As the regulatory landscape is constantly evolving, Compliance Risk Concepts (“CRC”) is issuing its monthly […]
On June 5, 2019 the Securities and Exchange Commission (“SEC”) voted to enhance the regulatory framework standard of conduct for broker-dealers (or “firms”) and provide an interpretation of the fiduciary duty for investment advisers by issuing Regulation Best Interest (“Reg BI”). The SEC is giving firms a transition period until June 30, 2020.
Reg BI framework is more expansive than the vacated Department of Labor (“DOL”) fiduciary rule as it covers all securities investment recommendations to retail customers rather than just those for retirement accounts. By setting out specific obligations of broker-dealers and investment advisers, the SEC is seeking to tailor requirements to the different types of products and services each provide in order to preserve customer choice in the industry. Reg BI sets out new rules which will increase compliance efforts for firms but provides a more uniform standard and does not include many of the onerous aspects of the DOL rule such as a private right of action.
The framework includes:
Reg BI consist of four obligations for broker-dealers when providing recommendations to retail customers. Reg BI does not expressly define “best interest,” instead stating that broker-dealers must act “without placing the financial or other interest of the broker ahead of the interest of the retail customer.” However, the SEC makes clear that the term does not create a fiduciary obligation and explains that it will determine whether a broker-dealer has acted in their customers’ best interest based on the four obligations: (1) disclosure, (2) care, (3) conflict of interest and (4) compliance.
Disclosure – Reg BI imposes an obligation on to provide a 2-page relationship summary (Form CRS) to clients in a question and answer format. Disclosures must contain a summary of fees, costs, conflicts, and standards of conduct along with alink to the SEC’s Investor.gov site.
The timing of the disclosure varies as following:
In addition, firms must provide additional disclosures when they:
So what does this mean: CRC recommends firms review their current customer agreements and disclosures to determine what changes will need to be made and involve technology teams to consider potential digital solutions. CRC also recommends a cross-functional team of business, compliance and operational employees work together to confirm disclosure of all material facts pertinent to a conflict of interest associated with the recommendation that are “full and fair”.
Care – Firms will have an obligation to provide reasonable “diligence, care, and skill” to satisfy three obligations: reasonable-basis, customer-specific and quantitative. Additionally, firms must evaluate reasonably available alternatives, however broker-dealers will not have to evidence review of all alternatives. Similar to the DOL fiduciary rule, Reg BI's care obligation covers recommendations concerning rollovers and account choice (e.g., brokerage or advisory), as well as those to take a retirement plan distribution for purposes of opening a securities trading account.
So what does this mean: We recommend firms dust off work done during their DoL fiduciary rule prep. Because the rule is not prescriptive, there is no “one size fits all” model for compliance. The compliance obligation requires firms to maintain policies and procedures to ensure compliance with Reg BI. Notably, this obligation provides an opportunity for the SEC and FINRA to bring enforcement actions for compliance failures without the existence of underlying violations of Reg BI. Therefore, firms should carefully develop Reg BI policies and procedures with a view towards how they will demonstrate that they have met the best interest standard - including documenting all written and oral disclosures to clients.
Conflict – Reg BI does not explicitly define material conflicts of interest. In contrast to the DOL rule, Reg BI allows firms to sell proprietary products, including initial public offerings, and continue to receive payments from third parties for shelf space – as long as they disclose conflicts of interest. For example, in instances where a registered representative holds a limited license (e.g., only to sell mutual funds), but the firm offers a full suite of products, the representative may need to disclose this to their customers. However, the final rule makes clear that there are certain conflicts of interest that cannot be cured through disclosure, specifically prohibiting certain types of sales contests and quotas within defined parameters (e.g., for specific security types in short time periods).
So what does this mean: CRC recommends firms review their range of products and services they offer along with their payout grid in order to identify potential conflicts and determine whether they will need to be mitigated, eliminated or disclosed. The final rule also instructs firms to develop a penalty system for any representatives that do not adequately manage or disclose their conflicts of interest. Firms will need to establish, maintain, and enforce written policies and procedures reasonably designed to:
Compliance – Reg BI requires firms to develop policies and procedures in order to demonstrate that they have met the best interest standard - including documenting all written and oral disclosures to clients. The SEC has made changes to Rules 17a-3 and 17a-4, which require broker-dealers to maintain records of all information collected and provided to retail customers pursuant to Reg BI for six years, including the identity of each natural person who is an associated person of the broker-dealer responsible for the customer accounts. Firms that fail to maintain adequate policies and procedures may face enforcement actions from the SEC and FINRA for compliance failures.
So what does this mean: CRC advises firms to review and enhance their policies and procedures that address: Product and Pricing; Operations; Technology; and Communications. Additionally, firms should put in place processes to capture and retain disclosures, provide training on the new requirements and ensure that there is a supervisory structure to oversee compliance.
Investment Advisers – While investment advisers have an existing fiduciary obligation, the SEC’s investment adviser interpretation of Reg BI makes these obligations explicit:
Because the final rule did not include enhancements contained in the proposal, investment advisor are not likely to require significant analysis or operational changes as those for broker-dealers, e.g. - licensing and continuing education requirements, provision of account statements to clients and similar financial responsibility requirements.
Determining whether broker-dealers’ advice provided to retail clients is “solely incidental” will be determined by 2 criteria:
So what does this mean: Investment advisers should be aware that the SEC is continuing to evaluate these enhancements and may add them in the future. The SEC also clarified the solely incidental exception under the Advisers Act: broker-dealers do not have a fiduciary duty to a retail investor unless that broker-dealer is exercising unlimited investment discretion with respect to the account, or the broker-dealer has agreed to continuous monitoring of the account
To qualify for an exemption from the Advisers Act (“the Act”), broker-dealers must satisfy 2 conditions:
DoL and States – After the DOL rule was vacated, a number of states began to introduce their own fiduciary or best interest standards. These rules vary across states – some states like Nevada, are contemplating a private right of action and a largely ongoing obligation. Others states like New York would only apply a best interest standard to the sale of life insurance annuities. These differences will make it challenging operationally for firms to adhere to each state’s specific requirements. The SEC declined to provide any opinion on whether its rules would preempt state standards and left the question to “future judicial proceedings.”
So what does this mean: The industry can likely expect litigation on this issue as states continue to move forward with their rulemakings and attempt to retain control over standards in their jurisdictions. Meanwhile, the DOL has stated that it will issue an updated version of its fiduciary rule later this year. While there have not been any explicit assurances, it is likely that the concepts and requirements from the DOL will align with Reg BI.
Not applicable – Equally as important, Reg BI will not:
 Firms can use the FINRA Report on Conflicts of Interest as guidance in managing, mitigating and eliminating conflicts of interest in their businesses.
 It is the SEC’s position that when a broker-dealer agrees with a retail customer to provide account monitoring services: (1) the broker-dealer would be required to disclose the material facts, scope and frequency of those services pursuant to the Disclosure Obligation, and (2) such agreed-upon account monitoring services involve an implicit recommendation to hold (i.e., an implicit recommendation not to buy, sell, or exchange assets pursuant to that securities account review) at the time agreed-upon monitoring occurs, which is a recommendation “of any securities transaction or investment strategy involving securities” covered by Reg BI.