Fiduciary Governance Blog

Weekend Reading: SEC Issues Interpretive Release on Investment Adviser Standard of Conduct

In conjunction with the passage of Regulation BI and the adoption of Form CRS, on June 5, 2019, the Securities and Exchange Commission issued a wide-ranging Interpretive Release that “reaffirms” and “clarif[ies]” certain aspects of the fiduciary duty that an investment adviser1 owes to its clients under Section 206 of the Investment Advisers Act of 1940. This Client Alert focuses on the practical implications of the SEC’s views on the scope of an adviser’s fiduciary duty to clients. Investment advisers registered with the SEC should take the SEC’s views contained in the Interpretive Release into account as they manage their business.

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Overall, the SEC stated that an investment adviser’s fiduciary duty is broad, applies to the entire adviser-client relationship and is made enforceable by the anti-fraud provisions of the Advisers Act. The Interpretive Release emphasizes the SEC’s specific view that an adviser’s fiduciary duty under the Advisers Act is comprised of both the duty of loyalty and the duty of care, which, when combined and in light of the adoption of Regulation BI,2 can be characterized as requiring an investment adviser “to act in the best interests of its clients at all times.

The SEC further explained that an adviser’s fiduciary duty follows the contours of the relationship between the adviser and its client, who may shape their relationship by agreement, provided that there is full and fair disclosure and informed consent.

Finally, the SEC specifically warned the industry that an adviser may not waive its fiduciary duty.3

WHAT IS THE DUTY OF CARE?

The SEC stated that the duty of care requires an adviser to provide investment advice in the best interests of its clients based on clients’ objectives. The SEC provided specific guidance by which an adviser can exercise care in its relationship with its clients as follows.

An Adviser Must Provide Advice That Is in the Best Interests of the Client

Notably, the SEC stated that an adviser needs to provide advice that is suitable for each client. In order to provide such advice, an adviser must have a reasonable understanding of each client’s objectives.

For retail clients, the SEC stated that an adviser should:

  • At a minimum, make a reasonable inquiry into the client’s financial situation, level of financial sophistication, investment experience and financial goals (i.e., understand the “investment profile”).
  • Update the client’s investment profile in order to maintain a reasonable understanding of the client’s objectives and adjust the advice to reflect any changed circumstances.4

For institutional clients, the SEC explained that the nature and extent of the reasonable inquiry into clients’ objectives generally is shaped by the specific investment mandates from those clients.5

For pooled vehicles, the SEC explained that the adviser would need to have a reasonable understanding of the fund’s investment guidelines and objectives.

An Adviser Must Have a Reasonable Belief That Advice Is in the Best Interests of the Client

The SEC confirmed that the duty of care includes the requirement that the adviser have a reasonable belief that advice is in the best interests of clients, and it provided specific guidance as to how an adviser can form that reasonable belief, noting the following:

  • The adviser should evaluate its advice in the context of the portfolio that it is managing for the client and the client’s objectives, taking into account the nature of the client (i.e., whether the client is a retail or an institutional client).
  • For high-risk products – such as penny stocks or other thinly traded securities – the adviser should generally apply heightened scrutiny to whether such investments fall within a retail client’s risk tolerance and objectives. A similar standard applies to complex products – such as leveraged or inverse exchange-traded funds (i.e., those designed primarily as short-term trading tools for sophisticated investors) – to the extent these products were in the best interests of a retail client initially, they would require daily monitoring.
  • The adviser should conduct a reasonable investigation into the investment so as not to base its advice on materially inaccurate or incomplete information.
  • The adviser should examine the cost (including fees and compensation) associated with investment advice, as well as the product’s or strategy’s investment objectives, characteristics (including any special or unusual features), liquidity, risks and potential benefits, volatility, likely performance in a variety of market and economic conditions, time horizon, and cost of exit.6

Finally, the SEC explained that the duty of care applies to all investment advice provided to clients, including advice about investment strategy, engaging a subadviser and account type.7

Duty to Seek Best Execution

Consistent with its prior statements, the SEC also specifically stated that an investment adviser’s duty of care includes a duty to seek best execution of a client’s transactions where the adviser has the responsibility to select broker-dealers to execute client trades. In meeting this obligation, the SEC stated that an adviser must seek to obtain the execution of transactions for each of its clients “such that the client’s total cost or proceeds in each transaction are the most favorable under the circumstances.” In seeking to further define this obligation of care, the SEC stated:

  • An adviser should seek to obtain the execution of securities transactions on behalf of a client with the goal of maximizing value for the client under the particular circumstances occurring at the time of the transaction.
  • An adviser should consider “‘the full range and quality of a broker’s services in placing brokerage including, among other things, the value of research provided as well as execution capability, commission rate, financial responsibility, and responsiveness’ to the adviser.” In other words, the SEC stated that the “determinative factor” is not the lowest possible commission cost “but whether the transaction represents the best qualitative execution.”
  • An investment adviser should “periodically and systematically” evaluate the execution of transactions it is handling for clients.

Duty to Provide Advice and Monitoring Over the Course of the Relationship

Finally, the SEC stated for the first time that an investment adviser’s duty of care encompasses the duty to provide advice and monitoring at a frequency that is in the best interests of the client, taking into account the scope of the agreed relationship.8 The SEC stated that as a general matter, an adviser’s duty to monitor extends to all personalized advice it provides to the client, including, for example, in an ongoing relationship, an evaluation of whether a client’s account or program type continues to be in the client’s best interests.

WHAT IS THE DUTY OF LOYALTY?

The second part of the Interpretive Release contained the SEC’s views on the duty of loyalty, which the SEC consistently has interpreted to mean that an adviser may not subordinate its clients’ interests to its own. The SEC stated that in order to meet its duty of loyalty, an adviser must make full and fair disclosure to its clients of all material facts relating to the advisory relationship, including the capacity in which the firm is acting with respect to the advice provided.9

In addition, the SEC stated that an adviser must eliminate, or at least expose through full and fair disclosure, all conflicts of interest “which might incline an investment adviser – consciously or unconsciously – to render advice which was not disinterested.” Finally, the SEC explained that whether disclosure is full and fair will depend on, among other things, the nature of the client, the scope of the services, and the material fact or conflict.10

To illustrate what it views as full and fair disclosure, the SEC provided guidance on the appropriate level of specificity that advisers should attain in their disclosure, and also discussed the considerations that investment advisers should take into account for disclosure regarding conflicts related to the allocation of investment opportunities among eligible clients.

Specificity of Disclosure

  • The SEC explained that for disclosure to be full and fair, it should be sufficiently specific so that a client is able to understand the material fact or conflict of interest and make an informed decision about whether to provide consent.
  • Moreover, the SEC explained that disclosure that an adviser “may” have a particular conflict, without more details, is not adequate if conflict actually exists.
  • The SEC elaborated that it would consider the use of “may” in disclosure to be inappropriate when the conflict exists with respect to some (but not all) types or classes of clients, advice, or transactions without additional disclosure specifying the types or classes of clients, advice, or transactions with respect to which the conflict exists.11

Trade Allocations

  • The SEC reaffirmed its prior position on how an adviser can meet its duty of loyalty with regard to trade allocations by noting that when an advisor allocates investment opportunities among eligible clients, the duty of loyalty requires the adviser to eliminate or at least expose through full and fair disclosure the conflicts associated with its allocation policies – including how the adviser will allocate investment opportunities – such that a client can provide informed consent.
  • The SEC confirmed that when allocating investment opportunities, an adviser is permitted to consider the nature and objectives of the client and the scope of the relationship and need not have pro rata allocation policies or any particular method of allocation.

In responding to commenters who objected to what they saw as subjectivity in the SEC’s proposed use of the term “informed” to describe a client’s consent to disclosed conflict, the SEC explained that full and fair disclosure does not require advisers to make an affirmative determination that a particular client understood the disclosure and that the client’s consent to the conflict of interest was informed. Rather, the SEC stated that the disclosure should be designed to put a client in a position to be able to understand and provide informed consent to the conflict of interest.12

Finally, in what can only be viewed as a warning to the industry, the SEC stated that some conflicts may be of such a nature and extent that it would be difficult to provide disclosure to clients that “adequately conveys the material facts or the nature, magnitude, and potential effect of the conflict sufficient for a client to consent to or reject it.” The SEC further warned that in some instances, disclosure may not be specific enough for a client to understand whether and how the conflict could affect the advice it receives. Specifically, for retail clients in particular, the SEC stated that where there are complex or extensive conflicts, it may be difficult to provide disclosure that is sufficiently specific but also understandable. In summary, the SEC stated that when an investment adviser cannot fully and fairly disclose a conflict of interest to a client such that the client can provide informed consent, the adviser should either eliminate the conflict or adequately mitigate (i.e., modify practices to reduce) the conflict such that full and fair disclosure and informed consent are possible.

CONSEQUENCES OF THE ADOPTION OF THE INTERPRETIVE RELEASE

Although the industry currently is digesting the suite of regulatory changes that the SEC adopted, given that the Interpretive Release becomes effective immediately, registered investment advisers should promptly consider examining their businesses for compliance with the Interpretive Guidance. Certain of the questions that we believe registered investment advisers need to ask include:

  • Does my code of ethics or other foundational governing document lay out that my business should be run to ensure that my business conducts itself as a fiduciary and in the best interests of our clients at all times?
  • Do my existing advisory contracts clearly describe the contours of the relationship and the services provided, and does that the contract, along with other disclosure documents, provide for full and fair disclosure and informed consent?
  • Do my advisory contracts have “hedge clauses,” and if so, are those clauses consistent with the guidance contained in the Interpretive Release?
  • Do I have sufficient processes to understand each client’s investment profile? And do I update that profile timely to reflect changed circumstances?
  • Does my firm have policies and procedures designed to provide me with a reasonable belief that the advice I provide is in my clients’ best interests? Do those policies and procedures address high-risk products for my “retail” clients? Do those policies and procedures include guidance on selecting account types and dealing with rollovers, including for prospective clients? Have I addressed each of the above questions if my firm also is registered as a broker-dealer?
  • Is how I define “best execution” in my standard advisory contract or Form ADV, Part 2, consistent with the definition contained in the Interpretive Release? Do I have best execution policies and procedures, and do those procedures require me to periodically and systematically evaluate execution on behalf of my clients?
  • Have I adopted policies and procedures designed to ensure that I monitor my clients’ accounts at an appropriate frequency and consistent with my advisory contracts?
  • Do I use the word “may” or similar words appropriately within my disclosure documents?
  • Do my trade allocation procedures consider the nature and objectives of each client and the scope of each relationship?

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1 The SEC specifically noted that the Interpretive Release applies to “robo” or “automated” advisers.

2 For an overview of the impact of Regulation BI and Form CRS, please see SEC Adopts Regulation Best Interest, Form CRS, and Advisers Act Interpretations, Risk&Reward, June 6, 2019.

3 The SEC specifically stated that a contract containing (i) a statement that the adviser will not act as a fiduciary, (ii) a blanket waiver of all conflicts of interest or (iii) a waiver of any specific obligation under the Advisers Act would be inconsistent with the Advisers Act, regardless of the sophistication of the client.

Moreover, in an interesting note, the SEC withdrew the Heitman Capital Management LLC SEC Staff No-Action Letter (Feb. 12, 2007) with regard to an adviser’s ability to use a “hedge clause” within an advisory contract (i.e., where the contract seeks to relieve the adviser from liability for conduct as to which the client has a nonwaivable cause of action against the adviser provided by state or federal law). Rather, the SEC stated that whether a hedge clause violates the Advisers Act’s anti-fraud provisions depends on all the surrounding facts and circumstances, including the particular circumstances of the client (e.g., sophistication). However, the SEC warned that there are few (if any) circumstances in which a hedge clause in an agreement with a retail client would be consistent with those anti-fraud provisions. The SEC further noted that whether a hedge clause in an agreement with an institutional client would violate the Advisers Act’s anti-fraud provisions will be determined based on the particular facts and circumstances.

4 According to the SEC, the frequency with which an adviser must update a client’s investment profile should be based on facts and circumstances, including whether the adviser is aware of events that have occurred that could render inaccurate or incomplete the investment profile on which the adviser currently bases its advice.

5 Interestingly, the SEC did not define what it views to be a “retail” versus an “institutional” client. While reference can certainly be drawn to definitions contained in Regulation BI and elsewhere throughout the federal securities laws, this lack of definition might have been deliberate so as to allow each adviser to assess how to classify its client base based on its own facts and circumstances.

6 According to the SEC, when an adviser considers similar investment products or strategies, the adviser would not satisfy its fiduciary duty by simply advising the client to invest in the lowest-cost investment product or strategy without further analysis of other factors. In that regard, the SEC stated that an adviser can recommend a higher-cost investment or strategy if the adviser reasonably concludes that there are other factors about the investment or strategy that outweigh cost and make the investment or strategy one that is in the best interests of the client, in light of that client’s objectives.

7 The SEC stated that advice about account type includes advice about whether to open or invest through a certain type of account (e.g., a commission-based brokerage account or a fee-based advisory account) and advice about whether to roll over assets from one account (e.g., a retirement account) into a new or existing account that the adviser or an affiliate of the adviser manages. The SEC also specifically stated that an adviser should consider all types of accounts offered by the adviser and acknowledge to a client when the account types the adviser offers are not in the client’s best interests. The SEC also noted that investment advisers have a fiduciary duty to “prospective” clients under the anti-fraud provisions of the Advisers Act – our view about these SEC pronouncements is that the SEC was indicating that an investment adviser cannot make materially misleading statements or omissions to prospective clients to induce them to become a client, and investment advisers must be able to provide appropriate advice to the client before the relationship formally starts.

8 The SEC indicated that an adviser and client may agree to the “scope” of the frequency of such monitoring, provided that there is full and fair disclosure and informed consent. In an important note, the SEC emphasized that the frequency of monitoring, as well as any other material facts relating to the agreed frequency, will be “a material fact relating to the advisory relationship about which an adviser must make full and fair disclosure and obtain informed consent.”

9 The SEC noted the importance of disclosure for dual registrants, stating that disclosure may be accomplished through a variety of means, including, among others, written disclosure at the beginning of a relationship that clearly sets forth when a dual registrant would act in an advisory capacity and how it would provide notification of any changes in capacity.

10 The SEC helpfully noted that full and fair disclosure for an institutional client (including the specificity, level of detail and explanation of terminology) can differ from full and fair disclosure for a retail client because institutional clients generally have a greater capacity and more resources than do retail clients to analyze and understand complex conflicts and their ramifications.

11 The SEC further explained that the use of “may” in disclosure would be inappropriate if it simply precedes a list of all possible or potential conflicts regardless of likelihood and obfuscates actual conflicts to the point that a client cannot provide informed consent. On the other hand, the SEC noted that the word “may” could be appropriately used to disclose to a client a potential conflict that does not currently exist but might reasonably present itself in the future.

12 The SEC explained that a client’s informed consent can be either explicit or, depending on the facts and circumstances, implicit. Importantly, the SEC indicated that such consent need not be in writing – for example, the SEC stated that an adviser could provide appropriate disclosure through a combination of Form ADV and other disclosure and the client could implicitly consent by entering into or continuing the advisory relationship. Finally, the SEC noted that it would not be consistent with an adviser’s fiduciary duty to infer or accept client consent where the adviser was aware, or reasonably should have been aware, that the client did not understand the nature and import of the conflict.

Webcast on July 9: Practical Effects of Regulation Best Interest, Form CRS and Advisers Act Interpretations on Broker-Dealers, Investment Advisers and Investment Companies

On July 9 at 2 p.m. EDT, Larry Stadulis, Sara Crovitz and John Baker of Stradley’s Fiduciary Governance Group will host a free webcast titled “Practical Effects of Regulation Best Interest, Form CRS and Advisers Act Interpretations on Broker-Dealers, Investment Advisers and Investment Companies.” They will discuss Regulation Best Interest, Form CRS and other rules and interpretations, and their effect on registered investment advisers, registered broker-dealers and investment companies.

Register to view the webcast here.

Impact of New SEC Regulation Best Interest and Other Standards of Conduct Rules on Broker-Dealers, Investment Advisers and Investment Companies

In addition to yesterday’s preliminary analysis and next week’s deep-dive, on July 31 @ 1:00 pm EDT, Larry Stadulis, Sara Crovitz and John Baker will host an on-demand webinar to discuss yesterday’s adoption of Regulation Best Interest, Form CRS and other rules and interpretations, and their effect on registered investment advisers, registered broker-dealers and investment companies. They will explain the practical implications for broker-dealers, investment advisers and investment companies on the Securities and Exchange Commission’s (SEC) new standard of conduct rules and guidance. Specifically, they will discuss:

  • Regulation Best Interest: How and why the SEC adopted, and the implications for firms of, a standard of conduct for broker-dealers and their associated natural persons when making a recommendation to a retail customer of any securities transaction or investment strategy involving securities.
  • Form CRS: How and why the SEC adopted, and the implications for firms of, a requirement for registered investment advisers and registered broker-dealers to provide a Form CRS relationship summary to retail investors.
  • Standard of Conduct for Investment Advisers: How and why the SEC adopted, and the implications for firms of, an interpretation of the standard of conduct for investment advisers.
  • “Solely Incidental”: How and why the SEC adopted, and the implications for firms of, an interpretation of the “solely incidental” prong of section 202(a)(11)(C) of the Investment Advisers Act of 1940, which provides that the term “investment adviser” does not include any broker or dealer whose performance of investment advisory services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefor.

Registration for the webinar can be found here. The webinar will supplement yesterday’s Risk & Reward analysis and our upcoming more detailed analysis, currently slated for next week or soon thereafter.

SEC Adopts Regulation Best Interest, Form CRS, and Advisers Act Interpretations

The Securities and Exchange Commission (“SEC”) has adopted a package of rules and interpretations governing the standards of conduct of broker-dealers and investment advisers and their associated persons, along with related disclosure requirements. The controversial actions were adopted on June 5, 2019, by a vote of 3 – 1, with Commissioner Robert Jackson dissenting on each vote. The rulemaking package consists of four separate actions:

  • Regulation Best Interest (“Regulation BI”) establishes a code of conduct for broker-dealers when making recommendations to retail customers.1
  • Registered broker-dealers and registered investment advisers will be required to provide a standardized relationship summary to retail investors on Form CRS.2
  • The SEC published an interpretation of the standard of conduct for investment advisers under the Investment Advisers Act of 1940 (“Advisers Act”).3
  • The SEC also published an interpretation of Section 202(a)(11)(C) of the Advisers Act, which excludes from the definition of “investment adviser” any broker-dealer that provides advisory services when such services are “solely incidental” to the conduct of the broker-dealer’s business.4

This Client Alert provides our initial, high  level summary of the SEC actions. We will be following up in the near future with a much more detailed analysis. In addition, as discussed below, we will be participating next month in a webinar that will examine the actions more thoroughly. In the meantime, please feel free to contact one or more of the individuals identified at the end of this Alert if you have specific comments or questions.

Overview

At a high level, the SEC’s final actions are consistent in content and scope with what it proposed.5 Consistent with its approach in the proposing releases, the SEC ultimately chose not to impose a uniform fiduciary duty on broker-dealers and investment advisers. Instead, it elected to enhance the obligations of broker-dealers to bring them more closely in line with those of investment advisers. These enhanced obligations are derived in part from fiduciary principles, but the SEC did not characterize them as imposing actual fiduciary status on broker-dealers.

Despite the SEC’s efforts to harmonize the obligations of broker-dealers and investment advisers, they will continue to be subject to different standards of conduct. Consequently, broker-dealers and investment advisers and their counsel will continue to have to consider and address the complexities associated with these different regulatory regimes.

Much of what is expected under the rules and forms, particularly Regulation BI, is not in the rules or forms themselves. Instead, important guidance is set forth in the releases. A thorough and detailed review of the SEC releases is critical to understanding the SEC actions and complying with them.

Regulation BI

The most prominent element of the rulemaking package is Regulation BI, which is Rule 15l-1 under the Securities Exchange Act of 1934. This “regulation” (really just a single rule) enhances the existing standard of conduct applicable to broker-dealers (and their associated persons who are natural persons) at the time they recommend to a retail customer a securities transaction or investment strategy involving securities. Notably, this includes recommendations of account types and rollovers or transfers of assets (e.g., to roll over or transfer assets in a workplace retirement plan to an individual retirement account). “Recommendations” also include implicit hold recommendations resulting from agreed-upon account monitoring.

General

Regulation BI requires that a broker-dealer, when making a recommendation, act in the retail customer’s best interest and not place its own interests ahead of the customer’s interests. This general obligation is satisfied only if the broker-dealer complies with four specified component obligations, referred to as the Disclosure Obligation, the Care Obligation, the Conflict of Interest Obligation, and the Compliance Obligation (collectively, the “Obligations”).

A customer’s “best interest” is not expressly defined. Whether a broker-dealer has acted in the customer’s best interest will turn on an objective assessment of the facts and circumstances of how the specific components of Regulation BI, including the Obligations, are satisfied at the time that the recommendation is made (and not in hindsight).

The Regulation BI standard is not a fiduciary standard, but it includes key elements that are similar to key elements of the fiduciary standard for investment advisers. The SEC’s intention is that, regardless of whether a retail investor chooses a broker-dealer or an investment adviser, the retail investor will be entitled to a recommendation or advice that is in the best interest of the retail investor and that does not place the interests of the firm or the financial professional ahead of the interests of the retail investor.

Regulation BI does not apply to advice provided by a broker-dealer that is dually registered as an investment adviser (“dual registrant”) when acting in the capacity of an investment adviser.  A dual registrant acts in the capacity of an investment adviser solely with respect to accounts for which the dual registrant provides advice and receives compensation that subjects it to the Advisers Act.

SEC Chairman Jay Clayton noted that he anticipates that FINRA will need to review and revise its rulebook and examination program in light of the enhanced broker-dealer standard of conduct reflected in Regulation BI.6

The Department of Labor has already indicated informally that it will pursue rulemakings and other guidance that “align” with Regulation BI. We expect that to occur this year, most likely in the Fall.

It is too early to tell whether these new rules will assuage the concerns of those states that have already introduced legislation or regulations aimed at governing broker-dealer and investment adviser standards of conduct (although the initial reaction is not promising). New Jersey and Nevada are the most notable examples to date.

Disclosure Obligation

Under the Disclosure Obligation, before or at the time of the recommendation, a broker-dealer must disclose, in writing, all material facts about the scope and terms of its relationship with the customer. This includes a disclosure that the firm is acting in a broker-dealer capacity; the material fees and costs the customer will incur; and the type and scope of the services to be provided, including any material limitations on the recommendations that could be made to the retail customer.

The broker-dealer must also disclose all material facts relating to conflicts of interest that are associated with the recommendation. A conflict of interest is defined as an interest that might incline a broker-dealer or associated person – consciously or unconsciously – to make a recommendation that is not disinterested.

In connection with its proposal of Form CRS, the SEC initially proposed a rule specifically prohibiting the use of “adviser” or “advisor” by brokerage personnel not subject to the Advisers Act. The SEC did not adopt this rule, but it states that the use of these terms in a name or title by a broker-dealer (that is not also an investment adviser) or associated person (that is not also a supervised person of an investment adviser) would be a violation of the capacity disclosure requirement.7 The SEC recognizes that there are exceptions to this general rule, such as for municipal advisors, commodity trading advisers, and advisors to special entities.

Care Obligation

Under the Care Obligation, a broker-dealer must exercise reasonable diligence, care, and skill when making a recommendation to a retail customer. The broker-dealer must understand potential risks, rewards, and costs associated with the recommendation. The broker-dealer must then consider those risks, rewards, and costs 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 and does not place the broker-dealer’s interest ahead of the retail customer’s interest. While costs must always be considered, they should be considered in light of other factors and the retail customer’s investment profile; the standard does not necessarily require the “lowest cost option.”

A broker-dealer should consider reasonable alternatives, if any, offered by the broker-dealer in determining whether it has a reasonable basis for making the recommendation. This does not require an evaluation of every possible alternative (including those offered outside the firm), nor does it require broker-dealers to recommend one “best” product. However, when a broker-dealer materially limits its product offerings to certain proprietary or other limited menus of products, it must still comply with the Care Obligation and cannot use its limited menu to justify recommending a product that does not satisfy the obligation to act in a retail customer’s best interest.

When recommending a series of transactions, the broker-dealer must have a reasonable basis to believe that the transactions taken together are not excessive, even if each is in the customer’s best interest when viewed in isolation.

Conflict of Interest Obligation

Under the Conflict of Interest Obligation, a broker-dealer must establish, maintain, and enforce reasonably designed written policies and procedures addressing conflicts of interest associated with its recommendations to retail customers. These policies and procedures must be reasonably designed to identify all such conflicts and at a minimum disclose or eliminate them.

The policies and procedures must be reasonably designed to mitigate conflicts of interests that create an incentive for an associated person to place his or her interests or the interest of the firm ahead of the retail customer’s interest. The SEC revised the mitigation requirement in the proposing release to focus on mitigating conflicts arising from associated persons’ incentives and to eliminate the distinction between financial incentives and all other conflicts of interest.

In addition, when a broker-dealer places material limitations on recommendations (e.g., offering only proprietary or other limited range of products), the policies and procedures must be reasonably designed to disclose the limitations and associated conflicts and to prevent the limitations from causing the associated person or broker-dealer to place the person’s or the firm’s interests ahead of the customer’s interest.

The policies and procedures must also be reasonably designed to identify and eliminate any sales contests, sales quotas, bonuses, and non-cash compensation (such as merchandise, gifts and prizes, travel expenses, meals and lodging) that are based on the sale of specific securities or specific types of securities within a limited period of time. The requirement is designed to eliminate such incentives when they create pressure (i) to sell a specifically identified type of security (ii) within a limited period of time. Other incentives and practices that are not explicitly prohibited are permitted, provided that the broker-dealer establishes reasonably designed policies and procedures to disclose and mitigate the incentive created to the representative, and the Care and Disclosure Obligations are complied with.

Compliance Obligation

Under the Compliance Obligation, a broker-dealer must establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Regulation BI as a whole. Thus, a broker-dealer’s policies and procedures must address not only conflicts of interest but also compliance with its Disclosure and Care Obligations.

Other Issues

The SEC will not have to show scienter (bad intent) to establish a violation of Regulation BI.

Although commenters urged the SEC to take a position that Regulation BI preempts or does not preempt state laws, the SEC chose not to do so. Instead, the SEC states that the preemptive effect of Regulation BI on any state law governing the relationship between regulated entities and their customers would be determined in future judicial proceedings based on the specific language and effect of that state law. In the open meeting, Chairman Clayton indicated that he hoped that states would work with the SEC going forward.

A broker-dealer will not be able to waive compliance with Regulation BI, nor can a retail customer agree to waive his or her protections under Regulation BI.

The SEC does not believe Regulation BI creates any new private right of action or right of rescission, nor does it intend such a result.

Compliance with Regulation BI will not alter a broker-dealer’s obligations under the general antifraud provisions of the federal securities laws. Regulation BI applies in addition to any applicable securities laws and regulations.

Form CRS Relationship Summary

The SEC has adopted rule and form amendments to require registered investment advisers and registered broker-dealers to provide a brief relationship summary to retail investors.8 The relationship summary is intended to inform retail investors about (i) the types of client and customer relationships and services the firm offers; (ii) the fees, costs, conflicts of interest, and required standard of conduct associated with those relationships and services; (iii) whether the firm and its financial professionals currently have reportable legal or disciplinary history; and (iv) how to obtain additional information about the firm. The relationship summary will have a standardized question-and-answer format and must be no longer than two pages (four pages for dual registrants). Under certain standardized headings, firms will generally use their own wording to address the required topics. Firms are encouraged to use graphics, hyperlinks, and electronic formats. If a firm uses electronic formats, there are requirements for embedded hyperlinks to facilitate layered disclosure.

The relationship summary is designed to help retail investors select or determine whether to remain with a firm or financial professional by providing better transparency and summarizing in one place selected information about a particular broker-dealer or investment adviser. The format of the relationship summary is intended to allow for comparability among the two different types of firms in a way that is distinct from other required disclosures.

The relationship summary includes a required introductory paragraph that provides a link to Investor.gov/CRS, a page on the SEC’s Office of Investor Education website that will offer educational information about investment professionals. This page currently summarizes the final release and promises future tailored information to educate retail investors about financial professionals, including tools to research firms and financial professionals, information about brokers and advisers, and information about brokers’ and advisers’ different services and fees. It also currently links to other resources that already were available on the Office of Investor Education website.

The relationship summary includes prescribed wording to describe the standard of conduct applicable to investment advisers and broker-dealers. In contrast to the proposed Form CRS, the standard of conduct is described as a “best interest” standard in all cases.9

As proposed, investment advisers must deliver a relationship summary to each new or prospective client who is a retail investor before or at the time of entering into an investment advisory contract with the retail investor. In a change from the proposal, broker-dealers must deliver the relationship summary to each new or prospective customer who is a retail investor before or at the earliest of (i) a recommendation  of an account type, a securities transaction, or an investment strategy involving securities; (ii) placing an order for the retail investor; or (iii) the opening of a brokerage account for the retail investor. Broker-dealers and investment advisers must update the relationship summary and file it within 30 days whenever any information in it becomes materially inaccurate, and any changes must be communicated to existing clients or customers within 60 days.

In the adopting release, the SEC provides for a review of the effectiveness of Form CRS. In particular, the SEC directs the staff to review a sample of relationship summaries and provide the SEC with results of this review. The directions do not include a description of the scope of the review, the timing of the review, or what the SEC will do with the staff’s report once it is provided.

Fiduciary Duty Interpretation

The SEC has issued an interpretive release on the standard of conduct for investment advisers under the Advisers Act. The release brings together in one place the SEC’s views on the fiduciary duty that investment advisers owe their clients. These views for the most part are long-standing, although the release does “clarify” certain aspects, as the SEC puts it.

The interpretation explains that an investment adviser’s obligation to act in the best interest of its client is an overarching principle that encompasses both the duty of care and the duty of loyalty. This fiduciary duty is made enforceable by the antifraud provisions of the Advisers Act. The fiduciary duty may not be waived, although it will apply in a manner that reflects the agreed-upon scope of the relationship, and the relationship may be shaped by agreement, provided that there is full and fair disclosure and informed consent.

The SEC clarified that in shaping its agreement with a client, and in considering full and fair disclosure and informed consent, an investment adviser may consider whether the client is institutional or retail. In particular, in describing full and fair disclosure, the SEC recognized that institutional clients “generally have a greater capacity and more resources than retail clients to analyze and understand complex conflicts and their ramifications.” Similarly, in describing an adviser’s duty of care, the interpretive release distinguishes between institutional and retail clients. In providing advice to institutional clients, the interpretive release recognizes that “the nature and extent of the reasonable inquiry into the client’s objectives generally is shaped by the specific investment mandates from those clients.”

An adviser’s fiduciary duty applies to all investment advice the investment adviser provides to clients, including advice about investment strategy, engaging a sub-adviser, and account type. Similar to Regulation BI and in a clear reference to the fiduciary duty rulemaking efforts of the Department of Labor, the interpretive release clarifies that account type includes “advice about whether to roll over assets from one account (e.g., a retirement account) into a new or existing account that the adviser or an affiliate of the adviser manages.”

In the proposal of this interpretation last year, the SEC stated that an adviser must seek to avoid conflicts of interest with its clients. The interpretation as adopted explains that an adviser may satisfy its duty of loyalty by making full and fair disclosure of conflicts of interest and obtaining the client’s informed consent. The SEC stated that the requirement to obtain informed consent “does not require advisers to make an affirmative determination that a particular client understood the disclosure and that the client’s consent to the conflict of interest was informed. Rather, disclosure should be designed to put a client in a position to be able to understand and provide informed consent to the conflict of interest. A client’s informed consent can be either explicit or, depending on the facts and circumstances, implicit.”  (Emphasis added.) Nonetheless, the interpretation, as adopted, still takes the position that there are some conflicts that cannot be cured through disclosure without providing examples of what such conflicts might be. In particular, the interpretation states that some conflicts “may be of a nature and extent that it would be difficult to provide disclosure to clients that adequately conveys the material facts or the nature, magnitude, and potential effect of the conflict sufficient for a client to consent to or reject it,” particularly with regard to retail clients where “it may be difficult to provide disclosure regarding complex or extensive conflicts that is sufficiently specific, but also understandable.” In such instances, the interpretation makes clear that disclosure alone is not sufficient, and the adviser should either eliminate the conflict or adequately mitigate it.

Rick Fleming, the SEC’s Investor Advocate, released a statement strongly criticizing the interpretive release, arguing that the SEC has taken a step in the wrong direction in its interpretation of the fiduciary duty that investment advisers owe to their clients. In particular, the statement indicates that the final interpretive release “weakens the existing fiduciary standard by suggesting that liability for nearly all conflicts can be avoided through disclosure.”10

The proposed interpretive release requested comment on several areas of enhanced investment adviser regulation. In particular, the SEC asked for comment on whether to harmonize areas such as licensing and continuing education, provision of account statements, and financial responsibility. The interpretive release indicates that the SEC is continuing to evaluate the comments received in response.

Solely Incidental Interpretation

The SEC also issued an interpretive release on the “Solely Incidental” prong of Section 202(a)(11)(C) of the Advisers Act. That provision excludes from the definition of investment adviser – and thus from the application of the Advisers Act – a broker-dealer “whose performance of such advisory services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation” for those services. The SEC did not propose this interpretation when it issued its other proposals last year, but it did request comment on the subject in the release proposing Regulation BI.

The SEC interprets the statutory language to mean that a broker-dealer’s provision of advice as to the value and characteristics of securities or as to the advisability of transacting in securities is consistent with the solely incidental prong if the advice is provided in connection with and is reasonably related to the broker-dealer’s primary business of effecting securities transactions. If a broker-dealer’s primary business is giving advice as to the value and characteristics of securities or the advisability of transacting in securities, or if the advisory services are not offered in connection with or are not reasonably related to the broker-dealer’s business of effecting securities transactions, the broker-dealer’s advisory services are not solely incidental to its business as a broker-dealer. Whether advisory services provided by a broker-dealer satisfy the solely incidental prong is assessed based on the facts and circumstances surrounding the broker-dealer’s business, the specific services offered, and the relationship between the broker-dealer and the customer.

The SEC explains that a broker-dealer’s exercise of unlimited discretion (i.e., having responsibility for a customer’s trading decisions) would not be solely incidental to the business of a broker-dealer. However, there are situations where a broker-dealer may exercise temporary or limited discretion without being an investment adviser. The SEC also explains that a broker-dealer that agrees to monitor a retail customer’s account on a periodic basis for purposes of providing buy, sell, or hold recommendations may still be considered to provide advice in connection with and reasonably related to effecting securities transactions.

Compliance Date

The fiduciary duty and “solely incidental” interpretations will be effective upon publication in the Federal Register. Regulation BI and Form CRS generally will have a compliance date of June 30, 2020.

Even before adoption, press reports indicated that certain constituencies were already considering challenging Regulation BI in court. To the extent that there is a court challenge, it could affect the compliance phase-in timetable.

For Further Information

The foregoing provides our initial, high level summary of the new SEC rulemaking package. We will be following up next week or shortly thereafter with a more detailed analysis.

In addition, various members of Stradley’s Fiduciary Governance Group will be hosting a webinar, “Impact of New SEC Regulation Best Interest and Other Standards of Conduct Rules on Broker-Dealers, Investment Advisers and Investment Companies,” on July 31 at 1:00 pm Eastern time. Those interested may register here.

In the meantime, feel free to direct any questions you may have about the SEC actions as follows:

Regulation BI

Larry Stadulis
Peter Hong
John Baker

Form CRS

Sara Crovitz
John Baker

Section 202(a)(11)(C) “solely incidental” Interpretive Release

Larry Stadulis
Peter Hong

Advisers Act Interpretive Release

Larry Stadulis
Sara Crovitz
John Baker
Alan Goldberg

State developments impacting broker-dealer and investment adviser conduct, particularly arising from the SEC rulemaking package

Larry Stadulis
George Michael Gerstein

Questions relating to the interrelationship between the SEC rulemaking package and ERISA

George Michael Gerstein

Litigation

Bill Mandia

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1 Regulation Best Interest: The Broker-Dealer Standard of Conduct, Release No. 34-86031(June 5, 2019).

2 Form CRS Relationship Summary; Amendments to Form ADV, Release Nos. 34-86032, IA-5247 (June 5, 2019); see also Appendix B: Form CRS.

3 Commission Interpretation Regarding Standard of Conduct of Investment Advisers, Release No. IA-5248 (June 5, 2019).

4 Commission Interpretation Regarding the Solely Incidental Prong of the Broker-Dealer Exclusion from the Definition of Investment Adviser, Release No. IA-5249 (June 5, 2019).

5 See SEC Rulemaking Package Would Impose Best Interest Standard of Conduct (April 20, 2018).

6 Jay Clayton, Chairman, SEC, Statement at the Open Meeting on Commission Actions to Enhance and Clarify the Obligations Financial Professionals Owe to our Main Street Investors(June 5, 2019).

7 In other words, Regulation BI requires a broker-dealer to disclose the capacity in which the broker-dealer is acting. By using “adviser” or “advisor” in a name or title, the broker-dealer (or associated person) would be falsely disclosing its capacity unless it also is registered as an investment adviser (or is a supervised person of an investment adviser).

8 “Retail investor” is defined for purposes of Form CRS as “A natural person, or the legal representative of such natural person, who seeks to receive or receives services primarily for personal, family or household purposes.” Thus, there is no exception for sophisticated natural person investors.

9 In particular, broker-dealers that provide recommendations subject to Regulation Best Interest must provide the following disclosure: “When we provide you with a recommendation, we have to act in your best interest and not put our interest ahead of yours.” Investment advisers must provide this disclosure: “When we act as your investment adviser, we have to act in your best interest and not put our interest ahead of yours.” Dual registrants that prepare a single relationship summary and provide recommendations subject to Regulation Best Interest must disclose the following: “When we provide you with a recommendation as your broker-dealer or act as your investment adviser, we have to act in your best interest and not put our interest ahead of yours.”

10 Rick Fleming, Investor Advocate, SEC, Statement Regarding the SEC’s Rulemaking Package for Investment Advisers and Broker-Dealers (June 5, 2019).

Fiduciary Governance Group Adds New Member

John P. Hamilton

John focuses his practice on private fund managers, advising on the formation and structuring of investment vehicles across a variety of alternative asset classes, including hedge funds, private equity and impact investment vehicles. He also counsels clients on related transactional and compliance matters. In addition, John represents institutional investors allocating to alternative investment funds.

Prior to joining Stradley Ronon, John was at Morgan Stanley in Hong Kong as the Asia Head of Hedge Fund Consulting, where he provided strategic guidance to hedge fund managers in launching and scaling their businesses. Previously, he served as in-house counsel at Highbridge Capital Management, LLC and practiced as a fund lawyer at another global law firm in New York. He obtained a law degree from New York University School of Law and earned his B.A. in foreign affairs from the University of Virginia.