Decoding the SEC Rulemaking Package on Standards of Conduct for Investment Professionals

In his posted remarks, SEC Chair Jay Clayton noted that the SEC has three objectives in proposing the Rulemaking Package: (1) to enhance retail investor protection and decision making, (2) to preserve investor choice and cost, and (3) to raise retail investor awareness of whether they are doing business with a registered financial professional. The three releases, which were included in the Rulemaking Package request comments on the following SEC proposals:

1. Interpretation Regarding Standard of Conduct of Investment Advisers[1] - in the IA Conduct Release, the SEC proposes an interpretation of certain aspects of a registered investment adviser’s fiduciary duty under section 206 of the Investment Advisers Act of 1940 (“Advisers Act”) and also requests comments on potential enhancements to investment adviser regulation.
2. Proposed Form CRS[2] - the Form CRS Release proposes new and amended rules and forms under both the Advisers Act and the Securities Exchange Act of 1934 (“Exchange Act”) to require registered investment advisers and registered broker-dealers to provide a brief relationship summary to retail investors at the beginning of the investor’s relationship with the firm. In addition, the Form CRS Release proposes new rules intended to reduce investor confusion.
3. Proposed Regulation Best Interest[3] - the Regulation BI Release proposes a new rule under the Exchange Act, which would require that all broker-dealers and natural persons who are associated persons of a broker-dealer, when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer, act in the best interest of the retail customer at the time the recommendation is made without placing the financial or other interest of the broker-dealer or natural person who is an associated person making the recommendation ahead of the interest of the retail customer (Regulation Best Interest). 

We discuss each of the three proposals below.

Interpretation Regarding Standard of Conduct for Investment Advisers

In the IA Conduct Release, the SEC notes that the purpose for its proposed interpretation of an investment adviser’s standard of conduct is “to address in one release and reaffirm – and in some cases clarify – certain aspects of the fiduciary duty that an investment adviser owes to its clients under section 206 of the Advisers Act.” The SEC clarifies in the IA Conduct Release that it is not intending to create any new or different obligations or requirements, but rather is attempting to gather in one place all of the various aspects of an investment adviser’s fiduciary duty.   

The IA Conduct Release reiterates that “an investment adviser is a fiduciary, and as such is held to the highest standard of conduct and must act in the best interest of its client.”[4] The IA Conduct Release reminds investment advisers that their fiduciary duty consists of two parts –a duty of care and a duty of loyalty. While an investment adviser may, with client consent, adapt the terms of the relationship through contract, the investment adviser cannot disclose or negotiate away, and the client may not waive, the fiduciary duty.     

1. Duty of Care: The IA Conduct Release notes that the duty of care includes, among other things,  
   • The duty to act and to provide advice that is in the best interest of the client, which includes:
     • A duty to make a reasonable inquiry into a client’s financial situation, level of financial sophistication, investment experience, and investment objectives (together, “investment profile”), and a duty to provide personalized advice that is suitable for and in the best interest of the client based on their investment profile;
     • A duty to update the client’s investment profile in order to adjust the investment adviser’s advice to reflect changed circumstances – how frequently the update must occur can depend on many factors, including whether the adviser is aware of events that have occurred that could change the investment profile (e.g., a change in tax law or knowledge that the client has retired); and
     • A duty to consider cost when determining if an investment is in the best interest of the client, although it is not necessarily required that the lower cost investment product or strategy is recommended.
   • The duty to seek best execution of a client’s transactions where the adviser has the responsibility to select broker-dealers to execute client trades.
     • An investment adviser can meet this duty by executing securities transactions on behalf of a client with the goal of maximizing value for the client under the particular circumstances occurring at the time of the transaction. In determining whether value has been maximized, it should be considered whether or not the “best qualitative execution” was achieved and not just whether or not the lowest commission cost was paid.
   • The duty to provide advice and monitoring over the course of the relationship.
     • The frequency at which advice and monitoring should be provided depends on both what is in the best interest of the client and the terms of the agreement between the investment adviser and the client. 
2. Duty of Loyalty: The IA Conduct Release notes that the duty of loyalty requires an investment adviser to put the client’s interests first, which means that the investment adviser must not favor its own interests over those of a client or unfairly favor one client over another. When seeking to meet the duty of loyalty, the adviser must:
   • Make full and fair disclosure to clients of all material facts relating to the advisory relationship;
   • Treat all clients fairly; and
   • Seek to avoid conflicts of interest and, at a minimum, make full and fair disclosure to clients of all material conflicts of interest that could affect the advisory relationship. 
     • In this regard, the IA Conduct Release notes that disclosure of a conflict alone may not be sufficient to satisfy the duty of loyalty under the Advisers Act.

In addition to reaffirming the SEC’s interpretation of an investment adviser’s fiduciary duty under the Advisers Act, the IA Conduct Release also requests comments on three potential enhancements to an investment adviser’s legal obligations. The IA Conduct Release notes that these are areas where investors have protections in the broker-dealer area but not currently in the investment adviser area.

1. Federal Licensing and Continuing Education: The IA Conduct Release requests comment on whether investment adviser representatives should be subject to federal continuing education and licensing requirements.
2. Provision of Account Statements: The IA Conduct Release requests comment on whether the SEC should propose rules to require registered investment advisers to provide account statements, either directly or through the client’s custodian, regardless of whether or not the investment adviser is deemed to have custody of the client assets.
3. Financial Responsibility: The IA Conduct Release requests comment on whether SEC-registered investment advisers should be subject to financial responsibility requirements along the lines of those that apply to broker-dealers.         

The full IA Conduct Release can be found here.

Form CRS

In the Form CRS Release, the SEC is proposing to require all registered investment advisers and registered broker-dealers to deliver a brief relationship summary (“Form CRS”) to retail investors. For investment advisers, initial delivery of the Form CRS would occur before or at the time the firm enters into an investment advisory agreement with the retail investor. For broker-dealers, initial delivery of the Form CRS would occur before or at the time the retail investor first engages the firm’s services. For dual registrants,[5] initial delivery of the Form CRS would occur at the earlier of entering into an investment advisory agreement with the retail investor or the retail investor engaging the firm’s services. For purposes of Form CRS, a “retail investor” would be defined as a prospective or existing client or customer who is a natural person.[6] This definition of a retail investor differs from the definition of a “retail customer” as discussed below under “Regulation Best Interest.”

Form CRS would be required to be a written disclosure statement using “plain English” and would be limited to four pages (or the equivalent if an electronic format is used) and would consist of a combination of tabular and narrative information. Much of the information to be provided on Form CRS would be prescribed by the SEC, and firms would not be allowed to add any additional information other than what the instructions to Form CRS require. Form CRS would be required to contain the following sections:

1. Introduction
   • This section would include a title highlighting the types of services and accounts the firm offers to retail investors, the firm name, whether it is registered with the SEC, and the date of the Form CRS.
2. Relationships and Services
   • This section would include information about the relationship between the firm and retail investors and about the services the firm provides. This section would include more detailed information related to the nature, scope, and duration of the relationships and services, including the types of accounts and services the firm provides, how often it offers investment advice, and whether the firm monitors the account.
3. Standard of Conduct to Retail Investors
   • This section would describe the applicable standard of conduct, which would depend on whether the firm is a registered investment adviser, registered broker-dealer, or dual registrant.
4. Summary of Fees and Costs
   • This section would include an overview of the specified types of fees and expenses that retail investors would pay in connection with an account, as well as the incentives the fee structure may give the investment professionals to place their own interests ahead of the retail investor. While this section is intended to give retail investors more clarity about the categories of fees that they may pay, it is not intended to be a comprehensive schedule of all fees or customized for each retail investor.
5. Comparisons of Services (not applicable to dual registrants)
   • In this section, a registered investment adviser would provide information about the principal types of fees paid to a registered broker-dealer for services, the types of services that a broker-dealer generally provides, a broker-dealer’s standard of conduct, and certain incentives broker-dealers have based on their fee structure. A registered broker-dealer would provide the same information about a registered investment adviser. 
6. Conflicts of Interest
   • In this section, investment advisers and broker-dealers would be required to summarize their conflicts of interest related to certain financial incentives. 
7. Additional Information
   • This section would include information on where retail investors can find out more about the firm. In addition, firms would be required to state whether or not they have any legal and/or disciplinary events disclosed on Form ADV (for investment advisers), on Form BD (for broker-dealers), or on Forms U4, U5 or U6 (for financial professionals).
8. Key Questions
   • This section would include questions that retail investors may want to ask their financial professional in order to help encourage discussions, which will result in retail investors making informed decisions.

For investment advisers, Form CRS would be required by new ADV Part 3 and Rule 204-5 of the Advisers Act and would be filed through the Investment Adviser Registration Depository (IARD). For broker-dealers, Form CRS would be required by Form CRS and Rule 17a-14 of the Exchange Act and would be filed on the Electronic Data Gathering, Analysis, and Retrieval System (EDGAR). Dual registrants would be required to file on both IARD and EDGAR. The SEC is proposing to require that a firm’s Form CRS be updated within 30 days whenever it becomes materially inaccurate.

The SEC is also proposing new rules to reduce investor confusion about who is providing them with financial services. In this regard, the SEC is proposing a new rule under the Exchange Act that would restrict broker-dealers and associated natural persons of broker-dealers from using the terms “adviser” or “advisor” as part of their name or title when communicating with a retail investor, unless the applicable broker-dealer is also registered as an investment adviser. 

The full Form CRS Release can be found here.

In addition, the SEC has created mock-ups of what Form CRS might look like for different types of registrants:

• Standalone investment advisers
• Standalone broker-dealers
• Dual registrants

Proposed Regulation Best Interest

In the Regulation BI Release, the SEC is proposing a new rule that would establish an express best interest obligation that would apply to broker-dealers when they are making a recommendation[7] of any securities transaction or investment strategy to a retail customer. For purposes of Regulation Best Interest, a “retail customer” is “a person, or the legal representative of such person, who: (1) receives a recommendation of any securities transaction or investment strategy involving securities from a broker, dealer or a natural person who is an associated person of a broker or dealer, and (2) uses the recommendation primarily for personal, family, or household purposes.” Regulation Best Interest would only apply when a broker-dealer is making a recommendation to a retail customer about a security transaction or an investment strategy involving securities but would not apply to the broker-dealer’s provision of any other services. In addition, Regulation Best Interest would not apply to a broker-dealer who is duly registered as an investment adviser as long as it is making the recommendation solely as an investment adviser.             

Regulation Best Interest would specifically provide that a broker-dealer would meet the best interest obligation by satisfying four component obligations: 1. the Disclosure Obligation, 2. the Care Obligation, and 3. the two Conflict of Interest Obligations (each defined below).

1. Disclosure Obligation
   • The broker-dealer or natural person who is an associated person of a broker or dealer, prior to or at the time of the recommendation, reasonably discloses to the retail customer, in writing, the material facts relating to the scope and terms of the relationship with the retail customer and all material conflicts of interest that are associated with the recommendation (the “Disclosure Obligation”).
   • The SEC notes in the Regulation BI Release that it would consider the following to be examples of material facts relating to the scope and terms of the relationship with the retail customer: (1) that the broker-dealer is acting in a broker-dealer capacity with respect to the recommendation (2) the fees and charges that would apply; and (3) the type and scope of services to be provided.
   • With respect to what would be considered a material conflict of interest, the SEC proposes that it would be interpreted as “a conflict of interest that a reasonable person would expect might incline a broker-dealer – consciously or unconsciously – to make a recommendation that is not disinterested.”
   • The SEC provides guidance in the Regulation BI Release of what it would consider to be “reasonable disclosure” and states that it is proposing that compliance with the Disclosure Obligation would be held to a negligence standard, not a standard of strict liability.
2. Care Obligation
   • The broker-dealer or natural person who is an associated person of a broker or dealer, in making the recommendation, exercises reasonable diligence, care, skill, and prudence to: (1) understand the potential risks and rewards associated with the recommendation, and have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers; (2) have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks and rewards associated with the recommendation; and (3) have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer’s best interest when viewed in isolation, is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile (the “Care Obligation”).
   • The SEC notes that a broker-dealer would not be able to meet the Care Obligation through disclosure alone.
3. Conflict of Interest Obligations
   • The broker or dealer establishes, maintains, and enforces written policies and procedures reasonably designed to identify and – at a minimum – disclose or eliminate all material conflicts of interest that are associated with such recommendations; and
   • The broker or dealer establishes, maintains, and enforces written policies and procedures reasonably designed to identify and disclose and mitigate or eliminate material conflicts of interest arising from financial incentives associated with such recommendations (together, these two are the “Conflict of Interest Obligations”).
   • As proposed, Regulation Best Interest would allow broker-dealers to exercise their judgment as to whether or not a conflict can be effectively disclosed, determine how to mitigate such conflict, and determine how, if necessary, to eliminate a conflict, as long as the broker-dealer’s policies and procedures are reasonably designed.

In the Regulation BI Release, the SEC notes that “whether a broker-dealer acted in the best interest of the retail customer when making a recommendation will turn on the facts and circumstances of that particular recommendation and the particular retail customer, along with the facts and circumstances of how the four specific components of Regulation Best Interest are satisfied.” 

The full Regulation BI Release can be found here.

The comment period for all three parts of the Rulemaking Package continues until August 7, 2018.