can be contacted at IABDQuestions@sec.gov.
Footnotes
1) The following are links to the SEC’s adopting and interpretative releases for the Final Rules:
Regulation Best Interest
Form CRS
Solely Incidental Interpretation
Standard of Conduct for Investment Advisers Interpretation
2) Consistent with his commentary related to the proposal of the rulemaking package in April 2018, Commissioner Robert Jackson Jr. voted against adopting the Final Rules, expressing his concern that they do not go far enough in their effort to protect investors from receiving conflicted advice from broker-dealers.
3) SEC Adopts Rules and Interpretations to Enhance Protections and Preserve Choice for Retail Investors in their Relationships with Financial Professionals, Press Release (June 5, 2019)
4) Regulation Best Interest: The Broker-Dealer Standard of Conduct, Release No. 34-86031 (June 5, 2019) (Reg. BI Adopting Release).
5) See Regulation Best Interest, Release No. 34-83062 (Apr. 18, 2018).
6) Under the Disclosure Obligation discussed below, the broker-dealer also would need to disclose the terms of the monitoring arrangement, including the frequency of the monitoring. As discussed in more detail below in connection with the solely incidental interpretive release, account monitoring arrangements will need to be reviewed to determine if they trigger an investment adviser's registration obligation.
7) Regulation Best Interest defines “retail customer investment profile” as including, but not limited to, “the retail customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the retail customer may disclose to the broker, dealer, or a natural person who is an associated person of a broker or dealer in connection with a recommendation.”
8) In fact, the SEC noted that the Care Obligation would not be satisfied if cost was the only factor considered in making the recommendation.
9) A conflict of interest under Regulation Best Interest is “an interest that might incline a broker, dealer, or a natural person who is an associated person of a broker or dealer – consciously or unconsciously – to make a recommendation that is not disinterested.” The SEC stated that the standard for materiality under the Disclosure Obligation would be consistent with the standard articulated by the Supreme Court in Basic v. Levinson – “information is material if there is a ‘substantial likelihood that a reasonable shareholder would consider it important.’”
10) As discussed further below, if a representative of the dual-registrant is acting in an advisory capacity, then the General Obligation would not apply, but the representative would remain subject to the fiduciary standards under the Advisers Act.
11) In his dissenting view (supra note 2), Commissioner Jackson expressly encouraged the states to continue to explore the establishment of new rules on a state-by-state basis. Several state (and other) initiatives are underway on this front, which raise considerable concerns, including with respect to the operational challenge of dealing with a “patchwork” of differing standards and rules.
12) Commission Interpretation Regarding the Solely Incidental Prong of the Broker-Dealer Exclusion from the Definition of Investment Adviser, Release No. IA-5249 (June 5, 2019).
13) The interpretation provides a non-exclusive list of examples of such temporary or limited circumstances, including discretion: (i) “as to the price at which or the time to execute an order given by a customer for the purchase or sale of a definite amount or quantity of a specified security;” (ii) “on an isolated or infrequent basis, to purchase or sell a security or type of security when a customer is unavailable for a limited period of time;” or (iii) “to purchase or sell securities to satisfy margin requirements, or other customer obligations that the customer has specified.”
14) The SEC suggested that broker-dealers may develop policies and procedures to provide acceptable account monitoring arrangements that would be consistent with the broker-dealer’s primary business and therefore consistent with the BD Exclusion.
15) See Commission Interpretation Regarding Standard of Conduct for Investments Advisers, Release No. IA-5248 (June 5, 2019).
16) Comment Letter of Dechert LLP re Proposed Commission Interpretation Regarding Standard of Conduct for Investments Advisers (Aug. 7, 2018).
17) Id.
18) In this connection, the Final Interpretation provides guidance as to when hedge clauses may be misleading and revokes the Heitman no-action letter (pub. avail., Feb. 12, 2007), which set forth the staff’s view on that subject.
19) Form CRS Relationship Summary; Amendments to Form ADV, Release Nos. 34-86032; IA-5247 (June 5, 2019).
20) Form CRS defines a dual-registrant as “[a] firm that is dually registered as a broker-dealer under section 15 of the Exchange Act and an investment adviser under section 203 of the Advisers Act and offers services to retail investors as both a broker-dealer and an investment adviser.”
21) The SEC proposed certain titling restrictions that would have prevented a broker-dealer that is not licensed as an investment adviser from using the terms “advisor” or “adviser” in its title. However, the SEC decided not to finalize the titling restrictions and to instead rely on provisions in Regulation Best Interest to address investor confusion and other industry concerns resulting from broker-dealers’ use of the terms “advisor” or “adviser.
