Publication

June 13, 2019Client Alert

SEC Issues New Regulations for Broker-Dealers and Investment Advisers

On June 5, 2019, the SEC passed Regulation Best Interest (“Regulation BI”) by a 3-1 vote. Regulation BI aims to expand and clarify the standards of conduct for investment advisers and broker-dealers. According to the SEC, the rule is also designed to help retail investors better understand and compare investment services. The SEC also passed a new Form CRS Relationship Summary, as well as interpretations of the Investment Advisers Act of 1940 regarding the standard of conduct for investment advisers and the “solely incidental” broker-dealer exclusion. Whether these rules will actually help investors is the subject of intense debate. But, with a compliance deadline of June 2020, the securities community will need to begin implementation of the new standards and preparing to meet the new disclosure requirements immediately.

Regulation Best Interest

Currently, broker-dealers are required to recommend investments that are suitable to their customers, based on personal characteristics such as age, goals, and risk-appetite. In contrast, an investment adviser owes a fiduciary duty to its clients, which includes the duties of care and loyalty. Although Regulation BI now requires broker-dealers to act in the best interest of their retail customers, the SEC never defines this term. Regulation BI does, however, outline the four obligations of a broker-dealer, which relate to disclosure, care, conflicts of interest, and compliance.

Under the disclosure obligation, broker-dealers must disclose all material facts related to the scope and terms of their relationship with the customer. Such facts include the fees and costs associated with the customer’s transactions and accounts. They also include the type and scope of services provided and material limitations of products offered.

The care obligation requires broker-dealers to have a reasonable basis for believing that an investment recommendation is in the best interest of a customer; broker-dealers may not place their interests before a customer’s. This involves taking into account the customer’s investment profile, including a customer’s age, investments, experience, financial situation, risk tolerance, tax status, and investment objectives. It also means that broker-dealers must understand the potential risks, rewards, and costs associated with the recommendations they make. Further, broker-dealers must consider reasonably available alternatives to their recommendations. This need not involve an evaluation of every possible alternative product, nor must broker-dealers recommend the single best decision. Instead, their consideration of alternatives must be reasonable under the circumstances, based on information reasonably known to them—that is, information based on reasonable diligence, care, and skill. The SEC also requires that broker-dealers have a reasonable process for determining what constitutes a reasonably available alternative. Since reasonableness will necessarily depend on the facts and circumstances surrounding the recommendation, broker-dealers may be acting with some uncertainty until the law further develops in this area.

Under the conflict of interest obligation, broker-dealers must establish, maintain, and enforce written policies and procedures reasonably designed to identify and either disclose or eliminate conflicts of interest associated with recommendations. Mercifully, the SEC does define conflict of interest. Unfortunately, the term is somewhat confusingly defined as an interest which may lead a broker-dealer to make a recommendation that is not disinterested. Broker-dealers must also eliminate sales contests, quotas, bonuses, and non-cash compensation based on making sales in a limited time (i.e., high pressure sales environments).

Finally, Regulation BI’s compliance obligation requires broker-dealers to establish, maintain, and enforce written policies and procedures “reasonably designed” to achieve compliance with Regulation BI. Although not within the compliance provision, Regulation BI also requires broker-dealers to record all information collected from, and provided to, a retail customer under the regulation.

Standard of Conduct for Broker-Dealers: “Solely Incidental” Interpretation

Section 202 of the Investment Advisers Act excludes from the definition of investment adviser any broker-dealer providing advisory services that are “solely incidental” to their business and generate no special compensation. The SEC’s interpretation clarifies that the exemption applies to a broker-dealer’s advice as to the value and characteristics of securities and securities transactions. To be excluded from the definition, the advice must also be provided in connection with, and be reasonably related to, the broker-dealer’s primary business of effecting securities transactions.

Standard of Conduct for Investment Advisers: Investment Adviser Interpretation

The SEC’s interpretation of Section 206 of the Investment Advisers Act re-emphasizes the fiduciary duties owed to clients. Advisers owe a duty of care to provide advice that is in the client’s best interest. This duty requires a reasonable inquiry into the client’s financial situation and investment sophistication, experience, and goals. The duty of care also incorporates a duty to seek the best execution of (i.e., maximizing value in) a client’s transactions, and a duty to provide advice and monitoring throughout the relationship. Advisers also owe their clients a duty of loyalty, which precludes an adviser from putting their interests above a client’s. Duty of loyalty further requires full disclosure of all material facts relating to the adviser-client relationship.

Form CRS Relationship Summary

The Form CRS Relationship Summary will require registered investment advisers and broker-dealers to provide retail investors with information about the professional-customer relationship. The Form will include information regarding services, fees and costs, conflicts of interest, the legal standard of conduct, and whether or not the firm and its professionals have any disciplinary history. The relationship summary will have a standardized, easy-to-understand question-and-answer format. Although firms may mostly write the form in their own wording, the form must also be factual; firms may not include exaggerated, unsubstantiated, or vague claims.

Conclusion

There are ongoing criticisms that Regulation BI does little, if anything, to improve the standards of financial professionals. It also remains unclear whether states will continue to be allowed to impose more stringent standards. This makes it all the more important to understand securities law and the implications for broker-dealers and investment advisers. Please do not hesitate to contact the experts at Michael Best for additional information on these new regulations and how they apply to you.

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