On June 5, 2019, the Securities and Exchange Commission adopted a long-awaited suite of rules, interpretive guidance and forms that, in the words of the accompanying press release, is “designed to enhance the quality and transparency of retail investors’ relationships with investment advisers and broker-dealers, bringing the legal requirements and mandated disclosures in line with reasonable investor expectations, while preserving access (in terms of choice and cost) to a variety of investment services and products.” The package consists of four elements, three of which had been proposed previously:
- Regulation Best Interest (Regulation BI), requiring a broker-dealer to act in the best interest of a retail customer when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer (Release No. 34-86031);
- Interpretive guidance regarding the standard of conduct for investment advisers (Release No. IA-5248);
- Rules for brokers and investment advisers creating a requirement to provide a new short-form relationship summary, in new Form CRS, for brokers, and in an amended Form ADV, for investment advisers (Release No. 34-86032 and IA-5247); and
- Interpretive guidance regarding the solely incidental prong of the broker-dealer exclusion from the definition of investment adviser (Release No. IA-5249). This guidance was not proposed previously but is, according to the release, consistent with prior SEC guidance and relevant case law.
Brokers. Beginning on June 30, 2020, brokers will be required to comply with the requirements of Regulation BI when making recommendations to retail customers. Although the components of the broker’s duty to retail customers is similar to and to some extent based on the Financial Industry Regulatory Authority’s suitability rule, FINRA Rule 2111, Regulation BI provides a greater level of detail around avoiding or remediating conflicts of interest, as well as other elements of the duty. FINRA has indicated that it is considering amending Rule 2111 or removing those parts of it that are inconsistent with or covered by Regulation BI. Existing brokers must file Form CRS through Web CRD by June 30, 2020, and deliver a copy to retail investors no later than July 30, 2020.
The SEC has added guidance for brokers that also provide investment advice, with respect to the “solely incidental” exception to registration as an investment adviser.
Investment Advisers. As discussed below, the SEC has provided interpretive guidance, in one place, concerning the investment adviser’s duty of care and duty of loyalty to its clients. The SEC has also added a requirement that investment advisers file a Form CRS relationship summary with the SEC, through the Investment Adviser Registration Depository, or IARD, and deliver copies of the relationship summary to clients who are retail investors, as defined in the instructions to the form. Existing investment advisers must file Form CRS by June 30, 2020, and deliver a copy to retail investors no later than July 30, 2020.
Regulation Best Interest
Regulation BI sets out the duty to act in the best interest of a retail customer when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer. Important elements of Regulation BI are the definitions and the components of the broker’s duty.
Consistent with its initial proposal, the SEC stated that whether a broker-dealer’s actions and communications trigger the obligations imposed by Regulation BI turns on specific facts and circumstances. The SEC explained that, in determining whether a broker-dealer communication (a “Communication”) constitutes a recommendation that triggers the best interest obligations set forth under Regulation BI (a “Recommendation”), it considers whether such Communication “reasonably could be viewed as a ‘call to action’” and “reasonably would influence an investor to trade a particular security or group of securities.” The SEC also noted that a Communication about a security or group of securities is more likely to be deemed a Recommendation to the extent such Communication is customized to a specific customer or a targeted group of customers.
For additional clarity, the SEC provided in the adopting release a list of Communications that it generally would not deem to be Recommendations, assuming such Communications, alone or taken together with other Communications, do not include a recommendation of a particular security or securities or a particular investment strategy involving securities:
(a) General financial and investment information, including: basic investment concepts, such as risk and return, diversification, dollar cost averaging, compounded return, and tax-deferred investment; historic differences in the return of asset classes (e.g., equities, bonds or cash) based on standard market indices; the effects of inflation; estimates of future retirement income needs; and an assessment of a customer’s investment profile;
(b) Descriptive information about an employer-sponsored retirement or benefit plan, participation in the plan, the benefits of plan participation, and the investment options available under the plan;
(c) Asset allocation models that are: based on generally accepted investment theory; accompanied by disclosures of all material facts and assumptions that may affect a reasonable investor’s assessment of the asset allocation model or any report generated by such model; and in compliance with FINRA Rule 2214 (Requirements for the Use of Investment Analysis Tools) if the asset allocation model is an “investment analysis tool” covered by such rule; and
(d) Interactive investment materials that incorporate the above.
(2) "Any Securities Transaction or Investment Strategy Involving Securities"
The SEC interprets Regulation BI to apply to a Recommendation of: (i) “any securities transaction” (purchase, sale, and exchange); and (ii) any “investment strategy” involving securities (including account recommendations). In addition, the SEC interprets Regulation BI to be applicable to hold recommendations and recommendations involving retirement accounts.
(a) "Account Recommendations"
In the adopting release, the SEC stated that “account recommendations” include recommendations by broker-dealers of securities account types, generally, as well as recommendations to roll over or transfer assets from one type of account to another (e.g., workplace retirement plan account to an individual retirement account, or IRA). Account recommendations are “investment strategies involving securities,” regardless of whether they are tied to a specific securities transaction, thus triggering the best interest obligations under Regulation BI.
(b) "Hold Recommendations"
Regulation BI applies to explicit Recommendations to hold a security or securities, consistent with existing broker-dealer regulations. In addition, the SEC explained that the phrase, “any securities transaction or investment strategy involving securities,” also includes implicit hold recommendations (i.e., Recommendations that are not actually communicated to retail customers) that are the result of agreed-upon account monitoring between a broker-dealer and retail customer, although Regulation BI does not impose a duty to monitor a retail customer’s account. Unless a broker-dealer has agreed to provide account monitoring services, Regulation BI only applies to explicit hold Recommendations regarding security positions in an account.
(c) Recommendations Involving Retirement Accounts
The SEC noted in the adopting release that recommendations to retail customers regarding retirement accounts are subject to Regulation BI, when such recommendations involve securities transactions or investment strategies involving securities. The SEC explained that recommendations to retail customers to take distributions from proceeds of specific securities or to take in-service loans from an employer-sponsored plan are Recommendations, as they would involve a recommendation to sell a security. However, the SEC clarified that, while such Recommendations to take plan distributions are subject to Regulation BI, general communications by broker-dealers relating to distributions in the context of a required minimum distribution or education regarding a plan’s options would not, by themselves, constitute Recommendations.
(3) "Retail Customer"
Regulation BI, as adopted, explicitly defines “retail customer” 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 associated person of a broker or dealer; and (ii) uses the recommendation primarily for personal, family, or household purposes. Although FINRA Rule 2111 defines an institutional account as including an individual with over $50 million in assets (consistent with the definition used in other FINRA rules), the Regulation BI definition does not contain a cap on the definition of retail customer based on assets or income.
In the adopting release, the SEC interpreted “legal representatives” to mean non-professional legal representatives of a natural person (e.g., a non-professional trustee that represents the assets of a natural person and similar representatives, such as executors, conservators and persons holding a power of attorney for a natural person) to clarify that institutions and certain professional fiduciaries are not covered for purposes of Regulation BI, while retaining coverage of certain legal entities (i.e., trusts that represent the assets of a natural person) specifically identified in the proposing release as “retail customers.”
Further, the SEC explained that a retail customer “uses” a Recommendation when, as a result of the Recommendation: (i) the retail customer opens a brokerage account with the broker-dealer, regardless of whether the broker-dealer receives compensation; (ii) the retail customer has an existing account with the broker-dealer and receives a recommendation from the broker-dealer, regardless of whether the broker-dealer receives or will receive compensation, directly or indirectly, as a result of that recommendation; or (iii) the broker-dealer receives or will receive compensation, directly or indirectly as a result of that recommendation, even if that retail customer does not have an account at the firm.
The SEC also interpreted the meaning of “personal, family, or household purposes” to mean that any recommendation to a natural person for his or her account would be subject to Regulation BI, other than recommendations to natural persons seeking these services for commercial or business purposes. Accordingly, under this interpretation, “personal, family or household purposes” would not include an employee seeking services for an employer, or an individual who is seeking services for a small business or on behalf of another non-natural person entity, such as a charitable trust. The SEC further noted that the term “personal, family or household purposes” encompasses retirement accounts (e.g., IRAs and individual accounts in workplace retirement plans, such as 401(k) plans and other tax-favored retirement plans), as retirement savings is a personal, household or family purpose.
The SEC clarified that Regulation BI would not apply to investment advice provided to a retail customer by a dual-registrant when the dual-registrant is acting in its capacity as investment adviser, even if the retail customer has a brokerage relationship with the dual-registrant, or if the dual-registrant executes the transaction in its brokerage capacity. Similarly, the SEC confirmed that a dual-registrant is an investment adviser solely with respect to those accounts for which the dual-registrant provides investment advice or receives compensation that subjects it to the Investment Advisers Act of 1940, as amended (the “Advisers Act”). Whether a dual-registrant is making a Recommendation in its capacity as broker-dealer depends on the facts and circumstances, with no one factor being determinative, but the SEC will consider, among other factors, the type of account, how the account is described, the type of compensation and the extent to which the dual-registrant made clear to the customer or client the capacity in which it was acting.
Component Obligations of Broker's Duty
Regulation BI provides that the General Obligation is satisfied only if the broker-dealer complies with four specified component obligations: (1) the Disclosure Obligation; (2) the Care Obligation; (3) the Conflict of Interest Obligation; and (4) the Compliance Obligation:
- Disclosure. The broker must, prior to or at the time of the recommendation, provide to the retail customer, in writing, full and fair disclosure of all material facts related to the scope and terms of the relationship, including all material facts relating to conflicts of interest that are associated with the recommendation.
In response to comments to the proposal, Regulation BI provides specific disclosures as examples of the minimum material facts that are related to the scope and terms of the relationship and must be disclosed. These examples cover the capacity in which the broker is acting; the material fees and costs that apply to the retail customer’s transactions, holdings, and accounts; and the type and scope of services provided to the retail customer, including any material limitations on the securities or investment strategies involving securities that may be recommended.
- Care. A broker-dealer 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. The broker-dealer must then consider these factors in light of the retail customer’s investment profile and make sure a recommendation is in the retail customer’s best interest.
Regulation BI as adopted differs from the proposal in two ways. First, it explicitly requires the broker-dealer to consider the costs of the recommendation by requiring the broker-dealer to have a reasonable basis to believe that a recommendation, or series of recommendations, does not place the financial or other interest of the broker-dealer or its associated persons ahead of the interest of the particular retail customer. Second, in response to commenter concerns, it does not use the term “prudence” to define a broker-dealer’s obligations under the Care Obligation.
- Conflicts of Interest. Regulation BI requires the broker-dealer to establish, maintain, and enforce written policies and procedures reasonably designed to identify and at a minimum disclose or eliminate conflicts of interest. Specifically, Regulation BI requires policies and procedures to: mitigate conflicts that create an incentive for the firm’s financial professionals to place their interest or the interests of the firm ahead of the retail customer’s interest; prevent material limitations on offerings -- such as providing a limited product menu or offering only proprietary products -- from causing the firm or its financial professional to place his or her interest or the interests of the firm ahead of the retail customer’s interest; and 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 of time.
Additionally, Regulation BI requires the broker to establish, maintain, and enforce written policies and procedures reasonably designed to (A) identify and at a minimum disclose, or eliminate, material conflicts of interest associated with the recommendation; and (B) disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with the recommendation. These additional requirements are enhancements to the original proposal that were provided in response to comments seeking more clarity and guidance surrounding when specific conflicts should be disclosed, mitigated or eliminated.
Compliance Obligation. Regulation BI requires broker-dealers to establish written policies and procedures reasonably designed to achieve compliance with Regulation BI as a whole. This requirements reflects the Commission’s decision to adopt certain commenters’ suggestions that the proposed requirement to develop policies and procedures as part of the Conflict of Interest Obligation be broadened to a general obligation to adopt policies and procedures to ensure compliance with Regulation Best Interest as a whole.
The Compliance Obligation provides flexibility to allow broker-dealers to establish compliance policies and procedures that accommodate a broad range of business models. The Compliance Obligation does not enumerate specific requirements that broker-dealers must include in their policies and procedures. Each broker-dealer should instead consider the scope, size, and risks associated with the operations of the firm and the types of business in which the firm engages when adopting policies and procedures. The Commission has stated that a reasonably designed compliance program generally would also include controls, remediation of noncompliance, training, and periodic review and testing.
Interpretive Guidance on Standard of Conduct for Investment Advisers
Under the “Advisers Act,” an investment adviser owes to its clients a fiduciary duty, which consists of a duty of care and a duty of loyalty. The application of these duties will be informed by the nature and scope of the adviser’s relationship with its client, as well as the types of clients the adviser services. The final interpretative guidance reaffirms and clarifies aspects of the fiduciary duty owed to clients under the Advisers Act.
Principles-Based Application of Fiduciary Duty
Recognizing that the scope of a relationship between an adviser and its client may vary significantly across clients, and that advisers may serve a range of types of clients, the final interpretative guidance indicates that advisers may take a “principles-based” approach to fulfilling their fiduciary duties. The application of fiduciary duty will depend on what roles the adviser has agreed to assume, as an agent, for its client. In other words, the obligations owed to a long-standing client, for whom the adviser has assumed ongoing portfolio management responsibilities, will differ from those owed to a client who contracts with the adviser for a single financial plan. Similarly, the obligations may be shaped by the type of client being served, ranging from retail, to institutional, to registered investment companies or private funds.
The scope of the duty owed to a client may be informed by the contractual relationship between the adviser and the client. However, the relationship will remain that of a fiduciary, and any contract provision purporting to generally waive the federal fiduciary relationship is inconsistent with the Advisers Act. Such impermissible provisions might include statements that the adviser will not act as a fiduciary, blanket waivers of conflicts of interest, or waivers of specific requirements of the Advisers Act.
Duty of Care
The final interpretive guidance addresses three particular aspects of the duty of care, as discussed below.
Duty to Provide Advice in Best Interest of Client
An adviser has a duty to provide advice that is suitable for its client and its client’s objectives, which requires that the adviser have a “reasonable understanding” of those objectives. In developing such a reasonable understanding for a retail client, the adviser should, at a minimum, make reasonable inquiries into the client’s financial situation and sophistication, as well as the client’s investment experience and financial goals, to form a picture of the client’s investment profile. The specific steps an adviser takes to form this understanding, and how often this investment profile needs to be updated or refreshed, will vary based on the facts and circumstances of the client. For an institutional client, the analysis is shaped instead by the investment mandates of that client—for example, if an adviser is engaged to provide advice on a specific segment of that client’s investment holdings, there is no expectation that the adviser should be familiar with the client’s broader investment objectives. Taking steps to update an understanding of the institutional client’s objectives would not be applicable, unless otherwise contemplated by an advisory agreement.
Furthermore, the adviser must have a reasonable belief that its recommendations are in the best interest of the client, based on its understanding of the client’s objectives. Notably, the adviser should consider the risk tolerance of its client and whether the risks of certain investments are justified by potential benefits. In forming a reasonable belief that an investment is in the best interest of the client, an adviser must conduct a reasonable investigation into the investment. In considering what is in the best interest of the client, the cost of a particular investment or strategy should be considered as one important factor, but it is not required to be, nor should it necessarily be, the only factor considered. It should be noted that this duty applies to all investment advice provided to the client, including as to account type, use of a sub-adviser or, more generally, investment strategy.
Duty to Seek Best Execution
When an adviser has the responsibility to select broker-dealers to execute client transactions, the duty of care includes seeking best execution for those transactions. The adviser should consider total cost or proceeds in making this determination, to maximize the value to the client at the time of the transaction. While cost is one important factor to consider, it is not the determinative factor—the adviser should take into account the full range and quality of the broker’s services. An adviser should also periodically assess the execution a broker is providing for its clients.
Duty to Provide Advice and Monitoring Over Course of Relationship
An adviser’s duty to monitor and provide ongoing advice to a client is indicated by the scope and duration of the agreed-upon relationship between the adviser and the client. In general, the duty to monitor extends to all personalized advice for a client; for example, in an ongoing advisory relationship, an adviser should evaluate whether an account type or investment program continues to be in the best interest of the client.
Duty of Loyalty
The duty of loyalty requires that an adviser “not place its own interest ahead of its client’s interests.” In order to meet this standard, an adviser must make “full and fair disclosure” of all facts material to its relationship with the client, including an indication of the capacity in which the adviser is acting (e.g., if the adviser is both a registered broker-dealer and investment adviser). The adviser must “eliminate or at least expose through full and fair disclosure” all conflicts of interest that could, consciously or unconsciously, influence an adviser’s ability to render disinterested investment advice, so that a client is able to provide informed consent.
The final interpretive guidance discusses in particular two aspects of “full and fair disclosure.” First, a disclosure will not be “full and fair” unless it is sufficiently specific to allow a client to understand the fact or conflict and make an informed decision on whether to consent. The use of “may” in the context of an existing conflict of interest is not sufficient, though the use of “may” might be sufficient for a potential conflict that does not currently exist. Additionally, the use of “may” should not simply precede a list of conflicts in a way that obfuscates actual or likely conflicts. The required level of specificity will depend on the type of client, services or material fact or conflict involved. Second, with respect to allocation of investment opportunities among eligible clients, an adviser must eliminate or expose through disclosure the conflicts associated with its allocation procedures. In considering allocations, an adviser can take into account the nature of the relationship with a client, and allocation procedures need not be pro rata (or any other particular method), as long as those procedures do not prevent the adviser from providing advice in the best interest of its clients.
Note that an adviser need not make an affirmative determination that a client understood a disclosure or that a client’s consent was informed as to a particular conflict. However, where an adviser should be aware that a client did not understand the nature or importance of a conflict, the adviser’s fiduciary duty implies that the adviser should not accept or infer consent from that client. In cases where a conflict cannot be sufficiently disclosed to obtain such informed consent, the adviser must eliminate the conflict or adequately mitigate it, such that it can be sufficiently disclosed and informed consent can be obtained.
Interpretive Guidance on “Solely Incidental” Exemption from Investment Adviser Definition for Brokers
Section 202(a)(ii)(C) excludes from the definition of “investment adviser” a broker or dealer providing investment advice “whose performance of such advisory services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation” for those services (“broker-dealer exclusion”). In the Regulation BI Proposal, the SEC requested comment on the scope of the exclusion as applied to a broker’s exercise of investment discretion. On the basis of comments received, which expressed divergent views on the exclusion and, in some cases, requested further guidance, the SEC determined to adopt interpretive guidance specifically with respect to the “solely incidental” prong of the broker-dealer exclusion.
The SEC interprets the statutory language, as a general matter, to mean “that a broker-dealer’s provision of advice as to the value and characteristics of securities or as to the advisability of transacting in securities is consistent with the solely incidental prong if the advice is provided in connection with and is reasonably related to the broker-dealer’s primary business of effecting securities transactions.” Conversely, a broker’s advice is not solely incidental if the broker’s primary business is giving advice or if the broker provides securities investment advice that is not in connection with or reasonably related to the broker’s business as a broker-dealer. The determination whether advice is solely incidental does not depend on the frequency or importance of the advice; investment advice need not be trivial, inconsequential or infrequent to qualify for the exclusion.
More specifically, the interpretive guidance addresses the topics of discretionary authority and account monitoring. The SEC considers permanent or continuing discretionary authority by a broker to be inconsistent with the broker-dealer exclusion. A broker may, however, exercise discretion on a limited basis, for example: (1) to determine the price or time of execution of an order given by the customer for the purchase or sale of a definite amount of a specified security; (2) on an isolated or infrequent basis, to buy or sell a security when a customer is unavailable to place an order for a limited period of time; (3) with respect to cash management, to exchange a position in a money market fund for another money market fund or cash equivalent; and (4) to purchase or sell securities to satisfy margin requirements or other customer obligations that the customer specifies. The interpretive guidance provides additional examples.
The SEC states that a broker who agrees to monitor a retail customer’s account on a periodic basis for purposes of providing buy, sell or hold recommendations may still be considered to provide advice in connection with its business as a broker. If a broker monitors a customer’s account voluntarily and without agreement with the customer, for the purpose of providing recommendations, the broker’s actions are, in the view of the SEC, done in connection with and reasonably related to the broker’s primary business of effecting securities transactions. The SEC declined to delineate every circumstance where agreed-upon monitoring would or would not be solely incidental to the broker’s business, but recommended that broker-dealers consider adopting policies and procedures that would help demonstrate (for example, in an SEC examination of the broker-dealer’s business) that any agreed-upon monitoring is in connection with and reasonably related to the broker-dealer’s primary business of effecting securities transactions.
The SEC invites further comment on this interpretation, which is effective immediately.
Relationship Summaries for Brokers and Investment Advisers
The SEC adopted a form of relationship summary, Form CRS, to be used by brokers and investment advisers to inform retail investors about:
- The type of client and customer relationships and services the firm offers;
- The fees, costs, conflicts of interest and required standard of conduct associated with those relationships and services;
- Whether the firm and its financial professionals currently have reportable legal or disciplinary history; and
- How to obtain additional information about the firm.
The relationship summary will also reference Investor.gov/CRS, a page on the SEC investor education website, which offers educational information to investors about investment advisers, broker-dealers and individual financial professionals, and other materials. Form CRS will be in a standard question-and-answer format, with topics presented in a prescribed order, within which firms will have the flexibility to provide their own wording in responding to questions. Relationship summaries are limited to two pages in length, or the electronic equivalent, for a broker or investment adviser, or four pages for dual registrants.
Form CRS and the associated rules use the term “retail investor” rather than “retail customer,” the term used in Regulation BI. Although the definitions are similar in most respects, the principal difference is that a person may be a retail investor, and the Form CRS delivery requirement may be triggered, before the person seeks or receives a recommendation.
Filing and Delivery Requirements and Compliance Dates
Brokers will be required to file their relationship summaries through Web CRD. Investment advisers will be required to file their relationship summaries through the IARD system in the same manner as they currently file Form ADV Parts 1A and 2A. Dual registrants will be required to file their relationship summaries through both Web CRD and IARD, whether they use one relationship summary or two.
An investment adviser must deliver a relationship summary to each new retail investor before or at the time the firm enters in an investment advisory contract, even if the agreement is oral. This timing generally tracks the initial delivery requirement for Form ADV Part 2A. A broker will be required to deliver the relationship summary to each retail investor before the earliest of: (1) a recommendation of an account type, a securities transaction or an investment strategy involving securities; (2) placing an order for the retail investor; or (3) the opening of a brokerage account for the retail investor.
The Form CRS instructions permit delivery in paper form or within the SEC’s existing guidance regarding electronic delivery. This framework consists of (1) notice to the investor that information is electronically available, (2) access to information comparable to that which would have been provided in paper form and that is not so burdensome that the intended recipient cannot effectively access it; and (3) evidence to show delivery.
Firms that are registered as broker-dealers or investment advisers, or investment advisers who have an application for registration pending, with the SEC prior to June 30, 2020, will have a period of time beginning on May 1, 2020, until June 30, 2020, to file their initial relationship summaries with the SEC. On and after June 30, 2020, each newly registered broker-dealer will be required to file its relationship summary with the SEC by the date on which its registration with the SEC becomes effective, and the SEC will not accept any initial application for registration as an investment adviser that does not include a relationship summary that satisfies the requirements of Form ADV. Firms required to file their initial relationship summaries on or before June 30, 2020, must deliver relationship summaries to all existing retail investors by July 30, 2020.
Implementing the New Rules and Guidance
Investment advisers and brokers have a year, until June 30, 2020, to (1) put in place policies and procedures for compliance with Regulation BI, in the case of brokers, and the interpretive guidance on conduct standards for investment advisers and (2) prepare and file relationship summaries in compliance with Form CRS.
Please contact your relationship lawyer at Goodwin if you would like more information about the new requirements or assistance in complying with them. You may also contact Peter LaVigne, at (212) 813-8844 with questions about Regulation BI and the requirements for brokers, or Brynn Peltz, at (212) 813-8823, or David Solander, at (202) 346-4023, with questions about the requirements for investment advisers.