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SEC Proposes New Standards of Conduct for Broker-Dealers and Investment Advisers

Insurance   |   Financial Services Regulatory   |   Life Insurance & Financial Lines   |   Securities and Derivative Litigation   |   April 19, 2018
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On April 18, the SEC voted four to one to propose new standards of conduct for broker-dealers (BDs) and investment advisers (IAs). Commissioner Stein was the lone dissenter, but Commissioners Jackson, Peirce, and Piwowar each made clear that they had significant concerns notwithstanding their votes in favor of releasing the proposals for public comment. Commissioner Jackson also noted that he could not support the proposals if they were the final rules. All five Commissioners strongly encouraged public comment on the proposals, which SEC Chairman Clayton referred to as a “comprehensive package” of rules and guidance. The following provides an overview of the proposals, highlights Commissioner comments, and offers some preliminary observations.

The Proposals

The proposed rulemaking package is embodied in the following three releases:

  1. Regulation Best Interest, available at: https://www.sec.gov/rules/proposed/2018/34-83062.pdf.
  2. Form CRS Relationship Summary, Amendments to Form ADV; Required Disclosures in Retail Communications and Restrictions on the Use of Certain Names or Titles, available at: https://www.sec.gov/rules/proposed/2018/34-83063.pdf, including
    Appendix A: Form ADV General Instructions
    Appendix B: Instructions to Form CRS
    Appendix C: Dual Registrant Mock-up
    Appendix D: Broker-Dealer Mock-up
    Appendix E: Investment Adviser Mock-up
    Appendix F: Feedback on the Relationship Summary, and
  3. Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on Enhancing Investment Adviser Regulation, available at: https://www.sec.gov/rules/proposed/2018/ia-4889.pdf.

Objectives of the Proposals

According to Chairman Clayton, the objectives of the proposals are to: (1) “enhance retail investor protection and decision making by [r]aising the standard of conduct for broker-dealers when they provide recommendations to retail investors, and [r]eaffirming and in some instances clarifying the terms of the relationships that retail investors have with their investment professionals;” (2) “preserve retail investor access (in terms of choice and cost) to a variety of investment services and products,” and (3) “raise retail investor awareness of whether they are transacting with registered financial professionals.”

Reasons for the Proposals

According to Chairman Clayton, there were three motivating reasons for the proposals, including:

  1. “investor confusion” regarding the “important differences between BDs and IAs – from differences in the variety of services they offer and how investors pay for those services, to the regulatory frameworks that govern their relationship,”
  2. the “need” to hold investment professionals to standards of conduct that meet reasonable investor expectations and that adequately address conflicts of interest, and
  3. “regulatory complexity” resulting from the DOL fiduciary rule and more generally from regulatory, inspection, and enforcement inconsistencies that apply to the provision of financial advice.

Overview of Regulation Best Interest

Proposed Regulation Best Interest would impose a best interest obligation on a BD and its individual associated persons by requiring them to act in the best interest of a “retail customer” when recommending a securities transaction or investment strategy involving securities, without placing their financial or other interests ahead of the interest of the retail customer. As written, the proposal essentially would provide a safe harbor by deeming the best interest obligation satisfied if the BD or its individual associated persons meet the following obligations:

  1. Disclosure Obligation. At or prior to the time of making a recommendation, the BD or individual associated person of the BD “reasonably discloses to the retail customer, in writing, the material facts relating to the scope and terms of the relationship with the retail customer, including all material conflicts of interest that are associated with the recommendation.”
  2. Care Obligation. In making a recommendation, the BD or individual associated person of the BD “exercises reasonable diligence, care, skill, and prudence to: (A) [u]nderstand 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; (B) [h]ave a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks and rewards associated with the recommendation; and (C) [h]ave 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.”
  3. Conflict of Interest Obligations. The BD establishes, maintains, and enforces written policies and procedures reasonably designed to: (A) “identify and at a minimum disclose, or eliminate, all material conflicts of interest that are associated with such recommendations;” and (B) “identify and disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with such recommendations.”

For this purpose, a “retail customer” means “a person, or the legal representative of such person, who: (A) receives a recommendation of any securities transaction or investment strategy involving securities from a broker, dealer, or a natural person who is an associated person of a broker or dealer, and (B) uses the recommendation primarily for personal, family, or household purposes.”

Commissioner Commentary

This proposal drew sharp criticism from Commissioner Stein, who stated, among other things, that it does not:

  • define the term “best interest,”
  • require full and fair disclosure of any conflicts of interests,
  • require financial professionals making investment recommendations to retail customers to be fiduciaries, and
  • require financial professionals to provide the “best available options” to retail customers.

According to Commissioner Stein, the proposal “merely requires broker-dealers to meet certain minimal obligations in order to get the protections of the safe harbor and thus be in compliance with their ’best interest standard.’” Commissioner Stein also stated that because there is no definition of “best interest in the proposal, the name of the rule in and of itself is confusing. Calling the proposal Regulation Best Interest could cause retail investors to reasonably believe that broker-dealers are required to act in their best interests.” She then suggested that the proposal could more accurately be named “Regulation Status Quo,” and went on to state that “calling it Regulation Best Interest is not just confusing, it is in effect a form of mislabeling, which may be misleading and which could have deleterious consequences.”

Commissioner Jackson joined Commissioner Stein in criticizing Regulation Best Interest, noting that he supported the DOL’s fiduciary rule vacated last month by the U.S. Court of Appeals for the Fifth Circuit. He expressed several concerns, including that:

  1. the standard in Regulation Best Interest is “far too ambiguous” and may be interpreted to permit conflicted advice to “taint” investment decisions or used by lawyers to defend BD conduct that has “no place in our markets,”
  2. the proposal strengthens the so-called suitability standard that “has so long failed to protect investors from conflicted brokers,”
  3. the mitigation of conflicts cannot be expected to address “the most egregious practices” in the industry such as sales contests, quotas, and bonuses for selling proprietary products, and he urged commenters to identify practices that should be “eliminated,” and
  4. the final rule he hopes will address the degree to which BDs hold themselves out in a manner that leaves investors confused about who they are and what are their obligations.

Commissioner Jackson also asserted that the proposal’s cost/benefit analysis “does not reflect a serious attempt to evaluate the effects of the proposals on investors,” does not deserve judicial deference, and will not be able to support a final rule unless the SEC does much more to understand how the proposals will affect investors. According to Commissioner Jackson, “perhaps the most glaring omission from [the SEC’s] economic analysis is the absence of any real attempt to quantify the benefits of honest advice for ordinary investors,” noting that he counted “17 occasions on which the proposal says [the SEC] is unable to quantify those benefits.”

By contrast, Commissioner Peirce stated that the suitability standard has “served investors well” but both she and Commissioner Piwowar expressed similar concerns regarding the lack of clarity of the proposal’s best interest standard of conduct. Commissioner Peirce suggested that it would be better to describe the proposal as “suitability plus” and to describe the “plus.” She also expressed concern that if the SEC did not get the standard right, it risks exacerbating the long-term trend of a declining number of BDs. In addition, Commissioner Peirce noted that the term “best interest” sets an “impossible standard” because “[d]etermining whether a particular recommendation is in a customer’s best interest is a value-laden judgment that could be interpreted to require the broker-dealer to see into the future and to evaluate possible states of the world in light of the broker-dealer’s notion of the customer’s best interest gleaned from the customer’s investor profile. It also requires the broker-dealer and its registered reps to understand the full range of available products.” Commissioner Peirce noted that “clearly [the SEC] cannot require either of these things,” but planning for what the SEC will demand for examinations and enforcement actions could be a “very expensive exercise” for BDs. In this regard, she expressed concerns that BDs might try to limit their potential exposure either by unduly limiting or overly broadening the range of products that they offer. Finally, Commissioner Peirce took issue with how the term “best interest” will be used, noting that she has found no one who can explain the term’s meaning, but fears the term will be used as an SEC-approved “incantation” that “charms investors into not asking questions precisely because it is devoid of concrete content.”

Commissioner Piwowar stated, among other things, that “after 45 days of reviewing and commenting on this release, I am not convinced that we have clearly and adequately explained the exact differences” between the proposal’s best interest standard, FINRA’s suitability standard, and the Adviser’s Act fiduciary standard.

Overview of the Form CRS Relationship Summary

The proposed Form CRS Relationship Summary would require BDs and IAs to provide a “retail investor” with eight items of disclosure including:

  1. Introductory Information, such as name and type of entity, e.g., BD, IA, dual registrant
  2. Relationships and Services, e.g., brokerage account services, investment advisory account services, services provided by affiliates, and fee information.
  3. Standard of Conduct, e.g., best interest for BDs, fiduciary standard for IAs.
  4. Summary of Fees and Costs, including principal fees and costs that retail investors will bear.
  5. Comparisons by standalone IAs and BDs of features of typical brokerage and advisory accounts, respectively.
  6. Conflicts of Interest.
  7. Additional information, including legal and disciplinary event information and sources for additional information, e.g., BrokerCheck and Form ADV.
  8. Key Questions to Ask.

For this purpose, a “retail investor” means a prospective or existing client or customer who is a natural person (an individual) and includes “a trust or other similar entity that represents natural persons, even if another person is a trustee or managing agent of the trust.” According to the proposing release, Form CRS uses a different term than “retail customer” in Regulation Best Interest because the SEC believes “it is beneficial to require firms to provide a relationship summary to all natural persons to facilitate their understanding of account choices, regardless of whether they will receive investment advice primarily for personal, family, or household purposes. The relationship summary is intended for an earlier stage in the relationship between an investor and a financial professional, potentially before discussing the investment purposes of the investor. In contrast, Regulation Best Interest focuses on recommendations to ‘retail customers’ who have chosen to engage the services of a broker-dealer after receiving the relationship summary.”

A Form CRS would need to be provided before or at the time a retail investor engages a BD or IA for its services, and for existing clients before or at the time (i) a new account is opened that is different from the investor’s existing account or (ii) changes to the existing account occur that would materially change the nature and scope of the relationship with the investor, including transfers from an advisory or brokerage account to the other or movements of assets from one type of account to another in a transaction not in the normal, customary, or already agreed course of dealing. Form CRS also would need to be provided within 30 days upon request by a retail investor.

Commissioner Commentary

Commissioner Stein expressed concern that Form CRS called for information that was “too generic and too legalistic such that retail investors won’t bother to read it.” She took particular issue with the fact that the Form placed the burden on the retail investor to take the initiative to raise questions with his or her financial professional on matters about which the investor may be confused. In addition, according to Commissioner Stein, the Form CRS fell short by permitting but not requiring the use of “visually dynamic” techniques to convey information to retail investors. Commissioner Piwowar noted that the sample relationship summaries provided were “in need of substantial public input” and welcomed comments from a wide range of commenters. Commissioner Peirce expressed several concerns, including that Form CRS may tend to exacerbate the problem of disclosure overload, that the Form took the unusual step of calling upon financial professionals to describe services that they did not offer, that the Form seemed to use ongoing monitoring as the main demarcation line between a BD and an IA when that may not reflect reality, and that the Form called for cost information that may be hard to provide with precision in advance.

Overview of Restrictions on the Use of “Adviser” or “Advisor” by BDs and Required Disclosure of Registration Status

The proposals also would prohibit BDs and individual associated persons of a BD from using the term “adviser” or “advisor” in communicating with a retail investor unless the BD is registered as an investment adviser either with the SEC or with a state, the individual associated person is a supervised person of the registered adviser, and such associated person provides investment advice on behalf of the registered adviser. The last requirement would prevent individual associated persons who do not provide investment advice as an investment adviser from using the term “adviser” or “advisor” merely because they are associated with a BD that is dually registered as an investment adviser.

The prohibition would apply to names such as “financial advisor,” “wealth adviser,” “trusted advisor,” and “advisory.” The prohibition would not apply to communications with institutional clients. The prohibition also would not apply when acting on behalf of a bank or insurance company, or when acting on behalf of a municipal advisor or commodity trading advisor.

In addition, the proposals would require a BD or an IA to prominently disclose whether it is registered as a BD or an IA in print or electronic retail investor communications.

Commissioner Commentary

These proposals did not spark much commentary by Commissioners. Commissioner Piwowar stated he was “thrilled” that the SEC was addressing confusion from the use of misleading titles and the resulting potential harm to retail investors. At the same time, Commissioner Stein expressed her belief that “more can, and should be done.” She posited as one example a broader, principles-based approach that precluded a BD from “holding itself out” as an investment adviser to the extent it was not one or acting in an advisory capacity.

Overview of Interpretation of Federal Fiduciary Standard Under the Advisers Act

The SEC’s proposed interpretation of the federal fiduciary standard under the Advisers Act seeks in a single release to “reaffirm - and in some cases clarify - certain aspects of the fiduciary duty that an investment adviser owes to its clients under section 206 of the Advisers Act.” The proposed interpretation states that an IA’s fiduciary duty “is similar to, but not the same as, the proposed obligations of BDs under Regulation Best Interest.” The proposed interpretation, however, does not expressly elaborate on the distinction. Also, like Regulation Best Interest, the proposed interpretation does not define what it means to act in the “best interest” of an advisory client.

In this regard, the proposed interpretation in a footnote cites to a 1994 proposed rule that the SEC never adopted but that would have made express the obligation of IAs to make only “suitable” recommendations. The proposed interpretation goes on to state, without citation, that this suitability obligation, “when combined with an adviser’s fiduciary duty to act in the best interest of its client, requires an adviser to provide investment advice that is suitable for and in the best interest of its client.” (Emphasis in the original.) The proposed interpretation later expands the scope of this obligation to apply “not just to potential investments, but to all advice the investment adviser provides to clients, including advice about an investment strategy or engaging a sub-adviser and advice about whether to rollover a retirement account so that the investment adviser manages that account.”

Regarding the contours of the advisory relationship, the proposed interpretation states that the “adviser and its client may shape that relationship through contract when the client receives full and fair disclosure and provides informed consent.”

In addition to describing other duties of an IA, the proposed interpretation seeks comment on three potential “enhancements” to the obligations of IAs that borrow from investor protections provided by the BD regulatory framework. These “enhancements” include (1) federal licensing and continuing education requirements for personnel of SEC-registered IAs, (2) the delivery of periodic account statements either directly or through the client’s custodian regardless of whether the adviser is deemed to have custody under the Advisers Act, and (3) financial responsibility requirements similar to those that apply to BDs, e.g., net capital requirements and fidelity bonds.

Commissioner Commentary

Commissioner Stein expressed confusion as to why the SEC “might be in the best position to issue interpretive guidance on an area that is heavily informed by decades of common law.” She also expressed concern that the interpretation may narrow an IA’s broader fiduciary duty. Commissioner Piwowar noted that the “relative lack of case law underpinning this proposed interpretation raises questions about our legal authority to issue this guidance….I am eager to know what legal authority exists to support the interpretation of advisers’ fiduciary duty that we are proposing today.” He went on to note that if support for the propositions is not available, but they have merit, then the SEC should engage in rulemaking rather than attempt to impose requirements through guidance. Commissioner Peirce shared Commissioner Piwowar’s concern regarding whether the SEC was making new law in the proposed interpretation. By way of example, she noted that regarding the statement in the proposed interpretation that the IA and its client can shape their relationship through disclosure and informed consent, the informed consent is “new” and its only basis is an instruction in Form ADV. Commissioner Peirce also went on to express her belief that the SEC lacks authority for the proposed federal licensing, continuing education, net capital, and fidelity bond requirements. She further stated that she did not favor steps to force IAs to look like BDs or vice versa.

Comment Period

The SEC issued the proposals for a 90-day comment period, which will commence following their publication in the Federal Register, which should occur in the next week or so.

Some Preliminary Observations

The concerns expressed by multiple Commissioners over the ambiguity of the term “best interest” suggest the need for and likelihood of significant changes to the proposals regarding the appropriate standard. This conclusion is supported by the dearth if not absence of authority under the Advisers Act and judicial interpretations thereof regarding the application of a best interest standard with respect to investment recommendations. For example, the proposed interpretation cites to but does not appear to square with the SEC’s release describing its 1994 rulemaking proposal regarding an IA’s suitability obligation, which nowhere mentions a “best interest” obligation with respect to an IA’s investment advice.

The SEC also does not explain clearly what best interest means in contradistinction to the suitability standard though it does state that best interest means something more. If that is true and the best interest obligation (however interpreted) is to be accorded some substantive weight in addition to the suitability obligation, then the proposed interpretation would appear to go beyond even what the DOL fiduciary rule requires by imposing both a suitability and a best interest obligation on an IA making a securities recommendation to its clients.

Regulation Best Interest is somewhat circular inasmuch as it deems a BD’s best interest obligation to be satisfied if, among other things, the BD makes recommendations that it reasonably believes are in the best interests of its retail customers.

Consistent with points made by various Commissioners, regulatory ambiguity may result in reduced investor choices as financial professionals increasingly gravitate toward a regulatory regime that exposes them to less regulatory uncertainty.

Chairman Clayton repeatedly emphasized his desire to engage with other regulators as the SEC moves forward with this rulemaking process. Ideally such engagement will result in harmonized standards at both the federal and state levels. In this regard, for example, Iowa Insurance Commissioner Doug Ommen, who also serves as Chair of the National Association of Insurance Commissioners’(NAIC) Life Insurance and Annuities “A” Committee and is also a member of the North American Securities Administrators Association (NASAA), issued a press release stating: “I look forward to continuing to work with the SEC on this topic in my dual roles with both the NAIC and NASAA. Our consumer protection rules that require insurance and investment professionals to abide by consumer-focused standards of care should help consumers choose the professional retirement security advice that is right for them.” Given the current state of the SEC’s proposals, however, harmonization is not likely to occur any time soon unless the yet-to-be-explained best interest standard is jettisoned in favor of the suitability standard with which federal and state regulators are arguably more familiar. In the meantime, it is conceivable that financial professionals may seek to migrate to products subject to the least amount of regulatory ambiguity.


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