On June 5, 2019, the Securities and Exchange Commission (“SEC”) announced it had adopted a number of rulemakings and interpretations aimed at tightening the standards of care governing broker-dealers and investment advisers and clarifying the duties of broker-dealers and investment advisers in providing investment advice.
Prior to the adoption of Regulation BI, broker-dealers (“BDs”) were held to a “suitability” standard that required BDs to sell products that were “suitable” for retail customers based on such characteristics as age, goals and risk tolerance. Under Regulation BI, BDs must act in the best interest of their retail customers and are not permitted to place their own self-interests ahead of their customers’ interests. This is an enhanced standard of care, but still is considered to be a less stringent standard than the required fiduciary duty an investment adviser has to its customers.
In principal part, Regulation BI includes the following obligations:
Disclosure Obligation: BDs must disclose material facts about the relationship between the retail customer and the BD, and recommendations BDs may make to their retail customers regarding particular securities transactions or investment strategies, including specific disclosures about the capacity in which the broker is acting, the fees charged, the type and scope of services provided, conflicts of interest, limitations on services and products, and whether the BD provides ongoing monitoring of account performance.
Care Obligation: A BD must exercise reasonable diligence, care and skill when making a recommendation to a retail customer. The BD must understand potential risks, rewards, and costs associated with the recommendation. The BD must then consider these factors in light of the retail customer’s investment profile and make a recommendation in the retail customer’s best interest. This obligation explicitly requires the BD to consider the costs associated with the recommended transaction.
Conflict of Interest Obligation: The BD must establish, maintain, and enforce written policies and procedures reasonably designed to identify and, at a minimum, disclose or eliminate conflicts of interest. This obligation specifically requires policies and procedures to:
- Mitigate conflicts that create an incentive for the firm’s financial professionals to place their interest or the interests of the firm ahead of the retail customer’s interest;
- Prevent material limitations on product offerings to retail customers (such as a limited product menu or offering only proprietary products) from causing the firm or its financial professional to place his or her interest or the interests of the firm ahead of the retail customer’s interest; and
- Eliminate sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sale of specific securities or specific types of securities within a limited period of time.
Compliance Obligation: BDs must establish, maintain and enforce policies and procedures reasonably designed to achieve compliance with Regulation BI as a whole.
Under the new Relationship Summary requirement, investment advisers and BDs must deliver a summary of their relationship with their retail customers at the start of the relationship. Among other things, the summary must be easy to understand and include information about services to be provided to customers, fees and costs, conflicts of interest, legal standards of conduct, and the disciplinary history of the firm and its financial professionals. The format will be standardized so retail customers will be able to more easily compare what different firms can offer.
Regulation BI and the Relationship Summary forms will become effective 60 days after their publication in the Federal Register, the U.S. government’s official publication for regulations, proposed regulations and similar administrative notices. There is a transition period until June 30, 2020, to give firms time to come into compliance with the new regulation.
The SEC also issued two pieces of commission-level interpretative guidance regarding: (i) the standard of conduct for investment advisers and (ii) the “solely incidental” test under which a broker-dealer is excluded from being considered an investment adviser under the Investment Advisers Act.
Standard of Conduct: The Investment Adviser interpretative guidance reaffirms and clarifies the fiduciary duty that an investment adviser owes to its clients under the Investment Advisers Act.
Solely Incidental: The “Solely Incidental” interpretative guidance reaffirms and clarifies the SEC’s interpretation of the “solely incidental” test under the Investment Advisers Act as to whether a BD is considered to be an investment adviser for purposes of the Act. Under the interpretive guidance, “a broker-dealer’s advice as to the value and characteristics of securities or as to the advisability of transacting in securities falls within the ‘solely incidental’ [test] if the advice is provided in connection with and is reasonably related to the broker-dealer’s primary business of effecting securities transactions.”
The interpretive guidance will take effect upon their publication in the Federal Register.