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Capital Markets, Money

Jun 27, 2019

Raising The Bar: Sec Adopts Broker-Dealer Standard of Care and Guidance on Investment Advisers’ Fiduciary Standard

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On June 5, 2019, the U.S. Securities and Exchange Commission (the “SEC” or “Commission”) culminated its multi-year consideration of commentary, reports, rulemaking, interpretations and guidance, adopting a package of regulations and guidance that alter retail investors’ relationships with investment advisers and broker dealers by promulgating and, through new guidance, seeking to clarify the applicable standards of care.[1] The new rulemakings and interpretations also standardize and implement additional disclosure obligations that will be required of broker-dealers and investment advisers when dealing with retail investors.

Specifically, the actions include adoption of:

  • Regulation Best Interest (“Regulation BI”),[2]
  • New Form CRS Relationship Summary,[3] and
  • Two interpretations under the Investment Advisers Act of 1940 (the “Advisers Act”).[4]

The text of the final rules adopted are attached here as Exhibit A.

The new rules and forms will be effective 60 days after publication in the Federal Register; the interpretations will be effective upon publication in the Federal Register. Regulation BI sets forth a compliance transition window, lasting until June 30, 2020.

Background

On April 18, 2018, the SEC published its proposed package of rules, interpretations and guidance (the “Proposed Rules”). In a statement made the same day, SEC Chairman Jay Clayton highlighted the key issues that, in his view, informed Commission action: (1) the potential harm from misalignment between reasonable investor expectations and actual legal standards that apply to financial professionals; (2) investor confusion regarding the differences between broker-dealers and investment advisers; and (3) increasing regulatory complexity and the potential to increase confusion and reduce service offerings and investor choice.[5]

Overview of the 2018 Proposed Rules

The Proposed Rules, generally, took the following shape:

  • Regulation Best Interest. Implement “Regulation Best Interest,” under the Securities Exchange Act of 1934 (the “Exchange Act”), which would establish a “best interest” standard of conduct applicable to broker-dealers when making a recommendation of a securities transaction to a retail customer;[6]
  • Form CRS relationship summary. Require broker-dealers and investment advisers to provide a relationship summary (limited to a maximum of four pages) to investors that captures certain information through the use of newly proposed Form CRS, and place restrictions on the use of names and titles, such as “adviser” and “advisor,” for certain firms and financial professionals;[7] and
  • Interpretation of investment adviser standard of conduct. Clarify, through guidance, the standard of conduct for investment advisers, and request comments with respect to enhancing investment adviser regulation under the Advisers Act, including requesting comment regarding the licensing of investment adviser personnel and capital requirements for investment advisers.[8]

The Proposed Rules followed the effective abandonment of the “Fiduciary Rule,” issued by the U.S. Department of Labor (the “DOL”) in 2016, which would have expanded the applicability of “fiduciary” status (and corresponding duties) to various financial service providers under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”). The Fiduciary Rule effectively imposed similar “fiduciary” status to comparable financial service providers to retail customers, including with respect to Individual Retirement Accounts (IRAs).[9] The United States Court of Appeals for the Fifth Circuit subsequently vacated the rule in toto, returning the definition of “fiduciary” for purposes of ERISA and Section 4975 of the Code to its prior status, which generally did not subject broker-dealers to “fiduciary” status or a heightened standard of care.[10] While the DOL chose not to contest the ruling, DOL Secretary Alexander Acosta recently announced plans to include a redrafting of the rule in DOL’s regulatory agenda for 2019.[11]

Provided below is a summary of the new rules and interpretations.

Regulation Best Interest: The SEC’s Broker-Dealer Standard of Conduct

The goal of Regulation BI is to improve investor protection by: (1) enhancing the obligations that apply when a broker-dealer makes a recommendation to a retail customer and (2) reducing the potential harm to retail customers from conflicts of interest that may affect such recommendations.

Regulation BI modifies the broker-dealer standard of care by requiring broker-dealers to:

  • act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker-dealer ahead of the interests of the retail customer; and
  • address conflicts of interest by establishing, maintaining, and enforcing policies and procedures reasonably designed to identify and fully and fairly disclose material facts about conflicts of interest, and in instances where the SEC has determined that disclosure is insufficient to reasonably address the conflict, to mitigate or, in certain instances, eliminate the conflict.

The rule has a yearlong transition window, lasting until June 30, 2020, to allow firms time to bring their operations into compliance.

Definition of a “Retail Customer”

Regulation BI, as promulgated, streamlines the language of the Proposed Rule to focus on natural persons and their legal representatives, defining a retail customer as “a natural person, or the legal representative of such natural person, who: (A) receives a recommendation of any securities transaction or investment strategy involving securities from a broker, dealer, or a natural person who is an associated person of a broker or dealer; and (B) uses the recommendation primarily for personal, family, or household purposes.”[12]

General Obligation to Act in Best Interest

In promulgating a “best interest” standard for retail broker-dealer recommendations, the SEC chose to adopt and rely on key principles underlying the fiduciary standard, including those applicable to investment advisers under the Advisers Act. The general regulatory requirement of the best interest standard (referred to in the Regulation BI adopting release as the “General Obligation”) provides that when making a recommendation of any securities transaction or investment strategy involving securities, a broker-dealer, or a natural person who is an associated person of a broker-dealer, “shall act in the best interest of the retail customer at the time the recommendation is made,” prioritizing the interests of the retail customer above any interests of the broker-dealer or associated persons thereof (emphasis added).[13]

The Commission declined to expressly define “best interest” in the rule text, deciding in favor of four specific component obligations – (1) the Disclosure Obligation, (2) the Care Obligation, (3) the Conflict of Interest Obligation and (4) the Compliance Obligation. These component obligations collectively set forth the meaning of acting “in the best interest” of the retail customer in accordance with the general obligation noted above. The SEC added that the specific component obligations of the rule are mandatory, stating that Regulation BI does not establish a “safe harbor.” The SEC drew a contrast with safe harbors, noting in the adopting release that “compliance with a safe harbor is optional, and failure to comply with the terms of the safe harbor does not necessarily violate the relevant legal requirement.”

We discuss the specific component obligations briefly below.

Disclosure Obligation

The Disclosure Obligation requires a broker-dealer, prior to or at the time of the recommendation, to provide to the retail customer, in writing, full and fair disclosure of (A) all material facts related to the scope and terms of the relationship with the retail customer; and (B) all material facts relating to conflicts of interest that are associated with the recommendation.[14] Specifically, this obligation explicitly requires the following disclosures: (1) that the broker, dealer, or such natural person, is acting as a broker, dealer or an associated person of a broker or dealer with respect to the recommendation; (2) the material fees and costs that apply to the retail customer’s transactions, holdings and accounts; and (3) the type and scope of services provided to the retail customer, including any material limitations on the securities or investment strategies involving securities that may be recommended to the retail customer.[15]

Care Obligation

The Care Obligation requires a broker, dealer or associated person of a broker or dealer in making the recommendation to exercise reasonable diligence, care, and skill to:

  • Understand the potential risks, rewards and costs associated with the recommendation, and have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers;[16]
  • Have a reasonable basis to believe that the recommendation is in the best interest of a particular 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 such natural person ahead of the interest of the retail customer; and
  • Have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer’s best interest when viewed in isolation, is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile and does not place the financial or other interest of the broker, dealer or such natural person making the series of recommendations ahead of the interest of the retail customer.

Conflict of Interest Obligation

The Conflict of Interest Obligation requires brokers and dealers to establish, maintain and enforce written policies and procedures reasonably designed to:

  • identify and, at minimum, disclose or eliminate all conflicts of interest associated with a recommendation;
  • identify and mitigate any conflicts of interest associated with such recommendation that create an incentive for a natural person who is an associated person of a broker or dealer to place the interest of the broker, dealer, or such natural person ahead of the interest of the retail customer;
  • (i) identify and disclose any material limitations placed on the securities or investment strategies involving securities that may be recommended to a retail customer and any conflict of interest associated with such limitation; and (ii) prevent such limitations and associated conflicts of interest from causing the broker, dealer or a natural person who is an associated person of the broker or dealer to make recommendations that place the interest of the broker, dealer or such natural person ahead of the interest of the retail customer; and
  • identify and eliminate any sales contests, sales quotas, bonuses and non-cash compensation that are based on the sales of specific securities or specific types of securities within a limited period of time.

Compliance Obligation

The Compliance Obligation, a new addition to the specific obligations under the general obligation, requires the broker or dealer to establish, maintain and enforce written policies and procedures reasonably designed to achieve compliance with Regulation BI.

Form CRS Relationship Summary

The Commission adopted a new regulation – Rule 17a-14 – and amendments to Form ADV to add a new Part 3: Form CRS. With Form CRS, investment advisers, brokers and dealers will be required to deliver a relationship summary to retail investors at the beginning of their relationship. Intended to be a short and accessible disclosure form, the Form CRS will allow firms to summarize information about services, fees and costs, conflicts of interest, legal standard of conduct and whether or not the firm and its financial professionals have disciplinary history.[17] The SEC hopes that retail investors will use the form to compare information about firms’ brokerage or investment advisory offerings.

Interpretive Guidance: ‘Solely Incidental’ Prong of Broker-Dealer Exclusion from the Definition of Investment Adviser

The Commission provided guidance elaborating on its views regarding Section 202(a)(11)(C) of the Advisers Act, which excludes from the definition of “investment adviser” any broker or dealer that provides advisory services when such services are “solely incidental” to the conduct of the broker’s or dealer’s business as a broker or dealer and when such incidental advisory services are provided for no special compensation. In sum, the SEC interprets the statutory language to mean that a broker’s or dealer’s provision of advice as to the value and characteristics of securities or as to the advisability of transacting in securities is consistent with the solely incidental prong if the advice is provided in connection with and is reasonably related to the broker-dealer’s primary business of effecting securities transactions.

Whether advisory services provided by a broker or dealer satisfies the “solely incidental” prong is then assessed under the facts and circumstances surrounding the broker’s or dealer’s business, the specific services offered, and the relationship between the broker or dealer and the customer. The SEC noted that advice can be solely incidental to a broker or dealer’s business without regard to the quantum or importance thereof.

To illustrate, the SEC discussed two advisory services – exercising investment discretion over customer accounts and account monitoring:

  • Investment Discretion - a broker-dealer’s exercise of unlimited discretion would not be “solely incidental” to the business of a broker or dealer within the meaning of Section 202(a)(11)(C) of the Advisers Act, as the level of discretion is so continuous and comprehensive that the provision of advice is not solely incidental to effecting securities transactions.
    In cases where a broker-dealer exercises temporary or limited discretion, limited by time, scope, or other manner, that lacks the “comprehensive and continuous” character of investment discretion, the totality of the facts and circumstances would be relevant to determine whether such a relationship, and advice coming therefrom, is consistent with the solely incidental prong.[18]
  • Account Monitoring - a broker or dealer that agrees to monitor a retail customer’s account on a periodic basis for purpose of providing buy, sell, or hold recommendations may still be considered to provide advice in connection with, and reasonably related to, effecting securities transactions.[19]
    Similarly, a broker-dealer who voluntarily and without any agreement with the customer reviews the holdings in a retail customer’s account for the purposes of determining whether to provide a recommendation to the customer is also acting in connection with, and reasonably related to, the broker’s or dealer’s primary business of effecting securities transactions absent an agreement with the customer.

Interpretive Guidance: Standard of Conduct of Investment Advisers

The SEC intends its investment adviser interpretive guidance “to reaffirm—and in some cases clarify—” various aspects of the fiduciary duty owed by an investment adviser to its clients under Section 206 of the Advisers Act. In addition, the interpretation seeks to align the Commission’s guidance in light of Regulation BI.

The Commission’s interpretation first outlines the framework of the fiduciary duty that investment advisers owe to their clients, stating that the duty must be viewed “within the context of the agreed-upon scope of the relationship between the adviser and the client.” Specific obligations that flow from the adviser’s fiduciary duty depend upon what functions the adviser has agreed to assume. The guidance notes, however, that the contract between the client and the adviser cannot negate or waive the adviser’s federal fiduciary duty, regardless of the sophistication of the client.

The Investment Adviser Interpretation Release describes the investment adviser’s fiduciary duty as being comprised of the following duties:

  • Duty of care. The SEC describes the duty of care, noting that the investment adviser’s duty of care includes, among other things: (1) a duty to act in the best interest of the clients, and a duty to provide advice that is in the best interests of the clients; (2) a duty to seek best execution of client transactions; and (3) a duty to provide advice and monitoring throughout the client relationship.[20] In respect of the duty of care, the SEC makes the following notable observations:
    • In providing personalized advice, the investment adviser’s ability to provide advice that is in the best interests of the client is dependent on a reasonable inquiry and understanding of the client’s objectives, which necessitates an understanding of the client’s investment profile or mandate. The Commission notes that it will be necessary for an adviser to update the client’s investment profile, to maintain a reasonable understanding of the client’s objectives, and adjust the advice given to reflect changed circumstances.
    • The duty to act in the best interests of the client requires a reasonable belief that the investment advice given is in the best interest of the client and their objectives, evaluated in the context of the portfolio being managed. This requires advisers to also conduct a reasonable investigation into the investment to sufficiently base advice on materially accurate and complete information.
  • Duty of loyalty. The SEC notes that the duty of loyalty is rooted in specific principles: an investment adviser must not favor its own interests over those of a client, or unfairly favor one client over another, and an adviser must make full and fair disclosure to its clients of all material facts relating to the advisory relationship, including all material conflicts of interest that could affect the advisory relationship. The disclosure must be clear and detailed, enabling the client to analyze and understand complex conflicts and their ramifications to make an informed decision to consent or reject advice involving conflicts of interest.

Conclusion

The new package of rules and interpretive guidance represents the most significant rulemaking for the retail financial services industry in many years. These changes will require the investment of significant time and resources to make necessary operational and other changes, including to mandatory disclosures, marketing materials and compliance systems.

Footnotes

[1] For more information on the development of the new regulations, please see our prior note, “Raising the Bar? SEC Proposes Broker-Dealer Standard of Care and Guidance on Investment Advisers’ Fiduciary Standard.”
[2] View the text of the final Regulation Best Interest.
[3] View the text of the final Form CRS Relationship Summary.
[4] View the text of the final interpretative releases, available at: https://www.sec.gov/rules/interp/2019/ia-5249.pdf and https://www.sec.gov/rules/interp/2019/ia-5248.pdf.
[5] See Jay Clayton, Chairman, U.S. Sec. & Exch. Comm’n, Statement at the Open Meeting on Commission Actions to Enhance and Clarify the Obligations Financial Professionals Owe to our Main Street Investors (June 5, 2019), available at: https://www.sec.gov/news/public-statement/statement-clayton-060519-iabd; see also Jay Clayton, Chairman, U.S. Sec. & Exch. Comm’n, Statement at the Open Meeting on Standards of Conduct for Investment Professionals (Apr. 18, 2018), available at https://www.sec.gov/news/public-statement/clayton-statement-open-meeting-iabd-041818.
[6] See Regulation Best Interest, Exchange Act Release No. 34-83062 (Apr. 18, 2018) https://www.sec.gov/rules/proposed/2018/34-83062.pdf. The proposal release defined “retail customer” as “a person, or the legal representative of such person, who: (A) Receives a recommendation of any securities transaction or investment strategy involving securities from a broker, dealer, or a natural person who is an associated person of a broker or dealer; and (B) Uses the recommendation primarily for personal, family, or household purposes.”
[7] Form CRS Relationship Summary; Amendments to Form ADV; Required Disclosures in Retail Communications and Restrictions on the use of Certain Names or Titles, Exchange Act Release No. 34-83063 (Apr. 18, 2018) https://www.sec.gov/rules/proposed/2018/34-83063.pdf (the “Relationship Summary Release”).
[8] Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on Enhancing Investment Adviser Regulation, Release No. IA-4889 (Apr. 18, 2018) https://www.sec.gov/rules/proposed/2018/ia-4889.pdf (the “Investment Adviser Interpretation Release”).
[9] For more information on the Proposed Rules, see please see our prior note, “Raising the Bar? SEC Proposes Broker-Dealer Standard of Care and Guidance on Investment Advisers’ Fiduciary Standard.”
[10] See Chamber of Commerce v. U.S. Dep’t of Labor, 885 F.3d 360 (5th Cir. 2018).
[11] R. Alexander Acosta, U.S. Secretary of Labor, Hearing Testimony, “Examining the Policies and Priorities of the U.S. Department of Labor,” U.S. House of Representatives Committee on Education and Labor, May 1, 2019.
[12] See Rule 15l-1(b)(1).
[13] See Rule 15l-1(a)(1).
[14] See Rule 15l-1(a)(2)(i).
[15] Id.
[16] This language is similar to that of FINRA Rule 2111 Supplementary Material .05(a) (the “reasonable-basis” component of suitability).
[17] View the Form ADV general instructions with the new Part 3 (Form CRS) included
[18] The Commission noted specific examples of temporary or limited investment discretion that, standing alone, would not support the conclusion that a relationship is primarily advisory — and therefore outside the scope of the solely incidental prong. These include 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; (iii) as to cash management, such as to exchange a position in a money market fund for another money market fund or cash equivalent; (iv) to purchase or sell securities to satisfy margin requirements, or other customer obligations that the customer has specified; (v) to sell specific bonds or other securities and purchase similar bonds or other securities in order to permit a customer to realize a tax loss on the original position; (vi) to purchase a bond with a specified credit rating and maturity; and (vii) to purchase or sell a security or type of security limited by specific parameters established by the customer. See also 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): https://www.sec.gov/rules/interp/2019/ia-5249.pdf.
[19] The Commission noted that monitoring agreed to between the broker-dealer and the customer would result in a recommendation to purchase, sell or hold a security interest each time the agreed-to monitoring occurs and would be covered by Regulation BI.
[20] Note: Regulation BI does not, as the interpretive guidance provides, have an ongoing requirement to monitor over the course of the relationship between the broker-dealer and the retail customer. The Care Obligation of Regulation BI applies at the time of the recommendation.

Authors and Contributors

Russell Sacks

Partner

Financial Institutions Advisory & Financial Regulatory

+1 212 848 7585

+1 212 848 7585

New York

Nathan Greene

Partner

Investment Funds

+1 212 848 4668

+1 212 848 4668

New York

Jennifer D. Morton

Counsel

Financial Institutions Advisory & Financial Regulatory

+1 212 848 5187

+1 212 848 5187

New York

Mark A. Dunham, Jr.

Associate

Capital Markets

+1 212 848 4767

+1 212 848 4767

New York