On April 18, 2018, the U.S. Securities and Exchange Commission (“SEC”) took the long-awaited step of proposing rules, interpretations and guidance (the “Proposed Rules”) that would seek to enhance and clarify the standards of care applicable to broker-dealers and to investment advisers when dealing with retail clients through standardized and additional disclosure, and through newly promulgated or clarified standards of care for broker-dealers and investment advisers. Three proposals have been published for comment, designed to be interlocked and complementary. The comment period for each proposal will be 90 days from each respective proposal’s publication in the Federal Register.
The Proposed Rules, which are further described below, follow recent developments in respect of the Department of Labor’s “Fiduciary Rule,” which expanded the applicability of “fiduciary” status (and corresponding duties) to various financial service providers under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), and effectively imposed similar “fiduciary” status to comparable financial service providers to retail customers, including with respect to Individual Retirement Accounts (IRAs).
In the open meeting introducing the proposals, SEC Chairman Jay Clayton highlighted that the goals of the Proposed Rules include better aligning regulations and obligations of broker-dealers and investment advisers with the expectations of retail investors, and preserving retail investor choice. With respect to the latter, Chairman Clayton suggested that confusion and compliance costs associated with certain federal and state standard of care requirements have created unintended consequences, such as disrupting or limiting the availability of transaction-based or pay-as-you-go retail investment models.
In addition, the web of regulation relating to professional standards of care extends beyond the U.S. border, as discussed below.
The Proposed Rules, generally, take the following steps, as described in greater detail below:
- Form CRS relationship summary. Require broker-dealers and investment advisers to provide a relationship summary (limited to a maximum of four pages) to investors that captures certain information, as discussed in greater detail below, through the use of newly proposed Form CRS, and place restrictions on the use of certain names and titles, such as “adviser” and “advisor,” for firms and financial professionals;
- Regulation Best Interest. Implement “Regulation Best Interest,” under the Securities Exchange Act of 1934 (the “Exchange Act”), which would establish a standard of conduct applicable to broker-dealers when making a recommendation of a securities transaction to a retail customer; and
- Interpretation of investment adviser standard of conduct. Clarify the standard of conduct for investment advisers, and request comments with respect to enhancing investment adviser regulation under the Investment Advisers Act of 1940 (the “Advisers Act”), including requesting comment regarding the licensing of investment adviser personnel and capital requirements for investment advisers.
A Recent History of Retail Standard of Care
2011 SEC Staff Study on Investment Advisers and Broker-Dealers and 2013 SEC Release
As a result of the requirement under Section 913 of the Dodd-Frank Act to evaluate regulatory standards of care, the SEC staff released a study on January 22, 2011 (the “2011 Study”) and made several recommendations addressing retail customer confusion about the differing standards of care applicable to broker-dealers and investment advisers.
In the 2011 Study, the staff of the SEC addressed the need for the establishment of uniform fiduciary standards applicable to broker-dealers and investment advisers. The language for this uniform fiduciary standard was based on SEC staff’s review of the broker-dealer and investment adviser industries, the regulatory landscape, issues raised by commenters and other considerations required by the Dodd-Frank Act. Additionally, the 2011 Study concluded that the SEC should engage in rulemaking and/or provide interpretive guidance on the following aspects of a uniform fiduciary standard:
- How to prohibit certain conflicts;
- How to facilitate effective disclosures to retail investors about the terms of their relationships with broker-dealers and investment advisers (including any material conflicts of interest);
- Specifying uniform standards for the duty of care owed to retail investors;
- Providing guidance on how to conduct principal trading; and
- Defining “personalized investment advice about securities.”
In determining the practicality of a uniform fiduciary rule, the staff of the SEC also considered the potential alternatives of: (i) eliminating the broker-dealer exclusion from the definition of “investment adviser” in the Advisers Act; and (ii) applying the duty of care and other requirements of the Advisers Act to broker-dealers. The SEC staff determined, however, that these alternatives “would not provide the Commission with a flexible, practical approach to addressing what standard should apply to broker-dealers and investment advisers when they are performing the same functions for retail investors.”
In addition to a uniform fiduciary standard, the 2011 Study suggested harmonizing the laws and regulations applicable to investment advisers and broker-dealers in order to provide retail investors similar protections when receiving like services from these two groups. These suggestions included:
- Rules about the content of advertising and similar communications about services;
- Disclosure requirements related to finders and solicitors;
- The harmonization of oversight of these entities;
- Maintaining consistency between similar disclosures required for registration and licensing; and
- The modification of the books and records requirements of the Advisers Act to be consistent with the rule applied to records requirements applied to broker-dealers.
Addressing certain concerns regarding the impact of a proposed rule, the staff of the SEC noted that
Section 913 explicitly provides that the receipt of commission-based compensation, or other standard compensation, for the sale of securities does not, in and of itself, violate the uniform fiduciary standard of conduct applied to a broker-dealer. Section 913 also provides that the uniform fiduciary standard does not necessarily require broker-dealers to have a continuing duty of care or loyalty to a retail customer after providing personalized investment advice.
After review of the 2011 Study, the SEC followed up with a release on March 1, 2013 (the “2013 Release”) requesting data concerning standards of conduct and the potential harmonization of certain other aspects of broker-dealer and investment adviser regulation. Assumptions in the 2013 Release intended to guide commentators provided the public with insight into the alternative proposals being considered by the SEC. Of most importance, commentators were instructed to assume that:
- A broker-dealer or investment adviser would not have a continuing duty of care or loyalty to a retail customer after providing personalized investment advice;
- Any action would apply to all broker-dealers and investment advisers; and
- The uniform fiduciary standard would be designed to accommodate various business models and fee structures.
In addition, the 2013 Release provided that a uniform fiduciary standard would not necessarily require all firms to:
- Provide the lowest-cost alternative;
- Stop offering proprietary products;
- Charge only asset-based fees (as opposed to charging commissions); and
- Continuously monitor all accounts.
Department of Labor Fiduciary Rule
Subsequently, in April of 2016, the Department of Labor (the “DOL”) issued new regulations and a series of prohibited transaction exemptions and amendments referred to collectively as the “Fiduciary Rule.” The Fiduciary Rule expanded the definition of “fiduciary” for purposes of ERISA and Section 4975 of the Internal Revenue Code of 1986, as amended (the “Code”), so as to include a broader array of financial service providers, including broker-dealers and other service providers not previously subject to ERISA or Section 4975 of the Code. Because both ERISA and Section 4975 of the Code prohibit “fiduciaries” from providing certain kinds of conflicted investment advice or receiving certain kinds of compensation, the Fiduciary Rule effectively prohibited several standard compensation arrangements for broker-dealers providing recommendations to investors subject to ERISA or Section 4975 of the Code, absent an applicable exemption. Anticipating this, the DOL included in the Fiduciary Rule several new exemptions and safe harbors for these kinds of arrangements. As applied to retail customers like owners of IRAs and participants in 401(k) plans, these exemptions typically required “fiduciaries” to conform to a heightened “prudent person” standard of care when making recommendations, to act “without regard to” conflicts of interest and otherwise comply with several technical, documentary and contractual conditions for relief.
While the Fiduciary Rule was intended to protect similar groups of investors and uses similar concepts, the Fiduciary Rule differs from the Proposed Rules in scope and method. For instance, the Fiduciary Rule applied to a broader range of recommendations. In addition, while both the Fiduciary Rule and the Proposed Rules would impose a “best interest” standard on broker-dealers in certain circumstances, the required standard of care under the Fiduciary Rule was a higher, fiduciary-level standard of care consistent with that imposed upon investment advisers.
The Fiduciary Rule became partially applicable on June 9, 2017, with full applicability ultimately delayed until July 1, 2019. During the intervening transition period, service providers could comply with a simplified subset of the Fiduciary Rule’s requirements and conditions for exemptive relief. However, on March 15, 2018, the Fifth Circuit Court of Appeals issued an opinion vacating the Fiduciary Rule in toto, which opinion is scheduled to take effect on May 7, 2018, absent petitions by the DOL for rehearing or appeal. Assuming that no such action by the DOL is taken, the Fiduciary Rule will be vacated in its entirety, returning the definition of “fiduciary” for purposes of ERISA and Section 4975 of the Code to the status quo ante, which generally did not subject broker-dealers to “fiduciary” status or a heightened standard of care.
In the increasingly unlikely event that the DOL challenges the Fifth Circuit’s decision, the Fiduciary Rule becomes fully applicable and the Proposed Rules are finalized as proposed, the two sets of obligations would likely apply simultaneously to service providers making recommendations to retail customers subject to ERISA or Section 4975 of the Code. The sources of regulatory authority under the Fiduciary Rule and the Proposed Rules are distinct, and while they are drafted to protect similar investors and employ similar concepts, it is not entirely clear how they would interact. For example, compliance with the Fiduciary Rule’s “Impartial Conduct Standards” may possibly satisfy broker-dealer’s best interest obligation under the proposed Regulation Best Interest, but broker-dealers may still be required to separately confirm that they are satisfying each of the Disclosure, Care and Conflict of Interest Obligations. In contrast, while the Investment Adviser Interpretation Release also describes advisers as acting in the “best interest” of clients, discharging this responsibility requires consideration of several factors not expressly required under the Fiduciary Rule. Thus, any investment adviser advising clients that are subject to ERISA or Section 4975 of the Code will have to separately confirm that its actions comport with its applicable obligations under each of the Fiduciary Rule and the Advisers Act.
Similar EU and U.K. Requirements
Similar rules in the EU and U.K. require broker-dealers (EU investment firms) and other regulated firms to apply enhanced standards when dealing with retail investors. Most of the requirements will apply to firms regulated under the EU or U.K. rules, but will apply regardless of where the retail client is located.
The U.K.’s Treating Customers Fairly (“TCF”) requirements have been in place for many years. TCF rules require all firms involved in retail financial services, whether or not they have a direct interface with the customer or are involved in all stages of the life cycle of a product to be able to show consistently that fair treatment of customers is at the heart of their business model. The Financial Conduct Authority is responsible for supervising TCF. TCF is interlinked with the requirement on all firms to “pay due regard to the interests of its customers and treat them fairly.” There are six specific customer outcomes that firms must endeavor to achieve, which focus on, among other things, ensuring retail clients receive clear information, that the advice provided to a retail client is suitable and that the products and services provided to a retail client take into account the client’s circumstances. Importantly, these requirements apply to firms dealing with retail customers, regardless of where the customer is located.
The FCA recently consulted on enhancing its approach to regulating for retail customers, including a supervisory expectation that firms will take reasonable steps to identify vulnerability and take appropriate action upon identifying a vulnerable customer. The FCA intends to publish the final Approach to Consumers in summer 2018. In addition, the FCA is expected to consult in 2018 on the possibility of introducing a duty of care, which would require firms to exercise reasonable skill and care in the provision of services to consumers.
Many of the existing TCF requirements can be satisfied by a firm’s compliance with the investor protection obligations in the EU Market in Financial Instruments package (“MiFID II”), which came into effect on January 3, 2018. MiFID II, however, does not apply to all regulated firms.
As with the Proposed Rules, MiFID II imposes requirements on firms dealing with retail clients in relation to conflicts of interest, communicating with clients in a fair, clear and not misleading manner, best execution, suitability and appropriateness of advice and products, as well as reporting and disclosure requirements. MiFID II enhances the investor protection regime that existed in its predecessor, MiFID I (which became applicable in 2007), by imposing more stringent requirements on firms, particularly in relation to conflicts of interests and inducements, and through the introduction of new requirements, such as the product governance regime.
In addition, the PRIIPs Regulation, which has applied directly across the EU since January 2018, imposes specific requirements on firms interacting with retail investors in relation to “packaged retail investment products” and “insurance-based investment products.” The PRIIPs Regulation and relevant Regulatory Technical Standards introduce detailed obligations on PRIIP manufacturers (including issuers and potentially underwriters) and sellers (including underwriters and other downstream distributors of capital markets instruments). PRIIP manufacturers (any entity manufacturing a PRIIP or making changes to an existing PRIIP) must produce and publish a Key Information Document (“KID”) on their website before the PRIIP can be made available to retail investors. KIDs are three-page product summaries following a prescribed template containing, inter alia, a description of the nature and main features of the PRIIP, a summary risk indicator, potential maximum loss and performance scenarios. PRIIP sellers (persons offering or concluding a PRIIP contract with a retail investor) must provide KIDs to the retail investor in “good time” before the retail investor is bound by any contract relating to that PRIIP.
The MiFID II and PRIIPs requirements do not generally apply to U.S. broker-dealers and non-EU investment banks unless they have a place of business in the EU. Certain exemptions that non-EU investment banks and brokers have previously relied on to operate in the EU unregulated, however, have been narrowed, which, depending on the particular member state and business models, may trigger local licensing requirements. Further, even if a non-EU investment bank or broker is outside the scope of MiFID II, it may be indirectly impacted in its dealings with entities that are subject to the full MiFID II requirements, in particular, the conflicts of interest rules and the inducement and research unbundling requirements.
Summary of the Proposed Rules
Form CRS Relationship Summary, Required Disclosures in Retail Communications and Restrictions on the Use of Certain Names or Titles
One of the overarching principles of the Proposed Rules is for firms and financial professionals to provide clear and understandable disclosures, communications and information to retail investors throughout the term of the relationship established between the firm or financial professional and the retail investor. Upon effectiveness of the Proposed Rules, this will now include the mandatory use of a relationship summary that outlines the relationship, and that seeks to provide clarity in communications to retail investors and allay confusion that can be created by the unregulated use of names or titles by firms and financial professionals.
The Proposed Rules will create a new form under the Exchange Act and Advisers Act, Form CRS, to provide a simple point of entry for retail investors to understand their relationship with their broker-dealer or investment adviser (the “Relationship Summary”), which will be provided at the onset of the investor’s relationship with the firm, and refreshed following any material change. This Relationship Summary will be a standardized document, will be limited in length to four pages and will provide investors with information and disclosure regarding:
- Primary services offered by the broker-dealer or investment adviser;
- Applicable legal standards of care;
- Information with respect to fees;
- Disclosure of material conflicts of interest;
- Whether the firm or its financial professionals have reportable legal or disciplinary events;
- Additional disclosures with respect to recommendations; and
- Key questions that they may wish to consider asking their financial professional.
It is intended that these Relationship Summaries will be provided to customers, posted online by the SEC in a compiled database and available on a firm’s website. Relationship Summaries are intended to be drafted using plain language in a concise and direct manner. While examples of Form CRS are provided with the Proposed Rules, it is intended that broker-dealers and investment advisers will have at least some degree of leeway with respect to the form and content of these Relationship Summaries, subject to the requirements of the relevant rules. This includes an electronic delivery option, and the option of firms to include graphics in their Relationship Summaries.
The Relationship Summary Release poses a number of specific questions with respect to “robo-advisers” and online broker-dealers. The Relationship Summary Release also notes that firms that offer online-only account opening and account transactions, such as robo-advisers and online broker-dealers, should require global consent to electronic delivery, to allow for electronic delivery of the Relationship Summary.
Required Disclosures in Retail Communications
The Relationship Summary Release also proposes rules under the Exchange Act and Advisers Act with respect to disclosing whether a firm or financial professional is registered as a broker-dealer or associated person, an investment adviser or supervised person or both in communications with retail investors. These proposed rules are intended to be complementary to any disclosure provided in a firm’s Relationship Summary, and are intended to prevent confusion among retail investors. Under the proposed rules in the Relationship Summary Release, firms or financial professionals would be required to provide prominent disclosure in print or electronic communications with retail investors. By way of example, a dual-hatted financial professional that is both an associated person of a broker-dealer and a supervised person of an investment adviser would have to provide disclosure to the effect that:
[Name of professional], a [title] of [Name of Firm], an associated person of an SEC-registered broker-dealer and a supervised person of an SEC-registered investment adviser.
The Relationship Summary Release notes that providing this disclosure to retail investors may help to provide clarity and foster understanding of their relationships with a firm or financial professional, even in cases where the retail investor currently may not understand the distinction between broker-dealers and associated persons, on one hand, and investment advisers and supervised persons, on the other hand.
Restrictions on the Use of Certain Names or Titles, Including “Adviser” and “Advisor”
The Relationship Summary Release notes that many retail investors do not understand whether their financial professionals are broker-dealers, investment advisers or both, or the differences among these categories. This distinction is important, because under current law, different standards of care apply to broker-dealers and investment advisers.
The Relationship Summary Release notes that while Form CRS will play a role in mitigating this uncertainty and confusion, the Relationship Summary alone is not sufficient. To this end, the Relationship Summary Release proposes restrictions on the use of certain names or titles—specifically the use of the titles of “adviser” or “advisor.” The proposed rule, to be implemented under the Exchange Act, would restrict use of these titles by broker-dealers or their associated persons when communicating with retail investors. These restrictions would not apply to communications with institutional investors, or communications where the broker-dealer or associated person is acting on behalf of a bank, insurance company, municipal advisor or commodity trading advisor.
With respect to dually registered firms and dual-hatted financial professionals, the Relationship Summary Release does not extend the restriction on use of these terms to describe firms that are dually registered as broker-dealers and investment advisers. The Relationship Summary Release expresses that extending this restriction to dually registered firms may create instances where firms use different names, which could lead to even greater retail investor confusion. With respect to dual-hatted financial professionals, the restriction on the use of “adviser” or “advisor” will not apply to financial professionals who provide both brokerage and investment advisory services, even if the financial professional is only providing brokerage services to a particular retail investor. The restriction would apply, however, to a financial professional that only provides brokerage services, regardless of whether the financial professional is dual-hatted or is employed by a dually registered firm.
Regulation Best Interest
Proposed Regulation Best Interest, to be implemented under the Exchange Act, would create a principles-based standard, which requires brokers, dealers or associated persons of a broker-dealer to act in the best interest of a retail customer, without placing their financial or other interests ahead of the customer, when recommending a securities transaction or investment strategy involving securities. This best interest obligation is satisfied if the broker, dealer or associated person complies with separate disclosure, care and conflicts of interest obligations. The Regulation Best Interest Release does not appear to provide a great deal of clarity with respect to whether compliance with these obligations provides a safe harbor under Regulation Best Interest, or if these three obligations are intended to be the sole means of compliance. Critically, the standard of care proposed in Regulation Best Interest would apply solely to broker-dealers—Regulation Best Interest does not represent a uniform broker-dealer and investment adviser standard. In this regard, the SEC proposes certain interpretations of the investment adviser’s fiduciary duty, and in doing so notes that the standards of conduct for broker-dealers and investment advisers retain differences on account of “different relationship types and models for providing advice.”
This prong of the best interest obligation requires broker-dealers or associated persons, prior to providing a recommendation to a retail customer, to reasonably disclose in writing, the material facts relating to the relationship with the retail investor, including all material conflicts of interest. This obligation appears to be related, at least in part, to the requirements of Form CRS, described above.
This obligation, which closely tracks the language of FINRA Rule 2111 (Suitability), requires a broker-dealer or associated person to exercise reasonable diligence, care, skill and prudence to:
- Understand the potential risks and rewards of the recommendation, and have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail investors;
- Have a reasonable basis to believe that the recommendation is in the best interest of the particular retail investor; and
- Have a reasonable basis to conclude that a series of recommendations, when viewed together, is not excessive and in the retail investor’s best interest.
Conflict of Interest Obligations
This obligation requires broker-dealers to establish, maintain and enforce written policies and procedures reasonably designed to identify and, at minimum, disclose or eliminate all material conflicts of interest associated with a recommendation, and to identify, disclose and mitigate, or eliminate material conflicts of interest that arise from any financial incentives associated with a recommendation.
Standards of Conduct for Investment Advisers and Enhancing Investment Adviser Regulation
Standard of Conduct for Investment Advisers
The Investment Adviser Interpretation Release provides a series of interpretations that are meant to address aspects of the investment adviser’s fiduciary duty, including in light of Regulation Best Interest. The Investment Adviser Interpretation Release notes that the interpretations discussed in the proposal will also apply to “robo-advisers.” The Investment Adviser Interpretation Release describes the investment adviser’s fiduciary duty as being comprised of the following duties:
- Duty of care. The SEC breaks down the duty of care, noting that the investment adviser’s duty of care includes, among other things: (i) a duty to act in the best interest of the customers, and a duty to provide advice that is in the best interests of the customers; (ii) a duty to seek best execution of customer transactions; and (iii) a duty to provide advice, and monitoring, throughout the customer relationship. In respect of the duty of care, the SEC makes the following notable observations:
- The SEC notes that, in respect of the provision of personalized advice, the investment adviser’s ability to provide advice that is in the best interests of the client is dependent on understanding the client’s investment profile.
- The SEC also notes that the duty to act in the best interests of the customer requires a reasonable belief that personalized investment advice is suitable for the customer.
- A customer’s investment profile must be updated to reflect changed circumstances.
- Duty of loyalty. The SEC notes that the duty of loyalty is rooted in specific principles: an investment adviser must not favor its own interests over those of a client, or unfairly favor one client over another, and an adviser must make full and fair disclosure to its clients of all material facts relating to the advisory relationship, including all material conflicts of interest that could affect the advisory relationship.
Enhancing Investment Adviser Regulation
The Investment Adviser Interpretation Release identifies certain specific areas of regulation and requests comment on prospective rulemaking in those areas. These areas of regulation are purported to be among those in which the framework for regulation of broker-dealers provides protections and regulations without substantial equivalent in the regulation of investment advisers. As such, any rulemaking in these areas would presumably be proposed with a view to harmonization of broker-dealer and investment adviser regulation. These areas are:
- Federal licensing and continuing education. Noting that broker-dealer representatives and principals are subject to FINRA registration and licensing, the SEC requests comment regarding whether there should be federal licensing and continuing education requirements for individual personnel of registered investment advisers. Specific areas on which the SEC requests comment include whether there should be federal licensing of investment adviser personnel; which personnel should be licensed; what information should be required to be disclosed regarding individual registrants; how examination and licensing should be structured; and what costs and benefits would arise from individual registration and licensing.
- Provision of account statements. The SEC requests comment as to whether rules should be proposed that require registered investment advisers to provide account statements, which statements would be required to disclose and clarify fees paid by the customer to the investment adviser.
- Financial responsibility. Broker-dealers are subject to comprehensive regulation of capital levels, and are required to maintain possession and control of customer assets, and to segregate certain customer assets. These regulations are designed to ensure that, even in times of financial stress, broker-dealer customers have ready access to their assets. The SEC requests comment regarding whether to propose financial responsibility requirements for investment advisers that would be designed to ensure that, in the event of fraud or financial distress, investment advisers would be able to compensate customers for losses.
While the Proposed Rules are likely to generate a high volume of comments and may undergo significant changes from initial proposal to final rule, the actions taken by the SEC in publishing the Proposed Rules represent an important first step in enhancing and clarifying the standards of care applicable to broker-dealers and to investment advisers when dealing with retail clients, and promoting clear, robust and meaningful disclosure to retail investors regarding their relationships with firms and their financial professionals. Unspoken at this time is how the current rulemaking will be harmonized, if at all, with existing FINRA suitability rules, with the Fiduciary Rule and with the EU and U.K. developments reported on here.