United States: SEC Adopts Regulation Best Interest And Issues Interpretive Release On The "Solely Incidental" Exclusion

On June 5, 2019, the SEC adopted two rules and published two interpretations "designed to enhance the quality and transparency of retail investors' relationships with investment advisers and broker-dealers." This Alert discusses the Regulation Best Interest adopting release and the SEC interpretive release regarding the "solely incidental" prong of the broker-dealer exclusion from the Advisers Act. Separate Ropes & Gray Alerts discuss the SEC release on the standard of conduct for investment advisers (available here) and the SEC adoption of Form CRS (available here).

REGULATION BEST INTEREST

Introduction. Regulation Best Interest (the "Regulation"), new Rule 15l-1 under the Exchange Act, imposes an overarching standard of conduct that requires broker-dealers and natural persons who are associated persons of a broker-dealer (unless otherwise indicated, each a "broker-dealer"), when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer,1 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 making the recommendation ahead of the interest of the retail customer (the "General Obligation").

The term "best interest" is not defined in the Regulation. Instead, whether a broker-dealer acted in the best interest of its customer is determined by an objective consideration of the facts and circumstances of how the specific components of the Regulation were satisfied when the recommendation was made. A broker-dealer's obligations cannot be modified or disclaimed by the broker-dealer, or otherwise waived by a retail customer.

Notably, the Regulation does not:

  • extend beyond the time a particular recommendation is made or impose a duty on a broker-dealer to monitor a customer's account.
  • require a broker-dealer to conduct an evaluation of every possible alternative in order to recommend the single best of all possible alternatives that exist, but, instead, requires the broker-dealer to consider reasonably available alternatives offered by the broker-dealer.
  • require a broker-dealer to refuse to accept an order from a retail customer that is contrary to the broker-dealer's recommendation, nor does it apply to investor-directed or unsolicited transactions by a retail customer.
  • create any new private right of action or right of rescission.

In determining what standard of conduct should apply to broker-dealers, the SEC opted not to apply the Advisers Act fiduciary standard to broker-dealers or to adopt a new uniform fiduciary standard that would apply to both broker-dealers and investment advisers. While the new standard of conduct under the Regulation includes several elements that are similar to key elements of the fiduciary standard applicable to investment advisers, the adopting release stresses that the Regulation's standard is not a fiduciary standard.

The compliance date for the Regulation is June 30, 2020.

Compliance with Regulation Best Interest

The General Obligation is triggered at the time a recommendation (including an implicit hold recommendation resulting from agreed-upon account monitoring services) is made to a retail customer,2 and is satisfied by a broker-dealer complying with the four specific obligations – Disclosure, Care, Conflict of Interest, and Compliance – described below.

The Disclosure Obligation. The Disclosure Obligation requires broker-dealers to provide the retail customer, prior to or at the time of the recommendation, in writing, full and fair disclosure of:

  1. all material facts relating to the scope and terms of the relationship with the retail customer, including:

    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;
    3. the type and scope of services provided to the retail customer, including any material limitations3 on the recommendation to the retail customer. In this regard, the broker-dealer must disclose the general basis for the recommendation and a discussion of the risks associated with the recommendation; and
  2. all material facts relating to conflicts of interest4 that are associated with the recommendation, such as those related to compensation arrangements and recommendations of proprietary products.

Supplemental Disclosure. The SEC recognized the importance of providing broker-dealers with flexibility regarding the time and manner in which disclosure of a particular material fact is made. Therefore, the SEC clarified in the adopting release that, in certain limited circumstances, the Disclosure Obligation may be satisfied by oral disclosure or disclosure after a recommendation is made if a broker-dealer provides initial, written disclosure that states what the material facts are and describes how the material facts will be supplemented, clarified or updated.5

Duty to Update. A broker-dealer must update when information provided becomes materially inaccurate or when there is new material information. In the adopting release, the SEC noted that the duty to update is based on facts and circumstances and, while it declined to provide a specific timeframe for when updates would be required, noted that broker-dealers generally should update disclosure documents as soon as possible and, in any event, no later than 30 days after a material change.

Use of Terms "Adviser" or "Advisor". Use of the words "adviser" or "advisor" in a name or title by (i) a broker-dealer that is not also registered as an investment adviser or (ii) an associated person who is not also a supervised person of an investment adviser will be presumed to violate the Regulation. The use of either of these words would directly conflict with the disclosure that the broker, dealer, or associated person is acting as a broker, dealer, or associated person of a broker or dealer.

The Care Obligation. The Care Obligation requires broker-dealers, in making recommendations to retail customers, to exercise reasonable diligence, care, and skill to:

  1. 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;
  2. have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on the 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 ahead of the interest of the retail customer; 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 customer's best interest when taken together in light of the customer's investment profile and does not place the financial or other interest of the broker-dealer making the series of recommendations ahead of the interest of the customer.

While it may not be clear exactly what "best interest" means, the adopting release does state that the Care Obligation "significantly enhances the investor protection provided as compared to current [FINRA] suitability obligations."

The Conflict of Interest Obligation. The Conflict of Interest Obligation requires broker-dealers to establish, maintain, and enforce written policies and procedures designed to:

  1. identify and at a minimum disclose, in accordance with the Disclosure Obligation, or eliminate, all conflicts of interest associated with recommendations to retail customers;
  2. identify and mitigate any conflicts of interest associated with recommendations that create an incentive for an associated person to place the interest of the broker, dealer, or associated person ahead of the interest of the retail customer;
  3. identify and disclose any material limitations on recommendations to a retail customer and any conflicts of interest associated with such limitations, in accordance with the Disclosure Obligation, and prevent such limitations and associated conflicts of interest from causing the broker-dealer to make recommendations that place the interest of the broker-dealer ahead of the interest of the retail customer; and
  4. 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.6

Where a conflict of interest creates too strong an incentive for a broker-dealer to make a recommendation that places the broker-dealer's interest ahead of the retail customer's interest, the Conflicts of Interest Obligation requires policies and procedures designed to eliminate the conflict or to both disclose and mitigate the conflict.

The Compliance Obligation. The Compliance Obligation, which is a new requirement that did not appear in the proposing release, requires broker-dealers to establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with the Regulation.

The SEC stated that a "reasonably designed compliance program" generally would include: controls, remediation of non-compliance, training, and periodic review and testing.

Recordkeeping. In connection with the Regulation, the SEC adopted new recordkeeping provisions under the Exchange Act. Specifically, Rule 17a-3(35) requires broker-dealers to retain a record of all information collected from and provided to a retail customer pursuant to the Regulation, as well as the identity of each associated person, if any, responsible for the account. With respect to information provided orally, the adopting release clarifies that broker-dealers must retain a record of the fact that oral disclosure was provided to the customer. The Regulation does not explicitly require broker-dealers to maintain a record of the substance of the disclosure.

INTERPRETATION OF "SOLELY INCIDENTAL" IN ADVISERS ACT § 202(A)(11)(C)

The Advisers Act regulates the activity of "investment advisers" as defined in the Act. Section 202(A)(11)(C) excludes from the definition of "investment adviser" brokers or dealers "whose performance of such advisory services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefor" (the "exclusion"). On June 5, 2019, the SEC published an interpretive release to clarify its position with respect to the exclusion.

According to the SEC, a broker-dealer is within the exclusion if "the advice is provided in connection with and is reasonably related to the broker-dealer's primary business of effecting securities transactions." This determination will be made based on the facts and circumstances related to the broker-dealer's business, services offered and relationship with its customer. Notably, the analysis does not rely on the amount of advice or the importance of the advice.7 As discussed below, the interpretation provides additional guidance on how the exclusion applies (i) when broker-dealers exercise investment discretion over customer accounts and (ii) when broker-dealers engage in account monitoring.

Investment Discretion

When a broker-dealer is given unlimited discretion over a customer account, the broker-dealer is not within the scope of the exclusion. When the broker-dealer is granted discretion on a temporary or limited basis, whether the broker-dealer is within the scope of the exclusion depends on the facts and circumstances.

The SEC included the following as examples of temporary or limited discretion that are typically within the scope of the exclusion: (i) discretion 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) discretion 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) discretion as to cash management, such as to exchange a position in a money market fund for another money market fund or cash equivalent; (iv) discretion to purchase or sell securities to satisfy margin requirements, or other customer obligations that the customer has specified; (v) discretion to sell specific securities and purchase similar securities in order to permit a customer to realize a tax loss on the original position; (vi) discretion to purchase a bond with a specified credit rating and maturity; and (vii) discretion to purchase or sell a security or type of security limited by specific parameters established by the customer.

Account Monitoring

Broker-dealers that agree to periodically monitor a customer's account for purposes of providing buy, sell or hold recommendations may be deemed to be providing advice in connection with effecting securities transactions and, therefore, may be ineligible for the exclusion.

The SEC differentiated this fact pattern from a broker-dealer that voluntarily, without any agreement with the customer, reviews the customer's account holdings for purposes of determining whether to provide a recommendation to the customer and, if the recommendation is determined to be appropriate, contacts the customer to make the recommendation. A broker-dealer whose actions are within this fact pattern is taking actions that are reasonably related to its primary business of effecting securities transactions.

The SEC recommended that broker-dealers consider adopting policies and procedures to govern when account monitoring is within the scope of the exclusion, stating that broker-dealers may include in their policies and procedures that:

a registered representative may agree to monitor a customer's account at specific time frames (e.g., quarterly) for the purpose of determining whether to provide a buy, sell, or hold recommendation to the customer. However, such policies and procedures should not permit a broker-dealer to agree to monitor a customer account in a manner that in effect results in the provision of advisory services . . . such as providing continuous monitoring.

Footnotes

1. "Retail customer" is defined as "a natural person, or the legal representative of such natural person, who (i) 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 (ii) uses the recommendation primarily for personal, family, or household purposes." Rule 15l-1(b)(1). The final rules narrowed the proposed definition by limiting "retail customers" to natural persons (and their legal representatives).

2. The Regulation applies broadly to recommendations of securities transactions and investment strategies involving securities. The adopting release points to existing FINRA guidance for determinations of whether a recommendation has been made, such as whether the communication "reasonably could be viewed as a 'call to action'" or "reasonably would influence an investor to trade a particular security or group of securities." Furthermore, the final rules expanded the proposed text to explicitly state that the Regulation covers recommendations of securities account types and recommendations to roll over or transfer assets from one type of account to another. As a result, account recommendations will be subject to the Regulation regardless of whether those recommendations are tied to particular securities transactions.

3. Material limitations include, for example, (i) recommending only proprietary products, a specific asset class, or products with third-party arrangements; (ii) recommending only products from a select group of issuers; and (iii) if a firm is dually registered as both a broker-dealer and an investment adviser, but an associated person of the firm is only permitted to provide brokerage services, the fact that the associated person's services are materially narrower than the services offered by other associated persons of the firm who are permitted to provide brokerage and advisory services.

4. The final Regulation adopts a definition of "conflict of interest" and provides that only the "material facts" of such conflicts must be disclosed. The Regulation defines "conflict of interest" as "an interest that might incline a broker, dealer, or a natural person who is an associated person of a broker or dealer—consciously or unconsciously—to make a recommendation that is not disinterested."

5. For example, with regard to product-level fees, a broker-dealer could provide an initial standardized disclosure of product-level fees generally (e.g., reasonable dollar or percentage ranges), noting that further specifics for particular products appear in the product prospectus, which will be delivered after a transaction in accordance with the delivery method the retail customer has selected, such as by mail or electronically. Similarly, with regard to the disclosure of a broker-dealer's capacity, a dually registered broker-dealer and investment adviser could disclose that recommendations will be made in the broker-dealer capacity unless otherwise expressly stated at the time of the recommendation, and that any such statement will be made orally.

6. The SEC believes that these incentives create the most problematic conflicts and cannot be reasonably mitigated.

7. According to the interpretation, "[a]dvice need not be trivial, inconsequential, or infrequent to be consistent with the solely incidental prong."

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions