SEC Proposes Rules Addressing Broker-Dealer and Investment Adviser Standards of Conduct

On April 18, 2018, the U.S. Securities and Exchange Commission (SEC) voted 4-1 to propose a package of rules and interpretations (Proposals)¹ intended to improve the retail investor experience and to provide greater clarity regarding investors’ relationships with broker-dealers and investment advisers.² During the open meeting, SEC Chairman Jay Clayton addressed the “gap between reasonable investor expectations” surrounding the investment services they receive from broker-dealers and investment advisers and the “legal standards” regarding such services. Chairman Clayton further stated that it should be the SEC’s goal, in closing this gap, that there not be any limitation of investor choices and access to investment professionals. Chairman Clayton noted that the Proposals are intended to supplant the Department of Labor’s fiduciary rule,³ as well as similar state initiatives, and that the SEC consulted with these regulators as well as the Financial Industry Regulatory Authority (FINRA) in developing the Proposals. 

The comment period for the Proposals is 90 days following their publication in the Federal Register. 

Below is a brief overview of the components of the Proposals, based on the discussions at the SEC meeting. 

Regulation Best Interest 

The SEC proposed a new standard of conduct for broker-dealers under the Securities Exchange Act of 1934 (Exchange Act), which would require a broker-dealer to act in the best interest of a retail customer when making recommendations, without putting its own financial or other interests ahead of the retail customer. 

The term “recommendation” would have the same definition as used by FINRA. As proposed, “recommendations” would not include communications providing general investor education (such as discussions of asset allocation strategies) or limited investment analysis tools (such as retirement savings calculators). “Retail customer” is proposed to be defined broadly as any person who receives a recommendation about a securities transaction or investment strategy involving securities from a broker-dealer, and who uses the recommendation primarily for personal, family or household use – without regard to the person’s net worth, investment experience or sophistication. Among other items, the Proposals would require: 

• A broker-dealer making recommendations to retail customers to provide written disclosure of the material facts relating to the scope and terms of the relationship with the customer, including the scope and nature of services, fees, and all material conflicts of interest that are associated with the recommendation. 

• Broker-dealers to maintain and enforce written policies and procedures reasonably designed to identify and, at a minimum, disclose, or eliminate, all material conflicts of interest related to a recommendation. In the case of financial incentives, broker-dealers would be required to establish, maintain and enforce written policies and procedures designed to identify and disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with a recommendation. During the meeting, the Director of the SEC’s Division of Investment Management, Dalia Blass, emphasized that disclosure alone would not be sufficient to satisfy these requirements. 

• Broker-dealers to have general and customer-specific best interest obligations, as with suitability obligations under FINRA’s rules, and to make sure that any series of recommended transactions is not excessive. The staff noted that the best interest obligation would apply to rollover advice, including in connection with 401(k) plans. 

New Disclosure Requirements for Financial Professionals 

Form CRS 

The Proposals include a new Form CRS (Customer or Client Relationship Summary), a standardized four-page disclosure document addressing, among other items: the services to be provided; the legal standard of conduct applicable to the services; the fees and costs the retail investor will pay; and conflicts of interest that may exist in the relationship. Broker-dealers and investment advisers would be required to provide this information to retail investors at the beginning of the relationship, and to post the summary on their websites, if they have websites. In certain circumstances, a relationship summary would need to be provided to existing retail clients, including when a retail client requests a summary. Pursuant to the Proposals, broker-dealers would publicly file via EDGAR, and investment advisers would publicly file through IARD as a new Part 3 of Form ADV, with any updates required within 30 days of changes. Broker-dealers and investment advisers that have no clients or customers to whom the disclosure must be delivered would not need to prepare or file Form CRS. 

The SEC intends the disclosure to promote access to information (e.g., disciplinary history) that it believes retail investors should consider before establishing a relationship with a broker-dealer or adviser. The SEC proposes to allow electronic delivery of Form CRS and encourages the use of graphics and links. 

Labeling Rules 

The Proposals would add a new requirement under the Exchange Act and the Investment Advisers Act of 1940 (Advisers Act) that broker-dealers and investment advisers disclose if they are a registered broker-dealer, registered investment adviser, or both. The SEC also proposed to restrict the use of the titles “adviser” and “advisor” to registered investment advisers or associated persons of registered investment advisers. 

Interpretive Guidance Regarding the Standard of Conduct for Investment Advisers 

The SEC proposed an interpretation of an investment adviser’s fiduciary obligation under the Advisers Act, which is similar, but not identical, to the best interest standard proposed for broker-dealers. The SEC indicated that there is a federal fiduciary duty that applies to investment advisers, which includes both a duty of care and a duty of loyalty. The applicable release further posits that the duty of care includes a duty to seek best execution and to provide ongoing monitoring over the course of the client relationship. Although the SEC’s proposed interpretation purports to be a clarification of investment advisers’ responsibilities under federal fiduciary duties, many of these duties (beyond disclosure obligations) are not universally recognized as arising under the Advisers Act (as opposed to state law), and have the potential to change the application of the Advisers Act to advisers’ relationships with institutional investors.⁴ Nonetheless, the SEC appears to be willing to mitigate the expansive force of its interpretation by conceding that disclosure is sufficient to address conflicts of interest, where it is full and fair. 

The SEC also is requesting comment as to whether investment advisers should be subject to certain compliance obligations similar to certain broker-dealer obligations, specifically: licensing and continuing education requirements; a requirement to provide account statements to clients; and financial responsibility requirements (including net capital and fidelity bond requirements). 

An upcoming Dechert OnPoint will provide further analysis of the Proposals, as well as potential issues for broker-dealers and investment advisers to consider. 

Footnotes 

_{1) The following are the SEC’s proposing releases for the Proposals:
Regulation Best Interest
New Disclosure Requirements for Financial Professionals
Interpretive Guidance Regarding the Standard of Conduct for Investment Advisers
2) Commissioner Kara M. Stein voted against the Proposals. Although Commissioner Robert J. Jackson Jr. voted to publish the Proposals, he stated that unless there are substantial changes, he would not vote to approve the Proposals as final rules.
3) Further analysis of the rule is provided in previous Dechert OnPoints. 
4) The discussion in the release is cast in terms of an adviser’s relationship with its retail clients. However, a footnote in the release makes clear that the SEC’s view is that the duty as interpreted in the release would apply to all clients and all aspects of the advisory relationship.}