In the wake of the recent federal court blow to the DOL Fiduciary Rule, on April 18 the SEC released a salvo of proposed rules for SEC-registered broker-dealers and investment advisers relating to standards of conduct. The SEC’s agenda took form in three separate, but related, proposals totaling over 900 pages: (i) Regulation Best Interest (Reg BI) for broker-dealers (and associated persons), (ii) a proposed Commission interpretation of investment advisers’ fiduciary duties and a request for comment on certain investment adviser regulation enhancements, and (iii) a new relationship summary (Form CRS) proposed to be required of both broker-dealers and investment advisers. Between them, the three proposals constitute a mixed bag for the relevant industries, and reactions to them are sure to vary significantly among different market participants.
Regulation Best Interest
In brief, Reg BI would impose a new “best interest” standard on broker-dealers when making investment recommendations to retail customers. Although existing federal securities laws and SRO rules impose obligations such as fair dealing and disclosures and mitigation of conflicts of interest, broker-dealers face no explicit obligation to put their clients’ interests ahead of their own when making investment recommendations. Reg BI seeks to remedy that situation by prohibiting broker-dealers from placing their interests ahead of their (natural person) retail clients at the time a recommendation is made.
Compliance with the new best interest requirement is to be achieved by adhering to four component, fiduciary-like requirements: a Disclosure Obligation, a Care Obligation, and a two-pronged Conflict of Interest Obligation.
Simplifying, the Disclosure Obligation requires broker-dealers to disclose to retail customers, in writing, the material facts relating to the scope and terms of the client relationship (an obligation only partly covered off by the new Form CRS disclosure) and all material conflicts of interest implicated by the recommendation. The Care Obligation imposes a duty of care on the broker-dealer, requiring the broker-dealer to have (i) a reasonable basis for believing that the recommendation is in the customer’s best interest and (ii) the competence reasonably to hold that belief. The two-pronged Conflict of Interest Obligation requires broker-dealers to create and abide by written policies designed to identify, disclose, eliminate or mitigate all (i) material conflicts of interest associated with recommendations and (ii) material conflicts of interest arising from financial incentives associated with investment recommendations.
Investment Adviser Fiduciary Duties
In short, the SEC has taken the trouble to set forth—legal memorandum style—its interpretation of the fiduciary duties incumbent upon investment advisers under current law, pursuant to Section 206 of the Advisers Act. Moreover, the SEC is seeking comment on whether aspects of its interpretation ought to be codified. This will be an interesting space to watch during the public comment period.
In the same release, the SEC has solicited comments on whether it ought to carry over various broker-dealer requirements into the investment adviser context, such as (i) licensing and continuing education, (ii) delivery of account statements and (iii) certain financial responsibility mandates, including net capital and bonding requirements.
This proposed interpretation, meant for investment advisers, is the one most likely to be viewed differently by different market participants, largely depending on (i) the extent to which they have already invested in conforming their operations to a well-informed understanding of fiduciary duties, and (ii) the extent of the overlap between their interpretation and the SEC’s proposed interpretation of those fiduciary duties.
Form CRS Relationship Summary
Form CRS is a new documentation and disclosure requirement, meant to educate the retail investor about certain industry basics. At a minimum, Form CRS promises to be a moderately expensive check-the-box headache for broker-dealers and investment advisers. But will the expense and headache it causes be more than offset by gains to the investing public and improvements in industry behavior?
A common theme in the Reg BI and Form CRS proposals is “investor confusion”—a phrase that appears scores of times between the two proposals. Summarizing, Form CRS is a new, brief (four pages or less), highly formatted, heavily specified, one-size-fits-all disclosure form. It is a “Broker-dealers and investment advisers for Dummies” – a four page introduction to basic aspects of the broker-client and adviser-client relationships, the types of services and accounts offered, legal standards, fees and costs, conflicts of interest, and, helpfully, a non-exhaustive list of ten required questions (but max 14!) that prospective clients are encouraged to ask of the adviser. Although the proposed rule prohibits the use of legal jargon, the SEC’s mock-up relationship summary includes the following disclosure: “We are held to a fiduciary standard that covers our entire investment advisory relationship with you.” Meanwhile, the interpretation of that fiduciary standard is the subject of the 38-page proposed interpretation addressed above.
Even though the actual content of the relationship summary is anodyne, high-level, formulaic, prescribed and generic, the proposed rule envisages that it ought to be utilized like a targeted, bespoke agreement by requiring that it be re-disclosed to the investor any time a new account is opened or changes are made that would materially change the nature and scope of the firm’s relationship with the retail investor. In this sense, the proposal seems to be at odds with itself, and re-disclosure rules would create an unnecessary headache for the industry. Why make firms navigate a thicket of questions about when and under what circumstances the form must be re-disclosed (not to mention record and store the information demonstrating such re-disclosure) given that Form CRS is a largely static, prescribed and generic disclosure in the first place?
It will be important for industry participants and investor-advocacy groups to make their voices heard during the public comment period in order to improve the quality and value of the proposed new rules for both the industry and the investing public. The SEC has solicited comments to scores of questions posed in respect to the proposed rules. As one example, the Commission asks, “Are retail investors likely to access and download relationship summaries of broker-dealers through EDGAR and investment advisers through IAPD?”
In light of the proposal on the table—to spoon-feed elementary information to retail investors—one wouldn't think this should be a question. More significantly, even if retail investors were likely to self-serve via EDGAR and IAPD, given the level of specification in the 471-page proposal, it seems likely that most firms’ Forms CRS will be largely interchangeable.