Alerts

SEC Adopts Investment Adviser and Broker-Dealer Rulemaking Package, Highlighted By The New "Best-Interest" Standard

Alerts / July 19, 2019

On June 5, 2019, the Securities and Exchange Commission (SEC) voted to adopt a highly anticipated set of rules addressing the standard of conduct of registered investment advisers (RIAs) and broker-dealers aimed at increasing protections for retail investors. Specifically, the package consists of the following four parts:

  1. Form CRS: RIAs and broker-dealers must provide a relationship summary to their clients who are “retail investors,” which is filed with the SEC as a new Part 3 of Form ADV.[1] A “retail investor” is defined as a natural person who seeks to receive services primarily for personal, family or household purposes. RIAs that manage only funds will not have any obligations, as their only clients are the funds. RIAs that have separate account clients will have to comply with the new requirement as to any clients that meet the definition of “retail investor.”
  2. Standard of Conduct for RIAs: The SEC provided a novel interpretation of the standard of conduct required of RIAs under the Investment Advisers Act of 1940 (Advisers Act),[2] which is that an RIA’s obligation to act in the best interest of its client encompasses both the duty of care and loyalty, and that such duties may not be waived.
  3. Regulation Best Interest: The SEC established a code of conduct for broker-dealers when they are making securities recommendations to their retail customers (Reg BI).[3]
  4. Interpretation of the “Solely Incidental” Prong: The SEC provided an interpretation of the meaning of “solely incidental” under Section 202(a)(11)(C) of the Advisers Act, which excludes from the definition of an “investment adviser” any broker-dealer that provides advisory services when such services are “solely incidental” to such broker-dealer’s business.[4]

Compliance Date: The new rules and forms will be effective 60 days from publication in the Federal Register, and the interpretations will be effective upon publication in the Federal Register. The new rules have a compliance date of June 30, 2020, so that RIAs and broker-dealers have a year to modify their policies, procedures and client agreements.

FORM CRS

The SEC will now require both broker-dealers and RIAs to provide their clients who are “retail investors” (as defined above) with a summary of their relationship. Form CRS will require disclosure and explanation of (i) the types of client and customer relationships and services the broker-dealer or RIA 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 form is subject to SEC filing and record-keeping requirements. It will be necessary to deliver Form CRS to any potential client that is a “retail investor” before the RIA enters into an advisory contract with the client.

STANDARD OF CONDUCT FOR RIAs

The SEC’s release does not present a novel concept regarding the fiduciary duty that RIAs owe their clients, but the SEC has attempted to clarify certain parts of the Advisers Act.

The SEC’s interpretation explains that an RIA’s obligation to act in the best interest of its client encompasses both the duty of care and loyalty. Such duties may not be waived, but may be shaped by the fully informed and disclosed contractual relationship between the RIA and the client. Certain investor advocates have argued that this interpretation is actually a step in the wrong direction, as such interpretation weakens the existing fiduciary standard by suggesting that liability for nearly all conflicts can be avoided through disclosure. Accordingly, RIAs, including fund managers, will want to further consider the disclosure that they are providing in their private placement memos or other disclosure documents that they give to investors and any separate account clients.

REGULATION BEST INTEREST

The foremost aspect of this package is the new Reg BI. The rule enhances the current standard of suitability applicable to broker-dealers and their associates (Broker-Dealers) when making a recommendation of any securities or investment strategy involving securities to a retail customer(Recommendation). Generally speaking, a duty will be imposed on Broker-Dealers to act in the best interest of their retail customer at the time a Recommendation is made, without placing the financial or other interest of the Broker-Dealer ahead of such customer. In order to satisfy this duty, the Broker-Dealer must comply with the following four obligations:

  1. Disclosure Obligation – Prior to any Recommendation, a Broker-Dealer must disclose, in writing, to its retail customer a full and accurate description of all material facts relating to the scope and terms of their relationship and any conflict of interest that may be associated with the Recommendation.
  2. Care Obligation – A Broker-Dealer must exercise reasonable diligence, care and skill when making a Recommendation. The Broker-Dealer must understand potential risks, rewards and costs associated therewith. The Broker-Dealer must then balance each factor with the retail customer’s investment profile and have a reasonable basis to believe that the Recommendation is in the retail customer’s best interest and does not place the Broker-Dealer’s interest ahead of the retail customer’s. Note that while cost must always be considered, the standard does not necessarily require the lowest-cost option.
  3. 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. These policies and procedures must be reasonably designed to identify all such conflicts and eliminate or, at a minimum, disclose them. Among other things, the policies and procedures must be designed to eliminate any sales contests, sales quotas, bonuses and noncash compensation that are based on the sale of specific securities or types of securities within a limited period of time.
  4. Compliance Obligation – A Broker-Dealer must establish, maintain and enforce written policies and procedures reasonably designed to achieve compliance with Reg BI.

It is important to note that Reg BI creates an independent standard applied to Broker-Dealers and is separate from the fiduciary standard applicable to RIAs. Further, Reg BI may not be waived by a retail customer, though it does not create any new private right of action or right of rescission.

‘SOLELY INCIDENTAL’

Section 202(a)(11) of the Advisers Act, which defines the term “investment adviser,” excludes from the definition, in subsection (C), a Broker-Dealer “whose performance of such advisory services is solely incidental to the conduct of his business as a broker or a dealer and who receives no special compensation” for such services.

The SEC interprets this exclusion so that giving advice about the suitability of a security, when such advice is offered by a Broker-Dealer to a client, is “solely incidental” if it is provided in connection with, and is reasonably related to, the Broker-Dealer’s primary business of effectuating a securities transaction. If the Broker-Dealer’s primary business is providing advice about securities to clients or suitability advice is not offered in connection with or is not reasonably related to the Broker-Dealer’s business of effectuating securities transactions, the Broker-Dealer’s advisory services are not solely incidental to its Broker-Dealer business, and the Broker-Dealer would need to register as an investment adviser (or meet the requirements of an exception to registration).

Please note that this Client Alert discusses this topic at a high level.

If you have any questions about this alert, please contact Adam D. Gale at agale@bakerlaw.com or +1.212.589.4294; or any other member of BakerHostetler’s Investment Funds team.

Authorship Credit: Adam D. Gale, Michael L. Lawhead and Jeffrey Slavin

[1] Form CRS Relationship Summary; Amendments to Form ADV, Release Nos. 34-86032, IA-5247 (June 5, 2019); see also Appendix B: Form CRS.
[2] Commission Interpretation Regarding Standard of Conduct of Investment Advisers, Release No. IA-5248 (June 5, 2019).
[3] Regulation Best Interest: The Broker-Dealer Standard of Conduct, Release No. 34-86031 (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).

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