United States: SEC Proposes Standards Of Conduct For Broker-Dealers, Investment Advisers

In a first step toward developing standards for advice to retail customers, the Securities and Exchange Commission recently proposed rules and interpretive guidance intended to enhance investor protections while preserving investment choice and access.

The Securities and Exchange Commission (SEC) voted on April 18 to propose standards for broker-dealers and investment advisers when providing recommendations and investment advice to retail customers in a three-part package that includes

We are reviewing the text (1,000+ pages), but here are our first impressions.

What happened?

  • Following an open meeting, the SEC voted 4–1 to propose the package of rulemaking and guidance. Commissioner Kara Stein was the dissenting vote, and Commissioner Robert Jackson voted to move forward to begin consideration of the proposals while noting he did not support the package.
  • Chairman Jay Clayton emphasized that the package is intended to close the gap between investor expectations and current law while preserving access and choice. He also sees this proposal as addressing concerns about a patchwork of standards developing for retail investment advice.
  • The proposal will be subject to a comment period ending 90 days after the releases are published in the Federal Register.

What do we know about the proposal so far?

  • What is “Regulation Best Interest”?

    • Proposed Regulation Best Interest would require broker-dealers to act in the best interest of the retail customer when they recommend a securities transaction or investment strategies involving securities, without placing the broker-dealer’s or registered representative’s financial or other interest ahead of the customer’s interest.

      • The SEC has not proposed to define the term “recommendation,” and instead would look to existing guidance from the Financial Industry Regulatory Authority (FINRA) as to when a broker-dealer communication is viewed as a recommendation, including a recommendation about a rollover, or is excluded from FINRA Rule 2111 (e.g., general financial and investment information, descriptive information about an employer-sponsored retirement or benefit plan, certain asset allocation models, and interactive investment materials).
      • “Retail Customer” would be defined as a person, or the legal representative of the person, who receives a recommendation of any securities transaction or investment strategy involving securities from a broker-dealer or registered representative, and uses the recommendation primarily for personal, family, or household purposes.
    • A broker-dealer would satisfy the best interest obligation if it satisfies three obligations:

      • Disclosure Obligation: The broker-dealer, prior or at the time of the recommendation, “reasonably” discloses to the retail customer, in writing, the material facts about the scope and terms of its relationship with the broker-dealer and all material conflicts of interest associated with the recommendation. The disclosure obligation would build upon disclosures required by Form CRS, but provide flexibility to broker-dealers in deciding how to provide the required disclosures.
      • Care Obligation: The broker-dealer would be required to exercise “reasonable diligence, care, skill, and prudence” to (1) understand the potential risks and rewards of the recommendation and have a reasonable basis to believe that the recommendation could be in the “best interest” of at least some retail customers; (2) have a reasonable basis to believe that the recommendation is in the “best interest” of the retail customer to whom it is made based on the retail customer’s investment profile and the potential risks and rewards associated with the recommendation; and (3) 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. The components of the care obligation are intended to incorporate and build upon existing reasonable-basis, customer-specific, and quantitative suitability obligations under the Securities Exchange Act of 1934 and FINRA Rule 2111.
      • Conflicts of Interest Obligation: The broker-dealer would be required to establish, maintain, and enforce written policies and procedures reasonably designed to identify and (1) at a minimum disclose, or eliminate, all material conflicts of interest associated with the recommendation; and (2) disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with the recommendations. The SEC has not proposed prescriptive policies and procedures that broker-dealers must adopt, and instead has proposed to allow broker-dealers flexibility to decide on the appropriate approach.
    • Finally, the SEC asked for comment on whether it should revisit whether a broker-dealer’s exercise of investment discretion should be viewed as “solely incidental” to the business of a broker-dealer.
  • What are the Form CRS and titling requirements?

    • Proposed Form CRS (Customer/Client Relationship Summary) will require a maximum four-page form disclosure document for broker-dealers, investment advisers, and dual registrants when interacting with retail customers.

      • Firms would be required to describe the differences between brokerage and advisory services, including fees, conflicts, service levels, and standards of conduct, and include sample questions for investors to ask their financial professional to better understand the services offered.
      • Three sample Forms CRS are available here:

    • Titling requirements and restrictions will seek to address investor confusion about whether an investor is dealing with a broker-dealer or investment adviser and will prohibit the use of the terms “advisor” and “adviser” by someone who is not an investment adviser representative.
  • What does the Standard of Conduct for Investment Advisers consist of?

    • This release consists of a proposed interpretation of the “federal fiduciary standard” applicable to investment advisers under Section 206(1) and (2) of the Advisers Act. The interpretation seeks to provide guidance about an investment adviser’s obligations under the duties of loyalty and care. According to the proposed interpretation, those duties require the following:

      • Duty of loyalty

        • Duty to put the client’s interest ahead of own interests
        • Duty not to unfairly prefer one client over another
        • Duty of full and fair disclosure
      • Duty of care

        • Obligation to provide advice that is suitable and in the client’s best interest
        • Duty to seek best execution
        • Obligation to provide advice and monitoring over the course of the relationship
      • Firms should consider how the obligations in the proposed interpretation compare to their understanding of current requirements.
  • The SEC also sought comment on whether it should impose additional obligations on investment advisers to address perceived gaps in regulation from what is required of broker-dealers, including

    • federal licensing and continuing education requirements for investment adviser representatives;
    • provision of account statements; and
    • financial responsibility requirements.

What should firms do now?

  • The SEC’s decision to propose this package is a first step toward developing standards for advice to retail customers, regardless of whether they are investing through a retirement or taxable account.
  • The proposal is subject to change through the notice and comment process, which closes 90 days after the releases are published in the Federal Register, although given the complexity of the issues raised, the SEC might be expected to extend the comment period.
  • We encourage firms to review the release and consider submitting comments as they evaluate the impact on their business models.

What is Morgan Lewis doing in response?

  • We are reviewing the proposal and preparing a client alert with a more detailed assessment.
  • We will prepare client briefings and presentations on the proposal and its impact, and work with clients to submit comment letters.
  • We are coordinating with our interdisciplinary fiduciary practice to analyze the impact of the proposal on broker-dealers, investment advisers, and dual registrants, including across various business lines and product offerings.

This article is provided as a general informational service and it should not be construed as imparting legal advice on any specific matter.

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