Hillel T. Cohn, Susan I. Gault-Brown, Lloyd S. Harmetz, and Kelley A. Howes
Banking + Financial Services, Financial Institutions + Financial Services, Financial Technology, Financial Services, Broker-Dealer Compliance + Regulation, Corporate Finance | Capital Markets, and Investment Management
This alert is one in a series of Client Alerts on recent SEC proposals regarding regulation of broker-dealers and investment advisers.
Related alert: “The SEC’s Standard of Conduct Proposals Would Raise the Bar on Investment Advisers”“SEC Proposes Simplified Relationship Summary for Broker-Dealers and Investment Advisers to Use with Retail Investors”
For many years, the distinction between investment advisers and broker-dealers was clear: investment advisers were counselors who were expected to provide advice that was in the best interest of their clients, while broker-dealers were salesmen, offering a range of investment products and services. Although broker-dealers often provide investment advice in the course of conducting their business, they are exempt from the requirements of the Investment Advisers Act of 1940, provided that the advice they furnish is “incidental” to their business and they do not separately charge for the advice. Thus, broker-dealers have generally not been subject to the fiduciary obligations imposed upon investment advisers, except when the broker-dealers exercise discretionary authority over client accounts. Although not fiduciaries, broker-dealers are subject to a comprehensive regulatory scheme under the Securities Exchange Act of 1934 (the “Exchange Act”) and are required to recommend investments that are “suitable” for their clients.
Over time, the distinctions between broker-dealers and investment advisers began to blur, with full-service brokers increasingly focused on asset-gathering and fee-based accounts. Moreover, many broker-dealers began to refer to their representatives as “financial advisers.” Congress concluded that there was a significant degree of confusion among retail investors regarding the respective roles and duties of broker-dealers and investment advisers. In Section 913 of the Dodd-Frank Act, Congress directed the Securities and Exchange Commission (SEC) to study the implications resulting from the different standards applicable to broker-dealers and investment advisers and empowered the SEC to adopt a uniform fiduciary standard for broker-dealers and investment advisers.
The prospect of being deemed “fiduciaries” posed three significant issues for broker-dealers:
Recognizing these concerns, Congress included in Section 913 of the Dodd-Frank Act a provision stating that the receipt of commissions or other “standard” forms of compensation by broker-dealers would not, in and of itself, violate any fiduciary duty that the SEC might implement. An SEC Staff Study released in 2011 recommended the adoption of a uniform fiduciary standard. The SEC conducted further evaluation of the potential uniform fiduciary standard but did not adopt a new standard of care for broker-dealers.
While the SEC remained on the sidelines, the Department of Labor (DOL) adopted its own rules addressing retail retirement accounts. The DOL fiduciary rule as originally adopted in 2016 was in many respects the worst nightmare come true for the brokerage community. Broker-dealers making any kind of investment recommendation to retail retirement investors would be deemed fiduciaries and would be prohibited from acting in a principal capacity or from receiving commissions except to the extent they complied with onerous Prohibited Transaction Exemptions. The DOL fiduciary rule was the subject of much criticism and many legal challenges, one of which resulted in a decision by the Fifth Circuit Court of Appeals in March 2018 that vacated the rule. As of the date of this Alert, it is not clear if the DOL will appeal the Fifth Circuit decision.
After being on the sidelines for some time, the SEC re-entered the fray on April 18, 2018 with a package of proposals intended to address the concerns identified by Congress in Section 913 of Dodd-Frank. That package includes a new Regulation Best Interest for broker-dealers and their associated persons when dealing with retail customers.
Regulation Best Interest – Purpose and Overview
The proposed Regulation Best Interest would establish a higher standard of care and disclosure for broker-dealers when making recommendations to retail customers; however, it would not create an explicit fiduciary duty. In this proposal, the SEC has refrained from adopting a uniform fiduciary standard for broker-dealers and investment advisers, as authorized by Section 913(g) of Dodd-Frank, and instead opted for new rules under Section 913(f) of Dodd-Frank, which authorizes rulemaking to address the “regulatory standards of care…for providing personalized investment advice” to retail customers.
Under the proposed regulation, broker-dealers and their associated persons would be required to act in the “best interest” of their retail clients and would be prohibited from placing their interests ahead of such clients. Broker-dealers could continue to act in a principal capacity in relation to their customers and could continue to receive commissions and other forms of transaction-based compensation. The SEC acknowledged that such practices constitute conflicts of interest that are “embedded” in the relationship between a broker-dealer and its customers. Rather than prohibit all such conflicts, however, the SEC is proposing more rigorous requirements to manage and disclose conflicts of interest, including conflicts that arise from the manner in which a broker-dealer is compensated.
The SEC explicitly noted that, while it wants to address gaps in customer protection and customer expectations, it also wants to preserve the commission-based model as a viable alternative form of account for retail investors. The SEC emphasized that some investors are better served by a commission-based account as opposed to a fee-based account. Moreover, the SEC expressed concern that imposing a standard that proved too burdensome for broker-dealers could result in reducing retail investor access to a wide range of investment products.
Although Regulation Best Interest introduces a new standard of care, it generally is flexible in permitting broker-dealers to design compliance policies and procedures that are suitable for the broker-dealer’s business. The Regulation tends to avoid prescriptive requirements based on the SEC’s observation that one size will not fit all when determining how best to ensure compliance.
The Best Interest Standard
Regulation Best Interest would require broker-dealers and their associated persons to act in the “best interest” of their retail clients when making investment recommendations. The key term – “best interest” – is not defined in the Regulation. The SEC states that determining what constitutes the best interest of a specific customer at a specific point in time will be a facts and circumstances test. A number of commentators and several SEC Commissioners have criticized the failure to define “best interest.” However, given the many variables that will bear upon the question of what constitutes the best interest of an investor at a particular point in time, it is difficult to envision a workable definition, as opposed to a list of significant factors that might be considered in evaluating best interest.
The Regulation will be applicable whenever a broker-dealer or its associated persons recommend to a retail customer a securities transaction or an investment strategy involving securities. The SEC proposes to utilize the guiding principles endorsed by the Financial Industry Regulatory Authority, Inc. (FINRA) for determining what constitutes a “recommendation.” “Retail customer” is defined to include any person or their legal representative who is investing for personal, family or household purposes. There is no distinction in this regard for high net worth or very sophisticated individual investors.
A broker-dealer would not be permitted to use the term “adviser” or “advisor” for its associated persons, unless such individuals are also representatives of a registered investment adviser.
Regulation Best Interest would not be a scienter-based requirement. In other words, violations of the Regulation may be found in cases where the broker-dealer was negligent; there is no requirement that violations be predicated on wrongful intent.
The Regulation states that a broker-dealer and its associated persons may not place their own interests ahead of the interests of a retail customer. The SEC chose this formulation rather than the construct used by the DOL, which stated that a fiduciary must act in the best interest of its client “without regard” for the interests of the fiduciary. The SEC indicated the “without regard” standard implies a requirement to eliminate all interests of the broker-dealer that might conflict with those of the customer. Such an approach is unrealistic in the SEC’s view given the inherent conflicts that exist in the broker-dealer business model.
Regulation Best Interest includes a pathway for compliance that could function as an effective safe harbor. The Regulation provides that a broker-dealer will be deemed to have acted in the best interest of its customer if:
The Disclosure Obligation
The Disclosure Obligation would work in tandem with proposed Form CRS, which was another part of the package of proposals introduced by the SEC on April 18, 2018. As proposed, Form CRS would be delivered by all broker-dealers and investment advisers to retail investors upon account opening. Form CRS would contain certain high-level disclosures about the nature of the relationship, services to be provided, fees and charges and conflicts of interest.
The SEC noted that it expects some of the required disclosures under Regulation Best Interest could be made through Form CRS or in other formats at the time of account opening. However, certain disclosures, such as a material conflict related to a specific investment recommendation, would likely need to be made at the point-of-sale. In this regard, the SEC indicated it anticipates broker-dealers would utilize “layered disclosure” that would combine disclosures at the account opening stage with periodic updates and point-of-sale disclosures to meet the Disclosure Obligations of Regulation Best Interest.
While the SEC stated that it intended to provide broker-dealers with flexibility in meeting their disclosure obligations, it is essential that the disclosures be made sufficiently prior to the point-of-sale to enable investors to give them proper consideration. Moreover, the SEC emphasized that the disclosures should be concise and in Plain English.
The Care Obligation
The Care Obligation closely tracks FINRA’s current suitability rule but requires that the evaluation be focused on what is in the best interest of the customer, not what is suitable for the customer. Thus, a broker-dealer will be required to evaluate (i) whether an investment product or strategy could be in the best interest of some investors, (ii) whether it is in the best interest of a specific investor and (iii) whether, when viewed with other transactions effected by such investor, it is in their best interest from a quantitative point of view (i.e., no excessive trading or churning). These tests align with the “reasonable basis suitability,” “customer specific suitability” and “quantitative suitability” currently found in FINRA Rule 2111.
The broker-dealer would be expected to exercise “reasonable diligence, care, skill and prudence” in undertaking these evaluations. The SEC indicates that this is intended to be an objective standard based on “prudent man” standards and industry norms. These evaluations would require broker-dealers to obtain information from their clients regarding their investment objectives, risk tolerance, financial circumstances, etc. The SEC notes that broker-dealers would not be required to evaluate the entire universe of available investment products, but would be expected to undertake a review of a sufficiently broad number of investment products in order to satisfy the reasonable diligence requirement.
As part of its proposal, the SEC would amend Rule 17a-3 under the Exchange Act to add a requirement that broker-dealers maintain the information furnished by customers as well as communications from the broker-dealer documenting their compliance with the Care Obligation of Regulation Best Interest.
The SEC noted that certain fact patterns suggest that a particular recommendation might not be in the best interest of a client and should be carefully scrutinized under the Care Obligation. For example, if a product is more expensive than comparable products, it might be difficult to conclude that the product is in the best interest of the customer. Similarly, the fact that a broker receives higher compensation for selling a particular product as compared to other products with comparable features indicates that the broker might be placing its interests ahead of its customer.
The SEC has indicated that, while costs and broker remuneration are important factors to be considered, they are not the only factors, and broker-dealers should also consider expected product performance in anticipated market conditions, risks, liquidity and volatility among other factors in evaluating whether a product or strategy is in the customer’s best interest. The broker-dealer should be able to demonstrate its reasoning in concluding that a higher-priced or more remunerative product or strategy is in fact in the customer’s best interest.
Similarly, the SEC indicated that it did not intend to eliminate higher-risk products, recognizing that, in certain circumstances, such products could be in the best interest of certain investors. Once again, the obligation will be on the broker-dealer to evaluate these products and document its basis for recommending a higher-risk or higher-cost product.
Importantly, the SEC has asserted that the Care Obligation imposes a standard of care that must be met irrespective of any related disclosures to the customer. It cannot be waived by the customer, nor can the broker-dealer cure any failure to meet the obligation through disclosure.
The Conflict of Interest Obligation
The SEC recognizes that there are many potential conflicts inherent in the broker-dealer business, such as those that arise from a broker-dealer’s compensation arrangements or a broker-dealer acting as a principal or selling proprietary products. The SEC chose not to prohibit any specific conflicts of interest. However, in Regulation Best Interest, it does intend to impose a more rigorous regime for management and disclosure of material conflicts of interest.
Under the proposal, a broker-dealer must have policies and procedures reasonably designed in light of the nature of its business to identify conflicts of interest. The procedures should be dynamic so that new conflicts can be identified as they arise. The policies and procedures must also provide for timely disclosure of material conflicts of interest unless the conflict has been eliminated.
A broker-dealer’s policies must also specifically address how conflicts of interest arising from remuneration arrangements will be mitigated. Disclosure alone will not suffice in the case of conflicts that relate to financial incentives or the manner in which associated persons are compensated. In this regard, the SEC suggested that certain sales incentives are best avoided, such as sales contests, sales-based vacation awards, etc. Other internal compensation arrangements should be carefully reviewed to ensure that they do not incentivize sales activity that would be inconsistent with the customer’s best interest. For example, compensation schemes that provide for higher payouts on certain products as compared to other products in the same product class with similar features are potentially problematic. Similarly, bonus arrangements that disproportionately reward increased sales activity could pose issues. The SEC has stated that disclosure will not necessarily cure such problems, and broker-dealers need to actively mitigate such conflicts.
The SEC also advised that in some other cases, disclosure will not suffice, and it will be incumbent on the broker-dealer to eliminate the conflict. For example, conflicts that cannot be effectively disclosed in straightforward language, or conflicts that cannot be adequately policed to ensure they are not incentivizing improper sales activity, may need to be eliminated.
The requirement to mitigate and potentially eliminate certain conflicts of interest is a departure from the SEC’s historical reliance upon full and fair disclosure to allow investors to make informed investment decisions. While the SEC has chosen not to prohibit any specific conflicts of interest, Regulation Best Interest will place the burden on broker-dealers to carefully evaluate potential conflicts of interest with retail customers in order to determine which conflicts must be eliminated or mitigated. To some extent, the brokerage industry has already begun this process through its preparations to comply with the DOL fiduciary rule. Internal compensation arrangements in particular should be scrubbed in order to minimize or eliminate compensation terms that could incentivize improper sales activity.
It appears that, while several of the SEC Commissioners raised concerns about various aspects of Regulation Best Interest, a majority are intent upon adopting a new standard of care for broker-dealers. Regulation Best Interest as proposed is likely to undergo some revisions based on the views expressed by Commissioners, as well as based upon comments received during the 90-day comment period. Some critics of the proposal have expressed the view that Regulation Best Interest effectively preserves the status quo for broker-dealers and fails to meaningfully increase the protection of retail investors. The failure to define “best interest” and the failure to prohibit certain conflicts have drawn particular criticism. Although the proposal may undergo some changes, the essential terms of the Regulation are likely to remain a “best interest” standard coupled with a more rigorous regime for management and disclosure of conflicts of interest.
While the brokerage industry is still evaluating the proposal, initial responses are generally positive. Many brokers had already begun implementation of a best interest standard of care to comply with the DOL fiduciary rule as well as to meet heightened customer expectations. The fact that Regulation Best Interest explicitly permits commissions and principal transactions is a welcome development, as is the flexibility built into the Regulation that should enable broker-dealers to develop policies that are sensible for their business.
However, that very flexibility will also pose some challenges. For example, how exhaustive an analysis of potential investment products is required to determine which products are in the customer’s best interest? Under what circumstances would a potential for a higher return on investment justify higher commissions or fees? What conflicts are so grave that they cannot be cured by disclosure?
The final rule may provide further insight as to how such questions may be best resolved.
 Chamber of Commerce of the U.S.A. v. U.S. Dep’t of Labor, No. 17-10238, (5th Cir. Mar 15, 2018).
 FINRA recently proposed amendments to the quantitative suitability requirements contained in Rule 2111. See our recent blog post.
 Commissioners Stein and Jackson expressed the view that the Regulation does not go far enough to protect retail investors.
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