Regulation & Legislation
6 MIN ARTICLE
On June 30, 2020, the Securities and Exchange Commission (SEC) made rules effective that regulate investment advice provided by brokers to any customers who invest for personal, family or household purposes. At 1,363 pages, it’s the most significant change to the regulation of investment advice since the much-discussed Department of Labor (DOL) fiduciary rule. The general purpose, according to the SEC press release is “to enhance and clarify the standards of conduct applicable to broker-dealers and investment advisers, help retail investors better understand and compare the services offered and make an informed choice of the relationship best suited to their needs and circumstances.”
To that end, the centerpiece of the rules is Reg BI, which requires broker-dealers to recommend only financial products or accounts (such as rollover IRAs) that are in their clients’ best interests, and to clearly disclose any potential conflicts of interest and financial incentives the broker-dealer may have with those products. The SEC announced, “Regulation Best Interest will enhance the broker-dealer standard of conduct beyond existing suitability obligations and make it clear that a broker-dealer may not put its financial interests ahead of the interests of a retail customer when making recommendations.”
Formerly, broker-dealers were not required to disclose potential conflicts of interest when recommending investment products or strategies, unlike investment advisers, who act as fiduciaries for their clients.
The SEC has been looking at the standard of care for brokers, dealers and investment advisers for many years. Nearly 10 years ago, the Dodd-Frank Act authorized the SEC to set out regulations addressing the standards of care for brokers, dealers and investment advisers when providing investment advice about securities to retail customers.
While the new rules apply a quasi-fiduciary standard of conduct to brokers, the SEC sought to protect the brokerage business model by preserving investor choice between receiving advice from a broker or adviser.
The regulations in brief
The broker-dealer must provide “full and fair disclosure” of all material facts, including:
- Role as a broker or broker-dealer;
- Fees that apply to customers’ transactions, holdings and accounts;
- Type and scope of services provided;
- Any conflicts of interest associated with the recommendation.
The broker must exercise “reasonable diligence, care and skill” in making investment recommendations, including:
- Understanding the potential risks, rewards and costs of any investment recommendation;
- Having a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that customer’s investment profile;
- Ensuring the recommendation doesn’t place the interests of the firm or broker ahead of the customer.
The broker-dealer firm must establish, maintain and enforce written “conflict of interest” policies and procedures that:
- Identify and, at a minimum, disclose (or eliminate) all conflicts of interest related to the recommendation, not just the most egregious conflicts;
- Identify and mitigate conflicts of interests that place the firm’s interests ahead of the customer, such as recommending proprietary products;
- Identify and eliminate sales contests, sales quotas, bonuses, etc. that are based on a specific product or type of securities within a limited period of time;
- Mitigate the conflict of interest that an adviser has if his or her compensation increases (which it ordinarily would) if a client moves from brokerage to advisory. The rule does not provide guidance as to what the appropriate methods of mitigation would be.
In addition to Reg BI itself, the SEC has implemented a newly required Customer/Client Relationship Summary (Form CRS) that both broker-dealers and advisers are obligated to provide to their prospects. Form CRS discloses whether or not the broker-dealers and advisors use proprietary products or receive revenue sharing.
Effect on registered investment advisors and other investment advisers
Additional guidance regarding the Investment Advisers Act issued at the same time as Reg BI clarified the standard of conduct for investment advisers. There were no material changes to current advisory practices or the fiduciary duty applied to investment advisers other than clarifying that account-type recommendations are covered recommendations.
Proposed state rules
Several states (including Nevada and New Jersey) recently released proposed rules that would impose more onerous requirements on brokers providing investment advice, and other states are considering similar rules. Since Reg BI does not contain any provisions preempting state regulations, the industry could face a patchwork of different regulations if state plans move forward, as well as potential litigation that challenges state regulation.
What about retirement plans?
The new rules apply to recommendations to 401(k) participants, but not 401(k) plan sponsors. The standard of care also stops short of the now-defunct DOL fiduciary rule, which would have required all financial professionals who work with retirement plans or provide retirement planning advice — advisers, broker-dealers, insurance agents — to hold to the fiduciary standard, bound legally and ethically to put their clients' interests first. There is no private right of action, for example, as there was with the DOL rule, to bring a lawsuit against a broker-dealer. Enforcement will lie with the SEC and the Financial Industry Regulatory Authority. The DOL intends to issue a proposed rule that would apply to retirement plans (including IRAs) by the end of the year, but we expect it to largely complement Reg BI.
More guidance to come from home offices
Although the rule is final, there are many questions about interpretation and implementation that arise. Each broker-dealer firm will have to assess the impact of these rules on the investment products they sell, the type of commissionable shares they offer, and the precise disclosures their brokers must give to their prospects and clients.