SEC Rules and Interpretations for Broker-Dealer Standard of Conduct
On June 5th, 2019, the SEC adopted a package of rule-makings and interpretations that are designed to enhance the quality and transparency of retail investors’ relationships with investment advisers and broker-dealers. Specifically, these actions include the new Regulation Best Interest (BI), the new Customer Relationship Summary (Form CRS), as well as two separate interpretations under the Investment Advisers Act of 1940 regarding financial advice and retail clients. The compliance date for Regulation BI and Form CRS is June 30, 2020 and the two new interpretations will become effective once they’re published in the Federal Register.
Regulation Best Interest
Regulation BI imposes a new standard for broker-dealer conduct that goes beyond existing suitability obligations. The rule specifically states, “When making a recommendation of a securities transaction or an investment strategy involving securities, a broker-dealer must act in the retail customer’s best interest and cannot place its own interests ahead of the customer’s interests.”
The regulation applies to account recommendations, including any recommendations for customers to roll over or transfer their assets in a workplace retirement plan account to an IRA, as well as recommendations to take a plan distribution. It also applies to implicit “recommendations to hold” that result from agreed-upon account monitoring.
Regulation Best Interest consists of the following four components:
- Disclosure Obligation
- Care Obligation
- Conflict of Interest Obligation
- Compliance Obligation
Disclosure Obligation Before or at the time of the recommendation, a broker-dealer must provide written disclosure of all material facts about the scope and terms of its relationship with the customer. This includes specific disclosures about the capacity in which the broker is acting, all fees and costs, the type and scope of services provided, limitations on services and products, and whether the broker-dealer provides monitoring services.
Care Obligation Broker-dealers must exercise reasonable diligence, care, and skill when making a recommendation to a retail customer. The broker-dealer must understand potential risks, rewards, and costs associated with the recommendation and have a reasonable basis to believe that the recommendation is in the customer’s best interest and doesn’t place the broker-dealer’s interest ahead of the retail customer’s interest.
The Care Obligation is based on FINRA’s three existing obligations for retail customer suitability—reasonable basis, customer specific, and quantitative. However, this obligation also explicitly requires the broker-dealer to consider the costs of the recommendation or strategy. Whether a broker-dealer has complied with the Care Obligation will be evaluated as of the time of the recommendation (not in hindsight).
Conflict of Interest Obligation Broker-dealers must establish, maintain, and enforce reasonably designed written policies and procedures to identify all conflicts, disclose them, and possibly eliminate them. This obligation specifically requires policies and procedures to:
- Mitigate conflicts that create an incentive for the firm’s financial professionals to place their interests or those of the firm ahead of the retail customer’s interest
- Prevent material limitations on offerings (e.g., a limited product menu or offering only proprietary products) from causing the firm or its financial professionals to place their interests or those of the firm ahead of the retail customer’s interest
- Eliminate sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sale of specific securities or specific types of securities within a limited period
Compliance Obligation Broker-dealers are required to establish, maintain, and enforce written policies and procedures that are reasonably designed to achieve compliance with all aspects of Regulation Best Interest.
Form CRS Relationship Summary
In association with Regulation Best Interest, the SEC also adopted the new Customer Relationship Summary (Form CRS). Registered investment advisers and broker-dealers will use this form to provide retail investors with simple, easy-to-understand information about the nature of their relationship with their financial professional.
The form will summarize information about the firms’ services, fees and costs, conflicts of interest, legal standard of conduct, and whether the firm or any of its financial professionals have disciplinary history. The relationship summary will use a standardized question-and-answer format to promote comparison by retail investors in a way that’s distinct from existing disclosures. The relationship summary will permit the use of layered disclosure so that investors can more easily access additional information from the firm about these topics. Form CRS will also include a link to a dedicated page on the SEC’s investor education website – Investor.gov.
Interpretations under the Investment Advisers Act of 1940
Along with adopting Regulation Best Interest and Form CRS, the SEC issued two interpretations under the Investment Advisers Act of 1940.
The first interpretation reaffirms and, in some cases, clarifies the SEC’s view of the fiduciary duty that investment advisers owe to their clients. This fiduciary duty is principles-based and applies to the entire relationship between an investment adviser and its client. The interpretation reflects how the SEC and its staff have applied and enforced the law in this area, but also how it has inspected for compliance.
The second interpretation relates to the “solely incidental” prong of the broker-dealer exclusion under the Advisers Act and intends to clearly delineate when a broker-dealer’s performance of advisory activities causes it to become an investment adviser within the meaning of the Advisers Act.
Specifically, the interpretation states that a broker-dealer’s advice regarding the value and characteristics of securities or the advisability of executing transactions in securities falls within the “solely incidental” prong of this exclusion if the advice is provided in connection with, and is reasonably related to, the broker-dealer’s primary business of effecting securities transactions.
The new rules and interpretations are designed to enhance the quality of retail investors’ relationships with broker-dealers and investment advisers. The rule-making package is designed to enhance investor protections, while preserving retail investors’ 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.
The rules will also provide additional transparency and clarity for retail investors through enhanced disclosures that are designed to help them understand who they’re dealing with and why that matters. The interpretations reaffirm, and in some cases clarify, the standard of conduct that investment advisers owe to their clients and also clarify the scope of the services a broker-dealer can provide consistent with the statutory definition of investment adviser.