The Securities and Exchange Commission (SEC) voted 3-1 last month to put in place new standards for broker-dealers and investment advisers. Brokers will have until June 30, 2020, to comply with the centerpiece of the package — “Regulation Best Interest.”
What does the reform package include?
The primary piece of the reform package is Regulation Best Interest (or Reg BI), which SEC chairman Jay Clayton says raises the broker standard beyond the current suitability model.
The other three parts of the package are:
• Form CRS, a relationship summary that is meant to help investors understand the differences between brokers and advisers.
• A reaffirmation of the fiduciary duty of conduct for investment advisers.
• An SEC interpretation of language that allows brokers to avoid registering as advisers – and being fiduciaries – if the advice they provide is “solely incidental” to their work and includes no special compensation.
The rules will become effective 60 days after their publication in the Federal Register. The compliance deadline for Reg BI for brokers is June 30, 2020.
What does Reg BI entail?
In a nutshell, Reg BI imposes an enhanced standard of conduct on broker-dealers when they provide recommendations to retail customers regarding a securities transaction or an investment strategy involving securities. Under Reg BI, a broker-dealer must act in the retail customer’s best interest and cannot place its own interests ahead of the customer’s interests. The final rule makes clear that this new standard of conduct applies to account recommendations, including a recommendation to roll over assets from a workplace retirement plan account to an IRA.
To meet the new standard, broker-dealers must meet four obligations: disclosure, care, conflict of interest, and compliance.
• Disclosure. Before or at the time of the recommendation, a broker-dealer must disclose, in writing, material facts about the scope and terms of its relationship with the customer. This includes disclosure that the firm or representative 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.
• Care obligation. Broker-dealers must exercise reasonable diligence, care and skill when making a recommendation to a retail investor. The broker-dealer must understand potential risks, rewards and costs associated with the recommendation and must then consider those risks, rewards and costs in light of the customer’s investment profile. In addition, the broker-dealer must have a reasonable basis to believe the recommendation is in the customer’s best interest and does not place the broker-dealer’s interest in front.
• Conflict of interest obligation. Broker-dealers must establish, maintain and enforce written policies and procedures that — at a minimum — disclose or eliminate conflicts of interest like sales quotas, bonuses and non-cash compensation based on the sale of specific securities.
• Compliance obligation. Broker-dealers must establish, maintain and enforce policies and procedures reasonably designed to achieve compliance with this standard as a whole.
What isn’t included in Reg BI?
Some retirement plan-related events are not subject to Reg BI. Among others, these include:
• Recommendations to distribute assets when not tied to a specific security (e.g., for required minimum distributions and hardship distributions).
• Information on plan education and plan features.
• Communication to make or increase contributions to a plan or IRA.
• Recommendations to individuals in their capacity as plan sponsors or trustees (unless intended for personal family use).
Other parts of the package
Both investment advisers and broker-dealers will be required to deliver a relationship summary (Form CRS) to retail investors at the beginning of the relationship. The relationship summary, which will be in a standardized question-and-answer format, will provide investors with information about a firm’s services, fees and costs, conflicts of interest, applicable legal standard of conduct and disciplinary history.
As part of the final rulemaking, the SEC has issued an interpretation that is intended to reaffirm and, in some cases clarify, the fiduciary duty that an investment adviser owes to its clients.
As noted above, the SEC has also issued an interpretation of the “broker-dealer” exclusion under the Investment Advisers Act of 1940, which provides that a broker or dealer whose performance of advisory services is “solely incidental” to the conduct of its business as a broker or dealer and who receives no special compensation is excluded from the definition of “investment adviser.”
What about the DOL?
The SEC took the lead on advice reform when the fiduciary rule from the Department of Labor (DOL) was vacated by a federal appeals court last year. The DOL measure would have required brokers to act in the best interest of their clients in retirement accounts. The DOL has indicated it will provide a fiduciary rule update at the end of this year. This would be a new proposal intended to closely coordinate with the SEC standards of conduct for broker-dealers and investment advisers. Among other items, the proposal will likely address situations that go beyond the scope of the SEC rules (e.g., it might address fixed annuities, which are not considered securities and are thus not covered by the SEC rules).
The SEC rule package could be vulnerable to a court challenge by critics who assert that the rules simply codify the suitability standard, which requires brokers to recommend products that fit a client’s objectives, but also allows brokers to select high-fee investments. Mr. Clayton has argued that Reg BI is tougher than suitability because it requires brokers not just to disclose but to mitigate conflicts of interest.
We’ll keep you posted.
InvestmentNews, “SEC releases new details on investment advice reform package,” Mark Schoeff Jr., June 5, 2019
NAPA Net, “SEC approves long-awaited investment advice package,” Ted Godbout, June 6, 2019
Investment Company Institute, “ICI member call on SEC final rulemakings on standards of conduct,” Sarah Bessin, June 11, 2019
Forbes, “The SEC issues new rules for broker-dealers: will they help investors?”, Fred Reish, June 13, 2019