On June 5, 2019, the Securities and Exchange Commission adopted, by a 3-1 vote, Regulation Best Interest (“Reg BI”) which, in the words of Chairman Clayton, would “substantially enhance the broker-dealer standard of conduct beyond existing suitability obligations.” The Chairman also noted: “the standard of conduct draws from key fiduciary principles and cannot be satisfied through disclosure alone.”
The Commission also passed the new Form CRS Relationship Summary and two interpretations under the Investment Advisers Act of 1940 (the “Advisers Act”). According to the Commission, the newly-adopted rules and interpretations are designed to (1) enhance and clarify the standards of conduct applicable to broker-dealers and investment advisers, (2) help retail investors better understand services offered and make informed choices regarding the relationship best suited to their needs and circumstances, and (3) foster greater consistency in the level of protections provided by each regime, particularly at the point in time that a recommendation is made.
According to the Commission, under Reg BI, broker-dealers will be required to act in the best interests of retail customers when making investment recommendations and may not put their financial interests “ahead of the interests of a retail customer when making recommendations.” Reg BI includes the following components:
- Disclosure Obligation: Broker-dealers must disclose to retail customers the capacity in which the broker is acting, fees, the type and scope of services provided, conflicts, limitations on services and products, and whether the broker-dealer provides monitoring services.
- Care Obligation: A broker-dealer must exercise reasonable diligence, care and skill when making a recommendation to a retail customer, with a clear understanding of potential risks, rewards, and costs associated with the recommendation. The broker-dealer must then consider these factors in light of the retail customer’s investment profile and ensure that the recommendation is in the retail customer’s best interest, including the costs of the recommendation.
- Conflict of Interest Obligation: The broker-dealer must establish, maintain, and enforce written policies and procedures reasonably designed to identify and, at a minimum, disclose or eliminate conflicts of interest. Those policies and procedures must (1) mitigate conflicts that create an incentive for financial professionals to place their interests or those of the firm ahead of the customer’s interests, (2) prevent limitations on offerings from causing the firm or its financial professionals to place their interests or the interests of the firm ahead of the customer’s interest, and (3) eliminate sales contests, quotas, bonuses and non-cash compensation based on the sale of specific securities or specific types of securities within a limited period of time.
- Compliance Obligation: Broker-dealers must establish, maintain and enforce policies and procedures reasonably designed to achieve compliance with Reg BI as a whole.
The Form CRS Relationship Summary will require SEC registered investment advisers and broker-dealers to provide retail customers straightforward and easy-to-understand information describing the nature of a customer’s relationship with their financial professional.
The Commission also issued two interpretations. First, the Commission issued an interpretation that reaffirmed and clarified its views of the fiduciary duty owed by registered investment advisers to their clients. Second, the Commission issued an interpretation that more clearly defined the “solely incidental” exclusion under the Advisers Act, which delineates when a broker-dealer’s performance of advisory activities causes it to become an investment adviser. The interpretation provides practical guidance by noting that exercising investment discretion over customer accounts and account monitoring are activities that would be beyond “solely incidental” to brokerage activity.
The new measures did not pass without controversy. Commissioner Robert Jackson cast the lone dissenting vote. At the Open Meeting and in a written statement, Commissioner Jackson stated that, while he hoped the new rules would leave “no doubt that investors come first,” the newly adopted rules create a “muddled standard” and “simply do not require that investors’ interests come first.” Earlier this year, a group of former SEC economists criticized the economic analysis underlying Reg BI as “weak and incomplete” for (1) failing to properly identify the specific problem(s) to be addressed by the rule, (2) inadequately discussing existing economic literature relating to financial advising, and (3) relying too heavily on advisers disclosing material conflicts of interest “without requiring advisers to provide a single, easy-to-digest periodic the retail customer’s actual cost of managing her funds.” Investor advocacy groups have also criticized Reg BI for (1) “making it easier for brokers to advertise themselves and weaken protections that currently apply under state fiduciary standards,” and (2) failing to require the elimination of conflicts of interest or to impose a fiduciary obligation on broker-dealers.
The documentation approved by the Commission on June 5th totals more than 1,400 pages. As the industry, counsel, consultants, other regulators, and other stakeholders wade through the materials, additional assessments will be provided.
Practical Considerations
The Commissioners, the Chairman, and the staff stressed the importance of continuing to review and assess the scope of the newly-adopted requirements and to assist firms with their implementation efforts. To facilitate effective and responsive engagement, the Commission is creating an inter-Divisional Standards of Conduct Implementation Committee. The Commission encouraged firms to engage with the Committee as questions arise during implementation. The Commission also has set up a “mailbox” to receive questions by email (IABDQuestions@sec.gov).
Reg BI and Form CRS will become effective 60 days after they are published in the Federal Register, and will include a transition period until June 30, 2020. By that date, registered broker-dealers must begin complying with Reg BI and broker-dealers and investment advisers registered with the Commission will be required to prepare, deliver to retail investors, and file a relationship summary. The interpretations will become effective upon publication in the Federal Register.
Should you wish to discuss requirements and/or implications of Reg BI, Form CRS Relationship Summary or newly issued statutory interpretations, please contact any of the authors or any of McGuireWoods’ securities enforcement and regulatory attorneys.
