SEC Unveils Proposed Standards of Care for Brokers and Investment Advisers

by McGuireWoods LLP

The SEC has proposed rulemaking and regulations targeted at the relationship between investors and their investment professionals. We previously reported on the U.S. Court of Appeals for the Fifth Circuit vacating the controversial Department of Labor fiduciary rule. The SEC’s approach is three-pronged and is applicable to broker-dealers and investment advisers. The SEC’s stated goal is to “enhance the quality and transparency of investors’ relationships with investment advisers and broker-dealers while preserving access to a variety of types of advice relationships and investment products.”

The first prong of the SEC’s proposed rulemaking would create a rule under the Securities Exchange Act of 1934 establishing a new standard of care for broker-dealers. Under the eponymous Regulation Best Interest, broker-dealers would be required to act in the best interest of the retail customer when recommending investments or strategies and would be prohibited from placing their own financial interest ahead of the investor’s. This is a departure from the current standard, which requires broker-dealers to recommend “suitable” investments to investors.

The SEC outlined what Regulation Best Interest requires of broker-dealers and their associated persons. Before making a recommendation, an associated person: (1) must disclose in writing to the investor the material facts relating to the scope and terms of the relationship and all material conflicts of interest related to the recommendation; and (2) must exercise reasonable diligence, care, skill, and prudence to understand the risks and rewards of the recommendation and have a reasonable basis to believe the recommendation is in the customer’s best interest. Broker-dealers, in turn, would be required to establish written policies and procedures: (1) to identify and disclose or eliminate material conflicts of interest associated with recommendations; and (2) to identify and disclose and mitigate material conflicts of interest arising from financial incentives associated with recommendations.

According to the SEC, Regulation Best Interest enhances investor protection and the regulation of broker-dealers in four ways: (1) educating investors as to the nature of the relationship with their investment professional; (2) creating an express standard of care broader than the current “suitability” standard; (3) enhancing the disclosures of material conflicts of interest; and (4) requiring mitigation or elimination of conflicts of interest arising from financial incentives.

The second prong is a proposed interpretation of the rules applicable to investment advisers under the Investment Advisers Act of 1940 who, unlike broker-dealers, are fiduciaries held to the highest standard of care. Whereas Regulation Best Interest is new to broker-dealers, investment advisers have always been required to serve the best interests of investors and keep investors’ interests ahead of their own. Under the SEC’s interpretation, an investment adviser’s fiduciary duty is twofold: a duty of care and a duty of loyalty.

Falling under the umbrella of the duty of care are the investment adviser’s duties to provide advice in the client’s best interest by considering the client’s investment experience and objectives, to seek best execution by minimizing the costs of transactions, and to provide ongoing advice and monitoring during the course of the relationship.

The duty of loyalty requires investment advisers to put their clients’ interests first. As with the proposed Regulation Best Interest, investment advisers must make full disclosure of the advisory relationship, avoid conflicts of interest, and disclose any material conflicts of interest that could affect the relationship.

The third prong brings together the first two by proposing that broker-dealers and investment advisers provide written summaries of the nature of the investment relationship in a short-form disclosure document called Form CRS (short for client or customer relationship summary). The SEC’s approach recognizes that broker-dealers and investment advisers provide different, valuable services to investors, but also that investors may not fully understand the difference between a broker-dealer and an investment adviser. Proposed Form CRS would be short and easy to read to close this gap. Significantly, among the eight required items, Form CRS would describe the relationship of the services the firm provides to retail investors, the standard of conduct applicable to those services, the fees and costs an investor would pay, the differences between brokerage and investment advisory services, and conflicts of interest.

Closely related to the advent of Form CRS is the restriction the SEC’s proposed rules place on the use of certain terms to avoid investor confusion. Specifically, broker-dealers and their associated persons will not be able to use the term “adviser” in their name or titles, including financial adviser, wealth adviser, trusted adviser, etc. – in communications with retail investors. The proposed restriction, according to the SEC, will prevent investors from wrongly thinking that their broker dealer is an investment adviser subject to a higher fiduciary duty.

The SEC will begin accepting comments on the proposed Regulation Best Interest, interpretation of the Advisers Act, and Form CRS 90 days following publication of the rules in the Federal Register. McguireWoods expects the proposed rules and interpretation to draw heavy comments, and we urge all clients to consider the potential implication of these rules on other areas. McGuireWoods can assist affected parties respond to the request for comments.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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