On June 15, Jay Clayton, the Chairman of the U.S. Securities and Exchange Commission (“SEC”) re-confirmed there will be no delay in the compliance date for Regulation Best Interest and Form CRS.[1]  In the statement, Chairman Clayton noted the SEC staff had been in discussions with broker-dealers, investment advisers, retail investors, other market participants, and FINRA over the past twelve months regarding the implementation of the regulation and Form CRS.  The Chairman stated firms have made “considerable progress in (1) adjusting their business practices, (2) supplementing and modifying their policies and procedures and (3) otherwise aligning their operations and preparing for the requirements of [Regulation Best Interest] and the obligation to file and deliver Form CRS.”   Finally, in light of the progress observed by the SEC with respect to the implementation of Regulation Best Interest and Form CRS, he confirmed the June 30, 2020 compliance date was appropriate.

Regulation Best Interest

On June 5, 2019, the SEC adopted Regulation Best Interest, which establishes a new standard of conduct under the Securities Exchange Act of 1934 (“Exchange Act”) for broker-dealers and persons who are associated persons of a broker-dealer when making a recommendation of any securities transaction or investment strategy involving securities (including account recommendations) to a retail customer.[2]  In conjunction with the adoption of Regulation Best Interest, the SEC also adopted Form CRS which requires SEC-registered broker-dealers and investment advisers, including dual-registrants,[3] to provide a brief relationship summary to retail investors. The SEC also adopted new rules and forms to require broker-dealers and investment advisers to provide a brief relationship summary (“Form CRS”) to retail investors.[4] In addition, the SEC adopted formal interpretations summarizing existing jurisprudence regarding an investment advisers’ standard of conduct under the Investment Advisers Act of 1940 (the “Advisers Act”)[5] and the “solely incidental” prong of the broker-dealer exclusion from the Advisers Act.  These are part of a long-standing SEC initiative to protect retail investors.[6]

For investment advisers, Form CRS will be a new Form ADV Part 3 that will be in addition to the currently required Form ADV Part 1 and Part 2 Brochures. Further, the Part 3 of Form CRS is subject to different delivery obligations than the Part 2 Brochure. The Form CRS relationship summary does not replace or substitute for any other reporting or disclosure obligations of an SEC-registered investment adviser firm. Regulation Best Interest imposes a new standard of care on broker-dealers that are similar, but not identical, to the fiduciary duties that are deemed to be imposed on investment advisers under the antifraud provisions of the Advisers Act. That said, it is a significantly greater obligation of care than had been in place under the prior regulatory regime for broker-dealers.

Investors Remain Front of Mind at the SEC

This statement follows Chairman Clayton’s statement in April 2020, in which he noted: “[f]inancial professionals are required to never put their interests ahead of the interests of their clients and customers . . . particularly important in these times of economic uncertainty.”[7]  The Chairman encouraged firms that are subject to Regulation Best Interest and that must file the Form CRS to “continue to make good faith efforts around operational matters to ensure compliance by June 30, 2020, including devoting resources as necessary and available in light of the circumstances.” Finally, recognizing the potential impact of COVID-19 he reminded broker-dealers and investment advisers that must comply with the regulation that are “unable to make certain filings or meet other requirements because of disruptions caused by COVID-19 . . [to] engage with [the SEC].”

Risky Strategies

While Chairman Clayton stated that he has seen considerable progress, including with dual-hatted personnel who serve roles with both affiliated broker-dealers and investment advisers, there are certain areas where progress could still be made. Certain risky strategies were emphasized as being less likely to be easily understood or for the benefit of Main Street investors. These strategies include:

• 401(k) Rollovers and Withdrawals.  The standard of care required for this kind of recommendation will increase a considerable amount.  In particular, the CARES Act allows eligible participants in certain tax-advantaged retirement plans to take early distributions of up to $100,000 during this calendar year without being subject to early withdrawal penalties and with an expanded window for paying the income tax they owe on the amounts they withdraw. Recommendations on those withdrawals and, in particular, recommendations to reinvest those distributions will be especially closely scrutinized.

• Complex or Risky Products.  A Main Street investor needs to place more reliance on its broker or adviser to make an investment in a complex instrument, and thus those need to be evaluated more closely.  It sounds like the standards for “reasonable basis” suitability might tighten, which would require broker-dealers to better understand the ins and outs of a complex instrument before recommending an investment in one to a retail investor.  Further, because there is more significant downside, care needs to be taken when recommending products that are significantly leveraged through margin or the use of options, futures and other derivatives. 

• Securities Marketed as a Response to the Effects of COVID-19.  The SEC has always been particularly sensitive to new types of investments with a risk of fraud. Some COVID-related stocks have been associated with pump-and-dump schemes, and other investments have been promoted on the basis of outright lies. These investments should be closely vetted, and investment recommendations based on macroeconomic trends resulting from the pandemic should also have documented rationales.  Securities intermediaries should consider the risk that a sector that seems to be flying high right now might fall back to Earth depending on how the economy restarts.

• SPACs and Structured Products. A SPAC is a typically public corporation that sells its shares so that it can acquire a private company in the future. It is somewhat like a blind pool, except there typically is only one investment. Normally if a SPAC is unable acquire a target within a certain period of time, then it returns funds to its investors.  Despite this feature, SPACs can be complex in their compensation and expense structure and might not have the cash to make investors whole. This should also be considered by broker-dealers.

[1] Statement, SEC Chairman Jay Clayton, Confirmation of June 30 Compliance Date for Regulation Best Interest and Form CRS (June 15, 2020), available at: https://www.sec.gov/news/public-statement/clayton-compliance-date-regulation-best-interest-form-crs.  

[2] Regulation Best Interest: The Broker-Dealer Standard of Conduct, Exchange Act Release No. 34-86031 (June 5, 2019), 84 Fed. Reg. 33318 (July 12, 2019), available at: https://www.govinfo.gov/content/pkg/FR-2019-07-12/pdf/2019-12164.pdf.  The SEC has also prepared a Regulation Best Interest Small Entity Compliance Guide, available at: https://www.sec.gov/info/smallbus/secg/regulation-best-interest and FINRA has prepared guidance on Regulation Best Interest, available at: https://www.finra.org/rules-guidance/key-topics/regulation-best-interest.

[3] A dual registrant is a broker-dealer that also is an investment adviser solely with respect to those accounts for which a dual registrant provides investment advice or receives compensation that subjects it to the Investment Advisers Act of 1940. Although this discussion focuses on the treatment of broker-dealers that are dually registered with the Commission as investment advisers, a broker-dealer should perform the same analysis when it is engaged in other financial services (such as a bank, a commodity trading advisor, or a future commission merchant).

[4] Exchange Act Release No. 86032, Form CRS Relationship Summary, Amendment to Form ADV (final rule) (June 5, 2019), 84 Fed. Reg. 33492 (July 12, 2019), available at: https://www.sec.gov/rules/final/2019/34-86032.pdf, Form ADV Instructions, available at: https://www.sec.gov/rules/final/2019/34-86032-appendix-a.pdf, and Form CRS Instructions, available at: https://www.sec.gov/rules/final/2019/34-86032-appendix-b.pdf.

[5] Investment Advisers Act Release No. 5248 (June 5, 2019), 84 Fed. Reg. 33669 (July 12, 2019), available at: https://www.govinfo.gov/content/pkg/FR-2019-07-12/pdf/2019-12208.pdf.

[6] See, e.g., 2010 Examination Priorities, Office of Compliance Examinations and Inspections, available at: https://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2020.pdf and 2019 Examination Priorities, Office of Compliance Examinations and Inspections, available at https://www.sec.gov/files/OCIE%202019%20Priorities.pdf.

[7] Chairman Jay Clayton, Public Statement: Investors Remain Front of Mind at the SEC: Approach to Allocation of Resources, Oversight and Rulemaking; Implementation of Regulation Best Interest and Form CRS (April 2, 2020), available at: https://www.sec.gov/news/public-statement/statement-clayton-investors-rbi-form-crs.