SEC Adopts Advice Standards and Form CRS (“Client Relationship Summary”) for Broker-Dealers and RIAs

On June 5, 2019, the SEC adopted Regulation Best Interest and the new Form CRS Relationship Summary, as well as two separate interpretations under the Investment Advisers Act of 1940. 

The SEC’s overarching goal in adopting this package of rules and interpretations is to ensure that retail investors have the opportunity to access and choose which type of professional they want to work with, the services they receive, and how they pay for these services. The SEC’s actions are also designed to:

•  Clarify the standards of conduct applicable to broker-dealers and RIAs, including when a broker-dealer’s advice will cause it to be viewed as an investment adviser;
• Enhance the quality and transparency of retail investors’ relationships with RIAs and broker-dealers, and the protection afforded investors in their dealings with financial professionals;
• Bring legal requirements and mandated disclosures in line with investor expectations;
• Help investors better understand and compare the services offered to them, so they can make an informed choice of the relationship that best suits their needs and circumstances; and
• Promote greater consistency in the degree of protection provided to retail investors across broker-dealer and investment adviser regulatory regimes, particularly at the time a recommendation is made.

 The SEC’s intention is that this rule-making will help ensure that regardless of whether a retail investor chooses to work with a broker-dealer or with an investment adviser, the investor will receive a recommendation (from a broker-dealer) or advice (from an adviser) that is in their best interest. However, the SEC’s actions stop short of imposing a fiduciary duty on Registered Representatives of broker-dealers. 

 The SEC’s rules and interpretations package focuses on the following four areas, which are summarized below:

•  Regulation Best Interest – Standard of Conduct for Broker-Dealers
• Form CRS (“Client Relationship Summary”)
• RIA Standard of Conduct
• “Solely Incidental” Prong of the Broker-Dealer Exclusion

Regulation Best Interest – Standard of Conduct for Broker-Dealers

Regulation Best Interest establishes a standard of conduct for broker-dealers and natural persons associated with a broker dealer when they make a recommendation to a retail customer of any securities transaction or investment strategy involving securities. Regulation Best Interest expands the broker-dealer standard of conduct beyond the traditional suitability obligations.

Brokers are required to document how they are acting in a client’s best interest, which is primarily accomplished through disclosure and mitigation of conflicts of interest. A broker-dealer may not put its financial interests above a retail customer’s interests when making recommendations.

Regulation Best Interest applies to account recommendations, including recommendations to roll over or transfer assets from a workplace retirement plan account to an IRA, as well as recommendations to take a plan distribution. It is also applicable to implied recommendations to hold securities that result from agreed-upon account monitoring.

Regulation Best Interest sets forth the following obligations:

• Disclosure Obligation: Broker-dealers must disclose material facts about the relationship and recommendations, including specific disclosures regarding the capacity in which the broker is acting, fees owed, the type and scope of services provided, conflicts of interest, limitations on services and products, and whether the broker-dealer provides monitoring services.

• Care Obligation: A broker-dealer must exercise reasonable diligence, care and skill when making a recommendation to a retail customer. The broker-dealer must take note of the potential risks, rewards, and costs related to the recommendation. The broker-dealer must consider these factors in view of the retail customer’s investment profile in order to make a recommendation in the retail customer’s best interest. The broker-dealer must also consider the costs that go hand-in-hand with the recommendation.

• Conflict of Interest Obligation: The broker-dealer must establish, maintain, and enforce written policies and procedures that are reasonably intended to identify and disclose or eliminate conflicts of interest. This obligation specifically requires policies and procedures designed to: (1) mitigate conflicts of interest that give an incentive for the firm’s financial professionals to place theirs or the firm’s interests above the retail customer’s interest; (2) prevent material limitations on offerings, such as a limited product menu or only offering proprietary products; and (3) eliminate sales contests, sales quotas, bonuses, and non-cash compensation based on the sale or type of specific securities.

• Compliance Obligation: Broker-dealers are required to establish, maintain and enforce policies and procedures that are reasonably intended to achieve compliance with Regulation Best Interest in its entirety.

The Regulation Best Interest standard is derived from important fiduciary principles and cannot be satisfied by mere disclosure. The Care Obligation under Regulation Best Interest requires a broker-dealer to have a reasonable basis to believe that a rollover is in the best interest of retail customers after considering their investment profile and other relevant factors such as potential risks, rewards, and costs.

Form CRS (“Client Relationship Summary”)

Form CRS describes the relationship between the client and the broker or adviser. Form CRS (also referred to “Form ADV Part 3” for RIAs) requires RIAs registered or registering with the SEC and broker-dealers to provide retail investors with simple and easy-to-understand information about the nature of their relationship with their financial professional. The question-and-answer format of the relationship summary is designed to permit a comparison between the two different types of firms in a manner that is distinct from other required disclosures. The summary will detail the firm’s services, fees and costs, conflicts of interest, legal standard of conduct, and whether the firm and its financial professionals have a disciplinary history.

RIAs and broker-dealers will be required to file relationship summaries with the SEC and deliver Form CRS to investors at the inception of their relationship and when changes are made to the services the firm provides. The relationship summary will enable investors to access additional information from the firm about these topics. Form CRS will also include a link to a dedicated page on Investor.gov, which will provide educational information about broker-dealers and RIAs.

Investment Adviser Fiduciary Duty Interpretation

The SEC also approved an interpretation to reaffirm and clarify the Commission’s views on the fiduciary duty owed by investment advisers. By highlighting the key principles of fiduciary duty, RIAs and their clients will have clear guidance regarding advisers’ legal obligations.

An RIA owes a fiduciary duty to its clients pursuant to the Investment Advisers Act. This duty is principles-based and encompasses the entire relationship between an RIA and its client. The SEC’s interpretation reaffirms and clarifies certain aspects of the federal fiduciary duty that an investment adviser owes to clients.

Interpretation of “Solely Incidental” Language in the Investment Advisers Act

The definition of “investment adviser” in the Investment Adviser Act excludes a broker or dealer whose performance of advisory services is solely incidental to the conduct of business as a broker or dealer and receives no special compensation for those services. The SEC’s interpretation of this language confirms and clarifies the Commission’s interpretation of the “solely incidental” prong of the broker-dealer exclusion. The SEC’s interpretation states that a broker-dealer’s advice as to the value and characteristics of securities or the advisability of transacting in securities falls within the “solely incidental” prong of this exclusion, as long as the advice is provided in connection with and is reasonably related to the broker-dealer’s primary business of effecting securities transactions.

The SEC attempted to articulate when a broker-dealer’s actions cause it to become an investment adviser within the meaning of the statute. This interpretation clarifies the SEC’s position on the solely incidental language and how it applies when a broker exercises investment discretion over customer accounts and monitors them

Conclusion

Regulation Best Interest and Form CRS are set to become effective sixty days after they are published in the Federal Register. The SEC’s interpretations under the Investment Advisers Act become effective immediately upon publication in the Federal Register.

By June 30, 2020, registered broker-dealers must be compliant with Regulation Best Interest. Broker-dealers and investment advisers registered with the Commission are required to prepare, deliver to retail investors, and file a relationship summary by June 30, 2020.

In the upcoming weeks, Foreside will provide blog posts dealing with each of the above four areas addressed in the SEC’s new rules and interpretations. The SEC’s package of rules and interpretations can be found at https://www.sec.gov/news/press-release/2019-89.

This article is not a solicitation of any investment product or service to any person or entity. The content contained in this article is for informational use only and is not intended to be and is not a substitute for professional financial, tax or legal advice.