SEC Adopted Regulation Best Interest on June 5! What Does this Mean for Your Firm?


What just happened?

The SEC has adopted Regulation Best Interest (“Reg BI”) and the Form CRS Relationship Summary (“Form CRS”), both of which were proposed on April 18, 2018. In addition, the Commissioners approved SEC staff interpretations of the meanings of “fiduciary” as applied to investment advisers and “solely incidental” as used to determine the difference between brokerage and advisory services. SEC Chair Clayton and Commissioners Pierce and Roisman voted in favor of all four proposals, while Commissioner Jackson voted against all of them.

The compliance date for Reg BI and Form CRS is June 30, 2020. The rules and forms will be effective 60 days after publication in the Federal Register, while the interpretations will be effective upon publication in the Federal Register.

What does this mean?

The adopting releases for these proposals were not available at the time of this writing. During the livestreamed Commission meeting, Commissioner Pierce held up what appeared to be at least a ream’s worth of paper and identified it as the adopting release, so it is likely that fully reviewing and putting it in context will take some time. However, based on the published comments of Chair Clayton, an SEC press release, and our own notes from the meeting, here are the headlines:

Reg BI

Reg BI will enhance the standard of conduct required of broker-dealers “at the time they recommend to a retail customer a securities transaction or investment strategy involving securities.”[1] In Chair Clayton’s words:

  • Importantly, regardless of whether a retail investor chooses a broker-dealer or an investment adviser (or both), the retail investor will be entitled to a recommendation (from a broker-dealer) or advice (from an investment adviser) that is in the best interest of the retail investor and that does not place the interests of the firm or the financial professional ahead of the interests of the retail investor.[2] (Emphasis original).

While Chair Clayton stated that the standard of care “draws upon key fiduciary principles,”[3] he clearly noted that Reg BI does not impose a fiduciary duty on broker-dealers. Rather, the standard of care under Reg BI has four component obligations: a Disclosure Obligation, a Care Obligation, a Conflict of Interest Obligation, and a Compliance Obligation.

The Disclosure Obligation requires disclosure of material facts about the broker’s relationship with the client, including certain required disclosures as well as any material conflicts of interest. Unlike an investment adviser, conflicts that the broker-dealer considers immaterial do not have to be disclosed.

That said, a member of the SEC’s Staff pointedly stated that Reg BI cannot be satisfied by disclosure alone.

The SEC Staff noted that the prohibition on registered reps using the title “adviser” or “advisor” exists unless they are also an investment representative. While that provision no longer appears as part of Form CRS, it is now considered a violation of the Disclosure Obligation

The Care Obligation requires that a broker-dealer must consider such factors as risk, rewards, and costs when making recommendations to a client and determine that the recommendation is in the best interest of the client. While cost is a factor to be considered, a broker-dealer is not required to recommend the security with the lowest cost. Reg BI requires consideration of cost as applied to a series of recommended transactions (which a member of the SEC Staff referred to as “quantitative suitability”). A Staff member noted that the best interest determination must be made at the time of the recommendation, and not in hindsight.

The SEC Staff also noted that, following an “implicit hold recommendation,” a broker-dealer would need to monitor that recommendation.

The Conflict of Interest Obligation requires firms to develop written policies and procedures to identify, disclose, mitigate or eliminate conflicts of interest associated with a recommendation. As part of this duty, broker-dealers must:

  • 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.[4]

The Compliance Obligation (which did not appear in the original proposal) requires broker-dealers to develop written policies and procedures for the specific purpose of complying with Reg BI.

Chair Clayton noted that the duty of care applies to “account recommendations, including recommendations to roll over or transfer assets in a workplace retirement plan account to an IRA, recommendations to open a particular securities account (such as a brokerage account or advisory account), and recommendations to take a plan distribution for the purpose of opening a securities account.” We will need to wait for the adopting release to learn if the definition of “retail customer” differs from that in the proposing release.

Form CRS

Broker-dealers and investment advisers must now provide retail clients with a relationship summary at the beginning of a client relationship. There were some changes in the content of Form CRS since it was initially proposed. These changes include:

  • Allowing more flexibility in drafting disclosures
  • Expanding the discussion of fees to include the compensation for the representative
  • Clarifying the description of the standard of conduct
  • Eliminating a comparison of BD and IA services, except for dual registrants
  • Adding disciplinary disclosures
  • Not requiring the disclosure of registration status

The SEC Staff also noted that the CRS does not have to be on paper.

Interpretation of “fiduciary” for investment advisers

The SEC Staff stressed that this interpretation did not offer a “new or watered-down fiduciary standard,” but consolidates decades of consistent interpretation. The Staff noted that this interpretation will:

  • Reaffirm the duties of care and loyalty.
  • Confirm that an adviser and its client may shape (but not waive) fiduciary duty by full and fair disclosure and content of advisory agreement.
  • Stress the importance of stating that adviser may have a conflict of interest.
  • State that an adviser is not obligated to independently determine if a client has understood the adviser’s disclosure and has provided full and informed consent.
  • Address the application of an adviser’s fiduciary duty in the context of rollovers, and how the duty applies in institutional and retail relationships.

Interpretation of when a broker-dealer’s advice is “solely incidental”

Under the adopted interpretation, advice is “incidental” to the extent that it is provided in connection with the broker-dealer’s primary business of effecting securities transactions. The SEC Staff clarified that, while a fully discretionary brokerage account would not be considered “solely incidental,” a brokerage account with limited discretion (for example, to the time or scope of the transaction) could be considered incidental. The Staff also said the release will include guidance on when ongoing monitoring is consistent with “solely incidental” advice.

What should my firm do?

Broker-dealer firms with retail clients should plan to spend the next thirteen months reviewing, planning, and implementing the many requirements of Reg BI. Don’t be lulled into complacency by the June 2020 compliance date – developing and implementing the required procedures alone will require months of work for most firms.

Investment advisers should, at a minimum, begin considering the format and delivery mechanism for Form CRS. And remember – there may be proposed amendments to the advertising rule later this year that could take up a lot of your time. Try to get on top of this early.

Dual registrants need to do all of the above and take a deep, deep dive into the new standard of conduct for broker-dealers and the interpretive releases on the meanings of “fiduciary” and “solely incidental.” The differences between brokerage and advisory services may not be as clear-cut as they have seemed (if, indeed, they ever were).
How can NRS help?

We will be:

  • Developing workflow tools to support the requirements of Reg BI and Form CRS;
  • Highlighting these new developments at our Fall Compliance Conference; and
  • Providing consultative advice to our customers as they design their implementations.

We’ll also be updating these blogs as the picture comes into sharper focus.

 


[1] Clayton, Jay, “Statement at the Open Meeting on Commission Actions to Enhance and Clarify the Obligations Financial Professionals Owe to our Main Street Investors” (June 5, 2019), https://www.sec.gov/news/public-statement/statement-clayton-060519-iabd.

[2] Id.

[3] Id.

[4] Press Release, “SEC Adopts Rules and Interpretations to Enhance Protections and Preserve Choice for Retail Investors in Their Relationships with Financial Professionals” (June 5, 2019), https://www.sec.gov/news/press-release/2019-89.