SEC Proposes Three Related Releases on Retail Investor Matters

I. Introduction

After a delay of almost eight years from the date that the SEC is authorized under the Dodd-Frank Act to provide for fiduciary standards for broker-dealers and investment advisers, the SEC, by a 4-1 vote, issued a detailed set of proposed rules in Release No. 34-83062 regulating the standard of conduct for broker-dealers, referred to as "Best Interest Regulation."While three Commissioners who voted for the proposal had misgivings about certain provisions of the rule, the overriding sentiment is that the rule needed to be released to commence the public debate about its provisions.

A second separate proposed rule, Release No. 34-83063 would:

(1) require broker-dealers and investment advisers to deliver to retail customers a short (i.e., four pages or equivalent limit if in electronic format) summary on new Form CRS, including: (i) the principal types of services offered; (ii) the applicable fees the retail customer may pay; (iii) the legal standard of conduct applicable to the broker-dealer and the investment adviser; and (iv) certain conflicts of interest;

(2) restrict broker-dealers and associated natural persons of broker-dealers, from using as part of a name or title "adviser" or "advisor" in certain circumstances; and

(3) require broker-dealers and investment advisers, and their associated natural persons and supervised persons, respectively, to disclose in retail investor communications the firm's registration status with the SEC and an associated person's and supervised person's relationship with the firm.

Also, the SEC in a third proposal, Release No. IA-4889 proposed an interpretation of the fiduciary standard of conduct for investment advisers and sought comments on proposals to modernize and enhance the rules regarding the standard of conduct by registered investment advisers. For example, the SEC requested comments on whether there should be certain potential enhancements to investment advisers' legal obligations by looking to areas where the current broker-dealer framework provides investor protections that may not have counterparts in the investment adviser context.

This article will focus on the first of these releases, the broker-dealer standard of care.

II. Regulation Best Interest

A. Overview

The proposal entitled "Regulation Best Interest" establishes a standard of conduct for broker-dealers and persons associated with a broker-dealer when making a recommendation (not defined and subject to a facts and circumstances analysis) of any securities transaction (including recommendations to roll  over or transfer assets from one type of account to another, such as a recommendation to rollover or transfer assets in an ERISA account to an IRA) or investment strategy involving securities to a retail customer. A broker-dealer would not be able to waive compliance, nor can a retail customer agree to waive protection under the Regulation Best Interest.

While the proposed regulation is titled "Regulation Best Interest," the proposal does not define the term "best interest," a matter that some Commissioners were critical of. Rather, its view is that whether a broker-dealer acts in the best interest of a retail customer when making a recommendation 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 Best Interest as described below.

The proposed 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 making the recommendation ahead of the interest of the retail customer. This obligation is satisfied if:

(1) before or at the time of the recommendation, the broker-dealer or a person who is an associated person of the broker-dealer, 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;

(2) the broker-dealer or natural person who is an associated person of the broker-dealer, 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 (the "Care Component");

(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; and

(4) the broker-dealer establishes, maintains and enforces written policies and procedures reasonably designed to identify and disclose and mitigate or eliminate material conflicts of interest arising from financial incentives associated with such recommendation. In the preamble to the proposed Regulation Best Interest, the SEC stated that the rule "would be separate and distinct from the fiduciary duty that has been developed under the Advisers Act," nor would the Regulation Best Interest have any effect upon the SEC's interpretation of the scope or nature of an investment adviser's fiduciary obligations. These proposed rules are not intended to establish a private right of action or right of rescission for retail customers, a difference in approach from the DOL Fiduciary Rule.

With respect to the Care Component, the Regulation Best Interest does not necessarily oblige a broker-dealer to recommend the least expensive or least remunerative security to satisfy the proposed regulation. While costs associated with a recommendation would be an important factor, other factors that a broker-dealer should take into account would include the product's or strategies' investment objectives, characteristics (including any special or unusual features), liquidity, risks and potential benefits, volatility and likely performance in a variety of market or economic conditions. Thus, "while cost and financial incentives would generally be important, they may be outweighed by other factors," and a broker-dealer that failed to take these other factors into account and focused solely upon cost would not satisfy the Regulation Best Interest.

In the preamble, the SEC listed (and also requested comment upon) a number of transactions involving conflicts of interest that would not per se be prohibited under the Regulation Best Interest:

  • Charging commissions or other transaction based fees;
  • Receiving or providing differential compensation based on the product sold;
  • Receiving third party compensation;
  • Recommending proprietary products, products of affiliates or a limited range of products;
  • Recommending a security underwritten by the broker-dealer or an affiliate, including an IPO;
  • Recommending a transaction to be executed in a principal capacity;
  • Recommending complex products;
  • Accepting a retail customer's order that is contrary to the broker-dealer's recommendation;
  • Considering the cost to the broker-dealer of effecting the transaction or strategy upon behalf of the customer; and
  • Allocating trades and research, including investment opportunities among different types of customers and between retail customers and the broker-dealer's own account.

The SEC requested comments as to whether the proposed rule is sufficiently clear that a broker-dealer is not required to monitor a retail customer's account unless there is a specific contractual obligation to that effect, but also solicits comment on whether a broker-dealer who provided ongoing monitoring should be treated as an investment adviser.

B. Relationship to DOL Fiduciary Rule

Although the SEC guidance takes into account the DOL Fiduciary Rule, and recognizing that under the common law of some states, in certain circumstances broker-dealers can be treated as fiduciaries, the SEC chose not to impose a uniform fiduciary standard upon both investment advisers and broker-dealers. The SEC, in explaining its decision, recognized that there would be advantages in having a uniform set of rules governing both investment advisers and broker-dealers, which it had the authority to promulgate under Section 913(g) of the Dodd-Frank Act such as enhancing the quality of advice, lowering the possibility of harm to investors, and potentially reducing retail customers' confusion with respect to investment advice.

However, in its view, the investment adviser business model is different from that of the broker-dealer, and having a uniform set of rules would undermine that distinction and have an adverse effect upon retail-customers. However, while not treating broker-dealers as fiduciaries, the SEC indicated that the Regulation Best Interest reflected the same objectives as the best interest component of the Impartial Conduct Standard under the BICE. In the preamble to the proposed Regulation Best Interest , the SEC indicated that in its view the proposed best interest standard "would result in efficiencies for broker-dealers that have already established infrastructures to comply with the DOL's best interest Impartial Conduct Standard." (The other two elements of the Impartial Conduct Standard were not included in the proposed Regulation Best Interest, because the SEC believed that the prohibition on misleading statements and the reasonable compensation requirement were rules to which broker-dealers were otherwise subject). However, the SEC also invites public comment on whether its assessment of the comparison between the DOL's best interest Impartial Conduct Standard and the Regulation Best Interest is an accurate one.

III. Takeaways

It is unclear what effect, if any, that these releases will have upon the decision to be made by the DOL in response to the decision of the Court of Appeals for the Fifth Circuit invalidating the Fiduciary Rule and the related prohibited transaction exemptions. The SEC has indicated that the DOL participated in the issuance of these proposed rules, but these rules also varied from the DOL rules in some key respects. Further, the parties affected by the DOL Fiduciary Rule were not limited to broker-dealers, although broker-dealers were probably the most affected category affected. For example, sellers of fixed annuity products would not be affected by the Regulation Best Interest. Third, even if the DOL would otherwise be inclined to accept the decision of the Fifth Circuit, that Court's narrow reading of permissible regulatory activity by the DOL would be reason enough to request the Fifth Circuit to hear the case en banc, i.e., before the entire Fifth Circuit, or to ask the Supreme Court to review the Fifth Circuit decision.

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, largely for the same reason that the SEC chose not to impose a fiduciary standard upon broker-dealers as the DOL Fiduciary Rule would have done, namely, 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.

This very detailed proposal will generate a large number of comments during the 90-day period for public comments, particularly from supporters of the DOL fiduciary rule who would have preferred the imposition of fiduciary duties upon broker-dealers, and we will keep you apprised of the next steps to be taken by the SEC.

Please contact  Marcia Wagner or Stephen Wilkes, if you have any questions.