First in a Series
In an open meeting on April 18, the Securities and Exchange Commission voted four to one to issue two new rules and one interpretative release that are intended to provide investor protections and regulatory clarity, as well as investor access and choice. Specifically, the SEC issued Regulation Best Interest, Investment Adviser Standard of Conduct Interpretation, and Form CRS – Relationship Summary. Each component of the SEC’s proposal is available for public comment for 90 days after publication in the Federal Register.
This is the first in a series of articles describing the SEC’s proposal package. This first article addresses the Regulation Best Interest portion of the package.
Regulation Best Interest
The SEC proposes adding a new rule under the Securities Exchange Act of 1934, the Regulation Best Interest rule, which establishes a standard of conduct for broker-dealers and their registered representatives. The rule requires that broker-dealers act in their clients’ best interest when making investment or investment-strategy recommendations.
Because the SEC believes that whether a broker-dealer is acting in a client’s best interest is determined based on the particular facts and circumstances, it declined to define “best interest.” Similarly, the SEC proposal does not define “recommendation.” Instead, the SEC believes that the determination of whether a recommendation has been made should rely on factors that have historically been considered, such as how tailored the communication is to a specific client, or whether the communication could reasonably be viewed to encourage a particular action. Nevertheless, the SEC explains in the proposal that recommendations include sale, purchase, and exchange transactions. The SEC further explains that recommendations of investment strategies include recommendations to rollover or transfer assets from an employer-sponsored retirement plan to an IRA.
While the SEC acknowledges that “…broker-dealers have a duty of fair dealing, which…requires broker-dealers to make only suitable recommendations to customers and to receive only fair and reasonable compensation,” it found that “…broker-dealers are not explicitly required to make recommendations that are in a customer’s ‘best interest’.”
The Regulation Best Interest rule is intended to bridge this gap by setting forth specific obligations that (if fulfilled) are deemed to satisfy the rule. The three obligations are:
- Disclosure Obligation: Prior to, or at the time of, making a recommendation, the broker-dealer must reasonably disclose, in writing, to the client the scope and terms of the relationship and all material conflicts of interest associated with the recommendation. Examples of the scope and terms of the relationship include: (1) whether the broker-dealer is acting in a broker-dealer capacity with respect to the recommendation, (2) fees and charges that apply to the client’s transactions, holdings, and accounts, and (3) the type and scope of services provided, such as monitoring of the client’s account.
- Care Obligation: In making a recommendation, the broker-dealer must exercise reasonable diligence, care, skill and prudence to: (1) understand the potential risks and rewards of a recommendation, (2) have a reasonable basis to believe the recommendation is in the client’s best interest, based on the client’s investment profile and the risk/rewards of the recommendation, and (3) have a reasonable basis to believe that a series of transactions is in the client’s best interest in light of the client’s investment profile.
- Conflict of Interest Obligation: The broker-dealer must establish, maintain, and enforce written policies and procedures that are reasonably designed to disclose (or eliminate) all material conflicts of interest associated with its recommendations. Material conflicts that arise from financial incentives associated with a recommendation must also be identified, disclosed and mitigated (or eliminated). Simple disclosure of financial incentive conflicts, such as compensation incentives and incentives to recommend proprietary products, is not sufficient.
Under the rule, a “material conflict of interest” is broadly interpreted as “a conflict of interest that a reasonable person would expect might incline a broker-dealer – consciously or unconsciously – to make a recommendation that is not disinterested.” A client’s investment profile is defined, for purposes of the rule, to include, but not be limited to, “…the [client’s] age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the [client] may disclose…in connection with a recommendation.” Additionally, the care obligation is intended to enhance the existing suitability obligations that applies to broker-dealers, and cannot be fulfilled through disclosure. While the SEC is proposing explicit requirements to fulfill the obligations under the Regulation Best Interest, broker-dealers are able to determine the most appropriate way to fulfill their disclosure obligations with respect to form, manner, and frequency. In addition, a broker-dealer’s compliance with the disclosure obligations will be measured against a negligence standard, rather than a strict liability standard.
In the preamble to the rule, the SEC makes clear that the Regulation Best Interest rule would not apply to a situation in which a broker-dealer is executing an unsolicited transaction for a client. The rule also would not apply to a dually-registered broker-dealer when making a recommendation in its investment adviser capacity. The rule is specific to the broker-dealer relationship and is not expected to have any impact on an investment adviser’s fiduciary duty under the Investment Advisers Act of 1940. The SEC also makes clear that it does not intend for the rule to “…create any new private right of action,” which has been a criticism of the Department of Labor’s Best Interest Contract Exemption.
The SEC explains that one purpose of the Regulation Best Interest rule is to streamline compliance for broker-dealers where other regulatory regimes, such as the DOL’s Fiduciary Rule, also apply. Thus, the rule is not intended to replace the obligations to which broker-dealers may be subject if the Department’s Fiduciary Rule and related prohibited transaction exemptions survive, but rather overlap them. As described in our March 21 article, the Fifth Circuit Court of Appeals struck down the DOL’s Fiduciary Rule and its associated prohibited transaction exemptions in a 2-1 decision. At this point, it is unclear whether the DOL will appeal that decision, but it has until May 6, 2018, to decide.
In putting forth its own effort to address investor confusion and harm, the SEC acknowledged during the open meeting that changes to, and clarification of, the proposals are expected (and necessary) before a final rule will be passed. While we expect that the final version of the Regulation Best Interest will differ from the proposal, we believe the SEC will issue a final rule that requires broker-dealers to act in their clients’ best interest when making investment or investment-strategy recommendations.
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.