SEC Adopts Rules & Interpretive Guidance Designed to Enhance and Clarify the Obligations of Financial Professionals
In April 2018, our team published an
On June 5, 2019, the SEC voted 3-1 (with the fifth seat on the Commission remaining vacant) to approve a package of rulemakings and interpretations including two adopted rules (each an “Adopted Rule” and, collectively, the “Adopted Rules”) and two separate interpretations under the Investment Advisers Act of 1940, as amended (“Advisers Act”). The adopted regulatory package does not adopt a uniform fiduciary standard for broker-dealers and investment advisers. Instead, the Commission acknowledged that the broker-dealer and investment adviser business models are inherently different and as a result, adopting a rule that would provide for a uniform fiduciary standard would not be in the best interest of retail customers.
This new regulatory package comes only weeks after the Department of Labor (the “DOL”) pushed back the expected date for its proposed “Fiduciary Rule and Prohibited Transaction Exemption” from September 2019 to December 2019,
At the Open Meeting on Commission Actions to Enhance and Clarify the Obligations of Financial Professionals (“Open Meeting”), SEC Chairman Jay Clayton noted that the regulatory package addresses the obligations of broker-dealers and investment advisers when they provide investment advice and services to retail investors. He further noted that the regulatory package is designed to enhance the quality and transparency of the financial professional-retail investor relationship, and includes two overarching objectives: (1) to bring the required standards of conduct for financial professionals and related mandated disclosures in line with reasonable investor expectations; and (2) to preserve retail investor access (in terms of both choice and cost) to a variety of investment services and products.
The four separate but complementary releases consist of two Adopted Rules: Regulation Best Interest: The Broker-Dealer Standard of Conduct (“Regulation Best Interest”), and Form Client Relationship Summary and Amendments to Form ADV (“Form CRS”); and two separate Commission interpretations: Commission Interpretation Regarding Standard of Conduct for Investment Advisers, and Commission Interpretation Regarding the Solely Incidental Prong of the Broker-Dealer Exclusion from the Definition of Investment Adviser. Each item is further discussed below.
I. Regulation Best Interest
Under the SEC’s Adopted Rule, 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
The SEC chose not to expressly define the term “best interest” in the rule text, but instead provided some color on what “acting in the best interest” means. The Regulation Best Interest Adopting Release (the “Adopting Release”) notes that whether a broker-dealer has acted in the retail customer’s best interest in compliance with Regulation Best Interest “will turn on an objective assessment of the facts and circumstances of how the specific components of Regulation Best Interest—including its Disclosure, Care, Conflict of Interest, and Compliance Obligations—are satisfied at the time that the recommendation is made (and not in hindsight).”
The Adopting Release notes that while the existing fiduciary standard under the Advisers Act would not apply to broker-dealers, “key elements of the standard of conduct that applies to broker-dealers under Regulation Best Interest will be substantially similar to key elements of the standard of conduct that applies to investment advisers pursuant to their fiduciary duty under the Advisers Act.”
Notwithstanding the similarities, the Adopting Release notes that obligations of a broker-dealer under the Adopted Rule and the obligations of an investment adviser pursuant to its fiduciary duty under the Advisers Act differ in certain respects. For example, an investment adviser’s duty of care encompasses the duty to provide advice and monitoring a client’s account at a frequency that is in the best interest of such client. In contrast, the provision of recommendations in a broker-dealer relationship is generally transactional and episodic, and therefore the Adopted Rule requires that broker-dealers act in the best interest of their retail customers at the time a recommendation is made, and imposes no duty to monitor a customer’s account following a recommendation.
It is important to note that the Adopted Rule does not require that a broker-dealer provide conflict-free recommendations. For example, under the Adopted Rule, a broker-dealer could recommend a more expensive security if the broker-dealer has a reasonable basis to believe there are other factors about the security that make it in the best interest of the retail customer, based on that retail customer’s investment profile.
According to the Adopted Rule, the “best interest” standard would be satisfied if the broker-dealer or its associated person complies with the following obligations:
Disclosure. Before or when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer, the broker-dealer must provide full and fair disclosure, in writing, of all material facts relating to the scope and terms of the relationship, and all material conflicts of interest associated with the recommendation.
Duty of Care. In making a recommendation, the broker-dealer exercises reasonable diligence, care, and skill to:
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;
have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on the retail 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
have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer’s best interest when viewed in isolation, is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile and does not place the financial or other interest of the broker-dealer ahead of the interest of the retail customer.
Conflicts of Interest. The broker-dealer establishes, maintains, and enforces written policies and procedures reasonably designed to:
identify and, at a minimum, disclose, or eliminate, all conflicts of interest associated with such recommendations;
identify and mitigate any conflicts of interest associated with such recommendations that create an incentive for the broker-dealer to place the interest of the broker-dealer ahead of the interest of the retail customer;
(i) identify and disclose any material limitations placed on such recommendations and any conflicts of interest associated with such limitations, and (ii) 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
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.
Compliance. The broker-dealer establishes, maintains, and enforces written policies and procedures reasonably designed to achieve compliance with Regulation Best Interest.
In a change from the 2018 proposal, the Adopting Release removed a provision that would have restricted broker-dealers and their associated persons, when communicating with retail investors, from using the term “adviser” or “advisor” as part of a name or title. The Commission noted that the reason it decided not to adopt a separate rule is because it “presume[s] that the use of the term ‘adviser’ and ‘advisor’ in a name or title by (1) a broker-dealer that is not also registered as an investment adviser or (2) an associated person that is not also a supervised person of an investment adviser, to be a violation of the capacity disclosure requirement under the Disclosure Obligation.” According to the Commission, the capacity disclosure requirement is designed to improve awareness among retail customers of the capacity in which a broker-dealer and/or financial professional is acting when making a recommendation. The Commission further noted that it believes that “in most cases broker-dealers and their financial professionals cannot comply with the capacity disclosure requirement by disclosing that they are a broker-dealer while calling themselves an “adviser” or “advisor.” Thus, according to the Commission, in most instances, the use of the titles “adviser” and “advisor” by brokers-dealers “would undermine the objectives of the capacity disclosure requirement by potentially confusing a retail customer as to type of firm and/or professional they are engaging.”
II. Form CRS
The Commission also adopted a new question-and-answer, open-ended disclosure document, in order to help address investor confusion about the nature of their relationships with investment professionals: a customer or client relationship summary—Form CRS. Form CRS is intended to provide retail investors with simple, easy-to-understand information about the nature of their relationship with their investment professional and would supplement other more detailed disclosures—in no more than four pages.
Form CRS requires broker-dealers and investment advisers to deliver to retail customers a short summary, including: (1) the principal types of services offered; (2) the applicable fees the retail customer may pay;
The relationship summary must be delivered to new or prospective clients or customers at the first possible opportunity, including the initial point of contact. The relationship summary is required whether or not there is a recommendation. Firms must update the relationship summary within 30 days whenever the relationship summary becomes materially inaccurate. Firms also must post the latest version on their website (if they have one), and electronically file the relationship summary with the Commission.
The biggest changes to Form CRS, from its corresponding proposal released in 2018, are to its format. Instead of prescribed text, like that of the proposed rule, the form will be in question-and-answer format. A firm can choose the questions posed to itself, and the Commission encourages the use of charts, tables, and other graphics, including hyperlinks, in its response. Firms may not omit any material facts necessary in order to make disclosures, but unlike the 2018 proposed rule, the Adopted Rule provides flexibility by taking into account the reality that not all material facts can be included within a short summary with a page limit.
Finally, unlike the proposal made in 2018, the Adopted Rule will require Form CRS data to be filed in a structured format in order to facilitate machine readability of the information and enhance an investor’s effort to compare among firms.
III. Standard of Conduct for Investment Advisers
In addition, on June 5, 2019, the Commission issued its interpretation of the fiduciary standard of conduct for investment advisers under the Advisers Act (“Final Interpretation”). While the Final Interpretation is similar in form and context to the 2018 proposal, it is worthwhile to note a few key differences.
In 2018, when discussing the duty of loyalty, the Commission noted that the duty of loyalty requires an investment adviser to put its “client’s interests” first. However, the Final Interpretation notes that the duty of loyalty requires that an adviser “not subordinate its clients’ interests” to its own. This revision prompted some harsh criticism from Commissioner Jackson. In his remarks he noted that “the final guidance the majority approves today removes language from last year's proposal stating that the law ‘requires an investment adviser to put its client's interests first.’ The guidance suggests that a careful reading of decades-old cases reveals that we were wrong last year to say that this is the law. I disagree.”
Another change from the 2018 proposal relates to conflicts of interest. In 2018, when discussing conflicts of interest, the Commission noted that an investment adviser must “avoid conflicts of interest with its clients, and, at a minimum, make full and fair disclosure to its clients of all material conflicts of interest that could affect the advisory relationship.” The Final Interpretation instead notes that “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. Furthermore, the Final Interpretation notes that “[w]e disagree that this Final Interpretation includes a requirement to eliminate conflicts of interest.” The Final Interpretation further notes that “…elimination of a conflict is one method of addressing that conflict; when appropriate advisers may also address the conflict by providing full and fair disclosure such that a client can provide informed consent to the conflict.”
The Final Interpretation also replaces the 2018 general statement about an inability to fully and fairly disclose material facts about the conflict with more specific examples of how advisers can make such full and fair disclosure. It also appears that a client’s consent to conflict of interest disclosure could be either explicit or implicit. The Final Interpretation notes, “an adviser could provide a client full and fair disclosure of all material facts relating to the advisory relationship as well as full and fair disclosure of all conflicts of interest which might incline the adviser, consciously or unconsciously, to render advice that was not disinterested, through a combination of Form ADV…and the client could implicitly consent by entering into or continuing the investment advisory relationship with the adviser.”
The Final Interpretation also acknowledges the ability of investment advisers and their clients to shape the scope of the advisory relationship to which the fiduciary duty applies. The Final Interpretation notes that “while advisers owe each of their clients a fiduciary duty, the specific obligations of, for example, an adviser providing comprehensive, discretionary advice in an ongoing relationship with a retail client will be significantly different from the obligations of an adviser to an institutional client, such as a registered investment company or private fund, where the contract defines the scope of the adviser’s services and limitations on its authority with substantial specificity.”
IV. Broker-Dealer Exclusion from the Definition of Investment Adviser
The final piece of the four-part regulatory package, which was not included in the Commission’s original proposals released in 2018, provides an interpretation of when a broker-dealer is outside the so-called “broker-dealer exclusion” of Section 202(a)(11)(C) of the Advisers Act and would therefore have to register as an investment adviser and meet Advisers Act fiduciary and other standards (if another exclusion or exemption is not available).
This interpretation was implemented in order to clarify the Commission’s view on the exclusion of those whose performance of such advisory services is solely incidental to the conduct of his/her business as a broker or dealer and who receives no special compensation for those services (the “broker-dealer exclusion”) from the definition of an “investment adviser,” as defined in section 202(a)(11) of the Advisers Act. The Commission stated that advice 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.”
The Commission noted that a broker-dealer that exercises unlimited discretion over a client’s account generally would not be able to satisfy the solely incidental prong. Nonetheless, the Commission acknowledged that in certain instances, 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. These types of relationships would be limited in time, scope, or other manner and lack the comprehensive and continuous character of investment discretion that would suggest that the relationship is primarily advisory.
V. Looking Ahead
The Adopted Rules and interpretations are expected to have implications concerning recommendations of investments in registered investment products such as mutual funds and unit investment trusts. Specifically, the Adopted Rules may require, among other things, disclosures at various points of a client relationship regarding potential conflicts of interest in making recommendations from among a group of similar products.
Commissioner Jackson, the sole dissenter, gave unenthusiastic and cautious assessments of the Adopted Rules and interpretations. He stated that the Adopted Rules “retain a muddled standard that exposes millions of Americans to the costs of conflicted advice. Even worse, contrary to what Americans have heard for a generation, the Commission today concludes that investment advisers are not true fiduciaries.”
It is important to also note that Regulation Best Interest does not expressly preempt state law.
To address at least some of the potential confusion for retail investors, according to Chairman Clayton’s remarks, the Commission is undertaking significant retail investor educational efforts to help investors understand the differences between broker-dealers and investment advisers. This will include online videos explaining basic information.
Regulation Best Interest 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 time to come into compliance. The Commission’s interpretations under the Advisers Act will become effective upon publication in the Federal Register.
The SEC’s press release can be found