LawFlash

SEC Adopts Standards of Conduct For Retail Advice

June 06, 2019

The US Securities and Exchange Commission voted on June 5 to adopt its long-awaited rules governing retail advice. These new standards of conduct include the adoption of Regulation BI and Form CRS, as well as interpretive guidance on the fiduciary duty for investment advisers and the “solely incidental” prong of the broker-dealer exclusion.

We wanted to share our initial thoughts on the package of rulemakings and interpretations the US Securities and Exchange Commission (SEC) adopted yesterday addressing the obligations of broker-dealers and investment advisers when advising retail investors. Following the SEC’s 3–1 vote to approve the measures (Commissioner Jackson voted against), the SEC published releases for each of the four components, which we are currently analyzing (and our thoughts below are preliminary and subject to that analysis).

COMPLIANCE DATES

  • Reg. BI: June 30, 2020
  • Interpretation of Investment Advisers’ Fiduciary Duty: No compliance date specified; effective as of the date of publication in the Federal Register
  • Interpretation of “Solely Incidental” Prong of Broker-Dealer Exclusion: No compliance date specified; effective as of the date of publication in the Federal Register
  • Form CRS Relationship Summary: June 30, 2020

For Reg. BI and Form CRS, 12 months is an aggressive timeframe. Firms will want to start analyzing the rules quickly and consider whether there are grounds to ask the SEC for additional time to comply. The interpretations take effect as of the date of publication in the Federal Register (as soon as the next few weeks).

The SEC seems to be assuming—and reasonable minds may differ—that the interpretations are entirely consistent with established legal principles and business practices, and that no changes will be needed. Depending on the substance of the interpretations, firms might want to request that the SEC set a compliance date or issue a nonenforcement position for a period of time sufficient for firms to come into compliance with the newly introduced aspects of the interpretations.

Given the scope of this rulemaking, there are many important questions that will affect investment firms. Here are some of the initial questions we are analyzing.

REGULATION BEST INTEREST

Best Interest Obligation: The rule 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).

  • How is the best interest obligation satisfied? A broker-dealer must satisfy four obligations—not three obligations as proposed: (1) the disclosure obligation; (2) the care obligation, (3) the conflict of interest obligation, and (4) a new compliance obligation.
  • What does it mean for an “account recommendation” to be in a retail customer’s best interest? The SEC expanded the best interest obligation to apply to recommendations of account type and rollovers. Firms will want to analyze what types of communications would go beyond solicitation or marketing of services and be viewed as a recommendation, what the SEC said about how this applies in the context of dual registrants, and how to apply the best interest obligation in this context.
  • Does the rule extend to implicit recommendations? One new facet of the rule is the extension of its requirements to “implicit” recommendations to hold securities that, according to the SEC press release, result from “agreed-upon account monitoring.” Firms should consider how this is articulated, including whether this might open the door to the concept of other “implied” recommendations and how this impacts arrangements under which they monitor customer accounts in a way that might imply a recommendation.
  • What legal representatives of a natural person are retail customers? Firms will want to consider the circumstances under which trusts, family offices, private family trust companies, and other vehicles used to invest family assets would be viewed as legal representatives of the underlying family members. This could have implications for FINRA’s suitability rule, where recommendations to such entities might be subject to FINRA Rule 2111 unless they may be treated as institutional accounts.
  • How does Reg. BI affect interactions with plan participants? It appears that the SEC clarified that individual plan participants are retail customers. Firms will want to examine closely the circumstances under which they would be subject to Reg. BI in dealings with plan participants and how Reg. BI impacts those interactions.
  • What happens to states’ efforts to impose fiduciary duties on broker-dealers? Chairman Clayton expressed concerns about “the potential patchwork of inconsistent state-level standards” in his opening remarks, while Commissioner Jackson argued the SEC should have stated unequivocally that Reg. BI “sets a federal floor, not a ceiling, for investor protection.” Litigation regarding the preemption of state law appears to be a possibility. The SEC stated that “the preemptive effect of Regulation Best Interest on any state law governing the relationship between regulated entities and their customers would be determined in future judicial proceedings based on the specific language and effect of that state law.”

Disclosure Obligation: The rule requires that prior to or at the time of the recommendation, the broker-dealer must provide the retail customer, in writing, full and fair disclosure of (1) all material facts relating to the scope and terms of the relationship with the retail customer, including capacity as a broker-dealer, fees and costs, and type and scope of services and any material limitations on securities that may be recommended; and (2) all material facts relating to conflicts of interest associated with a recommendation.

  • What manner of disclosure is allowed? Discussion at the open meeting suggested that disclosure could be provided in writing, through other media, or orally. Firms will want to analyze the benefits and drawbacks of different ways of disclosing information, such as when oral disclosure would be sufficient or when memorialization of the oral disclosure might be required. From a litigation standpoint, reliance on oral disclosures without any written or electronic backup would not appear prudent.
  • Are broker-dealers required to disclose all conflicts or only material conflicts? While investment advisers have been required to disclose facts about material conflicts under past SEC and staff guidance, including as reflected in Form ADV, Reg. BI requires broker-dealers to disclose material facts about all conflicts without regard to the materiality of a particular conflict. Reg. BI defines a conflict broadly 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.” Understanding how the SEC reached this judgment will be important, including because there potentially is a big difference between a requirement to disclose material facts about all conflicts without regard to materiality versus a requirement to disclose material facts about material conflicts.

Care Obligation: The rule requires that, in making a recommendation, the broker-dealer must exercise reasonable diligence, care, and skill to satisfy reasonable basis, customer-specific, and quantitative obligations.

  • What does it mean for a recommendation to be in a retail customer’s “best interest”? The SEC did not define “best interest” in Reg. BI. Firms will want to closely examine the SEC’s guidance on what “acting in the best interest” means, including how it relates to the condition in the care obligation that a broker-dealer “not place [its] financial or other interest . . . ahead of the interest of the retail customer,” and what, if anything, best interest requires beyond not placing the broker-dealer’s interest ahead of the retail customer’s interest.
  • What is the impact of cost in making a recommendation? The SEC added to Reg. BI a requirement that a broker-dealer consider the costs of a recommendation, in addition to the customer’s investment profile and potential risks and rewards. This elevates cost as a consideration for each recommendation. The SEC, however, indicated that cost remains but one consideration out of many and that the recommendation of the “lowest cost” security could violate Reg. BI without consideration of other factors. Firms will want to consider how this is articulated, including how the SEC’s guidance differs from longstanding FINRA guidance about cost under its suitability rule.
  • When will compliance with the care obligation be determined? The SEC states that this should be determined at the time of the recommendation, and not based on hindsight.

Conflict Obligation: The rule requires that a broker-dealer establish, maintain, and enforce written policies and procedures reasonably designed to (1) identify and at a minimum disclose or eliminate all conflicts of interest; (2) mitigate conflicts of interest that create an incentive for a broker-dealer’s financial professionals to place their interests or the broker-dealer’s interests ahead of the retail customer’s interest; (3) prevent material limitations on offerings (e.g., proprietary or other limited range of products) from causing the broker-dealer or its financial professionals to place their interests ahead of the retail customer’s interests; and (4) eliminate sales contests, sales quotas, bonuses, and non-cash compensation based on the sale of specific securities or specific types of securities within a limited period of time.

  • What does mitigation require? In proposing Reg. BI, the SEC provided guidance on mitigation without detailing specific requirements that would sufficiently mitigate a conflict. Firms will want to closely examine how the SEC articulated principles underlying mitigation, including how broker-dealers can appropriately earn compensation, and compensate their employees, without violating Reg. BI.
  • How does this impact the recommendation of proprietary products? Arguably, disclosure that a broker-dealer only provides proprietary products or a limited range of products should be sufficient to address conflicts of interest, especially given related Advisers Act precedent. It is not immediately clear if the chosen test for limited or proprietary products is based on duty of loyalty concepts (i.e., placing the broker-dealer or its financial professional’s interests ahead of the retail customer’s interests) versus duty of care concepts or a combination of the two.
  • Are any sales contests, sales quotas, bonuses, and non-cash compensation permissible? The rule bars these, but there may be questions about the scope of the bar in relation to acceptable contingent compensation, including what the SEC means by a “limited period of time.”

Compliance Obligation: A broker-dealer would be required to establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Reg. BI.

  • How will the SEC apply this obligation? As a separate obligation under Reg. BI, it appears the SEC could allege a broker-dealer violated Reg. BI based solely on having inadequate policies and procedures, as has been the case with policies and procedures on handling of material nonpublic information required by Exchange Act Section 15(g) and Advisers Act Section 204A, as well as the Advisers Act rule on policies and procedures, Rule 206(4)-7.

INTERPRETATION OF INVESTMENT ADVISERS’ FIDUCIARY DUTY

Is the interpretation consistent with the established federal fiduciary duty under Capital Gains and its progeny? The SEC stated that the “final interpretation reaffirms, and in some cases clarifies, certain aspects of the federal fiduciary duty that an investment adviser owes to its clients.” We will want to consider how the SEC defines that federal fiduciary duty and whether it differs from common law principles. For example, the interpretation goes back to language in the US Supreme Court’s SEC v. Capital Gains Research Bureau, Inc. decision referring to “congressional intent to eliminate, or at least to expose, all conflicts of interest” as the basis to require advisers to disclose all conflicts without regard to materiality, seemingly overriding decades of SEC and staff statements—and the text of Form ADV—that limited an adviser’s disclosure obligations to material conflicts: “Under federal and state law, you are a fiduciary and must make full disclosure to your clients of all material facts relating to the advisory relationship. As a fiduciary, you also must seek to avoid conflicts of interest with your clients, and, at a minimum, make full disclosure of all material conflicts of interest between you and your clients that could affect the advisory relationship.” General Instruction 3 to Part 2 of Form ADV (emphasis added).

What did the SEC say about adequacy of disclosure? The SEC states that “for disclosure to be full and fair, it should be sufficiently specific so that a client is able to understand the material fact or conflict of interest and make an informed decision whether to provide consent.” But the SEC also appears to suggest that the adequacy of disclosure might be different when dealing with institutional clients versus retail clients.

What did the SEC say about the use of “may”-based disclosure? The use of “may”-based disclosure has been a constant focus of the SEC’s examination and enforcement staffs (for example, the recent Robare decision). The SEC states that “disclosure that an adviser ‘may’ have a particular conflict, without more, is not adequate when the conflict actually exists.” Firms will want to analyze disclosures in light of the SEC’s articulation of when the use of “may” would be viewed as inadequate.

How did the SEC articulate the concept of informed consent? The SEC has sought to clarify that investment advisers are not required to make subjective judgments about whether each individual investor has understood the disclosure. Firms nonetheless will want to examine the SEC’s guidance as to when consent is informed in light of existing disclosures.

INTERPRETATION OF ‘SOLELY INCIDENTAL’ PRONG OF BROKER-DEALER EXCLUSION

How did the SEC interpret “solely incidental?” 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 and account monitoring.

What does the SEC mean by “effecting securities transactions?” For purposes of determining broker status, the courts and SEC have generally looked to whether the person participates in transactions at key points in the chain of distribution. However, in other contexts, such as Section 28(e) of the Securities Exchange Act of 1934, the SEC has construed effecting transactions to include executing, clearing, or settling transactions or engaging in one of four specified functions: (1) taking financial responsibility for customer trades; (2) making and/or maintaining records relating to customer trades required by Commission and SRO rules, including blotters and memoranda of orders; (3) monitoring and responding to customer comments concerning the trading process; and (4) generally monitoring trades and settlements.

What kind of discretion would be “solely incidental” to brokerage? Over the years, the SEC has stated that discretion exercised on a temporary or limited basis would be viewed as “solely incidental.” Firms will want to analyze how the SEC articulated this concept and related examples of discretion exercised on a temporary or limited basis in light of existing offerings and arrangements with customers.

What type of account monitoring would be “solely incidental” to brokerage? How the SEC articulated the concept of permissible account monitoring will be important in determining how broker-dealers should examine their agreements and business practices to avoid investment adviser status.

FORM CRS RELATIONSHIP SUMMARY

What does Form CRS require? The SEC appears to have made significant revisions to the form, including to provide greater comparability of information in Form CRS.

How flexible are the delivery requirements? Commissioner Peirce suggested that Form CRS could be provided in multiple formats, including digitally. As with the disclosure obligation under Reg. BI, firms will want to analyze the benefits and drawbacks of different ways of disclosing information, including ways to effectively provide this information.

Did the SEC ban the use of titles? The SEC has not adopted a separate rule banning the use of titles (e.g., adviser) by broker-dealers, and instead has provided that the use of the term “adviser” or “advisor” in a name or title by a broker-dealer that is not dually registered as an investment adviser, or an associated person that is not also a supervised person of an investment adviser, might violate the capacity disclosure requirement of Reg. BI.

NEXT STEPS

As noted, this is a summary of our preliminary impressions of the SEC standards package. In the meantime, we will be

You can find more analysis, materials, and events in our Regulation of Retail Investment Advice resource center.

CONTACTS

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:

Boston
David C. Boch
Jason S. Pinney

New York
Jennifer L. Klass
Christine M. Lombardo
Eric L. Perelman

Orange County
Chris Cox

Washington, DC
John V. Ayanian
Brian J. Baltz
Thomas S. Harman
Lindsay B. Jackson
Daniel R. Kleinman
Amy Natterson Kroll
Monica L. Parry
Michael B. Richman
Ignacio A. Sandoval
Steven W. Stone
Kyle D. Whitehead