The SEC, by a 3-1 party line vote, issued in a timely fashion its final regulations with respect to broker-dealer conduct, referred to as Regulation Best Interest (“Regulation BI”). The SEC’s related press release can be found by clicking here. Regulation BI is separate and distinct from the fiduciary duty that has been developed under the Advisers Act. It is not intended to establish a private right of action or right of rescission for retail customers, a difference in approach from the vacated DOL Fiduciary Rule. The compliance date for Regulation BI is June 30, 2020.
A second rule, Release No. 34-86032 addresses new Form CRS, a brief relationship summary that registered investment advisers and registered broker dealers are required to provide to retail investors. The relationship summary, to be provided at the beginning of the relationship, is intended to inform retail investors about (i) the types of client and customer relationships and services that the firm offers; (ii) the fees, costs, conflicts of interest and required standards of conduct associated with these relationships and services; (iii) whether the firm and its financial professionals currently have reportable legal or disciplinary history; and (iv) how to obtain additional information about the firm.
Separately, the SEC also issued, Release No. IA-5248 and Release No. IA-5249. Release No. IA-5248 reflects the SEC’s interpretation regarding the fiduciary standard of conduct for investment advisers under the Investment Advisers Act of 1940 (“Advisers Act”), focusing primarily upon the component elements of the duty of loyalty and the duty of care. In its proposed form, investment advisers were required to both avoid and disclose conflicts of interest. Under Release No. IA-5248, investment advisers can choose between elimination or disclosure of conflicts. The SEC also eliminated language from the proposal that required an investment adviser to put its clients’ interests first. The final interpretation now states that investment advisers should not “subordinate” their clients’ interests.
Release No. IA-5249 reflects the SEC’s interpretation of the “solely incidental” prong in the Advisers Act which excludes from the definition of “investment adviser” any broker-dealer that provides advisory services when such services are “solely incidental” to the conduct of the broker-dealer’s business and when such incidental advisory services are provided for no special compensation. The SEC adhered to its prior guidance in concluding that the solely incidental requirement is satisfied if the advice is provided in connection with and is reasonably related to the broker-dealer’s primary business of affecting securities transactions. Whether advisory services provided by the broker-dealer satisfies the solely incidental test is a facts and circumstances test based upon a broker-dealer’s specific business, the specific services offered, and the relationship between the broker-dealer and its customers. The amount or value of the advice provided was not a significant determinant with respect to this issue. A broker-dealer with unlimited discretion over a customer’s account would not satisfy the conditions of the exclusion, although the SEC recognizes there are certain limited exceptions to this rule, such as: (i) on an isolated and infrequent basis, purchase or sell of securities when a customer was unavailable for a limited period of time; (ii) discretion as to price at which or the time at which to execute an order given by a customer for the purchase or sale of a definite amount or quantity of a security; or (iii) the purchase or sale of a security to satisfy margin requirements or other customer obligations that a customer has specified, such as collateral calls. However, the SEC did not delineate the circumstances under which an arrangement for the agreed upon monitoring of an account is solely incidental to a broker-dealer’s brokerage business.
This article will focus on the first of these releases, Regulation BI.
Regulation Best Interest
Regulation BI establishes a standard of conduct for broker-dealers (and any associated persons) when making a “recommendation” (which remains undefined and subject to a facts and circumstances analysis) of any securities transaction or investment strategy involving securities to a retail customer, and the factors that a broker-dealer should take into account when making such recommendations. The types of securities transactions covered under Regulation BI include recommendations to roll over or transfer assets from one type of account to another, (e.g., a recommendation to rollover or transfer assets in an ERISA account to an IRA), recommendations to open up a particular type of account (broker or advisory), and recommendations to take a retirement plan distribution for purposes of opening a securities account. A broker-dealer is not able to waive compliance, nor can a retail customer agree to waive protection under the Regulation BI. Scienter (that is, intent or knowledge of wrongdoing) is not required to establish a violation on the part of the broker-dealer.
The final Regulation BI modified the definition of “retail customer” to apply to any natural person, including high net worth individuals, who receive a recommendation for the natural person’s own account, including the account of an individual plan participant. However, the definition is not extended to cover retirement plans and the fiduciaries of such plans. Regulation BI also provides that the legal representative of a natural person can include nonprofessional legal representatives, such as nonprofessional trustees.
Regulation BI does not define the term “best interest,” as was the case in the proposed rule. Rather, whether a broker-dealer acts in the best interest of a retail customer will depend upon the facts and circumstances of the particular recommendation and the particular retail customer, along with the circumstances of the four specific components of the Regulation BI, described below. Regulation BI provides examples of conduct showing the broker-dealer acted, or did not act, in the best interest, of retail customers.
The required standard of conduct is to act in the best interest of the retail customer at the time a recommendation is made without placing the financial interest or other interest of the broker-dealer or a person associated with a broker-dealer ahead of the interest of the retail customer (“General Obligation”). This obligation is satisfied if:
(1) before or at the time of the recommendation, the broker-dealer (or an associated person) discloses in writing to the retail customer the material facts relating to the scope and terms of the relationship, and all material conflicts of interest associated with the recommendation (“Disclosure Component”).
Regulation BI modified the disclosure requirement as it appeared in its proposed form by requiring the “full and fair” disclosure of material facts. In last year’s proposal, broker-dealers were required to reasonably disclose such information, providing guidance as to the level of specificity, and the form and manner and timing and frequency of such disclosure. At a minimum, a “full and fair” disclosure must indicate whether account monitoring services will be provided, account minimums, and any material limitations on the securities or investment strategies that may be recommended to the retail customer.
(2) the broker-dealer (or any associated person), in making the recommendation, exercises reasonable diligence, care, skill and prudence to: (i) understand the potential risks and rewards associated with the recommendation, and have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers; (ii) have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on the retail customer’s investment profile and the potential risks and rewards associated with the recommendation; and (iii) have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer’s best interest when viewed in isolation, is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile (“Care Component”).
Regulation BI expressly requires that a broker-dealer understand and consider the potential costs associated with the recommendation and have a reasonable basis to conclude that the recommendation does not place the financial interest of the broker-dealer ahead of the interest of the retail customer. However, just as a retirement plan fiduciary is not required to select the least expensive investment or service provider, cost is not the only consideration and there is no requirement that the broker-dealer select the lowest cost option. Recognizing that, because of the facts and circumstances nature of the inquiry, it may be difficult to draw a bright line with respect to satisfying the Care Component, Regulation BI indicates how a broker-dealer could establish a reasonable basis to believe that a recommendation was in the best interest of the retail customer, and the circumstances under which a broker-dealer could not establish such a reasonable belief. Further, The final rule clarifies that an evaluation of the reasonable best alternatives does not require the evaluation of every possible alternative or the recommendation of one “best” product. Regulation BI also describes what the evaluation of reasonable alternatives will require in certain contexts, such as a firm with open architecture.
(3) the broker-dealer establishes, maintains, and enforces written policies and procedures reasonably designed to identify and at a minimum, disclose, or eliminate, all material conflicts of interest that are associated with such recommendation (“Conflict of Interest Obligation”).
Regulation BI modified the conflict of interest mitigation requirement to: (i) eliminate the distinction between financial and other incentives and (ii) focus upon mitigating conflicts of interest associated with recommendations that create an incentive for an associated person to place the interest of the firm or his or her interests ahead of the interests of the retail customer. It also expands upon potential mitigation methods to promote compliance with this obligation. It sets forth the elements of written policies and procedures that place material limitations on securities or investment strategies available to retail customers, for example, only making recommendations of proprietary or a limited range of products. Additionally, broker-dealers are be required to establish written policies and procedures reasonably designed to identify and eliminate any sales contests, sales quotas, bonuses and non-cash compensation that are based upon the sale of specific securities or sales of specific types of securities within a limited period of time. However, the fact that a particular practice is not on this list does not mean that it is presumptively valid under Regulation BI. The practice still needs to satisfy the applicable Regulation BI requirements.
(4) A general compliance obligation to require broker-dealers to establish policies and procedures to achieve compliance with Regulation BI (“Compliance Obligation”).
Regulation BI includes a clarification that if a broker-dealer is providing account monitoring services, any buy, sell, or hold recommendation will be subject to Regulation BI, even if the hold recommendation is implicit. Guidance was also provided on how dual registrants should comply with Regulation BI, including clarification that the rule does not apply to a dual registrant when it is acting in its capacity as an investment adviser.
Preemption to be Determined by the Courts
Many hoped the SEC would specifically address the preemptive effect of Regulation BI, a potentially significant issue in light of actions taken by states such Nevada and New Jersey. However, the SEC deferred this decision to the courts, stating that “the preemptive effect of Regulation BI on any state law governing the relationship between regulated entities and their customers would be determined in future judicial proceedings based on the specific language and effect of that state law.” The SEC believes that Regulation BI and the related guidance would serve as focal points for promoting clarity, establishing greater consistency in the level of retail customer protections provided, and easing compliance across the regulatory landscape and the spectrum of investment professionals and products.
The Dodd-Frank Act authorized the SEC to promulgate a uniform standard of fiduciary conduct for both registered investment advisers and broker-dealers, but the SEC chose not to do so, the reason being that the investment advisor and broker-dealer business models were two different business models, and adopting a rule that might have the effect of combining those two business models might not be in the best interest of retail customers. In all likelihood, Regulation BI will face legal challenges just as the DOL Fiduciary Rule did.
It is anticipated that the DOL will issue proposed regulations in December 2019 supplementing Regulation BI.