On June 4, 2019, the SEC issued a number of sweeping changes in the rules and regulations regarding the ways broker-dealers and investment advisers interact with their clients. In an effort to curb the abuses of financial professionals placing their own interest above that of their clients, the SEC enacted Regulation Best Interest, adopted Form CRS, attempted to clarify an investment adviser’s fiduciary duty, and provided addition clarification on the solely incidental prong of the broker-dealer exception form the definition of investment adviser.
Regulation Best Interest
The SEC issued the final version of Regulation Best Interest. This measure seeks to enhance the standard of conduct that applies when broker-dealers make recommendations to retail customers. These new measures are designed to “improve investor protection by enhancing the quality of broker-dealer recommendation to retail customers and [to reduce] the potential harm to retail customers that may be caused by conflicts of interest”. In order to achieve this goal, the SEC strengthened the obligations on broker-dealers to more-closely resemble the fiduciary obligations of Investment Advisers. Broker-dealers and their associated persons must act in a retail customer’s best interest and cannot place its own interest ahead of the customer’s interest when making a recommendation.
Part (a) (1) of regulation best Interest States:
“A broker, dealer, or a natural person who is an associated person of a broker or dealer, when making a recommendation of any securities transaction or investment strategy involving securities (including account recommendations) to a retail customer, shall act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker, dealer, or natural person who is an associated person of a broker or dealer making the recommendation ahead of the interest of the retail customer.”
While the obligations on broker-dealers draw their inspiration form the fiduciary standard found in the Investment Advisers Act of 1940, this does not mean that the SEC has created the equivalent of the Investment Adviser fiduciary standard for broker-dealers. Regulation Best Interest deviates from the Adviser Act fiduciary standard substantially in an effort to accommodate the broker-dealer business model. For example, a broker-dealer still has no duty to provide ongoing advice and monitoring after making the recommendation. The Regulation Best Interest standard is far more lenient than the fiduciary standard of Investment Advisers and may actually be fulfilled by satisfying four-part “General Obligation” test. The four obligations are as follows
- The Disclosure Obligation
A broker-dealer must provide certain prescribed disclosures before or at the time of the recommendation about the recommendation and the relationship between the retail customer and the broker dealer
- The Care Obligation
A broker-dealer must exercise reasonable diligence, care, and skill in making the recommendation.
- Conflict of Interest Obligation
A broker-dealer must establish, maintain, and enforce policies and procedures reasonably designed to address conflicts of interest.
- The Compliance Obligation
A broker-dealer must establish, maintain, and enforce policies and procedures reasonably designed to achieve compliance with Regulation Best Interest.
Many of the components of these obligations may be satisfied by having a reasonable basis to believe that they are acting in the retail customer’s best interest or by having appropriate disclosures. This seems to go just shy of saying that you may be deemed as acting in the client’s best interest if you have a reasonable basis to believe that you are acting in the client’s best interest and/or disclose that you may be doing otherwise. Meanwhile, what actually is or is not in the client’s best interest remains undefined. Perhaps we well hear more before Regulation Best Interest goes into effect next year.
Form CRS- Customer Relationship Summary
Along with issuing Regulation Best Interest, the SEC also adopted a new form for both investment and broker-dealers: Form CRS (Customer Relationship Summary). The relationship summary will inform retail investors about: 1) the types of client and customer relationships the firm offers; 2) the fees costs, conflicts of interest, and required standard of conduct associated with those relationships and services; 3) whether the firm and its financial professionals currently have reportable legal or disciplinary history; and 4) how to obtain additional information about the firm. This form will also reference Investor.gov/CRS, which will serve as an educational resource to retail investors.
This new form shall be provided to retail investors at the beginning of the client relationship and clients will be informed of updates to the relationship summary after material changes and other events. Much of the form serves to educate clients, comparing the services of broker-dealers to investment advisers, describing the standard of conduct, and containing key questions an investor should ask, or “Conversation Starters”. These “conversation starters”, include questions such as, “Given my financial situation, should I choose an investment advisory service? Why or why not?”.
All of this this information should be provided “in plain English”, avoiding legal jargon and technical terms (unless you can easily define them within the summary) while being as concise and direct as possible. If you have any questions concerning Form CRS or you require assistance in developing a Form CRS for your firm, please contact Red Oak before the rule goes into effect next year.
Reaffirmation of an Investment Adviser’s Fiduciary Duty
The SEC reaffirmed the fiduciary duty of an investment adviser. Although many critics of the current fiduciary standard requested that the SEC adopt rule text, the SEC will continue to enforce a principles-based approach to evaluating the fiduciary standard. The SEC affirmed that the fiduciary duty under the Advisers Act comprises of 1) a duty of care and 2) a duty of loyalty, which is encompassed by the adviser’s obligation to act in the best interest of their client (not that this standard is different from Regulation Best Interest as state above).
The adviser cannot place the interest of the client above their own. The duty of care “requires an investment adviser to provide investment advice in the best interest of its client, based on the client’s objectives”. The duty of loyalty requires that “an investment adviser must eliminate or make full and fair disclosure of all conflicts of interest which might incline an investment adviser- consciously or unconsciously- to render advice which is not disinterested such that a client can provide informed consent to the conflict”. This fiduciary duty is mailable and is determined by the scope of the client relationship and the disclosures made to, and consent of, the client.
Solely Incidental Prong of the Broker-Dealer
The SEC also sought to update their interpretation of the solely incidental prong of Investment Advisers Act of 1940, which states how much investment advice a broker-dealer can provide before becoming an Investment Adviser and having to register as one. The SEC sought to clarify this prong with respect to the amount of investment discretion a broker-dealer may exercise and what sort of account monitoring a broker dealer may perform.
The commission elected to allow temporary or limited investment discretion, provided that it is not indicative of a relationship that is primarily advisory in nature. Broker-dealer discretion is limited in time, scope or other manner and “lacks the comprehensive and continuous character of investment discretion” that comes with an investment advisory relationship.
As far as account monitoring is concerned, a broker-dealer may monitor a retail customer’s account on a periodic basis for purpose of providing buy, sell, or hold recommendations. The commission delineate “every circumstance where agreed-upon monitoring is and is not solely incidental to a broker-dealer’s brokerage business”. The commission instead suggested adopting appropriate policies and procedures that would address account monitoring. For example, a broker-dealer may establish procedures that only allow monitoring an account at specific times for the sole purpose of determining whether to buy, sell or hold recommendation to the customer.
If you would like help in developing these procedures, or anything else related to Regulation Best Interest, Form CRS, or the updated fiduciary standard, please contact Red Oak at your earliest convenience and we can help you remain compliant in this ever-changing landscape.
Written by Joshua Kelly, Red Oak Senior Consultant
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