On June 5, 2019, the US Securities and Exchange Commission approved the following new rules and interpretations aimed at clarifying the duties that broker-dealers and investment advisers owe to their retail customers and clients:
- Regulation Best Interest (Reg BI). The SEC adopted rules that create a new standard of conduct governing broker-dealers' recommendations to their retail customers.
- Form CRS Relationship Summary. The SEC adopted new rules and forms to require both broker-dealers and registered investment advisers to provide a brief relationship summary to retail investors.
- Interpretation regarding the standard of conduct for investment advisers. The SEC issued an interpretation reaffirming and clarifying its views of the fiduciary duty that investment advisers owe to their clients under the Investment Advisers Act of 1940 (Advisers Act).
- Interpretation regarding the "solely incidental" prong of the broker-dealer exclusion under the Advisers Act. The SEC issued an interpretation to delineate when a broker-dealer's performance of advisory activities causes it to be deemed an investment adviser subject to the Advisers Act.
In its press release about the new rulemaking and interpretations, the SEC stated that "these actions are designed to enhance and clarify the standards of conduct applicable to broker-dealers and investment advisers, help retail investors better understand and compare the services offered and make an informed choice of the relationship best suited to their needs and circumstances, and foster greater consistency in the level of protections provided by each regime, particularly at the point in time that a recommendation is made."1
The SEC also sent a strong message that its intent is not to create a "one size fits all" standard for both broker-dealers and investment advisers. Rather, the SEC attempted to design a regulatory framework to protect retail investors while, at the same time, preserving choice. For example, SEC Chairman Jay Clayton emphasized during Senate testimony that "these standards should reflect what retail investors would reasonably expect of these financial professionals, while preserving access and choice for investors."2 In the SEC's press release, Chairman Clayton stated: "This rulemaking package will bring the legal requirements and mandated disclosures for broker-dealers and investment advisers in line with reasonable investor expectations, while simultaneously preserving retail investors' access to a range of products and services at a reasonable cost."3
The new regulatory framework has its supporters and critics, and the industry will undoubtedly continue to make itself heard in the months (and years) to come. As firms implement policies and procedures and modify their practices in response to the new framework, and as enforcement investigations and actions begin to be brought, the essential question will be: Does the framework actually protect the best interest of retail customers and advisory clients?
II. REGULATION BEST INTEREST
Reg BI constitutes a significant overhaul that impacts the standard of conduct applicable to broker-dealers when dealing with retail customers. It represents the culmination of a process that began with a study mandated by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) and then took a diversion through a Department of Labor (DOL) fiduciary rule, which covered some of the same issues in the context of certain individual retirement and tax-qualified accounts. The DOL fiduciary rule (which was first proposed in 2010, re-proposed in 2015, and adopted in 2016) created controversy due, in part, to the potentially different standards of care it established for broker-dealers, investment advisers, and bank trust departments, depending on the type of account involved. After a number of financial industry trade associations challenged the fiduciary rule in federal court, the US Court of Appeals for the Fifth Circuit vacated the entire rule in March 2018, and the vacatur went into effect in June 2018 when the Fifth Circuit issued a final mandate certifying its decision.4
In April 2018, as the DOL fiduciary rule was awaiting its final fate, the SEC issued a release proposing Reg BI.5 In response, the SEC received more than 6,000 comment letters from individual investors, consumer advocacy groups, broker-dealers, investment advisers, insurance companies, investment professionals, industry and trade associations, state securities regulators, bar associations, and others. As a result of these comments and further analysis by the SEC, the final version of Reg BI contains enhancements and additions to the issues outlined by the SEC in its initial rule proposal.6
Prior to Reg BI, broker-dealers were required to comply with the Financial Industry Regulatory Authority (FINRA) "suitability standard" found in FINRA Rule 2111, which states: "A member or an associated person must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer's investment profile." According to the SEC, Reg BI "enhances the broker-dealer standard of conduct beyond existing suitability obligations, and aligns the standard of conduct with retail customers' reasonable expectations."7
A. General Obligation
The essence of Reg BI is found in the following new general obligation that is being imposed on broker-dealers: "A broker, dealer, or a natural person who is an associated person of a broker or dealer, when making a recommendation of any securities transaction or investment strategy involving securities (including account recommendations) to a retail customer, shall 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, or natural person who is an associated person of a broker or dealer making the recommendation ahead of the interest of the retail customer."8
The SEC has made it clear that this general obligation and the component obligations discussed below go "beyond existing suitability obligations." According to the Reg BI Adopting Release, although certain cases and guidance have interpreted FINRA's suitability obligation to require that recommendations "be consistent" with a customer's best interests, this obligation "is not explicitly required by FINRA's rule." Instead, FINRA Rule 2111 merely requires a broker-dealer to make recommendations that are "suitable" for its customer. Moreover, the SEC is taking the position that Reg BI "significantly enhances" the current suitability obligations by requiring recommendations to actually "be in the best interest of the retail customer" and by prohibiting recommendations that "place the broker-dealer's interests ahead of the retail customer's interests."9
B. Component Obligations
A broker-dealer only satisfies the general obligation identified above if it meets Reg BI's four component obligations related to disclosure, care, conflicts of interest, and compliance. According to the SEC, these component obligations "cannot be satisfied through disclosure alone," and they draw from "key principles underlying fiduciary obligations, including those that apply to investment advisers under the Advisers Act."10
1. Disclosure Obligation
The disclosure obligation requires a broker-dealer and its associated persons to make a "full and fair" disclosure of all material facts about the scope and terms of its relationship with a retail customer, including the broker's acting capacity, material fees and costs, the type and scope of services, and any material limitations on the broker-dealer's recommendations. These disclosures must be made in writing, although the SEC believes that "some flexibility" with respect to oral disclosures "is appropriate in certain circumstances" where it is impossible or impractical to provide written disclosures at the time of a recommendation, in which case oral disclosures must be documented in the firm's records. In addition, when a broker-dealer cannot fully and fairly disclose a conflict of interest in accordance with this obligation, Reg BI states that the broker-dealer "should eliminate the conflict or adequately mitigate (i.e., reduce) the conflict" in order to achieve compliance.11
2. Care Obligation
Under the care obligation, a broker-dealer and its associated persons must exercise "reasonable diligence, care, and skill" when making a recommendation to a retail customer and must understand the potential risks, rewards, and costs associated with that recommendation. These considerations must be assessed against a customer's investment profile, and a broker-dealer must have a "reasonable basis to believe" that its recommendation is in line with the customer's best interest, without placing the broker-dealer's or associated person's own financial or other interests ahead of the customer's. A broker-dealer also must have a "reasonable basis to believe" that a series of recommended transactions, even if appropriate when viewed in isolation, is not excessive and is in the customer's best interest. Although available investment alternatives must be considered under the care obligation, the SEC clarified that the obligation does not require "an evaluation of every possible alternative," nor does it require broker-dealers to recommend the "one 'best' product." A broker-dealer is not required to prepare and maintain documentation regarding the basis for each specific recommendation, although the SEC cautioned that it will be "more important" for broker-dealers to be able to establish that they met the care obligation in "circumstances where the 'match' between the retail customer profile and the recommendation appears less reasonable on its face."12
3. Conflict of Interest Obligation
The conflict of interest obligation requires a broker-dealer to establish, maintain, and enforce written policies and procedures that address the conflicts of interest associated with recommendations to a retail customer. Reg BI states that these policies and procedures should be "reasonably designed" to (i) disclose or eliminate all conflicts of interest associated with such recommendations, (ii) mitigate any conflicts that create an incentive for an associated person to place his/her interest or that of the broker-dealer ahead of the customer's interest, (iii) disclose any material limitations placed on the securities strategies that may be recommended to a customer and prevent such limitations from causing a recommendation that places the interest of the broker-dealer ahead of the customer's interest, and (iv) 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. As for this last component, the SEC cautioned that conflicts arising from the enumerated compensation benefits cannot be reasonably mitigated and must be eliminated, because such benefits "create high-pressure situations for associated persons to increase the sales of specific securities or specific types of securities within a limited period of time and thus compromise the best interests of their retail customers."13
4. Compliance Obligation
The compliance obligation requires a broker-dealer to establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Reg BI as a whole. This means that a broker-dealer's policies and procedures must address compliance with all component obligations of Reg BI. Rather than mandating specific requirements under the compliance obligation, the SEC advised that a broker-dealer's "compliance policies and procedures should be reasonably designed to address and be proportionate to the scope, size, and risks associated with the operations of the firm and the types of business in which the firm engages."14
C. Definitions and Guidance on the Application of Reg BI
In addition to stating that all terms have the same meaning as set forth in the Securities Exchange Act of 1934 (Exchange Act), Reg BI contains the following specific definitions:
- Retail Customer means 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.
- Retail Customer Investment Profile includes, but is not limited to, the retail customer's age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the retail customer may disclose to the broker, dealer, or a natural person who is an associated person of a broker or dealer in connection with a recommendation.
- Conflict of Interest means 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.15
The SEC also provided guidance on certain elements of Reg BI's application. For example, according to the Adopting Release, the definition of "retail customer" is intended to cover all individual accounts, including retirement accounts (such as IRAs and 401(k) accounts held at a workplace), given that "retirement savings is a personal, household, or family purpose."16The SEC also clarified that the retail customer definition covers "non-professional legal representatives" acting on behalf of natural persons, including "a non-professional trustee that represents the assets of a natural person and similar representatives such as executors, conservators, and persons holding a power of attorney for a natural person." The SEC stated that this was meant to extend the definition of retail customer "to non-professional persons who are acting on behalf of natural persons but who are not regulated financial services industry professionals." The definition, however, does not include natural persons seeking services for commercial or business purposes, such as an employee seeking services for an employer or an individual seeking services for small businesses or other entities such as charitable trusts.17
Other examples of guidance from the SEC's Adopting Release regarding the application of specific provisions of Reg BI include the following:
- Despite receiving comments suggesting otherwise, the SEC clarified that Reg BI does not create a "safe harbor" because all of its specific component obligations are mandatory, and the failure to comply with any of these components would constitute a violation of Reg BI's general obligation. Compliance with a safe harbor, on the other hand, would be optional—and the "failure to comply with the terms of the safe harbor does not necessarily violate the relevant legal requirement."18
- Reg BI does not (i) extend beyond a particular recommendation, (ii) require a continuous duty to a retail customer or impose a duty to monitor, (iii) require a broker-dealer to refuse a customer's order that is contrary to the broker-dealer's recommendation, or (iv) apply to self-directed or unsolicited transactions (whether or not the customer also receives separate recommendations from the broker-dealer).19
- The recommendations that are subject to Reg BI include, among other things, (i) recommendations relating to securities account types (e.g., what type of account to open), (ii) recommendations to transfer assets from one type of account to another (e.g., rolling over assets in a workplace retirement plan account to an IRA), (iii) recommendations to take a plan distribution, (iv) explicit recommendations to hold a security, and (v) certain "implicit recommendations" that result from agreed-upon account monitoring.20
- Reg BI does not apply to investment advice provided to a retail customer by a broker-dealer that is dually registered as an investment adviser when acting in that capacity, even if the retail customer has a brokerage relationship with the dual-registrant or the dual-registrant executes a transaction as a broker-dealer. Similarly, a dual-registrant is solely an investment adviser with respect to accounts for which it provides advice and receives compensation that subjects it to the Advisers Act. Determining the capacity in which a dual-registrant makes a recommendation is a "facts and circumstances test, with no one factor being determinative." The SEC will consider, among other things, "the type of account, how the account is described, the type of compensation and the extent to which the dual-registrant made clear to the customer or client the capacity in which it was acting." When an account recommendation is made by a financial professional who is only registered as an associated person of a broker-dealer (regardless of whether that broker-dealer is a dual-registrant), Reg BI will apply to the recommendation.21
- The SEC provided examples of the conduct that is expected of broker-dealers under each of Reg BI's component obligations as well as conduct that would be deemed to meet such obligations. For example, with respect to the disclosure obligation relating to product-level fees, the SEC stated that "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."22
- While the SEC received many comments requesting that the final version of Reg BI explicitly state that it does not confer a private right of action, the SEC declined to add this language to the rule. In the Adopting Release, however, the SEC stated that it does "not believe Regulation Best Interest creates any new private right of action or right of rescission, nor do we intend such a result."23
- Fraudulent conduct will continue to be dealt with under existing law, and the SEC stated that compliance with Reg BI "will not alter a broker-dealer's obligations under the general antifraud provisions of the federal securities laws." The SEC also indicated that establishing violations of Reg BI will not require a showing of intent or extreme recklessness, stating that "[s]cienter will not be required to establish a violation" of Reg BI.24
- Finally, while cost is a consideration highlighted in Reg BI, the SEC has made it clear that preserving a retail customer's choice and access to a variety of investments is important. For example, the SEC stated that Reg BI "is not intended to limit or eliminate recommendations that encourage diversity in a retail customer's portfolio through investment in a wide range of products, including, when appropriate, products that may involve higher risks or cost to the retail customer." In fact, Reg BI does not obligate a broker-dealer to recommend the "least expensive" or the "least remunerative" security or strategy, provided that the broker-dealer complies with the specific obligations of Reg BI.25
III. THE FORM CRS RELATIONSHIP SUMMARY
At the same time it adopted Reg BI, the SEC also adopted new rules and forms (as well as amendments to existing rules and forms) under both the Advisers Act and Exchange Act, which require both registered investment advisers and broker-dealers to provide a "brief relationship summary" to retail investors. This client or customer relationship summary will be reported on a "Form CRS," which firms must first file by June 30, 2020.26 The Form CRS is designed to inform retail investors about:
- The types of client/customer relationships and services the firm offers;
- The fees, costs, conflicts of interest, and required standard of conduct associated with those relationships and services;
- Whether the firm and its financial professionals currently have reportable legal or disciplinary history; and
- How to obtain additional information about the firm.27
After proposing the relationship summary on Form CRS in April 2018, the SEC received numerous comment letters, including mock-ups of forms and reports of surveys and studies, and the agency also engaged the RAND Corporation to conduct investor testing of the proposed relationship summary, including reporting on a survey of more than 1,400 individuals. According to the SEC, the majority of comments and survey responses supported the Form CRS and found it to be a useful tool for retail investors.28
While some commenters took the position that Form CRS is unnecessary because it is duplicative of other required disclosures, the SEC concluded that the relationship summary will "help retail investors select or determine whether to remain with a firm or financial professional by providing better transparency and summarizing in one place selected information about a particular broker-dealer or investment adviser." The SEC also emphasized this one-stop shopping concept by stating that both "broker-dealers and investment advisers must provide disclosures on the same topics under standardized headings in a prescribed order to retail investors, which should benefit retail investors by allowing them to more easily compare services by comparing different firms' relationship summaries."29
After making modifications to the proposed Form CRS based on comment letters and the RAND Corporation report, the SEC adopted a format and instructions so that the disclosures in the Form CRS will:
- Use language that is "concise and direct" and limited in length (a maximum of two pages for investment advisers and broker-dealers, and four pages for dual-registrants that include their brokerage and advisory services in a single filing);30
- Be written largely in a firm's "own wording," which must be in "plain English," rather than using prescribed language;31
- Be organized under "standardized headings" in the form of questions that will be "in a prescribed order";32
- Use "layered disclosures" consisting of references or links to additional information (although without "incorporating by reference" other documents);33
- Include "charts, graphs, tables, text colors, and graphical cues" where possible, and include "white space" and other design features to make the Form CRS "easy to read";34
- Contain "suggested follow-up questions for retail investors to ask their financial professional" that will be in the form of "conversation starters" throughout the Form CRS;35 and
- Provide a link to a "dedicated page" on the SEC's investor education website (Investor.gov), which contains educational information and search tools for retail investors, including providing the ability to research investment advisers, broker-dealers, and financial professionals.36
The Form CRS requirements apply to investment advisers and broker-dealers with "retail investor" clients or customers. For purposes of the Form CRS, "retail investor" is defined as "a natural person, or the legal representative of such natural person, who seeks to receive or receives services primarily for personal, family or household purposes." This definition is consistent with the definition of "retail customer" in Reg BI discussed above. The primary difference is that, unlike the Reg BI definition, the Form CRS definition makes no mention of any recommendation having been made. In other words, firms must file and deliver a Form CRS to "any prospective and existing" retail investor clients or customers regardless of "whether or not there is a recommendation."37
The SEC identified certain relationships between broker-dealers and customers that are not covered by the Form CRS requirements because they do not involve "services to a retail investor." These relationships include "clearing and carrying broker-dealers that are solely providing services to third party or affiliated introducing broker-dealers" as well as "a broker-dealer that is serving solely as a principal underwriter to a mutual fund or variable annuity or variable life insurance contract issuer." According to the SEC, when acting in such capacities, these broker-dealers "would not be subject to the Form CRS requirements."38
As for filing requirements, investment advisers and broker-dealers will be required to file the Form CRS with the SEC as well as post it to their own website (if one exists). Investment advisers will file through the Investment Adviser Registration Depository (IARD), and broker-dealers will file through the Central Registration Depository (Web CRD®). As a result, Forms CRS will be accessible via the public interfaces of IARD and Web CRD® (IAPD and BrokerCheck, respectively) as well as the SEC's education website (Investor.gov). Firms also must continue to meet their existing disclosure requirements (for example, filing and amending their Form ADV or Form BD) in addition to filing a Form CRS.39
Investment advisers and broker-dealers also are required to deliver the Form CRS to retail investor clients and customers. Firms may make delivery within the framework of the SEC's existing guidance on electronic delivery. For new or prospective clients or customers, firms also may make delivery in a manner that is consistent with how the retail investor requested information about the firm. For existing clients or customers, firms should make delivery in a manner consistent with the firm's existing arrangement with that client or customer.40
The SEC identified the following requirements regarding when the Form CRS needs to be delivered to clients and customers:
- For initial deliveries of the Form CRS, investment advisers must deliver the form to each retail investor client "before or at the time the firm enters into an investment advisory contract, even if the agreement is oral." Broker-dealers, on the other hand, must make an initial delivery to each retail investor customer "before or at the earliest of (i) a recommendation of an account type, a securities transaction, or an investment strategy involving securities; (ii) placing an order for the retail investor; or (iii) the opening of a brokerage account for the retail investor."41
- Both investment advisers and broker-dealers also must "deliver the most recent version of the relationship summary to a retail investor if they (i) open a new account that is different from the retail investor's existing account(s); (ii) recommend that the retail investor roll over assets from a retirement account into a new or existing account or investment; or (iii) recommend or provide a new brokerage or investment advisory service or investment that does not necessarily involve the opening of a new account and would not be held in an existing account."42
As for updating the Form CRS, "within 30 days whenever any information in the relationship summary becomes materially inaccurate," investment advisers and broker-dealers must (i) update the Form CRS, (ii) post the updated version on their website (if one exists), and (iii) electronically file it with the SEC (along with an exhibit highlighting the changes) using the same methods discussed above. Firms then have 60 days after the update was required to be made to either deliver the updated version to their retail investor clients and customers or communicate the new information by delivering another form of disclosure that includes such information.43
IV. SEC INTERPRETATION REGARDING THE STANDARD OF CONDUCT FOR INVESTMENT ADVISERS
In addition to adopting Reg BI and Form CRS, the SEC issued an interpretation "to reaffirm and, in some cases, clarify the Commission's views of the fiduciary duty that investment advisers owe to their clients under the Advisers Act." According to the SEC, the "interpretation reflects how the Commission and its staff have applied and enforced the law in this area, and inspected for compliance, for decades." As a result, although the SEC's interpretation does not create any new legal obligations for investment advisers, it substantiates those that already exist.44
An investment adviser's fiduciary duty to its clients is not defined in the Advisers Act, and it has not been articulated through rulemaking but rather through interpretations of equitable common law principles, case law, and related guidance.45 An investment adviser's fiduciary duty arises out of the relationship between the adviser and its client, which is "a relationship of trust and confidence." The fiduciary duty "follows the contours" of each particular relationship, and the adviser and client "may shape that relationship by agreement, provided that there is full and fair disclosure and informed consent." Given the variations in the scope of services provided to different clients, the "fiduciary duty must be viewed in the context of the agreed-upon scope of the relationship between the adviser and the client," and the "specific obligations that flow from the adviser's fiduciary duty depend upon what functions the adviser, as agent, has agreed to assume for the client, its principal." This means that the obligations of an investment adviser providing a wide range of discretionary services and advice in an ongoing relationship with a retail client will be "significantly different" than the obligations of an investment adviser providing specific services to a registered investment company under a contract that defines scope and identifies limitations on authority.46
An investment adviser's fiduciary duty to its clients is comprised of a duty of care and a duty of loyalty. According to the SEC:
- "[T]he duty of care requires an investment adviser to provide investment advice in the best interest of its client, based on the client's objectives."47
- "Under its duty of loyalty, an investment adviser must eliminate or make full and fair disclosure of all conflicts of interest which might incline an investment adviser—consciously or unconsciously—to render advice which is not disinterested such that a client can provide informed consent to the conflict."48
This combination of duties means that an investment adviser must "act in the 'best interest' of its client at all times" and "cannot place its own interests ahead of the interests of its client."49
Under the duty of care, an investment adviser must (i) "provide advice that is in the best interest of the client" (including making a "reasonable inquiry" into the client's objectives and having a "reasonable belief" that the advice provided is in the best interest of the client), (ii) "seek best execution of a client's transactions where the adviser has the responsibility to select broker-dealers to execute client trades," and (iii) "provide advice and monitoring over the course of the relationship." The SEC provided specific guidance under each of these obligations. For example, while cost (including fees and compensation) is "one of many important factors" for an investment adviser to consider, "the fiduciary duty does not necessarily require an adviser to recommend the lowest cost investment product or strategy." Similarly, when seeking best execution, the "determinative factor is not the lowest possible commission cost, but whether the transaction represents the best qualitative execution." As for providing advice and monitoring over the course of a relationship, this will depend on the relationship between the investment adviser and its client. Unless the adviser and client agree to a limitation or expansion of this obligation, "the scope of the duty to monitor will be indicated by the duration and nature of the agreed advisory arrangement."50
Under the duty of loyalty, an investment adviser must "not subordinate its clients' interests to its own." To satisfy this duty, an adviser "must make full and fair disclosure to its clients of all material facts relating to the advisory relationship." Disclosures should be "sufficiently specific" so that an investment adviser's client is able to understand a material fact or conflict of interest and "make an informed decision whether to provide consent." If there has been full and fair disclosure of a conflict as well as a client's informed consent, then the mere presence of the conflict will not itself result in a violation of an investment adviser's duty of loyalty. Significantly, however, "such disclosure and consent do not themselves satisfy the adviser's duty to act in the client's best interest." Moreover, if an adviser discloses that it "may" have a particular conflict, without more, this "is not adequate when the conflict actually exists." Whether or not a disclosure is full and fair "will depend upon, among other things, the nature of the client, the scope of the services, and the material fact or conflict."51
As for waiving an investment adviser's fiduciary duty, the SEC emphasized that an adviser's "federal fiduciary duty may not be waived." As a result, contract provisions that purport to waive the duty (such as a statement that the adviser will not act as a fiduciary, a blanket waiver of all conflicts of interest, or a waiver of a specific obligation) would "be inconsistent with the Advisers Act, regardless of the sophistication of the client.52
The SEC also addressed "hedge clauses" in advisory agreements, which purport to limit an adviser's liability under such an agreement. Notably, as part of this discussion, the SEC withdrew a 2007 No-Action Letter issued to Heitman Capital Management (Heitman Letter), which had concluded that whether a hedge clause would violate the antifraud provisions of the Advisers Act would depend on "all of the surrounding facts and circumstances." In its new interpretation, the SEC did not change the Heitman Letter's conclusion with respect to institutional clients—i.e., "whether a hedge clause in an agreement with an institutional client would violate the Advisers Act's antifraud provisions will be determined based on the particular facts and circumstances." The SEC also concluded, however, that "there are few (if any) circumstances in which a hedge clause in an agreement with a retail client would be consistent with those antifraud provisions, where the hedge clause purports to relieve the adviser from liability for conduct as to which the client has a non-waivable cause of action against the adviser provided by state or federal law." Finally, aside from the applicability of the antifraud provisions, the SEC reiterated that "an adviser's federal fiduciary duty may not be waived, though its application may be shaped by agreement."53
V. SEC INTERPRETATION REGARDING THE "SOLELY INCIDENTAL" PRONG OF THE BROKER-DEALER EXCLUSION UNDER THE ADVISERS ACT
In addition to the interpretation regarding investment advisers' fiduciary duty, the SEC issued a separate interpretation addressing the circumstances under which "a broker-dealer's performance of advisory activities causes it to become an investment adviser within the meaning of the Advisers Act." According to the SEC, this new interpretation "confirms and clarifies the Commission's position, and illustrates the application in practice in connection with exercising investment discretion over customer accounts and account monitoring."54
Section 202(a)(11)(C) of the Advisers Act excludes from the definition of investment adviser (and, as such, from the application of the Act) any broker-dealer whose performance of advisory services is "solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation" for those services. This exclusion reflects that broker-dealers commonly provide some level of investment advice to their customers but, despite this activity, should not be brought within the scope of the Advisers Act. The exclusion, however, is explicitly limited to circumstances in which the advisory services are both "solely incidental" to a broker-dealer's regular business and when the broker-dealer receives "no special compensation" for the advisory services provided. The SEC issued the new interpretation "to confirm and clarify the Commission's position with respect to the solely incidental prong."55
After addressing prior guidance and related case law, the SEC provided the following interpretation:
- "We interpret the statutory language to mean that a broker-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."56
- "If a broker-dealer's primary business is giving advice as to the value and characteristics of securities or the advisability of transacting in securities, or if the advisory services are not offered in connection with or are not reasonably related to the broker-dealer's business of effecting securities transactions, the broker-dealer's advisory services are not solely incidental to its business as a broker-dealer."57
- "Whether advisory services provided by a broker-dealer satisfy the solely incidental prong is assessed based on the facts and circumstances surrounding the broker-dealer's business, the specific services offered, and the relationship between the broker-dealer and the customer."58
- "The quantum or importance of investment advice that a broker-dealer provides to a client is not determinative as to whether or not the provision of advice is consistent with the solely incidental prong. Advice need not be trivial, inconsequential, or infrequent to be consistent with the solely incidental prong. Indeed, . . . broker-dealer investment advice can be consequential even when it is offered in connection with and reasonably related to the primary business of effecting securities transactions."59
The SEC also illustrated the application of its interpretation in practice by addressing (i) investment discretion over customer accounts and (ii) account monitoring. As for investment discretion, the SEC made it clear that "unlimited discretion" would not satisfy the solely incidental prong of the exclusion. There are situations, however, where "a broker-dealer may exercise temporary or limited discretion in a way that is not indicative of a relationship that is primarily advisory in nature." The SEC provided examples of this permitted temporary or limited discretion, including, among others, exercising discretion regarding the price or time at which to execute a specific order from a customer, trading securities on an isolated or infrequent basis when a customer is unavailable, and trading securities to satisfy margin requirements, collateral calls, or other obligations that the customer has specified.60
As for account monitoring, the SEC disagreed with commenters "who suggested that any monitoring of customer accounts would not be consistent with the solely incidental prong." Instead, a broker-dealer would meet the prong if it "voluntarily and without any agreement with the customer" reviews a customer's holdings and contacts the customer to provide a recommendation based on that review. Even if a broker-dealer has an agreement with a customer to monitor the customer's account "on a periodic basis for purposes of providing buy, sell, or hold recommendations," this still could be considered providing advice "in connection with and reasonably related to effecting securities transactions." The SEC declined to identify "every circumstance where agreed-upon monitoring is and is not solely incidental to a broker-dealer's brokerage business," but it suggested that broker-dealers consider adopting policies and procedures to "help demonstrate that any agreed-upon monitoring is in connection with and reasonably related to the broker-dealer's primary business of effecting securities transactions."61
VI. INTERPLAY BETWEEN THE INVESTMENT ADVISER AND BROKER-DEALER STANDARDS
The new regulatory framework presented by the SEC addresses standards of conduct, disclosure, and related obligations in the context of both advisory and broker-dealer services. As a result, the framework is likely to raise questions regarding the interplay between the investment adviser and broker-dealer roles and where those obligations align and diverge throughout the industry.
Significantly, the standard of conduct for broker-dealers under Reg BI, while higher than the existing standards, stopped short of imposing the fiduciary duties applicable to investment advisers. The SEC made this decision notwithstanding that a "new uniform fiduciary standard of conduct that would apply equally to both broker-dealers and investment advisers" was recommended by (i) the Study on Investment Advisers and Broker-Dealers (which was prepared by the SEC's own staff as required under Section 913 of Dodd-Frank), (ii) a majority of the SEC's Investor Advisory Committee (which was established under Dodd-Frank to advise the SEC on regulatory priorities and related initiatives), and (iii) others who submitted comment letters.62
The SEC declined to extend the investment advisory fiduciary duties to broker-dealers or to craft a new uniform fiduciary standard for both types of firms for the following reasons:
- "Adopting a 'one size fits all' approach would risk reducing investor choice and access to existing products, services, service providers, and payment options, and would increase costs for firms and for retail investors."63
- A uniform approach also "would not appropriately reflect the fact that broker-dealers and investment advisers play distinct roles in providing recommendations or advice and services to investors, and may ultimately harm retail investors."64
- The existing fiduciary standard under the Advisers Act "is not appropriately tailored to the structure and characteristics of the broker-dealer business model (i.e., transaction-specific recommendations and compensation), and would not properly take into account, and build upon, existing obligations that apply to broker-dealers, including under FINRA rules."65
- Applying a new uniform standard "would mean jettisoning to some extent the fiduciary standard under the Advisers Act that has worked well for retail clients and our markets and is backed by decades of regulatory and judicial precedent."66
The SEC also used the differences between investment advisers and broker-dealers to highlight once again its goal of preserving choice for investors. The SEC noted that "an investment adviser's fiduciary duty generally includes a duty to provide ongoing advice and monitoring, while Regulation Best Interest imposes no such duty and instead requires that a broker-dealer act in the retail customer's best interest at the time a recommendation is made." According to the SEC, maintaining this dichotomy will preserve what it positively describes as "retail investor access (in terms of choice and cost) to different types of quality investment services and products."67
At the same time, the SEC emphasized that the new standard of conduct for broker-dealers under Reg BI includes "key elements" that are "substantially similar to key elements of the standard of conduct that applies to investment advisers pursuant to their fiduciary duty under the Advisers Act at the time that a recommendation is made." In fact, for each component of Reg BI discussed in its Adopting Release, the SEC incorporated a cross-reference to the parallel obligations of investment advisers and broker-dealers and the differences between those respective roles.68
The SEC, however, has not yet addressed the practical and competitive market implications of the new framework, including how it may change the ways investment advisers and broker-dealers market themselves to prospective clients, how each type of firm works to distinguish its role from the competition, and how the new regulatory framework could impact automated technology and "robo-adviser" developments in the financial services industry. The industry can certainly anticipate questions about Reg BI to the extent it may blur the lines between the investment adviser and broker-dealer roles or result in a collapse of one role into the other over the course of its extended implementation.
Although some might suggest that Reg BI could diminish a marketing advantage that investment advisers attempt to employ over broker-dealers (i.e., highlighting to prospective clients that, unlike a broker-dealer, the adviser will owe a fiduciary duty to the client), it is unclear whether any marketing advantage will be affected by the new regulatory framework. It may be premature to forecast the impact this new regime will have on the business models and the future of wealth management technology, but it is not too early for firms to begin thinking about how it impacts their practices.
VII. INDUSTRY RESPONSE
It is no surprise that the new regulatory framework has both its critics and supporters. Investor rights advocates have argued that the new framework does not go far enough in clarifying explicit standards or in raising the obligations of broker-dealers to a level that will protect retail customers. For example:
- Perhaps the most significant objection was voiced by Robert Jackson Jr., the one dissenting SEC Commissioner, who noted in his statement on the new framework: "I hoped to join my colleagues in announcing that the Nation's investor protection agency has left no doubt that, in America, investors come first. Sadly, I cannot say that. Rather than requiring Wall Street to put investors first, today's rules retain a muddled standard that exposes millions of Americans to the costs of conflicted advice."69
- In addition, after the new framework was announced, the Consumer Federation of America issued a press release, stating: "These new rules seriously erode the Commission's traditional interpretation of the Advisers Act fiduciary standard, giving brokers virtually unlimited ability to act as advisers, while simultaneously failing to regulate them accordingly, and making it easier for brokers to mislead their customers into believing they are getting trusted, best interest advice when they are actually getting investing recommendations biased by toxic conflicts of interest."70
- Similarly, AARP issued a press release, stating: "AARP is alarmed by the outcome of SEC's rule-making today on the standards of conduct for financial professionals. Often described as an important opportunity to protect Americans saving for retirement, the new rule does not strengthen investor protections, nor does it improve the quality of advice upon which investors rely."71
- Yesterday, the US House of Representatives approved an amendment to the Financial Services and General Government Appropriations Act of 2020 (H.R. 3351) that would prohibit the SEC from using funds "to implement, administer, enforce, or publicize" Reg BI, Form CRS, and the SEC's two investment advisory interpretations. The amendment was offered by House Financial Services Committee Chairwoman Maxine Waters, D-California, who is one of several Democratic politicians who have criticized the new regulatory framework. It is unclear, however, whether the amendment will survive the appropriations process in the US Senate later this year.72
On the other hand, industry groups and others have expressed at least some level of support for the new regulatory framework while, at the same time, expressing certain concerns. For example:
- In a press release, the Securities Industry and Financial Markets Association stated: "As written, the SEC's Regulation Best Interest rule will impose a materially heightened standard of conduct for broker-dealers when serving retail clients. . . . Not even the so-called fiduciary standard under the Investment Advisers Act includes the obligation to eliminate or mitigate conflicts. It is undeniable that this rule will directly enhance investor protection and contribute to increased professionalism among financial service providers. . . . Compliance with the rule will not be easy for the industry. Firms will need to make substantial changes. The costs to implement will no doubt be significant, but, we believe, worthwhile to uniformly enhance investor protection to the level investors should and do expect, while preserving investor choice and access to investment advice."73
- The Investment Adviser Association issued a press release, stating: "While we are pleased that the Commission seems to have made several of the clarifications we requested to the proposed interpretation, we would be disappointed if the Commission dropped the most effective, widely used, and straightforward articulation of the fiduciary duty—to put your client's interest first at all times—an articulation that has long framed fiduciary duty. We are encouraged by the descriptions of some of the changes we heard this morning relating to Form CRS and Reg BI. However, we are concerned about the scope of the "solely incidental" interpretation. It also remains to be seen whether this combined package will significantly alleviate investor confusion."74
- The Investment Company Institute issued the following statement: "With the adoption of Regulation Best Interest and the three related regulatory actions today, the SEC has concluded a long and difficult process. ICI strongly commends the Commission for its efforts. Regulation Best Interest will better serve investor interests by ensuring investors are afforded strong protections when they receive recommendations from broker-dealers. We look forward to engaging with the SEC and our members as they work to implement the new standards."75
- The US Chamber of Commerce, which was one of the challengers to the DOL fiduciary rule that was vacated, issued the following statement: "The new best interest standards create strong new protections for investors against bad actors, provide clearer information that will help Americans invest and save for their futures, allow investors to choose the right type of advice to fit their needs, and help small businesses provide retirement benefits for their employees."76
VIII. IMPLICATIONS GOING FORWARD
It remains to be seen whether the new regulatory framework will gain more supporters or detractors going forward, but there is no doubt that this will depend on the implementation of the framework as well as how the SEC chooses to examine and enforce it.
As an initial matter, the industry has some time to transition to the new rules, whether it is Reg BI (broker-dealers only) or Form CRS (both broker-dealer and investment advisers). Both sets of rulemaking will become effective 60 days after they are published in the Federal Register, but they provide a consistent transition period allowing firms until June 30, 2020 to comply. The SEC has noted that it will offer assistance to firms through the transition of Reg BI to ensure effective implementation, including establishing an inter-divisional "Standards of Conduct Implementation Committee" comprised of representatives from the SEC's Division of Investment Management, Division of Trading and Markets, Division of Economic and Risk Analysis, Office of Compliance Inspections and Examinations, and Office of the General Counsel.77 Firms should begin to anticipate and prepare for the implementation immediately, including devoting resources to reviewing and enhancing policies, procedures, training, and disclosures to comply with the comprehensive rule changes.
As for examinations that cover compliance with Reg BI, the SEC has effectively elevated an issue that was formerly addressed solely by a FINRA rule to one that is, for the time being, simultaneously addressed by both FINRA and the SEC. This raises the question of whether the SEC will defer to FINRA with respect to examination efforts moving forward. On the day that Reg BI was adopted, Chairman Clayton stated: "In light of the Commission's actions today, we anticipate that FINRA will need to review and revise its rulebook and examination program in light of the enhanced broker-dealer standard of conduct reflected in Regulation Best Interest. We look forward to working with FINRA in these efforts."78 In addition, before Reg BI was adopted, FINRA's Chief Legal Officer stated that FINRA would assess the overlap between its suitability rule and Reg BI and consider revamping or eliminating the suitability rule as a result, particularly given that FINRA will "be enforcing Reg BI."79 The examination waters would become even muddier if the House amendment prohibiting SEC involvement in implementing or enforcing Reg BI were to survive the Senate appropriations process.80
As for enforcement efforts (whether standalone or following an examination), the industry will need to wait and see what enforcement regime the SEC imposes. For now, the following are examples of some issues to monitor:
- According to the SEC, compliance with the component obligations of Reg BI "will be evaluated as of the time of the recommendation (and not in hindsight)"—and this "not in hindsight" language is used five times in the Adopting Release. Given that it is common practice of the SEC enforcement staff to use 20/20 hindsight when conducting its investigations, it will be interesting to learn whether this guidance is followed.81
- As discussed above, scienter is not required to establish a violation of Reg BI. In investigations involving allegations of both scienter and non-scienter based violations, settlement discussions often revolve around what charges will be included in the settled action. Depending on the specific facts and circumstances, defense counsel will need to assess whether Reg BI violations can be a more palatable alternative to violations of the antifraud or other provisions of the federal securities laws. Conversely, it remains to be seen whether the SEC enforcement staff will include more tenuous antifraud allegations when it is seeking to resolve a matter involving Reg BI violations.
- As for the CRS Form, the instructions state that "all information in the relationship summary must be true and may not omit any material facts necessary in order to make the disclosures, in light of the circumstances under which they were made, not misleading." As a reminder, however, there is a two-page limit for each Form CRS filed by a broker-dealer or investment adviser. To address this issue, the SEC added the words "in light of the circumstances under which they were made" to clarify that the disclosures should be read as being part of a mere summary. The SEC also allowed for "layered disclosures" that provide links to other information. When an issue arises with respect to a firm's Form CRS, however, the question will be "how much is enough" in the eyes of the enforcement staff.82
Although many might view Reg BI, Form CRS, and the two investment advisory interpretations to be a step backward in providing customers with clarity on the standards of conduct for broker-dealers and investment advisers, the industry and investors may need to be patient. It will take time for firms to implement the changes required by the new framework, and even more time to determine if the framework achieves its intended goals. Moreover, given the complexity of the various implementation, examination, and enforcement issues, it is likely that the SEC could clarify certain of these issues prior to the final compliance date of June 30, 2020.
1. Press Release 2019-89, SEC Adopts Rules and Interpretations to Enhance Protections and Preserve Choice for Retail Investors in Their Relationships With Financial Professionals (June 5, 2019) (hereinafter, SEC Press Release 2019-89).
2. Review of the FY2020 Budget Request for the CFTC & SEC: Hearing Before the Financial Services and General Government Subcommittee of the US Senate Committee on Appropriations (May 8, 2019) (testimony of Jay Clayton).
3. SEC Press Release 2019-89.
4. Arnold & Porter Advisory, DOL's Fiduciary Rule Vacated--But the Best Interest Concept Appears Here to Stay (July 9, 2018); Arnold & Porter Advisory, DOL Delays Fiduciary Rule--But Significant Portions of New Rule Are Likely to Take Effect in June 2017 (April 17, 2017); Arnold & Porter Advisory, Department of Labor Adopts Sweeping Rules Regarding Fiduciary Investment Advice (April 21, 2016).
5. Release No. 34-83062, Regulation Best Interest (April 18, 2018).
6. Release No. 34-86031, Regulation Best Interest: The Broker-Dealer Standard of Conduct, at 5 (June 5, 2019) (hereinafter, Reg BI Adopting Release).
7. Reg BI Adopting Release at 1, 5.
8. Id. at 765-66.
9. Id. at 252-54.
10. Id. at 5, 19.
11. Id. at 14-15, 130-245, 319, 766.
12. Id. at 15, 38-39, 245-302, 766-67.
13. Id. at 15-16, 62, 302-56, 767-68.
14. Id. at 16, 357-60, 768.
15. Id. at 769.
16. DOL is expected to issue guidance and/or prohibited transaction exemptions relating to the impact of Reg BI on recommendations made to IRAs and other tax-qualified retirement accounts.
17. Reg BI Adopting Release at 34, 113-17.
18. Id. at 48, 72.
19. Id. at 76-77.
20. Id. at 96-105.
21. Id. at 35, 99-100, 124-29.
22. Id. at 138.
23. Id. at 32, 44.
24. Id. at 43.
25. Id. at 75-76.
26. As discussed below, the compliance date for both Reg BI and Form CRS is June 30, 2020. Firms must file their initial Forms CRS between May 1, 2020 and June 30, 2020.
27. Release No. 34-86032, Form CRS Relationship Summary; Amendments to Form ADV, at 1 (June 5, 2019) (hereinafter, Form CRS Adopting Release).
28. Id. at 6-19.
29. Id. at 19.
30. Id. at 32.
31. Id. at 27-28, 32-33.
32. Id. at 19, 31.
33. Id. at 22, 43, 51-59.
34. Id. at 21, 30-31, 51-56.
35. Id. at 59-67.
36. Id. at 80, 86-87.
37. Id. at 189-201.
38. Id. at 224-25.
39. Id. at 201-06, 232-33.
40. Id. at 207-14.
41. Id. at 226, 498.
42. Id. at 226-27.
43. Id. at 234-38.
44. SEC Press Release 2019-89; Release No. IA-5248, Commission Interpretation Regarding Standard of Conduct for Investment Advisers, at 29 (June 5, 2019) (hereinafter, Standard of Conduct Interpretation).
45. See, e.g., SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963).
46. Standard of Conduct Interpretation at 6, 8-10.
47. Id. at 7-8.
49. Id. at 6-8.
50. Id. at 12-21.
51. Id. at 21-29.
52. Id. at 10-11.
53. Id. at 11.
54. SEC Press Release 2019-89; Release No. IA-5249, Commission Interpretation Regarding the Solely Incidental Prong of the Broker-Dealer Exclusion from the Definition of Investment Adviser, at 2 (June 5, 2019) (hereinafter, Solely Incidental Interpretation).
55. Solely Incidental Interpretationat 2-3, 5.
56. Id. at 12.
57. Id. at 12-13.
58. Id. at 13.
60. Id. at 14-18.
61. Id. at 19-21.
62. Reg BI Adopting Release at 19-21, 46, 48-51, 56-60.
63. Id. at 20-21.
64. Id. at 56.
65. Id. at 20.
66. Id. at 21.
67. Id. at 18, 45.
68. Id. at 58.
69. SEC Commissioner Robert J. Jackson, Jr., Statement on Final Rules Governing Investment Advice (June 5, 2019).
70. Consumer Federation of America, SEC Adopts Anti-Investor Advice Standards on Partisan Vote, Investors Will Be Misled Into Expecting Protections the Rule Does Not Deliver, CFA Warns (June 5, 2019).
71. AARP, AARP Alarmed by SEC's Approval of Final 'Regulation Best Interest,' New Rule Fails to Put the Interests of the Investor First (June 5, 2019).
73. Securities Industry and Financial Markets Association, SIFMA Statement on the SEC's Final Regulation Best Interest Rule (June 5, 2019).
74. Investment Adviser Association, IAA Initial Statement on SEC Adoption of Final Standards of Conduct Rules Package (June 5, 2019).
75. Investment Company Institute, ICI Welcomes SEC's Adoption of Regulation Best Interest (June 5, 2019).
76. US Chamber of Commerce, US Chamber Statement on the SEC's Final Best Interest Standards (June 5, 2019).
77. SEC Chairman Jay Clayton, 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).
79. Melanie Waddell, FINRA May Nix Suitability Rule Due to Reg BI Overlap, Think Advisor, (Mar. 26, 2019); Melanie Waddell, SEC's Reg BI Doesn't 'Raise the Bar' Over FINRA's Suitability Rule: Consumer Groups, Think Advisor, (Apr. 26, 2019).
80. See, e.g., Securities Industry and Financial Markets Association, Letter to Members of the US House of Representatives regarding Amendment to H.R. 3351 (June 25, 2019) ("Were Congress to prohibit the SEC from using any funds to implement, provide guidance or interpretations or enforce Reg BI, firms would still be obligated to follow the rule. Presumably FINRA (a non-governmental, congressionally mandated self-regulatory organization) would examine and regulate firms subject to the provisions of Reg BI. Consumers could continue to bring claims asserting violation of provisions under Reg BI through FINRA arbitration. However, regulated firms would not be provided the benefit of guidance from the SEC, nor would the SEC be able to bring enforcement actions pursuant to Reg BI. More importantly, the amendment will prevent the SEC from educating consumers about the new protections this rule would provide.").
81. Reg BI Adopting Release at 15, 36, 73, 130, 290.
82. Form CRS Adopting Release at 39-44.
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