The Securities and Exchange Commission (SEC) has adopted a package of rules and interpretations on the provision of advice to retail customers. Some of these rules come with tight compliance dates, and firms that will be impacted should quickly review the rules and evaluate how they will affect their businesses.
Congress, state legislatures, and federal and state regulators have grappled over the last 20-plus years with the appropriate standards of conduct for broker-dealers and investment advisers when providing advice to retail customers. From the Tully Report through the since-vacated Merrill rule and US Department of Labor (DOL) fiduciary rule, there have been many stops and starts along the way. On June 5, the SEC adopted its long-awaited package of rules and interpretations governing the provision of advice to retail customers. The SEC has done a laudable job in adopting the rule package considering that the varying business models of broker-dealers and investment advisers, and the complex dynamic among regulators—including the SEC, DOL, and the states—have made the issue a difficult one to resolve.
The rule package has four parts: (1) Regulation Best Interest (Reg. BI); (2) Interpretation of an investment adviser’s federal fiduciary duty (IA Interpretation); (3) Form CRS Relationship Summary (Form CRS); and (4) Interpretation of the “solely incidental” prong of the broker-dealer exclusion from the definition of investment adviser in Section 202(a)(11)(C) of the Investment Advisers Act of 1940 (Advisers Act).
We encourage firms to quickly begin digesting the nearly 1,400 pages of rules and guidance and assessing the impacts on their businesses. The rules are relatively brief, but the companion releases provide important guidance on the many questions on how the rules are intended to operate and will be enforced. We can expect more guidance from the SEC Staff, which has set up a special working group to consider and answer the questions to come. The compliance date for Reg. BI and Form CRS is June 30, 2020, which is an aggressive timeframe. Firms impacted by the IA Interpretation and the “solely incidental” interpretation appear to have even less time to make any needed changes – the SEC did not provide a compliance date and the interpretations are effective upon publication in the Federal Register.
We briefly describe Reg. BI, the IA Interpretation, Form CRS, and the “solely incidental” interpretation, and discuss some initial observations below.
Reg. BI requires that 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” (emphasis added). The “best interest” obligation includes four components: (1) disclosure obligation; (2) care obligation; (3) conflict of interest obligation; and (4) compliance obligation.
Disclosure Obligation. The SEC described the disclosure obligation as “a more explicit and broader disclosure obligation” than currently exists designed to “promote broker-dealer recommendations that are in the best interest of retail customers.” Under Reg. BI, prior to or at the time of a recommendation, a broker-dealer must provide full and fair disclosure, in writing, of all material facts relating to the scope and terms of the relationship with the retail customer, including capacity as a broker-dealer, material fees and costs, and type and scope of services, including “any material limitations on the securities or investment strategies involving securities that may be recommended.” The broker-dealer must also disclose “[a]ll material facts relating to conflicts of interest that are associated with a recommendation.” The SEC defined conflict of interest as “an interest that might incline a broker, dealer, or a natural person who is an associated person of a broker or dealer—consciously or unconsciously—to make a recommendation that is not disinterested.”
Care Obligation. The care obligation requires a broker-dealer to exercise reasonable diligence, care, and skill in satisfying three obligations when recommending a security or investment strategy involving securities: a reasonable-basis obligation, a customer-specific obligation, and a quantitative obligation.
The care obligation goes beyond existing suitability obligations. First, the care obligation requires that a broker-dealer “exercise reasonable diligence, care, and skill,” although the SEC decided to avoid articulating this as a prudence standard because of possible confusion. Second, it requires that a recommendation be in the “best interest” of the retail customer—not just suitable—in light of the retail customer’s investment profile and the potential risks, rewards, and costs (an additional consideration in the final rule), and that the broker-dealer and its financial professionals not place their financial or other interests ahead of the retail customer’s interests. It is unclear, however, what “best interest” means in this context and whether it requires something beyond not placing the broker-dealer’s interest ahead of the retail customer’s interest. Third, the SEC elevated consideration of costs to the rule text, meaning that cost, along with potential risks and rewards, must always be considered when making a recommendation. Fourth, the SEC’s articulation of the care obligation encompasses quantitative suitability as to all retail customer relationships, not only situations where a broker-dealer exercises actual or de facto control over an account, which is the focus on quantitative suitability under current law.
Conflict of Interest Obligation. Reg. BI creates an overarching obligation to establish, maintain, and enforce written policies and procedures reasonably designed to identify and either disclose or eliminate all conflicts—the proposed rule was limited to material conflicts—and requires a broker-dealer to mitigate certain identified conflicts (if those conflicts were not otherwise eliminated). A broker-dealer’s policies and procedures must be reasonably designed to identify and mitigate conflicts that create an incentive for a broker-dealer’s financial professionals to place either their interests or the broker-dealer’s interest ahead of the retail customer’s interest. In addition, the policies and procedures must be reasonably designed to identify and disclose any material limitations on offerings (e.g., proprietary or other limited range of products) and any conflicts associated with the limitations, and prevent the limitations and associated conflicts from causing the broker-dealer or its financial professionals to place their interests ahead of the retail customer’s interests. Finally, Reg. BI outright prohibits “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,” although there are some vagaries in how this bar applies.
Compliance Obligation. Finally, Reg. BI requires a broker-dealer to establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Reg. BI.
The IA Interpretation reaffirms that, under the Advisers Act, an investment adviser stands in a fiduciary relationship with its clients. According to the SEC, the fiduciary duty includes an overarching “obligation to act in the best interest of its clients” that “encompasses both the duty of care and the duty of loyalty.” The “fiduciary duty must be viewed in the context of the agreed-upon scope of the relationship between the adviser and the client.” While the adviser and client can agree on the scope of the relationship, “an adviser’s federal fiduciary duty may not be waived.”
Duty of Care. According to the SEC, the duty of care “includes a duty to provide investment advice that is in the best interest of the client, including a duty to provide advice that is suitable for the client,” based on “a reasonable understanding of the client’s investment objectives.” The SEC acknowledged that the basis for such a reasonable understanding generally would include an understanding of a retail customer’s investment profile (i.e., financial situation, level of financial sophistication, investment experience, and financial goals) or an understanding of an institutional client’s investment mandate. The duty of care also requires an adviser “to seek best execution of a client’s transactions where the adviser has responsibility to select broker-dealers to execute client trades (typically in the case of discretionary accounts),” and “to provide advice and monitoring at a frequency that is in the best interest of the client, taking into account the scope of the agreed relationship.”
Duty of Loyalty. The SEC stated that the duty of loyalty “requires that an adviser not subordinate its clients’ interests to its own,” or, “[i]n other words, an investment adviser must not place its own interest ahead of its client’s interests.” An adviser is not required to eliminate conflicts of interest, but at least must expose all conflicts through “full and fair disclosure.” In the SEC’s view, “disclosure must be clear and detailed enough for the client to make an informed decision to consent to the conflict of interest or reject it.” The SEC cautioned, however, that where an adviser cannot make full and fair disclosure, “the adviser should either eliminate the conflict or adequately mitigate (i.e., modify practices to reduce) the conflict such that full and fair disclosure and informed consent are possible.” The SEC also stated, without additional clarification, that “may”-based disclosure is inadequate to describe situations in which an adviser does have a conflict, including where the conflict applies only with respect to a subset of an adviser’s clients, advice, or transactions.
In an effort to help retail investors make more informed choices about financial services providers, the SEC is requiring broker-dealers and investment advisers to deliver Form CRS to retail investors. Proposed Form CRS was the subject of numerous comments and investor studies, with many expressing concerns that its prescribed language and format would increase investor confusion. The SEC sought to address these concerns in the final rule by preserving the comparative format, but allowing firms greater flexibility in describing their services, fees, costs, and conflicts of interest, as well as in how this information is conveyed to investors (permitting and encouraging digital and graphical formats). Both advisers and broker-dealers must state: “We have to act in your best interest and not put our interest ahead of yours.”
Form CRS must be filed with the SEC and delivered to retail investors. While advisers must deliver Form CRS before or at the time of entering into an advisory agreement, broker-dealers must deliver the form before or at the earliest of (1) making a recommendation; (2) placing an order; or (3) opening a brokerage account. Because many broker-dealers do not currently provide “point-of-sale” disclosures, the delivery requirements may require operational changes.
Section 202(a)(11)(C) of the Advisers Act excludes from the definition of “investment adviser” any broker-dealer whose advice is “solely incidental” to its brokerage business and who does not receive “special compensation” for that advice. In this rule package, the SEC sought to clarify its views as to the “solely incidental” prong, stating that a broker-dealer’s advice would be viewed as “solely incidental” where it is “provided in connection with and is reasonably related to the broker-dealer’s primary business of effecting securities transactions.” The SEC provided two examples of activities that might not be “solely incidental” to brokerage: exercise of investment discretion, other than on a temporary or limited basis, and certain account monitoring.
Reg. BI and the IA Interpretation seek to establish comparable “best interest” obligations for broker-dealers and investment advisers when providing advice to retail customers, although broker-dealers are required to mitigate certain conflicts. The rules and guidance, however, raise many important questions that will affect firms.
Disclosure of Conflicts. Firms might consider analyzing the impact of the requirement to disclose all material facts about all conflicts. Under longstanding SEC and staff statements, as well as the text of Form ADV, investment advisers have only been required to make full disclosure of material conflicts. While the SEC stated in Reg. BI that “it would be difficult to envision a ‘material fact’ that must be disclosed pursuant to the Disclosure Obligation that is not related to a conflict of interest that is also material,” it is unclear how this plays out in practice, including whether the SEC ultimately takes the position that the existence of a conflict is a material fact that must be disclosed without regard to the materiality of the conflict and how this impacts conflicts that advisers have deemed immaterial and excluded from disclosures.
Mitigation of Conflicts. While investment advisers are not required to mitigate any particular conflicts, in both Reg. BI and the IA Interpretation the SEC introduced the concept that mitigation might be required where full and fair disclosure of a conflict is not possible. The SEC, however, has not clarified or provided guidance on when disclosure alone would be viewed as inadequate or, in those circumstances, what level of mitigation would be required.
Layered Disclosure. The SEC views Form CRS as the first layer in a “layered disclosure” regime that should cross-reference additional disclosures for more detailed information. Firms should carefully consider their approaches to the SEC’s “layered disclosure” regime, including its pros and cons. In developing a layered disclosure approach, firms might consider leveraging existing customer disclosures (e.g., account agreements, advisory brochures, guides to services, fee schedules, 408(b)(2) disclosures, prospectuses and other offering documents) and disclosures developed for other purposes (e.g., for the since-vacated DOL Best Interest Contract Exemption). Firms might also keep in mind the challenges in mapping and maintaining consistency among disclosures where changes and updates are made.
Account Types and Rollovers. Reg. BI applies to account recommendations. Similarly, the SEC stated that an adviser’s fiduciary duty applies to investment advice about account types. Unfortunately, the SEC provided limited guidance about how broker-dealers and investment advisers should apply their obligations in these circumstances. For example, it is unclear when a broker-dealer would be viewed as making an account “recommendation,” and not simply engaging in sales activity. It is also unclear whether investment advice about account types includes discussions that do not involve a recommendation. Developing policies and procedures, and related controls, around this new concept of identifying an account type that is in a retail customer’s best interest may prove to be especially challenging for firms with a large number of offerings, and particularly those that are dually registered. Advisers might also consider the impact of the SEC’s statement that an “adviser must also satisfy its fiduciary duty with respect to any such advice (e.g., regarding account type) when a prospective client becomes a client,” including how this extension of the fiduciary duty impacts procedures regarding account opening that have been developed under well-established principles that an investment adviser does not owe fiduciary duties to a client before the adviser-client relationship is established.
As the rules and interpretations are nearly 1,400 pages, it will take time to understand fully the ultimate impact on broker-dealers’ and investment advisers’ business practices. As we detailed in a prior LawFlash, even the initial questions are numerous. While firms will likely soon begin to make changes to comply with the rules, the ultimate impact on investor protection and market participants will play out over the next several years.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
 See Investment Advisers Act of 1940 § 215(a) (“Any condition, stipulation, or provision binding any person to waive compliance with any provision of this title or with any rule, regulation, or order thereunder shall be void.”)