SEC: Regulation Best Interest
As many of you know, on June 5, 2019, the SEC passed Regulation Best Interest (Regulation BI) and related rules and interpretations that were intended to enhance investor protection and clarify the difference between broker-dealers (BDs) and registered investment advisers (RIAs). The rule and two final interpretations were over 1,300 pages long, ugh. When I think about reading that many pages of bureaucracy inspired legalese, I think of my former colleague Rich Rudman saying that when it comes to legal writing (actually, I think he applied it to almost everything): Be Bold, Be Brief, Be God. With that in mind, we’re going to summarize the whole thing in one article that is less than 2,000 words. Here we go!
Regulation Best Interest has four parts.
1. Regulation Best Interest: Standard of Conduct for Broker-Dealers
Regulation BI’s standard of conduct applies only to BDs, not RIAs (unless your a hybrid RIA, in which case your brokerage business will fall under the regulation). BDs will need to act with their customers' best interests in mind. Best interest isn’t defined in the SEC’s rule. You would think that’s a problem since its a legal standard that BDs need to meet. (Nevermind that investment advisers have been meeting the same standard for 80 years. Oh wait, the SEC says the term applies differently to BDs and RIAs. More to come.) The SEC received many comments on this issue but still declined to define the phrase, probably because they are creating two versions of best interest. A fiduciary version that applies to investment advisers and something else that applies to broker-dealers. But the SEC did say that the new BI standard is influenced by fiduciary principles, including the deceased DOL Fiduciary Rule. Basically, the SEC punted on the issues, and as all good punters know, you don’t want to be too close to your own end zone or the other team’s end zone.
The collaboration with the DOL brings up the first two major areas of emphasis under Regulation BI: rollover of retirement accounts and whether to open a brokerage account or advisory account for your retirement assets. The regulation also applies to the recommendation to hold a position.
There are four obligations under the Best Interest Standard of Conduct for Broker-Dealers. I guess the SEC likes the symmetry of four.
- Disclosure Obligation. BDs must now disclose material facts about the relationship and recommendations that they make, including whether they are acting as a BD or a fiduciary, fees, services, conflicts and information on the products they are selling.
- Care Obligation. BDs must now exercise reasonable diligence, care, and skill when making recommendations to retail customers. The BD must understand the potential risks, rewards, and costs associated with the products they sell, and they must consider how these factors apply to the retail customer’s investment profile. Interestingly, the SEC’s language tracks the three aspects of FINRA’s suitability rule, even though the SEC is establishing a standard that goes beyond suitability. A BD’s care obligation is now based on (1) suitability, (2) parts of the DOL Fiduciary Rule and (3) disclosure of conflicts of interest in a way that is similar to how RIA’s must disclose their conflicts. In other words, it’s like Frankenstein, pieced together from parts of other people’s bodies. How did that story end? Mary Shelley would be proud.
- Conflicts-of-Interest Obligations. BDs must create written policies and procedures to identify and minimize or eliminate conflicts of interest. Specifically, registered reps must put their interests behind the customer’s interest, the firm cannot simply sell its own product, and no more of the fun sales contests, quotas, and bonuses that BD’s currently rely on to motivate their salespeople. In other words, it’s like the last 30 minutes of the Wolf of Wall Street.
- Compliance Obligations. No compliance rule would be complete without the requirement to adopt written policies and procedures to implement the rule. Regulation BI is complete. BDs must adopt and implement written policies and procedures that are...wait for it...reasonably designed to achieve compliance with the rule.
After reading this list, do any of you wonder what BDs were disclosing before the rule?
Key Point: One area of difference between the Regulation BI definition of “best interest” and the fiduciary requirements of an RIA, is that best interest under Regulation BI applies at the time of the transaction or recommendation, there is no ongoing duty to monitor the effects of the transaction or recommendation (unless you created one contractually). Whereas an RIA has an ongoing duty to monitor all recommendations and transaction in a client’s account.
2. Form CRS Relationship Summary
In case you missed it, you have another disclosure form to provide. First, it was your investment advisory agreement and Form ADV Parts 2A and 2B. Now you must also include Form CRS, which summarizes your relationship with your client, you know, in case they didn’t realize why they were meeting with you. The Form CRS Relationship Summary is required by both BDs and RIAs. Its purpose is to provide retail investors with comparative information on their relationship with you. Many parts of Form CRS are already summarized in your Form ADV, including your services, fees and costs, and conflicts of interest. The form also requires that you include your legal standard of conduct. For RIAs, this is already encompassed in your Form ADV, for BDs your legal standard will be the squishy best interest standard that the SEC refused to define. Luckily, the SEC has thought of all the questions that your clients should ask you before signing your agreement, and Form CSR presents those questions. Oh, and the SEC’s investor education website gets a plug.
BDs and RIAs must deliver this new disclosure form to retail investors only, and at the start of the relationship. You also have to provide the form whenever you make a new account recommendation (e.g., moving from advisory to brokerage or vice verse, opening a new account, etc.), at the time of a rollover recommendation for retirement accounts, or similar types of events. The form is also filed with the SEC.
3. Standard of Conduct for Investment Advisers
First, note that the SEC declined to adopt a uniform standard of conduct that would apply to both BDs and RIAs, so for now, we’re going to continue perpetuating this perplexing phrase, maybe for perpetuity. Instead of applying a uniform standard, the SEC will keep its current guidance in place, which they think “worked well for retail clients and markets.” Many industry participants are aware that most investors don’t understand the difference between a BD and RIA. The SEC’s goal is to eliminate this confusion.
Lucky for you, the SEC is reaffirming and clarifying all its prior guidance, like the fact that your fiduciary standard is principles-based and applies to your entire relationship with the client. The interpretation synthesizes all those court cases and interpretative releases that you’ve been reading about for the past 80 years. And in Form CSR fashion, here’s a summary.
You have a Duty of Care, which includes the duty to provide advice that is in the client’s best interest, not yours (check). The duty to act in your client’s best interest includes the requirement to know your client’s financial situation and investment objectives. You must also seek the best execution for your client, which is still being interpreted since most RIAs execute all transactions through a few dominant custodians (partial check). But let’s not get distracted with anti-trust laws and their applicability to custodian/brokerage giants. Finally, your duty of care includes providing ongoing advice throughout your relationship with the client (um, big check).
You also have a Duty of Loyalty, which presumably is covered by all the same elements in your Duty of Care. But the Duty of Loyalty does include the requirement to provide full and fair disclosure to clients, including the disclosure of conflicts of interest. In fact, the Duty of Loyalty requires that the investment adviser seek to avoid conflicts of interest, where possible.
While Regulation BI and its components do not take effect until June 30, 2020, the staff’s interpretative release is immediately effective upon publication of the rule.
- Ensure that the IAR is undertaking periodic reviews of client objectives and portfolios
- For RIAs that use a single custodian, you need to consider your best execution policy and procedures to ensure you are meeting your Duty of Care requirements. For example, some advisers require their clients to direct brokerage to the custodian. Others have tried to “waive” the best execution requirement in their advisory contracts, but our experience is the staff will not accept a waiver of this duty.
- Disclose in your Form ADV Part 2 all the benefits that the custodian provides to the RIA
- Disclosure and informed consent from the client cannot eliminate the duty to act in the client’s best interest
- Simply disclosing that an adviser “may” have a conflict is not sufficient if the conflict actually exists, even if occasionally
4. Solely Incidental Exemption from RIA Registration
The final piece of Regulation BI is the broker-dealer exclusion under the Investment Advisers Act of 1940, which says that a broker-dealer is not acting as an investment adviser if it provides the exact same advice that an adviser would, but such advice is solely incidental to the BDs primary business as a BD. In other words, even though BDs are moving towards fee-only arrangements that look like management fees and they refer to themselves as financial advisors (with an “o”, people) and they are recommending the same types of products as investment advisers, they are not investment advisers if they do all these things while collecting a transaction fee from you. Got it?! I hope so because the SEC thinks this distinction has worked well for retail clients. I’m sure your clients know that an “advisor” is a broker-dealer and an “adviser” is an investment adviser and they have different best interest standards that govern them.
Key Points: The Solely Incidental Exemption does not apply to the following circumstances.
- When you have discretionary authority, other than temporary or limited authority, or you have discretion over
- The price or time of execution of a security transaction;
- Whether to make a purchase or sales transaction, even if on a limited or infrequent basis;
- Cash management;
- The purchase or sale of a security to meet margin requirement or other customer obligations;
- Whether to purchase a bond with a specified credit rating and maturity; and
- Whether to purchase or sell a security, even if you are operating under instructions specific parameters established by a customer.
- When you have continuous monitoring obligations.
BDs relying on this exemption need written policies and procedures that demonstrate their advice is related to effecting securities transactions. Further, BDs relying on this exemption cannot have unlimited discretion over any accounts or assets. But there is no clear standard as to how much monitoring or advice would eliminate the exemption and require RIA registration.