The compliance date of June 30, 2020, is looming for U.S. broker-dealers subject to Regulation Best Interest (Reg. BI) and broker-dealers and investment advisers required to prepare and provide relationship summaries pursuant to Form CRS and related rules. Staff of the U.S. Securities and Exchange Commission (SEC) have provided answers to several FAQs and guidance regarding related exam priorities. This alert provides a brief overview of Reg. BI and Form CRS requirements and highlights a few areas of continued focus (and potential pitfalls) for firms.
What is Regulation Best Interest?
Reg. BI imposes a “best interest” standard of conduct on broker-dealers and their associated persons when making a recommendation to a retail customer of any securities transaction or investment strategy involving securities. A broker-dealer must 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 the broker-dealer making the recommendation, ahead of the interest of the retail customer. A firm satisfies Reg. BI by complying with four obligations, with respect to : (1) disclosure; (2) care; (3) conflicts of interest; and (4) compliance. The protections afforded by Reg. BI, including the four obligation prongs, are not waivable by retail customers.
What is Form CRS?
Form CRS requires broker-dealers and investment advisers to deliver a brief relationship summary to retail investors. In essence, the relationship summary is designed to inform investors of the services they are receiving, the cost of those services, potential conflicts of interest, and whether the firm or its personnel have any disciplinary history. Firms must file an initial relationship summary with the SEC and periodically file amendments as needed.
Broker-dealers must deliver a current relationship summary to retail investors before or at the earliest of (i) a recommendation of an account type, a securities transaction, or an investment strategy involving securities; (ii) placing an order for the retail investor; or (iii) the opening of a brokerage account for the retail investor. It is important to note that “retail investor,” used for purposes of the Form CRS requirement, has a different definition from “retail customer” as used in Reg. BI, and both definitions take a different approach from the retail/institutional account distinction under Financial Industry Regulatory Authority (FINRA) rules.
The Reg. BI disclosure obligation is separate and distinct from the relationship summary, but a standalone broker-dealer may be able to use the relationship summary to cover its obligation to disclose the capacity in which it is acting.
Investment advisers must deliver a current relationship summary to retail investors before or at the time they enter into an investment advisory contract with a retail investor.
For existing retail investors, broker-dealers and investment advisers also must deliver a current relationship summary before or at the time of (a) opening a new account that is different from the retail investor's existing account(s); (b) recommending that the retail investor roll over assets from a retirement account into a new or existing account or investment; or (c) recommending or providing a new brokerage service or investment advisory service, respectively, or investment that does not necessarily involve the opening of a new account and would not be held in an existing account.
Deadlines are Quickly Approaching
SEC Chairman Jay Clayton recently confirmed that (at least for now) the SEC will not delay the June 30, 2020, compliance deadlines. Reg. BI and Form CRS are intended to enhance investor transparency and clarity, which Chairman Clayton emphasized is more important than ever in times of market volatility. Furthermore, the SEC adopted Reg. BI and Form CRS on June 5, 2019, and thus firms will have had over a year to work toward compliance by the time June 30, 2020, arrives.
Firms should continue to work in earnest toward the June 30, 2020, deadlines. If we look back at where we were six weeks ago in late March, it seems fair to say that we have no idea what our “new normal” will look like on June 30, 2020. This is not meant to insinuate that the SEC will change course and issue a delay. But we do think the agency will continue to listen to outreach from the industry and consider whether the current deadline is appropriate. The SEC is mindful that we are in uncharted waters, and that beyond the health concerns we are all facing, the securities industry mostly is operating under business continuity and pandemic plans. The agency could reconsider delaying the deadlines, either broadly or on a firm-by-firm basis, due to staffing issues (workforce shortage or impediments to training) or logistical issues (lack of printer or other fulfillment resources). We will continue to monitor for any updates on this front.
Q2 Statement Stuffers and Early Delivery Permitted
SEC staff blessed the approach of those firms that wish to include Reg. BI disclosures and relationship summaries with their June 2020 quarterly statement mailings to existing clients. For firms sending these paper mailings, this should result in postage savings versus sending the disclosures in a separate mailing. In those cases, firms may send relationship summaries within one week after June 30, 2020. Of note for mailings, the SEC clarified that when a relationship summary is sent in paper format with a package of other documents, the relationship summary must be displayed first among the package of documents. However, that mailing will not cover the Reg. BI disclosure obligation for any recommendations made between June 30, 2020, and the time the required disclosures are provided.
Firms may deliver relationship summaries in advance of the June 30, 2020, compliance deadline. Firms also may file early with the SEC. Item 7(iv) of the Form CRS Instructions notes that delivery is required “[w]ithin 30 days after the date by which [the firm is] first required to electronically file…” However, there are two different delivery deadlines for firms to consider: (1) the fixed deadline of July 30, 2020 (30 days after June 30, the date by which filing must be made), and (2) the moving deadline that is based on when a firm makes a recommendation to, or places an order or opens a brokerage account for a retail customer. Due to that moving deadline, which can require delivery on a case-by-case basis at varying times on and after June 30, it may be a best practice for firms to deliver Form CRS to everyone by June 30, 2020, in order to avoid any operational issues.
A Rose By Any Other Name…
It turns out, for Reg. BI purposes, there’s a lot in a name. For broker-dealers (and their representatives) that are not also registered investment advisers, the default rule of thumb should be to not use the terms “adviser” or “advisor” in their titles. Other than in a handful of scenarios, absent investment adviser registration, the SEC will consider use of “adviser” and “advisor” in firm names and individual titles to be a violation of the Reg. BI disclosure obligation. This holds true even if the firm is affiliated with a registered investment adviser. However, SEC staff does consider a state-registered investment adviser to be “registered as an investment adviser.”
Mind the Gap — Between Retail and Institutional Definitions
The definitions of “retail investor” and “retail customer” for purposes of Reg. BI and Form CRS, respectively, are different than the retail/institutional distinction to which the securities industry is accustomed. In particular, the historical $50 million asset threshold does not apply to Reg. BI and Form CRS. SEC staff recently noted that the definition “does not exclude high-net worth natural persons and natural persons that are accredited investors.” To further confuse things, even the Reg. BI and Form CRS definitions vary slightly. For Form CRS, a retail investor is a natural person, or the legal representative of such natural person, who seeks to receive or receives services primarily for personal, family, or household purposes. For Reg. BI, a retail customer is a natural person, or the legal representative of such person, who: (1) receives a recommendation of any securities transaction or investment strategy involving securities from a broker-dealer; and (2) uses the recommendation primarily for personal, family, or household purposes. Thus, firms may be required to provide Form CRS disclosure to prospective customers before they have made a recommendation.
Besides being mindful of the elimination of any asset threshold for natural persons, firms should carefully analyze how their obligations might differ when dealing with retail investors (a) directly, (b) through a non-professional legal representative, or (c) through a professional legal representative. SEC staff recently noted that the term “legal representative” only covers non-professional (i.e., non-regulated) legal representatives. The accompanying examples of non-professional legal representatives are non-professional trustees that represent the assets of natural persons and similar representatives such as executors, conservators, and persons holding a power of attorney for a natural person. Legal representatives who are regulated securities industry professionals fall outside the scope of the “retail investor/customer” definitions. SEC staff noted the following as “professional” legal representatives: registered investment advisers and broker-dealers, corporate fiduciaries (e.g., banks, trust companies, and similar financial institutions) and insurance companies, and the employees or other regulated representatives of such advisers, broker-dealers, corporate fiduciaries, and insurance companies. Family offices and their professional staff are excluded from the definition of “investment adviser” if they meet the requirements of Rule 202(a)(11)(G)-1 under the Advisers Act. As of this time, the SEC and SEC staff have not published guidance concerning whether a family office is a legal representative for purposes of the definition of retail customer. However, if a family office to whom a broker makes a recommendation is acting for a partnership or other entity owned by family members, rather than individual family members, the broker may be able to conclude that it is not making a recommendation to the legal representative of a retail customer (i.e., an individual).
Firms should carefully consider whether the legal representatives with which they are dealing are professional or non-professional and how that affects the obligations under Reg. BI and Form CRS.
What to Expect During SEC Examinations?
On April 7, 2020, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) released two risk alerts, one for Reg. BI and one for Form CRS. Collectively, these risk alerts lay out the SEC’s initial exam priorities regarding Reg. BI and Form CRS, which can be summarized as a focus on “best efforts” to establish and implement “policies and procedures reasonably designed to achieve compliance.” Examinations are set to begin after the compliance date and are likely to occur within the first year thereafter. However, it remains unclear if the SEC will be able to stick to that timeline or what form the examinations may take due to the COVID-19 pandemic. The risk alert for Reg. BI implies that exams will focus on the four obligations of Reg BI.
- Disclosure. The SEC may look at documents to review the content and timing of the disclosure. Potential documents for review could include schedules of fees and charges, compensation methods for registered personnel, disclosures related to monitoring and material limitations on accounts, and lists of proprietary products sold to retail customers.
- Care. The SEC may review information collected from retail customers to develop their investment profiles, the broker-dealer’s process for having a reasonable basis to believe that the recommendation(s) are in the best interest of the retail customer, how the broker-dealer makes recommendations related to significant investment decisions and its reasonable basis to believe such investment strategies are in the retail customer's best interest, and how the broker-dealer makes recommendations related to more complex, risky or expensive products and its reasonable basis to believe such investment strategies are in the retail customer's best interest.
- Conflict of interest obligation. The SEC may review the broker-dealer’s policies and procedures for how the firm addresses conflicts that create incentives to place its interest ahead of the interest of the retail customer, conflicts associated with material limitations on securities or investment strategies and the elimination of conflicts from sales contests, sales quotas, bonuses, and non-cash compensation. The SEC may also review these policies and procedures for how a broker-dealer seeks to identify and assess conflicts that may arise now or as the business evolves, how they seek to mitigate or eliminate such conflicts of interest and the disclosure of these conflicts.
- Compliance obligation. The SEC may review the broker-dealer’s policies and procedures to evaluate any controls, remediation of noncompliance, training, and periodic review and testing included as part of those policies and procedures.
The risk alert for Form CRS sets out the likely areas on which SEC staff exams will focus, including (i) delivery and filing; (ii) content; (iii) formatting; (iv) updates; and (v) recordkeeping. The documents the SEC may review to evaluate these areas include the broker-dealer’s policies and procedures, the investor relationship summaries, and the firm’s records related to delivery.
Rule 15l-1 under the Securities Exchange Act of 1934 (“Exchange Act”).
 See Exchange Act Rule 17a-14; see also https://www.sec.gov/rules/final/2019/34-86032-appendix-b.pdf. See Rule 204-5 under the Investment Advisers Act of 1940 (“Advisers Act”); see also https://www.sec.gov/about/forms/formadv-part3.pdf.
 See the discussion below under “Mind the Gap.”
 SEC staff recently noted that broker-dealers may use the terms adviser or advisor “when they are acting in a role specifically defined by federal statute that does not entail providing investment advisory services to retail customers, for example, as a municipal advisor, commodity trading advisor, or advisor to a special entity.” Staff also noted that “[a] broker-dealer that provides advice in other capacities outside the context of investment advice to a retail customer may in its discretion use the terms ‘adviser’ and ‘advisor’.” https://www.sec.gov/tm/faq-regulation-best-interest.
 See, e.g., FINRA Rule 4512(c), which is not affected by Reg. BI or Form CRS.