Bates Research | 06-13-19
SEC Adopts Regulation Best Interest: Early Reaction and its Impact
On the day the SEC approved a set of regulatory proposals affecting the obligations that broker-dealers and investment advisers owe retail investors, Commissioner Hester Peirce issued a “plea” to critics to “take a fair look at what it says before you proclaim it a success or failure.” In this article, Bates reviews the core elements of the rules and related guidance, and some of the early reactions.
Regulation Best Interest
Regulation Best Interest ("Reg BI") is actually part of a package of rules and interpretive guidance directing broker-dealers to act in the “best interest” of the retail client when recommending a securities or investment strategy. To fully understand the scope of the package, all of its parts must be considered. Here are some of the highlights under the new rule:
Under the new standard, a broker-dealer who makes recommendations to a retail client must satisfy obligations related to (i) disclosure, (ii) diligence, skill and care, (iii) conflicts of interest and, generally, (iv) compliance.
The disclosure obligation requires a broker-dealer to provide in writing to a retail client all “material facts” about the broker-dealer’s relationship with that client. This includes disclosing that the broker-dealer is acting in the capacity of a broker or dealer but not as an investment adviser; the type and scope of services to be provided; the costs of those services; any “material limitation” on a recommendation or investment strategy; and all material conflicts of interest.
The care obligation requires a broker-dealer to exercise reasonable “diligence, care and skill” when making investment recommendations. In order to satisfy the Reg BI obligation, a broker-dealer must understand and communicate the “risk, rewards and costs of any recommendation;” have a reasonable basis to believe that the recommendation is in the best interest of the client and, therefore, not place the interests of the broker-dealer over that of the client; and that any series of transactions are not “excessive,” given the client’s investment profile.
The conflicts of interest obligation requires a broker-dealer to create written policies and procedures and to monitor, mitigate and/or eliminate potential perceived conflicts. A conflict is defined as “an interest that might incline a [broker-dealer] . . . consciously or unconsciously . . . to make a recommendation that is not disinterested.” Consequently, the obligation requires firms to eliminate sales contests and sales quotas, or other techniques that are based on the sale of specific securities in a limited period of time and/or to prevent incentive compensation that may lead to broker-dealers prioritizing their interests over those of a client.
The compliance obligation is an important enforcement provision requiring a broker-dealer to establish, maintain and enforce their written policies and procedures reasonably designed to obtain compliance with the entirety of the Reg BI package.
Client Relationship Summary
A key requirement under the Reg BI package is that both broker-dealers and investment advisers must provide a Client Relationship Summary form (“Form CRS”) to their retail clients. The SEC provided for significant flexibility in the design of a firm’s Form CRS, as it is intended to provide simple and understandable information to retail clients about their relationship with their financial professional. That said, the form is specific in a number of ways. For example, the Form CRS must include information on fees and costs incurred by the client, compensation structures and relationship models of the firm, types of services offered, the differences between investment advisers and broker-dealers and perceived general conflicts of interest. It also prohibits broker-dealers from using the term “advisor” or "adviser" when communicating with retail clients.
Additional Guidance on Investment Advisers
In addition to the core elements required under Form CRS, the SEC also published interpretive guidance that further distinguishes this new best interest standard from that of the fiduciary duty requirement owed to retail clients by registered investment advisers. The fiduciary duty requirement owed under the Investment Advisers Act requires an investment adviser to satisfy both a duty of care and a duty of loyalty. The new guidance explains that an investment adviser’s duties apply to the entire adviser-client relationship. The guidance also refers to an investment adviser’s relationship to institutional clients and provides additional clarity on full and fair disclosure and informed consent. Additionally, the guidance provided clarification that the best interest standard under Reg BI would only apply to recommendations made by the broker-dealer unless the broker-dealer has disclosed or stated there would be an ongoing duty of care to the client for those recommendations.
More Clarity on “Solely Incidental” Advice
The SEC also provided interpretive guidance on Investment Advisers Act registration exemptions for broker-dealers who provide certain investment advice that would otherwise make these broker-dealers subject to the regulations required for investment advisers. The guidance clarifies that if a broker-dealer’s advice is "solely incidental" to the conduct of their business, and if they don't receive "special compensation," broker-dealers would be exempt from investment adviser registration requirements under the Investment Advisers Act. According to the new guidance, if such advice is “reasonably related to the broker-dealer’s primary business of effecting securities transactions,” then the advice would be “solely incidental” and within the exemption.
In a definitive vote, the SEC Commissioners voted 3-1 in favor of the proposed rules and guidance issued under Reg BI. Acknowledging the “courage and commitment” of the staff in delivering the final 750+ page package, Chair Jay Clayton restated the SEC’s objectives: “to bring the required standards of conduct for financial professionals and related mandated disclosures in line with reasonable investor expectations; and … to preserve retail investor access (in terms of both choice and cost) to a variety of investment services and products.” The Chair and the other SEC Commissioners supporting the package—some with notable reservations—stated that the rule achieves both objectives. Dissenting, Commissioner Robert J. Jackson Jr. disagreed, saying broadly that Reg BI (i) fails to put retail clients first, (ii) fails to be based on a proper cost benefit analysis, (iii) fails to protect America's savers from conflicted advice, and (iv) does not raise the standard for investment advice.
Upon the adoption of the new rule, SIFMA President and CEO Kenneth E. Bentsen, Jr. applauded the new framework, saying it “will impose a materially heightened standard of conduct for broker-dealers when serving retail clients.” He noted that in some instances, the duties imposed on broker-dealers under the rule go further than those required of investment advisers. Specifically, he said, that “not even the so-called fiduciary standard under the Investment Advisers Act includes the obligation to eliminate or mitigate conflicts.”
He also recognized that “compliance with the rule will not be easy … and the costs to implement will no doubt be significant, but we believe, worthwhile to uniformly enhance investor protection to the level investors should and do expect, while preserving investor choice and access to investment advice.”
Reportedly, the Public Investors Arbitration Bar Association, the Consumer Federation of America (“CFA”) and Better Markets all contended that the new rule package would not raise broker advice obligations above the existing suitability standard. In a statement released by the CFA, director of investor protection Barbara Roper said, “the SEC is throwing ‘Mr. and Ms. 401(k)’ under the bus.” Among other concerns, she said that Reg BI will make “it easier for brokers to mislead their customers into believing they are getting trusted, best interest advice when they are actually getting investing recommendations biased by toxic conflicts of interest.”
Bates has been covering the efforts to reform broker-dealer best interest standards for many years (see here, for example), and it was no surprise that Commissioner Peirce’s admonition against prematurely judging the new regulation went unheeded.
That said, the adoption of the Reg BI package still only represents the beginning of a long journey toward achieving the aims articulated by Chair Clayton. As he reminded us: “there are an estimated 43 million American households that have a retirement or brokerage account; there are over 2,700 SEC-registered broker-dealers that provide services to retail investors, with nearly $4 trillion in total assets and almost 139 million customer accounts; there are over 8,000 SEC-registered investment advisers that provide services to retail investors, with over $41 trillion in assets under management and over 40 million client accounts; and there are approximately 960,000 women and men employed by broker-dealer and investment advisory firms that provide services to retail investors.”
The significance of the new rules is undeniable. There will no doubt be many compliance, enforcement and litigation stops likely along the way.
Bates Group can help firms with their Reg BI needs and services. Please visit our Reg BI service page or contact Robert Lavigne, Managing Director, Bates Compliance Solutions, at firstname.lastname@example.org.