On June 5, 2019, the Securities and Exchange Commission (SEC) adopted a highly anticipated package of rulemakings and interpretations popularly known as “Regulation Best Interest” or “Reg BI.” The SEC said that this package would “enhance the standard of conduct that broker-dealers owe to their customers and align the standard of conduct with retail customers’ reasonable expectations” and “will also provide additional transparency and clarity for retail investors through enhanced disclosures designed to help them understand who they are dealing with, and why that matters.”
The package includes several parts:
- Regulation Best Interest, which requires broker-dealers to act in the “best interest” of retail customers when recommending securities transactions or investment strategies;
- the Form CRS relationship summary, which registered investment advisors and broker-dealers are required to provide to retail investors in the form of simple, easy-to-understand information about the nature of their relationship with their financial professional;
- an interpretation to clarify the SEC’s views on the nature of the fiduciary duties that investment advisors owe to their customers under the Investment Advisers Act of 1940; and
- an interpretation of the “solely incidental” prong of the Investment Advisers Act’s broker-dealer exclusion, which clarifies circumstances in which advisory activities will cause a broker-dealer to be regulated as an investment advisor.
The SEC explained that “[t]he rulemaking package is designed to enhance investor protections while preserving retail investor access and choice in: (1) the type of professional with whom they work, (2) the services they receive, and (3) how they pay for these services.”
For broker-dealer practitioners who advise firms about the proper standard of care, design compliance programs, and defend firms and brokers in enforcement actions and customer arbitrations, Reg BI changes the rules of the game, although it remains to be seen by how much.
Background of the Changes
Although both broker-dealers and investment advisors serve important functions for retail investors, those functions historically have been distinct—they maintained different types of relationships with their customers, offered different services, and used different compensation models. Traditionally, broker-dealers were paid primarily to execute trades on behalf of customers and at their customers’ direction. Investment advisors, on the other hand, were paid to counsel customers concerning investment strategies and risks. Because of their role in guiding the investment decisions of their customers, investment advisors have been charged with a fiduciary duty (including a duty of care and a duty of loyalty) toward their customers. In contrast, broker-dealers have not been considered fiduciaries and thus have not been held to the high standard imposed on investment advisors. Instead, broker-dealers have been subject to a “suitability” standard, under which they were required to have a reasonable basis to believe that a recommended transaction or investment strategy was suitable for customers based on the customer’s age, financial situation, risk tolerance, and other factors.
The role of broker-dealers has changed over time as the automation of trading has obviated many of their execution responsibilities. Broker-dealers now often perform more of an advisory function for their clients. Recognizing that change, the SEC has permitted broker-dealers to call themselves financial advisors but has not also imposed fiduciary obligations on them.
With the lines between broker-dealers and investment advisors increasingly blurred, many retail investors do not fully understand what sets broker-dealers and investment advisors apart. For example, the SEC commissioned a 2008 study by the RAND Corporation that found that participants largely did not understand the differences between broker-dealers and investment advisors, the legal duties they respectively owe investors, or the meaning of the term “fiduciary.”
To address this knowledge gap, a 2011 SEC staff study recommended adoption of a uniform fiduciary standard that would govern both broker-dealers and investment advisors. In 2016, the Department of Labor issued a stricter “fiduciary rule,” which would have required broker-dealers who handle retirement assets to satisfy a heightened duty of loyalty. The Trump administration, however, deferred adopting the rule pending further consideration of the issues. Following a legal challenge, in 2018 the Fifth Circuit vacated the proposed regulation on several grounds, including that the Department of Labor had exceeded its authority.
The New Rulemakings and Interpretations
- Regulation Best Interest. The final rule implementing Regulation Best Interest (often referred to as “Reg BI”) enhances the standard of broker-dealer conduct beyond prior suitability requirements. Importantly, the new standard is not coextensive with the fiduciary obligations of investment advisors—the SEC did not go that far—although it incorporates some similar principles and may not be satisfied solely by disclosure of potential conflicts of interest. The rule includes the following components:
- Disclosure obligation: Broker-dealers must disclose material facts about their relationships with and recommendations made to customers (e.g., fees, the type and scope of services provided, conflicts, limitations on services and products).
- Care obligation: Broker-dealers must exercise reasonable diligence, care, and skill when making recommendations to customers. That includes understanding and considering potential risks, rewards, and costs associated with their recommendations and making recommendations that are in their customers’ “best interest,” a standard that will evolve with further interpretation.
- Conflict-of-interest obligation: Broker-dealers must implement written policies and procedures reasonably designed to identify, and at least disclose if not eliminate, conflicts of interest. Specifically, the policies and procedures must (1) mitigate conflicts that create an incentive for the broker-dealer’s financial professionals to place their interests or the interests of the firm ahead of customers’ interests; (2) prevent material limitations on offerings from causing the firm or its financial professionals to place their interests or the interests of the firm ahead of their customers’ interests; and (3) eliminate sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sale of specific securities or types of securities within a limited period of time.
- Compliance obligation: Broker-dealers must implement policies and procedures reasonably designed to achieve compliance with Regulation Best Interest as a whole.
- Form CRS relationship summary. Both investment advisors and broker-dealers are required to deliver a Form CRS relationship summary to retail investors at the beginning of their relationship. Among other things, the disclosure must concisely (in four pages or less) summarize information about services, fees and costs, conflicts of interest, legal standard of conduct, and whether the firm and its financial professionals have any disciplinary history.
- Investment advisor interpretation. In its investment advisor interpretation, the SEC purports to reaffirm, and in some cases clarify, certain aspects of the principles-based federal fiduciary duty that investment advisors owe to their clients.
Among other things, the interpretation states that the duty of care requires an investment advisor “to provide investment advice in the best interest of the client, based on the client’s objectives.” To satisfy this obligation, an investment advisor must make a reasonable inquiry into the client’s objectives (which includes updating the client’s investment profile as necessary to reflect changed circumstances) and reasonably believe that the advice given is in the best interest of the client (e.g., by considering whether the client is willing to tolerate the risks of the particular investment and investigating the investment so as not to base the advice on materially inaccurate or complete information). The duty of care also requires an investment advisor to seek the best execution of a client’s transactions, where the advisor is responsible for selecting broker-dealers to execute the client’s trades, and to provide advice and monitoring at a frequency that is in the best interest of the client.
The interpretation also states that the duty of loyalty prohibits an investment advisor from placing its own interests ahead of its clients’ interests. To satisfy this duty, the advisor must “make full and fair disclosure to its clients of all material facts relating to the advisory relationship” and “eliminate or at least expose through full and fair disclosure all conflicts of interest which might incline an investment adviser—consciously or unconsciously—to render advice which was not disinterested.”
- “Solely incidental” interpretation. Under the securities laws, a broker-dealer’s advice as to the value and characteristics of securities, or as to the advisability of a securities transaction, is “solely incidental” to the broker-dealer’s business if the advice “is provided with and is reasonably related to the broker-dealer’s primary business of effecting securities transactions.” Therefore, broker-dealers whose primary business is effecting securities transactions generally will be excluded from being regulated as an investment advisor. The SEC’s “solely incidental” interpretation confirms and clarifies the agency’s interpretation of that prong of the broker-dealer exclusion of the Investment Advisers Act. In general, the SEC states that, if giving advice is the broker-dealer’s primary business or not offered in connection with or reasonably related to the business of executing trades, the services will not qualify for the exclusion. Whether a broker-dealer’s advisory services satisfy the “solely incidental” prong depends on the facts and circumstances surrounding the business, the services offered, and the relationship with the customer.
- Broker-dealers should begin to assess how to implement policies and procedures satisfying Regulation Best Interest. Registered broker-dealers do not need to comply with Regulation Best Interest until June 30, 2020, but they should begin to assess what steps must be taken to ensure compliance. (Firms that already began to alter their policies and procedures in response to the Department of Labor’s short-lived fiduciary rule might already be ahead of the game.) To be sure, the SEC made it easier for broker-dealers to revise current practices by requiring them to act in clients’ “best interests” and not imposing the same fiduciary obligations that exist for investment advisors. But for those firms that do not already meet the Regulation Best Interest standards, compliance will require a comprehensive assessment of what policies and procedures need to be put in place, creating and implementing those policies and procedures, training on those policies and procedures, and a method for ensuring ongoing adherence.
- Broker-dealers may need to wait to find out what “best interest” means in practice. Regulation Best Interest—which leaves the term “best interest” undefined—is not a model of clarity. In fact, SEC Commissioner Robert J. Jackson Jr. commented in a dissent to the new rules and interpretations that “the core standard of conduct set forth in Regulation Best Interest remains far too ambiguous about a question on which there should be no confusion.” The SEC asserts that it “will enhance the broker-dealer standard of conduct beyond existing suitability obligations.” Indeed, using language almost identical to that in the SEC’s investment advisor interpretation, Regulation Best Interest prohibits broker-dealers from placing their interests “ahead of the interests of the retail customer.” Others, including Commissioner Jackson, contend that the new rule does not go far enough. In practice, the Financial Industry Regulatory Authority (FINRA)—not the SEC—is likely to be the frontline enforcer of Regulation Best Interest through its extensive examination and disciplinary programs. The impact of Regulation Best Interest will likely be felt first through the scope of information FINRA seeks in examinations, and future public statements and enforcement actions may better indicate how FINRA interprets the new rule. While this standard evolves, broker-dealers ought to monitor FINRA and SEC advisories, guidance, and filed and settled actions to gain clarity and conform their conduct as closely to the standard as possible over time.
- It is not clear whether Regulation Best Interest preempts state laws. Unlike the SEC, many states have extended fiduciary obligations to broker-dealers, particularly in recent years as they awaited SEC action in this area. The SEC did not take a position regarding preemption. For now, broker-dealers in those states should continue to observe the higher state standard. Ultimately, however, whether Regulation Best Interest displaces those state laws will likely be determined through litigation. The final rule itself states that “[w]hether Regulation Best Interest would have a preemptive effect on any state law would be determined in future judicial proceedings, and would depend on the language and operation of the particular state law at issue.”
- The new rules and interpretations likely will have little impact on investment advisors’ current practices. With the exception that investment advisors must provide customers with a relationship summary, the SEC’s new rules and interpretations purportedly do not enhance the obligations already imposed on investment advisors. On the one hand, the SEC maintains that its interpretation merely reaffirms (and, in some cases, clarifies) existing obligations. On the other hand, in his dissent from the approval, Commissioner Jackson contended that the interpretation actually lowers the standard for investment advisors, stating that “the Commission today concludes that investment advisers are not true fiduciaries.” He added that “[t]housands of advisers who have taken pride in putting clients first for decades will be surprised to learn that, all along, the SEC has had lower expectations for their work.” Indeed, the obligation set forth in the SEC’s interpretation not to subrogate clients’ interests (the same standard Regulation Best Interest appears to adopt for broker-dealers) is potentially less onerous than a rule requiring investment advisors to put clients’ interests first. But whether that is the case may very well have to be decided by the courts in the future. In the meantime, it might be safest for investment advisors to stick with the standards they currently observe.
Daniel Nathan is a partner in the Washington, D.C., and New York offices of Orrick, Herrington & Sutcliffe LLP. Trace Schmeltz is a partner in the Chicago and Washington, D.C., offices of Barnes & Thornburg LLP. Daniel Streim and Nicholas Peterson are managing associates in the Washington, D.C., office of Orrick, Herrington & Sutcliffe LLP.
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