By Jessica Kinslow
The SEC recently adopted Regulation Best Interest (“Reg BI”), which changes the regulatory landscape for broker-dealers and investment advisers.[i] Although the SEC staff had recommended a uniform fiduciary standard applicable to both broker-dealers and investment advisers, Reg BI does not go so far. However, Reg BI does narrow the gap between the duties owed by broker-dealers and investment advisers. This article summarizes the regulatory landscape pre-Reg BI, clarifies what aspects of that landscape remain intact, explains the changes that Reg BI makes, and identifies unanswered questions that remain.
The Landscape Before Reg BI
Traditionally, there was a vast difference in the duties owed by registered investment advisers (“RIAs” and broker-dealers (“BDs”). RIAs owe their clients a fiduciary duty to “act in the best interest of their clients and to make such recommendations as will best serve such interest.”[ii] This fiduciary duty includes the duty to avoid conflicts of interest, but such conflicts can be mitigated by making disclosure of such conflict, and obtaining the client’s “informed consent to such dealings.”[iii] This fiduciary duty also requires RIAs to make “full and frank disclosure of [their] practice of trading on the effect of [their] recommendation.”[iv]
BDs, on the other hand, have traditionally not owed a fiduciary duty to their clients, instead owing the lesser duty to recommend “suitable” securities to their clients.[v] BDs were treated as salespeople, offering a range of investment products and services to pick and choose from, rather than acting as fiduciaries.
Over time, however, product offerings and services of both BDs and RIAs became more complex, and the distinctions between the two different roles became murky. BDs and RIAs began to compete with each other for business. BDs focused on assets under management and fee-based accounts, while RIAs began referring management of assets to third parties and collecting a fee. Some firms became dually registered in order to offer even more options to their customers, and with the introduction of industry certifications with names such as Financial Adviser and Financial Planner, further confusion of the roles and their duties became apparent.
Against this backdrop, the Dodd-Frank Act required the SEC to conduct a “Study on the Effectiveness of Legal and Regulatory Standards of Care for Broker Dealers and Investment Advisors.”[vi] The SEC staff’s resultant study recommended that “[t]he SEC should make rules specifying a uniform fiduciary standard of conduct applying to both broker-dealers and investment advisors when providing personal advice about securities to retail investors, that is no less stringent than the current standard required of investment advisors.”[vii]
What Reg BI Does Not Do
Contrary to the SEC staff’ recommendation, Reg BI does not create a uniform fiduciary standard applicable to BDs and RIAs, but it does narrow the gap between the duties owed by BDs and RIAs. The SEC explained that it had “chosen not to apply the existing fiduciary standard under the Advisers Act to [BDs] in part because of concerns that such a shift would result in fewer [BDs] offering transaction-based services to retail customers, which would in turn reduce choice and may raise costs for certain retail customers,” and because it “would discard decades of regulatory and judicial precedent.”[viii]
Instead, the SEC chose to enhance existing obligations for BDs when making recommendations to retail customers.[ix] These enhanced suitability standards and disclosure requirements more closely align the nature of BD and RIA relationships with their clients.
What Reg BI Does
The primary purpose of Reg BI is to establish more transparency about the relationship between BDs, RIAs, and their retail customer clients. Reg BI, and the companion Form CRS and Adviser’s Act Interpretations adopted at the same time, accomplish this with two key changes: (1) a new “best interest” standard applicable to BDs, which encompasses four additional obligations; and (2) a new requirement that BDs and RIAs provide a relationship summary to retail clients.
The New “Best Interest” Standard
Reg BI requires BDs and their associated persons to act in the “best interest” of their retail clients when making a recommendation.[x] Reg BI does not define “best interest” as a term, but it instead states that “acting in the best interest means”[xi] complying with four additional obligations—the “disclosure obligation,” the “care obligation,” the “conflict of interest obligation,” the “compliance obligation”—and adhering to a “recordkeeping” requirement.[xii]
The purpose of the “disclosure obligation” is to facilitate the retail customer’s awareness of certain key information about the relationship with the BD or RIA. This prong of the rule is designed to work in concert with Form CRS, which must be delivered by all BDs and RIAs to their retail customers upon opening of an account. Form CRS contains high-level disclosures about the nature of the relationship, services to be provided, fees, charges, compensation, and conflicts of interest.
In addition, in order to reinforce the distinction between BDs and RIAs, BDs may not use the terms “adviser,” or “advisor,” unless they are dually registered as such. Although most of the disclosures required by Reg BI can be made through Form CRS, certain additional disclosures, such as material conflicts related to recommendations about a specific product, will likely need to be made at the point-of-sale,[xiii] because they would be unknown at the time of opening an account where ongoing sales are expected to occur.[xiv]
The intention of the “care obligation” is to incorporate and enhance existing suitability requirements that are applicable to BDs, while also imposing a “best interest” requirement, that the BD shall not put its own interests ahead of the retail customer’s interest when making recommendations.
The care obligation requires a BD, when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer, to exercise reasonable diligence, care, and skill to do the following: (a) understand the potential risks, rewards, and costs associated with the recommendation, and have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers (reasonable basis suitability); (b) have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks, rewards, and costs associated with the recommendation and does not place the financial or other interest of the broker, dealer, or such natural person ahead of the interest of the retail customer (customer specific suitability); and (c) have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer’s best interest when viewed in isolation, is not excessive and is in the retail customer’s best interest when taken together in the light of the retail customer’s investment profile and does not place the financial or other interest of the broker, dealer, or such natural person making the series of recommendations ahead of the interest of the retail customer (quantitative suitability).[xv]
The purpose of the “conflict of interest obligation” is to enhance the disclosure of conflicts of interest in order to educate retail customers about those conflicts and to help them evaluate recommendations received from BDs. Reg BI imposes an obligation on BDs to not only disclose, but also mitigate, conflicts of interest arising from financial incentives associated with their recommendations. Common conflicts include compensation arrangements, as well as the BD acting as a principal in the sale of certain proprietary products.
The reason for the “compliance obligation” is to create a holistic, affirmative obligation with respect to Reg BI, while maintaining sufficient flexibility to allow BDs to establish and implement their own compliance procedures, thus accommodating a broad range of business models.[xvi] Thus, Reg BI does not enumerate specific requirements that BDs must include in their policies and procedures. Instead, when adopting policies and procedures, BDs should consider the nature of that firm’s operations and how to design such policies and procedures to prevent violations from occurring, to detect violations that have occurred, and to correct promptly any violations that have occurred.
The New Relationship Summary Requirement
Reg BI also requires BDs and RIAs to provide a brief relationship summary to retail investors[xvii] and to inform retail investors of the types of client and customer relationships and services the firm offers; the fees, costs, conflicts of interests, and required standard of conduct associated with those relationships and services; whether the firm and its financial professionals currently have reportable legal or disciplinary history; and how to obtain additional information about the firm.[xviii]
As a companion to Reg BI, the SEC also adopted a Form CRS Relationship Summary,[xix] which requires RIAs and BDs to provide a concise, plain English summary detailing the nature of the relationship, including the standard of care provided to the customer through the services, products, and relationship.[xx]
Reg BI leaves a number of unanswered questions, including whether it preempts state law and how it applies to dual-registrants.
Preemption of State Law. Some states have implemented, or have proposed implementing, fiduciary standards or expanded standards of care for BDs that go beyond those imposed by Reg BI. Many commentators urged the SEC to either preempt or avoid preempting state fiduciary rules.[xxi] However, the SEC decided to “retain the overall structure and scope”[xxii] without stating whether Reg BI preempts state fiduciary rules.[xxiii]
Dual-Registration. In the Proposing Release, the SEC stated Reg BI would apply only when a dual-registrant representative had its BD hat on, and whether or not additional disclosure or obligations would apply to dual-registrant firms would be based on a “facts and circumstances test.”[xxiv]
However, unanswered questions still remain. For instance, for dual-registrant firms, is there a conflict of interest when offering the same product, such as variable annuities, under either the BD or RIA models? Does Reg BI dictate under which model the firm should sell the investments to the client? Are dual-registrants required to disclose that a product could be sold under both models and provide a side-by-side comparison?
Although many critics have expressed that Reg BI does nothing more than preserve the status quo for BDs, while failing to increase protection for retail investors, the “best interest” standard, coupled with a more stringent regime for disclosure of material conflicts, achieves a more harmonized standard of care and disclosure for both RIAs and BDs, even if it falls short of imposing a uniform fiduciary standard.
Jessica Kinslow graduated from the University of Idaho College of Law in 2013. Jessica lives in Portland, Oregon and has worked as in-house counsel and compliance specialist for dual-registrant firms throughout her career. Jessica enjoys racing sailboats and playing with her Scottish Terrier, Duffy.
[i] Release 34-86031 (June 5, 2019) (hereafter “Release”), available at: http://bit.ly/2KbhJE8.
[ii] In re Arleen Hughes, Exchange Act Release No. 4048, 27 S.E.C. 629 (Feb. 18, 1948).
[iv] SEC v. Capital Gains Research Bureau, 375 U.S. 180 (1963).
[v] See FINRA, FINRA Rule 2111 (SUITABILITY).
[vi] Dodd-Frank Act, Section 913.
[vii] Staff of the U.S. Securities and Exchange Commission, Study on Investment Advisers and Broker-Dealers As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Jan. 2011) (“913 Study”) at 8-12, available at www.sec.gov/news/studies/2011/913studyfinal.pdf (discussing the range of brokerage and dealer services provided by broker-dealers).
[xi] See Release at p.35.
[xii] Rule 15l-1(a)(1) under the Exchange Act.
[xiii] See Proposing Release at 21605.
[xiv] See Release at 234.
[xv] See Release at 253.
[xvi] See generally Release atSection II.C.4, Compliance Obligation.
[xvii] 17 CFR Parts 200, 240, 249, 275, and 279, p.1.
[xix] Release 34-86032 (June 5, 2019) (the “CRS Release”), available at: http://bit.ly/2XIK1Jl.
[xx] The SEC also issued an interpretation reaffirming and clarifying the fiduciary duty that RIAs owe to their clients under the Investment Advisers Act of 1940 (Advisers Act) and an interpretation of the “solely incidental” prong of the broker-dealer exclusion under the Advisers Act, both of which are addressed in a separate Client Alert.
[xxi] See Release at p. 32.
[xxii] See Release at p. 33.
[xxiii] Id. Any express preemption would arise under 15(i)(1) of the Exchange Act, prohibiting states from establishing certain differing requirements already established under the Securities Laws.
[xxiv] See Release at p. 127.