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On June 5, 2019, the Securities and Exchange Commission (the “SEC”) voted to adopt two new rules intended to protect retail investors. We discussed the practical impact of one of those rules, the rule requiring the new Form CRS here. On the same date, the SEC also provided guidance on the fiduciary duties owed by investment advisers to clients under Section 206 of the Investment Advisers Act of 1940 (the “Advisers Act”) and clarified its interpretations on the “solely incidental” prong of the broker-dealer exclusion under the Advisers Act.
In addition to promulgating the new Form CRS, the SEC adopted Regulation Best Interest (“Reg BI”) to further enhance the quality and transparency of retail investors’ relationships with broker-dealers. Reg BI requires broker-dealers and natural persons who are associated persons of a broker-dealer to act in the best interest of the retail customer when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer. Reg BI requires that broker-dealers and their associated persons be held to a higher standard of care than the current suitability standards without rising to the levels of fiduciary duties imposed upon investment advisers.
Best Interest Obligation
Reg BI makes it clear that broker-dealers dealing with retail customers will be held to a higher standard that cannot be satisfied by disclosure alone. The regulation requires broker-dealers to act in the best interest of the retail customer when recommending a securities transaction or investment strategy and requires broker-dealers to establish, maintain, and enforce policies and procedures to identify and disclose material facts about conflicts of interest.
The SEC did not provide a definition for “best interest,” but indicated that the “best interest” standard is consistent with many key components of the Department of Labor’s Impartial Conduct Standards and incorporates principles that underlie the Department of Labor Fiduciary Rule. Reg BI is intended to require broker-dealers to take steps to reduce the effect of, and in some cases eliminate, conflicts that create an incentive to place a broker-dealer’s, or an associated person’s, interest ahead of the retail customer’s interest when making a recommendation.
The adopting release does make clear that the best interest standard is not the same as the fiduciary duties owed to a client by an investment adviser. The recent SEC guidance referenced above reaffirms and provides guidance regarding those fiduciary duties and adds that the duty is broad, principles-based and applies to the entire adviser-client relationship. This SEC guidance also provides examples of what constitutes full and fair disclosure as well as requirements for investor informed consent. Contrasting the duties owed to its clients by a registered investment adviser helps to further inform the best interest standard.
Broker-dealers will be considered to have met the best interest obligation if they satisfy four components when making a securities transaction or investment strategy recommendation which are described in greater detail below:
- the Disclosure Obligation,
- the Care Obligation,
- the Conflict of Interest Obligation, and
- the Compliance Obligation.
Reg BI applies to account recommendations at the time such recommendation is made, including recommendations to roll over or transfer assets in a workplace retirement plan account to an IRA, and recommendations to take a plan distribution for the purpose of opening a securities account.
Regulation Best Interest is codified in the Securities Exchange Act of 1934 as a new rule at 17 CFR 240.15l-1 and as amendments to 17 CFR 240.17a-3(a)(25), and 17 CFR 240.17a-4(e)(5).
Definition of Retail Customer
A Retail Customer is defined as a natural person, or the legal representative of such natural person, who (i) receives a recommendation of any securities transaction or investment strategy involving securities from a broker, dealer or a natural person who is an association person of a broker or dealer; and (ii) uses the recommendation primarily for personal, family or household purposes. Reg BI applies any time a retail customer receives a recommendation by a broker dealer and uses that recommendation, not just for recommendations that result in a broker-dealer receiving compensation. This definition excludes natural persons seeking investment services for commercial or business purposes; however, if a person is seeking services for a mix of personal and non-personal purposes, Reg BI would be applicable. We note that this definition of “retail customer” does not differentiate between natural persons based on net worth or other criteria, and as such any natural person seeking to receive services for personal, family, or household purposes would be deemed to be a “retail customer.” We also note that the definition is very similar to, but not precisely the same as, the term “retail investor” used in Form CRS.
Quasi Safe Harbor
As described above, Reg BI provides that the best interest obligation is satisfied if four specific requirements are met:
Broker-dealers are required to disclose, in writing, certain material facts relating to their relationship with the retail customer, including (i) specific disclosures related to the capacity the broker-dealer acts in, fees, and the type and scope of services provided and (ii) conflicts, limitations on services and products, and whether the broker-dealer provides monitoring services. It should be noted that this disclosure obligation is intended to complement the disclosure to be provided in the new Form CRS. This obligation is intended to cause the broker-dealer to provide additional and deeper information than that contained in the Form CRS.
Broker-dealers are required to exercise reasonable diligence, care and skill when making a recommendation to a retail customer. The SEC states that this is a higher standard of care than merely assessing the suitability of an investment for a particular investor. While not explicitly acknowledged, we note that the exclusion of the word “prudence” from this standard distinguishes it from the language formulation in the ERISA fiduciary standard. We believe this may prove significant in time. In particular, the broker-dealer must (i) understand the risks and rewards associated with a recommendation and have a reasonable basis to believe that the recommendation could be in the best interest of some retail customers, (ii) determine that the recommendation is in the best interest of a particular retail customer based on that individual investment’s risks and rewards and the retail customer’s investment profile, and (iii) determine that a series of recommended transactions is not excessive and is in the retail customer’s best interest when considered in light of the retail customer’s investment profile. In addition, the regulation explicitly provides that the broker-dealer must consider the costs of the recommendation to the retail customer.
Conflict of Interest Obligation
Broker-dealers are required to establish, maintain, and enforce written policies and procedures, which are reasonably designed to identify and eliminate, or at a minimum disclose, conflicts of interest. The required policies and procedures must:
- Mitigate conflicts that incentivize the broker-dealer’s personnel to place their interest or the interest of the broker-dealer ahead of the retail customer’s interest.
- Prevent material limitations on the offerings provided by the broker-dealer, including offering only proprietary products or a limited range of products, which may cause the broker-dealer’s personnel to place the interest of the broker-dealer ahead of the retail customer’s interest.
- Eliminate compensation practices which are based on the sale of specific securities or types of securities over a specific period of time.
The first two required policies and procedures are taken from the Department of Labor’s Fiduciary Rule proposal. The third represents a more strict and expensive requirement (with less room for interpretation) than the existing requirements in FINRA’s non-cash compensation rules. It should be noted that compliance with FINRA rules, even in regard to conflicts of interest, will not serve as a prima facie determination that the broker dealer has satisfied the Conflict of Interest Obligation because Reg BI purports to impose a broader obligation to address conflicts at the firm and associated person level.
Broker-dealers must establish, maintain, and enforce policies and procedures reasonably designed to achieve compliance with Reg BI. We note that, arguably, this requirement exists which respect to all rules applicable to broker-dealers.
Regulation Best Interest will become effective 60 days after it is published in the Federal Register, and the date by which investment advisers and broker-dealers must comply is June 30, 2020.
The full text of the SEC’s release regarding Reg BI can be found here.