SEC Adopts New Broker-Dealer and Investment Adviser Conduct Standards and Disclosure Requirements | Practical Law

SEC Adopts New Broker-Dealer and Investment Adviser Conduct Standards and Disclosure Requirements | Practical Law

The Securities and Exchange Commission (SEC) adopted a rulemaking package, including Regulation Best Interest, new Form CRS Relationship Summary and two interpretations of the Investment Advisers Act of 1940, designed to enhance the quality and transparency of retail investors' relationships with investment advisers and broker-dealers.

SEC Adopts New Broker-Dealer and Investment Adviser Conduct Standards and Disclosure Requirements

by Practical Law Corporate & Securities
Published on 06 Jun 2019 • USA (National/Federal)
The Securities and Exchange Commission (SEC) adopted a rulemaking package, including Regulation Best Interest, new Form CRS Relationship Summary and two interpretations of the Investment Advisers Act of 1940, designed to enhance the quality and transparency of retail investors' relationships with investment advisers and broker-dealers.
On June 5, 2019, the Securities and Exchange Commission (SEC) adopted a package of new rules, amendments and interpretations aimed at increasing standards of conduct and transparency in broker-dealer and investment adviser relationships with retail customers. The package included the adoption of:
Broker-dealers and investment advisers must begin complying with the new rules by June 30, 2020.

Regulation Best Interest

Regulation Best Interest imposes a new standard of conduct for broker-dealers when making recommendations to retail customers. The new rule requires a broker-dealer to act in the best interest of its retail customers when making a recommendation of any securities transaction or investment strategy involving securities (including account recommendations), without placing the broker-dealer's financial or other interest ahead of the interest of the customer.

Retail Customer

For the purposes of Regulation Best Interest, "retail customer" is defined as any natural person who receives a recommendation from a broker-dealer and uses that recommendation primarily for personal, family or household purposes. The SEC interprets this to mean that any recommendation to a natural person for that person's own account would be subject to Regulation Best Interest.
The SEC also clarified in the adopting release that retail customers include any non-professional legal representatives of natural persons, including:
  • Executors.
  • Conservators.
  • Persons holding a power of attorney for a natural person.
  • Retirement plan representatives only if:
    • the person is a sole proprietor or other self-employed individual that participates in the plan; and
    • the recommendation was received primarily for personal, family or household purposes.
Other persons that are not legal representatives of a natural person under the new rule include:
  • Registered investment advisers.
  • Corporate fiduciaries.
  • Banks.
  • Trust companies.

Investment Strategies and Account Recommendations

Regulation Best Interest does not expressly define "recommendation" or "investment strategy." In the adopting rule release, the SEC makes it clear that investment strategies include account recommendations, and stated that it interprets account recommendations to include recommendations to:
  • Roll over or transfer assets in a workplace retirement plan to an Individual Retirement Account (IRA).
  • Open a particular type of securities account.
  • Take a distribution from one securities account to open another.
  • Explicitly or implicitly hold a security or securities.
  • Take distributions from proceeds of specific securities or in-service loans from an employer-sponsored plan.
The SEC also indicated that the following would not constitute a recommendation or investment strategy:
  • General financial and investment information, including basic investment concepts and assessment of a customer's investment profile.
  • Descriptive information about an employer-sponsored retirement or benefit plan, including the benefits of participation and the investment options available under the plan.
  • Asset allocation models based on generally accepted investment theory.
  • Information about the need to take a required minimum distribution from a retirement plan (unless the communication includes a recommendation about which securities to sell or purchase with the proceeds of any sale).

Best Interest

The new rule also does not expressly define best interest. However, the obligation to act in a client's best interest is satisfied if four elements are met:
Whether a broker-dealer has acted in the customer's best interest will depend on an objective assessment of how each component obligation has been satisfied.

Disclosure of All Material Facts

The broker-dealer must provide certain disclosures to the customer in writing before or at the time a recommendation is made:
  • All material facts relating to the scope and terms of the relationship between the broker-dealer and the customer, including:
    • that the firm is acting in a broker-dealer capacity.
    • a description of the material fees and costs the customer will incur because of recommended transaction.
    • the type and scope of services to be provided, including any material limitations on the securities or the investment strategies that may be recommended.
  • All material facts relating to conflicts of interest associated with the recommendation.
The new rule defines a conflict of interest as an interest that might incline a broker-dealer, consciously or unconsciously, to make a recommendation that is not disinterested.
Examples of material facts that may indicate a conflict of interest include:
  • If the products being recommended or used in a transaction are proprietary to the firm or an affiliate.
  • If the firm provides account monitoring services.
  • If the broker-dealer is receiving payment from a third-party related to the transaction.

Reasonable Care, Diligence and Skill

A broker-dealer must exercise reasonable care, diligence and skill to:
  • Understand and consider the risks, rewards and costs of any contemplated recommendation, and have a reasonable basis to believe the recommendation could be in the best interest of at least some retail customers.
  • Have a reasonable basis to believe a recommendation, at the time it is made based on a customer's investment profile, is in the best interest of the customer, and does not place its financial interest ahead of the customer's interest.
  • Have a reasonable basis to believe that a series of recommended transactions is not collectively excessive and is in the best interest of the customer in light of the customer's investment profile, and does not place its financial interest ahead of the customer's interest,
A broker-dealer must consider reasonably available alternative investments when determining if it has a reasonable basis to make a recommendation.
In the adopting release, the SEC stated that this obligation goes beyond FINRA's suitability requirements (for more information on the current suitability standard, see Practice Note, Broker-Dealer Suitability Obligations).

Conflicts of Interest

A broker-dealer must establish, maintain and enforce written policies and procedures reasonably designed to:
  • Identify and disclose or eliminate all conflicts associated with a recommendation.
  • Identify and mitigate any conflict that creates an incentive for a broker-dealer to place its interests ahead of the interests of its customers.
  • Identify and disclose any limitations on securities or investment strategies that may be recommended and any conflicts of interest associated with that recommendation, and prevent those limitations or conflicts of interest from encouraging the broker-dealer to put its interests first.
  • Identify and eliminate, if based on the sale of specific securities or types of securities within a given timeframe:
    • sales contests;
    • sales quotas;
    • bonuses; and
    • other non-cash compensation.

Compliance with Regulation Best Interest

A broker-dealer must establish, maintain and enforce policies and procedures that are reasonably designed to achieve compliance with the new rule. These policies and procedures must address all aspects of compliance with the new rule, including the other three elements described above.

Recordkeeping

In connection with Regulation Best Interest, the SEC adopted rule amendments to Rules 17a-3 and 17a-4 under the Exchange Act to establish additional recordkeeping requirements, including:
  • The broker-dealer must create a record of all information collected from and provided to the retail customer in accordance with compliance with Regulation Best Interest, including a list of every registered representative responsible for each customer account.
  • The records must be maintained for six years after the earlier of the date the customer account was closed or last updated.
To learn more about existing broker-dealer recordkeeping requirements, see Practice Note, Broker-Dealer Recordkeeping.

Form CRS Relationship Summary

Broker-dealers and investment advisers will now be required to provide their retail customers with a summary of certain facts when first entering into a relationship with a customer. Form CRS (Customer Relationship Summary) is designed to help customers compare information about broker-dealers and their offerings. The instructions to the form require a standardized format for the summary incorporating the use of specific questions and statements and encourage the use of charts, graphs and tables and electronic formats.
The relationship summary must include the following elements:
  • An introductory paragraph.
  • A description of the types of client relationships and services the firm offers.
  • The fees and other costs of the relationship and services.
  • Conflicts of interest and the standards of conduct associated with each relationship or service type.
  • If the firm has reportable legal or disciplinary history.
  • How to find more information about the firm.
Form CRS must also include a reference to the SEC's investor education website.
Broker-dealers and investment advisers must deliver Form CRS to their customers and potential customers, file Form CRS with the SEC and post Form CRS on their websites.
Form CRS must be filed with the SEC beginning May 1, 2020.

Standard of Conduct for Investment Advisers

The SEC published a final interpretation to reaffirm and clarify the standard of conduct for investment advisers. Investment advisers owe customers a fiduciary duty that consists of:
  • A duty of care that requires the adviser to provide investment advice that is in the best interest of the client, based on the client's objectives.
  • A duty of loyalty that that requires the adviser to eliminate or make full and fair disclosure of all conflicts of interest. A conflict of interest is anything that might incline the adviser to render advice that is not disinterested so that a client can provide informed consent to the conflict.
If disclosure alone does not allow the client to provide informed consent, then the adviser should eliminate or mitigate the conflict so that informed consent can be given.

The Broker-Dealer Exclusion from the Advisers Act

The SEC issued a new interpretation of the Advisers Act that clarifies the main exemption from the Act that broker-dealers operate under. Broker-dealers who provide investment advice are excluded from the definition of investment adviser if:
  • The investment advice is solely incidental to its business.
  • The broker-dealer does not receive any special compensation for the investment advice.
The interpretation clarifies the meaning of "solely incidental to the broker-dealer's business" by indicating that:
  • Whether investment advice is solely incidental requires a facts specific analysis.
  • The key issue is whether the investment advice is reasonably related to the broker-dealer's business.
  • The amount and importance of the advice is not relevant to the question of whether it's reasonably related to the broker-dealer's business.
The interpretation provides specific guidance with respect discretionary authority:
  • Investment advice that is in the form of unlimited discretionary authority is not solely incidental to the broker-dealer's business.
  • If the investment discretion is limited in time, scope or in another way, then the investment advice is solely incidental.
The interpretation also provides specific guidance around monitoring of customer accounts.
  • Investment advice is incidental to a broker-dealer's business when it voluntarily reviews a customer's investment holdings to make a recommendation.
  • A broker-dealer that agrees to monitor a customer account on a periodic basis or at some specific time in the future is deemed to be providing advice that is solely incidental to its business.
  • Ongoing and continuous monitoring provided as part of agreed-upon services is not solely incidental to the broker-dealer's business.
The SEC recognized that broker-dealers often give substantial investment advice to their customers. This interpretation makes clear that broker-dealers can continue to make recommendations to their clients without being subject to the Act.