FIRST IN A SERIES
On June 5, 2019, the Securities and Exchange Commission adopted a rulemaking package that is applicable to investment advisers and broker-dealers. The package includes two final rules and two interpretations – Regulation Best Interest, Investment Adviser Standard of Conduct Interpretation, Form CRS – Relationship Summary, and Solely Incidental Broker-Dealer Exclusion Interpretation. While these rules and interpretations are consistent with the proposed guidance described in our April 2018, three-article series, the SEC made various modifications based on feedback it received during the proposal’s comment period.
The Regulation Best Interest and Form CRS requirements are effective 60 days after they are published in the Federal Register, with a transition period for compliance that ends on June 30, 2020. The SEC’s interpretations are effective upon publication in the Federal Register.
This is the first in a series of articles describing the SEC’s rulemaking package. This first article addresses the Regulation Best Interest portion of the package.
Regulation Best Interest
The Regulation Best Interest final rule (“Reg BI”) under the Securities Exchange Act of 1934 establishes a standard of conduct for broker-dealers and their registered representatives. Reg BI requires that broker-dealers act in their retail customers’ best interest when making investment or investment strategy recommendations. The SEC believes that the rule enhances the broker-dealer standard of conduct beyond existing suitability requirements and aligns the standard of conduct with retail customers’ reasonable expectations.
In its proposed rule, the SEC requested comments regarding the scope and definition of the term “retail customer” in the regulation. In response to those comments, the SEC modified the definition to mean “a natural person, or the legal representative of such natural 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.” According to the SEC, the focus of the definition is on natural persons (rather than any persons).
As in the proposed rule, determining whether a broker-dealer makes a “recommendation” will be based on how that term is currently interpreted under broker-dealer regulations. The SEC explains that “[t]he more individually tailored a communication to a specific customer or a targeted group of customers about a security or group of securities, the greater the likelihood that the communication may be viewed as a recommendation.” Thus, the facts and circumstances of a particular situation will determine whether a broker-dealer has made a recommendation for purposes of Reg BI.
While the SEC declined to define “recommendation” under the rule, it identified various types of communication that it does not consider to constitute a recommendation, provided, that the communication – on its own or in combination with other communications – does not include a recommendation of a particular security or investment strategy. For example, the following kinds of communication generally are not considered a recommendation:
- General financial and investment information, such as basic investment concepts, historic asset class returns, estimates of future income needs, and investment profile assessments;
- Descriptive information about an employer-sponsored retirement plan, such as the benefits of participating in the plan and the investment options available under the plan;
- Asset allocation models, subject to certain requirements and disclosures; and
- Interactive investment materials, subject to certain conditions.
As referenced above, Reg BI applies to recommendations of “any securities transaction or investment strategy involving securities (including account recommendations).” Commenters on the proposed rule requested clarification about what is considered a securities transaction or investment strategy. The SEC responded by saying that the rule should apply broadly and by adding the parenthetical “(including account recommendations)” to the text of Reg BI. Further, the SEC described several types of recommendations that it considers to be covered by the rule. For example, recommendations to:
- Rollover or transfer assets from one type of account to another (e.g., from an employer-sponsored retirement plan to an IRA);
- Take distributions from proceeds of specific securities or take in-service loans from an employer-sponsored plan;
- Open an IRA or other brokerage account; or
- Implicitly hold a security, if the broker-dealer agreed to provide account monitoring services;
are subject to the regulation.
Similar to the proposed rule, Reg BI sets forth specific obligations that (if fulfilled) are deemed to satisfy the rule. Under the proposed rule, broker-dealers were required to comply with the Disclosure Obligation, the Care Obligation, and the Conflict of Interest Obligation. These obligations (with some modification) continue to apply under the final rule. In addition, the rule includes a fourth obligation – the Compliance Obligation.
- Disclosure Obligation: Prior to (or at the time of) a recommendation, broker-dealers must provide retail customers with all material facts relating to the scope and term of the relationship and all material facts relating to conflicts of interest that are associated with a recommendation. The SEC identified in Reg BI the threshold information that it considers to be “material facts” that broker-dealers must provide to satisfy this standard. For example, Reg BI requires broker-dealers to disclose: (1) that the broker, dealer, or natural person is acting as a broker, dealer, or an associated person of a broker-dealer with respect to a recommendation, (2) the material fees and costs that apply to the retail customer’s transactions, holdings, and accounts, and (3) the type and scope of services provided to the retail customer, including any material limitations on the securities or investment strategies that may be recommended to the retail customer. The SEC emphasized, however, that broker-dealers will need to determine whether other material facts relating to the scope and terms of the relationship with the retail customer need to be disclosed.
Under the Form CRS portion of the proposed package, the SEC restricted broker-dealers from using the term “adviser” or “advisor” as part of a name or title when communicating with retail customers. In the final package, the SEC determined that it was not necessary to adopt this restriction. Instead, the SEC believes that the disclosure obligation under Reg BI creates a presumption that the use of these terms in a name or title by (1) a broker-dealer that is not also registered as an investment adviser, or (2) an associated person that is not also supervised by an investment adviser, is a violation of the Disclosure Obligation. Thus, broker-dealers should review their names, titles, and marketing practices to ensure that these terms are removed (if applicable).
Reg BI defines a “conflict of interest” associated with a recommendation that must be disclosed to mean “an interest that might incline a broker, dealer, or a natural person who is an associated person of a broker or dealer – consciously or unconsciously – to make a recommendation that is not disinterested.” Compensation practices associated with recommendations to retail customers and related conflicts of interest – whether at the broker-dealer or the associated person level – must be disclosed. The SEC further explains that the disclosure should summarize how the broker-dealer and its financial professionals are compensated for their recommendations and the conflicts of interest that such compensation creates.
- Care Obligation: The final Care Obligation that applies to broker-dealers under the final regulation is substantially the same as under the proposed rule. As described above, broker-dealers are required to act in the retail customers’ best interest. While Reg BI does not specifically define “best interest,” the SEC illustrates its meaning primarily when describing this obligation. Specifically, a broker-dealer’s financial or other interests cannot be placed ahead of the retail customer’s interests when making a recommendation. For example, a broker-dealer must have a reasonable basis to believe that a recommendation to open an IRA or to roll over assets into an IRA is in the best interest of the retail customer and does not place the broker-dealer’s financial or other interests first.
In addition, the SEC added “cost” as a factor that broker-dealers must consider in fulfilling their obligation, but only to emphasize that it is one of many factors to take into consideration when making a recommendation.
- Conflicts of Interest Obligation: As a starting point, broker-dealers have an obligation to establish written policies and procedures to identify and disclose (or eliminate) all conflicts of interest associated with a recommendation. They also must establish policies and procedures that are reasonably designed to mitigate or eliminate certain conflicts of interest. For example, Reg BI requires that broker-dealers identify and eliminate “any sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sales of specific securities or specific types of securities within a limited period of time.”
- Compliance Obligation: In response to comments received on the proposed rule, the SEC modified the Conflicts of Interest Obligation to focus primarily on conflicts, and added a separate Compliance Obligation. The Compliance Obligation creates an affirmative duty under the Exchange Act to establish ongoing compliance policies and procedures. Broker-dealers are required to establish, maintain, and enforce written policies and procedures to achieve compliance with Reg BI. The SEC recognized that broker-dealers provide services under various business models. Thus, the rule allows broker-dealers the flexibility to design their compliance policies and procedures to: (1) prevent violations of Reg BI, and (2) promptly detect and correct violations based on the firm’s scope, size, and the risks associated with the firm’s business and operations.
Compliance with Reg BI will require the creation and updating of broker-dealer disclosures, as well as the development (or revision) of policies, procedures, and systems. Thus, the SEC specified an effective date for Reg BI that is 60 days after the rule is published in the Federal Register, and a compliance date of June 30, 2020. This transition period provides time for broker-dealers to make the required changes for Reg BI compliance.
This blog post was drafted by Beth Miller, an attorney in the Spencer Fane LLP Overland Park, KS office. For more information, visit spencerfane.com.