SEC Finalizes Investment Adviser, Broker-Dealer Standards

Financial Services Law

By a 3-to-1 vote, the Securities and Exchange Commission (SEC) adopted a rulemaking package concerning investment adviser and broker-dealer standards of conduct.

The package features a new rule establishing a standard of conduct for broker-dealers when making recommendations to retail customers (dubbed “Regulation Best Interest”), new rules for registered investment advisers and registered broker-dealers to provide retail investors with a relationship summary (the “Form CRS”), and a Commission interpretation of the standard of conduct owed by investment advisers under the Investment Advisers Act, as well as the Commission’s interpretation of the “solely incidental” prong of the broker-dealer exclusion.

What happened

“Individually and collectively, these actions are designed to enhance and clarify the standards of conduct applicable to broker-dealers and investment advisers, help retail investors better understand and compare the services offered and make an informed choice of the relationship best suited to their needs and circumstances, and foster greater consistency in the level of protections provided by each regime, particularly at the point in time that a recommendation is made,” the SEC explained.

The interpretations became effective upon publication. Although Regulation Best Interest and Form CRS will take effect 60 days from publication in the Federal Register, the SEC built in a transition period until June 30, 2020.

To assist firms with planning for compliance with these new rules, the Commission established an inter-Divisional Standards of Conduct Implementation Committee, comprising representatives from the SEC’s Division of Investment Management, Division of Trading and Markets, Division of Economic and Risk Analysis, Office of Compliance Inspections and Examinations, and Office of the General Counsel.

The Commission encouraged firms to “actively engage” with the new committee.

To read the SEC’s final rules and Commission interpretations, click here.

Why it matters

“This rulemaking package will bring the legal requirements and mandated disclosures for broker-dealers and investment advisers in line with reasonable investor expectations, while simultaneously preserving retail investors’ access to a range of products and services at a reasonable cost,” SEC Chair Jay Clayton said in a statement. Firms face immediate compliance requirements with the new interpretations but have until June 30, 2020, before enforcement kicks in for Regulation Best Interest and Form CRS.

  • Regulation Best Interest. The new standard of conduct specifically for broker-dealers substantially enhances the current obligations and makes it clear that a broker-dealer may not put its financial interests ahead of the interests of a retail customer when making recommendations, the agency said.

    Broker-dealers will be required 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—the standard cannot be satisfied through disclosure alone.

    The agency expanded application of the standard from its initial rule proposal to include account recommendations (including recommendations to roll over or transfer assets in a workplace retirement plan account to an IRA, for example, and recommendations to take a plan distribution) as well as implicit “recommendations to hold” that result from agreed-upon account monitoring.

    As for disclosures, broker-dealers must disclose “material facts,” including the capacity in which the broker is acting, fees, the type and scope of services provided, conflicts, limitations on services and products, and whether the broker-dealer provides monitoring services.

    The standard also imposes a care obligation, mandating that broker-dealers exercise reasonable diligence, care and skill when making a recommendation to a retail customer. The broker-dealer must consider the potential risks, rewards and costs associated with a recommendation in light of the retail customer’s investment profile and make a recommendation in the retail customer’s best interest, the SEC said.

    Also required: written policies and protocols reasonably designed to identify (and at a minimum, disclose or eliminate) conflicts of interest.

    Broker-dealers must establish, maintain and enforce policies and procedures to mitigate conflicts that create an incentive for the firm’s financial professionals to place their interests or the firm’s interests ahead of the retail customer’s interest; prevent material limitations on offerings (such as 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 firm’s interests ahead of the retail customer’s interest; and eliminate sales contests, sales quotas, bonuses and noncash compensation that are based on the sale of specific securities or specific types of securities within a limited period of time.

    In another change from the proposed rule, broker-dealers must establish, maintain and enforce policies and procedures reasonably designed to achieve compliance with Regulation Best Interest as a whole.
  • Form CRS. At the beginning of a relationship, investment advisers and broker-dealers will be required to provide retail investors with a relationship summary featuring information about services, fees and costs, conflicts of interest, the legal standard of conduct, and whether or not the firm and its financial professionals have prior disciplinary records.

    The form—which cannot be more than two pages (or four pages, for dual registrants)—will feature a standardized question-and-answer format presented in simple, easy-to-understand language. The SEC encouraged the use of graphics, text features, online tools and layered disclosure. The form should also refer retail investors to the Commission’s investor education website.
    • Investment Adviser Interpretation. To reaffirm and clarify the Commission’s views of the fiduciary duty that investment advisers owe to their clients under the Advisers Act, the interpretation reflects how the SEC has applied and enforced the law in this area (and inspected for compliance) for decades, the agency said.

      Pursuant to the Advisers Act, an investment adviser owes a fiduciary duty to its clients that is principles-based and applies to the entire relationship between an investment adviser and its client.

      The two-part duty includes a duty of care, which covers the duty to provide advice in the client’s best interest and to seek best execution, as well as a duty to provide advice and monitoring. The second duty includes the duty of loyalty, under which investment advisers must not subordinate a client’s interests to their own and must make full and fair disclosures of all material facts relating to the advisory relationship.
    • Solely Incidental Interpretation. The definition of investment adviser found in the Advisers Act at Section 202(a)(11)(C) contains an exclusion for brokers or dealers whose performance of advisory services is “solely incidental” to the conduct of his or her business as a broker or dealer, and who receives no special compensation for those services.

      The Commission’s interpretation confirms and clarifies 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 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.

      For example, the SEC said that the exercise of limited discretion that is solely incidental would be to purchase or sell securities to satisfy margin requirements or other customer obligations that have been specified; in the context of account monitoring, periodic, agreed-upon monitoring may be solely incidental, depending on the facts and circumstances (as contrasted with continuous monitoring, which would not be solely incidental).