On June 5, 2019, the U.S. Securities and Exchange Commission (SEC), by a 3-1 vote, adopted two rules and two interpretations related to the standard of conduct requirements for broker-dealers and investment advisers:
- Regulation Best Interest (Regulation BI), a new rule imposing a “best interest” standard of conduct on broker-dealers making recommendations to retail clients (compliance date: June 30, 2020)
- Form CRS Relationship Summary and Form ADV Amendments (Form CRS), a new rule requiring both broker-dealers and investment advisers to provide retail clients with information about the nature of their relationship (compliance date: June 30, 2020)
- Standard of Conduct for Investment Advisers, a new interpretation clarifying an investment adviser’s fiduciary duty to its clients (effective upon publication in the Federal Register, expected June 2019)
- Broker-Dealer “Solely Incidental” Exclusion, a new interpretation of Section 202(a)(11)(C) of the Investment Advisers Act of 1940 (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 or dealer’s business and when such incidental advisory services are provided for no special compensation (effective upon publication in the Federal Register, expected June 2019)
It has been almost 10 years since the Dodd-Frank Wall Street Reform and Consumer Protection Act directed the SEC to study and, if necessary, address the standard of care applicable to the provision of financial advice by broker-dealers and advisers to retail investors. Regulation BI and Form CRS accomplish that statutory mandate in a way that seeks to enhance investor protection while preserving the choice between the broker-dealer and investment adviser service models for individual investors. Regulation BI will require substantial work to implement its standards (and poses many unanswered questions).
These new rules and interpretations, which have been championed by Chairman Jay Clayton, are generally consistent with the original proposals, which were summarized in a previous Sidley Update;1 although the “solely incidental” interpretation is new, it is based on comments to the Regulation BI proposal. We summarize below some of the most consequential differences in the other rulemakings and provide an overview of the new “solely incidental” interpretation.
- The definition of “retail investor” was sharpened to focus on accounts for natural persons (including some trusts and individual retirement accounts (IRAs), but not advice to retirement plan sponsors) and now conforms to the Form CRS definition.
- Unlike the Financial Industry Regulatory Authority (FINRA) institutional suitability approach, there is no ability for high-net-worth individuals to opt out of coverage.
- Regulation BI explicitly requires policies and procedures that eliminate product-specific sales contests and sales quotas.
- It is specifically applicable to account recommendations (e.g., whether to open a brokerage account or an advisory account or to roll over a 401(k) into an IRA).
- It allows dually registered broker-dealer/investment advisers to use the term “adviser” or “advisor” but it would presumptively violate the Regulation BI disclosure obligation for a broker-dealer that is not dually registered to use such terms.
- While Regulation BI maintains the written disclosure requirement for product-level fees and costs (which may be problematic in the case of telephone recommendations), it provides some flexibility for the written disclosure to occur after an oral recommendation (e.g., in the prospectus or trade confirm).
- The final Form CRS instructions contain less prescribed language, with standardized questions serving as the headings, but firms are generally allowed to use their own wording to address the required topics.
- In place of the proposed separate “Key Questions to Ask” section, firms must integrate questions for retail clients to ask their financial professionals as headings or as “conversation starters.”
- New Item 3 integrates sections covering fees, costs, conflicts of interest, and standards of conduct, modifies the standard of conduct disclosure and broadens the types of conflicts disclosure required.
- Firms must use the term “best interest” to describe their standard of conduct.
- Firms must disclose conflicts information regarding proprietary products, third-party payments, revenue sharing, and principal trading (if applicable).2
- The proposed prescribed disclosure attempted to explain the concepts of full and fair disclosure, mitigation, and informed consent. As adopted, this explanation has been replaced with a “conversation starter” encouraging firms to discuss with retail clients how their standard of conduct requires them to address conflicts of interest. The purpose of this section is to highlight for retail clients that conflicts exist; firms are not required by this item to explain how conflicts will be mitigated.
- The requirement to differentiate between broker-dealer and investment advisory services has been replaced by cross-references to SEC materials with more details.
Standard of Conduct for Investment Advisers3
- The final interpretation reviews the elements of the fiduciary standard,4 including the point that, generally speaking, an investment adviser can simply disclose conflicts for purposes of obtaining informed consent, with no categorical duty to mitigate or eliminate those conflicts.5
- However, the SEC states that if an investment adviser “cannot fully and fairly disclose a conflict of interest to a client such that the client can provide informed consent, the adviser should either eliminate the conflict or adequately mitigate (i.e., modify practices to reduce) the conflict such that full and fair disclosure and informed consent are possible.”
- According to the SEC, stating that an adviser “may” have a conflict is insufficient if the conflict actually exists, but using the term “may” can be appropriate if the conflict does not currently exist but might reasonably present itself in the future. Applying this guidance may require a nuanced approach in certain circumstances.
- The release interprets investment advisers’ obligations to all clients (not only retail clients), but it states that sophisticated clients such as registered investment companies and private funds are permitted to shape the scope of their relationships to which fiduciary duties apply. The release confirms that while no adviser can ask any client to waive fiduciary status entirely, “it will apply in a manner that reflects the agreed-upon scope of the relationship.”
- A client’s informed consent following “full and fair” disclosure can be either explicit or, depending on the facts and circumstances, implicit.
- The question of whether a hedge clause seeking to limit an adviser’s liability violates the Advisers Act’s anti-waiver provisions depends on all of the surrounding facts and circumstances, including the sophistication of the client.
- The original interpretation proposal in April 2018 requested comment on licensing and continuing education requirements for personnel of SEC-registered investment advisers, delivery of account statements to clients, and financial responsibility requirements for SEC-registered advisers. The SEC noted in the final interpretation that it is continuing to evaluate the comments received on these concepts.
Broker-Dealer “Solely Incidental” Interpretation
- The broker-dealer “solely incidental” interpretation was not part of the SEC’s original set of proposals in April 2018 but was adopted in response to comments the SEC received on the Regulation BI proposal. That interpretation addresses the portion of the definition of “investment adviser” that excludes any broker or dealer that provides advisory services, so long as such services are “solely incidental” to the conduct of the broker or dealer’s business and when such incidental advisory services are provided without special compensation.
- The new interpretation affirms and refines interpretations issued by the SEC in 20056 and 2007.7 The interpretation provides two illustrations of conduct by broker-dealers that may be consistent with the “solely incidental” exclusion: (1) exercising investment discretion over customer accounts that is limited in time, scope or other manner and lacks the comprehensive and continuous character of investment discretion that would suggest that the relationship is primarily advisory,8 and (2) monitoring customer accounts in connection with effecting securities transactions.
Commenting, Implementation and Certain Other Matters
In response to the proposals in April 2018, the SEC received thousands of public comments, some supportive and many critical. FINRA has indicated that it will need to review and possibly remove its own suitability standard for member broker-dealers.9 The SEC stated that Regulation BI does not purport to create a private right of action. Nonetheless, in light of the judicial invalidation of the U.S. Department of Labor’s fiduciary rule,10 certain U.S. states have proposed their own legislation imposing a higher fiduciary standard of care on broker-dealers.11 These state proposals raise preemption concerns, which the releases expressly declined to address, but the industry is likely to challenge those state rules if adopted. Although the final Regulation BI does not vary significantly from the proposals, Regulation BI may be challenged by those who believe it should be more stringent.
Firms have a little over one year to review and update their policies and procedures to comply with Regulation BI and Form CRS. Many interpretive issues under the new rules remain open, including (1) what level of disclosure is necessary in connection with recommendations of individual equity and bond transactions; (2) how to disclose compensation for principal transactions with an inventory account; (3) how the rules would apply to recommendations of illiquid private funds to high-net-worth individual investors; and (4) how a firm with a limited product set will determine whether a recommendation is in a client’s best interest.
The SEC states that Regulation BI is meant to be principles-based and should be implemented using a risk-based approach. The SEC also states that it will not apply the rule on strict liability basis and will determine whether firm procedures and policies are “reasonable” as of the time of the recommendation, not on a hindsight basis. But for practical purposes, interpretation and application of the rule will be determined by examination and surveillance teams of FINRA and the SEC. As we have seen with the enforcement of similar broadly applicable rules, this approach can lead to inconsistent interpretations and applications of the rule, regulation by enforcement action, and informal, less transparent staff-level guidance.
For Regulation BI, requests for practical guidance should be presented to the SEC long before the rule’s compliance date. This will assist firms’ compliance and can also facilitate FINRA’s examinations and enforcement actions with specific and detailed guidance from the SEC that is uniform and consistent with the SEC’s intent and design.
1 “SEC Proposes New Standard of Care for Broker-Dealers: Overview and Considerations for Investment Professionals” (May 7, 2018), https://www.sidley.com/-/media/update-pdfs/2018/05/sec-proposes-new-standard-of-care-for-brokerdealers-overview-and-considerations-for-investment-profe.pdf?la=en.
2 According to the SEC, firms without these particular conflicts must disclose at least one material conflict.
3 The final interpretation is largely consistent with previous SEC statements on the federal fiduciary standard, including those in the original proposal in April 2018. However, the SEC made a number of changes in response to requests received during the comment period. The precise legal effect of an interpretive release is beyond the scope of this Update. Although the release is an interpretation of what the SEC characterizes as existing obligations, and is not set forth in a formal rule, the release was issued pursuant to formal notice and comment rulemaking. A court would presumably defer to the SEC’s interpretation to the extent required under Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 468 U.S. 837 (1984), although “Chevron deference” could be subject to at least some modification by the present Supreme Court. There also may be less basis for such deference in the context of interpreting the fiduciary duties of investment advisers, because those duties reflect principles set forth in cases (in particular the Capital Gains case referred to in note 4 of this Update). In any event, the positions taken by the SEC in the release would presumably inform the positions to be taken by the SEC or the staff thereof in examinations and enforcement under the Advisers Act.
4 The release cites SEC v. Capital Gains Research Bureau, Inc. 375 U.S. 180 (1963); In the Matter of Arleen W. Hughes, Exchange Act Release No. 4048 (Feb. 18, 1948).
5 Commissioner Robert Jackson dissented from the entire package of releases. He argued that the SEC should have applied a full fiduciary standard to broker-dealers and that the investment adviser standard of conduct as adopted was weaker than as proposed and under existing law.
6 Certain Broker-Dealers Deemed Not to Be Investment Advisers, Investment Advisers Act Release No. 2376 (Apr. 12, 2005).
7 Interpretive Rule Under the Advisers Act Affecting Broker-Dealers, Investment Advisers Act Release No. 2652 (Sept. 24, 2007).
8 Examples of investment discretion that should consistent with the “solely incidental” exclusion 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.
9 Robert Cook, President and Chief Executive Officer, Financial Industry Regulatory Authority, Remarks at the Securities Industry and Financial Markets Annual Meeting (Oct. 2, 2018).
10 U.S. Chamber of Commerce v. U.S. Dep’t of Labor, No. 17-10238, 2018 WL 1325019 (5th Cir. Mar. 15, 2018).
11 See, e.g., The Investment Transparency Act, New York Senate Bill 2872A (2019) (mandating enhanced disclosure by non-fiduciaries that provide investment advice and reintroduced in January 2019); Suitability and Best Interests in Life Insurance and Annuity Transactions Regulation, 11 NYCRR 224 (2018) (promulgating an amendment to Insurance Regulation 187 that adopts a best-interest standard for insurance brokers in 2018 and takes effect on August 1, 2019); An Act Protecting the Interests of Consumers Doing Business With Financial Planners, Connecticut Public Act 17-120, HB 6992 (2017) (requiring financial planners to disclose whether or not they are a fiduciary and effective as of July 5, 2017); An Act Concerning Non-Fiduciary Investment Advisors, New Jersey Assembly Bill 335 (2018) and New Jersey SB 735 (2018) (requiring broker-dealers and advisers to be subject to an express fiduciary duty and introduced in both chambers in January 2019); New Jersey Bureau of Securities, Fiduciary Duty Notice of Pre-Proposal, 50 NJR 2142(a) (2018) (issuing a notice of a preproposal to solicit comments on rule); An Act Relating to Financial Planners, Nevada SB 383 (2017) (imposing a fiduciary duty on financial planners (including broker-dealers and advisers), but leaving core requirements to Nevada Securities Division to decide and adopted in 2017); Nevada Securities Division, Notice of Draft Regulations and Request for Comment (Jan. 18, 2019) (releasing proposed regulations in January 2019 to be added to Chapter 90 of the Nevada Administrative Code).
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