On June 4, 2019, the SEC issued several sweeping changes in the rules and regulations regarding the ways broker-dealers and investment advisers interact with their clients. 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, and attempted to clarify an investment adviser’s fiduciary duty. For those who are dual registrants, it’s crucial to understand the responsibilities for both the investment advisory and broker-dealer sides of your firm.
When Acting in a Broker-Dealer Capacity
Dual registrants will need to apply Regulation Best Interest (Reg BI) when acting in a broker-dealer capacity. Reg BI 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 when making a recommendation.
While the obligations on broker-dealers draw their inspiration from 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. Reg BI 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 Reg BI standard is far more lenient than the fiduciary standard of investment advisers and may actually be fulfilled by satisfying the four-part “General Obligation” test.
The four obligations are as follows:
- 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;
- 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; and
- Compliance Obligation
A broker-dealer must establish, maintain, and enforce policies and procedures reasonably designed to achieve compliance with Regulation Best Interest.
- Disclosure Obligation
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. Meanwhile, what actually is or is not in the client’s best interest remains undefined. Perhaps we will hear more before the compliance date this June.
When Acting in an Investment Advisory Capacity
The SEC reaffirmed the fiduciary duty of an investment adviser, not to be confused with the Best Interest standard. 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 Reg BI as stated above).
The adviser cannot place their own interest above the interest of the client. 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 malleable and is determined by the scope of the client relationship and the disclosures made to, and consent of, the client.
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.
💡 Pro tip: While you can start filing your Form CRS on May 1, 2020, you must have it complete and filed by June 30, 2020. Dual registrants must file their Form CRS with IARD and Web CRD.
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. For dual registrants, you must deliver Form CRS to clients at the earlier of the timing requirements for the investment adviser or broker-dealer. Much of the form serves to educate clients, comparing the services of your broker-dealer and investment advisory sides, describing the standard of conduct, and containing key questions an investor should ask, or “conversation starters.”
These “conversation starters” are different for dual registrants, which must include:
- “Which Type of Account is Right for You- Brokerage, Investment Advisory or Both?”
- “There are different ways you can get help with your investments. You should carefully consider which types of accounts and services are right for you. Depending on your needs and investment objectives, we can provide you with services in a brokerage account, investment advisory account, or both at the same time. This document gives you a summary of the types of services we provide and how you pay. Please ask us for more information. There are some suggested questions on page [ ].”
All of 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. Dual registrants only have four pages to provide all of this information, including the mandatory “conversation starters.”
💡 Pro tip: You can provide your Broker-Dealer and Investment Adviser forms separately (2 pages per CRS), or you can combine them into one, four-page CRS. Before you start getting creative, the SEC mandates that the Form CRS be in 11-point font or greater using a reasonable font type on 8 ½” x 11’’ pages.
If you prepare two separate Form CRS’, you must furnish copies of both to each retail investor of the dually registered firm with regard to whether the particular retail investor receives both broker-dealer and advisory services.
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About Red Oak Compliance Solutions
Red Oak Compliance Solutions is the global advertising review software of choice in the financial services industry. It is a comprehensive suite of SEC 17A-4 compliant features that are 100% books and records compliant and provides clients with 35% faster approvals and 70% fewer touches or better. We also offer Smart Review(SM), which solves for the storage and maintenance of disclosures, helping firms reduce risk, decrease review times, and increase the speed of distribution of marketing materials. Smart Registration(SM) automates the licensing and registration management process to help reduce regulatory risk and time spent on manual processes. Overall, Red Oak allows firms to minimize risk, reduce costs, and increase compliance review process effectiveness and efficiencies.