The SEC, on June 5th, adopted a comprehensive set of rules and interpretations that will have a profound effect on the brokerage and advisory industries going forward, first and foremost by revising the standard-of-conduct applicable to broker-dealers and their registered representatives in dealings with retail customers. Even casual observers will likely be familiar with the various proceedings just concluded at the SEC, which resolve debates that have raged in the investment industry for decades as to the need to align the higher fiduciary “standard-of-conduct” applicable to investment advisers with the lesser suitability standard applicable to broker-dealers. While the June 5th releases do not equalize the two standards—as many commentators would have desired—they do significantly raise the standard applicable to broker-dealers from suitability to “best interests.” The SEC’s releases number four separate documents, each covering a distinct aspect of the standard-of-conduct controversy, and run over 1200 pages. Accordingly, this note will seek to identify the major headlines from the various releases. Look for future writings, wherein we will explore the nuances of the June 5th releases in greater detail.
As noted, the SEC released a package of Final Rules and Interpretive Releases comprising four separate components: (1) Final Rules implementing Regulation Best Interest (“Reg BI”), the new enhanced standard for brokers; (2) Final Rules implementing a new Form CRS Relationship Summary (“Form CRS”), a new disclosure document applicable to both brokers and advisers (that, for advisers, will function as a new Part 3 to Form ADV); (3) an Interpretive Release clarifying the SEC’s views of the fiduciary duty that investment advisers owe to their clients; and (4) an Interpretive Release intended to more 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. All four components of the regulatory package were approved by a 3-1 vote of the SEC’s Commissioners, with Commissioner Robert Jackson being the sole dissenter.
While the June 5th releases are the culmination of a decades-long controversy, they are the proximate result of a formal rulemaking commenced on April 18, 2018, at which time the SEC published initial proposed versions of Reg BI, Form CRS and the advisory interpretations. The Final Rules for Reg BI and Form CRS will become effective 60 days after they are formally published in the Federal Register; however, firms will be given a transition period until June 30, 2020 to come into compliance. The two Interpretive Releases will become effective upon formal publication.
1. Regulation Best Interest. The cornerstone of the standard-of-conduct regulatory package released last week is Reg BI, which imposes a new standard-of-conduct specifically for broker-dealers and their registered representatives in place of the existing suitability obligation that has prevailed for decades. Under that standard, brokers need only ensure that recommendations be “suitable” for a customer in light of the customer’s investment objectives and risk tolerance. The new “best interest obligation” as stated in section (a)(1) of Reg BI requires that, when making a recommendation of a securities transaction or an investment strategy involving securities to a retail customer, a broker-dealer, or registered representative, must always act in the retail customer’s best interest and cannot place his, her or its own interests ahead of the customer’s interests. While not explicitly defining the term “best interests” (an aspect of Reg BI engendering considerable criticism from commentators), Reg BI articulates four unique elements or components of the “best interest obligation,” specifically:
- Disclosure Obligation. This obligation requires “full and fair disclosure” of “all material facts relating to the scope and terms of the relationship” with the retail customer, including, specific disclosures about the capacity in which the broker is acting, fees, the type and scope of services provided, and conflicts of interest.
- Care Obligation. Key to satisfying this obligation is exercising “reasonable diligence, care and skill” when making a recommendation to a retail customer. This entails understanding potential risks, rewards, and costs associated with the recommendation, and considering these factors in light of the retail customer’s investment profile in order to make a recommendation that is in the retail customer’s best interest.
- Conflict of Interest Obligation. The crux of this obligation is that the broker-dealer must establish, maintain, and enforce written policies and procedures reasonably designed to identify and, at a minimum, disclose or eliminate conflicts of interest. One aspect of this obligation is an explicit requirement that broker-dealers 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.”
- Compliance Obligation. Under this obligation, broker-dealers must establish, maintain and enforce policies and procedures reasonably designed to achieve compliance with Reg BI as a whole.
Again, while the term “best interests” is undefined, we note that Reg BI does rather broadly define a “conflict of interest” to mean any “interest that might incline a broker, dealer, or a natural person who is an associated person of a broker or dealer —consciously or unconsciously—to make a recommendation that is not disinterested (emphasis added).”
2. Form CRS Relationship Summary. Unlike the new Reg BI, which only applies to broker-dealers and their registered representatives, the new Form CRS Relationship Summary disclosure document is applicable to both broker-dealers and SEC-registered investment advisers (“RIAs”). Form CRS, which will summarize information about the firm’s services, fees and costs, conflicts of interest, legal standard of conduct, and whether or not the firm and its financial professionals have disciplinary history, will need to be delivered to retail investors by RIAs and broker-dealers at the beginning of the firm-client relationship.
The SEC had previously proposed a more robust document template; however, in response to the criticism of commenters during the rulemaking phase, the Commission has adopted a somewhat less cumbersome format. For example, the total number of required sections has been reduced from eight to five, and the total required page length has been reduced from four to two pages. The five required sections/categories are as follows: (i) Introduction; (ii) Relationships and Services; (iii) Fees, Costs, Conflicts and Standards of Conduct; (iv) Disciplinary History; and (v) Additional Information. A firm’s Form CRS will need to link to the SEC’s investor education website, http://www.investor.gov/, which offers educational information to investors about investment advisers, broker-dealers, and other financial professionals. A firm’s Form CRS should be written in plain English; indeed, firms are instructed to avoid using legal jargon and highly technical terms.
For RIAs, Form CRS will constitute a new Part 3 of the adviser’s Form ADV, which will need to be electronically filed along with its Parts 1 and 2, via the Investment Adviser Registration Depository (IARD) system. Broker-dealers, in turn, will need to electronically file Form CRS via the Central Registration Depository (CRD) system.
- When will RIAs need to amend their Form ADV to include the new Form CRS? RIAs that are currently registered with the SEC or that have an application for registration pending with the SEC prior to June 30, 2020, must amend their Form ADV by electronically filing with IARD an initial Form CRS beginning on May 1, 2020 and by no later than June 30, 2020. On or after June 30, 2020, the SEC will not accept any initial applications for registration that do not include a Form CRS (i.e., a Part 3 of Form ADV).
3. Investment Adviser Fiduciary Duty Interpretive Release. Unlike a broker-dealer—which, up to this point has been subject to the “suitability” standard, and, going forward, will be subject to the “best interests” standard—an investment adviser owes a fiduciary duty to its clients under the Advisers Act. As part of its package of releases issued on June 5th, the SEC also published an Interpretive Release designed to “reaffirm and, in some cases, clarify the Commission’s views of the fiduciary duty that investment advisers owe to their clients under the Advisers Act.” This Interpretive Release finalizes a draft interpretation published on April 18, 2018 in tandem with the Commission’s draft rules for Reg BI and Form CRS, after full consideration of the comments received in connection with that draft interpretation.
While we will table an in-depth discussion of this particular release until a later date, we do note that the SEC took time to account for the recent Robare decision (which we have discussed at length in our blog), commenting that “disclosure that an adviser ‘may’ have a particular conflict, without more, is not adequate when the conflict actually exists.” Among other things, the court in Robare held that an adviser’s disclosure that it may receive a certain type of compensation was inadequate because it did not reveal that the adviser actually had an arrangement pursuant to which it received fees that presented a potential conflict of interest.
4. Investment Adviser Broker-Dealer Exclusion Interpretive Release. According to the SEC, this last of the four releases “confirms and clarifies the Commission’s interpretation of the ‘solely incidental’ prong of the broker-dealer exclusion of the Advisers Act.” In turn, the “solely incidental prong” of the broker-dealer exclusion excludes from the definition of investment adviser any broker-dealer whose performance of advisory services is solely incidental to the conduct of its business as a broker-dealer and who receives no special compensation for those services. The new Interpretive Release interprets this to mean that a broker-dealer’s advice “as to the value and characteristics of securities or as to the advisability of transacting in securities” falls within 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.”
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