(June 14, 2019) – Securities and Exchange Commission (SEC) adopted a package of regulatory items in four parts intended to "substantially enhance" the standards of conduct for financial professionals. On June 5, 2019 the Securities and Exchange Commission (SEC) adopted a package of regulatory items in four parts intended to "substantially enhance" the standards of conduct for financial professionals. While the SEC's package includes a release about the Client Relationship Form (CRS) required, interpretative guidance on the fiduciary obligation under the Investment Advisers Act of 1940 (Advisers Act), and interpretative guidance on the "solely incidental" prong of the Advisers Act, the principal focus of the release is the adoption of Regulation Best Interest (Reg BI) as the new standard of conduct applicable to the brokerage industry.
Reg BI requires that a broker-dealer, when making a recommendation to a client that is a natural person who uses the advice for non-commercial purposes (a retail customer), act in the "best interest" of the retail customer. It applies to both "buy" and "sell" recommendations, but also applies to explicit and implicit "recommendations to hold" that result from agreed-upon account monitoring. The regulation would apply where the retail customer is represented by a "nonprofessional" agent, but not by a professional adviser or other similar fiduciary. Retail customers, regardless of their sophistication, are not permitted to contract out of Reg BI.
Reg BI provides that the "general obligation" to act in a retail customer's best interest will be satisfied by complying with four specific obligations: disclosure, care, conflict, and compliance.
The Disclosure Obligation
The disclosure obligation can be met by providing required written disclosures before or at the time of any recommendation to the retail customer of all the "material facts" as to its relationship with the customer. According to the SEC, these must include (a) disclosure that the firm is acting as a broker-dealer (and not as an investment adviser); (b) the type and scope of services that the retail customer will be provided, including any "material limitations" involving the securities or investment strategies that may be recommended to the retail customer; (c) the material costs to the retail customer; and (d) all material facts relating to conflicts of interest that are associated with a recommendation to a retail customer.
The Care Obligation
To fulfill the care obligation, a broker-dealer must exercise reasonable "diligence, care, and skill" in recommending any transaction or "series of transactions." The broker-dealer is required to (a) understand the "risks, rewards, and costs" of any recommendation and have a reasonable basis to believe such recommendation could be in the best interest of at least some retail customers; (b) have a "reasonable basis" to believe the recommendation is in the best interest of a particular retail customer based upon the customer's investment objectives and risk profile, rewards, and costs and does not place the interests of the broker-dealer ahead of such customer; and (c) have a "reasonable basis" that a series of recommended transactions is not excessive in light of the customer's investment profile. The broker-dealer will effectively have to satisfy all of the elements of FINRA's existing suitability rule (FINRA Rule 2111) and additional elements.
The Conflict Obligation
Reg BI defines a "conflict of interest" associated with a recommendation as "an interest that might incline a person. . . consciously or unconsciously. . . to make a recommendation that is not disinterested." To fulfill this obligation, broker-dealers should establish, maintain, and enforce written policies and procedures reasonably designed to address conflicts of interest.
Specifically, a broker-dealer must establish, maintain, and enforce written policies and procedures that identify and address conflicts of interest, either by disclosing them or by eliminating them. This obligation requires firms to (a) monitor and mitigate or eliminate conflicts that provide financial incentives for sales persons to prioritize their interests over those of a retail customer; (b) prevent limitations on retail customer offerings, such as only selling proprietary products, from causing the firm or the firm's personnel to place their interest or the interests of the firm ahead of the retail customer's interest; and (c) eliminate sales contests or other compensation based on the sale of specific securities within a limited period of time.
The Compliance Obligation
In addition to policies and procedures required under the conflict obligation, the compliance obligation is satisfied if a broker-dealer establishes, maintains, and enforces written policies and procedures that are reasonably designed to obtain compliance with Reg BI.
Reg BI and Form CRS will become effective 60 days after they are published in the Federal Register, and will include a transition period until June 30, 2020, to give firms sufficient time to come into compliance. The SEC's interpretations under the Advisers Act will become effective upon publication in the Federal Register.
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