SEC Adopts Enhanced Standard of Conduct for Broker-Dealers and Clarifies Fiduciary Duties of Investment Advisers

The U.S. Securities and Exchange Commission, on June 5, 2019, voted 3-1 in favor of adopting a package of rules, amendments and interpretations (Final Rules) intended to improve the retail investor experience and to provide greater clarity for investors regarding the differences in the roles played by, and standards of conduct applicable to, broker-dealers and investment advisers. The Final Rules consist of two rulemakings (Regulation Best Interest and Form CRS) and two interpretive releases (pertaining to the “solely incidental” prong of the broker-dealer exclusion from registration as an investment adviser, and the standard of conduct for investment advisers).

SEC Chairman Jay Clayton stated that “[t]his rulemaking package will bring the legal requirements and mandated disclosures for broker-dealers and investment advisers in line with reasonable investor expectations, while simultaneously preserving retail investors’ access to a range of products and services at a reasonable cost.”3

In the end, and consistent with the initial proposals from April 18, 2018 (Proposed Rules), the SEC decided not to create a uniform standard of conduct for broker-dealers and investment advisers, but instead “adopt[ed] an enhanced investor-protection standard for broker-dealers that maintains the availability of both the broker-dealer model and the investment adviser model.”4 The SEC reasoned that adopting a uniform standard “would not appropriately reflect the fact that broker-dealers and investment advisers play distinct roles in providing recommendations or advice and services to investors, and may ultimately harm retail investors.” Rather, the set of actions taken by the SEC on June 5 clarify that the fiduciary responsibilities of investment advisers apply to their entire relationship with clients, whereas the duties of broker-dealers are generally “transactional and episodic,” unless otherwise agreed to by contract.

The SEC’s interpretation of the standard of conduct for investment advisers and the “solely incidental” prong of Section 202(a)(11)(C) of the Investment Advisers Act of 1940 will become effective upon publication in the Federal Register. Regulation Best Interest and the Form CRS Relationship Summary will become effective 60 days after their publication in the Federal Register. As discussed below, the compliance date for Regulation Best Interest and Form CRS is June 30, 2020.

This Newsflash provides a brief overview of the Final Rules. Dechert will provide a more in-depth analysis in an upcoming OnPoint as to the Final Rules and the issues broker-dealers and investment advisers are likely to face.

Regulation Best Interest

The SEC adopted Regulation Best Interest largely as proposed, including choosing not to include a definition of “best interest;”5 however, the final Regulation Best Interest rules reflect certain meaningful modifications. Regulation Best Interest requires broker-dealers to act in the best interest of retail customers when making recommendations to them regarding any “securities transaction or investment strategy involving securities (including account recommendations)” and to place the interests of the retail customer ahead of the financial or other interests of the broker-dealer (General Obligation). The SEC stated that scienter is not needed to show a violation of Regulation Best Interest; however, the SEC further stated that it does not intend to provide for a private cause of action or rescission rights in the event of a violation.

The General Obligation is triggered when a recommendation is made to a retail customer. The definition of “retail customer” remains substantially unchanged from the proposed rule, and covers persons, or legal representatives of such persons, who receive a recommendation of a securities transaction or investment strategy involving securities and use the recommendation “primarily for personal, family or household purposes,” including ERISA retirement accounts. Consistent with long-standing FINRA interpretations, the SEC did not adopt a specific definition or bright-line test for when a “recommendation” is made, instead choosing to retain the principles-based approach outlined in the proposed rule. Accordingly, determining if a recommendation has been made (and therefore the General Obligation is triggered) is based on traditional factors such as “whether the communication ‘reasonably could be viewed as a call to action’ and ‘reasonably would influence an investor to trade a particular security or group of securities’” and whether the communication was tailored to a specific customer or group of customers.

As adopted, the General Obligation explicitly applies to recommendations as to the type of account a retail customer might consider, including recommendations to open accounts generally and recommendations to roll over assets from one type of account to another. These recommendations are viewed by the SEC as “investment strategies.” The SEC also clarified that broker-dealers are not required to monitor their retail clients’ accounts on an ongoing basis. However, if a broker-dealer agrees to provide ongoing monitoring, the General Obligation is triggered and, even if a broker-dealer does not expressly recommend a change, the broker-dealer will be viewed as having made an implicit hold recommendation.6

Further, the SEC clarified that, with respect to ERISA retirement accounts, the General Obligation is triggered when a recommendation is made to a retail client about taking distributions “from proceeds of specific securities or to take in-service loans from an employer-sponsored plan,” because these transactions involve the sale of a security. The General Obligation will not be triggered, however, by a broker-dealer’s communications relating to required minimum distributions, or education regarding a plan’s options.

The General Obligation will be satisfied if the broker-dealer complies with the four component obligations of care, disclosure, conflicts of interest and compliance. 

• Care Obligation. The key component of the best interest standard is the Care Obligation, which incorporates and enhances the current suitability standards applied by the SEC and FINRA. The Care Obligation requires that, in making a recommendation, a broker-dealer exercise “reasonable diligence, care, and skill” in satisfying the following three requirements: 
  • Reasonable Basis Requirement: The broker-dealer must have a reasonable basis to believe that its recommendation with respect to a particular security or investment strategy could be in the best interest of “at least some” retail customers, taking into account the “potential risks, rewards, and costs associated with the recommendation.”
  • Customer-Specific Requirement: The broker-dealer must have a reasonable basis to believe that the recommendation is in the best interests of the specific retail customer, “based on that retail customer’s investment profile and the potential risks, rewards and costs associated with the recommendation and does not place the financial or other interest of the [broker-dealer or the associated person of the broker-dealer] ahead of the interest of the retail customer.” The broker-dealer must take into consideration: the retail customer’s investment profile;7 risks; and the fees and costs associated with the recommendation or series of recommendations.
  • Quantitative Requirement: With respect to a series of transactions, the broker-dealer must have a reasonable basis to believe that the series, viewed as a whole, is in the best interests of the retail customer and is not excessive, even if each transaction would be in the retail customer’s best interests when viewed individually. Further, the recommendation cannot place the “financial or other interest of the [broker-dealer or the associated person of the broker-dealer] ahead of the interest of the retail customer,” and the broker-dealer must take into consideration the same factors as with respect to the customer-specific requirement.

Notably, Regulation Best Interest does not require a broker-dealer to exercise prudence in meeting its duty of care, as originally proposed. While the SEC linked this determination to concerns about legal uncertainty and confusion, it also noted that inclusion of “prudence” would have been redundant in light of the requirement that a broker-dealer exercise “diligence, care, and skill.”

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