In this Ropes & Gray podcast, asset management counsel Brynn Rail and David Tittsworth discuss the SEC’s new rules and interpretations that deal with standards of conduct for brokers and investment advisers. Specifically, they cover the topics of Regulation Best Interest (Reg BI), Form Customer Relationship Summary (Form CRS), and the SEC’s fiduciary duty interpretation under the Advisers Act.
David Tittsworth: Thank you for joining us today. My name is David Tittsworth, I’m a counsel with Ropes & Gray in our Washington, D.C. office. I’m joined today by my good friend and colleague Brynn Rail, counsel in our New York office. During this podcast, Brynn and I are going to give you a quick overview of the SEC’s new rules and interpretations that deal with standards of conduct for brokers and investment advisers. We have a lot of ground to cover today and I know we won’t be able to answer all the questions you may have. We have however, prepared some slides that we’d be happy to share with anyone – all you have to do is contact Brynn or me and we’ll send them to you. I’ll turn it over to Brynn
David Tittsworth: Absolutely. So it’s a vast understatement to say that the SEC has been struggling with issues for a very long time. For years, the distinction between broker-dealers and investment advisers was well-established. Brokers were excluded from the definition of “investment adviser” under the Advisers Act, so long as the broker-dealer did not receive any “special compensation” (that is, commissions, markups, or markdowns) and if the advice rendered was “solely incidental” to the broker’s primary business. But about 20 years ago, brokers began providing more advice – they also started establishing fee-based programs that were at odds with the “special compensation” prong of the Advisers Act. The question some people were asking was, “If a broker is essentially providing the same services as an investment adviser, why shouldn’t the broker be subject to the same laws and regulations as the investment adviser?” In 1999, the SEC proposed a rule that would have allowed brokers to receive fee-based compensation under certain circumstances. The SEC adopted a final rule in 2005, but that rule was overturned by the D.C. Circuit Court of Appeals in 2007 after the Financial Planning Association challenged the SEC’s legal authority for the rule. But that didn’t kill the issue. Without going into everything that transpired thereafter, let me highlight a couple of other major headlines. In 2008, the SEC commissioned the RAND Corporation to do a study, which concluded, not surprisingly, that investors are very confused by the differences between broker-dealers and investment advisers and the legal standards that govern each. And then in 2010, the Dodd-Frank Act authorized (but didn’t require) the SEC to adopt rules setting forth standards for broker-dealers and investment advisers. Of course, the other major development was the Department of Labor’s so-called Fiduciary Rule, which was first proposed in 2010. After a very tortuous path, the Department published a final rule on April 8, 2017. Brokers, insurance agents, and the groups that support them vigorously opposed that rule because it would have elevated all financial professionals who work with retirement plans to the level of a fiduciary under ERISA. But in yet another dramatic reversal, the DOL rule was invalidated in its entirety by the 5th Circuit Court of Appeals early last year. And now, the DOL says it’s working with the SEC on a revised rule. So that’s a really brief summary of how we got to where we are now. Brynn, can you please explain what the SEC did in June of this year?
Brynn Rail: Certainly, David. So the SEC adopted two rules and two interpretations that cover a wide range of issues: Reg BI; Form CRS; the Commission Interpretation of the Advisers Act Fiduciary Duty; and the Commission Interpretation of the “solely incidental” prong of the broker-dealer exclusion from the Advisers Act. We’ll cover all but the “Solely Incidental” interpretation today.
So let’s start with a broker-dealer’s obligation under Reg BI. Reg BI has a compliance date of June 30, 2020, and it requires a broker, a dealer, or a natural person who is associated with a broker-dealer, when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer to act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker, dealer, or associated person, ahead of the interest of the retail customer.
David Tittsworth: That’s a lot to take in, Brynn. Could you break it down a bit?
Brynn Rail: Absolutely. There are three main components to the Reg BI obligation. First, what constitutes a recommendation? Second, who is and who is not a retail customer? And third, how does a broker-dealer accomplish acting in a retail customer’s “best interest”?
On the first point, whether a recommendation has been made, should be analyzed exactly as it has always been analyzed in connection with FINRA’s suitability rule—which is to say by looking at the facts and circumstances. A recommendation has been made if a communication reasonably could be viewed as a “call to action” or reasonably could be expected to influence an investor to trade a particular security. The more tailored a communication is to a specific customer or targeted group of customers, the more likely it is to constitute a recommendation.
Second, the definition of “retail customer” is a critical component of understanding Reg BI. The term “retail customer” is defined as a natural person, or the legal representative of a natural person, who receives a recommendation from a broker-dealer and uses the recommendation primarily for personal, family, or household purposes. To be considered a “retail customer,” the customer has to actually use the recommendation. The Reg BI adopting release indicates that a customer “uses” a recommendation if: the broker-dealer has an account for the customer or if the broker-dealer will receive compensation, whether directly or indirectly, as a result of the recommendation. One open question for broker-dealers that recommend their affiliated investment adviser’s investment funds but do not themselves receive compensation for their sales efforts, is whether the receipt of a management fee or an incentive allocation by the broker-dealer’s affiliate constitutes “indirect compensation” for the broker-dealer. Finally, to constitute a “retail customer” a customer has to use the recommendation primarily for personal, family, or household purposes. A recommendation used for commercial or business purposes, such as a charitable foundation, would not fall within the scope of Reg BI.
Third, let’s talk about the term “best interest.” This term is not defined in the rule, but the rule provides that the best interest obligation will be satisfied if the broker-dealer complies with four obligations: (1) Disclosure Obligation; (2) Care Obligation; (3) Conflict of Interest Obligation; and (4) Compliance Obligation.
David Tittsworth: Brynn, again, that’s also a lot to take in. Could you break down those four obligations that comprise “best interest”?
Brynn Rail: Yes, let’s talk at a very high level about each of these newly established obligations.
So, to meet its disclosure obligation, before or at the time of a recommendation, a broker-dealer must make certain written disclosures to the retail customer. These disclosures include disclosure about the scope of services to be provided by the broker-dealer, disclosures relating to fees and costs associated with the recommendation, and disclosure of all material facts relating to conflicts of interest associated with the recommendation (for example, conflicts relating to compensation).
The second obligation is the care obligation. Here, the broker-dealer must understand the risks, rewards, and costs associated with the recommendation and the broker-dealer must consider those factors in light of the customer’s investment profile and have a reasonable basis to believe that the recommendation is in the customer’s best interest.
Next, the conflict of interest obligation requires the broker-dealer to identify conflicts of interest and at a minimum disclose or eliminate them. The broker-dealer must also mitigate conflicts that create an incentive for an associated person to place his or her interest, or the interest of the broker-dealer, ahead of the retail customer’s interest. The broker-dealer should also disclose material limitations on its recommendations (for example, if applicable, the broker-dealer offers only proprietary products). Under the conflict of interest obligation, broker-dealers also must eliminate sales contests and other forms of compensation that are based on the sale of specific securities or types of securities within a limited period of time.
Finally, there’s the compliance obligation. Here, the broker-dealer must establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Reg BI. It’s important to note that Reg BI: does not require a broker-dealer to recommend the single best security or the least expensive or least remunerative security; it does not impose upon a broker-dealer an ongoing obligation to monitor a position; and it does not require a broker-dealer to refuse to accept an order that is contrary to the broker-dealer’s recommendation.
David Tittsworth: Wow, I know that’s just a high-level view and that there are a lot of details that you didn’t go into, but it’s very clear to me that Reg BI is going to require a lot of time, attention, analysis, and work for broker-dealers. But we need to keep going. Can you give us some information about the new rule on Form CRS?
Brynn Rail: Sure. Form CRS applies to both broker-dealers and investment advisers. Under the rule, broker-dealers and investment advisers must deliver to “retail investors” a Form CRS. The term “retail investor” is defined as a natural person or the legal representative of a natural person who receives services primarily for personal, family, or household purposes. Form CRS must include certain prescribed information, including information regarding the nature and scope of services provided by the firm, the types of fees investors will incur, a description of the standard of conduct under which the firm operates, a description of the conflicts of interest faced by the firm, and a description of the firm’s disciplinary history. Form CRS may not exceed two pages (or four pages for dual registrants). No later than June 30, 2020, firms must deliver, on an initial one-time basis, Form CRS to existing customers and clients who are retail investors. Thereafter, an investment adviser must deliver Form CRS before or at the time the investment adviser enters into an investment advisory agreement with a client. And a broker-dealer must deliver Form CRS to a customer at the earliest of: making a recommendation, placing an order, or opening a brokerage account. Form CRS must be filed with the SEC and must be amended if information within it becomes materially inaccurate.
David Tittsworth: Thanks so much, Brynn. Let me finish now with a brief description of the SEC’s Investment Adviser Fiduciary Duty Interpretation. This new Commission Interpretation has the force of law. It says explicitly that it’s intended to reaffirm and clarify the fiduciary duty of an investment adviser and it also says it does not create any new legal obligations for investment advisers. An investment adviser’s fiduciary duty has been a longstanding, principles-based standard. The duty is not expressly defined anywhere, but it certainly includes the responsibility to eliminate, or at least to expose, conflicts of interest. The overarching obligation to act in a client’s best interest is comprised of both a duty of care and a duty of loyalty. The duty of care includes the duty to provide advice that is in the best interest of the client. It also includes the duty to seek best execution of client transactions as well as the duty to provide advice and monitoring throughout the relationship. On the other hand, the duty of loyalty requires an investment adviser to not subordinate the client’s interest to its own interest; to make full and fair disclosure of material facts; and to eliminate or expose conflicts of interest. And finally, an investment adviser and its client may shape the scope of the relationship by their agreement, but there has to be full and fair disclosure and informed consent.
Brynn Rail: So that’s a 90-mph tour of the new rules and interpretations for broker-dealers and investment advisers. David you noted that these issues have been contentious, so it shouldn’t come a surprise that they’ve been the subject of some criticism. What have you seen in that regard?
David Tittsworth: Well I think the big news is that two lawsuits have just been filed against the SEC arguing that the SEC exceeded its authority under Dodd-Frank in promulgating these rules, that the SEC’s rules are arbitrary and capricious, and that Reg BI should require broker-dealers to register as investment advisers and be subject to the Advisers Act fiduciary duty. So we might see more lawsuits filed—we certainly saw the same thing with the Department of Labor’s Fiduciary Rule—and I would advise people to keep their eyes and ears open for these developments that are going to occur. We’ll obviously be monitoring these and other developments closely during the coming months. And Brynn, I’d ask you to just end by summarizing some of the key takeaways that you’d provide for people who have to deal with these new rules and interpretations.
Brynn Rail: Thanks, David. So broker-dealers are going to be most impacted by the new rules. Reg BI applies only to broker-dealers, not to investment advisers. So broker-dealers will have to look at their businesses to determine whether they make recommendations to retail customers. If they do, they’ll have to ensure that all required disclosures will be provided to their retail customers. They’ll also want to scrutinize their conflicts of interest to determine whether any of those conflicts are unsustainable under the heightened “best interest” standard. And they’ll have to update their policies and procedures to achieve compliance with Reg BI generally. For a broker-dealer that sells its affiliated investment adviser’s funds, we expect that the Reg BI-required disclosure can be provided in some combination of the prospectus or PPM plus Form CRS. Other types of broker-dealers may have to be more creative. Broker-dealers should also look out for expected changes to FINRA’s suitability rule. There are elements of that rule that just won’t work anymore in light of Reg BI, so we expect more to come in that regard. And then there’s Form CRS. That requirement applies to broker-dealers and investment advisers alike. Investment advisers and broker-dealers that provide services to retail investors, will have to provide Form CRS to their retail investor clients and customers. In the investment funds space, however, the Form CRS requirement will not impact some investment advisers because the clients of those investment advisers are not “retail investors” but are instead the funds themselves. On the other hand, broker-dealers in the investment funds space, may provide services generally to retail investors, so Form CRS will affect broker-dealers in this space more broadly. And of course, as you pointed out earlier David, all of us will have to monitor the lawsuits that have been brought challenging the SEC’s rules. Despite these lawsuits, I would strongly urge all firms that are affected by the new rules to prepare for the implementation of Reg BI and Form CRS. We simply don’t know how those lawsuits will be resolved and it would be unwise to ignore the rules that have been adopted.
Thank you, David. And thank you to our listeners. For more information on the topic we discussed today, or other topics of interest to the fund community, please visit our website at www.ropesgray.com. And of course, if we can help you navigate any of these areas, please don’t hesitate to contact either one of us.
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