Securities Litigation, Investigations & Enforcement Alert | June.12.2019
Last week, the Securities and Exchange Commission (SEC) voted to adopt what is popularly known as “Regulation Best Interest” (often referred to as “Reg BI”). Notwithstanding the name, Reg BI is actually a package of rulemakings and interpretations years in the making and represents the SEC’s attempt to implement a more palatable regulatory regime than the controversial fiduciary rule that the Department of Labor enacted in 2017 (which was ultimately vacated in U.S. Chamber of Commerce v. DOL, No. 17-10238, 2018 WL 1325019 (5th Cir Mar. 15, 2018)). In adopting Reg BI, the SEC said this package will “enhance the standard of conduct that broker-dealers owe to their customers and align the standard of conduct with retail customers’ reasonable expectations” and “will also provide additional transparency and clarity for retail investors through enhanced disclosures designed to help them understand who they are dealing with, and why that matters.”
This package includes several parts:
The SEC explained that “[t]he rulemaking package is designed to enhance investor protections while preserving retail investor access and choice in: (1) the type of professional with whom they work, (2) the services they receive, and (3) how they pay for these services.”
The Context of the Changes
Although both broker-dealers and investment advisers serve important functions for retail investors, those functions historically have been distinct – they maintained different types of relationships with their customers, offered different services and used different compensation models. Traditionally, broker-dealers were paid primarily to execute trades on behalf of customers and at their customers’ direction. Investment advisers were paid to counsel customers concerning investment strategies and risks. Because of their role in guiding the investment decisions of their customers, investment advisers have been charged with a fiduciary duty (including a duty of care and a duty of loyalty) towards their customers. Broker-dealers, by contrast, have not been considered fiduciaries and thus have not been held to the higher standard imposed on investment advisers. Instead, broker-dealers historically have been subject to a “suitability” standard, whereby they were required only to have a reasonable basis to believe that a recommended transaction or investment strategy was suitable for the customer based on the customer’s age, financial situation, risk tolerance and other factors.
But the role of broker-dealers has changed over time as the automation of trading has obviated many of their execution responsibilities. Broker-dealers now often perform more of an advisory function for their clients. As a consequence, the SEC has permitted broker-dealers to call themselves financial advisers without imposing fiduciary obligations. The end result is that the lines between broker-dealers and investment advisers have become increasingly blurred, and many retail investors no longer appreciate the distinctions between broker-dealers and investment advisers. In 2006, for example, the SEC commissioned a study by the RAND Corporation that found that participants did not understand the differences between broker-dealers and investment advisers, the legal duties they owe investors, or the meaning of “fiduciary.”
To address this knowledge gap, a 2011 SEC staff study recommended adoption of a uniform fiduciary standard that would govern both broker-dealers and investment advisers. In 2016, the Department of Labor issued a stricter “fiduciary rule” that would have required broker-dealers to handle retirement assets with a heightened duty of loyalty. The Trump administration, however, deferred adopting the fiduciary rule pending further consideration of the issues. Following a legal challenge, the Fifth Circuit vacated the proposed regulation in 2018 on several grounds, including that the Department of Labor had exceeded its authority.
The New Rulemakings and Interpretations
Regulation Best Interest
The final rule implementing Regulation Best Interest enhances the standard of broker-dealer conduct beyond mere suitability requirements. Importantly, the new standard is not co-extensive with the fiduciary obligations of investment advisers, although it incorporates some similar principles and may not be satisfied solely by disclosure. The rule includes the following components:
Form CRS Relationship Summary
Pursuant to the Form CRS Relationship Summary, both investment advisers and broker-dealers will be required to deliver a relationship summary to retail investors at the beginning of their relationship. Among other things, the disclosure must concisely (in four pages or less) summarize information about services, fees and costs, conflicts of interest, legal standard of conduct and whether the firm and its financial professionals have any disciplinary history.
Investment Adviser Interpretation
In its investment adviser interpretation, the SEC purports to reaffirm, and in some cases clarify, certain aspects of the principles-based federal fiduciary duty that investment advisers owe to their clients.
The interpretation states that the duty of care requires an investment adviser “to provide investment advice in the best interest of the client, based on the client’s objectives.” To satisfy this obligation, an investment adviser must make a reasonable inquiry into the client’s objectives (updating the client’s investment profile as necessary to reflect changed circumstances) and reasonably believe that the advice given is in the best interest of the client (e.g. by considering whether the client is willing to tolerate the risks of the particular investment and investigating the investment so as to not base the advice on materially inaccurate or complete information). The duty of care also requires an investment adviser to seek best execution of a client’s transactions where the adviser is responsible for selecting broker-dealers to execute the client’s trades, and to provide advice and monitoring at a frequency serving the best interest of the client.
The interpretation also states that the duty of loyalty prohibits an investment adviser from placing its own interests ahead of its client’s interests. To satisfy this duty, the adviser must “make full and fair disclosure to its clients of all material facts relating to the advisory relationship” and “eliminate or at least expose through full and fair disclosure all conflicts of interest which might incline an investment adviser – consciously or unconsciously – to render advice which was not disinterested.”
Solely Incidental Interpretation
In its “solely incidental” interpretation, the SEC purports to confirm and clarify its interpretation of that prong of the broker-dealer exclusion of the Advisers Act. Specifically, a broker-dealer’s advice as to the value and characteristics of securities, or as to the advisability of a securities transaction, is “solely incidental” to the broker-dealer’s business – thereby excluding the broker-dealer from being regulated as an investment adviser – if the advice “is provided with and is reasonably related to the broker-dealer’s primary business of effecting securities transactions.” Thus, if giving advice is the broker-dealer’s primary business or not offered in connection with or reasonably related to the business of executing trades, the services will not qualify for the exclusion. Whether a broker-dealer’s advisory services satisfy the solely incidental prong depends on the facts and circumstances surrounding the business, the services offered and the relationship with the customer.